Economic & Market Overview - Q4 2018

| January 02, 2019
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After posting successive record highs last September, stocks corrected in Q4 as values disconnected from market fundamentals.  Despite solid US economic growth, a strong employment market, and double-digit corporate earnings growth, market sentiment turned negative and volatility turned up.  The culprits include ongoing US-China trade tensions, rising short-term interest rates, and decelerating economic growth overseas.  A recent government shutdown, senior government official resignations, and heightened political polarization have also contributed to market volatility.  Here is a closer look at what is going on in the markets and economy.

Markets                                       

Stocks

Markets have become increasingly sensitive to any hint of economic slowdown as we enter a late-cycle expansion phase.  US stocks retreated three times in Q4 before officially lurching into market “correction” territory – defined as a 10% drop from the prior market high – in December.  Stock gains during the first nine months of the year were washed away in the extremely volatile Q4 period.  Overall, the US stocks were down 13.5%for the quarter and off 4.4% for the year.  Overseas stocks produced losses due to ongoing trade disputes, a rising US dollar, and weak economic data out of China, Europe, and Japan.  International developed market stocks were off 12.5% in Q4 and 13.4% for the year.  Emerging market stocks, the best performing asset class in 2017, fell 7.8% in Q4 and 16.6% in 2018

Bonds

Bonds benefitted from the recent stock market malaise as investors sought the security of lower risk assets.  Yields on longer-term US bonds, from US Treasuries to corporates – remain range bound.  The 10-year US Treasury bond yield declined from 3.1% to 2.7% during Q4, a level not seen since year-end 2013.  As bond yields fall, bond values rise.  Factors keeping longer-term US rates in check include moderate inflation, international demand for Treasuries, and an expected eventual end to Federal Reserve Bank rate hikes.  Taxable bonds rose 1.6% in Q4 and were flat for the year.  Tax-free municipal bonds were up 1.6% for both the quarter and 2018.

Economy

Despite a volatile stock market, the US economy continues to display signs of strength. US GDP slowed from Q2 to Q3 but still grew at an impressive 3.5% last quarter. Growth was driven by a 4% rise in consumer spending combined with the strongest employment market in almost 50 years.  Still-easy monetary policy, controlled inflation, and lack of elevated financial vulnerabilities point to ongoing economic expansion.  However, the US economy is entering a late-cycle phase and faces uncertainty over US-China and Brexit trade issues as well as political gridlock.  While a US economic recession is not imminent, growth is likely to moderate as tax reform benefits begin to wane and the ongoing trade war impacts corporate profits.

Employment

Unemployment fell to 3.7% in both October and November, the lowest rate since 1969.  November represented the 98th consecutive month of job creation as monthly job gains averaged in excess of 200,000 in 2018.  The labor market’s strength was apparent across age, gender and racial demographics.  The greatest employment gains occurred in the healthcare, manufacturing, and transportation sectors. While wages grew at a 3.9% rate in November, inflation remained in check just below the Fed’s 2.0% annual target.

Earnings

Corporate earnings rose 28% year-over-year in Q3.  Growth was broad-based with all sectors providing positive contributions.  Healthy economic conditions in the form of solid consumer spending and strong pricing power accelerated revenue growth by 9% for the quarter.  Just over 77% of companies reported earnings above analysts’ expectations, outpacing the long-term average of 64%.  Q4 earnings look to be exceeding estimates as well with 78% of reporting companies surpassing estimates.

Interest Rates

In December, the Fed raised short-term interest rates for the fourth time in 2018 by increasing the federal funds rate to 2.5%.  The Fed justified its recent action, citing economic activity rising at a strong rate and continued strengthening in the labor market.  The federal funds rate rests just below the Fed’s “neutral” rate, the rate that maintains full employment and 2% inflation without accelerating or slowing economic growth. 

Inflation

Inflation continues to rise, though at a slower pace. The Personal Consumption Expenditures Index, which is the Fed’s preferred measure of inflation, continues to fall short of the Fed’s goal.  While inflation inched up 0.1% month-over-month in October and November, year-over-year it is at just 1.9%.

Final Thoughts

The stock market appears to have disconnected from the economy.  Above-trend economic growth, healthy corporate earnings, and accommodative monetary policy signal ongoing economic expansion.  Still, the US economy is entering a late-cycle expansion phase.  Unresolved global trade disputes and unclear policy directives in Washington present headwinds.  Economic growth is likely to moderate due to diminishing tax reform stimulus and market volatility is likely to continue into the New Year.  Given these various tail and headwinds, we encourage clients to resist the urge to time the market or abandon equities.  We are taking advantage of the recent stock market downturn to harvest tax losses and rebalance portfolios, where applicable.  We remain committed to a disciplined, balanced, globally diversified, and low-cost investment management strategy. 

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