After surging to new highs over the first three quarters of 2018, equity markets tumbled and posted their worst year in a decade. The S&P 500 index fell -4.4% (including dividends), finishing the year 14.5% lower than its September high point. At its lowest level in late December, the index just barely missed a ‘technical bear market’ decline of -20%. Amidst the chaos, CBOE’s volatility index was up almost 200% on Christmas eve from its level at the beginning of the quarter.
Volatility manifested itself quite violently amongst the sectors making up the S&P 500 as prior trends turned abruptly. Previously high flying sectors like Technology fell more than -17% over the quarter, while defensive sectors like Utilities rose in rank.
Risk-off sentiment saw investors rushing back to that tried and tested safe asset, US Treasuries. Yet again, forecasts of the US 10-year Treasury yield topping the 3.0 mark by the end of 2018 (including predictions of 3.50) were confounded. US 10-year yields did rise, but ended the year at 2.69, just 29 basis points higher than where it began 2018.
If anything, some of the reasons touted as the cause of market turmoil – including Federal Reserve hikes amid a slowing economy as fiscal stimulus fades – are only expected to exacerbate in 2019. Though as always, we shy away from making forecasts and predictions, believing in the Warren Buffet maxim that forecasts tell you a great deal about the forecaster and nothing about the future. We prefer to focus on a few important things that may be critical over the next year, framing these as questions. The most obvious one starting with the Federal Reserve (Fed).
Will the Federal Reserve back away from their projected rate hike path?
What was confusing about the market chaos was that there did not appear to be new information that triggered the sell-off. It came about as the economy surged at its highest pace since 2015 amid stimulus (tax cuts) from lawmakers in Washington DC. So much so that the Fed hiked interest rates four times in 2018 to prevent the economy from ‘overheating’, believing that 3 percent GDP growth was well above their long-run estimate of 1.9 percent. This may well have been the proximate cause behind tumbling equity prices, with the market believing that the economy was in no danger of overheating.
The net result of the discord between the Fed’s interest rate hikes and market expectations was that the yield curve ended up inverting. As we have written in the past, the yield curve inverted prior to the last nine recessions, with only one false positive.
While we are yet to see ‘full inversion’ – which typically focuses on the spread between 10-year yields and 3-Month/1-Year yields – we do note that 2018 ended with the 10-year yield just 6 basis points higher than 1-year yields.
As is often the case (at least in the previous couple of cycles), the Fed tends to discard the yield curve as a recession indicator as it gets closer to inversion. Back in June 2018, Fed staff introduced a new indicator that is superior to the yield curve – a “near-term forward spread model” that tracks market expectations of monetary policy in the near future. At the time the indicator was far from the zero mark, i.e. showing no threat of recession. However this spread fell into negative territory on the first trading of 2019, for the first time since 2008. Simply put, the market is expecting a rate cut in early 2020 as the Fed tries to fight recession.
As of this writing, the federal funds futures market is pricing a 100% probability of the Fed not raising rates at all in 2019 and 50%+ probability of them actually lowering rates by January 2020. Yet Federal Reserve member projections from their recent December meeting indicate at least two rate hikes in 2019.
At the moment, economic data looks reasonably strong, especially in the labor market. But if it starts coming in softer, the question is whether the Fed will use it as an excuse to immediately take its foot off the gas pedal, or stick to its projected schedule. This gets us to our next two questions – on the US consumer and US business.
Will consumer spending continue to hold steady, or will housing lead to a downshift?
The data here are clearly mixed at the moment. Housing is clearly in a downtrend, while auto sales have plateaued. Yet consumer confidence is close to cycle highs as consumers remain bullish about their income and employment prospects. The labor market data concurs, with initial unemployment claims, as good a leading indicator as any, at its lowest level since the late 1960s. Not to mention unemployment rate sitting at 3.7 percent.
That housing is heading down is not surprising. Last summer we wrote about how Fed interest rate hikes typically works itself in to the economy via residential investment. Housing declined during the previous four tightening cycles, dragging down the economy with it.
However, as we discussed in our piece, there is a key difference between the current expansion and earlier ones: residential investment is a significantly smaller part of the economy today than it was during the previous four expansions. Residential investment has contributed less to economic growth this cycle (hence the sluggish recovery) and is only 3.9 percent of GDP currently, which is significantly lower than where it was at the beginning of prior tightening cycles.
The latest new home sales data from December was unavailable as of this writing but we leave with a quote from Glenn Kelman, CEO of Redfin Corporation, the online real estate brokerage (hat/tip to Planet Money’s The Indicator podcast for highlighting this). It was made during a recent Q3 2018 earnings call in response to an analyst question on whether headwinds are abating or getting worse.
“The market was significantly better in October than it seems to be going into November and December. You know, we are not ending the year market-wide with a bang but with a whimper.”
The question is how big of a threat is slowing housing to the economy. And whether another sector will step up to compensate, which gets to our next question.
Will business spending collapse or resume its upward trend?
Business spending has been in a sharp uptrend since mid-2016, when oil prices recovered and US energy companies reinvested. This was given an added boost when tax cuts were passed at the end of 2017. Most of the tax cuts were indeed targeted toward businesses, including lower tax rates on profits, an accelerated schedule for depreciating capital investments and new incentives for multinationals to bring home income earned overseas.
However, we are yet to see a significant change in behavior. As Mathew Klein pointed out in a recent Barron’s article, most profits that had been retained offshore have not been repatriated while mergers and acquisitions are yet to pick up to even 2016 levels.
Business investment was growing at a year-over-year pace of more than 10 percent at the end of 2017, but has plateaued since the middle of 2018. Just as concerning is the fall in business sentiment – ISM manufacturing PMI collapsed 5.2 percentage points to 54.1 percent in December.
Business strength is still expanding at the moment but demand is clearly softening. Companies recently spent a record amount on share buybacks – close to $600 billion over the first nine months of 2018. Buybacks in and of itself are not a bad idea but it is telling that corporations prefer returning money to shareholders rather than investing in future growth.
Another headwind is the fact that oil prices fell close to 40% over the final quarter of 2018 and that does not bode well for capital spending if the 2015-2016 precedent holds. Though one positive outcome of that slowdown was that it forced US energy companies to become more productive, and as a result the threshold oil price for profitability has fallen.
In any case, it remains to be seen if the recent plateauing/downtrend for business investment is a temporary blip or the beginning of something deeper.
Will inflation rise, creating a conundrum for the Fed?
In theory, a tight labor market should result in rising wages, which should ultimately boost inflation. This traditional framework is behind the Fed’s inclination to raise interest rates as unemployment hits historic lows.
After several years of false starts, wage growth finally picked up sharply in 2018. Wages grew at a 3.2 percent annual growth rate in October – the first time it crossed the 3 percent mark since the end of the Great Financial Crisis. At the same time, core inflation (using the Fed’s preferred measure of core personal consumption expenditures) peaked at 2 percent in July 2018 and has fallen back slightly since then.
What is interesting is that market expectations of future inflation collapsed over the final quarter of 2018. The 5-year breakeven inflation rate, a measure of inflation expectations computed as the difference between yields on nominal 5-year US treasury bonds and yields on inflation-linked 5-year bonds, fell from 2.03 at the end of September to 1.51 by the end of the year.
Risk-off sentiment was responsible for falling inflation expectations, but the disconnect between hard economic data and market expectations is remarkable. This also translates into a disconnect between the market and the Fed (who are more or less letting data guide policy at the moment), as we discussed earlier.
The question is whether the market will snap back or if the data will revert downward as recessionary winds blow. Of course, if wage growth continues to pick up and inflation creeps up again, we will see the Fed caught between a rock (market expectations) and a hard place (economic data). Though with fading fiscal stimulus and slowing global growth it seems unlikely that the economy will continue to power ahead at anywhere close to the 3 percent mark in 2019 and beyond. Not to mention uncertainty surrounding US trade policy, which we discuss next.
Related: The Yield Curve Inverted: Now What?
Will the uncertainty around US trade policy continue?
The US – China trade war seemed to get a reprieve in the aftermath of President Trump’s meeting with Chinese President Xi Jinping in Argentina in early December. This was short-lived as conflicting reports came out about what exactly was agreed. One big thing was the postponement of US tariffs on an additional $200 billion of Chinese goods on Jan 1st. Yet this is only temporary and by March, the US will decide if China has done enough in key areas like intellectual property beyond recycling old promises.
In any case, the existing sanctions imposed in early 2018 and threats of more to come are clearly having an impact in China, and the blowback is now hitting US multinationals. Case in point: Apple. For the first time in 20 years, Apple cuts its revenue outlook citing weaker demand in China amid rising trade tensions. Directly quoting Apple CEO, Tim Cook, from his January 3rd investor letter:
“China’s economy began to slow in the second half of 2018. The government-reported GDP growth during the September quarter was the second lowest in the last 25 years. We believe the economic environment in China has been further impacted by rising trade tensions with the United States. As the climate of mounting uncertainty weighed on financial markets, the effects appeared to reach consumers as well, with traffic to our retail stores and our channel partners in China declining as the quarter progressed. And market data has shown that the contraction in Greater China’s smartphone market has been particularly sharp.”
The letter shocked Wall Street and led Apple shares to fall 9% the next day. Interestingly, it’s not really a secret that China’s economy has been slowing but the news was a massive surprise, especially the degree and speed of impact. Clearly even Apple were surprised, as they provided better guidance as recently as October. Once again from the letter:
“While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China.”
Note that this is happening even as the Chinese government is providing fiscal stimulus (though not to the degree it did in 2008). Also keep in mind that almost 40% of revenue for S&P 500 companies come from outside the US, with the number close to 60% for Technology firms. So there will be a lot of re-evaluation of the impact of slower global growth and trade tensions on company bottom-lines.
If the data continue to soften (and markets remain volatile) amid trade uncertainty, we could see more resolve from the US and China to reach some sort of a deal/truce, whether or not it makes a long-term difference.
At the same time, there are two additional trade-related concerns beyond the battle with China. One is whether President Trump will follow through on his threats to impose 20% plus tariffs on auto imports, which will hit allies like the EU and Japan in particular.
Second is whether the new Congress will back Trump’s new deal with Canada and Mexico – the USMCA – because if not, he has threatened to withdraw from NAFTA altogether (which he has come close to doing in the past). This is an outside risk, but a risk for sure.
There certainly is a lot more to come on all these fronts and we will be following along closely.
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