12 Month Market Review – as at December 31, 2018

Q4 2018

In 1966, Nobel Prize-winning economist Paul Samuelson remarked that “the stock market has predicted nine of the last five recessions”. Fast-forward fifty or so years and it seems little has changed.

Dismal December

To say that markets have been highly strung in recent months would be an understatement. The decline in the S&P 500 Index of over 6 percent in 2018 is dismal enough, but the erratic nature of some of the price movements adds further concern. Stock prices became progressively more volatile throughout the fourth quarter, culminating in the S&P 500 losing 15 percent of its value in those weeks of December leading up to Christmas Day. Some of this was regained during the day after Christmas however when the index surged by a stunning 5 percent, highlighting that the market really can’t make up its mind.

Uncertainty Over Policy

Investors are concerned over the extent to which mistakes in policy-making may steer the US economy towards a hard landing. Indeed at times, there is a ‘comedy of errors’ feel to the political landscape. For example, fallout from the row over President Trump’s demands for a wall to be built along the country’s border with Mexico has brought about the partial shutdown of the US government. And recent estimates suggest that the trade tension between the current US administration and China has resulted in around $250 billion worth of tariffs being placed on goods imported to the US from China.

Clumsy rhetoric by the Federal Reserve (the Fed) does not go down well when the market is struggling to digest interest rate increases at a time of slowing growth. However it was encouraging in this regard to see Fed Chairman Powell recover from the ill-judged remark that the Fed is on “autopilot” when it comes to reducing its balance sheet. He later reassured markets that the Fed’s approach will be “patient” and data-dependent.

Some Perspective

Yet although the political climate is unsettling, and even at times bewildering, the situation remains that the consensus expectation is for the US economy to expand by 2.6 percent in 2019. And US corporate earnings are expected to grow by 8.3 percent this year. This is some way off the heady levels seen in 2018, but hardly an obvious harbinger of recession. Also, even though we’ve recently had weaker-than-expected manufacturing activity, employment data showed that the US economy created 312,000 new jobs in December, which was nearly twice that expected by analysts.

The International Monetary Fund still forecasts global growth of around 3.7 percent in 2019. Labor markets are largely quite tight, fiscal policy is easing overall and monetary policy remains loose by historical standards. Increased financial market volatility and falling export orders are likely signals that the peak of the economic cycle is now past, and that the global slowdown will continue. But they don’t necessarily mean that a global recession is now upon us; at least not yet.

Recent movements in stock indexes across the globe however indicate that the aggregate view of global investors is that a recession may well be imminent. The MSCI All-Country World Index fell by 11 percent last year, its worst performance since the global collapse of 2008. China was the world’s worst performing major market, with the Shanghai Composite Index down 25 percent over 2018, wiping $2.4 trillion off the value of Chinese stock values.

Growth Problems Outside the US

Investors fear the possibility that Chinese growth may suffer a severe and disorderly slowdown. Economic data indicates that the Chinese economy is slowing, with the latest factory survey showing a contraction in Chinese manufacturing. Indeed, when Apple recently announced their first revenue warning in 16 years it cited weak iPhone sales in China as one of the major contributing factors.

In terms of how the Chinese authorities manage these challenges, the reality is that they now have far less scope for an aggressive policy response than they did in, say, 2008 and 2015, since there has been a rapid increase in indebtedness in the last ten years. And as US rates are rising, any bold interest rate cuts from the People’s Bank of China could trigger strong capital outflows, putting pressure on the Chinese currency.

It’s not just China that’s having growth problems. Japan, whose Topix Index fell by 18 percent over 2018, suffered an economic contraction in the third quarter of last year, with GDP declining by 0.6 percent (quarter-on-quarter). Natural disasters, such as flooding and earthquakes, weighed on capital investment and personal consumption, and exacerbated the decline.

The German economy also shrank - by 0.2 percent over the third quarter of 2018 - its first quarterly contraction since early 2015, due to declines both in exports and in household consumption. The DAX Index fell by 18 percent over 2018, its worst performance in a decade and indeed technically slipped into a bear market after a drop of more than a fifth since it peaked in January 2018. A large proportion of constituents of the DAX are exporters, and so movements reflect global trade sentiment as well as what’s going on in Germany. Emergent nationalism and protectionism around the world casts a cloud over this index. Bloomberg reports that companies such as car manufacturers BMW and Daimler, sugar producer Suedzucker and retail behemoth Ceconomy issued profit warnings; some of them a number of times this year. Indeed, Commerzbank’s struggles to turn round revenue has resulted in its market value declining so far that it has fallen out of the index.

Political strain in Germany clouds matters further. Chancellor Merkel gave up her post as party head after an unexpected revolt in her parliamentary caucus. There has been considerable strife and disagreement within her three-party coalition, particularly regarding refugees. She announced that this term (ending 2021) would be her last as chancellor.

Economic conditions in the UK are unlikely to take up the slack in European growth prospects. Uncertainty over Brexit is compounding a broader economic slowdown. The Bank of England released data that show a slowdown in consumer spending and house buying in the last few months of 2018. Indeed, since July, consumer credit has averaged at £0.9 billion ($1.1 billion) per month, compared with £1.5 billion ($1.9 billion) per month between January 2016 and June 2018. The outlook is not helped by edging ever closer to March 29th – when the UK is scheduled to leave the EU - with no deal in place. Consultancy Ernst & Young estimate that assets worth nearly £800 billion ($1 trillion) have been shifted from the UK to various European financial hubs due to concerns over Brexit. The FTSE 100 Index fell by over 12 percent over 2018.

Gauging Fear

Investor attitudes towards Brexit are instructive, in terms of how potential events are factored into asset prices. The Financial Times reports that UK investor confidence is now lower than it was even during the worst of the financial crisis. Clearly, Brexit poses a substantial structural risk to the UK, but the financial crisis resulted in fears that the entire global economy would implode. The ten-year average for the index is 94 and the lowest point during the crisis was 61. It’s now 52.

Mr Samuelson’s quip regarding the erratic and impulsive nature of the stock market remains insightful.