The markets registered another solid month, with all of the major indicators moving further into double-digit returns for 2019. The strong performance, surprising to many economists and analysts, comes in spite of the lukewarm earnings gains for many companies.
Weaker earnings gains were anticipated by the market, but some had gone too far, predicting actual losses rather than smaller increases when compared with 2018.
The U. S. economy continues to chug along, though at a slower pace than the Trump Administration might have hoped for. The benefits of last year’s major tax legislation appear to be waning, with little or no increase in capital expenditures by business. Most of the funds freed up by lower tax rates appear to have been spent on stock buybacks. Another reason for slower economic growth over the past couple of years has been the moribund U. S. housing market. So far, this year has proven no different. Existing-home sales fell 1.2% in January, their third straight monthly decline. Year-over-year, the decline was 8.5%.
Another perspective on the history of the real estate sector comes from so-called “housing starts.” New construction fell dramatically during the Great Recession of 2007-2008, falling from almost 2.4 million units per year before the financial crisis to a little more than 1.2 million units last year.
Interest rates, specifically mortgage rates, have always been a key factor in the strength of the housing market. That belief too now appears to be in question. Ten years of ultra-low mortgage rates haven’t sparked a recovery in new home construction. Another reason often given for the continuing weakness is the lack of demand from young people – the millennial generation, which is already burdened by more than $1 trillion in student loan debt.
Another data item of interest last week was the outflow of funds associated with foreign investors. For the first time in six months, foreigners withdrew more than they invested, leaving net withdrawals of -$48.3 billion. As usual, most of their activity was concentrated in Treasury and Agency securities, not common stocks.
The markets gave back some of their recent gains, with all of the major indicators headed south. Including dividends, however, all of the year-to-date figures are still in positive, double-digit territory.
Of course, the hot news from the Fed was a cooling off of their campaign to “normalize” short-term interest rates. Chairman Jerome Powell announced at his news conference after the meeting last week that there would likely be no further increases in rates for 2019. In addition, he said that the FOMC’s efforts to trim its balance sheet would probably come to an end in September. Powell also noted that the economy was doing well overall and that the Fed was near its twin goals of stable prices and full employment. The markets didn’t react too violently, either to the committee’s report or to Powell’s comments and explanations. It certainly was a substantial pivot, however, from the committee’s aggressive stance late last year.
Long-term interest rates dipped sharply last week, while short-term rates were steady. That resulted in a further flattening of the yield curve, and for a time, the short end of the curve was inverted. That shook investors’ confidence and likely resulted in Friday’s big drop in share prices. Bank shares and other financial stocks will likely continue to suffer from the flat curve. It certainly continues to limit their profitability. And, an inverted curve, where short-term rates are higher than long-term rates, has often been a sign of an upcoming recession. I don’t think that’s actually very likely, but it will worry the markets in the coming months.
What should investors make of the current situation? First, I think we should focus our attention on corporate earnings for 1Q 2019 which will be coming out in mid-April. First quarter results are likely to be weak, and most analysts are expecting a stronger second half of the year. If that’s true, there’s no need to rush into buying stocks. Also, there’s bound to be some fallout from the delivery of the long-awaited Mueller report to the U. S. Attorney General last Friday afternoon. Whatever the outcome, it’s likely to add to uncertainties affecting the markets in the coming months.
The 3 percent to 4 percent plunge in the major American indexes earlier this month is unsettling for investors who have grown accustomed to low U.S. market volatility in recent years. What’s more disturbing is that most of the traditional hedges against such a large equity sell-off, both within and across market segments, did not work well.
Yet neither of these developments should come as a great surprise given the following five factors that also point to what’s ahead:
1. After years of seemingly unquestioned central bank support — including the so-called “Fed Put” — stock and bond markets are transitioning away from a world where liquidity injections underpin asset prices and moving toward a greater role for fundamentals. Almost by definition, this is a volatile process: Think of a plane changing engines while flying at a high altitude. Turbulence is to be expected.
2. Unusual divergence in economic performance and policies within the advanced world is complicating this liquidity-to-fundamentals market transition. U.S. growth is increasingly outpacing other countries’, powered by the combination of higher household income, increasing business investment and government spending. In addition, the Federal Reserve is well ahead in normalizing monetary policy, after ending quantitative easing, hiking interest rates eight times, publishing the timetable for reducing its balance sheet, and signaling further rate increases for both this year and next.
3. The resulting dispersion in asset prices has placed some extra strains on markets. And it’s not strictly a matter of divergence. There are also a wide range of views on whether other countries will eventually converge with the U.S. in achieving higher growth or whether the U.S. will be pulled down.
4. Trade tensions are adding to the uncertainties about the market transition. Specifically, it’s not yet clear how long it will take China to realize that the least bad alternative for its development is to pursue the same path that other countries (South Korea, Mexico and Canada) ultimately followed — that is, make concessions to the U.S. It also isn’t clear what concessions would satisfy the Trump administration.
5. Finally, technical conditions in markets are not helping by amplifying large moves in the short term rather than tempering them. Over the longer term, success in the ongoing transition in the liquidity-fundamentals paradigm will place markets on a more solid footing. So will repricing that allows traditional stock-bond diversification to provide better risk mitigation. The short term, however, is likely to be quite volatile.
As I’ve mentioned before, the stock market was lifted to record highs by just a few stocks that have disproportionate weightings. We are talking about Apple, Facebook, Amazon, Netflix, Google and Microsoft, although there were others that helped along the way. Since those stocks are in nearly every technology index fund and major ETF, they can either be very helpful in a rally, or very heavy in a sell-off. We are experiencing the latter and its impossible to say when investor sentiment will turn back in their favor. The sector rotation out of growth and technology stocks and into value has been happening since August. It may get worse as we approach the end of the year since there are very few catalysts to change perceptions.
After two-consecutive winning weeks on Wall Street, which included a nice rally at the start of November, the bears took back control of trading last week. Most of the damage was done early in the week, including a notable selloff last Monday, which saw the Dow Jones Industrial Average fall more than 600 points. Last week started with three straight losing days for the U.S. equity market before the bargain hunters returned over the final two trading days to pare the weekly losses. For the week, the Dow Jones Industrial Average, the NASDAQ, and the broader S&P 500 Index finished 2.2%, 2.1%, and 1.6% lower, respectively.
There are many variables in play for Wall Street right now, and we think some of the uncertainty arising has played a big hand in the spike in volatility this fall. Last week, the market was unnerved by a few events, most notably the signs that amicable Brexit deal stills appears far off. That has brought a good deal of uncertainty for the United Kingdom and the European Union. There were also continued worries about the health of Italy’s financial system; the ongoing global trade disputes and the effect it will have on the global economy; rising U.S. bond yields, and the impact such has on emerging market yields; and the recent slowing pace of GDP growth in China. The concerns about China’s economy, and the impact it will have on oil consumption has pushed crude oil prices into bear market territory, which is defined of a retreat of more than 20% from its most recent high. Not surprisingly, against this backdrop, it is easy to see why there has been a spike in equity market volatility. The CBOE Volatility Index (or VIX) rose more than 3% last week.
The sell-off we have been experiencing, while painful, is not historically bad, by any means. The numbers are large, because, well… the numbers are large. We’ve had multiple market records over the past two years, so a 10 percent decline looks bad, smells bad and feels bad.
Around two-thirds of the stocks in the S&P 500 are in a correction, and about one-third are in a bear market today. The index itself is flat for the year, which is a function of the performance of a select few stocks that outperformed in the first half of the year.
But the declines are comparable to other pullbacks, as we will demonstrate in our chart of the day, below:
The BMO Investment Strategy Group ran the numbers from the last correction back in February and showed that even fewer stocks entered bear market territory, although more stocks were in a correction. Every correction going back to 1990 was far worse, except for November 2012, June 2012, August 2004 and April 1997. This is not to say that this selloff won’t get worse and turn into a full blown correction or bear market. We can’t predict that one way or the other. It’s just important to keep this perspective when we have days like today and last week when all we see is red.
The headline on the front page of Saturday’s Wall Street Journal said it all, “Stocks Cap Worst Week Since 2008.” All three of the major indicators tumbled badly for the week and are likely to remain in negative territory for the year. The S&P 500 finally broke the lows set in February and March. Now it’s about 18% off the recent peak. U.S. small cap stocks and international stocks already went into a bear market (>20% off peak). Of the eight big asset classes — everything from bonds to U.S. and international stocks to commodities, not a single one of them is on track to post a return this year of more than 5%, a phenomenon last observed in 1972. So, you are looking like at another historically tough year. Nothing’s working, not large or small-cap stocks in the U.S., not international or emerging equities, not Treasuries, investment-grade bonds, commodities or real estate. Most of them are down, and the ones that are up are doing so by percentages in the low single-digits. That’s all but unique in history. Normally when something falls, something else gains. Amid the financial catastrophe of 2008, Treasuries rallied. In 1974, commodities were a bright spot. In 2002, it was REITs. In 2018, there’s nowhere to run.
As I noted in last month’s newsletter, there are a host of economic and political issues worrying the markets: interest rates, trade and tariffs, slowing growth in China, and “Brexit”. As of midnight Friday, you can add the partial federal government shutdown to that weighty list. The Trump Administration and Congress couldn’t agree on a funding plan even for the next couple of months. Presumably, the main sticking point was the President’s insistence on funding for a wall on the U.S. southern border. I doubt that the shutdown will have much impact on the economy so long as it is relatively short-lived. The markets were also disappointed in what they heard from Fed Chair Jerome Powell last Wednesday as the Fed’s FOMC Committee increased short-term interest rates by a quarter of one percent. The Committee evidently feels that two additional increases may be justified in 2019, even though they lowered their growth projection, and there is virtually no evidence of inflation in the economy.
The yield “spread” between short and long-term rates narrowed, putting additional pressure on the shares of banks and other financial institutions. The yield curve continued to flatten, worrying some analysts that it might become inverted, with short-term rates higher than long-term rates. Mortgage rates were virtually unchanged, though the housing sector continues to be weak. There’s a wide difference of opinion about where the U.S. economy is headed in the year ahead. Many economists and analysts believe that we’ll continue the strong performance we’ve had in 2018. They expect strong job growth to continue, wages to rise, and inflation to remain low. Others are less optimistic, worried that growth will not only slow, but that there’s a good chance of a recession just over the horizon. Which camp you’re in, if either, will color your reaction to last week’s announcement by the Federal Reserve that they would be increasing short-term interest rates, continuing on a path to “normalize” rates over the next year or two.
The markets begin 2019 with a “stealth recovery” as all of the major indicators recorded positive increases. What’s driving the advance over the past three to four weeks? It doesn’t seem to be corporate earnings, which have been mixed for the companies that have reported so far. Projected earnings gains for the coming year are expected to show a growth rate of mid to high single-digits, compared with average gains last year of over 20%.
The gains have also come in the face of the longest government shutdown in our history. The shutdown was eating into 1Q GDP growth at the rate of 0.1% each week, according to some analysts. My guess is that the markets are finally coming to realize that they front-loaded the benefits of the 2017 tax bill, which are now beginning to fade. Those gains will pretty much be exhausted by 2020. Averaging the results for 2018 and 2019 might be the best way to handle the situation.
The wall! The government shutdown! Trump! Pelosi! McConnell! So many things to think about and to worry about. Do they have an impact on the U. S. economy or don’t they? It’s becoming more obvious that they do matter and that the general dysfunction in Washington, DC, is starting to infect the rest of the country. Quite a few years back, I heard Bill Seidman, an economist and then head of the FDIC, wittily introduce himself at a banking conference. He said, “I’m Bill Seidman, and I’m from Washington, DC. That’s 37 square miles surrounded by reality!” Everyone chuckled, but it’s becoming more obvious each day that he was on to something.
The government shutdown was a harsh reality for the 800,000 or so federal workers who didn’t received a paycheck and became more of a problem for millions of others whose jobs are interconnected with the U.S. government in some way or another.
Analysts are scrambling to figure out what the impact will be on the nation’s GDP for the first quarter of 2019. Some have predicted that each week of the shutdown will subtract a tenth of a percentage point from the nation’s overall output. A few extremists have even projected a flat or negative GDP for the quarter if the shutdown continues for another couple of months.
The economic impact of the shutdown obviously has to be weighing on the minds of the Federal Reserve and its FOMC Committee. My guess is that they will push back any short-term interest rate increases until at least late 2019, in order to offset the damage done to the economy from the shutdown. If the Fed doesn’t raise rates in 2019 it will likely give a boost to stock prices, and even bond prices as well.
How will the shutdown impact the monthly jobs numbers and the nation’s unemployment rate? No one knows for sure, and even some of the government agencies responsible for the data have been shut down. As economists are entering into relatively uncharted territory.