QUARTERLY MARKET UPDATE as of January 2019
Stocks were slammed in the fourth quarter dropping 14% as measured by the S & P 500, and volatility spiked up sharply from the historically low levels last summer. The market had one of the largest monthly declines for any December along with the biggest Christmas Eve drop in history, only to roar back with the largest ever day after Christmas percentage gain and the biggest one-day price increase in history. Small Caps fared even worse declining 20%, and International stocks reflected by the MSCI EAFE index were off 13%. All sectors were down with the exception of Utilities which increased less than 1%, while Energy incurred the biggest move down of -25%.
The U.S. dollar continued to strengthen against the Euro after riots in France and renewed budget concerns in Italy. Dollar strength and deteriorating energy fundamentals contributed to a sharp 40% plunge in oil prices over the quarter. A global slowdown in growth reduced oil demand forecasts, while supply remained stable or increased. Production in the U.S. which remains the top global producer increased 15% in 2018 and is expected to increase by that same amount again this year. OPEC cutbacks will be needed to stabilize oil prices, otherwise the Energy sector may continue to languish.
Short term interest rates increased another 25 basis points, or ¼ of a percent after the Federal Reserve increased the target range on the Federal Funds rate to 2.25% to 2.50% in December. The fund flow out of stocks went into treasury bonds pushing prices up and yields lower on the longer end of the yield curve. Interest rates dropped more than 50 basis points on longer term bonds. The 10-year note declined more than ½ of a percent, from 3.25% in early November to 2.68% at year end, essentially flattening the yield curve. The 1-year treasury note closed only a few basis points less at 2.62%. Traders are clearly signaling concerns about growth going forward. While the global economy has slowed, we believe the recent market correction for both stocks and bonds has overshot the reality of current economic conditions in the U.S.
Preliminary estimates for growth in the 4th quarter by the closely watched GDP forecasts of the Atlanta and New York Federal Reserve Banks is 2.5%. This has slowed from above average increases in the 2nd and 3rd quarters in 2018, but remains above the average increase of 2.2% over the last eight years of our economic expansion. Consensus estimates for 2019 show growth coming down to 2.3%, a still relatively healthy rate. A survey last year from the Atlanta Fed measuring firms’ expectations showed that despite uncertainty over tariffs and trade policy, businesses remain optimistic and expect to maintain their capital expenditures this year.
The unemployment rate remains at 3.7%, the lowest level achieved since the 1960s. With the consumer making up 70% of the economy, we expect this very healthy employment environment to continue to drive the economy. Wages have steadily increased and may currently be the single most important factor to weigh on the Federal Open Market Committee’s decision for more increases in the fed funds rate this year. The last two reports showed wages increased at a moderate rate of 0.2%, or 2.4% on an annual basis. This came in at the low end of expectations and was a slight deceleration from past months. Annual inflation as measured by the Personal Consumption Expenditures (PCE) price index is right at the Fed’s 2% target, while the core PCE excluding food and energy was a notch below that at 1.9%. The argument can be made that inflation is under control which should rein in a more hawkish Fed. Two more interest rate increases are expected, but the FOMC can adjust that higher or lower depending on upcoming employment and inflation reports.
Fourth quarter corporate earnings reports are due out later this month. Estimates by FactSet have earnings increasing by 12%, but slowing down to 8% for 2019. Both are healthy numbers and contrary to the recent gloomy market sentiment. Revenue growth is expected to be closer to 5%. We will look closely at corporate guidance for insights in the markets direction this year. Some progress in China / U.S. trade talks is being made. These talks will continue to have a significant influence on volatility, the direction of the markets, and global growth going forward.
The forward price earnings ratio has declined from 17.5 last quarter to an average p/e level of 15.5. With reasonable valuation levels and a healthy economy there are reasons for optimism in the year ahead. Increased risk of a slowdown is already priced in at current levels, and the market frequently rebounds after a down year. Volatility may remain high, and further downside is well within the possible outcomes. But our investment decisions are based on fundamentals and current economic conditions are more supportive of a bounce back.