Global Economy: Glass Half Full or Half Empty?
Investors’ appetite for risk, while elevated for much of 2018, evaporated as the year drew to a close and wiped out positive returns for the year across broad asset classes (T-bills being a notable exception). Concerns over tighter monetary policy and the global withdrawal of stimulus measures, unresolved trade disputes, falling oil prices, slower global growth, and softer data in some U.S. indicators overshadowed other robust aspects of the domestic economy. U.S. Treasury prices rose, expectations for Fed hikes in 2019 dissipated, and the S&P 500 had its worst December since 1931.
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Market sentiment clearly reflected the “glass half empty” viewpoint, with the S&P 500 at one point falling nearly 20% from a record level hit only a few months earlier. Meanwhile, the “safe haven” status of U.S. Treasuries attracted investors and pushed yields lower—the 10-year Treasury yield dropped 55 bps from a multi-year high of 3.24% reached in early November to close the year at 2.69%.
Those who espouse a “glass half full” viewpoint point to a number of economic data points in the U.S. to support their view. The unemployment rate remained near a 50-year low at 3.7%, and wages have been growing. As of Nov. 30, average hourly earnings were up 3.2% year-over-year, the most since April 2009. Consumer confidence remains elevated, though measures of future expectations have recently begun to turn downward. Similarly, small businesses continue to be optimistic; the NFIB Small Business Survey remains significantly above its average. And early data suggests that holiday sales were the strongest in six years, according to Mastercard SpendingPulse, which tracks both online and in-store sales. While the consensus for 2019 GDP is down from the 3.4% rate registered in the third quarter, the estimate among Federal Reserve officials for 2019 is 2.3%, far short of a recession.
At the same time, shadows have emerged in certain sectors and dampened enthusiasm for 2019 prospects. Thus, those with a “glass half empty” viewpoint harbor worries over tightening monetary policy, the global impact of trade tariffs, and falling oil prices. Specifically, December data revealed a weakening manufacturing picture—the Federal Reserve Bank of Richmond’s monthly manufacturing survey unexpectedly fell sharply and marked the fourth district bank factory survey to drop in December. The impact of tariffs has been widely cited as the key driver of weakness in manufacturing. The housing market also appears to have softened. Pending home sales fell to a four-year low as rising mortgage rates and relatively high prices deterred buyers, and spending on building and improvements has also weakened.
Inflation remained benign. The CPI was up 2.2% in November (year-over-year) for both the headline and core statistic. While energy prices are up over the last 12 months, recent declines will be reflected in inflation measures in coming months. The Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) Deflator, rose 1.8% over the trailing year. As widely expected and in spite of political pressure aiming to curb rate hikes, the Federal Open Market Committee (FOMC) voted unanimously to increase its federal funds rate target by 25 bps, bringing it to 2.25%–2.50%. The Fed further indicated that “risks to the economic outlook are roughly balanced,” providing no help to the “half full vs. half empty” debate. That said, investors took a much more gloomy view—the year-end read of fed funds futures prices indicated a nearly 90% probability of no Fed hikes in 2019, a view that has shifted sharply from just two months ago when futures signaled a 90% likelihood of at least one hike in 2019. The FOMC also reduced its projections for 2019 rate hikes from three to two.
News from overseas also contributed to investors’ slate of worries. Uncertainty over the details of a Brexit deal (or lack thereof), the magnitude of the slowdown in China, and numerous geopolitical worries weighed on markets. The UK faces the prospect of a “no deal” Brexit in March, an event that would likely have severe repercussions for the country. Political and fiscal turmoil in Italy, protests in France, and withdrawal of stimulus measures also weighed on markets. The European Central Bank confirmed that it would discontinue its monthly bond purchases at the end of December 2018 but will continue to reinvest maturities.
Euro zone GDP rose just 0.2% in the third quarter (+1.6% year-over-year). Meanwhile, the Japanese economy contracted 0.6% in the third quarter (-2.5% annualized), the most in over four years. Japan was hurt by several natural disasters as well as a decline in exports. China’s third quarter GDP post was +1.6% (+6.5% year-over-year), but the impact of trade tariffs appears to be taking a toll; its manufacturing index fell below 50, a level that signals a contraction, and retail sales in November grew at the slowest pace in 15 years.
Recent volatility is not remarkable from a historical standpoint and could well be a harbinger of 2019 market performance given a wide array of economic, political, and market-related scenarios that are currently vexing investors. That said, 2018 was an unusual year, where virtually all asset classes posted negative returns, and one that is unlikely to be repeated in 2019. As we have stated in the past, adherence to an appropriate and well-defined asset allocation (including periodic rebalancing!) remains the best course of action to manage the path to successful attainment of long term investment goals.