Please write one page or less explaining what happened to the markets during 2018 Q4.It may be an understatement to say that markets were a bit squishy in the fourth quarter. The sell-off in risk-seeking assets was swift and relatively severe. By the time the quarter was over, there really wasn’t a public market asset that was in the black on a year-to-date basis. You needed to own T-bills and convertibles to escape the drawdown. There was no place to hide. Amid tightening US monetary policy and deteriorating trade relations between the US and China, global stocks declined sharply. On one hand, companies strained under the weight of rising tariffs and threats of further retaliation and on the other hand, signs of slowing global economic growth pressured stocks. Together, this led to the worst quarterly returns since 2011. Consequently. US Treasury bonds rallied on safe-haven buying amid rising volatility in global financial markets. The US Federal Reserve raised short-term interest rates in December.
The US Treasury curve flattened with both the short- and long-end higher in yields. The very front end of the yield curve led everything higher with the 1-month T-bill rate +117 bps on the year. U.S. equities tumbled, with the major indexes experiencing their worst quarter since 2011. A deepening trade conflict with China as well as a partial inversion of the yield curve renewed concerns about the sustainability of the current economic expansion and bull market. Global trade tensions intensified after the arrest of a senior executive at Chinese telecommunications giant Huawei. A temporary pact between the U.S. and China to suspend additional tariffs did little to calm investors. Political disputes also rankled markets as disagreements over security funding contributed to a partial U.S. government shutdown during the final week of the year. West Texas Intermediate oil prices plummeted 38%, punishing the shares of energy companies. Bond yields fell dramatically, while credit tumbled. U.S. bond markets returned 1.6% overall as falling yields outweighed wider credit spreads.
The benchmark 10-year Treasury yield fell 36 basis points to 2.69%. In December, the Federal Reserve hiked the federal funds target rate by 25 basis points for the fourth time in 2018, to a range of 2.25%–2.50%. European stocks declined sharply amid slowing economic growth and continuing uncertainty over the U.K’s impending departure from the European Union. A worsening global trade dispute between the U.S. and China also weighed heavily on Europe’s trade-dependent economy. In fixed income markets, European government bonds rallied on safe-haven buying and investor speculation that the ECB may forego raising interest rates until late 2019 or beyond. Emerging markets stocks fell for a third consecutive quarter. China’s slowing economy, uncertainty over U.S.-China trade relations and weaker commodity prices all hurt sentiment. Chinese equities suffered their worst quarterly decline since 2015, while persistent dollar strength and higher U.S. interest rates also pressured equity prices. Overall, the MSCI Emerging Markets Investable Market Index lost 7%.
Debt issues in emerging markets perked up following a long period of subdued demand. Oil’s steep decline helped energy-importing countries such as Indonesia, India and Turkey. Please write one page or less explaining your outlook for the markets for the first half of 2019. I do not believe that the fundamentals have not turned that dramatically worse. Cheaper equity market valuations began to attract investment as liquidity returned to the markets after the holidays. On the 10 occasions the index has suffered a negative December since then, only two have been followed by a down year. Many of the up years saw substantial gains, with the last four returning between 17% and 33%. The S&P 500 dropped 15.0% between November 30th and December 26th before rebounding to end the month down 9.2% in 2018. This rebound continued into 2019 with the S&P 500 up 10.7% YTD as Feb 15 2019. We may well see a constructive back-drop for stocks in 2019. The rollercoaster of 2018 has recalibrated equity valuations. The trailing P/E of the S&P 500 ended the year at 16.7, lower than any of the prior five years and the lowest level since year-end 2012 (14.4).
Other domestic stock indices ranged between 15 and 43 (SPX = 16.7, DJIA = 15.0, Nasdaq = 29.7, Russell 2000 = 42.8) and have diverged. Equity markets outside the US have seen valuations uniformly adjusted downward and remain more attractive given lower P/E ratios (TSX = 15.5, FTSE = 15.1, Eurostox 50 = 13.2, DAX = 11.5, CAC 40 = 14.6, Nikkei = 14.1). Economic indicators have weakened and stock market valuations globally reflect that. Headwinds that we continue to see affect markets are political in nature, and they aren’t abating. The world is closely monitoring the Brexit situation. Political acrimony is dominating headlines globally. There are a number of acute political issues, both domestically and abroad, to distract markets: the longest US Government shut down in history (and another one waiting in the wings?), the ongoing investigation by Special Counsel Mueller, ongoing trade wars with China, the transition of power in Venezuela which may involve the use of US armed forces, countries like the US and Russia walking from nuclear treaties, as well as building evidence of climate change triggering a polar vortex which gripped the US over the past week and an unprecedented heatwave in Australia.
And yet the market seems relatively underwhelmed by the noise. Monetary policy is reflective of a late-cycle expansion. The Fed changed stance and has signaled to the market a willingness to stand by and wait. They will be data dependent, suggesting the Fed may be near neutral. The balance sheet consolidation known as QT or Quantitative Tightening — $80 B of Treasury bond and mortgage-backed assets that were rolling off monthly – has ceased for now coinciding with the Fed’s recently stated message that they prefer to use traditional monetary policy tools right now.
Of the major sovereign bond markets, only the US, UK, Canada and Australia have the entirety of their yield curve term structure trading with positive yields. Negative yields persist in Europe and Japan, making the US bond market, despite having the yields decline, a relatively good value compared to other major bond markets. In fixed income, I no longer believe there are significant tailwinds to push rates higher. Inflation is tame, QT has paused and the Fed is no longer tightening. We are likely to see interest rates stay relatively range-bound as long as the economy remains strong enough to avoid recession but with no new catalyst to trigger higher yields. Please create two portfolios using ETFs. Create one equity portfolio using ACWI as the benchmark. The second portfolio should be a fixed income portfolio with AGG as the benchmark. There is no limit to the length for either portfolio.
