Fourth Quarter, 2018 Economic and Market Commentary


 · High levels of volatility, which have not been seen in several years, returned to the equity markets to close out 2018, as global equity markets retreated on fears related to trade issues, rising interest rates, and slowing economic growth amongst other factors.

· China’s efforts to stimulate consumer demand are being hindered by a slowing local economy and fears of a trade war with the U.S.

· The unique political structure of the European Union continues to complicate its economic recovery efforts. Meanwhile, the U.K. is staring down a March Brexit deadline with the very real possibility of either leaving the EU without a trade deal, or not leaving the EU at all.


The final quarter of 2018 began innocently enough with the U.S. mid-term election outcome broadly in line with expectations.  The Democrats took control of the House of Representatives, while the Republicans retained the Senate.  A divisive episode of U.S. politics came and went without any significant repricing in equities.  Unfortunately, this stability was short-lived as vigorous volatility returned to the equity markets shortly after the mid-term elections.  Stock markets will fluctuate after all, as J.P. Morgan once famously said.  The commonly attributed causes of the recent volatility are rising interest rates, trade issues, slowing economies overseas, a sharp decline in oil prices, issues with the Trump administration and inflation concerns.  Sometimes short-term investors brush off concerns and other times they become nervous and react as has been the case with the large daily market swings seen at the end of the year.  A mix of positive and negative signs makes it unclear whether or not the Trump Bump is about to give way to the Trump Slump.

Although it is never pleasant to experience declines in investment value, market declines are a normal part of investing and long-term investors should expect to experience multiple bear markets during their lifetimes.  Fortunately, equity markets tend to more than make up for their losses, especially as you expand the time horizon.  Despite the late sell-off in the equity markets, 2018 was actually a good year for the U.S. economy, with strong job growth, accelerating pay increases and tame inflation.  We believe it reasonable that the economy may resume the slow, steady and enduring recovery that began after bottoming out in the second quarter of 2009.  However, corporate earnings, a source of comfort for much of the nine-year rally, are now becoming a source of anxiety, with 2019 estimates under pressure in the face of higher input costs and tariffs, and dimmer expectations for global growth.  Earnings could come under further pressure if consumer spending growth slows in the months ahead as the spending impetus from 2017 income-tax cuts starts to fade.  On the other hand, strong household savings and low unemployment may temper any sharp drop-off in spending.  Indeed, consumers are enjoying their best wage growth in a decade in the midst of the biggest increase in hiring in three years.  

Another big driver of recent growth, government spending, is also likely to be tested this year with the budget agreement that increased federal government spending by $300 billion above earlier spending caps running out in September.  Unless Congress agrees to increase the limit again, which we believe to be unlikely given a divided congress, the impact from this spending will likewise fade.  

Business investment might be the biggest wild card for future growth.  On one hand, business tax cuts and a lower corporate tax rate meant to increase investment in capital projects.  However, uncertainty about U.S. trade disputes with China and other countries appears to be making business executives hesitant about proceeding aggressively with new projects, as business investment growth slowed considerably towards the end of 2018 compared to growth rates seen earlier in the year.  This could be a case of perception leading to reality, with businesses not wanting to spend because they fear the economy is potentially going into a recession.

In the face of all these economic headwinds, Federal Reserve Chairman Jerome Powell has recently stated that the Fed is now in a place where it can be patient and flexible with regard to future interest rate increases due to concerns about global growth.  Although the groundwork has been laid for the Fed to take a break from raising short-term interest rates in the coming months, Mr. Powell has been consistent in his belief that the goal of the Fed is to maximize employment and limit inflation.  This is independent of President Trump’s sustained criticism of its rate increases or how the equity markets react to Fed statements and decisions.  Fed rate hikes and uncertainty about more to come are said to discourage investment and increase the risk of a recession.  This is because, as the “risk free” rate rises, investors demand higher returns on equities.  Likewise, more volatile equity prices increase the risk premium that investors demand for holding stock. Thus, uncertainty about future Fed interest rate increases also increases the cost of equity.  On the positive side, market volatility can sometimes force investors of capital to pay more attention to its cost and improve the quality of their investments by feeding capital to investments that sustain productive growth and not oversupplying capital to businesses that are not as profitable.

Although government officials are trying to play down the impact of U.S.-China trade tensions on the world’s second-largest economy, the trade dispute appears to be taking a toll on China’s economy, with economic expansion weakening to its slowest pace in almost three decades.  China’s export-oriented manufacturing sector has been hit especially hard, reducing new orders for business and forcing factories to cut production and delay decisions on investing and hiring.  China has been attempting for years to make its economy less dependent on manufacturing and more oriented toward domestic consumption, but the factory sector still accounts for almost one-third of its economic output.  To this point, China’s policy makers have taken a more measured stimulus approach aimed at stimulating consumer spending, rather than the old approach,which used a big stimulus package to pump money into infrastructure, fueling a debt binge.  That is probably a good thing longer term, but may create some near term strain, especially with Chinese consumers pulling back on spending due to shaken confidence.   This newfound belt tightening by Chinese consumers is rippling across the globe, crimping oil producers, electronics makers, travel services and a slew of other sectors.

The Eurozone economy also remains extremely sensitive to global trade and any problems in either the U.S. or China would likely affect these countries.  This is a headwind that the Eurozone does not need, as self-imposed barriers such as political disunity and a focus on fiscal discipline are already hindering economic growth in this region.  This is a complicated issue due to the unique setup of the union - 19 countries, each with their own tax and spending policies, sharing a single currency.  Eurozone inflation hit an eight-month low and activity in manufacturing and services fell to a four-year low in December just as the European Central Bank stopped adding stimulus to the economy by ceasing its $3 trillion bond-buying program.  With economic growth slowing to its weakest level in four years and its biggest economy, Germany, contracting due to weaker exports and softer demand at home, the ECB might find it difficult to raise interest rates this year.   

On top of the complications facing the EU  as they unwind their quantitative easing program, they also have to deal with the pending departure of the U.K. who is attempting to negotiate a trade deal before it is scheduled to leave the union at the end of March.  The key sticking point in negotiations has become the border between Northern Ireland and the Republic of Ireland, with the former being part of the U.K. and the latter an independent country and EU member.  British Prime Minister Theresa May has proposed a deal to the EU where the border between the two would remain open until 2020 when, hopefully, a long-term solution will have been negotiated. The problem is that proponents of Brexit want a hard border and restricting the movement of people across Britain’s borders was a major reason that Brexit passed in the first place.  

Exasperating the problem for Prime Minister May and the U.K. is that the EU has no incentive to make it easy for member states to leave because the smaller the union, the less influence they jointly have to serve as a global counterweight to larger countries like the U.S., Russia and China.  In addition, it is unequivocally not in the EU’s interest to let a departing country have a better deal out of the union than they could get in it.  It is hard to imagine a more difficult job in politics right now than that of British Prime Minister, with Theresa May knowing that no plan she agrees to with the EU will get the backing of both the pro-Europe and the hard-line Brexiteer factions in her party.  To this point May has rejected calls for a second referendum, but that could change as the Brexit deadline approaches if Britain is faced with choosing from two extreme outcomes – leaving the EU without a deal, a path that could lead to serious economic dislocation, or not leaving the EU at all.  At this point, consensus seems to be that leaving the EU will be bad for Britain, diminishing the U.K.’s standing in the world, punishing the British pound, hurting its ability to trade across borders with Europe, its largest trading partner, and jeopardizing London’s status as Europe’s financial capital.

In real life, the present determines the future. In the equity markets, it is the other way around.  Volatility has spiked and equity markets are down from all-time highs set in early 2018, but markets eventually settle down and start moving based on actual business conditions.  The economist John Maynard Keynes once wrote, “The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.  Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.”  We agree and continue to espouse an investment policy that shuns debt and incorporates cash and fixed income exposure that is substantially representative of anticipated portfolio withdrawals over the next several years.  Only after allowing for this lower risk fixed income exposure is it appropriate to consider an investment in the equity markets with the residual capital.  Those equity markets will continue to be inherently volatile, but have rewarded, and should continue to reward, long-term, buy-and-hold investors over most market cycles.

Urban Financial Advisory Corporation – January, 2019