Economic Commentary | Fourth Quarter 2018

Shortly after the stock market surpassed the longest bull run in history, investor sentiment turned starkly negative in the face of myriad challenges to the global economy. These headwinds included the trade wars between the US and its largest trading partners (particularly China), higher interest rates as the Fed removes monetary stimulus, slowing global growth, and geopolitical tensions around the world. 2018 brought us a burst bubble in cryptocurrencies, bear markets in the FAANG stocks, and an-almost 40% drop in the price of oil. For the Fourth Quarter 2018, the large cap S&P 500 index declined by 13.5%, the mid/small cap Russell 2000 index was down 20.2%, the international MSCI EAFE index lost 12.5%, and the emerging markets MSCI EM fell by 7.9%.

While the tit-for-tat escalation of tariffs between the US and China, the world’s two largest economies, began earlier in the year, evidence of the resulting drag on both economies did not materialize until this fall. In recent letters, we have mentioned our concern that investors were underappreciating the trade war’s impact on economic growth and corporate earnings. We saw the first signs of the damage in early October in the form of disappointing manufacturing reports out of both countries. China reacted to this news with $174B in stimulus while Jinping reassured markets by continuing to stress his government’s pro-business support. By the middle of October, China reported the weakest GDP growth since 2009, albeit still relatively strong when compared to US growth. In response, China announced a plan to pump credit and capital into private companies to boost growth. By the end of October, multinational US companies began to quantify the likely hit to earnings from the tariffs, with one-third of the companies in the S&P 500 index discussing the fallout from the protracted trade war. Throughout November, tensions continued to rise, culminating in a face-to-face meeting between Trump and Jinping at the G20 summit in Buenos Aires. Early reports seemed to suggest optimism that tensions had cooled as the two leaders agreed to a temporary truce, but these hopes were quickly dashed when Trump unhelpfully dubbed himself “tariff man.” China closed out the year with two ominous reports: the earnings for the country’s industrial firms dropped for the first time in three years while its manufacturing industry officially contracted for the first time in more than two years.

Not only were investors on edge because of tensions with China, but anxiety was also fueled by the Fed’s intended path to remove monetary accommodation. With eight rate hikes in this cycle behind him, Chair Jay Powell’s early October statement reinforced expectations of further hikes as he discussed the positive economic outlook, low unemployment, and low inflation. The Fed did as it had telegraphed and raised rates for the ninth time in mid-December, bringing the range for the Fed Funds rate to 2.25% – 2.50%. The Fed is nearing a neutral level, which is the rate at which monetary policy neither stimulates nor restricts growth, and further moves are likely to be dependent upon what economic data reveals. Following the lead of the US in reducing stimulus, the European Central Bank, headed by Mario Draghi, announced in early December that it would end its quantitative easing program which had injected billions of euros into the European economy since 2015. We have been looking forward to a return to more normal global interest rates for quite some time, as higher rates throughout the yield curve should reward conservative capital allocators like the CEOs of the companies in which our managers are invested.

Oil prices fell dramatically during the quarter on developing worries of a global supply glut. In early November, renewed sanctions on Iran took effect, but they failed to curtail oil output from the country. Initially, Saudi Arabia announced that it would cut its own supply in response; however, the potential involvement of the Crown Prince MBS in journalist Jamal Khashoggi’s murder muddied the waters and made a coordinated response difficult to achieve. OPEC did finally announce significant production cuts in early December, which boosted prices for a short while until persistent global growth concerns overshadowed these attempts to stem the price decline. By the end of the quarter, crude oil had fallen almost 40% from its price at the beginning of October.

On top of the dispute regarding Khashoggi’s murder imperiling the US relationships with Saudi Arabia and Turkey, geopolitical tensions were widely prevalent during the fourth quarter:

  • The UK’s prolonged and painful separation from the European Union threatened to rattle the somewhat-fragile remaining coalition;
  • Trump’s announcement of a pullout of American troops from Syria’s civil war led to fears of a power vacuum in which ISIS could gain influence;
  • Italy’s battle with the EU over government spending levels threatened the Italian banking system; and
  • Yellow-vest protests in France challenge the young presidency of Emmanuel Macron.

While the direct impact on stock prices of these myriad tensions is difficult to pinpoint, there is little doubt that this sort of global unrest unnerves investors and thus dampens stock prices.

Despite these challenges, the US economy continues to demonstrate impressive resilience. While the pace of expansion for manufacturing slowed from its 14-year high reached in August, the service sector continued to accelerate further into expansion territory. The final read on Gross Domestic Product showed a respectable gain of 3.4% on top of the growth from the prior quarter, which at 4.2% was the fastest pace in more than four years. The labor market also continued to register impressive gains, with an additional 568K jobs created during the quarter and the unemployment rate falling to 3.7%. Wage gains continue to creep higher, ending the quarter with a year-over-year gain of 3.1%.

The slowdown in housing that began over the summer continued into the fourth quarter. Skyrocketing prices over the past couple of years have outstripped buyers’ marginally-higher incomes, causing a slump in home sales. Affordability has also been hampered by higher mortgage interest rates and materials costs increases. Housing starts and permits, which are leading indicators, saw gains in the last monthly read of 2018, which is an encouraging sign for a housing rebound in 2019. Demographics will provide support to housing in the coming years as millennials are finally beginning to move out of their parents’ homes, but confidence in the economy will be the main driver for housing in the months to come.

Corporate earnings for the S&P 500 index surged over 20% during 2018, but much of these gains came courtesy of the fiscal stimulus of the late-2017 corporate tax cuts, which are only expected to boost profits temporarily. After such a strong year, further earnings growth will be harder to come by, and FactSet’s projections are calling for a more modest 6% gain in earnings for 2019. Expectations for a slower growth environment in 2019 was buttressed by Duke University’s survey of CFOs in December, which found that nearly 50% of respondents predict a global recession by the end of 2019, with 82% predicting a recession by the end of 2020. This sort of negative outlook on the part of businesses can become a downward spiral as it dampens confidence, which can lead to reduced plans to hire and invest in capital.

In the coming months, we will be closely following confidence indicators, both for businesses and for consumers, as both are likely to provide early signs of the health of the 2019 economy. We will also have an eye on inflation readings, as this will be key to the Federal Reserve’s policy going forward. If inflation remains at the current level of 2%, then the Fed has the leeway to take a slower approach to raising rates; however, if prices heat up, we will see a Fed more actively reducing accommodation. Finally, we are paying particular attention to news on the trade dispute between the US and China, as the longer this disagreement grinds on, the more likely it is to disrupt global supply chains, squeeze company margins, and dampen confidence. These impacts of the trade war may well result in the Chinese government, along with the People’s Bank of China, adopting fiscal and monetary stimulus measures to offset the resulting economic drag.

With a slowing global economy, uncertain Fed policy, and simmering trade tensions likely to determine the fate of stock markets in 2019, we continue to be reassured by our value managers’ focus on quality companies run by astute chief executives, many of whom had stellar operating results in 2018 which have not yet been reflected in their stock prices. We are encouraged that our managers are performing well relative to the S&P 500 index in this first quarter of 2019 while value managers are finally reaping the rewards of strong operating results in portfolio companies.