Market volatility spiked in the last quarter of 2018 driven by a variety of economic and political factors. At the top of the list remained U.S./China trade tensions, coupled with the uncertainty of the Federal Reserve’s path for further rate hikes. In addition, concerns over mid-term elections, slowing global economies, Brexit, and a US government shutdown weighed on investor sentiment. During the 4th quarter of 2018, the Dow Jones Industrial Average one-day changes ranged from down 831 points (-3.15%) on October 10th to up 1,086 points (4.98%) on December 26th, which included the third largest intraday point swing since 1987.
Dow Jones Industrial Average
December was the worst month for stocks since the Great Depression, and 2018 registered the first negative annual return in 10 years. Investors can take some solace in the fact that historically, markets do not tend to have back-to- back down years. In fact, there have only been four back-to-back down years since 1929. It is normal for investors to get nervous when they see significant movements in stock prices. For the past several years, the markets have experienced a somewhat calm and consistent upward track. But the reality is that the types of movements experienced in the last quarter are historically common. Since the beginning of 2009 there have been 15 “corrections” (i.e. a price decline of 10% or more).
Although increased levels of volatility can be concerning, investors should be careful not to interpret these swings as a sign to head for the exit. Market volatility can lead investors to make reactionary changes to their investments, which could potentially disrupt their long-term financial plans. Our message remains the same: pullbacks are a healthy part of market cycles, and we emphasize staying fully invested. As the U.S. economy moves through the latter portion of its typical cycle, growth is expected to remain positive, but at a slower rate. But even though growth may be slowing, consumer spending continues at a healthy pace, job growth remains strong, and wages are ticking higher.
These are also times when individual stock picking could provide returns that are superior to more passive approaches. We are firm believers in diversification across all S&P 500 sectors and weighting them according to economic and market conditions. Any changes to investment decisions should focus on being slightly more defensive in stock selection and sector weightings. Exposure across multiple asset classes reduces a portfolio’s volatility and can protect on the downside. As difficult as it may be at times, always let your goals and objectives drive your investment decisions, and put emotions aside.
VIX – CBOE Volatility Index
Investors moved away from riskier assets towards more stable, income producing assets. Only one sector had positive returns for the 4th quarter: Utilities. Typically, the Utility sector offers a “safe haven” for investors when markets become uncertain, with utilities often viewed as bond substitutes due to their dividend yields. The concern over tariffs and trade tensions weighed heavily on most sectors. Equity prices moved lower to reflect a reduction in forward earnings, rising labor and material costs. The cost of capital has been rising, and the potential for further rate hikes forced many companies to take a conservative stance and reduce their forward earnings. While all other sectors recorded negative returns for the fourth quarter, the Energy sector was the biggest loser.
4th Quarter Sector Performance
With the increased volatility during the quarter, markets experienced a shift in investment style performance. Stocks can be divided into two main groups: growth and value. Growth stocks, which are those seen with greater potential for expansion than the overall markets, can tend to be more volatile and are typically not the best dividend payers. Value stocks trade at levels that do not necessarily reflect their fundamental worth, and are typically larger, more established companies that pay out a consistent dividend. Over the past 10-year period of expansion and bull market, there has only been one year where value stocks outperformed growth stocks. While this trend continued for 2018, the 4th quarter showed a reversal where value outperformed growth. It was the first quarter since 2016 where value returns were superior to growth returns. With the uptick in equity markets swings caused by concern over trade talks and potential Fed action, investors began looking to take risk off the table, and growth stocks came under added pressure. As long as most of the economic and political issues remain, it is unclear if this trend of value over growth will continue into the new year. Since most Value indices are heavily weighted in the Financials and Energy Sectors, and Growth is heavily weighted in Technology and Health Care, it will be interesting to watch the performance of these sectors to identify ongoing trends.
Growth vs Value Quarterly Returns
Domestic and global economic fundamentals have shifted, but reasons for being cautiously optimistic remain. In spite of market swings being driven by headlines and macro issues versus fundamentals, job growth continues to be strong as an increase in the job participation rate rises.
Initial Jobless Claims
2018 will be noted for market volatility, but also as a year where corporate earnings soared. Of the companies that have reported earnings in the 4th quarter, 90% have exceeded analyst expectations. While the expectations for next year are not in the 20% year-over-year range, the forward outlook for earnings remains positive as the consumer continues a healthy spending pattern. As the markets navigate the tensions of China and U.S. trade relations and rising wages, the potential for an increase in inflationary pressures will exist. Inflation levels continue to run in the 2% range, just where the Federal Reserve is most comfortable.
Fixed Income Markets
At the beginning of the quarter, Federal Reserve Chairman Powell made some rather hawkish comments about future rate hikes. The initial interpretation caught the markets off guard and in November, those comments were softened. The Federal Reserve raised interest rates in December, which was anticipated, but many debated the need for the hike. In a press conference following the FOMC meeting, the Chairman stated the committee expected the economy to perform well into 2019, but also indicated the ongoing reduction of the balance sheet would continue on “autopilot”. Understandably, the markets did not react well. Globally, central banks have been reducing their balance sheets for the first time since the financial crisis began. It is not a coincidence that the reduction in liquidity had a dramatic effect on markets. Interest rates had been moving slightly lower over the quarter, but fell further at the end of December as did the equity markets.
The yield curve has been flattening throughout the year, due to short-term interest rates moving higher and the lack of inflationary pressure keeping longer term yields down. In December, there was a slight inversion of yields. The 2-year the 3-year Treasury note yields were higher than the yield on the 5-year note and caused many to fear a further inversion was imminent. As the U.S. approaches the late part of the economic cycle, GDP is around 3%, employment is strong, and other than the shape of the shorter end of the yield curve, there are no other conclusive signs we are heading for a recession. With that said, the potential for an inverted yield curve repeatedly made the headlines throughout the quarter. What would be worth noting is if the 10-year Treasury dipped below the 2-year Treasury.
U.S. Treasury Yield Curve
High Yield Markets
As interest rates moved lower over the past 10 years, investors’ desire for income drove them to the high-yield bond market. Appetite for riskier assets allowed the high-yield market to soar and with the exception of 2015, it has logged positive annual returns since 2008. But that run took a turn in the 4th quarter. The same economic and political tensions that fueled the “risk - off” trade in the equity markets weighed on the bond market. As a result, the high-yield bond market had a negative year. Nervous investors witnessed
corporate bond yield spreads widening. The high- yield debt market suffered a negative return for the quarter as investors moved out of the sector, seeking higher quality options. Liquidity also became an issue as new issues totally dried up in December. This would typically be another warning sign of a dramatic economic slowdown, but we have seen signs that this is a short-term reaction. Investors are, in fact, dipping back into the riskier asset arena.
4th Quarter Fixed Income Performance
ELIZABETH D. SWARTZ
Investment Services Manager
December 31, 2018
- DJIA 2017
Dow Jones Industrial Average: Price weighted index of 30 U.S. large cap stocks.
Chicago Board Options Exchange: Implied volatility of S&P index options.
- 3. Asset Class Performance
Morningstar: Smal Cap – Russell 2000 Index, Mid Cap- CRSP Mid Cap Index, Large Cap – S&P500, Dev. Int’l – EAFE Index, Em Mkts – FTSE Em Mkt Index.
- 4. Growth vs Value Quarterly Returns
Morningstar: iShares Russell 1000 Growth ETF, iShares Russell 1000 Value ETF.
- Initial Jobless Claims
Federal Reserve Economic Research. 4 week moving average of filings to receive unemployment insurance benefits.
- S. Treasury Yield Curve
Federal Reserve Economic Data.
7. 4th Quarter Fixed Income Performance
Morningstar: Bloomberg Barclays U.S. Credit Index, Bloomberg Barclays U.S. Mortgage Backed Securities Index, Bloomberg Barclays Global Aggregate ex-U.S. Index, Bloomberg Barclays U.S. Corporate High Yield Index, Bloomberg Barclays Municipal Bond Index.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chesapeake Wealth Management), or any non-investment related content, made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Chesapeake Wealth Management. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he or she is encouraged to consult with the professional advisor of his or her choosing. Chesapeake Wealth Management is neither a law firm nor a Certified Public Accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Chesapeake Financial Group, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.