By Thomas Dillman
For the year 2018, the S&P 500® Index declined 4.4%, its worst performance since 2008. All of the negative performance for the year came in December, when the index was down 9.0%. After beginning the year with a 7% race to new, all-time highs, the market settled into a range around 0% until mid-July, when it began a steady advance to another all-time high, before sliding 19.3% from the end of September through December. This latter period was characterized by substantial volatility, with the market reacting primarily to concerns regarding global growth. U.S. stock markets were not the only ones to suffer, as all but a few stock markets tracked by the MSCI World Index declined for the year.1
U.S. bond markets fared no better during 2018. Long-term Treasury bonds fell 1.7%, U.S. corporate bonds declined 2.2%, and below-investment-grade corporates declined 2.1%, with spreads widening in December, most dramatically among below-investment-grade (junk) bonds. Aggregate global bonds declined 1.2%.2 On the commodity front, gold declined 0.9% and oil prices plummeted 25%. Cash was the only major asset class to post positive returns, up 1.9% for the year.3
The primary reasons for the volatile and declining markets in 2018 were a rising concern among investors that global growth was slowing and the prospects of an earlier-than-expected recession on the horizon. First, China's growth is clearly slowing as the result of internal policies to restrain lending, as well as some disruptions caused by U.S. tariffs on more than $200 billion worth of Chinese goods. A recent Wall Street Journal article noted a significant slowdown in Chinese consumer spending, not just on Apple products (Apple lowered estimates for 2019 significantly because of disappointing 2018 iPhone sales in China), but also on luxury goods and everyday products. Consumers in China constituted three-quarters of that country's economic growth last year, but that percentage is likely to fall to only two-thirds this year.4 Despite recent stimulatory efforts including tax cuts, lower interest rates and encouragement of lending (after a year of discouraging such lending), China's high and rising debt is a restraint.
As the second-largest economy in the world, a precipitous slowdown would have a serious negative impact on the health of the global economy. Markets likely will react poorly if current U.S. negotiations with China over issues such as trade, technology transfer, and patent and copyright protection, as well as aggressive actions by China to expand its territory and influence, prove unsuccessful. Should President Trump raise the current 10% tariff rate on $260 billion of Chinese imports to a threatened 25%, expand that amount to another $200 billion of imports, and exercise his threats to place tariffs on automobiles and auto imports from Europe, Japan, Canada and South Korea, global tariff rates would reach levels not seen since the 1940s.5 The era of globalization will have passed, almost assuredly reducing growth prospects for the world.
Few other major economies are showing signs of strength. In fact, most statistics from Europe and Japan remain lackluster and have been deteriorating slowly over the last year. Japan has failed to generate Gross Domestic Product (GDP) growth in excess of 2.0% since 2010. And, except for 2014 and 2008, inflation has not exceeded 1.0% in 20 years. Despite Prime Minister Abe's efforts and the most expansive quantitative easing (QE) program in the world, Japan has not been and, in all likelihood, will not be, an engine of global growth in the foreseeable future.
In Europe, among the big four countries of Germany, Spain, Italy and France, only Germany and Spain have generated GDP growth above 2.0% over the past year, with Italy and France barely crawling along at 1.0% or less. Beyond the economic data, Europe has a number of serious problems that are existential in nature. French President Emmanuel Macron has been forced to essentially scrap his business-oriented reform program in the face of protesters known as the "gilets jaunes," for the yellow vests they wear during demonstrations. The United Kingdom's decision to exit the European Union (EU) represents a significant rupture in the fabric of the collection of the 28 nations that joined together in a single market, fostering the free movement of people, goods, services and capital within its borders. The exit of Britain, often referred to as Brexit, besides severing important commercial and financial interrelationships, creates a precedent for other members to leave the EU. As for Italy, it is essentially bankrupt and unable to carry its huge debt load. The EU and Italy are sparring over Italy's budget, with the EU demanding less spending and lower deficits—in short, austerity—a formula that worked in Spain and Portugal, and to an extent, Greece. The difference in the case of Italy is the magnitude of its debt load and the exhaustion of the EU's capacity to bail out its faltering constituents.
The EU is on the verge of ending its QE program because it purchased European bonds up to the legal limit over the past few years. The vision of Europe as a single economic unit on par with the U.S. and China has become tarnished. The essential flaw, identified at inception, is that while the EU is largely united (19 of 28 members) under a single monetary system (the euro), the block has no centralized taxing authority and, therefore, no ability to regulate debt levels or allocate funds where they are most needed. The disintegration of the EU would have profound effects on global economic growth, as well as on international political relations, which are already in flux.
The other potential source of deteriorating growth is in the U.S. The Federal Reserve Board reversed its QE program over the past three years by discontinuing the purchase of Treasury and mortgage securities, thus reducing the size of its balance sheet and, as a consequence, the amount of liquidity available to the global market. Of greater consequence, it has been raising the Federal Funds rate, the benchmark level for short-term rates. Beginning in December 2015, the Fed has raised this rate in 25-basis-point increments nine times, from 0%-0.25% to a current range of 2.25%-2.50%. The frequency of these rate increases has accelerated over time, with only one rate increase each in 2015 and 2016, three in 2017 and four in 2018.6 The current level is approaching the recent level of 10-year rates, and comparisons among a number of shorter maturity rates have inverted, such that the Fed Funds rate is higher than some rates between two- and five-year maturities. As discussed in past issues of Economic Perspective, lenders cannot make profits when the rate at which they borrow is higher than the rate at which they lend. And borrowers cannot borrow if lenders keep raising their lending rates to attempt to maintain profit margins.
The debate among investors over the last six months is whether the Fed raised the Fed Funds rate too high and/or too quickly, such that the expansion will be cut off and precipitate a recession. The Fed is trying to engineer a so-called "soft landing," slowing growth enough to preclude an inflationary spike without damaging the labor market. While the most recent hike in December was well telegraphed by the Fed, investors were clearly hoping that the Fed might defer, or at least suggest a pause in, future rate hikes. In fact, one explanation for the volatile decline in stock prices at the end of 2018 was the market's fear that the December rate hike was a mistake. Comments by the Chair of the Federal Reserve, Jerome Powell, immediately following the rates meeting in December, did nothing to dissuade investors from their concerns that the Fed was pushing the economy into recession—and not just the U.S. economy. Because the international trading and financial system is fueled by the U.S. dollar, Fed policy affects every individual economy in the world, as it is the only institution that can increase or decrease world dollar supply. Its current program is officially designed to reduce the amount of dollars in the domestic economy to curb inflation and reestablish a "normalized," self-regulating demand/supply economy. But the centrality of the U.S. dollar to the global economy makes Fed policy de facto global.
Comments by Powell and other Fed governors since the last meeting, and after the markets' freefall reaction, have been a bit more dovish without acknowledging that the last increase was a mistake. While the Fed's official statement from the meeting suggested two or three more rate hikes for 2019, most commentators are forecasting one or none, based on recent data indicating that domestic economic conditions are decelerating rapidly.
Specifically, the first round of manufacturing data for December was surprisingly weak. The first hint of trouble came on December 17, with the release of the New York Fed Empire State Manufacturing Survey, which showed a month-over-month decline from 23.3 to 10.9 versus an expectation of 20. Later that week, the Philadelphia Fed Manufacturing Business Outlook Survey reported a decline from 12.9 to 9.4 versus a consensus estimate of 15. The following week, the Kansas City Fed Manufacturing Survey reported a decline from 15 in November to 3 in December versus an expectation of 13. A few days later, the Richmond Fed Fifth District Survey of Manufacturing Activity came in at -8 compared with November's reading of 14 and an expectation of 15. Finally, the Dallas Fed Texas Manufacturing Outlook Survey registered -5.1, down from 17.6 versus an expectation of 15. The only Regional Federal Reserve Bank survey that showed some stability was the Chicago Fed National Activity Index, down from 0.24 to 0.22 versus an expectation of 0.20. Each Regional Fed Survey uses its own scale for comparing month-to-month economic activity in its region. The economic significance of each is represented by the direction and magnitude of change.
The implication of these regional surveys was confirmed in early January with the release of the United States Institute of Supply Management (ISM) Series Indexes: the Purchasing Managers' Index (PMI) dropped from 59.3 in November to 54.1 in December; the Employment Index fell from 58.4 to 56.2; the Prices Index declined from 60.7 to 54.9; and most worrisome, the New Orders Index declined from 62.1 to 51.1. All of the current numbers remain in expansion territory, but the slowdown was greater and more rapid than anyone expected. These results may prove to be seasonal, in that after ramping for the holiday season, companies slowed production to realign inventories. In a similar vein, strong retail sales from November to December may obscure excess inventories that had to be reduced by heavy markdowns, thus pinching retail margins.
The same seasonal explanation may account for the extremely strong jobs report (e.g., the change in total nonfarm payroll employment) that came out the day after the ISM data showing that 312,000 new jobs were created in December versus 155,000 in November and an expectation of 184,000. However, other data on employment was strong. While the unemployment rate rose from 3.7% to 3.9%, that was largely a function of an increase in the labor participation rate, meaning more people found jobs or are looking for them. Additionally, average hourly earnings on both a month-over-month and year-over-year basis advanced ahead of expectations, with the year-over-year rate registering 3.2%, the highest for the cycle.
It is not unusual to be faced with seemingly contradictory data over short periods of time. We will have to wait to see subsequent data to discern actual trends in the underling economy. Despite the negative result from the manufacturing surveys, many current indicators suggest the U.S. economy remains healthy. These include strong consumer spending, inflation levels well within Fed targets and low unemployment. That said, a number of recent corporate reports suggest tariffs are beginning to bite. Capital expenditures have begun to decelerate. And a government shutdown that began on December 22, prompted by President Trump's insistence on receiving funding for a "wall" on the U.S. southern border before he will sign the remaining budget bills for fiscal 2019, is the longest shutdown in U.S. history. Through January 18, an estimated 800,000 federal workers across the country were still furloughed or required to work without pay. The longer the shutdown continues, the greater the impact on GDP growth. As important, the stalemate is beginning to sap business and consumer confidence in the government's ability to function, adding more uncertainty to the list of worries.
ISM data also are leading indicators that are highly correlated with the direction of change in the future, while employment data are lagging or coincident indicators correlated with what is happening now. Despite the strength of GDP and corporate earnings in 2018, and given the waning positive impact of last year's tax cut, both GDP and corporate earnings most likely will be much less robust in 2019. Analyst earnings estimates for 2019 are declining, although growth rates remain positive. The key issue is whether the Federal Reserve will be able to maintain the expansion at a positive, though slower, rate of growth, or make a mistake by raising rates too high and throwing the economy into recession.
Markets will continue to be volatile as they react to a number of key issues, including tariffs, Chinese growth, how Europe deals with the threats to its existence as a single economic bloc, and most importantly, in our judgment, to the actions of the Federal Reserve.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.
|1||Bank of America, Savita Subramanian, "U.S. Performance Monitor: Worst Month and Year since the Financial Crisis," January 2, 2019.|
Wall Street Journal, "Chinese Consumers Tighten Their Belt and the World Feels the Squeeze," January 3, 2019.
J.P. Morgan, Eye on the Market, Michael Cembalest, November 7, 2018.
Mutual of America Research.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.