The Fourth Quarter of 2018: Forest Ranger on Duty

By Eric Schopf

The Standard and Poor’s 500 turned in the worst fourth quarter performance since the depths of the financial crisis of 2008. The fourth quarter total return of -13.52% wiped out all performance gains for the year, which finally settled at -4.38%. It was also the worst quarterly result since the third quarter of 2011 when the S&P 500 contracted by nearly 14%. While these figures pale in comparison to the 22% correction in the fourth quarter of 2008, they serve as a good reminder about investment time horizon, asset allocation and risk tolerance.

In typical fashion, as the stock market swooned, the bond market rose. With the exception of the very shortest term instruments, interest rates on United States Treasury securities fell across the yield curve. Ten-year rates dropped from 3.05% to 2.68%. However, the ten-year rate touched 3.23% intra-quarter which made the decline even more impressive. As a proxy for mortgage rates, the ten-year rate is an important economic gauge. Rates on one-, three- and six-month Treasury Bills continued to climb during the quarter in reaction to the Federal Reserve’s most recent interest rate hike imposed in December. The higher short-term rates have kept money market fund rates elevated.

The credit market, however, did not experience lower interest rates. The drop in U.S. Treasury interest rates reflected a flight to quality. The spread between rates on Treasuries and riskier corporate offerings expanded during the quarter as investment-grade corporate bonds remained essentially unchanged. The spread on non-investment grade or junk bonds widened even further as bond prices fell. The widening spread is an indication of the concerns about corporate earnings power and their ability to meet future credit obligations.

Getting to the root cause of the market turbulence requires unpacking the contents of a very busy quarter. Trade tensions persisted despite a truce between President Trump and China President Xi. Although concessions have been made by China to reduce tariffs on U.S. auto imports and to resume the purchase of soybeans, no broad trade agreement has been reached. The situation was exacerbated by the arrest of a Chinese executive in Canada at the request of the United States. Meng Wanzhou, chief financial officer and deputy chairwomen of Huwei, was arrested for violations of sanctions against technology sales to Iran. China quickly retaliated and detained three Canadian nationals for allegedly endangering China’s national security.

Nationalist frictions also surfaced during the arrest and detention of Nissan Motor Company Chairman Carlos Ghosn by Japanese officials. Mr. Ghosn was initially charged with underreporting his compensation on Nissan’s financial statements. As the case unfolded, news of tensions between Renault, a French automobile manufacturer, and Nissan surfaced. Renault, Nissan and Mitsubishi, another Japanese auto company, are in a strategic partnership through a cross-sharing agreement. Renault controls 43% of Nissan shares which is the sticking point with Japan. The timing of these charges seems to coincide with Japan’s attempt to regain some control of Nissan.

A Federal District Court Judge in Texas ruled that the Individual Mandate of the Affordable Care Act is unconstitutional. Furthermore, he ruled that the individual mandate cannot be severed from the rest of the Act, and therefore the entire law must be declared invalid. Although the ruling may be overruled on appeal, it was one more piece of disruptive news.

The mid-term elections also dominated the third quarter news cycle. As we all now know, the Democrats took control of the House of Representatives while the Republicans maintained their majority in the Senate. The prospect of a divided house unleashed a torrent of political activity prior to the change of control.

Turmoil within the President’s cabinet continued with the resignation of Defense Secretary James Mattis over a difference of opinion on Middle East policy. The President announced plans to withdraw 2,000 troops from Syria and the prospect of as many as half the 14,000 troops from Afghanistan. Mattis tendered his resignation fewer than 24 hours after the surprise announcement.

The inability of the President and Congress to reach a budget deal led to a partial government shut down late in the quarter. With no movement in sight, the shutdown is just one more drop of uncertainty behind an already stressed dam.

The Federal Reserve delivered the decisive blow to the security market dam. Leading up to the quarter-point rate hike in December – the fourth this year, were statements from the Fed Chairman Jay Powell, declaring that the economy “was a long way from neutral” and that “we may go past neutral” in reaching policy goals. The stage was set for continued restrictive policy, and the market shuddered. The combination of higher interest rates and the continued reduction of Treasury security holdings accumulated through the years of quantitative easing have proven to be too much. The selloff continued when the Fed discounted market reaction. Steve Mnuchin, Secretary of the Treasury, made matters worse by delivering a Trump-like tweet telling the world that he reached out to the CEOs of the nation’s six largest banks to confirm that they have ample liquidity for operations. The issue of liquidity was not even on the radar screen of analysts and reflected images of the financial crisis.

The U.S. economy has continued to perform well in the face of the unsettling events. Gross domestic product has remained solid and employment is still robust. Consumer confidence is high and holiday spending was strong. However, some cracks have begun to form. The Institute for Supply Management manufacturing and non-manufacturing business indexes took downturns in October and again more decisively in December. These coincident indicators are a barometer of current economic conditions. Slowing demand abroad, fading fiscal stimulus and the lagged impact of Fed policy have all played a part in the slowdown. Higher interest rates are impacting interest-sensitive industries such as housing, autos, construction and manufacturing. Business confidence also continued to slip albeit from the record levels reached earlier in the year.

We did not anticipate the fourth quarter market volatility. We viewed monetary policy as the Fed taking their foot off the gas, not as applying the brakes. None the less, the September stock market peak to December trough was roughly a 20% correction. The future direction of the markets depends primarily on the Fed’s next move. All economic expansions end and most end because the Fed raises rates excessively. Knowing this, why would the Fed continue on their current path? The primary concern in letting the economy run hot is a widely held belief within the Fed that tight labor markets lead to wage inflation and wage inflation is the primary cause of price inflation. The fear is that tight labor markets could lead to runaway inflation. For this reason, and rightfully so, the Fed is very focused on the labor market. Employment has been so strong that the Job Openings and Labor Turnover Survey presented by the Bureau of Labor Statistics revealed 7.14 million job openings in the U.S. in October. The number of job openings now exceeds the number of unemployed.

The wild fires that spread through California last year serve as a metaphor for central bank policy. A forest that grows unattended without clearing flammable underbrush and a population expanding into areas ill-suited for civilization make a natural occurrence, like fires, exponentially more dangerous. Fed interest rate policies are designed to remove financial excesses that accumulate during periods of strong economic activity. Fed regulations are attempts to prevent settlements in danger zones. The optimal level of intervention keeps the forest healthy and vibrant while excessive management stymies growth.

As we enter 2019, risks facing the markets are a Fed policy that is too restrictive and the threat of a full trade/technology war with China. The large supply of U.S. government debt may also put upward pressure on interest rates, which may impact economic growth. The U.S. budget deficit rose from $666 billion in 2017 to $779 billion in 2018. Revenue rose by 0.4% while outlays rose 3.2%. Economic growth and higher tax receipts were part of the calculus involved with the cut in corporate taxes implemented earlier this year. Positive developments would be a more accommodative Fed hitting the pause button on interest rate hikes and the impact of lower energy prices. Brent crude oil, which reached $84.25/barrel in October, fell to $53.80/barrel at year-end. West Texas crude oil experienced a similar price reversal which bodes well for manufactures and consumers.

The year will bring many challenges and opportunities. We will continue our best efforts to take advantage of the opportunities and make the new year prosperous for you.

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