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Aon Retirement and Investment Blog

Fourth Quarter 2018 Market Review and Outlook

Key Highlights

  • Economic releases continue to underwhelm with measures of economic activity reflecting a slowing global growth environment. The effects of fiscal stimulus are still, however, evident in the U.S.
  • The global growth outlook has been called into question which alongside elevated trade tensions and tightening financial conditions made it a difficult environment for risk assets in Q4 2018. Developed market equity performance was poor across the board over the fourth quarter although more defensive sectors such as utilities managed to generate positive returns. This does not change our view that we are in a transition market environment where market rebounds, however short, are possible.
  • After marching higher early in the quarter, U.S. bond yields tumbled significantly thereafter due to the same concerns that afflicted equity markets. The prospect of an inverted U.S. yield curve caught widespread attention and interest as investors contemplate what the Fed will do in 2019.
  • Credit markets suffered again in the last quarter of 2018 with further spread widening, particularly for high yield corporate bonds. Yes, credit spreads may be above our estimates of fair value but risks of further spread widening remain
Macroeconomic and Political Moves
Global growth engine losing steam?

For a while now, we have relied on U.S. economic strength to prop up increasingly weak growth in the rest of the world. While this remained the case in Q4, we did start to see some cracks appear in the U.S. growth story.

Two data releases illustrated this point. First was third quarter GDP growth. Growth slowed from its impressive 4.2% second quarter reading to 3.4% over the third quarter, but this was still quite an impressive above-trend reading and indicated that the impulse created by last year’s tax cuts continued to hold sway. The second was the more contemporaneous manufacturing activity index for December, released by the Institute of Supply Management (ISM). This index tends to be a reliable indicator of the strength of the whole economy, not just the manufacturing sector. While the December index reading remained firmly in expansionary territory at 54.1, it also fell by the largest amount since October 2001. The U.S. mid-term result, which saw the Democrats win the House of Representatives significantly dents the prospects of fresh fiscal stimulus in the future. Is the U.S. economy definitively slowing? It’s too early to tell but we should not be too hasty to call the end of the cycle whilst consumer confidence remains high and the labour market remains as strong as it continues to be – the December payrolls report beat analyst expectations handily.

One implication of tight labour markets is that wage growth is finally starting to accelerate – average hourly earnings rose by approximately 3.1% year-on-year. The upward trend in wage growth has, however, not been reflected in core inflation, as measured by the core Personal Consumption Expenditure price index, which is currently just shy of the U.S. Federal Reserve's 2.0% target.

Nonetheless, there has been some mounting worries about the U.S. economic outlook with further tightening financial conditions and the gradual shift from fiscal thrust to fiscal drag often cited as reasons for this change in view. 'Nowcast' estimates of Q4 2018 GDP growth have levelled off at 2.5% while Q1 2019 estimates have moved lower to around 2.1% - still above trend growth of circa 2.0%.

Like the U.S., measures of economic activity fell further in Europe with the manufacturing Purchasing Managers' Index (PMI) falling to 51.4. The same measure was relatively unchanged in Japan while China's manufacturing PMI slipped into contractionary territory (below 50) with a reading of 49.4. There is the expectation that Chinese authorities will unleash a degree of stimulus in order to counteract a slowing domestic economy although the efficacy of this policy is uncertain given China's aims to reduce its reliance on debt-financed investment spending.

Trade war fears between the U.S. and China ratcheted up throughout the quarter as a number of tit-for-tat measures were adopted. The announcement of a 90-day truce to last until the beginning of March has brought some temporary relief but any denouement in trade negotiations during this short period does seem unlikely. Although there is bipartisan support in the U.S. for a hard-line to be taken with China, the performance of the U.S. stock market and its reflection on the U.S. administration could lead to some restraint on further rhetoric used or may even bring about an amicable end to negotiations. The situation remains fluid and unpredictable, however.

Political ructions were not solely isolated to the U.S., as Brexit continues to dominate news-flow in Europe. Despite the proposed Withdrawal Agreement being reached, the UK remains no closer to leaving the European Union in an orderly fashion. A no-confidence vote won by Prime Minister Theresa May could provide some stability for the UK government. But this is unlikely to quell parliamentary dissenters, with the looming vote on the much-criticised exit-plan looking highly likely to result in a heavy defeat for the UK government if there are no substantive concessions from the EU. Consequently, we have raised our probabilities for a no-deal Brexit as well as for a second EU referendum which could lead to a vote to remain.

While 2017 saw European politics fight back against the threat of populism, mainstream European politics in 2018 and going into 2019 looks to be on shakier ground. Following recent German election setbacks, German Chancellor Angela Merkel announced that she would step down as party leader in 2021 while the "gilets jaunes" protests have raised questions about French President Macron's reform agenda. This political uncertainty may stifle business investment as uncertainty remains high. We see this as an important headwind for European asset returns.

Monetary Policy
How far from neutral? Will the Fed dare to invert the yield curve?

As widely expected, the Federal Open Market Committee decided to raise the federal funds rate target to 2.25%-2.50% at its December meeting. While starting the quarter with a more hawkish stance and indicating that several more hikes would be needed in the future, the Fed later back-tracked with comments intimating U.S. rates are not far from reaching the Fed's neutral rate estimate. Moreover, Fed meetings in 2018 culminated in a dovish downward revision in its median forecasts for 2019 rate hikes from three to two.

The U.S. yield curve, specifically the shape of it, has garnered significant attention as it appears to be on a trajectory to invert, which has typically been a precursor to recessions. In the absence of inflationary pressures, would the Fed dare to unnerve financial markets and persist on its hiking path? We believe that should the inflation environment remain subdued and growth does slow, the Fed could decide to take a pause. While this may lead to a bounce-back for risk assets, we do not believe this would result in a return to a bull-market environment.

No changes were made by the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) to their respective policy rates. The former did end their quantitative easing programme which has seen trillions of euros used to purchase European debt and cheapen financing in the bloc. Without the support and greater liquidity afforded by these programmes, risk assets are seemingly losing one of their most important tailwinds of recent years.

Trade war and economic momentum concerns saw developed market equities end the year on a low 

Global equities were rocked by rising concerns of slowing global growth and trade wars in Q4 2018. In local currency terms, the MSCI AC World Investable Market Index returned -13.0% while U.S. dollar strength led to a slightly lower return of -13.2% in USD terms. Negative returns were fairly widespread with only a handful of regions generating positive returns over the quarter.   

Is this the start of a prolonged bear market? Despite this market turbulence, we believe our assessment that we are currently in a transition market environment still stands. This was particularly evident in the fourth quarter where equities were bookended by two months of strongly negative returns. While this is certainly a challenging environment for equity markets and we do not expect a return to strongly positive trends soon, we do believe that there is potential for market rebounds this year, however short-lived they may turn out to be. Commentators, including Jerome Powell (Fed Chair), have quite reasonably pointed out that markets have been recently ‘ahead of the data’ in pricing in downside economic risks (see chart below). We must also remind ourselves that the U.S. economy and company profits remain strong and the risks of a near term recession are still quite remote.

We think this rebound potential should be seen as more of a tactical opportunity than a medium-term view and as such, rebalancing to target weights is fair for well-diversified portfolios. Others that are less well buffeted against market pain would be better served to use periods of market strength to reduce equity reliance, in our view. As we have stressed throughout 2018, diversification will play a key role in portfolios but these should be stress-tested in order to optimise portfolio resilience to volatility.

U.S. stocks failed to build on their impressive streak with a 'perfect storm' that undermined confidence

Up until November 2018, U.S. equities had generated high-single digit returns. Fast forward one month, and those gains had evaporated into large losses. The Dow Jones Total Stock Market Index dropped by 14.4%, translating into an overall 5.3% fall for the year. Most notably, the technology stocks which had been such a strong driver for the U.S. market moved sharply lower over the quarter. Earnings growth expectations, particularly in the tech sector where optimism was perhaps excessive, were revised down.  

Although it is difficult to discern a single trigger point for the recent market sell-off, it can be said that a confluence of factors – the view that the Fed has made a policy error by hiking rates, worries over the health of the Chinese economy, falling commodity prices, the U.S. government shutdown or the ongoing trade tensions – created an environment that shifted investor sentiment.

Despite greater exposure to the underperforming Technology sector, U.S. large cap stocks outperformed small-cap stocks over the quarter as the Russell 1000 Index returned -13.8% against the -20.2% posted by the Russell 2000 Index.

Worries over economic slowdown and global trade cast a long shadow over globally-exposed stocks

Equity market returns were similarly poor outside of North America. The global deterioration in economic momentum and the return of risk aversion coincided with a strengthening of the Japanese yen and resulted in the Japanese equity market being the weakest performer over the quarter, returning -18.3% in local currency terms. Yes, Japanese GDP growth was negative in Q3 but this was distorted by a set of natural disasters that disrupted exports and consumer spending. European equities only fared slightly better in comparison, falling by 12.2% while UK stocks declined by 10.6%. Alongside slowing momentum, Europe also had to contend with rising political uncertainty which undermined sentiment.

A couple of bright spots among emerging market equities, but not enough to offset general equity market weakness 

In stark contrast to the preceding couple of quarters, emerging market equities outperformed relative to their developed market peers; the MSCI EM IMI returned -7.3% in local currency terms. This is despite the ongoing U.S.-China trade saga and building concerns over global growth. The more than 10% decline in Chinese stocks were partially mitigated by positive double-digit returns from Brazilian stocks. The election win for Jair Bolsonaro was welcomed by markets due to his party's pro-market focus and reform agenda. From a sector perspective, financial stocks were the main outperformers with a comparatively small decline of -0.9% over the quarter. We have maintained our view that EM equities are well placed over the medium term but remind that the near term is likely to remain highly volatile.

Government Bonds and Yields
The upward march of yields was snapped over Q4 as the yield curve continued to flatten

Government bond yields rose in the early stages of the quarter as investors priced in faster than initially perceived U.S. rate hikes with the 10-year U.S. treasury yield topping 3.20%. This made the overall 37bps quarterly fall in the 10-year yield to 2.68% all-the-more spectacular. Bonds profited from the same concerns that plagued equity markets. Against rising short-term rates, the U.S. nominal yield curve continues to flatten; the 10-2 year spread stood at just 18bps. Although, the inversion of the yield curve, should it occur, has typically been a precursor to a recession we believe that the fall in term premia, which has likely been depressed by bloated central bank balance sheets, has impacted its reliability as an indicator. That being said, even models which use near-term forward interest rates (i.e. not as affected by the collapse in term premia), which has arguably better presaged recessions, points toward very mild recession risks. 

Amid falling yields, the Barclays U.S. Treasury 20+ year total return index posted a 4.2% return over the quarter – one of the strongest performers over what was a volatile period.

Just as in equity markets, credit markets suffered as investor sentiment soured

Credit weakness was a theme that played out throughout the quarter. In general, negative returns from widening credit spreads more than offset the positive gains from the fall in underlying government bond yields. In particular, high yield bonds (as measured by the Bloomberg Barclays Global High Yield Index), which had been a relative outperformer amongst fixed income assets prior to the fourth quarter, were shunted by a 165bps increase in credit spreads and resulted in a 3.5% loss over the quarter. 

Unlike the 2015/6 high yield shakeout, this was not dominated by poor returns from the energy sector but was more widespread. Investment grade credit spreads did not fare much better, rising 55bps to 2.03% with the Bloomberg Barclays Global Credit Index slipping by 1.0%.

Following the sharp spread widening over the quarter, U.S. credit spreads are now above our fair-value estimates, meaning they have moved into more attractive territory. That is not to say we would advocate allocating more into credit yet. From where we are in the credit cycle, there is limited upside from holding corporate bonds while the considerable debt accumulation alongside pressure on earnings bring downside risks. We, therefore, still recommend underweighting to credit in portfolios.

Within the Eurozone, 10-year government bond yields fell with the exception of Greek bonds. Progress appeared to have been made on Italian budget talks as the Italian government proposed a revised budget plan with a deficit of 2.04% rather than 2.4% which drew the ire of the European Commission. Other Eurozone bond yield movements were more muted in comparison. The Bloomberg Barclays Euro Aggregate Index rose by 0.9% over the quarter in local currency terms but this translated to a 0.7% loss in U.S. dollar terms due to U.S. dollar strength.

Risk-off environment supported the yen while sterling continued to be buffeted by Brexit concerns 

As measured by the U.S. dollar index (DXY), the U.S. dollar moved slightly higher by 0.5% over the quarter. Benefiting from the relative strength of the U.S. economy, the 'greenback' appreciated against most major currencies with the exception of the Japanese yen, which appreciated strongly across the board – benefiting from the risk-off environment. However, given the high current account deficit and aging economic cycle, we believe that momentum is likely to wane  and turn into a moderately weaker trend over the medium term.

With time ticking precariously down to 29 March (the day in which the UK leaves the EU, subject to no extension or removal of Article 50) and no resolution in sight, sterling was generally weak. Looking ahead, the uncertain outlook for sterling's prospects was highlighted by the three-month measurement of implied volatility on sterling options rising to its highest level since the EU referendum vote in 2016.

In Canada, with the pace of future rate hikes in question, the Canadian dollar dropped precipitously over the quarter – a fall of more than 5% against the U.S. dollar and 8.6% against the yen.


OPEC + Russia production cuts unable to arrest downward trend in oil prices. Potential upside risks capped by slowing global economy.

The agreement to cut crude oil production by OPEC and Russia late in the quarter was not enough to stymie tumbling crude oil prices, brought lower by U.S. inventories rising faster than expected, a slowdown in the Chinese economy, the unexpected waiver on Iranian oil importer sanctions and of course the weaker outlook for global growth. WTI crude oil spot prices fell by 37.9% to $45.44/bbl while industrial metals had a more muted 7.0% decline over the quarter. The energy-sensitive S&P Goldman Sachs Commodity Index (GSCI) returned -22.9% over the quarter and unsurprisingly gold (up 7.7%) had one of its better quarters in recent times as investors flocked to safe-haven assets.

Commodities remain a useful diversifier in portfolios, especially during episodes of rising inflation and political risk but, as the recent fluctuations show clearly, the particular volatility of this asset class must be taken into account when investing.

Equity Market Table

Past Performance is no guarantee of future results. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect any fees or expenses. Investors cannot directly invest in an index. Please refer below for Index Definitions and other General Disclosures.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.

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