2018 was a challenging year for investors on many fronts with steep total return declines across the global investible universe. The fourth quarter punctuated a year that will go down in history as one that most investors would likely prefer to forget, with strong risk-off clouds darkening the markets, particularly in December. From the constant torrent of worrisome geopolitical developments to immediate macro risks—such as unresolved trade tensions, and fears of a global slowdown triggered by removal of global central bank-supplied liquidity and waning fiscal stimulus tailwinds—global asset allocators were presented with a remarkably difficult market environment to navigate.
In the global equity markets, domestic generally outperformed international throughout most of the year, a trend that reversed sharply in the fourth quarter amid heightened concerns of a Federal Reserve “policy error” and signs the U.S. economic expansion may be peaking. Stylistically, growth outperformed value and large cap outperformed small cap within domestic markets in 2018.
Interest rates rose to begin the year against a strong economic backdrop and signs of accelerating inflation, but abruptly declined in December amid safe-haven investor flows. The late-year risk-off environment helped drive core bond returns into incrementally positive territory for the year. Conversely, the relative tranquility of the high yield bond market was upended in the fourth quarter, as credit spreads widened from previously established cycle lows.
The diversification benefits of real assets were fleeting during the fourth quarter and the year, with losses realized across real estate, commodities, and energy infrastructure. Deflationary forces in the form of precipitous declines across oil prices, rising U.S. interest rates, an appreciating U.S. dollar, and global growth worries weighed on the asset class.
AN ECONOMIC ISLAND IN A SEA OF UNCERTAINTY
The Throughout 2018, U.S. economic activity appeared robust, with strength emanating from nearly every corner of the economy—particularly the labor market. Annual U.S. nominal GDP growth, for example, accelerated to 5.5% through the third quarter, a 12-year high. With incoming data supported by fiscal stimulus tailwinds, strong capital flows, and generally-elevated animal spirits, the U.S. economy’s fortune may have come at the expense of key trading partners, such as China, Europe, and Japan. Illustrating this relative strength is the U.S.’s real GDP growth rate through the third quarter—the strongest since second quarter 2015—contrasted against steadily declining growth rates for many of the world’s largest economies.
Chinese real GDP growth (not included in the graph), slowed to 6.5% year-over-year (YoY) through the third quarter, representing the weakest annual growth rate since 2009. While China’s economic engine is currently growing at more than double the pace of the U.S., the spread between these growth rates has narrowed significantly since the Global Financial Crisis (GFC) and remains near the tightest in more than two decades.
With many economies abroad struggling during the year with capital outflows, trade-related slowdown pressures, and the global return to monetary normality, the U.S. the U.S. resembled an economic island, seemingly unaffected by the growing number of macroeconomic headwinds.
Entering 2019, the global economy seems to have reached a critical juncture: Will the U.S. economy enter a growth slowdown phase similar to the ongoing cooling abroad, or will recent U.S. strength lift those struggling economic regions out of their current rut, helping the global economy enter a renewed, re-synchronized growth phase?
RUNNING OUT OF RUNWAY
The current U.S. economic expansion—in place since summer 2009—is the second-longest on record, dating back to the 1850s.¹ Barring an unforeseen significant deterioration in economic conditions, the expansion is likely to become the longest on record in 2019.
However, the fourth quarter highlighted a growing disconnect between economic backdrop and market performance, and since most economic data is backward-looking, the sell-off across the risky asset universe in the fourth quarter may foreshadow an economic slowdown on the horizon.
Market-based measures corroborated the potential for a cyclical business cycle inflection as well as an end to the Fed’s deliberate procedure of moderating business activity
vis-à-vis monetary tightening. Certain portions of the Treasury yield curve, for example, inverted for the first time in more than a decade, with the spread between 2-Year and 5-Year Treasury yields breaching negative territory in early-December.
Of course, an inverted yield curve does not necessarily signal an imminent recession. It does, however, indicate a long-in-the-tooth expansion and a likely truncated runway for a further material tightening in monetary conditions. Additional increases to short-term interest rates would presumably pressure the yield curve even flatter, perhaps even developing into a descending curve.
Indeed, during the fourth quarter, both official sector and market-implied expectations for near-term interest rate hikes shifted. Several months ago, rate hikes were all but guaranteed.
At their December meeting, the Federal Open Market Committee (FOMC) made a downward revision to their “dot plot” estimate for 2019 increases to the federal funds rate (FFR), from September’s estimate of three rate hikes to an updated forecast of two rate hikes. The FOMC also revised-lower their estimate for the theoretically “neutral” FFR—that level which is neither accommodative nor restrictive for economic growth—from 3.00% to 2.80%. With a current FFR of 2.50%, it appears the Fed is essentially one interest rate hike away from achieving a neutral policy backdrop.
Market participants are pricing in an even shallower path than the recently downgraded forecast by the FOMC, with eurodollar futures prices currently forecasting zero rate hikes in 2019 and growing potential for an interest rate cut by 2020.
The principle risk behind this recent development is a lack of traditional policy tools (aka “ammunition”) to combat anything outside of a soft landing, since a 2.50% FFR leaves limited room to cut rates and the Fed’s balance sheet—which has declined $400 billion from the $4.5 trillion peak in 2015—remains historically large, at $4.1 trillion as of year-end 2018. In addition, the country’s current fiscal position, as proxied by the federal budget balance (deficit) as a percentage of GDP, remains much weaker than at the beginning of past recessionary episodes.
ENERGY PRICE VOLATILITY
Energy price volatility was significant in 2018, with spot prices for West Texas Intermediate (WTI) crude trading in a wide $34 price range. After reaching a localized high of $76.41 in early October—a YTD gain of more than 25%—crude oil spot prices plunged more than $30/barrel from mid-October to year-end, representing an overall YTD decline of 25%. Interestingly, oil prices peaked on October 3, the very day that Fed Chairman Jerome Powell communicated that, despite being “a long way” from neutral at the time, the Fed might ultimately hike interest rates “past neutral.”
Crude oil is not the only energy-related commodity of concern for energy-infrastructure portfolio managers and investors, as a large portion of the constituent universe of the Alerian MLP Index deals in the midstream gathering, processing, and transportation of natural gas.
Natural gas spot prices were also quite volatile in 2018. Prices started the year at $2.95/million Btu, spiked to $4.84 in mid-November, then ended the year near where they began, at $2.94. The suspected culprit for this volatility was unsubstantiated rumors of disorderly unwinds of long-oil, short-natural gas speculative positions.
Overall, record U.S. crude oil production, global slowdown fears, and global supply growth outpacing global demand growth helped drive oil prices lower in 2018. Beginning in September 2018, the world oil market shifted into an over-supplied posture, which was a key headwind to oil prices late in the year.
One should recall, however, that lower oil prices translate to lower gas prices and can boost consumer activity if the job market stays healthy.
CONCERNS IN CREDIT
As is typically the case deep into an economic expansion, U.S. corporations have levered their balance sheets amid generally supportive economic conditions and historically low interest rates. Through the third quarter, aggregate U.S. corporate debt was just shy of $10 trillion, or nearly half the size of the U.S. economy and well above the long-run average of 35%.
As indicated in the graph, corporate debt burdens of this magnitude have historically coincided with recessionary environments.
In addition to elevated debt loads, the relatively inflated size of the BBB-rated corporate bond market compared to the high yield market may point to a sizable share of issuance that has the potential to become “fallen angels”—i.e., bonds previously rated investment-grade that have been downgraded to junk status—should business conditions sour. Historically, the BBB corporate market has averaged 1.5 times the size of the high yield market, with the current 2.7x multiple well above previous peaks.
The high corporate debt levels hovering just above high yield ratings illustrates the potential for meaningful stress in the credit markets during the next downturn may serve as a harbinger to a substantial credit opportunity.
Equity investors—particularly those with a globally diversified mandate—were handsomely rewarded in 2017 with strong returns posted across the board. This positive momentum carried over into January 2018, but quickly stalled by February as rising interest rates and trade war-related worries rippled throughout the markets. Stark performance divergences began to surface in May, with an appreciating U.S. dollar (USD) and an ongoing draining of monetary liquidity by the Fed helping drive returns lower among international equities. From May to October, domestic equity markets appeared to be pulling away from the rest-of-the-world, a phenomenon which dissipated by October.
The fourth quarter presented sizable headwinds to global equity returns, particularly in U.S. markets, bucking the trend that was in place for the majority of the first three quarters of the year. As an example, U.S. small cap equities posted a decline of 20.2% for the Russell 2000 Index during the quarter and underperformed U.S. large cap equity by a large margin for the calendar year. Against a continued robust earnings backdrop, U.S. small cap valuation multiples contracted significantly in 2018 but concluded the year essentially at long-term average levels.
The fundamental backdrop underpinning U.S. large cap companies remained solid in 2018, with strong earnings growth and historically elevated profitability. Net income margins for S&P 500 constituents, for example, concluded 2018 at 10.1%, well above the mid-single-digit historical average.
Earnings expectations were tempered to end the year, and will be worth watching throughout 2019. Wages have shown signs of increasing due to the tight labor market and could pressure margins. With the tax cut boost already incorporated into 2018 earnings, we expect that further earnings growth will rely on a combination of continued health in the economy, a resolution to trade concerns with China, reinvestment of the tax cut benefits into profitable projects.
U.S. Treasury interest rates generally trended higher in 2018, with a particularly strong upward bias in the first four months of the year. By November, the yield on the 10-Year U.S. Treasury note had ascended to 3.24%, the highest yield since May 2011 and more than 80 bps greater than yield levels entering 2018.
Rising interest rates contributed to the volatile market conditions early in the year, sparking declines across interest rate-sensitive sectors, which sparked declines across rate-sensitive sectors such as REITs, utilities, and high-quality bonds.
The narrative began to evolve in November when Fed Chairman Powell stated in a late-November speech at The Economic Club of New York: “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that be neutral for the economy.”
Market movements immediately following the comments signaled a dovish interpretation of the Chairman’s sentiment, which contrasted meaningfully with his comments from October 3 in which he shared that the FOMC: “… may go past neutral. But we’re a long way from neutral at this point, probably.”
Perhaps coincidentally, the timing of this dovish reversal came at the end of the worst monthly performance for U.S. equities and on the tail of harsh criticisms of the Fed’s ongoing rate hikes from President Trump.
However, the risk-on rally—sparked by what seem to be an implied “Powell put” supporting risky assets—was short-lived, as darkening risk-off clouds gathered over the market in December. The safe-haven rally across the fixed income market during the month helped drive the Bloomberg Barclays U.S. Aggregate Bond Index’s 2018 total return into positive territory—by only one basis point. Despite largely negative returns across the equity landscape in 2018, core bonds simply protected capital for investors.
The structure of the U.S. core fixed income market has evolved to provide historically low compensation per unit of assumed interest rate risk, as yields have trended lower over time and the duration of the index has extended from three-and-one-half years in 2009 to six years today. As such, the ratio of yield-to-duration currently stands at 0.6, essentially half the historical average.
Similar to the equity markets, real assets experienced elevated volatility in 2018. REITs were negatively-impacted by the YTD rise in Treasury rates and the related general increase in rate volatility, while commodities and energy infrastructure faced headwinds in the way of an appreciating U.S. dollar, rising interest rates, and a fourth quarter rout in oil prices.
In terms of real estate, the pace of commercial property price appreciation among major U.S. markets slowed to the weakest pace in the post-GFC era last year, with a 3.8% annual growth rate through November.
Positive fundamental data points still remain, however, including modest REIT leverage multiples, a historically tight labor market, and low vacancy rates.
On the residential front, the fundamental backdrop has come under pressure in recent quarters due primarily to rising mortgage rates, which, when combined with elevated home prices, has led to a sharp decline in home affordability. Similarly, home sale growth rates have slowed meaningfully in recent years, while new mortgage application activity remains subdued. Partially counterbalancing the above includes historically low mortgage delinquency and foreclosure rates.
A key theme highlighted in this quarter’s commentary includes performance challenges across most global asset classes and categories. It would be natural to assume that this environment would present a fruitful backdrop for liquid diversifying strategies (DS). However, this dynamic failed to occur; instead, many liquid DS indices generated negative performance in 2018.
Pronounced trend reversal across global equities, energy, and interest rates did not bode well for systematic macro strategies during 2018, while robust deal activity throughout the year failed to support liquid event-driven strategies. It is worth noting, however, that less-liquid DS market performance fared modestly better throughout the year.
As investors entered 2018, an increasingly supportive U.S. fiscal backdrop combined with improving economic conditions provided sound evidence for optimism. These assumed tailwinds were overwhelmed by an alarming number of macroeconomic risks, including heightened geopolitical tensions, trade war disputes, a lack of clarity around Brexit, an ongoing draining of global monetary liquidity, and a late-year pivot by the Federal Reserve.
By the time dust settled at the end of the year, virtually every major (liquid) asset category had fallen victim to the plethora of macro headwinds, despite conditions at the micro level that appeared sound, particularly for U.S.-based companies. With monetary accommodation in the rearview mirror and the long-term efficacy of fiscal stimulus questionable in the face of trade disputes, a third pillar of support in the way of a supportive economic environment failed to impress investors.
Although, we do not see a dire and immediate recession risk, we are watching conditions closely because many measures are worthy of attention. Given continued elevated valuation levels, a fundamental backdrop that appears to favor negative surprises, and a long-in-the-tooth business cycle, FEG recommends positioning portfolios to weather the next potential downturn.
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Published January 2019
The Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class.
The Bloomberg Barclays Capital Aggregate Bond Index is a benchmark index made up of the Barclays Capital Government/Corporate Bond Index, Mortgage‐Backed Securities Index, and Asset‐Backed Securities Index, including securities that are of investment‐grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.
The HFRI Monthly Indices (HFRI) are equally weighted performance indexes, compiled by Hedge Fund Research Inc., and are utilized by numerous hedge fund managers as a benchmark for their own hedge funds. The HFRI are broken down into 37 different categories by strategy, including the HFRI Fund Weighted Composite, which accounts for over 2000 funds listed on the internal HFR Database. The HFRI Fund of Funds Composite Index is an equal weighted, net of fee, index composed of approximately 800 fund of funds which report to HFR. See www.hedgefundresearch.com for more information on index construction.
The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes. The developed market country indexes included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indexes included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey* and United Arab Emirates.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Information on any indices mentioned can be obtained either through your consultant or by written request to firstname.lastname@example.org.