Volatility Returns with a Vengeance
Financial markets tested investor resolve as volatility began surging in the final quarter of 2018. Nearly steady gains through the first three quarters of the year produced a 9% rise for the S&P 500. Then volatility returned with a vengeance, driving the market down 14% in the final quarter and resulting in a 6% loss for the year. From the peak in late September to the trough in late December, the broad market index fell 20%, earning the “bear market” designation. We believe the market overreacted as investors violently priced in an unlikely near-term recession and losses snowballed with year-end tax loss selling. It’s a new year and the market is currently in the process of repairing that damage. Consequently, the S&P 500 rebounded 11% during January and February, and has gained over 18% from the irrational low in late December.
The primary concern among investors is that slowing global growth could lead to a domestic recession. Economic weakness in China and Europe, uncertainty regarding tariffs and trade wars, rising interest rates, the government shutdown and Brexit have all combined to rattle investors and constrain growth in the U.S. Of note, the current economic expansion is nearly ten years old and is the second longest on record. Growth, while choppy at times, has averaged 2% over this period. Fueled by the 2017 tax cut, real GDP growth accelerated in 2018. The rate of increase peaked last year in the second quarter at 4.2%, moderated to 2.6% in the fourth quarter and grew 3.1% for 2018 as a whole. For 2019, we anticipate that GDP growth will begin the year slowly, but ultimately increase in line with the 2% average for this cycle.
While the probability of an impending recession is low, in the fourth quarter many stocks still declined to near recession-level valuations. With the employment outlook, consumers, and businesses all strong, we see few signs of a recession. By and large, recent economic reports are solid. Even those series which have weakened slightly still point to economic growth. The unemployment rate continues to decline, reaching 3.8% in February. 2018 holiday sales showed the largest percentage gain in years. Consumer confidence remains high and is rebounding post the government shut down–a positive indication since consumer spending accounts for two-thirds of our economy. Business spending continues to grow. In short, this is not the type of environment which leads to an imminent recession.
Importantly, steps are underway to promote economic expansion. With a steadfast focus on returning interest rates to more normal levels, the Federal Reserve raised rates four times in 2018. The most recent quarter-point hike occurred in December even as stock prices were plunging. With a profoundly negative market reaction and low levels of inflation, the Federal Reserve chairman Jerome Powell quickly changed his message, stating that the Fed is closer to its desired target than he had previously indicated, and that additional rate hikes are on hold. This new direction has calmed investors and added considerable support to the market. Further interest rate increases will be deferred until after markets have stabilized. It is even possible that the next move by the Fed could be a rate cut if conditions warrant such action.
Macroeconomic trends in China, the world’s second largest economy, continue to deteriorate. Chinese GDP growth has slowed to its weakest level since early 2009. Manufacturing activity is contracting, retail sales growth has slumped to its lowest level since 2003 and auto sales are shrinking. To combat this the government recently implemented new fiscal and monetary stimulus, including cutting taxes, increasing infrastructure spending and reducing bank reserve requirements. Even more impactful, we believe, would be resolution of the tariff war with the U.S. Both sides stand to gain when that occurs, as exports account for 19% of China’s GDP and 8% of the U.S. economy. China, which clearly has more at stake, has already made concessions. Discussions between the countries appear to be progressing, and we are hopeful that an agreement can be reached sooner rather than later.
Despite these challenges, U.S. corporate earnings continue to grow rapidly, helped in part by lower tax rates. For the first nine month of 2018 earnings grew by over 25%. Fourth quarter earnings growth was in the mid-teens. Following last year’s strong gains and in the face of slowing economic growth, we expect 2019 earnings will increase at a more modest and normal pace. Historically, the 2% GDP growth we anticipate has translated to an 8% increase in earnings. This is both in line with analyst estimates and a level which we believe is achievable.
With stock prices down and earnings up over the past year, valuations have become attractive again. The market entered 2018 with a forward price to earnings ratio (P/E) of 18.4 times and exited the year below 15 times, a discount to long-term averages. February’s month-end P/E ratio of 16.6 times is still very compelling considering the low level of interest rates and accommodative Fed policy, both of which make future earnings more valuable today and stocks more attractive relative to other investment options.
For 2019, our economy is well positioned to continue expanding, albeit at a slightly slower pace with corporate earnings growth in the range of 5-10%. Much of what was troubling investors late last year has abated. Already, the Fed has shifted its position about the level of interest rates. The government shutdown is behind us and work seems to be advancing on the tariff and trade situation. The market is still attractively valued, despite the strong rebound from year-end panic selling. Additionally, history is on our side as there have only been four instances of back-to-back market declines since 1928. As the issues overhanging the market are resolved, higher earnings combined with increased valuations on those earnings may result in stock market returns exceeding expectations. In conclusion, despite a challenging final quarter of 2018, there are numerous reasons to maintain a positive outlook for the stock market in 2019.
Holger Berndt, CFA Director of Research