The Economy and the Markets | Fourth quarter 2018

Negative news overseas and the prospect of slower growth at home sparked market volatility. Cracks in global economic momentum spooked the markets in December, sending the Standard & Poor’s 500 Index down almost 14 percent in the quarter — finishing with a 4.4 percent loss for the year, its first down year since 2008. A partial government shutdown added more uncertainty.

While the economy is slowing, its foundation remains strong. Unemployment remains near record lows. More than 312,000 jobs were added in December, the most since February 2018.1 The U.S. Department of Labor reported nearly 7 million jobs were going unfilled.1 The unemployment rate rose to 3.9 percent, as the robust jobs market pulled more people into the workforce.

Employers are paying more to attract workers. According to the Bureau of Labor Statistics, average annual hourly compensation increased by 2.9 percent in the third quarter.2 Better pay and greater job security kept consumer confidence and spending high. Holiday sales appeared on track to exceed expectations.

Small businesses and manufacturers are also feeling good, based on sentiment surveys — though confidence has taken a hit in recent weeks. Corporate earnings dropped off from earlier in the year, but remained solid. Analysts expect strong earnings growth in 2019.

There are many positives about the U.S. economy. So why do the markets see a glass that’s half empty?

Uncertainty arises across the globe

Markets dislike uncertainty. And uncertainty about economies outside the United States has surged, with global growth slowing faster than expected.

Geopolitical risk has popped up everywhere. The United Kingdom’s Brexit process has been chaotic, raising the specter of economic disruption. Political upheaval has arisen   in France, and some indicators point to a potential economic contraction there. Growth of the German economy has slowed. Italy and the European Commission sparred over the country’s budget deficit. The European Central Bank in December ended its bond- buying program, removing an important source of stimulus in the eurozone.3

China added more uncertainty, with the world’s second-largest economy showing slower industrial production and lower retail sales. A slowdown in the Chinese economy is bad news for the economies of its many trading partners, including the United States

These global economic issues have led investors to question whether the U.S. economy can continue to grow in the face of worldwide headwinds, and those doubts stirred volatility.

2018 Market volatility

The Chicago Board Options Exchange Volatility (CBOE VIX) Index shows the market’s implied 30-day volatility based on a wide range of S&P 500® Index options.

Source: Bloomberg

From hawk to dove?

While the Fed’s approach to raising rates created concern in 2018, it may be shifting its stance. In December, the Fed appeared to adopt a more dovish view as higher market volatility contributed to tighter financial conditions. Chairman Jerome Powell announced rates were close to neutral, neither stimulating nor slowing the economy.

At its December meeting, the Fed projected two increases in 2019 (down from the four it made in 2018). Market participants now think the Fed may not raise rates at all in 2019, and markets are currently pricing no expected rate hikes this year.

The Fed has two mandates: keep employment high and inflation low. For now, it’s winning on both fronts. The question is whether the Fed’s focus on keeping inflation low risks pushing the U.S. economy into a recession. Uncertainty about the economy’s direction means the Fed will depend heavily on economic data in future decisions.

The 10-year Treasury rallied from its high in early November back to levels last seen in early February 2018

Yield curve flashes yellow

The interest rate yield curve also reflects rising concern over future economic growth, with the gap between long- and short-term interest rates flattening.

Many analysts view an inverted yield curve, in which long-term rates fall below short-term rates, as a predictor of a future recession — and in the fourth quarter, the curve between one- and seven-year Treasuries inverted. The Fed’s research shows an inversion of the three-month and 10-year Treasuries has been the best recession predictor, and right now the 10-year yield remains higher than the three-month. Inverted curves are imprecise in predicting when a recession may take place, occurring as much as one to two years before a downturn.

Credit markets had a very tough quarter. As gauged by the Bloomberg Barclays U.S. Corporate High Yield Index, high yield bonds produced a negative total return of over 4.5 percent during the quarter, finishing the year down 2 percent; additionally looking at the Bloomberg Barclays U.S. Corporate Bond Index investment grade bonds produced   a negative excess return of over 3 percent for both the fourth quarter and the year. Treasuries became a safe haven in the fourth quarter, as the Bloomberg Barclays U.S. Treasury Index returned over 2.5 percent. Investors are nervous enough to make quality their to priority.

Inflation expectations have plunged, with the TIPS (Treasury Inflation-Protected Securities) rate falling to 1.76 percent (as of January 4, 2019), well below the Fed’s 2 percent inflation target rate.

U.S. Treasury Yield Curve

Strong, but not smooth

We believe the economy, in spite of the obstacles it faces, will continue to expand through 2019. The ingredients for a slowdown exist, but we don’t think the conditions for a recession are in place. Employment is too robust and consumer spending too strong for an economic contraction to be likely in the next several quarters.

Still, the “r word” is on many minds. Duke University recently found that 50 percent of Chief Financial Officers expect a recession by the end of 2019.4 The negative news about trade doesn’t improve the mood, even though trade actions to date have not had a major negative economic impact. Expectations of recession, continued worries about trade, and tighter credit could prompt companies and consumers to pull back, creating the downturn they feared.

We believe the economy will enter 2019 with enough questions marks and potential potholes to make the year ahead anything but smooth. The markets are clearly rattled. We expect the economy to make progress, but we believe the road ahead will likely be quite bumpy. Investors may want to buckle up.