The divergence between financial markets and the US economy continued to widen in December.
Equities sold off and bonds rallied while the broad swath of data suggested a modestly slowing yet still robust US economy.
Unemployment hovered near historically low levels, inflation was tame, manufacturing surveys pointed to continued expansion, housing cooled off from an aggressive pace, and importantly, the full extent of the 2017 tax reform act has yet to be realized. The real litmus test will be upcoming Q4 earnings reports which begin in earnest in a couple of weeks. Consumer confidence will be key going forward given the pullback in equities.
The Unemployment Rate for November held steady at 3.7% as 155k new jobs were created (slightly below estimates for +198k). Average Hourly Earnings ticked up by +0.2% and were up +3.1% YoY, matching estimates.
Initial Jobless Claims ticked marginally higher, averaging 216k in December.
Consumer prices were unchanged in November while producer prices ticked up +0.1%. On an annual basis, CPI rose +2.2% while PPI edged higher by +2.5%. The PCE Deflator rose +0.1% in November and is up only +1.8% YoY.
The Markit US Manufacturing PMI for December came in at 53.9, down slightly from the prior months reading of 55.3, although still suggestive of an expanding US economy. Industrial Production for November edged up +0.6% (beating estimates for +0.3%) while Capacity Utilization came in at 78.5%.
The S&P Corelogic US Home Price Index continued to trend lower, however at +5.5% YoY suggested a still robust demand for housing. Declining interest rates throughout Q4 should help spur demand as we head into the spring selling season. Housing Starts, Building Permits and Existing Home Sales all edged up in November.
The Federal Reserve hiked short term interest rates by .25% in December, however they walked back slightly their rate forecast for 2019. It remains to be seen how changes to historically low short term rates affect the broader economy, but the future pace of tightenings will be critical to further growth in 2019.
U.S. Equities gave back their gains in the fourth quarter, reminding investors how quickly market sentiment can turn. U.S. Large-Caps, as measured by the S&P 500 index, lost -9.03% in December, as volatility surged and selling pressures intensified. Mid- and Small-Caps, as measured by the S&P 400 and 600 indices, were not far behind, losing -11.32% and -12.08%, respectively on the month. Large-Caps suffered their “worst” loss since 2008, with the benchmark S&P 500 index losing -4.39% on the year. Mid- and Small-Caps, underperformed Large-Caps for the year, returning -11.10% and -8.52%, respectively.
Growth sectors which had propelled the market higher over much of the nearly 9-year bull market stumbled the most, with the S&P 500 Citi Growth Index losing -14.71% in the fourth quarter. Their performance contrasts with Value stocks, as measured by the S&P 500 Citi Value Index, which lost -12.05% during the period. For the year, Growth and Value stocks diverged significantly in terms of performance, with Growth stocks largely flat compared to Value stocks’ -8.97% return.
From a sector standpoint, all 11 GICS sectors finished the month in negative territory. Value oriented sectors such as Energy, Financials, and Industrials were the worst performers in December, losing -12.67%, -11.28%, and -10.70%, respectively. December’s best performing sector was Utilities, down -4.02%. Utilities were also the quarter’s best performer, up +1.36% (the only positive sector performer) as defensive sector positioning took hold. For the year, defensive sectors reigned, with Healthcare the top performer up +6.47%, followed by Utilities and Consumer Discretionary, up +4.11% and +0.83%, respectively. Energy remained an underperformer as oil prices plummeted, losing -18.10% on the year. The Energy sector remains the worst performer over the past five years, returning an annualized -5.56%.
Lastly, a closer look at valuations highlights many opportunities for 2019. Bottom up consensus earnings estimates for 2019 currently stand at $171.84, according to Bloomberg. At a recent 2,507 level on the S&P 500,
that means U.S. Large-Cap stocks currently trade at a forward P/E of 14.6x, below its 15-year average of 16x.
Value stocks look cheap as well, along with money center banks, some of which trade below book values.
Midand Small-Cap multiples also look cheap, with forward P/E estimates of 14.2x and 16.5x, respectively.
Current market prices likely already reflect fears of slower earnings growth, and at current prices long-term investors once again have an opportunity to invest in U.S. equities at attractive prices.
International equities outperformed Domestic equities during December’s market rout, despite posting small losses.
Developed International equities, as measured by the MSCI EAFE Index, lost -4.83%, while the more volatile Emerging Markets equities, as measured by the MSCI EM Index, lost -2.81%. International equity returns were notably better than the S&P 500’s -9.03% monthly loss. For the quarter, Developed International equities lost -12.49%, while Emerging Markets equities lost -7.60% – both outperforming the S&P 500’s -13.52% loss. For the year, both segments of the international market underperformed domestic equities, with the MSCI EAFE and MSCI EM indices down -13.32% and -14.49%, respectively.
From a sector standpoint, all 11 GICS sectors finished the month of December in negative territory, with Healthcare the worst performer down -6.70%. For 2018, 10 of 11 sectors finished the year in negative territory, with Utilities the lone positive performer, up +2.43% for the year. In the Eurozone, the MSCI EMU index lost -5.86% in December, and -11.79% for the year (both in EUR terms) as political risks took center stage. Whether it was the yet unresolved Brexit saga, newly launched “yellow vest” protests in France, or the continued Italian budget drama, these political risks largely over shadowed trade issues plaguing the Eurozone with China (consumer) and the U.S (autos). Despite the known country specific risks, the real story of 2019 is the impending end to stimulus by the European Central Bank (ECB) and a potential hard Brexit. A Brexit resolution and an end to negative interest rates could once again attract capital flows to the Eurozone in 2019.
In China, the impact of trade wars was felt more directly, with the Shanghai Composite Index losing -22.74% YTD in CNY terms. Upcoming trade talks between China and the U.S. could pave the way for a reduction or removal of tariffs; however, the key for market sentiment is likely preventing an increase in current rates from 10% to 25%, which would be billed as a worst case scenario. While U.S./China tariffs have largely grabbed headlines, fears of an economic slowdown in China have taken a back seat (playing into the U.S. playbook), despite weakening manufacturing data and increasing levels of corporate debt. Chinese authorities, however, remain keen to these risks, vowing more fiscal stimulus in 2019, along with a likely reserve ratio cut to improve bank liquidity. A coming wave of passive investor cash is also coming to China in 2019, as index provider MSCI seeks to ramp China A share exposure in its benchmarks.
Benchmark inclusion is yet another catalyst that could propel Emerging Markets in 2019 if trade issues are resolved, the U.S. Dollar weakens, or a rotation to international equities gathers steam. International equity valuations remain compelling in our views, with Emerging Markets potentially offering the greatest upside trading at 10.7x forward earnings.
This article was written by the team at Nottingham Advisors, a participant in the ETF Strategist Channel.