As is our custom, we like to look back at economic and market performance before talking about our expectations for the upcoming year. From an economic perspective, 2018 didn’t look all that different than 2017. But it looked entirely different when it came to market performance. Let’s review.
In 2017, we had one small correction of -2.58% of the S&P 500. In 2018, the S&P 500 hit two record highs, each followed by a 10% plus correction, and it finished negative for the year. To say stock market volatility increased in 2018 would be an understatement. Look at the chart below to see the stark difference between the two years. 
In 2017, we had a volatile market day (defined as a price change of 1% or more) 1 of every 31 trading days, or about once every six weeks. In 2018, we had a volatile day 1 of every 4 days! What changed? The level of certainty among investors. Historically, the capital markets hate uncertainty and there were a number of factors that raised doubts over the course of the year:
- U.S. Trade/Tariff issues, especially with China
- The anticipation of slowing global economic growth
- Being closer to the end than the beginning of a U.S. economic expansion
- Political turmoil, here and abroad
- Short-term interest rates in line with long-term interest rates
- Beginning reversal of Central Banks’ accommodative monetary policies
- U.S. Government shutdown over the holidays
I remember presenting to clients last year and stating that 2017 was a rare year where there was low volatility, but high equity returns. I cautioned that we should not get used to such markets, as they are very rare (the last such market was in 1958). The true character of the stock market revealed itself in 2018 and reminded us that investing in stocks is not suitable for those with short investment time horizons.
Comments on Our 2018 Estimates
Our range estimates for 2018 were generally spot-on (see the table below). We projected higher economic growth in the U.S., contained inflation, a lower unemployment rate and higher short and longterm interest rates. We definitely were in the right zip code. We missed a bit on our estimate of the Fed Funds target rate, which is the short-term U.S. interest rate. We believed there would be 1 to 3 0.25% increases. Instead, the Fed increased rates by 25 basis points (0.25%) on 4 separate occasions, resulting in an end-of-year Fed Funds rate of 2.50%. We also were too conservative on our S&P 500 earnings growth rate prediction of a 9-15% increase. The actual number was closer to 23%. Earnings growth was much more robust than we predicted, driven largely by the Tax Cut and Jobs Relief Act of 2017. Absent that, 2018 played out much as we thought it would.
Generally, when you have a positive economic backdrop and robust earnings growth, you would reasonably expect to see positive returns for the U.S. equity markets. The U.S. economic situation was similar to the Goldilocks story – not too hot and not too cold. Instead of thriving, however, the U.S. equity markets posted negative returns and showed a large degree of instability throughout the year. We did correctly anticipate higher volatility and at least one 10% plus correction in 2018. What we did not anticipate was how much higher volatility would be, nor that there would be two 10% plus corrections.
Looking to 2019
We are now 114 months into this economic expansion that began in July 2009. If the current expansion continues through July of 2019, it will be the longest expansion in U.S. history. Generally, equity market volatility increases near the end of a business expansion, as investors anticipate the possibility of a slowdown, or even a recession. But expansions do not die of age, they die for cause. The ordinary causes are high interest rates, high inflation, over-leveraged U.S. companies and individuals, and/or an overheating economy. None of these are current in evidence. In 2017, the U.S. economy grew at 2.2%. In 2018, it accelerated to 2.9%, a 32% increase. We do not anticipate a recession in 2019, or at least believe it to be a low-probability event. We do, however, expect a slowing of economic growth, both here in the U.S. and abroad. In fact, outside of the U.S., economic growth is already slowing. Inside the U.S., some of the positive effects of decreased regulation and tax cuts appear to be waning. But slowing economic growth does not mean recession. The average annual economic growth rate in this current business expansion has been about 2%. We expect growth to be between 2.0 – 2.5% for 2019.
The unemployment rate is tricky to predict. Why is this? If an economy improves, it incentivizes those out of work to begin actively looking for work. If that happens, the rate will actually increase for a short time as workers are assimilated back into the work force. This is counterintuitive, as we generally equate a strong economy with lower unemployment. Having said that, we believe that the unemployment rate will stay low or go even lower. The U.S. job market is so promising right now that over 400,000 unemployed workers returned to the U.S. labor workforce this last December. Why is this important? U.S. economic growth is primarily driven by consumer spending. The more workers who are earning wages, the more consumer spending increases. And the more consumer spending increases, the more U.S. economic growth increases. And thus our robust job market creates a virtuous circle that is likely to result in continued U.S. economic growth.
We have had very low inflation over the last decade. In 2018, we finally saw the inflation rate show a healthy move over 2%. The Federal Reserve (the Central Bank of the U.S.) targets a stable 2% inflation rate through the use of its monetary policy. A long business expansion like we have seen in the U.S. typically results in a strongly rising inflation rate, driven by scarce (and higher priced) commodities and higher wages from a tight labor market. This has not happened. A slowing Chinese economy and technological advancements in oil and natural gas extraction have softened commodity prices across the globe. Also, higher U.S. wages stemming from the tight U.S. labor markets have not found their way into the overall inflation rate. Many economists point to higher “hidden” productivity due to technology advancements as the reason for this mysterious result. Add to this equation a slowing economic growth scenario for the U.S. and overseas economies and you can see why we anticipate lower inflation in 2019.
The Federal Reserve has a great degree of control in setting U.S. short-term interest rates, but that’s not the case with long-term interest rates. Long-term interest rates are primarily controlled by buying and selling in the capital markets.
We anticipate that the Fed will increase short-term interest rates one to two times in 2019 by a quarter point (0.25%), resulting in a Fed Funds rate of 2.75 to 3.00% by the end of the year. We definitely do not anticipate the four, quarter point (0.25%) pace that we have had over the past two years. In fact, there is a possibility that the Fed may not increase the target rate at all this year. We believe that Chairman Jerome Powell has recognized the need to potentially take a pause in interest rate hikes due to the softening of economic growth projections, softening inflation, as well as the large market decline in late 2018. On January 4th, Powell stated that the Fed is willing to be “patient.” He noted that to keep the US economic expansion on track, “there is no preset path for policy.” Powell brought up the example of 2016 when the Fed expected to raise rates four times. If inflation recedes as we predict, Chairman Powell will feel even less of a need to raise short-term interest rates.
Ten-year U.S. Treasury notes ended 2018 at 2.69%, which was 0.25% higher than at the end of 2017. We truly do not have a great feel for where this rate will go in 2019. If there is more market volatility and a flight to safety, this yield could go down. If the markets settle in and economic prospects look brighter, this rate could go up. Our prediction of this rate is between 2.5% and 3.5%. Obviously, our range of outcomes highlights our uncertainty over long-term U.S. interest rates.
We do anticipate, however, that short-term interest rates will stay lower than or near the same level of the ten-year U.S. Treasury rate during 2019.
Last year we believed that positive economic fundamentals and robust corporate earnings would be supportive of U.S. and international equity returns in 2018. This was not the case, due to the many market concerns previously listed. Developed international stocks were down 14.09%. Emerging market stocks were down 14.58%. U.S. stocks were down 4.38%. We believed that stock market volatility would return and we would have one 10% plus correction. That did come to pass. Historically, on average, the U.S. stock market suffers a 10% correction every 18 months. We had two last year.
We anticipate that growth in U.S. corporate earnings will slow in 2019, but remain positive. This is primarily driven by the slowing of economic growth across the globe. The S&P 500 is currently trading around fifteen times (15x) its projected 1-year forward earnings estimate. The 25-year average forward price-to-earnings ratio (P/E ratio) of the S&P 500 is 16.1. Based on that measurement, U.S. stocks are slightly undervalued judging by historical averages.
Current valuations, a positive economic outlook, and anticipated positive corporate earnings growth could provide a tailwind for stock returns in 2019. Of course, there can never be any guarantees of this and wholly unexpected events that influence the markets can occur at any time. The surest bet is probably that volatility will continue to be present in 2019, as the current economic expansion continues to age and very likely becomes the longest in U.S. history.
Our cautious predictions for 2019 are subject to the following risks, which we are closely monitoring:
- Trade War with China – The current Presidential administration started a tariff/trade war with major trading partners in late January/early February of 2018. This caused a lot of market volatility throughout the year. Since then, the U.S. has negotiated positive settlements with the European Union, Canada, and Mexico. China and the U.S. are in negotiations to settle the current trade spat. If these negotiations implode and a full trade war begins, global capital markets could become very turbulent. On the other hand, if there is a successful resolution to the trade issues, global capital markets could respond quite positively.
- Higher Short-Term Interest Rates – If the Federal Reserve raises its target short-term interest rate too quickly or too high (relative to investor and market expectations), the current business expansion could slow down and potentially turn into a recession.
- Problems with the European Union – There are threats to the unity of the European Union (“EU”). Currently, there are worker protests in Paris against French President Macron’s fiscal policies related to taxation and immigration. This is causing political instability. His poll support is at all-time lows near 20-25%, depending on which polls you look at. The United Kingdom is reaching the end game for its exit from the UE (affectionately named “Brexit”). What form will it take? A negotiated exit or a hard, no-deal exit at the end of March? In addition, Italy’s back and forth negotiations with the EU on the size of its fiscal budget deficit may be laying the groundwork for a protracted fight with Brussels, which could further pressure Italian bonds. All of these items separately or in the aggregate could negatively affect assets sensitive to European political risks when economic growth is slowing down in the Eurozone.
- BBB Corporate Bonds – The rising risk in the U.S. corporate bond market (defined as bonds issued by U.S. corporations and not government entities) resides in the BBB rating category, which contains the lowest rated investment grade bonds. A BBB rating indicates that the issuing company has adequate capacity to meet its financial commitments, but that adverse economic conditions or changing circumstances may weaken its capacity to meet its financial commitments. This means that a company has sufficient resources to make principal and interest payments on its debt, but if the economy weakens or there are negative market events, they may not be able to meet their financial commitments.
What does this mean to you?
First Command continuously assesses economic and market conditions. Currently, they look positive for 2019. However, we had the same economic backdrop in 2018 and that did not convert into positive equity returns for the year. The stock volatility, unfortunately, will most likely carry into 2019. We passionately believe, however, that a well-designed, globally diversified portfolio, that is in complete alignment with your financial plan, investment time horizon, and risk tolerance is the best approach to help you pursue your financial goals. Please consult your First Command Financial Advisor with regard to any comments, questions, or concerns you may have.
Thanks for taking a look!
- International Monetary Fund (IMF), Morningstar (2019), and Bloomberg (2019).
- As measured by the 10 year U.S. Treasury note.
- From March 1 through April 13. Morningstar (2019).
- From September 21 through December 24, 2018, the S&P 500 Index return was -19.36%, just shy of the “technical” definition of a bear market correction of 20%.
- Bloomberg (2019).
- Bloomberg (2019) and First Command Investment Management Team. Estimates are as of 1/2/2019. Forecasts are not guaranteed and are subject to change. Past performance is no guarantee of future results.
- The longest economic expansion on record was from March 1991 – March 2001, lasting 10 years or 120 months. National Bureau of Economic Research (www.nber.org) (2019).
- Bureau of Labor Statistics – U.S. Department of Labor (www.bls.gov) (January 4, 2019).
- U.S. consumers account for around 70% of U.S. economic growth.
- Average Hourly Earnings or AHE increased by 3.2% in 2018. Bureau of Labor Statistics – U.S. Department of Labor (www.bls.gov) (January 4, 2019).
- The U.S. government attempts to predict productivity gains but their methodology is fraught with many assumptions. There are many economists who believe that the U.S. government’s productivity estimates are lower than reality would indicate. A “true” higher productivity number would have the effect of keeping higher wage inflation from impacting the overall inflation rate.
- Morning Briefing, Yardeni Research, Inc. (January 7, 2019).
- MSCI World ex USA Index (net returns in U.S. dollars), Morningstar (2019).
- MSCI Emerging Market Index (net returns in U.S. dollars), Morningstar (2019).
- S&P 500 Index (total returns), Morningstar (2019).
- This is called a P/E ratio or Price of the Index over Earnings. This is a short-hand valuation ratio that can give you a quick picture of whether a stock market is currently over- or under-valued.
The information in this report was prepared by John Weitzer, Chief Investment Officer of First Command. Opinions represent First Command’s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. First Command does not undertake to advise you of any change in its opinions or the information contained in this report. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Should you require investment advice, please consult with your financial advisor. Risk is inherent in the market. Past performance does not guarantee future results. Your investment may be worth more or less than its original cost. Your investment returns will be affected by investment expenses, fees, taxes and other costs.