Economic Growth & Inflation
Fiscal stimulus in the United States during the past year helped the near record-long expansion gather steam, with 2018 real GDP growth expected to come in above 3% for the first time since 2005. Household spending, which accounts for roughly 70% of the U.S. economy, benefited from the rising incomes, tax reform and asset--price appreciation (at least until recently). Despite positive momentum overall for the U.S. consumer, housing and auto sectors are beginning to feel the impact of higher interest rates.
Numerous measures of labor market tightness (e.g., more job openings than job seekers for the first time) reached record-setting territory. Job conditions reached the point of generating real wage gains for U.S. workers, tilting the scales towards “Main Street” versus “Wall Street.” The Federal Reserve’s (Fed) favorite inflation gauge – Core Personal Consumption Expenditures (PCE) – moved higher this year, but long-term inflation expectations remain anchored near the 2% level. The steep sell-off in oil prices (down 40% at one point) since October reduces the risk of higher inflation next year.
Global economic growth was disappointing this year, especially in light of upbeat expectations from the outset. Signs of economic and financial market stress arose across numerous developed and emerging market economies. U.S. dollar appreciation, coupled with declining commodity prices, created challenges for emerging market economies, with significant dollar-denominated liabilities taken on since the financial crisis. Escalating trade tensions and new tariffs imposed by the Trump administration pose downside risks to the Chinese economy, which is already struggling with slowing growth and an overheated real estate market.
Italy joined the list of countries with political populism on the rise following May’s election results. Italian bond yields spiked on the news and will continue to be pressured by mounting budget deficits and eventually less support from European Central Bank (ECB) bond purchases next year. Difficult Brexit negotiations and political protests in France have increased uncertainty across the Eurozone as well as downside risk for the European economy and markets.
The Fed under Jerome Powell’s leadership picked up the pace of tightening this year from his predecessor, Janet Yellen. Despite frequent calls from President Trump for moderation, it raised interest rates four times in 2018, double the number from last year. In a significant procedural shift for the Fed, Powell will hold a press conference after all eight FOMC meetings next year. This change raises the possibility of even more hikes should economic growth or inflation surprise to the upside.
The ECB and Bank of Japan joined the Fed in the gradual unwinding of quantitative easing (QE) in the form of sovereign and corporate bond purchase activity. For the first time since QE started in 2008, aggregate global central bank asset holdings are declining. Liquidity conditions remained accommodative for much of the year, but deteriorated alongside declining financial asset prices to finish 2018. With more than seven trillion in global sovereign bonds still trading with negative yields, risks are mounting of a negative financial market reaction to central bank attempts to normalize monetary policy from unprecedented territory.
Interest Rates and Credit
The long-anticipated bond bear market gained traction as the year progressed with long-term Treasury yields breaking above post-crisis highs during October. Record Treasury bond supply and prospects for even tighter Fed policy pressured bond prices. However, the rise in rates quickly reversed course in November as investors sought safety in the midst of the steep decline in equity and commodity prices. Bond bears ultimately were forced to give way to equity bears to close the year.
Yield-curve flattening remained the one consistent trend across the U.S. fixed income markets during 2018. Interest rates across the entire yield curve appeared ready to land at 3%. Both policy-makers and investors focused on the slope of the Treasury yield curve as it flirted with inversion (short-term rates above long-term rates). Inversions historically have been a reliable indicator for economic weakness in the United States and abroad.
Gradual tightening in credit spreads since early 2016 came to an abrupt end alongside the return of equity market volatility in early February. After reaching post-crisis tights in January, the investment-grade (IG) credit spread nearly doubled thereafter. Fears surrounding the growing volume of BBB-rated debt and higher corporate leverage weighed on valuations throughout most of 2018.
Strength across high yield credit outlasted IG debt during 2018. Less interest-rate sensitivity and limited new issuance supported high yield valuations through the first three quarters. Sharply lower oil prices and weaker equities broke the back of high yield markets during the fourth quarter.
Exhibit 1. Bond Market Performance (YTD as of 12/31/2018)
Record-low equity market volatility during 2017 did not last long into 2018. The environment changed in early February just as the new Fed chairman was being sworn into office. Forced (and painful) unwinding of leveraged exchange traded funds (ETFs) fueled the rapid sell-off in stocks with certain ETFs losing nearly all of their value. The ensuing recovery was almost as rapid, with large capitalization technology stocks quickly recovering all of their losses.
Passage of corporate-friendly tax reform, positive economic fundamentals and strong corporate profit growth sustained U.S. equity prices through the first three quarters of the year. Higher earnings kept valuations reasonable even in light of rising interest rates and cash becoming a more competitive investment alternative. Concerns about narrow stock market leadership – large-cap technology names generating the majority of S&P 500 returns – came to be realized in the fourth quarter as FAANG stocks led the overall market lower.
Following solid returns and relative outperformance during 2017, global equity markets (similar to global economic growth) struggled to meet elevated expectations. Nearly all developed and emerging equity markets experienced double-digit declines during 2018. While valuations remain attractive versus U.S. equities, prospects for slowing global growth, escalating trade tensions between the U.S. and China and removal of monetary accommodation weighed on global stock valuations.
Exhibit 2. Equity Market Performance (YTD as of 12/31/2018)
Now that 2018 has come to an end, what can investors expect in 2019? Be sure to check back next week for our 2019 Economic and Market Outlook!
Bloomberg Barclays U.S. Aggregate Bond Index – An index that is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
Bloomberg Barclays U.S. Corp High Yield – An index that measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
S&P 500 Index – An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
MSCI EAFE Index – An index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.
Russell 2000 Index – An index measuring the performance of approximately 2,000 small cap companies in the Russell 3000 Index, which is comprised of 3,000 of the largest U.S. stocks.
MSCI Emerging Markets Index – A free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
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The views expressed in this material are the views of PMAM through the year ending December 31, 2018, and are subject to change based on market and other conditions. This material contains certain views that may be deemed forward-looking statements. The inclusion of projections or forecasts should not be regarded as an indication that PMAM considers the forecasts to be reliable predictors of future events. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate. Actual results may differ significantly.
Past performance is not indicative of future results. The views expressed do not constitute investment advice and should not be construed as a recommendation to purchase or sell securities. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. There is no representation or warranty as to the accuracy of the information and PMAM shall have no liability for decisions based upon such information.