Michelle Cluver2018 started with market exuberance and ended in fear. The market shrugged off more than a few potential risks during the 2nd and 3rd quarters while dwelling on every adverse sentiment in Q4. Among others, it looked past the U.S.’ self-imposed trade war with China, tariffs, Federal Reserve (Fed) tightening, and Brexit uncertainty.
Then the risks became real. Increased trade war uncertainty gave the market fits in the second half, as did tariffs beginning to pressure corporate earnings, another hike from the Fed, and the lack of progress in negotiations between the UK and EU.
By the end of Q4, weakening macroeconomic data and declining oil prices conspired to reduce earnings expectations amid too many geopolitical issues to count. It was quite the turn, as 2018 started with a shift away from synchronized global growth to optimism about U.S.-focused growth. Lower corporate taxes from the Tax Cut and Jobs Act helped boost earnings and entice share buybacks, but at the expense of what was supposed to be a new era of capital expenditure.
Risk-off sentiment crept up steadily throughout Q4. Concerns about yields and monetary policy grew and played a significant role in equity market struggles. Not even a post-Christmas Santa rally helped; U.S. equities had their weakest December since 1931 and the S&P 500 notched its worst quarter since Q4 2008. Fixed income had a better go of it as the flattening yield curve boosted long-duration Treasuries, which is typical of a risk-off environment.
Below, we break down the market’s performance in Q4 and fiscal year 2018.
Equity indexes: Gains reverse
Along with everything else, lower oil prices got U.S. and global indexes off on the wrong foot in Q4. Thereafter, excess supply and expectations for dampened global demand proved to be stiff headwinds. A total return of -13.5% erased the S&P 500’s solid returns from the first nine months of the year and brought its total fiscal year 2018 return to -4.4%.
Abroad, the MSCI World ex USA NR USD Index returned -12.8% in Q4 to take its 2018 total to -14.1%. The MSCI Emerging Markets (EM) NR USD Index outperformed developed markets with a return of -7.5% during the quarter, which took its 2018 return to -14.6%.
Small cap stocks were adversely impacted by the sharp decline in oil prices putting pressure on credit markets and raising concerns about their exposure to rising interest rates. The Russell 2000 Index entered bear market territory, declining 20.2% during the quarter. The Russell 1000 Index returned -13.8%.
Growth stocks were hit hard in Q4 after leading value during the first nine months of the year. The Russell 1000 Value Index (-11.7%) led, followed by the Russell 1000 Growth Index (-15.9%), the Russell 2000 Value Index (-18.7%), and the Russell 2000 Growth Index (-21.7%).
For the year, large-cap growth held onto its lead with the Russell 1000 Growth Index (-1.5%) the top-performer, followed by the Russell 1000 Value Index (-8.3%), the Russell 2000 Growth Index (-9.3%) and the Russell 2000 Value index (-12.9%).
U.S. sectors: Volatility returns
Volatility’s reemergence in Q4 drove a shift to quality. Momentum and growth provided positive investment themes in 2017 and through the first nine months of 2018, but they ran out of steam as fear gripped investors.
Street’s “fear gauge,” the Cboe Volatility Index (VIX Index), reached an all-time low of 9.14 in November 2017 but shot up in 2018. It averaged 16.6 for the year, including 21.1 in Q4. The increased volatility resulted in negative total returns for every GICS sector except one in Q4. For the year, just three of the 11 GICS sectors had positive returns.
Within the S&P 500 Index, the Utilities (+1.4%), Real Estate (-3.8%), and Consumer Staples (-5.2%) sectors performed the best in Q4, i.e., the three sectors widely viewed as defensive with reasonably stable cash flows and good dividend yields.
The decline in the 10-year Treasury yield was beneficial for these bond proxy sectors, particularly Utilities, which often outperforms during periods of elevated volatility. Consumer Staples benefited from strong performance among the household products and beverages industry groups, though changing consumer preferences continued to weigh on the tobacco industry.
Energy (-23.8%), Industrials (-17.3%), Information Technology (-17.3%), and Consumer Discretionary (-16.4%) were the weakest sectors in Q4.
Concerns regarding excess supply and expectations of reduced global demand resulted in an almost 40% decline in West Texas Intermediate (WTI) crude prices. On the supply side, the Organization of the Petroleum Exporting Countries (OPEC) and especially Saudi, had been ramping up their crude production during 2018. In December OPEC agreed to reduce production by around 1.2 million barrels per day starting in 2019. However, the increase in U.S. crude supply is expected to remove most of OPEC’s reduction. On the demand side, global growth concerns dampened the outlook for energy markets.
Global growth concerns detracted from the Industrials and Information Technology (Tech) sectors as well. Industrials are highly sensitive to global GDP growth, given that it drives demand for their products. Tech is less sensitive to global GDP growth but more sensitive to market sentiment turning away from the growth factor. Recent data breaches also have large firms in Tech and Communication Services under increased regulatory scrutiny. The EU’s General Data Protection Regulation (GDPR) digital tax starting in 2019 is now a consideration as well.
Consumer Discretionary is a highly cyclical sector that depends on consumer spending. Currently, the consumer is still in a good position; however, there is growing concern that the rate of Fed interest rate increases could adversely affect the economy.
For the year, Health Care (+6.5%), Utilities (+4.1%), Consumer Discretionary (+0.8%), and Information Technology (-0.3%) performed the best. Energy (-18.1%), Materials (-14.7%), Industrials (-13.3%) and Financials (-13.0%) were the weakest sectors.
Fixed Income: Risk off
Fixed income had a robust Q4, relative to equities anyway. The Bloomberg Barclays U.S. Aggregate Bond Index returned +1.6% and took its 2018 return to 0.0%. Long duration yields fell as investors purchased long-term U.S. Treasuries in response to renewed market turmoil. This helped make long duration U.S. Treasuries one of the top performing fixed income segments while raising fears of a potential yield curve inversion.
The spread between the 10-year and 2-year U.S. Treasury yield, a common yield curve measure, continued its downward trajectory after spiking in February. It started the year at 0.51%, ended Q1 at 0.47%, retreated to 0.33% at the end of Q2, declined to 0.24% at the end of Q3, and closed Q4 at 0.21%. The 10-year Treasury yield rallied above the important psychological 3% level in September, only to end the year at 2.69%.
Risk-off sentiment increased the Corporate spread relative to Treasuries, which dampened performance. The yield spread between Investment Grade Corporate bonds and the 10-year Treasury, as measured by the U.S. Corporate BBB/Baa 10-year Treasury Index, started the year at 1.28%, ended Q2 at 1.64%, ended Q3 at 1.47%, and then peaked at 1.86% at the end of Q4.
High Yield Corporate bonds comprised one of the weakest areas of fixed income due to their high exposure to the Energy sector and sensitivity to equity market volatility. High yield credit default swap spreads increased to their highest level since the Energy crisis of 2015/2016. The Markit CDX North America High Yield Index increased from 331.01 basis points (bps) at the end of Q3 to 449.15 bps by the end of Q4.
Conclusion
Geopolitical risks increased during 2018 and are expected to remain elevated in 2019. Please refer to our 2019 Market Outlook piece for more detail on our current views on the market.