What Correction?

With the S&P 500 suffering its worst December since 1931, and the equity market falling by nearly 20% at one point during the month, suffice it to say that 2018 ended with a thud rather than a bang. However, just as we saw a snap-back from the drawdown in early 2018 (for different reasons), the market once again exhibited a far more “risk-on” mood in January, paving the way for double-digit equity gains as well as robust returns across high yield, bank loans, and a variety of other “plus” sectors within fixed income.

So what changed? Not a whole lot. In hindsight, poor liquidity late in the fourth quarter exacerbated the sentiment-driven sell-off in risk markets (high yield and leveraged loans in particular) while unexpectedly dovish comments from the Fed in the early part of the year acted as a catalyst for a swift reversal.

While there is some evidence of softening conditions in the U.S., data do not suggest that a recession is imminent:

  • Corporate fundamentals remain solid, and while after-tax profits moderated in the fourth quarter, EPS was up 14% on a year-over-year (y-o-y) basis.
  • Likewise, unemployment remains low at 3.8%, and wages are rising as average hourly earnings surprised on the upside with a 4% increase over the past 12 months (February), the fastest in a decade.
  • Fourth quarter GDP was revised down to 2.2%, but while “sluggish” may be an apt term, this pace is not of recessionary ilk (full year GDP was 2.9%).
  • Manufacturing showed signs of slowing, with the most recent Purchasing Managers’ Index (as of March) indicating that the U.S. remains in expansionary territory (above 50) with the latest reading at 54.2.
  • Consumer spending softened during the fourth quarter and first two months of the year, but the consumer remains in good shape with household debt service as a percentage of disposable income at the lowest level since at least 1980, when the data was first collected.
  • And inflation remains benign, with the Consumer Price Index (CPI) up 1.5% in February (y-o-y), notably lower than the 2.5% read from just a few months ago as falling energy prices (Energy CPI: -5.1% y-o-y) weighed heavily on the headline number. The Core CPI measure (excluding food and energy) was up 2.1% while the Fed’s preferred inflation gauge, the PCE Deflator, rose 1.8% over the trailing year.

In March, the Fed’s pause was expected, but its dovish language was not, leading to a dizzying plummet in U.S. Treasury yields. The Fed voted unanimously to leave rates unchanged at 2.25%-2.50% and further indicated that no hikes were likely for the remainder of the year, while lowering expectations for 2019 GDP from 2.3% to 2.1%. Finally, balance sheet “normalization” (maintaining the size of the balance sheet by reinvesting proceeds from maturities) was escalated to September 2019, sooner than expected. The yield curve is flirting with inverted status, but as of quarter-end the widely watched spread between the 2-year and 10-year Treasury was +14 basis points. An inversion has been an accurate harbinger of recession, albeit up to 20 months out. In a stark reversal from the fourth quarter, Fed fund futures revealed a 65% probability of a fed cut in 2019.

The picture is more worrisome overseas. With ambiguities regarding Brexit, recession in Italy in the fourth quarter, and surprisingly weak manufacturing numbers (PMI 44.7) out of Germany, the ECB lowered its projections for euro zone GDP growth from 1.7% to 1.1%. It also indicated it would leave rates on hold at least through the end of the year. Further, in early March the ECB announced a new bank lending program to support growth. Euro zone GDP grew 1.1% in the fourth quarter (+1.6% y-o-y), and the OECD estimates growth of just 1% for 2019, down from 1.8%. In Germany, the yield on the 10-year government bond turned negative for the first time since late 2016 and closed the quarter at -0.07%.

China was also a worry—it lowered its growth target to 6.0%-6.5%, and the profits of industrial companies fell 14% in the first two months of 2019 versus one year ago, the worst since the Global Financial Crisis. (Spoiler: On April 1 China released its version of the PMI, beating expectations and hitting the highest level in eight months, thus tempering worries over a dramatic slowdown.)

Closing Thoughts

With such a torrid start to the year for broad asset classes following an almost equally disappointing end to 2018, it will be very interesting to observe how investors react to the next series of potential market events. More periodic bouts of volatility seem almost inevitable, global growth concerns (particularly in Europe) are not going away, and of course there’s the plodding and still undetermined outcome on a final Brexit deal. Thus, just as we have stated in the past, adherence to an appropriate and well-defined asset allocation remains the best course of action to manage the path to successful attainment of long-term investment goals.

© 2019 Callan LLC

Post Written by: David Welsch, CFA – Callan


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