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Market Update for the Quarter Ending December 31, 2018

Terrible December caps off tough year for markets

Unfortunately, investors who were holding out hope for a year-end rally were disappointed. Among U.S. markets, the Nasdaq Composite saw losses of 9.40 percent for the month and 17.29 percent for the quarter. For the year, the Nasdaq was down 2.84 percent. The Dow Jones Industrial Average lost 8.59 percent for the month and 11.31 percent for the quarter, contributing to a loss of 3.48 percent for the year. The S&P 500 declined by 9.03 percent in December. This led to a drop of 13.52 percent for the quarter and 4.38 percent for the year.


December’s selloff resulted from concerns over the government shutdown. All three U.S. indices remained below their 200-day moving averages. As such, investors’ outlook on U.S. equities may be turning more negative.


Still, fundamental earnings growth continues to be supportive for equities. The estimated earnings growth rate for the S&P 500 in the fourth quarter is 12.4 percent. From a valuation perspective, the S&P 500 forward 12-month price-to-earnings ratio is now below its 5- and 10-year moving averages, indicating that the index is relatively inexpensive compared with the recent past.


Concerns surrounding slowing growth in China and the Brexit negotiations hit international markets. The MSCI EAFE Index declined by 4.85 percent for the month, 12.54 percent for the quarter, and 13.79 percent for the year. The MSCI Emerging Markets Index saw losses of 2.60 percent, 7.40 percent, and 14.25 percent over the same time periods. Both indices remained below their 200-day moving averages.


Fixed income had a better end to 2018. The Bloomberg Barclays U.S. Aggregate Bond Index gained 1.84 percent in December and 1.64 percent in the fourth quarter. But the large decline in yields at year-end was barely enough to offset earlier volatility. In fact, the index eked out a gain of only 0.01 percent for the year. The Federal Reserve (Fed) raised rates three times in 2018, as the unemployment rate remains at multidecade lows and inflation measures are above the Fed’s target range.


High-yield fixed income saw a loss of 2.14 percent in December, leading to a quarterly loss of 4.53 percent and an annual loss of 2.08 percent. High-yield spreads increased in December, as investors reevaluated the risk-and-reward potential for the asset class.


Economic growth continues

Despite the past few months of market volatility, the economy remains solid. The U.S. consumer continues to make and spend more money. High levels of consumer confidence showed that shoppers were willing to spend. We have seen solid growth in retail sales for the past two months. Personal income and wage growth in November were also healthy.


Business owners also remain confident in the economy. The manufacturing and nonmanufacturing sentiment surveys increased in November. The Institute for Supply Management Composite Index shows confidence near postrecession highs (see Figure 1).


Figure 1. Institute for Supply Management Composite Index, 2007–2018


November’s durable goods orders, considered a proxy for business investment, rose by 0.8 percent on increased aircraft orders. Industrial production also increased in November. Here, though, cold weather effects likely made this growth figure look better than it actually was.


Housing slowdown continues

Unfortunately, this good news didn’t carry over into one of the other major sectors of the economy: housing. Home builder sentiment, which collapsed in November, continued to drop. Pending home sales fell by 0.7 percent. But housing starts actually rose, against an expected decline.


An unexpected increase in existing home sales may indicate a moderating slowdown. Further, slowing sales have led to more inventory, which could lead to lower prices and increased activity. Lower mortgage rates will also help.


Government shutdown highlights political risks

December started with a spat between the Fed and the White House over rising interest rates. It ended with a confrontation between Congress and the White House, resulting in the government shutdown. Both led to increased market volatility.


Historically, the impact of a short-term shutdown on economic growth has been minimal. There is even some potential upside. If congressional leaders and the president can find a compromise, it would likely help markets recover.


There were also political risks outside the U.S. The trade war with China rumbled on, raising fears of an economic slowdown there. Plus, the British political debacle around Brexit rattled European markets.


Markets are now pricing in terrible outcomes. But positive events, including a resumption of trade talks between the U.S. and China and more clarity on Brexit, could lead to a market rally.


Risks remain, but U.S. outlook remains strong

The U.S. economy continues to expand at a healthy pace, driven by confident consumers and business owners spending more. Corporate fundamentals also remain strong. Although the effects of tax reform may moderate, deregulation should help support these results.


Political risks are likely to continue to drive volatility in 2019, however. As such, a well-diversified portfolio matched with an investor’s time horizon remains the best path to meet financial goals.


All information according to Bloomberg, unless stated otherwise.


Disclosure: Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Bloomberg Barclays Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Bloomberg Barclays government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Bloomberg Barclays U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable 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.


Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, and Sam Millette, fixed income analyst, at Commonwealth Financial Network®.


© 2019 Commonwealth Financial Network®