Summary of 4Q/2018: Gridlock Arrives and Volatility Returns
The fourth quarter saw a reversal of the third quarter gains, with the major market indices ending well into correction territory (down more than 10% from highs). At the close of December 24th, after dropping 2.7%, the S&P 500 was technically in a bear market (down 20% from high), but it quickly escaped on December 26th when it went up a stunning 5%. Indeed, it was one of those days that remind us how all the market’s annual gain usually comes in just a handful of unpredictable days, so it is crucial to always be invested at an appropriate risk level. The unprecedented nine-year winning streak from 2009 to 2017 was finally broken in 2018 thanks to the worst December since 1931.
For the quarter, international developed companies took a similar beating and remain far worse for the year (about 9% lower than US stocks). Compared to international, emerging markets did better for the quarter by about 7% but were nearly identical for the year. Real estate also experienced a better quarter than US equities yet still closed lower for the year. High quality bonds provided a damper on the volatility of equities for the quarter, but their annual performance was relatively flat.
Naturally, the dominant political story of the quarter was the mid-term election where the Democrats took control of the House. As of today (1/2/2019), we are well into a federal government shutdown with no end in sight. For 2019, we can expect the House to be a thorn in Trump’s side in terms of both legislation and investigation. Whether it will go as far as impeachment is highly questionable, as the prediction markets (predictit.com) currently assign it less than a 50% probability. Even if impeachment happens, it is quite clear that the Senate will not vote to remove Trump from office.
The Federal Reserve, in contradiction to the tweeted advice from President Trump, increased the federal funds rate to 2.5% and signaled two more increases in 2019. The 10-year Treasury yield ended the quarter at 2.69%, down 0.36% from where it began. The fourth quarter continued the trend of the flattening of the yield curve, as measured by the spread between 10-year and 2-year Treasuries. In other words, there is now less of a return premium for taking on term risk by buying longer maturity bonds. To be clear, this does not mean that term risk should be minimized or avoided. Nobody can say authoritatively that a 2-year Treasury yielding 2.48% is a more prudent investment than the 10-year Treasury yielding 2.69%, especially for an investor with a long-term time horizon who must consider reinvestment risk as well as interest rate risk.
The table below summarizes the estimated returns for various asset classes based on the performance of Vanguard index funds. Please note that they do not represent the returns of the funds or portfolios utilized by Clarity Capital Advisors.
Asset Class Ticker Used 4Q/2018 Return Year-to-Date 12/31/2018
US Total Market VTSAX -14.3% -5.2%
US Large Growth VIGAX -16.3% -3.3%
US Large Value VVIAX -10.9% -5.4%
US Small Growth VSGAX -19.3% -5.7%
US Small Value VSIAX -17.5% -12.2%
International VTMGX -13.1% -14.5%
Emerging Markets VEMAX -6.3% -14.6%
US Real Estate VGSLX -6.4% -6.0%
Int’l Real Estate VGRLX -4.3% -9.5%
US Bond Market VBTLX 1.6% 0.0%
US TIPS VAIPX -0.5% -1.4%
In a reversal of the prior quarter, value beat growth thanks in part to the information technology sector (down 17.3% based on VITAX). There were many negative tech-related stories such as slowing sales at Apple, increasing congressional scrutiny of the social media giants (especially Facebook, which has experienced an ongoing public relations catastrophe), and foreign taxation of high-revenue companies such as Google.
At the beginning of 2019, the US economy still appears to be operating at full employment, but the Eurozone and Chinese economies have begun to slow down. With the 10-year breakeven inflation rate now holding around 1.7%, unexpected inflation appears to be less of a concern. Spurred by weakening global demand, crude oil prices were down by 37%, and the US energy sector fell alongside it (down 25.4% based on VGELX).
As for our market outlook for 2019, well to repeat J.P. Morgan, “It will fluctuate.” Seriously, every day going forward has the same expected return, and as long as markets are functioning properly, it is positive. After a ridiculously calm 2017, the volatility of 2018 reminded us of the risk of equities, but it is only for bearing risk that we can expect a return. So our advice, as always, is to be invested and stay invested at an appropriate risk level.