15 Jan Not such a Merry Christmas!
Historically, the month of December has been one of the best performing months for the S&P 500. Since 1928, the average percent change for the index in December has been 1.3%, the same as the month of April and only second to July, which on average has returned 1.6%. December has given investors a positive return in 66 of the past 91 years1. As such, the concept of the “Santa Claus Rally” has some merit. Unfortunately, for this year, the Grinch did steal Christmas.
After seeing the US equity market rise for the past 10 years, a major pull back was inevitable. The big question was the timing of this pull back. Some had been calling for it for the past couple of years while others were still confident that conditions remained favourable to a continuing bull run. The US market peaked at the end of September before starting its precipitous fall into year end, losing 13.5% during the fourth quarter, which included the worst loss for a month of December since 1931, a fall of 9.0%. As a result, the US market finished 2018 with a loss of 4.4%.
The pain was correspondingly shared amongst equity investors across the world. European equities, which had struggled all year to stay in positive territory, lost 11.3% in the fourth quarter, for an annual loss of 10.6%. Meanwhile, Canadian, Japanese, and Emerging Market equity indices fell, respectively, 10.1%, 17.6% and 7.4% in the quarter, resulting in annual losses of 8.9%, 16.0% and 10.1% (all in local currencies).
Rising US interest rates, slower European and Chinese economic activities and geopolitical concern
Many factors affected the change in investor sentiment, and the resulting poor performance of global equity markets, during the fourth quarter. Rising US interest rates for one, seen earlier in the year as a healthy sign, and necessary result, of US economic growth, were now being viewed as a burden on consumer spending and corporate earnings. Even the tone used by US Federal Reserve Chairman Jerome Powell changed during the quarter from more hawkish (a bias toward further rate increases) to more dovish (a bias toward a pause or reduction). Slower European and Chinese economic activities and geopolitical concerns, including Italian politics, Brexit, French protests, US-China trade tensions, and the build-up toward the US government shut-down, to name just a few, all added to market anxiety.
Also contributing to the market pullback was the scaling back of corporate earnings growth estimates, particularly with the expectations that US economic growth would slowdown in concert with the rest of the global economy in 2019. As such, market estimates2 on October 1st were for S&P 500 earnings to grow by 10.2% in 2019. As of December 31st, those estimates had been revised down to a growth rate of 7.3%. The combination of earnings downgrade and price multiple contraction, due to higher interest rates, is never a good one.
Temptation to rush back into defensive
With equity markets in turmoil, investors rushed back into defensive and more attractive fixed income securities, especially with yields being more attractive than they had been all year. The US 10 year government bond was yielding just above 3.0% at September 30th, compared to 2.4% at January 1st.. As well, high quality US corporate bonds (Aaa) were now yielding 4.0% at the start of the quarter, compared to 3.5% at the start of 2018. Corporate yields were also very attractive versus an earnings yield (inverse of the P/E ratio) on the S&P 500 of 4.7% at September 30th. Government yields globally, even in Germany and Japan, were generally trending higher at the start of the quarter before the flight to safety. As such, in the fourth quarter, the Barclays Global Aggregate Bond Index returned a positive 1.20% (in USD, unhedged), led by a gain of 2.12% for the Treasury sector, as government yields fell back globally. On the flip side, with concerns over the state of the global economy, the global Corporate bond sector fell 0.81% and the global High Yield sector fell 3.49%. For example, the spread on US high yield bonds widened from 3.28%, at the start of the quarter, to 5.33% on December 31st. An increase in high yield spreads is usually a good precursor of upcoming economic turmoil as bond investors require greater compensation for the increased risk of corporate defaults. For the year as a whole, the Global Bond index finished in negative territory, with a return of -1.20%.
With this flight to safety, the USD continued to gain during the quarter versus other major currencies, except vis-à-vis de Yen. The USD advanced by 5.65%, 2.17% and 1.19% versus the Canadian Dollar, Sterling and the Euro, respectively. However, it did lose 3.53% versus the Yen. Gold was another asset that benefitted from the risk off environment as it rallied 7.69% to $1,282 during the quarter.
It is difficult to assess at this time whether the market has effectively washed out and is ready to resume its long-term bull run, or whether this is the beginning of a long bear market cycle. On the one hand, global equity markets are clearly the cheapest that they have been in the past 5 years. Also, while slowing, the global economy as a whole is not going into a recession just yet. On the other hand, earnings are being revised down. In addition, the easy monetary policies that have fuelled the bull market for the last 10 years are being reversed, which could arguably cause the opposite effect going forward.
Given the current market uncertainty and nervousness, one would rather err on the side of prudence. The greatest risk remains with equities. However, with interests rates having fallen back, bonds do not represent a very interesting alternative either. Therefore, and as mentioned in some of our previous communications, we favor assets that offer absolute uncorrelated returns to traditional public markets such as: real estate, private equity, private debt, agriculture, infrastructure, and certain hedge fund strategies.
We take this opportunity to wish our readers, and their families, all the best for the new year!
1 Source: Yardeni Research, Inc.
2 Source: Thompson Reuters, I/B/E/S data from Refinitiv