The year 2018 was a turbulent one for the financial markets as stocks around the world suffered significant losses while returns to fixed-income investments were essentially zero. For US stocks, 2018 was the worst year since 2008. In sum:
- US stocks lost 4.4%.
- Global stocks lost 10.2%.
- Investment grade bonds returned 0%.
- Foreign stocks lost 13.8%.
- Emerging market stocks dropped 14.9%.
- Inflation accelerated to 2.2% in the US.
Volatile Markets
The first two graphs illustrate cumulative returns during the year; they starkly show how dramatic and deep the losses were, particularly in the fourth quarter.
US stocks, which had risen 9.2% through the third quarter, in the fourth quarter lost about 22% before recovering somewhat and closing out the year with a 7% loss in price and a 4.4% loss on a total return basis which includes dividends. The third graph illustrates on a monthly basis how the major markets performed during the year.
Foreign markets, after a jump up in January, were in fairly steady decline throughout the year as the tariff wars and rising US interest rates dampened economic prospects for foreign economies.
How Far Will the Fed Go?
Since the beginning of 2016 the Federal Reserve has been gradually increasing interest rates, starting effectively at zero percent (which had been the rate since the Great Financial Crisis) and gradually increasing rates through 2018 to 2.25-2.5%. The essential reasoning for rate hikes was that when, like now, economies are performing at capacity, then low interest rates tend to generate excessive economic activity that in turn generates heightened inflation. With inflation recently rising to a level around 2%, which is the Fed’s target rate for inflation, the Fed has been pushing rates up in order to prevent inflation from moving uncomfortably higher in the future.
Effective Federal Funds Rate
Yet in economics, like in life generally, change is the only constant. Just three months ago Fed Chair Jerome Powell remarked that the economy was “remarkably positive” and suggested that there was “no reason to think this cycle can’t continue…indefinitely”. He also opined that interest rates were “a long way from neutral”, suggesting that future rate increases were highly likely in order to move to the Fed’s goal of 3.0-3.5% interest rates by about year-end 2019 or in 2020. But there was also economic data and President Trump putting pressure on the Fed to slow if not stop the rising interest rate policy. First, President Trump weighed in because he viewed higher rates as unnecessary and potentially hurting his economic policy. Ironically, the massive fourth quarter stock market losses coincided with Trump’s criticisms of the Fed, criticisms which historically were considered inappropriate for a President to voice because they may compromise the independence of the Fed.
The pressure to slow rate increases also was reflected in the bond markets, where the interest rate yield curve, which compares rates over different maturity terms, seemed to be flashing a warning sign. The graph shows how today’s yield curve reflects only a 0.4% premium paid to investors in 20-year bonds over 3-month Treasury bills; for comparison, just last September (about the time Trump began to criticize the Fed for raising rates) the premium was 1% and, back in 1995 the same premium paid to 20-year bonds was 2.1%.
A lessened maturity term premium usually suggests pessimism among businesses that borrow, and that perceived pessimism then leads to stock market sell-offs. However, in this case the lessened premium may have been driven by President Trump’s comments and, in turn, the market may have interpreted the lessened premium as a negative sign for stocks and that lead to the sell-off.
That said, in light of the economic data which remain strong, there is a reasonable likelihood that there will be no recession in the near-term and the Fed will continue to push up rates, albeit at a slower pace than previously planned. Yet if longer term rates do not rise soon, then the Fed will pause and reassess their plans
John Bogle – The Passing of a Giant
John Bogle, a true giant of the investment world who created the first commercially viable index fund in 1976, died in January 2019. Mr. Bogle was the founder of the Vanguard funds company which he built on the basis of his belief that most investors, professionals and amateurs alike, were unable to meaningfully and consistently outperform the market averages because of the high costs of traditional active management. A measure of his success is that index funds today hold almost 50% of all mutual fund assets! Mr. Bogle also was a pioneer in another way: The Vanguard company adopted a business structure where the company eliminated sales charges and became a pure no-load mutual fund complex. Moreover, Vanguard fund investors own the Vanguard company and the company operates solely in the interests of the investor shareholders. These innovations propelled Vanguard to achieve the lowest costs in the industry and set the standards by which others are compared and compete. At Grossman Financial Management, the Vanguard philosophy and their funds are widely used; on our bookshelf can be found no less than seven books by Mr. Bogle about investing.
Looking Back & Ahead
GFM client portfolio returns in 2018 were generally in line with overall markets and strategies in accordance with client portfolio asset allocation specifications. Your accompanying report provides details.
Going forward, investors should continue to hold realistic expectations about returns and risks from both stocks and bonds. Foreign stocks are reasonably priced, but American stocks still trade at levels that historically were eventually followed by unusually steep downturns. Bond yields remain low but have the potential to move higher if the economy continues to perform well.