Fourth Quarter 2018 – Quarterly Commentary
Dear 2018, Good-bye and Good Riddance
It seems that Rudolph’s nose burned out this year, forcing Santa to stay home, skipping the traditional “Santa Rally” in stock prices. The Santa Rally refers to the tendency of stock prices to drift higher in the last weeks of the year, as tax loss selling ends and traders start to think about ski vacations, rather than restructuring their portfolios. In fact, 2018 won the dubious honour of being the worst December since at least 1948!
The cross-currents that left markets in a quandary this year were of memorable proportions. If we cast our recollections back to January, when the U.S. passed legislation implementing a series of corporate tax cuts, lighting a fire under an already booming economy and triggering a surge in stock prices, it seems a far cry from the miserable final quarter of the year. But in January investors were buoyant over the promise of huge earnings growth, held in check only by concerns about high valuation levels and a central bank determined to “normalize” interest rates. By February the early excitement had already waned as markets suddenly realized the Federal Reserve, after many false starts in recent years, was serious about raising interest rates. Investors barely had time to catch their breath and recover from that dip when trade stepped up to take centre stage, beginning with the U.S. slapping tariffs on various forms of steel. In this environment, earnings growth became an afterthought in trader’s conversations. After all, who cares about a booming economy when someone wants to start a trade war!
Back to Basics!
Despite the market’s disregard for fundamentals in recent weeks, we are going to return our attention to the underpinnings that are critical to stock prices. In 2018 the early promise of exceptional earnings growth did come to fruition (S&P500 companies saw earnings grow on average in excess of 20% over the year) but investors had stopped caring. At the same time, valuation concerns have evaporated. Simply put, if you measure value as Price / Earnings, when the earnings number rises and the price stays the same (or declines), the ratio drops. And so it did, to end the year at a level near the long term average valuation for the S&P500. For the Canadian market, valuation levels have now dipped below the long-term average. So, as we enter 2019, valuation is no longer a pressing concern.
The same cannot be said for interest rate policy, as determined by the U.S. Federal Reserve or the Bank of Canada. Following four rate hikes in 2018 in the U.S. and three in Canada (a fourth is expected to be announced in January), the question remains, how far and how fast can the central banks raise interest rates? In a world where both central banks see a strong economy and full employment, it makes an easy case for bankers to try and “normalize” interest rates, in anticipation of the next recession. In other words, they want to raise interest rates enough so that they have room to drop them when the economy stumbles. Recall, the point of raising interest rates is to slow the economy to prevent it from overheating and creating inflation. If the Central Banks overshoot and raise rates too much, forcing the economy to slow too much, the process ends in a recession. Is it any wonder that equity markets start to get a little jittery once the central banks begin to squeeze the juice out of the economy?
Adding to investors’ worries is a slightly inverted yield curve. The yield curve is the interest rate paid on government debt for each respective country, although as is often the case, it is the U.S. yield curve that garners the most attention. An inversion of the yield curve (where short-term interest rates are higher than longer term rates) has proceeded most recessions. However, it is often joked that the yield curve has predicted ten of the last seven recessions, in other words, not every inversion leads to a recession. Historically, the key has been whether the three-month rate is higher than the 10-year rate. Equity markets have tended to rise until that inversion. We are not at that point yet – but we, along with everyone else are watching.
But the true question becomes, what happens next for interest rates? The Bank of Canada is likely to play a bit of “follow the leader” with its dominant neighbor to the south, so the bigger question is what will the U.S. Federal Reserve do? At its last meeting of 2018 the Bank eased its expectations of rate hikes to two increases in 2019 from the three previously anticipated. But that reduction in the forecast was not sufficient to appease grumpy investors.
What would likely appease grumpy investors would be an easing of trade tensions. We have no more clues than anyone else as to whether a trade deal can be achieved between the U.S. and China. At the time of writing both the U.S. and China had indicated progress was being made in negotiations. There seems to be some desire on both sides to find a resolution, but with upheaval the norm in the White House, it is hard to say whether that position is likely to be maintained. Also, a fight with China is politically popular in the U.S., which may be a disincentive to reaching an agreement. If the U.S. were to proceed with another round of tariffs against China, it would be economically damaging to the global economy – including the U.S. When the economy slows, so does earnings growth for companies.
These are the “walls of worry” that equity markets must try and surmount. But in all of these concerns it is important to remember that these are concerns in an environment that overall remains healthy. Global economic growth is likely to remain over 3% in 2019 and leading indicators in the U.S. continue to point to a strong economy. Growth seems destined to slow from the brisk pace of 2018 but slowing growth does not equal a recession. In this environment earnings growth should remain healthy, although certainly not the blowout numbers created in 2018 by the tax cuts in the U.S.
In Canada the earnings generated by companies in our main index, finally matched the peak earnings reached during the commodity boom that topped out in mid-2008. It took 10 years to repeat that performance, and this time without any help from commodity prices. We often discuss the link between corporate earnings and stock prices and the Canadian market provides a timely example. The Index has hovered near its 2008 highs for most of 2018, as the earnings once again matched the previous peak. Even with commodity prices under pressure, Canada is also expected to experience solid earnings growth in 2019. Now imagine the potential for Canada and the Canadian equity market if we could get oil out of Alberta without a steep discount!
Oil is a Slippery Topic.
Oil will likely remain a heated topic for 2019 – and not just due to debate around Canadian pipelines or the lack thereof. Global oil prices have had some big swings in 2018 and most of them have been driven by politics – not supply and demand. Or perhaps, more accurately, politics have manipulated the supply / demand balance and therefore oil prices. Oil prices surged in the summer and fall, after the U.S. pulled out of the agreement with Iran. With Iranian oil anticipated to become stranded, with no market come November, the U.S. applied pressure to its ally Saudi Arabia to increase production, keeping oil prices low going into the mid-term elections and to ensure there were no shortages. But with predictable unpredictability, just as the sanctions on Iran were about to take hold, Trump granted export waivers to seven major purchasers of Iranian oil. As Iranian oil did not get shut out of the market and the Saudi’s were now pumping merrily away, oil prices tumbled into the winter.
Strangely enough, the Saudis and Russians have been somewhat reluctant to fix the problem that Trump built and fissures are starting to show in OPEC. So where do oil prices go in 2019? Most likely higher as there will be some production cuts from Saudi Arabia and Russia. A decline in Venezuelan production is almost a certainty; although we often forget about Venezuela, they remain a significant (although rapidly declining) supplier to global markets even as the country collapses.
What does this mean to you?
But all of this leads us to the most pressing question for investors as we end 2018 – is this downturn merely another correction in a bull market, or is the bear now growling at our heels. The distinction is important as the price declines in a bear market tend to average close to 30%. Much like recessions, bear markets can only be determined with the 20/20 vision of hindsight, but here are our thoughts.
Declines of about 8% – 15% are regular events in equity markets and there is generally one decline of that magnitude in each year. It is not unheard of to have two within 12 months, without it turning into a full-blown bear market. To see a period with multiple dips not leading to a bear market we only need to think back a few years to 2011 – 2012 as the European banking crisis rattled investors. Equity markets declined close to 20% in the summer of 2011 followed by a full recovery, only to dip a second time in the spring of 2012, with a more modest pullback of 10%.
It is rare to have a bear market without a recession. Although we acknowledge that most Federal Reserve rate hiking cycles end with a recession, the lag time can be significant. We track the Purchasing Managers Indices as one of the forward-looking indicators of economic growth and in every major economy, except China, those continue to point towards solid growth. Corporate earnings are likely to stay strong into next year and valuations are now back to being reasonable. All of these suggest we are in for a correction, not a bear market.
The elephant in the room and likely the determining factor in whether this market recovers quickly or grinds into a steeper decline is trade. A full blow trade war and an implementation of the 25% tariffs threatened by the U.S. skews the discussion towards a bear market, a resolution likely gives a relief rally and buys some time for this cycle.
During our discussions with our clients throughout this year, we have been cautious as our belief is that we have entered the later stages of the business cycle. Although some of the areas of concern (slowing earnings growth and high valuation levels) have eased, we have not shifted to a more aggressive position. This may not be a bear yet, but if you listen carefully, you can probably hear it growling somewhere in the distance. The challenge is to determine that distance, so for now, we remain somewhat cautious.
Logan Wealth Management
December 31, 2018