In the final quarter of 2018, interest rate and growth fears, along with geopolitical events, sparked volatility in the financial markets and reversed many of the outsize stock gains notched earlier in the year. The S&P 500 posted a loss of about 6.2% for 2018. After falling into bear market territory, defined as a drop of more than 20% from recent highs, the tech-heavy NASDAQ was down 3.9% for the year overall.1-2
For the first time since 2008, all three of the major U.S. stock indexes (Dow, S&P 500, and NASDAQ) were set to record annual losses.3 Investors may feel shell-shocked after the worst December for stocks since 1931, but it’s important to maintain some perspective.4 The recent correction was preceded by the longest bull market in history, so it could be viewed as an overdue repricing of stocks, as well as a reality check brought on by waning growth expectations.5
Here are some of the specific headline risks that have sparked market volatility, along with a review of economic projections for 2019.
Treasury yields rose through most of 2018 (causing prices to drop) in response to solid growth and central bank tightening. However, the climb in the 10-year Treasury yield stalled after reaching a seven-year high in early November, when trade tensions, doubts about future economic growth, and stock market volatility ramped up.6
In December, the difference between two-year and 10-year U.S. Treasury yields was the narrowest since 2007. A flat yield curve has some economists and investors worried about the possibility of an economic downturn. An inversion in the curve (which occurs when short-term yields are higher than longer-term yields) has preceded every recession since 1975.7
Global economic growth is showing signs of weakness, which could eventually take a toll on U.S. growth. Some export-driven economies have been hit especially hard, partly due to trade disputes. China, the world’s second largest economy after the United States, is growing at its slowest rate in nearly a decade. Economic growth in Japan and Germany (the third and fourth largest economies) also contracted in the third quarter.8
In addition, uncertainty surrounding the United Kingdom’s exit from the European Union — or Brexit — has begun to restrain growth in the region. Investors seem to be especially nervous about the possibility of a disorderly Brexit. If a deal can’t be finalized by the March 2019 deadline, supply chain disruptions and tariffs imposed on traded goods could slow growth further.9
The Federal Reserve has been gradually lifting the federal funds rate (now in a range from 2.25% to 2.5%) and slowly reducing its balance sheet.10 These policies are intended to reduce liquidity in the economy and help control inflation, but higher interest rates are also a headwind for stocks, because they help less-risky assets such as bonds attract more capital.
It’s normal for the Fed to tighten financial conditions and remove support for the economy as it strengthens. Rates were increased four times in 2018, and the committee’s most recent estimate is for two more rate hikes in 2019 rather than three.11 Still, there is some concern that interest rates will rise more rapidly than the economy can tolerate, putting the brakes on growth.
Despite financial market turbulence, economic forecasts suggest that the United States entered 2019 in a fairly strong position. In December, the Federal Reserve’s median forecast for 2019 gross domestic product growth was 2.3% (down from 2.5% in the previous forecast). The unemployment rate, which was 3.7% in November 2018, is expected to keep falling to 3.5%.12
However, if trade talks between the United States and China fail to ease tensions, tariffs could cut more deeply into the profits of U.S. companies and/or push up costs for consumers. Nearly half (47.3%) of economists polled by The Wall Street Journal believe the trade war with China is the most serious risk to the U.S. economy in 2019. Other economists cited a slowdown in business investment (12.7%), weakening global growth (9.1%), and interest rate hikes (7.3%) as the biggest potential threat.13
Unresolved geopolitical issues (including a prolonged government shutdown) or disappointing economic reports could continue to upset the stock market in the coming months. Even so, if you flee the market during a downturn, you won’t be in a position to take advantage of growth on an upswing. And if you are investing for a long-term goal such as retirement, a down market may be an opportunity to buy more shares at lower prices. Though it can be difficult to take the headlines in stride and control your emotions, sticking to a sound investment strategy is often the best course of action.
The return and principal value of stocks and bonds fluctuate with changes in market conditions. Shares, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.
The S&P 500 is an unmanaged group of securities that is considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results. Actual results will vary.
1, 3) The Wall Street Journal, December 31, 2018
2) Reuters, December 21, 2018
4) Bloomberg.com, December 31, 2018
5) The New York Times, December 19, 2018
6-7) The Wall Street Journal, December 4, 2018
8) The New York Times, December 9, 2018
9) The Guardian, October 30, 2018
10-12) Federal Reserve, 2018
13) The Wall Street Journal, December 13, 2018
From all of us here at SeaCure Advisors, have a restful and safe holiday and may 2019 be the best year of your life!
On September 6, 2018, the MSCI Emerging Markets (EM) Index — which tracks stocks in 24 of the world’s largest developing economies — dropped 20% below its January high, a level of decline that is commonly considered a bear market.1 Hong Kong’s Hang Seng Index reached the same negative milestone a few days later. China’s benchmark Shanghai Composite entered bear territory in June.2
In the meantime, the U.S. bull market continued its charge, with major indexes setting new highs despite escalating trade tensions.3
What’s behind the big declines in emerging markets? And how might the stalking bear in these economies affect U.S. investors?
The trade conflict between the United States and China is only one of several challenges facing emerging markets, but it has played a major role in recent declines. China, the world’s second largest economy, is the giant of emerging markets, with trade relations around the globe. Any policy that threatens China reverberates throughout the developing world. And declines in Chinese stocks, which account for about 30% of the MSCI EM Index, have an outsized effect on the markets.4
Although the threat of a trade war is serious, the deeper problem for developing economies lies in the credit markets. After the financial crisis, when interest rates in the United States, Europe, and Japan were at rock bottom lows, investors were attracted to higher rates in emerging economies.5
This generated a massive flow of cash into these countries that spurred business growth and helped prop up national governments, often covering underlying weakness in both the private and public sectors. From 2007 to 2017, total emerging market debt tripled from $21 trillion to $63 trillion.6 Much of this was in U.S. dollars, which provided valuable hard currency but required repayment in dollars.7
As interest rates have risen in the United States, investors have shifted to less risky U.S. securities, drying up the flow of cash into developing economies.8 At the same time, the dollar has grown stronger, increasing the cost of dollar-denominated debt payments and driving down asset values in weakened local currencies. Without new inflows, many companies and governments in developing countries may be unable to meet their debt obligations.9
Although high debt is an issue throughout the developing world, some countries are more exposed than others. Turkey and Argentina have been in the spotlight due to especially dramatic breakdowns. Both have very low foreign exchange holdings in relation to debt obligations, meaning they can’t pay their bills without further borrowing. Other countries that are underwater by this measure include Pakistan, Ecuador, Poland, Indonesia, Malaysia, and South Africa.10
High debt and instability scare off investors, which has pounded bond prices in Turkey and Argentina, and sent their national currencies plummeting against the dollar.
Inflation is spiraling in both countries, and their central banks have set sky-high interest rates (24% in Turkey and 60% in Argentina) in a desperate effort to gain control of their economies.11-12
Many analysts believe that Turkey and Argentina are outliers and that most developing countries and companies are strong enough to weather the crisis.13 But some see the potential for currency collapse in other countries, including Sri Lanka, South Africa, Pakistan, Egypt, and Ukraine.14
If weakness in emerging markets turns into a global crisis, Europe may be most directly affected. European stocks have already been hit by the declines in EM stocks, and the European economy, which has lagged the U.S. economy in growth and monetary policy, is more vulnerable to fallout from EM credit and currency woes. A hard hit to Europe could spread to the United States.15
On this side of the Atlantic, the crisis has primarily affected U.S. companies with wide exposure in the developing world, and investors, including some large pension funds, who were overweighted in EM securities in an effort to chase high yields.16-17 So far, the broader U.S. market has been insulated by a strong economy and stellar corporate earnings.18 That may change if trade conflicts with China and other trading partners heat up or if multiple countries begin to flounder like Turkey and Argentina.
Even if U.S. markets stay on course, the credit crisis in emerging markets is a cautionary tale of fragile economies. It’s not wise to overreact to foreign events, but you may want to keep an eye on further developments. This might also be a good time to make sure your portfolio reflects your goals, risk tolerance, and time horizon.
All investments are subject to market volatility and potential loss of principal, but investing internationally carries additional risks such as differences in financial reporting and currency exchange risk, as well as economic and political risk unique to the specific country. These risks can be greater when investing in emerging markets, where stocks may be substantially more volatile and less liquid than the stocks of companies located in more developed countries. This may result in greater share price volatility. These additional risks also apply to foreign bonds, along with the default and interest rate risk associated with all bonds. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher rates of return also involve a higher degree of risk.
1, 4) MSCI, 2018
2-3, 18) The Wall Street Journal, September 11, 2018
5, 7-8) Bloomberg, May 28, 2018
6, 9-10) Bloomberg, September 2, 2018
11) The New York Times, September 13, 2018
12) The Wall Street Journal, September 4, 2018
13) The Wall Street Journal, September 10, 2018
14) Bloomberg, September 9, 2018
15) Bloomberg, September 10, 2018
16) CNBC, August 13, 2018
17) The Wall Street Journal, September 8, 2018