Equity - Review of 2018

Market Summary – Year-End 2018

Equities

Global stocks declined on an annual basis for the first time since 2015, pressured by rising interest rates and a decidedly unfriendly global trade environment. Tighter U.S. monetary policy and a brewing trade war involving the U.S., China, and Europe reverberated around the world, threatening to halt one of the longest-running bull markets in history.

Cyclical stocks posted the most significant losses, underscored by double-digit declines in the financials, industrials, and materials sectors. Technology stocks fell sharply in the fourth quarter but lost just 3% overall due to strong gains earlier in the year. Traditionally defensive sectors fared better. Health care and utility stocks rose 3% and 2%, respectively.

Fixed income

U.S. Treasury bonds rose modestly, boosted by safe-haven buying as volatile financial markets sent investors fleeing for cover. The positive gains, however, masked a more tumultuous year as rising U.S. interest rates jolted markets around the world.

Investment-grade and high-yield corporate bonds finished the year in negative territory, as did emerging markets debt.

The Federal Reserve raised interest rates four times during the year, citing a strong U.S. economy, moderate inflation, and a tight labor market. In foreign exchange markets, the U.S. dollar rallied against the euro, the British pound and most emerging markets currencies.

North America

U.S. equities declined on an annual total return basis for the first time since 2008. Concerns over trade conflicts, slowing global growth and high valuations contributed to persistent volatility.

Energy and materials

Falling commodity prices further pressured companies. Small-cap stocks rallied during the first half of the year but ultimately lagged large caps by a wide margin.

A series of retaliatory tariffs between the U.S. and China elevated geopolitical tensions across the globe.

The world’s two largest economies levied tariffs on imports worth hundreds of billions of dollars and faced off over intellectual property protection issues. The U.S. also clashed with traditional allies within Europe and North America, threatening to discard established trade deals and add new tariffs. In late December, a partial US government shutdown over budget disagreements also shook markets.

Tax cuts boosted corporate earnings and economic growth, supporting equities for much of the year. The U.S. economy had its two strongest quarters of growth since 2014 in the second and third quarters – rising 4.2% and 3.4%, respectively. The unemployment rate remained at 3.7% in November, the lowest level in nearly 50 years. Company earnings were estimated to have grown 20% in 2018, according to data aggregator FactSet. However, many companies lowered profit forecasts for 2019, adding to volatility in the fourth quarter.

The energy sector had the steepest decline, after plummeting oil prices in the fourth quarter erased gains from earlier in the year. West Texas Intermediate crude oil prices sank more than 40% from early October and finished the year down 25%. Shares of industrial giant General Electric plunged 55% amid deteriorating profits, a CEO change and the reduction of its dividend to a penny.

Growth-oriented sectors bested defensive stocks but experienced wild swings throughout the year.

Amazon, Netflix and Microsoft shares continued to surge, each gaining more than 20%. Facebook sank 26% amid ongoing scrutiny over privacy issues, and Apple shares dipped 5%. Health care had the best sector return, led by strong gains by pharmaceutical companies Merck, Pfizer and Eli Lilly.

In a turbulent year, a fourth-quarter rally helped bonds outperform most other asset classes. The Bloomberg Barclays U.S. Aggregate Index ended the year faintly positive, erasing nearly all previous losses over the year. The yield on the benchmark 10-year Treasury ended the year at 2.69%, 29 basis points higher than it started. The Federal Reserve hiked the federal funds' target four times during 2018, to a range of 2.25% – 2.50%.

Corporate bonds lagged, with investment-grade bonds losing 2.5% and high yield declining 2.1% for the year. Investment-grade corporate bond spreads widened to levels last seen in 2016. Wider spreads indicate the market is pricing corporate bonds lower, all else held equal.

Europe

European stocks declined precipitously as a slowing economy, political turmoil and global trade disputes combined to hammer the 19-member Eurozone. In an unexpected shift from the prior year, the European economy lurched nearly to a halt as a high level of uncertainty hurt investor sentiment and sent the euro tumbling against the U.S. dollar and the Japanese yen. Overall, the MSCI Europe Index lost 11% in local currency terms and 15% in dollar terms.

Deteriorating trade relations weighed heavily on European stocks, given the region’s dependence on international trade. As business sentiment plummeted, Eurozone economic growth slowed to an annualized 0.6% in the third quarter, down from 2.7% at the end of 2017.

Worries about the U.K.’s impending exit from the European Union and Italy’s new populist-leaning government also rattled markets at times.

Adding to those concerns, the European Central Bank ended its bond-buying stimulus program in December, removing a degree of support for the economy.

Nearly all sectors fell sharply, led by a 19% decline among financial stocks. Bank stocks were hit particularly hard as concerns about lackluster economic growth, ultra-low interest rates and exposure to troubled loans battered the shares of Europe’s largest financial institutions, including BNP Paribas, Banco Santander, and HSBC.

Real estate and consumer discretionary stocks also posted significant declines, with each sector losing about 14% in aggregate.

Defensive stocks generally fared better, highlighted by a 3% gain in the utility sector. Shares of Spanish electricity company Iberdrola rallied as investors rotated into traditionally defensive sectors amid rising volatility in global equity markets.

Several major drug companies were also among the top contributors to the MSCI Europe Index. Shares of AstraZeneca, GlaxoSmithKline, and Sanofi, enjoyed double-digit gains for the year.

In fixed income markets, European government bonds advanced, supported by safe-haven buying and investor speculation that the ECB may delay its timetable for raising interest rates in 2019. The yield on Germany’s benchmark 10-year note fell 17 basis points to end the year at 0.25%. Italian bond yields declined sharply in December after a compromise deal was reached with EU leaders over Italy’s federal budget.

In currencies, the euro slipped 5% against the dollar and 7% against the yen.

Asia-Pacific

Asia-Pacific stocks fell sharply. Slower growth in Japan, China, and Europe, along with trade conflicts and rising U.S. interest rates, weighed on markets late in the year. The MSCI Japan Index ended down 15% on a local currency basis – the worst performance among the region’s developed markets. The MSCI Pacific ex Japan Index fell 4%. Only New Zealand rose, by just 2%. The Japanese yen rang up a 7% year-to-date gain by late March but ended the year with a 3% gain against the U.S. dollar.

Japan’s economy stumbled. Japanese GDP contracted in the first quarter – the first drop since 2015 – as private consumption faltered. Output also declined in the third quarter, owing mainly to natural disasters that hurt exports and tourism.

In September, exports fell year over year for the first time since 2016. Global trade tensions remain a concern for Japan’s export-oriented economy; trade talks between the U.S. and Japan are expected to begin in early 2019.

The Bank of Japan kept stimulus taps open. The central bank maintained loose monetary policy as inflation remained well below its 2% target. In July, policymakers permitted a wider trading range for the 10-year government bond yield around its 0% target – a move seen as a small step toward policy normalization – but also trimmed inflation forecasts through fiscal 2020 and pledged to maintain meager interest rates for an “extended period.”

The materials sector had the most significant decline, losing 27%. Shin-Etsu Chemical, a provider of silicone products used in electronics manufacturing, fell 24% in a bumpy year for chipmakers. Information technology shares retreated 23%, while the financials and energy sectors each lost 21%.

Utilities posted the sole positive return for the year. Tokyo Electric Power gained 46%, and Kansai Electric rose 23%. Health care and consumer staples fell the least, by 5% and 3%, respectively. Big gainers included drugmaker Sumitomo Dainippon Pharma (+112%) and convenience store chain FamilyMart (+78%).

Australian shares fell into the red in the fourth quarter, posting a 2% loss for the year. Slower economic growth, stress in the property market, drought and global trade concerns weighed on the market. Hong Kong was the best performing stock market in the world in 2017 but even the Hang Seng came under pressure in the 4th QTR and Singapore both fell 8% for the year.

Emerging markets

Emerging markets stocks tumbled, dragged down by China’s weakening economy, heightened U.S.-China trade frictions and a rally in the U.S. dollar. Rising U.S. interest rates and bouts of political and economic turmoil in Turkey, Brazil, and Argentina also shook sentiment. The MSCI Emerging Markets Investable Market Index declined 15% after two consecutive years of strong gains.

Chinese stocks posted their worst annual return since 2011. Selling intensified in the second half of the year as China’s economy decelerated and its trade clash with the U.S. escalated. The slowdown followed measures by government leaders aimed at reducing debt and curbing risks in parts of the economy.

As growth weakened and concerns grew over U.S. trade tariffs, Chinese leaders increased liquidity in the economy and proposed tax cuts and other measures to sustain growth.

Shares of Asia’s leading technology-related companies fell from lofty levels. Tencent, China’s largest social media platform, and Alibaba, China’s biggest e-commerce provider, dropped after climbing to record highs. Both stocks pulled back by more than 20% on valuation concerns, heightened government scrutiny and weaker profit margins stemming from increased business investments. Korean giant Samsung Electronics retreated on weaker memory chip prices and softer smartphone sales.

Shares of Apple components supplier AAC Technologies and electronics contract manufacturer Hon Hai Precision also declined.

Indian equities slumped despite strong economic growth. India is a large oil importer, and higher oil prices for most of the year weighed on the country’s current account deficit. A large number of non-performing loans among state-owned banks and specialty lenders raised further worries about India’s economy.

Challenging conditions hit the rupee, which slumped to record lows against the dollar.

In Latin America, Brazilian commodities producers and banks notched solid gains. Shares of mining giant Vale advanced, bolstered by strong demand from Chinese steelmakers for its higher quality iron ore and a new dividend policy and share repurchase program. State-owned energy company Petrobras benefitted from debt reduction and improved profitability. Signs of a slowly improving economy helped Brazil-based lenders Itaú Unibanco and Banco Bradesco.

Dollar strength and rising U.S. rates jolted emerging debt and currency markets. The Turkish lira and local currency bonds both plunged due to mounting concerns about Turkey’s economic policies and geopolitical turmoil. South African dollar bonds and the rand declined as Africa’s second-largest economy fell into a recession. Meanwhile, the Argentine peso plummeted 50% amid economic woes.

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