Market Correction

2018 ended on an ugly note as December was one of the worst months ever for stocks. The final quarter saw a marked increase in volatility as investors demanded a higher risk premium in the face of tighter monetary policy (rising interest rates). Trade tensions between China and the United States provided an additional overhang for stocks. Overall, it was an awful quarter for stocks as the S&P 500 declined by 14.0% and the S&P / TSX fell by 10.9%. Many stocks fell more than 20%, putting them in bear market territory. Since reaching their lows in late December, stocks have rebounded. The bond market provided a measure of stability returning 1.8%.

While earning reports this quarter were solid, they were not as robust as in prior quarters. Investor fears related to a peak in economic growth and earnings weighed on stocks. We currently do not envision a recession this year but acknowledge that growth will not match the level of 2018. A deceleration in earnings growth warrants a reduction in stock prices but corporate America is still healthy notwithstanding the slower earnings growth. With the recent pull back, stocks are currently trading below 15 times 2019 earnings, which is close to its long-term average. Lower equity prices, no material change in earnings prospects and no impending recession puts equities at more attractive levels than three months ago.

As expected, the Fed increased short term interest rates in December. They also signaled that they would be less aggressive with respect to raising rates in 2019. Inflation is a more serious threat than at any time in the last ten years due to low unemployment and a shortage of skilled workers. This threat is offset by slower economic growth. The net result is a Fed that will take a wait and see stance that is more data dependent. Chairman Powell has also stated that interest rates are currently near a neutral level (neither too restrictive or accommodative) which is beneficial for economic growth.

The US yield curve briefly inverted during the quarter. This means that longer dated bonds were yielding less than shorter term bonds. Investors were spooked as this is typically looked on as a recessionary indicator. We are not overly concerned as this indicator gives plenty of false signals and the inversion was ever so slight (5 basis points) between the one- and five-year bonds. Typically, investors who follow this indicator tend to monitor the spread between the two and the ten-year bonds and this segment of the yield curve never inverted.

The Bank of Canada held its benchmark interest rate steady at 1.75% during their December meeting. Lower oil prices and slower economic momentum were the primary reasons for officials striking a more cautious tone and casting doubts about future rate increases. This dovish tone from the Bank of Canada resulted in a meaningful decline in the Canadian Dollar vs the US Dollar.

We can’t write about the quarter without mentioning the US Political situation. The midterm elections resulted in the Republicans adding to their slim majority in the Senate, and the Democrats convincingly taking control of the house. A divided government is typically positive for markets as gridlock and a do-nothing government allows businesses to thrive. Unfortunately, we are not in a normal environment. The political environment is divisive, with little civility between the two parties. Democrats winning a majority in congress results in their chairing house committees. They will probably use this new power to search for proof of Trump’s malfeasance. Whether they are serious about impeaching President Trump or just making noise to embarrass the president is moot. The investigations will create additional political uncertainty which is never positive for the markets.

The economic outlook remains bright but not without risk. This cycle is one of the longest on record, but that does not necessarily presage its impending doom. Political, trade and potential monetary mistakes are all risks that could derail this cycle or the bull market. We do not expect these risks to materialize this year, but we will remain vigilant for any changes to the outlook. From a “glass is half full” positive perspective, the recent swoon in stocks has resulted in more attractive valuations with no change in the fundamental outlook. The economy continues to chug along and there has not been a material change to corporate earnings prospect. Consequently, we continue to prefer stocks over bonds and will maintain this stance until a change is warranted. As always, we welcome your thoughts and comments.