The US economy has started to show signs of deterioration in data such as business surveys and housing, albeit from high current readings. Tailwinds from the corporate tax cuts have started to fade as tighter financial conditions have contributed to the fear that the best of times may be behind us. US consumers, however, have bucked the trend of softening economic data after having been bolstered by the tax cuts, a strong job market, and now cheaper energy prices. This is an encouraging development, as US consumption growth has remained positive despite data showing that many have improved their financial condition by paying down debt.
3rd quarter real GDP shows that the US economy grew at a quarter-on-quarter (QoQ) seasonally-adjusted annualized rate of 3.4% according to the Bureau of Economic Analysis (BEA). Estimates for Q4 2018 real GDP growth are varied, with the Federal Reserve Bank of Atlanta’s GDP estimate at 2.7% and its New York counterpart’s estimate at 2.5% as of December 28th.
The ebb and flow of news on trade war negotiations between the US and China has taken its toll on US businesses when budgeting for future inventory and investment. The uncertainty alone has caused hiccups in economic data as repercussions continue to appear in lagging data. The latest news has been optimistic for the likelihood of a China-US trade deal, with open lines of communication and a 90-day pause in further escalation of tit-for-tat tariff increases. Fair trade and intellectual property theft across countless interested parties are no simple matters and not likely to be solved quickly, but progress can be made if both sides appear to negotiate in good faith by keeping open the lines of communication.
Many US housing markets have started to cool off despite no notable increase in supply of new single-family homes, as affordability has started to become a concern. Although rising mortgage rates are likely the culprit for the softness, they have stabilized in the latter half of Q4 and are still low by historical standards. Data from the National Association of Home Builders showed their Housing Market Index plunged in November and eased further in December, as slowing home sales and contracting traffic weighed heavy.
Inflation data has remained steady, near the Federal Reserve’s (Fed) target, but expectations for future inflation have come way down as odds rise for slowing global growth in 2019 and beyond. With the outlook for global growth lowered, the demand for oil has dropped, for example, and caused oil prices to fall, lowering energy costs and the basket of goods measured for inflation. The market’s expectation for lower inflation is displayed in the chart below.
The Fed, however, certainly does not believe the economy is going off a cliff and did not yet cease raising interest rates or decreasing the amount of their balance sheet run-off. In their December FOMC meeting announcement, they raised rates ¼ point, to a target 2.25% to 2.50%, yet seemingly begrudging took the opportunity to calm markets by lowering projections of their own path of planned interest rate increases.
Low unemployment and employers unable to find qualified candidates have not contributed to the kind of wage inflation expected with such tight labor conditions, putting less pressure on the Fed to raise rates in the foreseeable future. The bond market has been a better predictor of future interest rates and right now it predicts the Fed should be done raising rates in this tightening cycle, as per the below chart. Lower interest rates are bullish for bonds and stocks.
It was a challenging 4th quarter for US Equity markets as the sugar high from corporate tax cuts started to wear off with lower forward earnings forecasts for members of the S&P 500. The Dow Jones Industrial Average fared slightly better, but still lost -11.31%, while the S&P 500 Index and the Nasdaq Composite fell -13.52% and -17.29%, respectively, on a total return basis. Small-cap stocks, represented by the Russell 2000, were particularly battered down -20.20%.
The Utilities sector was the only major S&P sector not to lose money during the quarter, with the Utilities Select Sector SPDR ETF (XLU) gaining 1.37% on a total return basis, as investors flocked to the stability provided by their non-cyclical nature and income. Real Estate, Consumer Staples, and Healthcare were the only sectors to be spared from double-digit losses, thanks also to their defensive nature.
The fall in oil from a high of $76.41 on October 3rd to a low of $42.53 on Christmas Eve may be an effective tax cut for consumers but is weighing heavy on the burgeoning US energy industry. It is no coincidence, however, that the interest rate spread of the Blomberg Barclays US High Yield Corporate Bond Index over US Treasuries also hit its low on October 3rd at 3.0%, when oil prices peaked, and is now 5.3% despite no increase in defaults.
Interest rates on the 10-Year US Treasury Note during the quarter failed twice to break above 3.25%, which now appears to be a double-top for yields, as a flight to safety was compounded with an expected sunsetting of the Fed’s interest rate hiking cycle.
Hanlon Tactical Portfolio Commentary
The large-cap equity portion of our Hanlon Tactical Models entered Q4 invested at market weight in all GICS sectors. In the middle of the quarter deteriorating market conditions led us to reduce by half the most cyclical sectors including Technology, Industrials, Financials, Consumer Discretionary, Energy, and Communications Services. We later removed the entirety of those positions and the smaller-weighted position to Materials, leaving only market weight exposure to the more defensive sectors Consumer Staples, Utilities, and Healthcare.
In the Managed Income portion of our Hanlon Tactical Models, we trimmed our exposure to High Yield Corporate Bonds, and removed allocations to Bank Loans, Energy MLPs, Convertibles, and Preferred stocks. Small allocations to Real Estate Investment Trusts (REITs), and Emerging Market Bonds remain.
Our tactical signals continue to dictate caution as volatility and uncertainty currently warrant higher levels of cash to be prudent.
Hanlon Strategic & All-Weather Portfolio Commentary
Risk-on assets performed poorly during the quarter as total market US equities gave back their gains for the year and then some, losing over -14% in Q4. Emerging Market equities were lower, though actually outperformed Developed Market equities by a wide margin after selling off earlier this year, losing in the mid-single digits.
The equity and commodity market weakness were felt in credit as the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) lost -4.99% for the quarter. The smaller allocation to the JPMorgan Alerian MLP ETN (AMJ) was the worst performer, down over -17%.
Investment grade bonds finished the quarter with positive returns, outperforming all other allocations in the Hanlon Strategic and All-Weather models. This was due to the large allocation to government debt in Q3 laggard turned Q4 leader, the iShares Core International Aggregate Bond ETF (IAGG) which gained 1.92%, followed by the iShares Core US Aggregate Bond ETF (AGG) which was up 1.85%.
As always, we will do what’s in the best interest of our clients consistent with our principals of Passion, Integrity, Vision, and Care. We will continue to monitor for opportunities, look-ahead for market dangers and make corresponding defensive moves in our Tactical allocations to seek downside protection and upside participation. For investors seeking a complete portfolio asset allocation solution, our Strategic Models or dynamic All-Weather Models that combine buy-and-hold strategy with tactical protection are the answer. We sincerely thank you for the opportunity to be of service.
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