December’s Sell-Off Could Be a Warning to Investors

The holiday season is typically a time for rest and relaxation, but investors were in for a rude awakening end-of-December. Volatility spiked in the fourth quarter, right around Christmas in particular. The S&P 500 dropped 2.7% on Christmas Eve, then bounced back 5% the next trading day—the index’s largest single-day gain since 2009. This recovery was barely a band-aid on December’s bloodbath, which itself set a record: the month’s worst performance since the Great Depression.

In all, 2018 gains were erased for U.S. equities during the fourth quarter, with the asset class posting its first decline since 2008. On top of that, commodities and international equities were slammed, while bonds barely managed a flat return for the year. The only major asset class with a gain was cash.

Three main factors can be pinpointed for the poor performance, starting with the trade war between the U.S. and China, who together comprise 53% of global GDP growth. Also in December, the Federal Research implemented its fourth interest rate hike of 2018. The market had only expected two or three for the year and fears about continued tightening sent stocks downward. Finally, the third U.S. government shutdown under the Trump administration began last month and continues today—the longest shutdown ever. About $1.2 billion is being lost per week, according to S&P Global Ratings. While there were bouts of volatility in previous quarters, these factors led to a breakdown in fundamentals during the fourth quarter and could signal the end of a decade-long bull market. The good news is that a full-blown economic recession is unlikely for 2019 (if it comes, it will likely be in 2020 or 2021). The outlook is still bleak thanks to rising tensions internationally, tighter financial conditions domestically, and the possibility of peak earnings. More specifically:

    1. The Chinese economy is huge and the country’s corporate debt is hefty. Thus, a material slowdown there would likely have effects far beyond its borders. On top of that, after two years of failed negotiations, the probability of a hard Brexit is rising. Britain is supposed to leave the European Union in March. If that happens without a deal, investors can expect short-term chaos, which could lead to sharply lower growth in the EU and UK.
    2. Earnings growth is expected to slow dramatically this year, despite the fact that last year saw impressive levels of corporate profits. A stronger U.S. dollar and the aforementioned unresolved trade tensions are the drivers of this prediction.
    3. Finally, the impact of the Fed’s hawkish stance is already being seen beyond investor sentiment. The growth of U.S. housing starts—historically a reliable leading economic indicator—have already slowed thanks to higher interest rates and material costs. In the past, they have often trended downward ahead of recessions.