By Joseph V. Amato, President and Chief Investment Officer – Equities
The year-end sell-off may have been as much about poor market liquidity as poor fundamentals.
It has been quite a month since we put out the last CIO Weekly Perspectives of 2018.
The sell-off in risk assets that began in October spiraled downward as the holidays approached, leaving the S&P 500 Index nursing its worst December return since 1931. Oil spilled into a bear market. The U.S. yield curve flattened dramatically. Fed Funds futures moved, with alarming speed, from pricing two to three rate hikes in 2019 to pricing a rate cut. Many economists' models indicated that markets were signaling a 50-60% chance of a U.S. recession this year.
By Friday, however, equities had roared back by around 10%, high yield bond spreads had tightened by some 80-90 basis points, oil was rallying strongly and Fed Funds futures were back to pricing in a small probability of a hike by June.
What changed over those weeks? Very little, it seems, fundamentally speaking.
Fedspeak turned more dovish, an important signal that the central bank recognizes the softening economic fundamentals that began showing up in September. But last week's data releases tell much the same story we were reading before Christmas: The November U.S. Job Openings and Labor Turnover Survey confirmed the robust employment picture painted by the recent payroll data; news of a tax stimulus and potentially looser fiscal policy out of China, combined with a further weakening in its consumer and producer price inflation; and more evidence of softening domestic demand out of Europe.
What did change, however, was a confluence of technical and market-liquidity factors. December seemed to us a perfect storm of poor market liquidity, tax-loss selling and a broad reluctance to take risk.
After sitting tight during October and November, investors ran for the exits in December. According to Deutsche Bank (NYSE:DB), the $86 billion withdrawn from global equity funds was the biggest monthly outflow since 2008, and the $56 billion outflow from U.S. equity funds set a new record.
There seemed to be a real reluctance to take risk going into year-end, understandable after a brutal year of returns. This was compounded by a seasonal dynamic, as the Q4 sell-off presented taxable investors with an opportunity to protect gains from the last few years through tax-loss selling - dumping stocks that are underwater and using those losses to offset year-end capital gains tax liabilities.
Add it all up, and you get the result that JPMorgan (NYSE:JPM) alluded to in a recent research note. Its analysts looked at the impact of futures trading volumes on prices (the so-called Hui-Heubel liquidity ratio) and found that the number of trades driving each point of price change in global equity markets has been getting lower and lower since Q3 of last year, approaching levels last seen at the start of 2016.
When our Asset Allocation Committee met at the beginning of December to decide our 2019 outlook, we were cautious on most equity markets. By the time we published last week, we had adopted a more positive view.
Our economic outlook has not really changed. We still think that the Fed's December hike could be the last one until at least the second half of 2019, and that this will help the U.S. to achieve a "soft landing" and the rest of the world's economies and markets to catch up again. We do not think the cycle is at an end. Markets moved the needle for us, however. If our soft-landing thesis has merit, December was an overreaction, current risk-asset valuations look attractive and there is an opportunity carefully to increase allocations.
In December 1931, the S&P 500 crashed by 14.5% and was down a further 9% by the end of 1932. But that was in the midst of the Great Depression. On the 10 occasions the index has suffered a negative December since then, only two have been followed by a down year. Many of the up years saw substantial gains, with the last four returning between 17% and 33%.
Mean reversion is not something we put all our faith in, but it is interesting to note. When markets experience a liquidity crunch against an essentially unchanging economic backdrop, it can happen - and it often happens fast. Investors who sit out now could miss a chunk of this year's returns.
In Case You Missed It
- ISM Non-Manufacturing Index: -3.1 to 57.6 in December
- China Consumer Price Index: +0.3% in December month-over-month and +1.9% year-over-year
- China Producer Price Index: -1.0% in December month-over-month +0.9% year-over-year
- U.S. Consumer Price Index: -0.1% in December month-over-month and +1.9% year-over-year (core CPI increased 0.2% month-over-month and 2.2% year-over-year)
- Eurozone Q3 2018 GDP (Final): +1.6% annualized rate
What to Watch For
- Tuesday, 1/15:
- U.S. Producer Price Index
- Wednesday, 1/16:
- U.S. Retail Sales
- NAHB Housing Market Index
- Thursday, 1/17:
- U.S. Housing Starts and Building Permits
- Japan Consumer Price Index
- China Q4 2018 GDP
- Andrew White, Investment Strategy Group
Statistics on the Current State of the Market - as of January 11, 2019
|S&P 500 Index||2.6%||3.6%||3.6%|
|Russell 1000 Index||2.8%||3.9%||3.9%|
|Russell 1000 Growth Index||3.2%||4.0%||4.0%|
|Russell 1000 Value Index||2.4%||3.8%||3.8%|
|Russell 2000 Index||4.8%||7.4%||7.4%|
|MSCI World Index||2.8%||3.9%||3.9%|
|MSCI EAFE Index||2.9%||3.9%||3.9%|
|MSCI Emerging Markets Index||3.8%||3.7%||3.7%|
|STOXX Europe 600||2.3%||3.9%||3.9%|
|FTSE 100 Index||1.2%||2.8%||2.8%|
|CSI 300 Index||1.9%||2.8%||2.8%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||-0.1%||0.0%||0.0%|
|Citigroup 10-Year Treasury Index||-0.3%||0.0%||0.0%|
|Bloomberg Barclays Municipal Bond Index||0.0%||0.3%||0.3%|
|Bloomberg Barclays US Aggregate Bond Index||0.0%||0.2%||0.2%|
|Bloomberg Barclays Global Aggregate Index||0.2%||0.6%||0.6%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||1.1%||3.4%||3.5%|
|ICE BofA Merrill Lynch U.S. High Yield Index||1.9%||3.2%||3.2%|
|ICE BofA Merrill Lynch Global High Yield Index||1.7%||2.5%||2.5%|
|JP Morgan EMBI Global Diversified Index||0.7%||1.7%||1.7%|
|JP Morgan GBI-EM Global Diversified Index||0.8%||2.4%||2.4%|
|U.S. Dollar per British Pounds||0.8%||0.7%||0.7%|
|U.S. Dollar per Euro||0.6%||0.4%||0.4%|
|U.S. Dollar per Japanese Yen||-0.3%||1.2%||1.2%|
|Real & Alternative Assets|
|Alerian MLP Index||2.8%||10.2%||10.2%|
|FTSE EPRA/NAREIT North America Index||4.9%||4.3%||4.3%|
|FTSE EPRA/NAREIT Global Index||4.3%||4.5%||4.5%|
|Bloomberg Commodity Index||1.7%||3.9%||3.9%|
|Gold (NYM $/ozt) Continuous Future||0.3%||0.6%||0.6%|
|Crude Oil (NYM $/bbl) Continuous Future||7.6%||13.6%||13.6%|
Source: FactSet, Neuberger Berman.
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