Santa’s sack of coal for the equity markets

In a year of extreme equity market movements, December took the prize as the most volatile month of all with many markets touching bear-market territory

Dec 2018


THE WORLD IN FIVE BULLET POINTS

  • In a year of extreme equity market movements, December took the prize as the most volatile month of all. Records broken included the worst Christmas Eve ever for US markets and the first-ever 1,000 point gain for the Dow Jones index in a single day’s trading. But by the end of the month, almost all markets were materially lower with the developed markets in the west taking the brunt of the selling. The reason for the sell off was largely political in nature as the US lost its Defense Secretary and a question mark suddenly appeared over Fed Chairman Jerome Powell after the Fed increased rates by 25 basis points.
  • One of the key drivers for equity market weakness in 2018 – the US-Sino trade dispute – should take a breather for the first 90 days of 2019. The respective presidents of China and the US called a ceasefire to the tariff hikes while at a G-20 meeting in Argentina, then later announced the two sides would meet in early January in an attempt to settle on a new path forward.
  • The agreement between the UK and EU on its ‘divorce’ settlement became unstuck after Britain’s Prime Minister Theresa May withdrew a vote on the agreement in UK’s parliament at the last moment, fearing a large defeat. The question of the Irish “backstop” – a mechanism to prevent a hard border between Northern Ireland and the Republic of Ireland returning – proved to be the clause with which most detractors disagreed on above all else. PM May then survived a vote of no confidence within her own party but the future of the bill in parliament looks shaky as the vote that was withdrawn still has to take place in January.
  • Staying in Europe, the EU and Italy reached an agreement that would see Italy lower its deficit target to 2.04% of GDP in 2019. The deal will likely avoid further confrontation between the two as well as EU sanctions on Italy because its original failure to comply with the EU’s requirements. But as one European country began to stablise, another, France, saw mass protests turn violent. The protests were originally called against a hike in fuel costs, a high cost of living and grievances over tax reform.
  • India’s central bank governor, Dr Urjit Patel, quit after months of speculation that relations between himself and the government had broken down. India has elections in the spring and the government was pushing for a loosening of monetary policy which would potentially deliver an economic uptick just in time for voting day, a move that Mr. Patel was resisting. Relations were thought to be on the mend following a meeting in November, so Dr. Patel’s resignation came as a surprise to the market.
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EQUITY MARKETS

  • Global equity markets were substantially lower in December with US losses dominating the headlines. The sell off brought the main US indices close to bear-market territory (20% down from a peak) and was largely driven by Washington questioning the Fed’s decision to raise rates. A series of phone calls to the large US banks by Treasury Secretary Steve Mnuchin to check on liquidity added to the jitters as did the news that Defense Secretary Mattis was to leave his position at the end of the year. Buoyant holiday sales data gave some support after the Christmas Eve sell off, leading to the first ever 1,000 point gain in the main Dow Jones index but by the then, the damage had been done.
  • European bourses were also lower with Germany down 6% and France losing 4.5% on worries of a general slowdown in the global economy and especially as the key export market of the US began to point to a slowdown ahead. The UK outperformed slightly as its large-cap dollar earners were boosted by a lower UK pound, which came under pressure as Prime Minister May appeared unlikely to have her Brexit deal approved by parliament, raising the spectre of a no-deal exit from the EU.
  • Amid the carnage in the Developed Markets in December, Emerging Markets outperformed with Latin America almost touching the flatline by the final day of trading. The MSCI Emerging Markets index fell 2.6% against the Developed Market index, which was down 7.6%, Asia ex Japan was in line with other emerging markets, and EMEA marginally underperformed. Asia saw Malaysia, Indonesia and the Philippines even record a modest gain for the month but China markets fell again to lose over 6%.
  • For the full-year, the US still outperformed the rest of the world quite comfortably despite December’s sell off. The MSCI US index ended 4.5% lower, while the European index fell 14.3%, with the outperformance largely driven by higher corporate earnings that partly came from the tax cuts introduced last December. At the same time, Europe was plagued by weakening economic data that appeared to show the continent falling from its economic peak; political problems in Italy, the UK, Spain, France and Germany; and the ending of the ECB’s quantitative easing programme also weighed.
  • Annual returns for Emerging Markets more or less mirrored Europe’s weak performance to finish down 14%, except for Latin America that fell just 6.2% as Brazil recovered in Q4 after a market-friendly president was elected. China and Korea led Asia lower as the trade dispute between China and the US heated up, threatening accelerated economic growth in both countries.
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FIXED INCOME

  • December capped a volatile year for fixed income markets, with a sizable decline in yields across most bond market segments during the month. In a widely-anticipated move, the US Federal Reserve hiked rates for the fourth time in 2018; the Fed’s median forecast for 2019 was lowered to just two hikes (from three hikes previously), with one more hike expected in 2020.
  • The 10-year US Treasury yield fell 30 basis points to end the year at 2.68%, an increase of just 28bps for the whole of 2018; the measure had been as much as 83bps higher at one point.
  • Asian domestic interest rates generally tracked the decline in US Treasury yields in December. With tighter monetary policy across major Asian economies in 2018 (South Korea, Malaysia, Indonesia, India, the Philippines and Singapore all tightened monetary policy), most Asian local bond yields finished the year higher; China and South Korea bucked the trend with notable declines in domestic bond yields.
  • In the Asian US dollar bond market, December’s performance was boosted by lower US risk-free rates, partially offset by a modest widening of credit spreads. Spread widening has been a key feature of Asian credit markets throughout 2018, contributing to the year-to-date underperformance of non-investment grade Asian credit, which experienced more pronounced spread widening compared to their investment-grade counterparts.

COMMODITIES

  • Oil prices fell more than 10% in December, almost all of that in a single week, on concerns over the future supply-demand balance. Crude plunged by more than 40% in Q4 after Washington unexpectedly gave sanction waivers to some of Iran’s largest oil importers while a slowing global economy put future demand estimates in doubt. Also during the year, the US became the world’s largest oil producer and with OPEC-led countries showing no meaningful cut in production, and, as supply surged and demand looked like slowing, WTI prices fell 25% and Brent fell 20% over the year.
  • Among other commodities, Gold was a notable outperformer for December as it regained its safe-haven status away from the US dollar, but it still fell 2% for the year, its first annual fall in three years. Other metal prices were lower for the month with aluminium plunging to 16-month lows after sanctions on Russia’s Rusal were lifted. Other metals suffered from contagion from the equity market volatility as the Fed signaled it may continue to raise rates in 2019, adding to annual losses for most metals. Palladium was a strong annual outperformer as it gained 19% on ongoing deficits.
  • Among soft commodities annual performances, cocoa gained the most on worries over harvest levels in the Ivory Coast, and wheat also rose on expectations of increased demand for US product amid a drying up of Russian exports.

CURRENCIES

  • With December being a quiet month for currencies, investors eyes turned to a more holistic overview for the year. 2018 was the year of US dollar (USD) strength but at the start of the year, most investors believed the USD would weaken. And while the USD did start the year on a weak note, it gained positive momentum in April after the Fed outlined its intention to hike rates more than the market had expected. That was one factor that weighed on currencies, and a second was the escalation of the trade war between the US and China, and indeed geopolitical concerns in general, which kept the US dollar and Japanese yen both well supported through the year.
  • Among major currencies, only the Japanese yen outperformed the USD while the higher beta currencies such as the Australian dollar and Swedish krona were the biggest underperformers. The UK pound traded within a 13% range thanks to Brexit while the euro also traded within a similar range.
  • Emerging market currencies took a big hit in 2018. As the Fed continued to raise interest rates, concerns over highly indebted countries rose, especially Turkey and Argentina, which saw their currencies depreciate by 28% and 50% respectively. Argentina sought assistance from the IMF while Turkey managed to muddle through its problems. Russia and Brazil were also hurt with the ruble down more than 17%, despite the rally in oil prices for most of the year, while the real was also affected by domestic economic problems and election concerns. These eased after the election of market-friendly candidate Jair Bolsonaro.
  • In Asia, all eyes were on the Chinese yuan as it flirted with the all important 7.00 level against the US dollar. After trading around the 6.30/6.40 levels for the first half of the year, it depreciated nearly 10% from June to October. Concerns over China’s deleveraging campaign coupled with US-China trade tensions left the currency vulnerable to a sell off. In India, the rupee reached a record high of 74 against the dollar while the Indonesian rupiah rose to a 20-year high. As the EM contagion gathered pace, emerging markets with twin deficits (such as Indonesia) sold off as investor drew parallels to Turkey and Argentina.
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ECONOMICS

  • US ISM data pointed to strong activity in both manufacturing and services sectors while core inflation remained tame at 2.2% yoy for November helped by falling fuel prices. Industrial production rose 0.6% supported by a cold snap which propelled utilities output. But elsewhere, several US economic data points showed the first hints of a slowdown - nonfarm payrolls rose just 155,000, below expectations, and the unemployment rate held at 3.7%. This didn’t stop the Fed from raising rates by 25 basis points to 2.25-2.50% but despite indications from its Chair Jay Powell that the Fed still favoured more hikes, the markets are now reconsidering its view of further rate rises in 2019. Indeed, Bloomberg says US money markets are now pricing out any rate hike next year and are pricing in more than a 50% chance of a rate cut in 2020.
  • The Bank of Japan widened its trading range of yields on government bonds, a move normally reserved for cooling an overheating economy but this time designed to improve the stability of profits at the banks. It also kept its central interest rates on hold as expected. Data at the end of the year pointed to Japan’s population falling by almost half a million in 2018.
  • The ECB ended its €2.6 trillion bond purchase programme although it also promised to continue to feed stimulus into Europe’s economies in the event of an unexpected slowdown and protracted political turmoil. It also kept its interest rates on hold while lowering its growth target to around 1.5%. Italy’s economy shrank 0.1% qoq in Q3 and with survey data showing weakness continuing into Q4, it is possible Italy will suffer its first recession in five years.
  • China’s economy continued to show signs of slowing. November retail sales grew at just 8.1%, their weakest pace since 2003, and down from 8.6% in October. Auto sales were down 10% yoy. Industrial output rose 5.4% - the slowest pace of growth in three years and below market expectations.
  • Elsewhere, Australia’s GDP growth slowed to just 0.3% qoq, the weakest since Q3 2016. As well as the rate hike in the US, Thailand, Mexico and Sweden all raised rates while Japan, India and Canada (among others) kept rates on hold. The UK’s BoE also held rates but said that business investment had been more subdued of late as the uncertainty of Brexit intensified.

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