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Castle Monthly Financial Markets Update - December 2018

Castle Monthly Financial Markets Update - December 2018

January 07, 2019
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Castle Monthly Financial Markets Update - December 2018


Financial Market Recap for November 2018

The final week of November drove the major stock market indices back into positive territory for the year-to-date with the S&P 500 rallying almost 5% on the week. The Index was up 1.75% for November and the both the S&P 500 and Dow are up 3.2% year-to-date as of the end of November.

However, the Nasdaq lost 0.26% in November but is up over 9% year-to-date. It sure has been a volatile year with two 10% corrections so far, but a Santa Claus rally seems to be in the making with the Fed signaling that there will be less interest rate hikes in 2019.

A 90-Day Truce Between the U.S. and China

Further good news arrived for the equity markets with a 90-day trade truce between the U.S. and China. Hopefully, this gives both sides time to negotiate resolutions to the escalating tariffs and trade disputes. Of note, U.S. officials have stated that the Chinese have agreed to buy a "very substantial amount" of agricultural, energy, industrial and other products from the U.S. to trim America's widening trade deficit with China. We are awaiting the Chinese to confirm this good news and provide further details. The financial market's wild gyrations of recent months could possibly return as the two countries strain to reach a permanent accord within the 90-day truce.

Company Earning Impact on the Markets

Yes, the Fed’s actions and trade amongst countries are significant factors, but company earnings historically drive equity returns over the long-term, as shown in Exhibit 1 below. Despite short-term dislocations and noise, which are typically the result of substantive macro risks, stock prices ultimately reflect the earnings growth of companies.


Financial Market Update December - earnings growth

In simple terms, show me a chart of a company’s earnings growth and I will show you a chart of a company’s stock price, as the two tend to move in tandem as noted in the chart above. The fact is that U.S. companies market earnings growth have been significantly higher than that of non-U.S. equity markets in the wake of the global financial crisis of 2008. Because of this, U.S. company stocks have enjoyed a greater comparative advance along with U.S. equity markets.

The Challenge with Diversifying into Foreign Markets  

I am pointing this out because I have been reading articles that many large Wall Street Investment firms have been directing clients for some time to diversify into foreign markets, which has not gone well for many investors. As of the end of November, the Euro Stoxx 600 index is down over 8% year-to-date. The Hang Seng is down over 11%, the Shanghai is down over 21%, and Nikkei is lower 1.8%. All indices have lost money for investors year-to-date.

On the other hand, the U.S. equity markets set record historical highs around the end of September and are coming up on the longest running bull stock market in U.S. history. Among the gathering signs of weakening global growth was China's official manufacturing PMI (Purchasing Managers' index) dropping to 50 in November, a 28-month low. Meanwhile, Eurozone economic confidence fell for the 11th straight month, the lowest level since May 2017. On a more positive note, U.S. third-quarter gross domestic product growth was unrevised at a 3.5% annual pace.

The Market Outlook

On a global macro basis, I think the trade cease-fire between the U.S. and China is mostly about optics. For example, the Wall Street Journal, Bloomberg, NY Times and Financial Times, among others, focused on the challenges in reaching a more comprehensive deal, especially given the fact that Beijing has yet to acknowledge the ninety-day time frame. More importantly, key issues such as forced technology transfer, IP protection, and non-tariff barriers/influence of state-owned firms are structural issues that will be difficult to solve. Further, lowering tariffs on U.S. autos (if it actually happens) is almost an ancillary issue.

With regard to the U.S., Bloomberg noted that based on the 14 forecasts for 2019, strategists expect the S&P 500 to rise 11% to 3,056 by the end of 2019. This is the most optimistic outlook since the bull market began in 2009. Bloomberg cites support expected to come from still growing corporate profits with valuations also more favorable at 15.8 times expected earnings. However, I am concerned that credit markets will soon run out of steam. If they do, equities will face another headwind going forward which will afford continued volatility in the new year. Rest assured we are monitoring situations globally and are proactively managing our valued clients’ accounts to achieve their long-term financial goals.

The Fed and Interest Rates

We often hear references to Hawks and Doves when federal reserve policies are being discussed. Doves are deemed to be people who offer peaceful policies. Upon Fed Chair Powell's recent soothing speech, both stocks and bonds prices rallied higher, with home loan rates coming down and hitting their best levels in nearly two months. Some of Fed Chair Powell's market-comforting words included:

  • We know that moving too fast (hiking interest rates) will risk the economic expansion
  • It may take a year or more to fully realize the effects of interest rate hikes
  • The Fed does not see "dangerous excesses" in the stock market
  • The policy rate (Fed Funds Rate) is "just below" neutral

In consideration of these remarks, the Fed is still very likely to raise the Fed Funds Rate in December. The financial markets took the speech as signs the Fed will not hike interest rates three times in 2019, which was the Fed's own forecast.

The Fed Fund Futures, which represent market opinion on the future of the Fed Funds Rate, now suggest there will be only one Fed Funds interest rate hike in 2019, which is bullish for equity markets. I think the Fed will be more “data reactionary” and incoming data, more specifically inflation, will determine whether we see more interest rate hikes in 2019.

Accordingly, I think the bottom line is that the present low inflationary environment and slowing global growth will continue to keep home loan rates historically low. This will help housing and support more economic growth going forward, which is needed to sustain the recovery.

As We Move Towards 2019

With the unprecedented worldwide debt that I have noted in prior issues, I believe that the major money crowd, and political leaders globally, will realize that the only way out of the looming debt bubble explosion is economic growth! Accordingly, I am optimistic that cooler heads will prevail in the US and China tariff negotiations and would hope that corrupt and inept politicians around the world will finally make the tough decisions to bring down worldwide debt. Otherwise, I think we are looking at a global financial meltdown worse than 2008.

Fortunately, Castle Financial is Co-Advisor on the All Terrain Opportunity Fund, which can potentially make money in both up markets and also in a bear stock market if we enter a more prolonged period of lower stock and perhaps even lower bond prices. For now, the current bull stock market trend is still intact, and the S&P 500 appears to be in a trading range of 2650 to 2850. We will need more earnings clarity to break-out of the range, which will not come until early January 2019, at the latest. Unfortunately, volatility will likely escalate if there is any more uncertainty added to the mix.