2018 started strong in January but ended with a December marked as the worst December since 1931. At the close of the 3rd quarter domestic stocks had recovered most of their losses from February and April, and appeared poised for a strong end to the year. All this changed early in October as the market hit correction territory for the third time in 2018. Throughout October and November volatility increased with triple digit swings almost daily. The good news was that the major indexes held above the lows of the year and a rally after Thanksgiving was encouraging.
Then early in December selling pressure from uncertainty at home and abroad took control of the market. The exit of the UK from the European Union is a serious concern globally, not just in Europe. Talks with China that seemed to be moving towards an agreement on trade a few weeks ago, now appear to be less promising. Concern over trade with China and resulting tariffs is weighing heavily on U. S. investors and is a global concern as well.
At home the Federal Reserve is aggressively tightening its monetary policy. December brought the 7th increase in short term interest rates in two years, but the Fed is also quietly shrinking its balance sheet. $50 billion of bonds is maturing monthly and not being replaced. Remember Quantitative Easing? For several years following the financial crisis, the Federal Reserve bought government bonds to increase the money supply. Now the opposite is taking place. Tight monetary policy strengthens the dollar which hurts our trading partners and is especially hard on emerging economies.
There is a caveat when it comes to interest rates. The Fed does not want to invert the yield curve. The Federal Reserve sets short term interest rates, but the market determines long term rates. When short term rates are higher than long term rates it is called an “inverted yield curve”. In a normal curve long term rates are higher than short term. In December Treasury yields declined. The 2-year yield at the end of December was 2.52% and the 10-year yield was 2.72%. This decline in market rates could well put the brakes on short term rate increases by the Fed in 2019.
With the market already in a steep decline a partial government shutdown began on December 22nd. In the absence of appropriation of funds for the upcoming fiscal year a continuing resolution is necessary, but Congress and the Administration are at an impasse.
All this uncertainty overwhelmed investors and supply is controlling the market. The decline was swift and by December 24th markets were within 1% of bear market territory for the first time since 2011. In spite of strong corporate earnings, good GDP numbers, rising wages and full employment, markets can go down.
Volatility is common in bear markets. Strong bounces often follow a swift decline and these up days may be encouraging, but caution is called for. The current trend is down and protecting assets is important until volatility subsides and the market resumes a positive trend.