Domestic equity markets declined significantly during the fourth quarter of 2018, wiping out the gains from the first three quarters and ending the year with negative calendar year returns for the first time since 2008. The S&P 500 Index fell 13.5% during the quarter, its worst quarterly return since the third quarter of 2011.
Large-cap stocks outperformed their small-cap counterparts during the quarter, with the Russell 1000 Index and Russell 2000 Index declining 13.8% and 20.2%, respectively. In contrast to the last two years, value-oriented stocks outperformed their growth-oriented counterparts across all market-caps. Defensive sectors faired best during the quarter, with the Utilities sector providing the only positive returns. Energy was the worst performing sector, declining 23.8% as oil prices collapsed, followed by the growth-oriented Technology, Industrials and Consumer Discretionary sectors.
Despite broad declines, international equity markets generally outperformed domestic markets during the fourth quarter. After struggling for most of 2018, Emerging Markets were one of the strongest performers, with the MSCI EM Index declining only 7.5% during the quarter, boosted by strong returns from Brazil. Conversely, Chinese markets continued to weigh on relative returns as concerns over trade and an economic slowdown intensified. Japanese stocks were some of the worst performers, with the MSCI Japan Index falling 14.2% as exporters suffered from increased strength in the yen. The S&P 500 Index significantly outperformed the rest of the world, as measured by the MSCI ACWI Ex USA Index, in 2018, returning -4.4% compared to -14.2%.
The Federal Open Market Committee (“FOMC”) lifted its federal funds target rate by 25 basis points to a range of 2.25% to 2.50% during its December meeting, but lowered forecasts for rate increases in 2019, citing recent market volatility, tame inflation, and slowing global growth. The U.S. yield curve moved marginally closer to inversion during the fourth quarter, with the yield on the 2-year Treasury declining 0.33% and the yield on the 10-year Treasury declining 0.36%, finishing the quarter at 2.48% and 2.69%, respectively. There was a flight to safety within fixed income markets with Treasury bonds and Mortgage-backed Securities providing greater than 2% returns, while High Yield bonds, historically more correlated with equity returns, declined 4.5%.
The initial estimate of fourth quarter gross domestic product (GDP), delayed by the government shutdown, is scheduled to be released February 28, 2019. Current expectations are for 1.5% annualized growth in the fourth quarter, a significant step down from the 4.2% and 3.4% growth experienced in the second and third quarter of 2018, respectively. Expectations for growth are lower as the positive impacts from tax reform wear off and the effect of the U.S.-China trade dispute deepens.
The unemployment rate increased from 3.7% to 3.9% during the fourth quarter of 2018. A tight labor market attracted a significant number of entrants to the labor force, with the labor force participation rate rising from 62.7% to 63.1%, accounting for a large proportion of the increased unemployment rate. The U.S. economy added an average of 232,000 jobs per month during the quarter.
The year-over-year headline inflation rate fell from 2.3% to 1.9% during the quarter, with a sharp decline in gas prices during December having the largest impact. During the same period, core inflation, which excludes food and energy, remained flat at 2.2%. Increases in the indexes for shelter, recreation, and medical care helped to offset declines in the indexes for airline fares, used cars/trucks, and vehicle insurance during December.
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