In Q4 the markets priced in a significant probability of recession next year. Global equities sold off, oil prices collapsed, and corporate bond spreads widened markedly. As a result, the 4th quarter was the worst quarter of market performance since 2011.
The sell-off began in October with the US market losing 7% from its highs, dragging other markets with it. However, by November the markets stabilized as most of the risks appeared to be factored in: the US economy slowing from full potential, slower US corporate earnings growth, trade tensions between the US and China, US mid-term elections and the Fed increasing interest rates to a “normal” level. Elsewhere the Chinese and European economies were slowing plus the Brexit saga continues.
Locally, we’ve made it more difficult to build pipelines, buy houses and generally do business in Canada. Our anti-business policies do not attract capital internally or globally, and we depend on a weak currency to be competitive. The Western Canadian Select crude price differential is an embarrassing symptom of our current structure. Canada continued to lag all markets in performance in the 4th quarter and the year.
The above risks and issues were well priced into the markets by November. So what changed to cause December to be so volatile and deepen the US market correction from the highs in September to -20% by Christmas? Answer – the absence of the “Fed Put”.
The “Fed Put” is when the market declines substantially the Fed comes to the rescue with accommodative monetary policy and bolsters market sentiment. Fed policy affects borrowing costs, bond yields, credit standards, liquidity, economic growth, and stock market sentiment - so don’t fight the Fed. “Mr. Market” has come to expect this but there was no whiff of a “Fed Put” at the December Fed meeting. The Fed chose to ignore signals that the market was in distress and stuck to their defined mandate of price stability (inflation) and full employment. Without the Fed support the markets sold off again.
While stock market corrections are normal during the investment cycle, they are painful and unpredictable as to when they will occur. Investor anxiety heightens as it is unknown whether the correction provides a buying opportunity or entering an economic recession that will take markets deeper and longer into bear market territory before a recovery can take place. This is where discipline, patience and understanding of how the markets work is essential.
We have experienced numerous mild corrections (-10% range) and two other severe corrections (-20% range) since the 2008 crisis. In 2011 and 2015 the markets anticipated a global recession, but a recession did not occur and the market recovery rewarded those who remained invested. We believe the current situation is similar to 2015 and there will be a recovery in 2019, as this latest correction was created by a recession of confidence and not an imminent economic recession. Please refer to our Outlook section.
The quarter was difficult to say the least. Credit spreads widened on corporate debt due to fears of a recession, which caused preferred shares to sell off. Fortunately, we reduced our preferred shares in October and November to 15% underweight, but it is never enough during a sell-off. Bonds provided stability for the quarter, as they should.
In equities, we’ve experienced a convergence between the leading US market and our international and emerging market exposure, benefitting our strategy of being globally diversified. Our Canadian equities did relatively well vs. the TSX composite as we have minimal exposure to the energy sector, but there was more carnage in Canada than anywhere else in 2018. It has benefitted to be underweight in Canadian equities since 2014.