Market volatility in December tested the emotions and confidence of even the most experienced investors. The resignation of James Mattis as secretary of Defense, rumors that President Donald Trump would fire Federal Reserve Chair Jerome Powell and the shutdown of the U.S. government were unwanted gifts for investors hoping for a restful holiday season.
The market may have overreacted to the latest developments in a turbulent year, and December’s market slide is more likely to be a pause in the bull market rather than the start of an extended bear market. Government shutdowns are becoming a more frequent occurrence, and this shutdown may end shortly into the new year. It is unclear whether Trump can legally fire Powell, and doing so would meet with opposition from both Democrats and Republicans on Capitol Hill. Fed policy wouldn’t likely change if Powell were removed from office, as the remaining members of the Board of Governors would be united in defending the independence of the central bank.
The primary drivers for the market outlook are expectations for economic growth, interest rates, and trade policy.
Economic growth is slowing from the rapid pace of the first three quarters of 2018. Global manufacturing indicators are weakening, a consequence of uncertainty about trade policy and slowing economic growth in China. Manufacturing growth continues to expand in most of the world, albeit at a slower pace. China is a notable exception, however, with the most recent data signaling a slight contraction in manufacturing activity.
The housing market has also lost momentum. Although home prices have been rising, indicators such as housing starts and mortgage applications are uninspiring. Rising interest rates, tax changes reducing the desirability of homeownership, and a shortage of entry-level homes are among the factors contributing to the housing slowdown.
Falling oil prices contributed to December’s market volatility, as investors worried that oil prices were a signal of collapsing economic growth. The fall in oil prices has more to do with an abundance of supply rather than a shortage of demand. The Trump administration granted waivers of sanctions on Iranian oil exports to eight major importers, which effectively added more than 1 million barrels per day to the global supply of oil.
The American consumer provides a considerable counterweight to the bad news of recent weeks. Consumers are benefiting from a tight job market, long-overdue wage increases and healthy personal balance sheets. Solid retail sales this holiday season and a blockbuster employment report for December offsets much of the negative news elsewhere in the economy. Overall, although U.S. economic growth will slow from the rapid pace of the first nine months of the year, fourth-quarter GDP growth is projected to remain above-trend for this economic expansion.
The Fed raised interest rates four times in 2018. Second-guessing the Fed is a popular pastime, but Trump is overstating the degree to which the Fed is to blame for the economic slowdown and market downturn. The Fed’s actions are consistent with the mandate to promote maximum employment, stable prices and moderate long-term interest rates. From the Fed’s perspective, tight labor markets are creating long-overdue wage growth, fiscal stimulus may contribute to inflationary pressures, and tariffs may be inflationary in the short term.
By raising rates to at least a “neutral” level and shrinking the Fed’s balance sheet, Powell is trying to regain the flexibility necessary to support the financial system during the next recession. The Fed is also aware that past periods of “easy money” gave rise to excesses in commercial and residential real estate, technology and commodities. However, the downturn in equity prices and widening of corporate credit spreads relative to government bonds seem to make that task less critical. Slowing growth and the flattening yield curve may cause the Fed to hit the “pause button” on rate hikes in 2019.