A harsh financial winter blew in over the fourth quarter, especially in December, as investment
markets were whipsawed by investor concerns regarding slowing global growth, trade deterioration,
and policy uncertainty. Volatility as measured by the Cboe VIX Index registered a sustained gain
– closing above 30 for four days – which further dampened the mood of investors who faced
a liquidity constrained environment at year-end. Overall, the final quarter of 2018 was one of
re-priced expectations, as the defining feature of this cycle – central bank support – continued to
be withdrawn. In the ninth such move since 2015, the FOMC raised rates at its December meeting,
bringing the target range for the Federal Funds rate to 2.25% - 2.50%. While this move was largely
anticipated, recent market volatility and concerns about the economic outlook led many investors
to expect the Fed to pause rate hikes in 2019, even as the Fed itself maintained a tightening
bias. This mismatch in expectations between the market and the Fed regarding the path of rates
increases the possibility for a policy misstep, adding to the numerous downside risks facing the
economy. The Fed did adjust its growth outlook downward, coinciding with softer manufacturing
and housing market data, which further contributed to a substantial drop in consumer optimism
just months after the gauge hit an 18-year high. Notably, housing is a leading indicator, and
current data points suggest a tightening environment going forward as home sales have been
sluggish against a backdrop of challenged affordability and early 2018’s rising mortgage rates.
Meanwhile, in other forward-looking metrics, the Treasury yield curve has flattened considerably
as inflation expectations collapsed, and actually inverted between 2- and 5-Year maturities in mid-
December. Whether the front-end inversion was a classic recession signal or just a short-term kink
that can be explained away by technical factors, it sent a warning flag to investors as the impact of
tax cuts and deregulation fade. The high-level view suggests a decade-old economic recovery that
is losing steam, while growth prospects are burdened with an enormous debt build-up that will be
increasingly more difficult to service prospectively...
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