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January 2019 Investment Commentary
The fourth quarter was sharply negative for stocks, thanks to major bouts of weakness in October and again in December. This turned modest year-to-date portfolio gains through September into losses by year-end. It was the toughest year since 2008.
Early-quarter reduction of small capitalization stocks and elimination of energy master limited partnerships (MLPs) were helpful, as these were two particularly weak areas, but this benefit was partially offset by redeployment of proceeds to diversified U.S. equity, which also dropped. Adding meaningful bond exposure, in April and again in July 2018, was helpful. Moreover, our bond manager group provided positive 2018 returns, versus the negative bond index return, shown below.
|Fourth Quarter||2018||Five Years (ann.)|
|Developed International Stocks||-12.5||-13.8||0.5|
|Global Hedge Funds||-5.6||-6.7||-0.6|
The sell-offs seemed more a pent-up recognition of established threats than a result of new negative surprises. On the trade front, the recent period if anything offered some reassurance in the form of a 90-day cease-fire with China, good until the end of February. Stocks reacted negatively to the Federal Reserve’s December quarter point federal funds rate hike to 2.25-2.50%, and projection of two more in 2019, though both had been well telegraphed ahead of time. Even the November mid-terms yielded the expected shift of the House to the Democrats while the Senate stayed in Republican hands, and the actual numbers of seats changed were within the bounds of forecasts.
An underlying theme, concern about decelerating economic growth, also is not new, but it sharpened in the quarter. This may simply reflect the approaching new year. Economists widely expect last year’s growth of around 2.9% to cool, to something in the 2.0-2.5% range in 2019, at least partly due to receding benefits of the late 2017 corporate tax cut and early 2018 spending bill. The Fed itself acknowledged increasing headwinds at the December meeting, reducing its 2019 forecast from 2.5% to 2.3%. (The current government shutdown, not factored into these numbers, could shave a few tenths off first quarter GDP growth.) The deeper worry may be that a recession lurks somewhere over this horizon. All expansions in history have given way to contractions at some point, and this recovery is indeed mature. It would hit the 10 year mark this July 1st, tying the longevity record.
Similarly, investors are grappling with an increasingly challenging earnings picture, also on the heels of 2018 success. After an 11% operating earnings decline in 2015, we’ve seen three steep stairsteps since – growth of 6% in 2016, 17% in 2017, and around the mid-20%s last year, the last jump having lower tax rates largely to thank. Expectations for 2019 understandably have been more muted for months, but have edged down further recently, from low double to high single digits, on a more cautious fundamental outlook. And one trading day into 2019, Apple issued its first revenue forecast downgrade in 15 years, citing two factors already on investors’ minds – duller economic growth, specifically in China, and the various effects of the trade dispute.
With the rough year-end markets and calendar turn to 2019, Fed Chair Jerome Powell publicly tweaked his position on future rate hikes, expressing a higher level of flexibility based on ground conditions. Market sentiment seemed to improve, as this addressed a disconnect: While the Fed finished 2018 with a fourth funds rate increase for the year, longer rates in fact moved lower, the resulting flatter yield curves reflecting a more cautious economic outlook. The 10-year U.S. Treasury rate, after rising from 2.41% to 3.06% over 2018’s first nine months, retreated to 2.68% over its last three. The 5-year Treasury rate dropped from 2.96% to 2.51% over the final quarter, the latter number roughly equaling the upper band of the Fed policy rate. Before Powell’s January pivot, Wall Street had already scrubbed expectations of further Fed rate hikes in 2019, moving toward a zero-hike forecast. Investors now may feel more on page.
As recession angst smolders, the very dullness of this economic recovery may work in its ongoing favor. A lack of excess suggests less need for major correction. Annual real GDP growth of 2.3% since mid-2009 not only falls well below the 4.3% average of ten previous post World War II recoveries, but also the 2.7% rate of the last 50 years, spanning all environments. Looking more closely at the consumer, the labor market closed out a solid 2018 on a very strong December note, its 312,000 jobs gain bringing the year to 2.64 million, the best this century other than 2014 and 2015. However, wage growth has only just in recent months exceeded 3% on a year-to-year basis, and even that is still below its 4.1% 50-year average. At the same time, household debt data do not suggest an overextended consumer: debt service payments currently represent 9.9% of income, the lowest in at least 40 years.
If we are able to sidestep big setbacks in economic and corporate performance, the steep sell-off has created a new valuation argument, both here and overseas. In terms of price to trailing earnings, the S&P closed the year at 15.9 times, compared to a 20-year average of 18.3 times. Developed non-U.S. markets offer an even steeper discount, ending 2018 at 12.8 times, versus its 17.8 times 20-year average, and the emerging group sold at 11.5 times, off its 14.4 times average. On these and a number of other measures, including estimated forward earnings, world stocks are cheaper than they’ve been in five or six years. And to the extent we do encounter a recession, the typical peak to trough equity decline has averaged 30% in response to the 11 post World War II recessions. We just traveled two-thirds down that path absent a recession, the S&P 500 dropping 19.8% from September 20th through Christmas Eve.
Clearly, corporate performance going forward will tell an important tale about the allure of valuations. Investors will need to weigh whether Apple’s news is a function not only of China GDP and trade challenges but also broader issues around the company’s innovation war chest or the technology cycle in general. As advances in iPhone functionality become less compelling, consumers will be more inclined to stay with older models, or, as we’ve seen in China, gravitate toward cheaper, local smartphones. This can happen quickly. With help from the iPhone 8, Apple’s market share in China was 24.3% at the end of 2017. A year later, it has fallen to 7.0%, fifth place behind four homegrown players, who collectively have a share of 81.7%. The company remains powerful in much of the rest of the world. But the pressure is on, and both the company and the industry in general will need to demonstrate that important innovation still lies ahead.
As always, political dynamics also will demand attention in the coming months. The Congressional power shift will bring new checks on President Donald Trump’s trade approach, including possible legislation to curtail White House usage of the national security argument (section 232 of the 1974 Trade Act) to unilaterally enact tariffs. The heat is likely to turn up regarding fiscal policy, as fiscal deficits and the national debt rise in the wake of the corporate tax cuts. (President Trump has suggested a 5% across the board spending cut.) Abroad, the clock will tick ever more loudly on the Brexit March 29th deadline. Resolution seems a lot less likely than some variety of can-kicks and a chance of a new referendum. And on October 31st, Mario Draghi’s eight-year single term as European Central Bank head ends. His “whatever it takes” 2012 statement reassured markets for years, and a hardliner successor, which is very possible, could challenge investor mind-sets.
While we’ve suffered a major sell-off, our view is to stay invested and rebalance on the weakness, following the recommended positioning put forward in October. Tactically, we remain moderately underweight long-only equity, and recent shifts have been made to dial back sector exposure (specifically, real estate and MLPs) given the lateness of the economic cycle. The increased bond allocation includes managers with the flexibility and demonstrated talent to navigate the current volatility, being opportunistic or defensive based on perceptions of the rate cycle, credit conditions, and the relative appeal of currencies.
During difficult markets, and at all times, it is helpful to keep the longer-term context in mind. Using U.S. indices, a 50/50 stock/bond portfolio has not posted a negative annual return over a calendar five-year period from 1950 through the end of 2018 -- 64 observations running. This is also true of all five of our guideline portfolios, allocations ranging from effectively 90/10 stock/bond to 20/80 stock/bond, over the nine calendar five-year periods since their 2006 launch through 2018. Interestingly, either stocks or bonds alone has in fact gone moderately negative in a five-year period, which speaks to the power of diversification. We certainly maintain adherence to that principle.
Markets notwithstanding, we hope the holidays treated you well. As always, but certainly during times of elevated worry, please feel free to contact any of us on the investment team.
David S. Beckwith, CFA
Managing Director & Chief Investment Officer
This letter may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.