2018 – Making Lemonade From a Lemon

2018 – Making Lemonade From a Lemon

Last year was a year many in the investing world would rather forget as investors were tested with two double-digit stock market corrections that felt particularly jarring following 2017, a year when volatility was abnormally low. These significant market pullbacks inevitably test the ability of both professional and amateur investors alike to maintain conviction and stay steadfast, and to focus on data and fundamentals rather than heightened emotions. Despite the fact that 2018 ended with almost every asset class delivering a negative return, it was also likely a year of opportunity for investors who have a long view and can look past the volatility of the moment.

Back in January of 2018, a spectacular performance for the previous year had just ended, with global economic growth synchronizing for the first time in nine years. New lower corporate tax rates were about to positively impact 2018 earnings projections, and interest rates were historically low, even though the Federal Reserve had telegraphed plans to increase them.  Valuation was also quite reasonable, particularly against a backdrop of 20%+ corporate earnings growth and little to no real inflationary pressures. By all measures, it seemed highly likely that the equity market would enjoy a positive return in 2018 against this backdrop.

Even though the first six months of the year were characterized by increasing volatility, year-to-date returns for U.S. large-cap stocks were actually up double-digits by the end of the third quarter, as stocks generally followed through accordingly based on strong economic indicators. However, sentiment quickly changed in early October as global growth began to show signs of slowing, and as trade tensions escalated and concerns grew about how much the Federal Reserve was paying attention to these shifting global developments. The end result was a closing quarter on the year of disappointing results across the board as equity market returns became negative and bonds eked out only a very slight positive return. Indeed, for the full year, cash – now yielding 2.5% following nine Federal Reserve rate hikes – was the best performing asset class. Sensible year-end tax loss harvesting compounded the decline, and algorithmic hedge fund trading clearly contributed further to the pronounced sell-off late in December before abruptly reversing itself somewhat as worst-case fears subsided.

Buried within the volatility and widespread hand-wringing was quite a bit of good news in the fourth quarter that was essentially ignored by too many short-term traders as emotions overheated. Specifically, third quarter corporate earnings were stronger than expected and grew over 20%. Plus, the outcome of the mid-term elections in the U.S. was relatively benign, the Federal Reserve became much more dovish, OPEC agreed to reduce the supply of oil (thus supporting prices), and some meaningful progress occurred toward a trade deal with China following the G20 meeting. In our view, much of this news was supportive of economic growth and gave us confidence to make a modest addition to your stock holdings during the quarter.

As we enter the eleventh year of this economic cycle, and as we recognize last year’s above-average corporate growth driven in large part by substantial tax and economic stimulus in the U.S., there is little question that growth will inevitably slow. Still, it’s important to keep in mind that there is a big difference between slowing growth and recession. According to the National Bureau of Economic Research (NBER), a recession is defined as a significant decline in economic activity across the economy, lasting more than a few months. Many of the measures used to determine the economy’s health are backward-looking, which helps explain why recessions are usually not “official” until they are well underway. Nevertheless, looking at current readings of these various measures, including employment, real income, retail sales, and other indicators, all suggest that we would need to see a major deceleration before getting close to being in recession.

A more likely outcome is that softening global growth will bottom out in the first half of 2019 and then stabilize at more normalized (and sustainable) levels. The International Monetary Fund recently projected global growth of 3.5% in 2019, as many central banks have stepped up their levels of accommodation. China recently increased efforts to stimulate its economy, and the Fed has indicated plans to take a “patient” approach, recently reducing the number of projected rate hikes this year from three to two and also signaling that the size of its current balance sheet may end up more permanent in nature. Importantly, more clarity on trade relations between China and the U.S. would also serve to provide more stability to the global economy and negotiations on this front continue to progress, albeit at a slow pace.

In our view, equity markets have recently “reset” in many ways and earnings estimates for this year have now declined to levels that look quite achievable, perhaps even beatable, particularly if many of the potential margin pressures fail to materialize. As a result, the expected returns of many asset classes have actually risen. Being disciplined to reduce equity exposure when the risk/reward trade-off looks less favorable compared to short-term bonds, now yielding over 2%, and then having the fortitude to focus on fundamentals during often emotional market pullbacks, this is the hallmark of what we have done historically and what we plan to keep doing for you going forward. We wish you a happy, healthy and prosperous year and look forward to sharing our ongoing perspective with you in the coming months.

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