Accounts underperformed for the quarter ended December 31, 2018 but outperformed for the full year. After the S&P 500 reached an all-time high at the beginning of October, the investment climate made a dramatic about face resulting in disproportionate selling of the last few years’ best performing stocks. We have owned many of them and, in fact, the two stocks which were the largest contributors to performance in the first nine months of the year were the two most significant detractors in the fourth quarter.
Fears regarding government policy (monetary and trade) coupled with the unknown magnitude of worldwide economic deceleration drove down equities and widened corporate bond yield spreads. To get a sense of why volatility spiked so dramatically, please compare the following statements from Jerome Powell, the new Chair of the Federal Reserve:
October 3, 2018: “… interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”
November 28, 2018: “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy-that is, neither speeding up nor slowing down growth.”
Given that the Federal Funds rate did not change from one statement to the next, investors’ consternation is easy to grasp. Throw in the binary nature of trade negotiations with China and the recipe quickly became distasteful at best or toxic at worst.
Our response was to reduce equity exposure by cutting holdings in banks and other economically sensitive stocks. In situations where long-term appreciation had resulted in outsized weightings, we reduced positions in select growth stocks. The proceeds from these sales have been largely retained as cash although we initiated probe positions in a few growth stocks where price dislocations created long-term opportunity.
Our outlook going forward, while flexible, holds the following assumptions:
– Recent communications from the Federal Reserve convince us that they will employ a data dependent policy. In other words, they are not likely to blindly follow a predetermined path of increasing rates until the economy drives off a cliff. This does not imply that the Fed will not increase rates in 2019 but that changes will be judicious. In a good scenario, we will see a long pause akin to the Fed’s actions in early 2016. Their current policy of gradually shrinking the balance sheet will likely remain in place, being held in reserve to counter unexpected weakness.
– Domestic economic growth will continue to decelerate to around the 2% level. Job and wage growth will be additive but overseas weakness and the anniversarying of recent tax cuts will take the edge off of growth. At recent points, the yield curve came close to inverting, which typically signals recession. We do not think that will be the case in 2019.
– Trade negotiation with China is the most difficult variable to handicap because it lies at the intersection of economics, politics, personality, and game theory (a very dangerous spot). With that caveat, we believe that a positive outcome is likely, simply because it is in both sides’ best interest. We fully expect volatility in financial markets as progress in reaching a deal ebbs and flows. However, China’s economic growth has severely contracted, and by some metrics, is the slowest in decades. We expect more stimulus, both fiscal and monetary, from their government but resolving the trade war with the United States would be their most effective tool. With tariffs being a de facto tax and the uncertainty of an escalation in the trade conflict dampening corporate capital spending plans, the U.S. would also benefit from resolution.
– Corporate profit growth will be challenged in 2019 by slower overseas growth, a U.S. dollar which is now about 5% higher than last year’s first quarter, and margin pressure from tighter labor markets. With recent oil quotes about 20% below their 2018 average, the energy sector should also drag on S&P 500 profits. However, the domestic economy is still expanding, buybacks will continue, and there are plenty of innovative companies adding secular growth into the mix. The net is that we expect modest gains in corporate profits, likely at the low end of strategists’ estimates. After a period of above trend profit growth, analysts’ earnings estimates tend to become upward-biased. We anticipate that avoiding earnings shortfalls will be a key factor in stock selection for 2019.
-Equity valuations are currently in line with historic norms with interest rates remaining below average. This should offer some cushion as we go through the expected volatility of the coming year’s events.
Our portfolio places emphasis on companies operating with secular tailwinds at their back. After the recent correction in valuation, we believe that these stocks’ earnings growth should stand out in a more muted economic backdrop.
The S&P 500 registered its worst December in fifty years. It would be easy to extrapolate this into the 2019 outlook. However, the financial world tends to hold some self-correcting mechanisms. For example, the Federal Reserve has noted market signals and is likely to modify policy. The President, who at times likes to use the Dow Jones Index to keep score, has also noticed the decline which may help soften Chinese negotiations. In other words, investors’ two biggest fears may be easing. Time will tell but the message is to be forward looking.