4Q18 Market Overview
Doom and gloom was a common global theme as we ended a volatile year. Instead of focusing on potential positives that might result in a continued yet slower economic global expansion, investors projected out worst case scenarios.
Although this type of thinking has negative emotional and financial consequences, it does create attractive investment opportunities for long-term investors. As we look in the rear view mirror at Dow 6,500 in March of 2009, we have definitely come a long way. Unfortunately, the markets surged past its true value and as a result experienced a quick and painful adjustment to reset valuations and future expectations.
Moving forward, the most notable headwinds that are likely to continue in the new year will be a possible yield curve inversion, trade negotiations with China and a potential disorderly Brexit. Other unknowns will most likely surface and add volatility in the new year. Regardless of the market direction, a well balanced and diversified portfolio will continue to protect you against market uncertainties, help you reach your financial goals and ultimately fulfill your cash flow needs.
Our rebalancing process will take advantage of the sharp market movements to shift towards our target allocations in the most tax-efficient manner possible while maintaining your desired risk level. Given the more attractive international market valuations and stronger U.S. dollar, our trade process will favor selling elevated U.S. asset classes in support of value oriented investments that have historically excelled in the late innings of a global economic expansion.
U.S. Equity Markets
The U.S. equity markets downward spiral peaked in December before the Russell 3000 posted a painful quarter loss of 14.3% and 5.2% annual defeat. Rather than focus on the positive S&P 500 earnings and steady company hiring, investors concentrated their attention on slower economic momentum, trade concerns, a possible disorderly Brexit, inflation and higher interest rates. By the end of December, the Russell 2000 small company index entered bear territory (down about 21% from its recent high). Considering that we are in the late stages of an exceptional U.S. expansion, concerns are expected and investors realize that this bull market could end with a recession. However, a recession might be a few years away and we should be able to still benefit from slower growth while company profit margins ease off peak levels for the foreseeable future. As we started the new year, the U.S. Labor Department reported that job growth surged 312,000 in December and the unemployment rate ticked higher to 3.9%. Assuming the trade talks and political risks don’t derail overall growth substantially, the markets should continue to march in the direction of actual earnings and slowing forecasts.
International Equity Markets
Under the weight of global growth concerns, International developed equity markets posted a quarter loss of 12.5% and 13.8% full year decline for the MSCI EAFE. Although International markets are closer to mid cycle growth compared to later stage growth in U.S. markets, trade tensions and Brexit weighed more heavily on their markets. Europe’s economic recovery will continue to be highly sensitive to external trade developments given their reliance on exports, especially to emerging markets. In Japan, Prime Minster Abe provides political stability that is missing in other key countries as he enters his seventh year in office. This stability will help Japan roll out their slightly higher 10% consumption tax and prepare for the upcoming 2020 Olympics in Tokyo which should further stimulate their economy. After exceptional returns in 2017, MSCI emerging markets lost 7.5% during the quarter and 14.6% for the full year. Macroeconomic and geopolitical pressure weighed on their markets throughout the year and led to a significant decline in investor sentiment. Given the decline and solid fundamentals, emerging markets are well positioned to grow faster than their developed counterparts. As the markets continue to work through the trade negotiations, both developed and undeveloped international markets look even more attractive from a valuation perspective. Valuations are now at a 20% discount to U.S. equities compared to their historical average discount of 10%.
Fixed Income Markets
Safety-minded investors experienced positive results as the closely watched Barclays Aggregate rose 1.6% during the quarter to finish the year flat. After the Fed raised rates in September for the fourth time in 2018, the 10-year Treasury retreated from 3.05% on September 30 to 2.69% on December 31. As the U.S. economy strengthened, the Fed felt it was necessary to continue its gradual tightening cycle without any end in sight. These comments spooked markets and ultimately led to a sharp sell-off in risk assets and rotation into fixed income securities to close out the year. Given the quick yield decrease, longer maturities benefited most. The Barclays US Government Long posted a 4.2% quarter gain, Intermediate 2.2% gain and Short 1.3% gain. In the international fixed-income arena, the JPM Non-US Unhedged gained 1.6%. The Barclays Municipal rose 1.7% with the help of increased demand as investors refocused their attention on the positive tax advantage of this asset class.