Island Light Quarterly Commentary (Jan 2019)
““Our bravest and best lessons are not learned through success, but through misadventure..”― Amos B. Alcott.”
Well, that was a dud. 2018 ended the year with a whimper and there was really no place to hide from the negative returns. A combination of inane trade policies, actions of the central bank, mid-term elections, market fatigue and mixed economic data triggered a large shift in investor sentiment causing global equity markets to drop substantially. The S&P 500 was down 4.4% for the year and 13.5% for the fourth quarter. The rapid change in sentiment was accompanied by a sharp increase in market volatility and extreme inter-day gains and losses. Assets with higher risk profiles (small cap, growth stocks), were hurt more than assets with lower risk profiles (utilities, value stocks).
International equity returns also performed poorly in the fourth quarter, albeit not quite as badly as U.S. stocks. The MSCI EAFE index returned -14.4% for the year and -13.1% for the fourth quarter. The late-year stability of the dollar, after a long period of strength, helped offset poor local market returns. Surprisingly, emerging markets performed better than their developed market brethren in the quarter, but still ended the year below all other major asset classes. The MSCI Emerging Markets index was down 15.1% for the year and 7.4% for the fourth quarter. Fears of the impact of US tariffs on the Chinese market were a major contributor to this extended underperformance.
Cash and short bonds were the only major asset categories that had a positive return for the year as government interest rate policy and a stronger economy caused bond yields to rise (bond prices move in inverse proportion to their yields). The Barclays Bloomberg US Aggregate Bond index returned 0.0% for the year and 1.6% for the year. Longer term bonds were most impacted by the rise in interest rates. Corporate bonds also suffered in the overall flight from risky assets as credit spreads continued to widen. This trend follows a multi-year period of tightening spreads and reflect a wider concern that the strong US economy may be weaker in 2019 and 2020.
In hindsight, the misadventure of markets in 2018 may be a learning experience. In the last ten years or so, it has been pretty easy to be complacent about market risk. Those unable or unwilling to ignore short term downward volatility of the sort experienced in the last quarter probably should not have a large exposure to equities at any time. After all, the 13.5% drop in US equity markets in the fourth quarter, capped a decade when US equity markets returned 13.1% per year, including the fourth quarter. Those who sold out of equities at the end of 2008 missed ten years of exceptional performance.
Looking forward, the largest uncertainty in the market remains the effect of the trade dispute between the US and China. While the Chinese may have more to lose in the long run if tariffs remain in place, the US also has a lot to lose. A slowing Chinese and US economy will also likely slow other non-US economies. The political uncertainty surrounding Brexit and the ongoing US government shutdown also contribute to uncertainty about future growth, increased volatility and negative investor sentiment. A slowing economy will reduce earnings, and earnings drive the equity market.
The world still has an enormous amount of liquidity in place, despite current monetary policies to raise short term rates and reduce the Fed’s balance sheet. We expect the Fed to temporarily halt its planned interest rate increases in the face of economic uncertainty. The European Central Bank, also awash in liquidity, looks to slow its monetary tightening regime, only recently begun. Both fixed and equity markets will welcome a slowdown in monetary tightening.
The drop in prices for global equities in the fourth quarter has had the obvious impact of making them more attractive on a fundamental basis. The major strategists that we pay attention to mostly agree that the US is not about to enter into recession and that the economy will return to the slow growth environment of the last decade. A goldilocks economy, not too hot nor too cold, as we have discussed in these pages before, is a good environment for stocks. Further, earnings growth is still positively impacted by the 2017 change in corporate tax rates and less federal regulation. Often, economic growth can be anticipated by examining the absolute level of cyclical sectors relative to their historic levels as a percentage of GDP. Few of these sectors (residential investment, business investment, auto sales, inventory levels) are above their historic averages. This gives us comfort that the economy still has room to grow.
Ten years ago, a US investor who put $100 into a low-cost S&P 500 index fund would have nearly $400 today. Had the same investor put that money into a non-US equity index fund, he would have a little more than $200. We are not ready to throw in the towel on non-US equity investing; on a valuation measure, foreign companies look more attractive than their US counterparts, and there is a still risk-reduction benefit in holding a global mix, with a US home bias relative to the market cap weighted global index.
We have a neutral outlook for the year, anticipating a rebound in the first part of the year and some muddling along, albeit with volatility, for the year. A lot depends on trade talks. If the tariff wars continue and settlement is not reached, we expect broad global economic weakness and a weak outlook for equities. If US policy brings a little measure of fairness into our trade imbalances with China, then there is reason for optimism. We hope for the latter and caution the former. Fixed income has returned to a more normal interest rate range, although we are not currently being paid to take on more duration risk (the yield curve is very flat). We will retain or move to a neutral position in our equity/fixed income target ranges.
Matthew V. Pierce
January 21, 2018