“If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too…”
– Rudyard Kipling
Just as investors were settling in for a modestly positive year, U.S. equity markets sold off sharply in the fourth quarter. The sell-off rattled market participants. In this environment, keeping our heads about us and trusting ourselves is critical to achieving long-term investment success, particularly with doubters all around us.
In semi-technical terms, 2018 was a lousy year. All asset classes underperformed U.S. money markets. Equity investors lost money. Bond investors lost money. Commodity investors lost money. Even hedge funds, designed to shine in times like this, fared poorly. There was no place to hide.
TOTAL RETURNS ACROSS ASSET CLASSES IN 2018: UNREWARDING
December’s S&P 500 return of -9.03% was the second worst December ever, trailing only 1931. The fourth quarter wiped out gains across global markets. The S&P returned a negative -13.52%, the MSCI All Country World fell -12.65% and the Nasdaq declined -17.28%. For the full year, returns were also negative, the S&P 500 down -4.38%, the MSCI All Country World down -8.93%, and the Nasdaq down -2.81%. Headlines such as “CFOs Predict 2019 Recession, Majority Expect Pre-2020 Crash,” “Market Crash Spooks Economists – Resembles Great Depression,” and “Things to Watch Out for in 2019? Doom and Plenty of Gloom,” reflected and reinforced anxieties.
From a historical perspective, 2018’s volatility was not extreme. The -19.78% peak to trough S&P 500 decline was comparable to the average of the past six non-recession corrections. In each case, the market was higher twelve months later. The volatility of 2018 felt much worse because 2017 was particularly benign with the maximum high to low decline a mere -2.8%, the second smallest on record. Also contributing to the uneasiness was the timing and suddenness of the decline, occurring during the seasonally strongest quarter of the year.
2019 will start with an economy approaching its longest expansion in history – with more consecutive months of job gains than any prior expansion and a job market that continues to grow. Inflation is close to the Fed’s target of 2%, and the unemployment rate is its lowest in decades. There doesn’t appear to be glaring investment or financial imbalances. Economic fundamentals are slowing but still relatively strong as the year begins, typically not a bad setup for equity markets. However, financial markets are indicating that something is wrong. Recession signposts have worsened. Yield curves have flattened and some intermediate segments of the curve briefly inverted. High yield spreads widened and bank stocks weakened. We believe we’re in the midst of a painful, but not abnormal bear market, not a recession-driven bear market. While risks have increased, price-earnings multiples have declined and the U.S. economy remains on firm footing. Earnings growth is expected to slow in 2019 as tax benefits roll off, the economy decelerates and the upside from higher-priced oil recedes, but an outright earnings recession seems unlikely and out of sync with economic data.
We think economic growth will slow from about 3% in 2018 to slightly below 2% in 2019. This is significant, but not necessarily recessionary. During the current expansion, we have seen two other slowdowns of this magnitude or larger. As long as the Federal Reserve’s actions are consistent with its commitment to be data dependent, we think policy will not become restrictive, returns on invested capital should stay positive and financial conditions conducive to growth.
A common trait of bear markets is that as the decline begins, most investors have no idea exactly why prices are falling. At some point, often much later, the root causes become clear triggering the final phase of a sell-off. Paul Samuelson quipped, “Wall Street has predicted nine of the last five recessions.” He’s not wrong. It is difficult to anticipate the precise timing of recessions. And, investors often overreact because of their inability to know when a downturn is a bull market correction, a mild bear market or recession-driven bear market.
There is a potential negative feedback loop that concerns us — the stock market. Household wealth has grown from five times the level of household income to seven times over the past two decades, its influence on consumption becoming more pronounced. The correlation between wealth and consumption has been rising. With stock prices turning volatile and declining and home prices softening, the wealth effect is a real risk. Financial assets account for 50% of total assets with roughly half that tied to stocks. If equity markets continue to decline, a negative feedback loop could push the economy toward recession. We don’t expect this, but would adjust our thinking if it did.
While we believe the threatened trade war with China will be averted, if it is not and the U.S. imposes another round of tariffs on Chinese imports, equity markets could decline further. As we have commented over the past four years, this bull market has largely been driven by margin expansion. New tariffs would likely put an end to margin expansion, represent a significant threat to earnings, and negatively impact a wide range of industries beyond those directly affected.
Potential Upside Surprises
Due largely to the tax cut, 2018 U.S. economic growth met or exceeded expectations, while the rest of the world largely fell short of projections. China and Europe were the most notable disappointments.
Many investors underestimate the importance of China, the second largest economy in the world and the single largest contributor to global growth for the past decade. Since 2014, there has been an 89% correlation between China’s Manufacturing PMI and the Global Manufacturing PMI ex China, with China serving as a leading indicator by three months.
Beijing’s changing economic policies have caused extreme volatility during the past five years, with rates swinging 200 basis points (2%) three times, unheard of swings by U.S. standards. Recently, growth in China’s economy has slowed.
Many have attributed the slowdown to conflict with the U.S., but facts do not support this. In fact, the slowdown has been concentrated in domestic demand, not trade. Chinese exports to the U.S. actually increased 13% in the first ten months of 2018 compared to the same period in 2017.
Chinese policymakers adopted a strict agenda to reduce debt-financed investment spending, recognizing that a sharp increase in private-sector debt contributed to a misallocation of capital. Recent government actions indicate they may now believe the pendulum has swung too far, potentially slowing growth too much. If, as a result, China initiates new stimulative policies, we think it could spur global economic growth to an upside surprise in 2019.
Europe also has the potential to generate positive surprises. Currently, it is hard to see positive developments in Europe with the Brexit conundrum, riots in Paris and economic discontent in Germany where wages haven’t risen in a generation. Voters are demanding faster economic growth. The three primary leaders in Western Europe, Teresa May in Britain, Emanuel Macron in France and Angela Merkel in Germany, and their respective political parties are fighting for survival. We think this makes it likely they will respond with expansionary fiscal policies.
Such a direct injection of demand could have multiplier effects as labor market tightness in a number of economies forces wages higher in a cycle that should boost domestic demand. In France, households will get an extra 10 billion euros in 2019 from tax concessions and companies are increasing pay raises and bonuses. In Spain, Prime Minister Pedro Sanchez, facing a challenge from right-wing parties, recently announced a 22% increase in the minimum wage. Assuming oil prices stay below $70 per barrel, headline Eurozone inflation should decline from 2.2% to a core level of 1.4%, further boosting real wages.
After a dismal 2018, in which the MSCI Europe fell 10.02% in local currency, a modest pickup in economic growth would be welcome, somewhat surprising, and provide market support.
During the second half of 2018, in balanced accounts, we reduced equity allocations to below the midpoint of portfolio target ranges. In both taxable and tax-exempt accounts, we increased weightings in four defensive sectors: healthcare, consumer staples, traditional telecom and utilities, and trimmed some higher-beta holdings. During the third quarter, these moves seemed premature. In the fourth quarter, the repositioning helped.
Nevertheless, we were not immune to the fourth quarter sell-off. Many of our thematic core holdings have a growth bias due to the disruptive nature of their businesses, and experienced declines greater than the market. If, as we anticipate, economic growth slows in 2019, these growth stocks should be relatively strong performers. Growth stocks tend to outperform value stocks when the economy is somewhat sluggish. Assuming current recessionary fears recede, this will likely be the economic backdrop by mid-2019. Importantly, the majority of our thematic growth companies have above average cash flow and above average earnings growth. Stock prices can diverge from fundamentals for a quarter or two, but usually not much longer.
In the last two weeks of the fourth quarter we began to take advantage of indiscriminate selling in higher-beta, growth stocks. We’ll likely continue this in the first quarter of 2019. Sell-offs like the one in December often represent great longer-term buying opportunities.
Additionally, if we see evidence that our European thesis is playing out, we will likely increase our exposure to that region. In general, we will remain at least neutral weight and likely overweight the U.S. market due to its domination in innovation and preponderance of strong cash flow generators, two of our primary focuses.
Our strategy of connecting thematic dots across strong secular or cyclical trends provides us with investment conviction which is especially important in times like these. We make allowance for doubts but trust our process.
At the start of 2018 most fixed income analysts once again called for “significantly higher” long-term bond yields of 3.50%-4.00%. Unlike prior years, when these forecasts seemed bold, in late 2017/early 2018 it seemed almost conservative to forecast a 3.50% yield on the 10-year U.S. Treasury since by the end of 2017 yields were already rising due to the expected passage of the Tax Cuts and Jobs Act. Within the first eight weeks of 2018, the 10-year Treasury yield rose almost 50 basis points to 2.94%. It remained range-bound, mostly just below 3.00%, until late in the third quarter when it finally broke above 3.00%. It continued climbing to a high of 3.24% on November 8. However, a month later, the yield once again fell below 3.00%. It ended 2018 at 2.69%, only 23 basis points higher than where it began.
We are not surprised that long term bond yields once again failed to meet higher expectations. Recent market action supports our long held view that it will be difficult for the 10-year Treasury yield to stay above 3.00% for a sustained period. Federal Reserve actions and rhetoric have likely been too hawkish as evidenced by the middle section of the Treasury curve inverting, high-corporate bond spreads expanding and financial stock prices dropping. However, if we are correct and the Fed responds to the market signals, these factors should begin to reverse and yields should not move much in either direction from current levels.
We continue to hold high quality bonds, the vast majority of which we hold to maturity. Therefore, mark-to-market fluctuations due to swings in yields, both positively and negatively, do not impact realized returns.