Portfolio & Market Review: Q4 2018
The fourth quarter of 2018 delivered some of the worst returns to investors since the current expansion began in 2009. Stocks across the globe fell on worries about slowing global growth, rising short-term interest rates, political gridlock in the US and UK, and a bleak outlook for a resolution of the trade war between the US and China. For the quarter, the MSCI All Country World Index (ACWI) was down 13% and finished the calendar year down 9%.
US stocks struggled mightily over the quarter, with the S&P 500 down almost 14% and small cap stocks, represented by the Russell 2000 index down over 20%. Market participants have started to worry that the US is in the late stages of the current economic cycle. While global growth remains solid, particularly in the US, growth momentum has been decelerating and recession indicators have begun to point to a modestly higher chance of a recession over the next year.
Outside the US, growth has continued to disappoint. Business surveys have been weakening all year, but over the last quarter they have moved closer to levels that indicate growth could be contracting. Political tensions in France, Italy and the UK along with a decline in manufacturing exports have tempered investor appetite within the region despite attractive valuations.
Emerging markets fared better during the quarter falling just over 7%. The emerging world benefited from lower valuations, a weaker dollar, and declining yields in the US.
US government bonds were a lone bright spot on a rather dismal quarter. Bond yields fell, thanks in part to lower oil prices and expectations that the US Federal Reserve Bank will moderate its pace of interest rate increases. Although the Fed did increase its target rate in December, they also lowered expectations for further increases in 2019 from four to three.
The global financial crisis of 2008-2009 was an extraordinary event. Global markets seized up in response to fears that the excessive leverage brought on by the housing market and related derivative instruments could destroy the world financial system. The response to this crisis, was a coordinated global effort to lower interest rates and provide emergency liquidity. Those actions allowed the markets to stabilize and begin a path towards recovery.
Although the crisis was more than 10 years ago, the actions and decisions taken by the world’s central banks in 2008-2009 are influencing what we experienced during the fourth quarter and, more broadly, over most of 2018. The lowering of interest rates to 0% during the crisis was like placing training wheels on a bicycle to provide stability for a very weak rider.
From 2009 to 2015, the training wheels (low interest rates) remained in place, allowing the rider (economy) to build confidence (growth) and maintain balance (stability). Over the last 10 years the rider has become stronger and less reliant on training wheels, and as such, the training wheels have been slowly taken away. The volatility we are experiencing today is like a rider riding his bicycle for the first time with no training wheels. As many of us have experienced when learning to ride a bicycle, the first few attempts can be very wobbly or downright scary.
As the US economy approaches a more normal level of interest rates, the financial markets are going be wobbly (experience increased volatility) as markets adapt to the new interest rate environment and its effect on growth, earnings and employment. While other issues negatively affected markets in 2018, such as tariffs, Brexit, and a strong dollar, rising interest rates were the overarching concern for the markets in 2018.
Looking ahead to 2019, the global economy is expected to continue to grow moderately. On the positive side, unemployment and inflation are expected to remain low, however, the tax cuts that provided a boost to profits in 2018 are not expected to have lingering effects into 2019, and the prospect of higher interest rates could put pressure on corporate profit margins. The big wild card going forward is what happens with international trade. The Trump Administration’s trade policies have clearly had a negative effect on asset prices across the globe. Any resolution to the trade dispute between the US and China could provide the needed boost to increase confidence and lead to stronger growth, particularly in international and emerging markets.
Market corrections, while unpleasant for many, are normal and required for markets to function efficiently. Over the long-term investors are well-served to stay the course and rely on a well-diversified portfolio to lessen the impact of market volatility.
Model Portfolio Update
In early December, we made changes to our model portfolio allocations, in the belief that both upside and downside risks are likely more elevated now. On the upside, the prospect of Chinese fiscal stimulus, an equitable resolution to Brexit in the UK, a potential trade deal between the US and China, a slowdown in the pace of Fed tightening, and lower oil prices could all be catalysts that boost growth and investor confidence in 2019. On the downside, the US and Europe could enter a recession, trade tensions could escalate further, and British politicians could fail to provide a Brexit solution. Additionally, lower oil prices and higher US interest rates could negatively affect some emerging markets.
Our response to this environment was to reduce our 5% equity overweight in favor of bonds. Within our bond portfolio, we eliminated our exposure to high yield credit and rotated towards higher quality sectors like US Treasuries, cash, and investment grade corporate debt.
These moves are intended to position us better should some of the downside issues arise, while still leaving us exposed to participate in any upside surprises.
As always, we are available to discuss these changes and how they may affect your portfolios in more detail.