Market Data for year end 2018:
• S&P 500 Stock Index: 2507, down 6.3%
• Ten-year Treasury Note Yield: 2.68%, up .27%
• Gold: $1,281 per ounce, down 2.1%
• Oil: $45 per barrel, down 24.3%
Global financial markets faced renewed volatility in 2018 as a confluence of macroeconomic factors increased investors’ sense of uncertainty, pressuring returns across almost all major asset classes. Stocks and corporate bonds had their worst annual performance since 2008, while basic commodities such as oil and copper experienced significant declines. Compared to the historic placidity of 2017, US stocks had two major corrections of greater than 10% in 2018.
The factors pressuring markets alluded to above are primarily threefold:
- Economic and corporate profit growth are decelerating. 2018 began with economies around the globe experiencing a synchronized expansion. In the US, economic growth and corporate profits surged on the back of the Trump/GOP corporate tax cut and increased federal spending. As 2018 came to a close, however, economic growth in the major economies of Europe and Asia was faltering, while US economic and corporate profit growth were projected to decrease substantially as the stimulus from the tax cuts and increased spending began to wear off. US economic growth in 2018 was approximately 3% in 2018, yet is expected to decelerate to 2.5% in 2019, and 2% in 2020. Similarly, corporate profits are seen decelerating from growth of 22% in 2018 to 8% in 2019.
- Liquidity (money available for lending/investment) in the financial system is being removed. The US Federal Reserve raised its target for the federal funds overnight interest rate a full percentage point in 2018 to over 2.25%. At the same time, it is effectively liquidating the substantial bond portfolio it accumulated during the post-crisis policy of “quantitative easing”, thus increasing the supply of debt on the market while simultaneously withdrawing funds from the banking system. Further compounding the liquidity draining activities of the Federal Reserve, the US Treasury is having to significantly increase its issuance of bills, notes, and bonds to finance the above cited tax cuts and increased spending. This all has the net effect of decreasing the funds available for private lending and investment.
- Trade tensions are suppressing corporate investment. In 2018, President Trump followed through on his promise to initiate trade wars on US trading partners. He began by putting on an across the board tariff on all aluminum and steel imports and then a 10% tariff on over $200 billion of goods from China. He has also held out the threat of further tariffs on Chinese imports and European automobiles, as well. Given the highly integrated nature of the global industrial supply chain, such threats are substantially disruptive, creating uncertainty for corporate executives, and decreasing corporate investment. Ultimately, decreased trade leads to higher prices and lower economic output, a lose-lose situation for all involved.
Whether or not 2019 turns out to be a better year for financial markets hinges primarily on the actions of the Federal Reserve and the trade agenda of President Trump. As the US economy is already decelerating, the market does not believe further monetary policy tightening is necessary. The Fed said in December that it sees itself raising the overnight interest rate a further half of a percentage point in 2019 and continuing to sell bonds from its portfolio. If they stick with their stated agenda, there is an elevated likelihood of an economic recession and lower share and corporate bond prices. Similarly, if President Trump cannot de-escalate the trade tensions he has injected into the global economy, we would expect corporate investment and global growth to continue to suffer, leading to further decreases in the prices of risk assets such as stocks and corporate bonds. Speaking more broadly, the President’s erratic behavior has become a distinct source of concern for the markets beyond any specific policy item.
We are admittedly agnostic on the points discussed above. The Federal Reserve has a poor track record of managing a decrease in liquidity without causing a recession, while President Trump’s inherent instability makes predictions on the outcome of the trade wars a highly fraught endeavor. In such an environment, we will stick to our strategy of focusing on investments in high quality companies, diversification, value, and patience. Such a strategy held up well in 2018, and we are confident in its continued performance regardless of the macroeconomic environment. For the remainder of the year we expect the US stock market, as represented by the S&P 500 stock index, to trade in a range of 2200 to 2800. It closed 2018 at 2507.
As always, we thank you for the trust and confidence you have placed in us. Please do not hesitate to contact us with any concerns you may have. We wish you a healthy and prosperous 2019.