Gill Capital Partners January 2019 Market Commentary
“In the business world, the rear view mirror is always clearer than the windshield.”
– Warren Buffett
Q4 & 2018 Market Review
The fourth quarter of 2018 saw the return of market volatility that intensified leading up to Christmas and resulted in one of the worst Decembers on record, as well as one of the worst years for equity performance in a decade. This followed a year in which most asset classes delivered significant positive returns to investors. Looking at 2018 asset class returns in the chart below, we see that cash beat nearly all other assets in 2018 with a positive return of just under 2% for the year. U.S. equities finished the year down between 3.5% and 11% on a total return basis, depending on the index. The S&P 500 was down 13.5% in Q4 and finished the year down roughly 4.5%. International and emerging market equities, as represented by the MSCI EAFE and the MSCI Emerging Markets indices, were down 13% and 14.5%, respectively, for the year, though they performed slightly better than U.S. equities in the fourth quarter. Fixed income was largely flat for the year with subsectors of fixed income, such as high yield bonds, delivering negative returns for the year.
The considerable selloff that occurred in the fourth quarter was initiated by fear of higher interest rates and an aggressive Federal Reserve, which sent short-term interest rates to the highest levels in ten years. While still low by historical standards, the fear of persistently rising rates spooked markets. These interest rate concerns, combined with slower corporate earnings growth projections, trade wars, and all-time high stock prices created the perfect mixture for a market correction. Have market fundamentals changed? We will discuss this in more detail below, but the short answer is that we do not believe that the fundamental U.S. economy has deteriorated significantly, though we do believe that the market movements have changed some of the fundamentals in a positive way for investors. We do anticipate slower growth rates, but do not foresee a recession in the near term. The recent correction, while unsettling, brings with it some silver linings that we will review below. The market pullback at the end of 2018 appears to be largely based on momentum and driven more by algorithmic trading than by economic deterioration. As of this writing, we have already seen a significant rally from the bottoms reached at the end of 2018.
Looking Ahead – Silver Linings & Potential Risks
As we saw at the end of 2018, momentum can be a powerful force, but often of a shorter-term nature. We are long term investors, not market timers, and long-term investing is centered largely on fundamentals. Below is a review of fundamental drivers and our interpretation of them, along with a few key fundamentals that have changed recently.
Economic Growth & Corporate Earnings: GDP grew at 3% year over year in the 3rd quarter, the fastest pace of growth in roughly 5 years. However, this pace is not sustainable. The effect of tax cuts will not be as impactful going forward, and tight labor markets, combined with low productivity growth, will also limit GDP growth. We see GDP growth slowing in the 4th quarter and into 2019, but not turning negative. We do not see a recession in the near term, though an extended government shutdown could change our outlook on that. Earnings growth will also slow as the effects of the tax cut are normalized, but most economists still see mid-to high single digit earnings growth in 2019.
Labor Market: The most recent jobs report showed a continued robust labor market, with unemployment at 3.7%, the lowest in over 40 years, and wage growth ticking up. Economists believe we will touch or possibly even dip slightly below 3% unemployment in 2019, and this low level of unemployment has the potential to persist for a while. Tight labor markets, like we have now, have historically created wage inflation, which generally forces the Federal Reserve to raise interest rates. However, while wage inflation is finally picking up, at 3.2% it is still well below its long-term average of 4.1%. Furthermore, economist do not project wage inflation to move significantly higher due to long term labor market fundamentals.
Inflation: As discussed above, economists are not predicting the labor market to drive wage inflation. While the fourth quarter selloff in equities was significant, the selloff in oil prices was even more dramatic. Here comes the first silver lining. Oil prices fell nearly 40% in the fourth quarter and are hovering around $50/barrel. Oil prices are a significant input into both the Federal Reserve’s preferred inflation gauge and consumer spending. As inflation expectations remain subdued, so too will the prospects for higher interest rates, as the Federal Reserve will have the cover they need to slow their pace or even stop raising rates all together. Furthermore, while the tax cuts may not be overly impactful for the average consumer, lower prices at the pump will be.
Federal Reserve: This is an area where the recent market correction may have significant impact on various fundamentals. While the Federal Reserve is largely focused on maximizing employment and price stabilization, they do take note of what is happening in the stock market. Major moves (up or down), like we have seen recently, do impact their decision making. As mentioned above, the drop in oil prices will bring their inflation indicators down.
Though raising interest rates is one way to cure speculative bubbles, the recent market correction has largely removed any speculative bubbles that may have been forming in equities. Just 3 months ago the market was anticipating the Federal Reserve to raise interest rates 3 times in 2019 and possibly more in 2020. The Federal Reserve recently reset their expectations to two interest rate hikes in 2019, though the market believes they will only raise once more, if at all, in this cycle. The prospect of interest rates capping out at current levels is new information and an input that equity market investors will look favorably upon.
Valuations: Another silver lining from the recent market correction is that stock valuations are now well below their 25-year average. This, combined with strong corporate earnings, means that the forward P/E ratio of the S&P 500 Index (shown in the chart below) now sits just above 14, below the 25-year average of about 16.
Source: JPMorgan Asset Management
Stocks are now attractive from a pure valuation perspective. The same is true for international equities, as they are also well below their historical valuation averages.
While the silver linings described above certainly point to opportunities for long term investors, risks including trade, the government shutdown, and ongoing political instability remain. It is not a time to take undue risk. That being said, it is also not a time to be overly conservative, as we know that in the long-run investors get rewarded for taking risk. As an owner of a diversified portfolio, it is helpful during times of volatility to remind yourself that you are a long-term owner of high quality, global companies that will continue to grow and innovate. It is time to be disciplined, take advantage of opportunities as they exist, rebalance, and know what you own. That is what we are here for.
As always, please let us know if you have any question or concerns, or if we can provide assistance with any other financial planning matters including education, taxes, insurance or estate needs.