4Q18 Insights

(January 21, 2019)  As we close out January 2019, it looks like our stock market prediction for Q4 might have been better aimed at Q1 of this year (S&P 500 up over 6% from year end levels). It appears we misjudged the angst that the trade war with China was creating and the Fed’s willingness to signal a pause in raising rates – all leading to a weak fourth quarter for stocks.

Going into the fourth quarter U.S. domestic stocks, regardless of market capitalization, were the best-performing asset class among the world’s developed as well as emerging markets.  All that changed in Q4 as most equity indexes recorded double-digit negative returns which pushed their full year returns into negative territory.

If the U.S. economy was strong (GDP exceeded 3%) and corporate earnings increased 20%, unemployment at 3.7% (close to a 50 year low) and wages rising above the inflation rate then why the collapse in stock prices? To answer this question, first recall that the markets are discounting mechanisms of possible future events/data. In today’s market it appears investors are contending with a variety of political, monetary, and economic issues that create the price volatility that we have seen. To recap those issues: Is the Fed tightening too quickly?; absence of clarity in trade talks; the government shutdown; Republican/Democrat inability to negotiate with each other; China’s slowing economy.

This volatility of stock prices lead investors to the relative safety of T-Bills and short-maturing bonds which bid up bond prices and produced full year returns just below 2%.  While certainly not earth-shaking returns, bonds did fulfill their role in clients’ portfolios: help stabilize overall returns and preserve principal.

Our outlook for bonds in 2019 largely hinges on a soft landing (no recession) U.S. economy & resumption of the post 2008 economic cycle. Recognition of this resumption will take months and will undoubtedly depend on increasing capital investment. Might this happen? One mark to monitor is the price of oil; that price has recently broken above the $50/barrel level – the price that historically has stimulated the energy sector (an important one) to increase investment spending. Our economy needs capital spending to rise – particularly that which increases productivity which in turn allows wages to rise without pressuring companies’ profit margins. And of course rising wages helps stimulate consumption in our economy – a key component.

If this ‘capex’ scenario unfolds, we would expect interest rates to rise, but gradually so as it will take months to quantify.  So bond prices will likely stay near current levels with a slight downward bias for the next 1 to 2 quarters.

Stocks on the other hand may continue their recent rally with a possibility of re-testing their recent lows in late December. A ‘help’ to this outlook would be for the Fed to pause or limit their Fed Funds increase to one in mid-2019.

To wrap up our comments/observations of 2018 we’d like to pass along a ‘wish list’ for 2019 as originally published in “An Investor’s letter to Santa Claus” by Jason Trennet of Strategas Research Partners:

• A Fed pause
• A trade deal with China
• Greater regulatory oversight over algorithmic trading
• More capital spending and less financial engineering
• Real pro-growth policies in Europe
• A real effort to stop the scourge of the opioid epidemic
• Stock splits/greater volume from real money investors

We will certainly be watching these and other influences on our markets as the year progresses.