Fourth Quarter 2018 Market and Economic Review

Market Review

After a multi-year rally in equity markets, 2018 began with promise but ended with a poor finish.

Beginning in January, U.S. equity investors witnessed their first stock market correction (defined as a 10% drop or more) since 2015. Stocks then rebounded, with the rally continuing through the second quarter and into the third quarter. During 2018, each of the three main U.S. stock indices reached new record highs.

In early October, U.S. markets turned again, and the downward trend progressed through the end of the year. For the year, the S&P 500 index fell 6.2 percent, the Dow 30 index fell 5.6 percent and the Nasdaq Composite index shed 3.9 percent. Small caps fared worse, with the Russell 2000 down 12.5 percent. Most stocks on the New York Stock Exchange were off more than 20% from their highs during this period.

Common explanations for the end of year downturn include the Federal Reserve raising interest rates in December, threats of a trade war between China and the U.S., a global economic slowdown, and increased risk of political gridlock.

On the positive side of things, we consider a lot of these problems fixable or reversible. Company earnings remain strong and the U.S. economy has been doing remarkably well. For these reasons, among others, we view this correction as a naturally occurring event which will be followed by a rally. What is unknown is the depth of the correction and the pace of the rally.

European markets followed a similar pattern but ended the year lower than U.S. markets. In Europe, the Euro Stoxx 600 index fell 13.2 percent in 2018, its biggest decline since 2008.

Emerging markets, which consist of developing countries like China, Brazil, Indonesia and Chile struggled throughout 2018. The iShares MSCI Emerging Markets ETF, which tracks multiple emerging market economies, fell over 17 percent. The Shanghai composite index, which tracks the Chinese stock market, was down 24.6 percent.

Contributing factors to global stocks’ struggles were a strong U.S. dollar, threatened and implemented tariffs, and a decrease in the Chinese economic growth rate, which causes a ripple effect in countries with close economic ties.

We can see from these numbers that U.S. markets are less affected by trade tensions than global markets. The U.S. consumes most of what it produces while other countries are much more reliant on exports. While the U.S. exports only 8 percent of what it produces, other economies like China (19%), Canada (25%), Mexico (35.6%) and South Korea (36.5%) export far more as a share of their country’s GDP.

While global economies may be slowing, we favor maintaining international exposure and think this trend presents buying opportunities at lower valuations.

U.S. Treasury bond prices started the year poorly with many expecting a bear market due to projected rising interest rate yields. However, after spending most of the year lower, Treasury bond prices ended 2018 nearly even with January prices.

At the start of 2018, January yields rose from 2.4 percent to 2.8 percent for the month, one of the largest increases in recent history. When yields rise new bonds pay more interest, in effect making older, lower yield bonds less valuable and causing prices to decrease.

Yields continued to appreciate, breaking 3 percent in April. Yields then fluctuated over the rest of the year before a sustained decrease in yields began in early November. The fourth quarter saw a rally in Treasury bond prices, benefiting many low risk investors.

The benchmarks, listed in the table below, are the same benchmarks as those in the Risk/Return and Account Analytics sections of client quarterly performance reports. By comparing your portfolio’s return to the benchmark with the closest risk/return characteristics, you get a more accurate reading of portfolio performance than using a less diversified benchmark, such as the S&P 500 index.

* Each benchmark is allocated based on assumed Risk Profile of underlying indexes.

**Benchmarks include a mixture of ICE BofAML US 3-month Treasury Bill Index, Barclays Global Aggregate Bond Index, Barclays US Aggregate Bond Index, MSCI EAFE Index, and the Value Line Composite Index (Geometric).

Economic Review

The Federal Reserve’s decision to increase interest rates by .25 percent in December was expected, yet widely controversial.

The Fed has been steadily increasing rates since late 2016 (with one hike in late 2015) on the assumption that the economic expansion is stable enough to continue without the zero interest rate policy that has been in place since the 2007-2009 recession.

Critics of the Fed’s move to increase interest rates argue that the Fed might be raising rates too quickly, which can reduce business investment and slow down economic growth. These critics believe that slowing global growth, unstable market prices, trade tensions and moderate inflation were reason enough for the Fed to pause on raising interest rates.  In fact, many pointed to the inversion of the yield curve with shorter term bonds as evidence that the Fed was going too far.

While the Federal Reserve did raise rates in December, they reduced their schedule of projected interest rate increases from three to two in 2019. Yet there is still a disconnect between Wall Street and the Fed. Per a recent poll, investors have priced in less than a 10 percent chance of any interest rate increases in 2019, far below the two rate increases the Fed expects to do.

Economically, the U.S. continues to report positive data. U.S. GDP growth for the third quarter of 2018 was reported at 3.5 percent. Unemployment rates remain at historic lows, sitting at 3.7 percent at the end of November. The hope amongst economists for 2019 is that continued low unemployment rates will drive up wages without sparking inflation and increase the number of Americans participating in the labor force. While there are some signs of a potential slowdown in the future, overall our economy remains robust.

As mentioned earlier, it is our belief that the recent market correction is a naturally occurring event which will be followed by a rally. What is unknown is the depth of the correction and the pace of the rally. We will continue to monitor all data very closely and adjust if/when we believe necessary to meet your personal investment objectives.