Quarterly Client Letter – Q1 2019

  • April 12, 2019
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Dear O’Brien Wealth Partners Investor,

The first quarter of 2019 certainly showed us a more benevolent side of the market than we experienced in the fourth quarter of 2018, with almost all risk assets showing positive returns for the quarter. As we mentioned in our last quarterly letter, while over the long run a stock may likely reflect a company’s true value, in the short run pricing is more often than not random. With such a benign market environment many were left wondering what transpired to stem the dramatic spike in volatility and the wild intra-day market swings that culminated in the negative investment performance of 2018.

2019 has brought some clarity to the three biggest risks that unnerved investors in 2018. Some progress, while slow-moving, has been made towards reaching resolution in the trade talks, with both the U.S. and China beginning to move a bit off their extreme positioning. In March the Federal Reserve provided direction around its intended interest rate path, with zero rate hikes forecasted for 2019, one in 2020 and none in 2021. Furthermore, the Fed’s forward guidance points to a muted yet still growing economy, with high employment and low inflation expectations. Global growth, by many measures, is slowing but still projected to increase in 2019 at 3.3% (per the IMF). Presently we seem to be in a slow but steady growth environment. Looking back, we have to ask ourselves how much of the decline in December was actually driven by sentiment.

How long will this protracted, slow expansion continue? Although we see some softness in recent economic data there are no major red flags that indicate an imminent recession. Many economists predict continued slow growth and have kicked the recession can down the proverbial road to late 2020 or 2021. However, analysts haven’t shown a particular acuity for forecasting lately, and while we can look to future predictions on timing, we feel that our best strategy is to assess the current situation in the moment as it is today. The absence of red flags does not mean there are no signs of caution. While we can look to economic fundamentals as indicators of recessions, market corrections are by definition unexpected. Geopolitical risks remain real, investor sentiment is mixed, and GDP and corporate profits are predicted to grow more slowly. We continue to pay close attention to these factors and to assess their potential impact on your portfolios.

In the equity markets, the U.S. showed strong performance across the board with small and mid-sized companies outperforming the bellwether S&P 500. The Russell 2000 (small cap), the Russell Mid Cap, and the S&P 500 returned 14.6%, 16.5% and 13.6% respectively, as investor appetite for risk led to buying across the spectrum of stocks. Growth stocks, which were the hardest hit in the fourth quarter of 2018, outperformed value stocks across the board, providing further indication of an increased appetite for risk. Defensive sectors, such as healthcare, consumer staples and utilities, underperformed their more volatile peers, including info tech and industrials. While trade tariffs continue to impact corporate earnings, the reality is that future earnings projections in the mid single-digits are in line with historical averages. It is likely that the market will react favorably to a resolution in trade friction, as the market tends to penalize the unknown and reward the known disproportionately. However a reasonable resolution is effectively “priced-in” and a surprise in either direction could cause a period of volatility.

Outside of the U.S., both the MSCI EAFE and the MSCI EM, broad measures of the developed and emerging markets on a dollar adjusted basis, were up approximately 10%. The single best ex-U.S. performer was China, which posted positive returns of 17.7% on a dollar adjusted basis. Europe, ex-UK, which is still struggling for resolution on Brexit, returned 12.6% in local terms and 10.7% dollar-adjusted. While the strength of the dollar has been a detractor to the returns of international stocks over the past several years, the relative stability of the dollar during the quarter resulted in less of an impact than in previous years. Valuations outside of the U.S. remain more attractive than those of U.S. stocks, with most major world indices close to their ten-year averages.

In the fixed income markets, the yield curve remains relatively flat with a synthetic inversion at the very short end propelled by the Fed’s rate increases in 2018. With unemployment and inflation near the target rates stipulated by the Fed, they have adopted a “watch and wait” policy. Given that several past recessions have been precipitated by the Fed either allowing inflation to get too high or raising rates too quickly, this more dovish stance is supportive of a continued slow expansion. Interestingly, we are also finally at a point where savings rates, as measured by CDs or money markets, are above inflation. The fixed income market (as measured by the Bloomberg Barclay’s Aggregate Bond Index) returned 2.9% for the quarter. Fixed income assets with corporate debt exposure, which have higher correlations with equities than other types of fixed income, fared better than their more conservative counterparts, reversing the performance we saw in the fourth quarter of 2018.

What does this mean for your portfolio?
We are now in the second longest economic expansion and corresponding bull market in history; however, it is also the shallowest. While there is no natural limit to an expansion, we are also reaching the late-mid to early-late part of the business cycle in the U.S. Accordingly, over the past several quarters we have positioned your portfolios in line with our belief that your stocks should be your growth engine and bonds should be your source of income and protection. Specifically, we have increased our exposure to non-U.S. equities given the relative valuations, the opportunities for active management and our views on the dollar. We also continue to maintain a core position in U.S. government bonds in your fixed income portfolios to buffer your portfolios in the event of a stock market decline. This approach should give you confidence in remaining invested throughout a market cycle, despite the natural discomfort that you might feel when markets are volatile or declining. More money is lost trying to time market corrections than in the corrections themselves, and missing the critical up days following a correction can have a material impact on your long-term returns and your ability to meet your goals. We remain vigilant in watching our positions, making changes where we feel prudent and looking for opportunities as they present themselves.

If you have any questions or would like to discuss the specifics of your portfolio, please contact your O’Brien Advisor.

Your O’Brien Wealth Partners LLC Investment Team