Quarterly Client Letter – Q4 2018
- January 17, 2019
- Investment Insight
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Dear O’Brien Wealth Partners Investor,
As we reflect back on 2018, we see it as a year of divergence in many respects. Most obviously, it marked the first year in many that the global stock markets almost universally delivered negative returns to investors. More subtly, this decline occurred despite the fact that economic fundamentals have not changed materially from 2017 and yet the experience for investors was such more somber this past year than last. This underscores the fact that we are long term investors for a reason. During the fourth quarter of 2018 the market didn’t really care how fantastic your stocks were. Over the long run a stock may likely reflect a company’s true value, but in the short run the pricing is more random. This is because on any given day stock prices are driven by thousands of random variables, as investors have different risk tolerances, time horizons, and behavioral reactions to the market. In the long run good investment decisions typically pay off because the fundamentals do matter, but in the short run there is seemingly no correlation between good decisions and good results. Time reveals truth.
Our job is both to select good long-term investments and to understand the risks and their potential impact on your portfolio. As we move forward into the new year the three biggest risks we will be watching are the same three risks that influenced much of the volatile performance in 2018: the relatively high levels of corporate and public debt fueled by years of historically low interest rates, the likelihood of the Fed raising interest rates and the great upheaval in global trade. As the Fed makes borrowing more expensive, the prevailing question is whether the economy is strong enough to stand on its own feet without support. While slowing growth is to be expected after the adrenaline that was injected into the markets in the form of fiscal stimulus, growth is still projected to be positive both in the U.S. and globally for the next several years.
Early in 2018 the market was fueled in part by a “sugar high” from last year’s tax reform and its positive impact on corporate earnings. By mid-year, and markedly in the fourth quarter, investor attention turned to fears of slowing global growth and political brinksmanship over trade. This resulted in a dramatic spike in volatility, and wild inter- and intra-day market swings. In December alone stocks both plummeted and had a record-setting one day surge. Swings of this magnitude, while unsettling to many, are typically somewhat reactionary and magnified by sentiment. The end result was a fourth quarter that erased all gains for the year and ended as one of the worst in recent memory. Surprisingly, the fundamentals have not changed all that much from 2017, a year in which we saw very contrasting results. GDP growth is still positive (albeit slowing), many companies saw double digit earnings growth, unemployment remains at historic lows and inflation remains in check. Given these relatively strong fundamentals the stock market results show how quickly sentiment and momentum can turn.
The S&P 500 Index, a measure of the 500 largest public companies in the U.S., started the year in positive territory but declined -13.5% in the fourth quarter to end the year with a -4.4% return. Growth stocks, which had led the market up for most of the year, were the hardest hit in the fourth quarter, leading the decline. The market finally penalized Facebook and Google for privacy issues, and increased government regulation and public scrutiny also contributed to the sell-off. Trade tariffs also contributed to the dip in U.S. equity returns as multinational companies felt the impact of diminishing overseas sales. Apple was a prime example: CEO Tim Cook went so far as to say, “100 percent of our year-over-year worldwide revenue decline occurred in Greater China across iPhone, Mac and iPad.” As trade disputes linger, investors are witnessing how interconnected the global economy has become and how damaging unresolved trade issues can be to market sentiment.
In effect, U.S. trade policy has acted as a brake on the global economy, with rising interest rates, a stronger dollar and growing trade concerns pushing the pedals. Outside of the U.S., the pace of global growth slowed throughout the year. In Europe, uncertainty around Brexit and political turmoil in Italy and France exacerbated market unease. The escalation of tariffs on China has continued to negatively affect the Chinese economy and Asian equities. A broad decline in commodity prices affected emerging market countries, especially those that rely on oil exports. Under this backdrop, international developed stocks dropped -12.5% (as measured by the MSCI EAFE Index) in the fourth quarter to end the year -9.4%.
With markets correcting, many expected the Fed to step in and placate the markets with either a pause in raising rates or a promise to support the markets. The Fed did neither in their December press conference, as they not only raised rates but gave mixed messages regarding their intentions for the coming year. Many saw this as an important step in the Fed maintaining their independence, staying ahead of the specter of inflation, and not being swayed by falling asset prices. Unemployment still remains remarkably low at 3.7%, with wage growth holding at a modest 3.2%. Inflation has held under the Federal Reserve’s 2% target and is expected to fall with energy prices. The fixed income market finished flat for the year at 0.01% (as measured by the Bloomberg Aggregate Bond Index), as increases in yields were offset by reductions in prices. Fixed income, however, served as an effective hedge to the equity markets in the fourth quarter as both municipal and taxable bonds earned positive returns.
What does this mean for my portfolio?
With bonds flat for the year and equities finishing with a negative return, there were few places for positive returns in 2018. Our fixed income holdings provided a ballast to portfolios, effectively accomplishing their role of buffering the equity markets. Our government securities position, which we purchased in the fall of 2017 to protect the portfolio during a stock market decline, did just that. It was one of our best performing funds in the fourth quarter, providing protection for our portfolio as designed. Our diversified global bond position also provided valuable alpha, offsetting declines in the equity markets. While our uncorrelated reinsurance fund struggled under the devastating force of the Californian wildfires, our opportunistic mortgage alternative provided stability in a volatile market. Within our equity positions, our continued exposure to U.S. growth stocks provided a boost as gains in the first half of the year helped cushion the sell-off at the end of the year. Our recent addition of an active, quality- oriented emerging markets manager also lessened the blow felt by the emerging markets, outperforming its index throughout the year. In general, our active managers did their job and added value amid the volatility, holding higher quality stocks and taking advantage of market dislocations to purchase stocks at cheaper valuations. Periods of higher volatility give active managers better odds of success and we have seen this transpire with our managers over the past few quarters.
In periods of market volatility, particularly those that persist, it is critical to maintain discipline. Although these can be times when it may be difficult for investors to stay the course, we believe we are well-positioned to weather storms in the market as they occur. At the same time, we are always vigilant in watching our positions and making changes where we feel prudent. Remaining on course with a sound investment plan will allow investors the best opportunity to achieve their long-term goals. 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