All the positive momentum from the historic tax reform package, robust economic growth, and buoyant stock prices came crashing to an end in the fourth quarter of 2018. From its high on September 20, the S&P 500 Stock Index collapsed nearly 20% by mid-December, before staging a modest recovery in the year’s final few trading days. Although the S&P 500’s total return for the year reflected only a modest loss of -4.4%, the sharp decline the fourth quarter made the pain seem much worse. For the S&P 500, it was the biggest yearly drop since 2008.
International equity markets fell more sharply than the US in 2018, although their fourth quarter declines were less severe. The MSCI EAFE Index of developed international equities fell 13.8% for the year, while emerging market stocks (MSCI Emerging Markets Index) dropped 14.6%. Overall, the MSCI ACWI (All Countries World Index) fell -9.4% in 2018.
The risk-averse mentality of investors in 2018 pervaded almost all asset classes. In fact, last year was the first year since 1972 when none of the major asset classes generated a total return greater than 5%. Outside of cash, only a sharp decline in bond yields at year-end (coupled with falling stock prices) allowed investment-grade fixed income (taxable and tax-exempt) to escape the year with small positive returns.
Combining last year’s weak result with the robust gains in 2017, asset class performance looks much more reasonable. The 2-year annualized performance of the Russell 3000 Index, a broad measure of US stock performance, was +7.1%. The MSCI EAFE gained 3.8%, and the MSCI Emerging Markets Index was up at an annualized rate of 8.3%. The Bloomberg Barclays Municipal 1-10 Year Index (a broad measure of the tax-exempt bond market) gained 2.6%, while investment grade taxable bonds (Barclays Intermediate Gov’t/Credit Index) gained 1.5% (both numbers are annualized). So despite the extreme volatility of the last few months, taking a longer view yields results that are much more in line with expectations.
Outlook and Strategy
As we begin 2019, investor anxiety remains at elevated levels. The markets have been grappling with the same fundamental issues for months now, including slowing US economic growth, Fed tightening, and trade disputes. More recently, evidence of further slowing in Europe and China, the threat of collapse of the Brexit negotiations between the UK and its European counterparts, and the partial shutdown of the US government over border security has further added to the uneasiness among investors.
Amid all the negative sentiment, we see reasons for optimism. Having raised rates for five consecutive quarters, the Fed has recently signaled its intention to slow the pace of interest rate hikes and pay more attention to the messages being sent by the markets. Indeed, according to the Wall Street Journal, futures markets are now predicting more than a 50% chance of a rate cut before the end of 2019. In all likelihood, such a move would be very positive for stock prices.
As predicted, the US economy is slowing to a more normal 2-3% annual GDP growth rate as the impact of higher interest rates is absorbed and the boost from tax reform wanes. Earnings growth, clocking in at an unsustainable 20%+ rate in 2018, caused largely by the sharp decline in corporate tax rates, will slow to a more typical high-single digit gain this year. Manufacturing activity has slowed, but remains well in expansion mode. In short, fears of an impending recession in the US are overblown, in our view.
Trade disputes remain an important area of concern for investors, as evidenced by Apple’s recent cut in revenue guidance owing largely to problems in China. While much of Apple’s problems are company specific, investors are viewing their announcement as further evidence of a much more dramatic slowdown in the world’s second largest economy than is currently believed. A successful resolution to the current trade dispute with the US will not cure all of China’s economic malaise, but it may lift much of the negative sentiment surrounding the issue.
Importantly, the sharp decline in equity prices has created an attractive entry point for long-term investors. Based upon consensus expectations for 2019 earnings growth, the S&P 500 was trading at 14.4 times earnings at year-end 2018, a sharp discount from its 25-year average of 16.1. Other valuation measures, including dividend yield, price-to-book, and relative attractiveness vs. bonds, also appear favorable. Overseas, international equities remain at substantial discounts to the US. Unless the US slips into recession, we believe that the risk/reward for global equities at these levels is attractive.
Although quite normal, market declines like the one we are currently experiencing are painful, trying the confidence of even seasoned investors. Many remember the brutal six month period between September 2008 and March 2009 when the S&P 500 lost approximately half its value. Even then, investors with a long time horizon experienced a return of more than 100% over the next decade if they just stayed invested. This is an important reminder for those investors feeling the urge to step to the sidelines until “the environment improves”. By then, much of the rebound will have already been realized. If your investment strategy is appropriately calibrated for your objectives and risk tolerance, the best advice is usually to stay the course.
Learn more about our Director of Research, Bruce Simon.
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