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4Q2018 Market Summary and Outlook

Overall Asset Allocation

The economy remains “above average” in terms of health and strength, but the market is very much in a forward-looking mode and is selling off on concerns that the best of times might be coming to an end sooner rather than later. As the markets often remind us, economic health does not guarantee market health, and vice versa, at least in the short run.

We are long- term investors and don’t typically project returns on a one-year basis, but for general discussion, we have reduced expectations for equity returns in 2019. Our base case would be low, single- digit total returns. There are tail risk cases to both the upside and downside with potential catalysts including trade wars (or resolution), other geopolitical risks, algorithmic trading overshoots, and potential economic recession as the business cycle ages. For bonds, we have similarly modest expectations and would expect low, single-digit returns for the asset class. Both the stock and bond markets are nervous about a potential “policy error” by the US Federal Reserve if it tightens monetary policy too far, too fast.

We enter 2019 market weight and neutral to our benchmarks. We believe there are still good opportunities to outperform passive benchmarks through active management and smart security selection, much like in 2018. We continue to tactically adjust positions in our preferred holdings.
 

US Equities 

We removed our overweight to equities in the middle of the year and are glad for that de-risking. Portfolios are in a more neutral position—we are holding stocks that we think are good long- term investments but also with the ability to add exposure as opportunities open up. As always, we are focused on finding quality companies with sustainable, quality- growth characteristics that will be resilient as the rising tide stops, lifting all boats and starts to leave behind companies that have been overly reliant on easy monetary policy, cheap debt or other less sturdy supports for their growth.

In many respects, the market is re-pricing and price-to-earnings (P/E) multiples are contracting to reflect that the best of times are starting to end. Interest rates are not as friendly as they were. Central bank support via quantitative easing is being reversed. The global regulatory environment is tightening for many tech and data companies. The global economy is still growing but not with as much synchronization as in prior years. Geopolitics are never totally healthy but are especially at risk now due to tariffs and trade tension.

All of these factors lead to an expectation of some downward earnings revisions from a combination of legitimate business weakness and also a recalibration of market sentiment to a less optimistic base case. Next year’s earnings will have harder comparisons to beat after the big bump they received in this year’s numbers from the tax changes.

On the positive side, the average US consumer is holding up well so far. Yes, income inequality remains a challenge and housing is less affordable now, but oil prices are down, employment is robust, and consumer confidence is healthy. With the consumer driving a majority of the US GDP picture, this is a positive offset to the negatives facing global markets and economies. However, there could certainly be a negative wealth effect and an erosion of confidence as a result of this stock market pullback once the holiday spending season is over and credit card bills arrive.

The market started the year heaping further reward and higher prices on the FAANG stocks (Facebook, Amazon, Apple, Netflix, Google/Alphabet) in deference to the internet and technology revolution becoming ever more pervasive in the world. However, sentiment has clearly changed and though the FAANGs are here to stay, they are no longer extrapolated toward perpetual hyper growth. The market is pricing in the new reality that these companies are subject to competition, regulation, and leapfrogging by new trends, styles, fads and technologies. Or ironically, in the case of companies like Apple, their existing technologies might be so good that people do not need or want to replace their iPhones as often as they used to.
 

International Equities 

International equities have certainly underperformed versus US equities, which likely sets up for eventual outperformance due to the more attractive valuations in international equities. We are more likely to be buyers than sellers in developed international and emerging markets, and have done some limited buying during the December weakness to reduce our successful underweight to the sector. A halt to the dollar’s strength, and perhaps a reversal as the US interest rate hiking cycle nears an end, would be further support for international equities to recover some of their lagging performance.

Though international equities are more attractively priced, it is typically hard for those markets to put up robust performance in a context where US markets and sentiment are faltering. Therefore, our additions to these positions are expected to be gradual.
 

Core Fixed Income 

In fixed income, our maneuvers have been similar to equities in that we spent much of 2018 retrenching back into our core, ballast holdings. For taxable clients, this is muni bonds and for tax-exempt clients, this is Treasury and Agency debt. In early December, we moved back to neutral fixed income by rotating our cash overweight into fixed income. We believe there will be fewer rate hikes in 2019 than the market was originally forecasting; bond yields are reasonable again, and if global growth does soften, bonds are an attractive holding.

  • Municipal Bonds – the supply of bonds in the municipal bond market declined in 2018 and exhibited less volatility than corporate bonds. After years of increased tax receipts, state budgets are in good order with surpluses added to their general reserve accounts. Pockets of weakness exist in some states, but these are well known.
  • Taxable Bonds – Corporate bonds produced some the weakest returns in the bond market as their spreads widened in 2018. There is growing concern about the size of the outstanding corporate debt load. More conservative positioning can be found via shorter maturity US government debt that is offering attractive yields compared to long-term securities.


Opportunistic Fixed Income

We have limited exposure to opportunistic fixed income and have been trimming our high grade corporate bond overweight throughout the year. We would look to a more pronounced spread widening in traditional high yield before adding any exposure there. We are closely monitoring opportunities in bank loans and emerging markets on weakness and could see adding to those positions if valuations get more attractive.
 

Cash and Enhanced Cash

In 2018, we relabeled our client reports from “cash” to “cash and enhanced cash” because the Fed rate hike cycle has finally lifted rates off of zero. There are now reasonable opportunities in T-bills, CDs and related very short maturity instruments beyond just staying solely in traditional cash.
 

Conclusion

The best of times in this extended bull market for both stocks and bonds are starting to wane. However, as discussed, we do not consider this a time only for selling— there are opportunities to rebalance or add to certain positions on weakness. We have been more active than usual during the second half of 2018, and especially in the month of December, to get portfolios ready for 2019.