After nine years of relatively calm markets, 2018 brought volatility back into focus with S&P 500 suffering two drawdowns of more than 10% during the year--in February (-11.8%) and October 3 to December 24 (-20.2%). For the year, the S&P index declined 6.24%. In anticipation of potentially negative catalysts, we recommended clients reduce overall equity exposure throughout early/mid 2018.
Despite a negative year for the S&P, US GDP estimates point to a 3% increase for 2018. Spurred by Trump’s corporate tax cut, earnings grew approximately 20% last year (FactSet, Feb 2019)--the strongest since 2010. Unemployment has been stable around 4.0% and inflation is contained. While we saw a second half slowdown in the rate of growth--largely related to President Trump’s unconventional trade tactics and the Federal Reserve Board’s (Fed) persistently hawkish comments--There are no signs of imminent recession in the United States.
On October 3, 2018, Fed Chairman Jerome Powell remarked:
"Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral. We may go past neutral, but we're a long way from neutral at this point."
This statement shook markets and economists who thought--after nine ¼ point hikes since late 2015--we were closer to neutral than Powell implied.
Communication issues are nothing new especially during the first year of an incoming Fed Chairman (Powell was sworn in February 2018). After ten years of extraordinarily accommodative monetary policy, Mr. Powell has been tasked with normalizing the Fed’s role and influence in financial markets. Following script, Powell’s Fed raised rates four times in 2018 and reduced the balance sheet by over $385 billion (FederalReserve, 2019). During his December press conference Chairman Powell acknowledged that strong domestic economic data evoked an additional rate hike, but then put his foot in his mouth, indicating that Quantitative Tightening--the reduction of assets on the Fed’s balance sheet--was on “autopilot.” Powell’s seemingly apathetic notions further unsettled markets which were already grappling with cloudy global growth prospects stemming from unresolved trade negotiations.
Heading into 2019, trade remains paramount. Markets dislike uncertainty, and trade tensions have been a driving headwind for nearly twelve months. A favorable resolution could rejuvenate global economic activity, but if China is unwilling to relent on their protectionist policies--particularly the forced transfer of intellectual property imposed on foreign firms--the Trump Administration will likely escalate tariffs. A 2015 economic policy paper published by the Minneapolis Fed estimates that “more than half of all technology owned by Chinese firms was obtained from foreign firms.” America is the largest foreign purchaser of Chinese exports, thus the pain inflicted by tariffs is disproportionate and should ultimately bring the regime to the negotiating table.
In our opinion, President Trump does not get enough credit for the trade initiatives he has launched. Before Trump, no Administration focused on the inequities embedded in our existing trade pacts. Most countries have protectionist policies much to the detriment of our multinational corporations. While controversial in the interim, these inequities with our trading partners need to be addressed, and today’s timing seems fortuitous. President Trump’s effort to correct these policies could lead to a new, stronger era of world trade.
We are blessed to live in a country where economic freedom fosters innovation, growth and an entrepreneurial spirit. Today we are witnessing remarkable advancements in areas of technology, healthcare and communications infrastructure. Artificial intelligence, cloud computing, “big data,” and gene-editing are pioneering new, powerful capacities and capabilities. The legalization of medicinal and recreational marijuana has given birth to a new multi-billion dollar industry. While many “blue-chip” companies continue to benefit from these growth trends, we remain vigilant to identify new entrants that may be the market’s next leaders.
After a turbulent fourth quarter, valuations have improved modestly. The volatility caught the Fed’s attention, and we’ve seen a pronounced shift in the Fed’s tone and narrative. In early January, Chairman Powell was quick to talk back interest rate hikes for this year. Their communication has become much more dovish stating that the “Fed is not on a preset path of rate hikes and that it will be sensitive to the downside risks markets are pricing in.” Importantly, Powell backed off the notion of systematic Quantitative Tightening--suggesting that they may slow the reduction of their balance sheet and if conditions warrant, reverse course altogether. In short, the “Fed Put” has not expired.
Moving forward, our plan is to maintain balanced portfolios. A patient Federal Reserve, lower tax rates and a strong consumer could spur markets higher, but risks to our aging economic expansion remain. The unsustainable trajectory of corporate and global government debt levels, potential for trade-war escalation, global economic deceleration, and other “black swan” market disruptions means we must maintain diligence, holding a buffer of cash and short-term notes to protect your assets. As risk managers, we will err on the side of safety. In this environment, we favor a balanced, diversified approach--holding high quality growth companies with strong management teams, yielding assets with healthy cash flow, along with select asymmetrical opportunities. This approach provides flexibility to take advantage of market dislocations as they occur. As always, we welcome the opportunity to meet and discuss your portfolio(s) individually.