Published on Jan. 24, 2019
Fourth Quarter 2018 | Equity Commentary
Stocks fell sharply to close out the year, with the S&P 500 declining by about 9% during December and approximately 13.5% for the fourth quarter of 2018. Weak global economic data, continuing trade tensions, and a chaotic government backdrop created a difficult environment for capital markets. While we share these concerns, we note that the US consumer has thus far proved quite resilient, and equity valuations appear reasonable. Still, we are cautious on the market as we enter the New Year and maintain the risk-oriented approach that has helped us outperform for the year.
Investor sentiment appeared to shift markedly towards the end of 2018. We were surprised by the abrupt nature of this dynamic, as many of the key risk factors facing markets have been apparent for some time. A number of international economies have been slowing over the last few quarters, and tariffs on Chinese imported goods have been in effect for several months. We think that the concept of reflexivity – the notion that the capital market dynamics can influence real economic data – may have been a factor here. For example, a recent Duke University survey of corporate CFOs found that nearly half of respondents expect a recession to occur within the coming year. We think that the recent stock market volatility influenced these views and yielded a result that in our view appears elevated. Moreover, many investors were likely alarmed by the results of this survey, perhaps leading to a further decline in stock prices, and sustaining this self-reinforcing cycle which we think contributed to December’s weak results.
Following strong results in recent quarters, we think that some choppy economic data out of the US also likely played a role in the recent market volatility. Of particular concern are the Federal Reserve’s regional surveys for December, which as a whole missed expectations by a wide margin and fell sharply from November’s results. While we believe that reflexivity may have been a factor, we think the magnitude of the weakness is still somewhat alarming. For example, the Empire Manufacturing Index came in at 10.9 for December, down from 23.3 in November and well below the 20 that analysts had forecast. The Philadelphia, Richmond, and Dallas regional indices all followed a similar lackluster pattern. Moreover, the national ISM manufacturing survey also came in below expectations, with the index falling from 59.3 in November to 54.1 in December. Of particular concern, in our view, is the new orders sub-index, which declined sharply from 62.1 in November to 51.1 in the most recent survey. An ISM index number below 50 is said to indicate that the manufacturing sector is in contraction.
In contrast to these results, the consumer has been a key bright spot for the US economy. The labor market has held up well and wages are moving higher; perhaps as a result, consumption has been quite strong. Retail sales for November 2018 grew by about 0.9% from the prior month, easily exceeding consensus expectations for a 0.4% advance. As well, October’s retail sales gains were revised higher, to 0.7%. For the holiday period (Nov. 1 –Dec. 24), sales were up by approximately 5.1%, the best showing in six years. Furthermore, with falling gas prices, lower mortgage rates, and potentially larger refund checks from the tax reform, we are optimistic that healthy consumer spending may be sustainable.
There are signs that trade-related tensions between the US and China may be easing. While the situation has proved to be quite volatile, the agreement made at the G20 to refrain from additional tariffs until early March 2019 was a positive step, in our view, and negotiations are continuing in the meantime. China has also taken certain actions which we think will be viewed favorably by the Trump administration. These actions include new penalties for intellectual property infringements, a temporary reduction of tariffs on US auto imports, and the resumption of purchases of US agricultural products. We are encouraged by these measures and believe that they increase the odds that the current negotiation deadline will be extended, assuming a deal is not reached beforehand. A resolution to this issue could go a long way towards improving investor sentiment, as in our view the slowdown in global growth is the number one risk factor currently facing capital markets. An agreement between the world’s two largest economies should help to alleviate global growth concerns.
Over the last few months, we have steadily shifted our portfolios towards a more late-cycle positioning. We added some exposure to holdings that we believe could outperform in an economic downturn, and have pared back on shares of what we view as higher risk companies with greater financial leverage. We increased our portfolios’ holdings of large-cap and value stocks, and raised modest levels of cash. In addition, where applicable, we added exposure to long-dated zero coupon US Treasury bonds, as we believe that these securities can be an effective hedge in the event that stocks continue to fall, causing investors to seek out safe-haven assets.
While we enhanced the defensive characteristics of our portfolios in aggregate, we purposefully maintained some exposure to higher beta holdings to reflect that we are cautious, but not overly bearish on the market. As always, we are closely monitoring key market risk factors and stand ready to adjust our positions if needed.
We currently hold a cautious outlook on stocks. We expect that tighter financial conditions and the slowing global economy will be incorporated into the 2019 guidance that may companies will soon be providing, which could make for a choppy earnings season. This coincides with a chaotic domestic political environment, as the Trump administration continues to experience high levels of turnover. In recent weeks, Chief of Staff John Kelly and Secretary of Defense James Mattis have announced their departures, the latter coming in the wake of President Trump announcing his intentions to pull US troops out of Syria. Meanwhile, it appears little progress has been made regarding ending the US government shutdown, and the longer it persists the greater the likelihood that it will weight on investor confidence. Finally, crude oil prices have fallen to a pivotal level, as further declines could weight on capital investment and creditworthiness in the space. While this may be a positive development for the consumer, we think that the aggregate impact of lower oil prices would be detrimental to the economy at large.
Our reasons for optimism include strength in consumer spending. Consumption is the largest component of US economic output and we are optimistic that its recent strength can be sustained. Moreover, equity valuations appear reasonable, and should global growth expectations begin to improve, valuation multiples could expand. An agreement between the US and China to end the trade war is one development which would likely go a long way towards improving sentiment on global growth. While we are encouraged by China’s recent concessions in this regard, we caution that the situation remains quite volatile and difficult to forecast.