Quarterly Newsletter

Transcription

1 Quarterly Newsletter The best way to measure your investing success is not by whether you re beating the market, but by whether you ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go. ~ Benjamin Graham, the Father of Value Investing TABLE OF CONTENTS CAPITAL MARKETS SCOREBOARD... 2 EQUITIES... 3 FIXED INCOME... 4 ECONOMICS... 5 WALLINGTON PERSPECTIVE... 6 A Look Ahead A Note to Investors 8900 Keystone Crossing, Suite 1015, Indianapolis, IN

2 CAPITAL MARKETS SCOREBOARD Page 2

3 EQUITIES In 2018, all major U.S. stock indices suffered their worst annual losses since The Standard & Poor s 500 index (S&P 500) posted a total return (price appreciation plus dividends) of -4.4%, the Dow Jones Industrial Average (DJIA) -3.5%, and the NASDAQ Composite Index (NASDAQ) -2.8%. Despite volatility early in the year, the markets performed well for the first nine months prior to a rough fourth quarter; the S&P 500 was down 13.5% for the quarter and 9.2% in December alone, its worst December since The S&P 500 narrowly avoided a bear market by official definition (down 20% or more from the peak using daily closing prices) prior to year-end, although it did reach a 20.2% decline using intraday prices. The NASDAQ did officially enter bear territory in Ten of the 11 sectors of the S&P 500 had negative returns in the fourth quarter, with the Energy (-23.8%), Technology (-17.3%), and Industrials (-17.3%) Sectors being the worst. Seven sectors posted double-digit negative returns, with the Utilities Sector posting the only positive return. For the year, only the Healthcare (6.5%), Utilities (4.1%), and Consumer Discretionary (0.8%) Sectors had positive returns. This year marked the first time in several decades the S&P 500 experienced two corrections (market decline of 10-20%) in a single calendar year. With down markets generally comes increased volatility. The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) was up over 175% in 2018, starting at 9.22 and ending at 25.42, more than doubling in the fourth quarter alone. The VIX surpassed 30 several times during the year. The S&P 500 had daily moves of at least 1% up or down 64 times in 2018, nine of which were in December, versus only eight for all of December was a bizarre month, especially during the last week. Both the DJIA and S&P 500 had their largest single-day point moves in history on December 26 the DJIA up 1,086 points and the S&P 500 up 117 points. On December 27, the DJIA experienced its biggest one-day reversal, down 600 points early but up 260 points at the close for a record 860-point reversal. The DJIA experienced a single-day record 19 intraday price reversals on December 28. U.S. stocks ended 2018 with valuations below historical averages based on the forward price-to-earnings (P/E) ratio. Assuming 2019 earnings growth of 6-8%, the S&P 500 is trading at 14.5x- 14.2x 2019 earnings, well below the 18.3x level seen at the beginning of Since 1994, this forward P/E ratio has traded at an average of 16.1x expected earnings. The S&P 500 s 14.0% price decline in the fourth quarter lowered stock valuations significantly. Foreign stock markets fared even worse than U.S. markets in Most foreign stock market indices had double-digit losses for the year and fourth quarter. The MSCI Europe, Australia, and Far East (EAFE) index was down 13.4% for the year and 12.5% for the fourth quarter. Stock markets in China, Germany, Italy, Japan, and several other countries experienced bear markets in Of major markets, only Indian and Brazilian equities had positive returns in Page 3

4 FIXED INCOME Global interest rates generally fell in the fourth quarter of 2018, as concerns over economic growth overcame further projected tightening of monetary policy. The 10-year U.S. Treasury (UST) yield rose to its highest level since 2011 in October, reaching a peak of 3.24% after starting the year at 2.40%. A flight-to-safety mentality overtook financial markets, however, and demand for USTs drove the 10-year yield back down to 2.68% to close out High-quality bonds provided shelter from the equity markets in the fourth quarter, as USTs in aggregate returned 2.6% as measured by BofA-ML indices. For the year, USTs returned only 0.8% amidst an environment of generally increasing interest rates. Developed market sovereign bonds recovered their losses as well when denominated in local currencies. A 2.0% return in the fourth quarter helped elevate their year-to-date (YTD) return to 1.0%. When denominated in USD, however, developed market sovereign bonds lost 0.3% due to a strengthening dollar. Corporate credit did not fare as well as more secure government-backed bonds in Investment-grade bonds were flat for the quarter and ended 2018 with a 2.2% loss. The lack of performance was entirely due to credit spreads (the yield differential between corporate and government bonds) widening. Credit spreads have widened as corporate balance sheets have deteriorated, and the ratio of BBB-rated bonds to A-AAA rated bonds has continued to rise. High-yield credit spreads fared even worse, and these bonds generated a -4.6% return for the quarter. High-yield bonds are very sensitive to economic uncertainty and pessimism, as economic downturns could be hazardous for their issuers. As a result, they have the potential to exhibit equity-like volatility and closed 2018 with a 2.3% loss. Recent federal funds rate hikes have been telegraphed by the Federal Open Market Committee (FOMC), forecast by analysts, and implied by futures markets. Still, December s increase from a range of % to 2.25%-2.50% received a great deal of attention and consternation throughout the quarter. Although Federal Reserve (Fed) Chair Jerome Powell lightened his tone on the necessity of future rate hikes, the FOMC still projects two additional increases in Markets have signaled this could be a misstep amidst growing global economic uncertainty and weakness in interest-rate sensitive sectors such as autos and housing. Fed funds futures markets are now implying a higher probability of a rate cut in 2019 than further rate increases, but whether the Fed is ultimately more concerned about these factors or the potential for inflation remains to be seen. One factor causing further concern regarding increases in short-term interest rates is the potential for a yield curve inversion. The yield curve is the plot of UST yields at their respective maturities. This curve is generally upward-sloping in a healthy market, as investors require higher yields to invest in bonds of longer maturities. When the curve inverts, or longer-term bonds have lower yields than shorter-term bonds, it has frequently been a negative indicator for the economy. In the fourth quarter there was some cause for alarm as 5-year USTs began yielding less than 2- and 3-year USTs. This indicates the market is predicting the Fed will raise rates too much, then have cause to cut rates in the next 5 years. While this type of minor inversion is more frequent and less insightful than 10- year USTs yielding less than short-term USTs, it still bears monitoring going forward. Page 4

5 ECONOMICS Third quarter U.S. Gross Domestic Product (GDP) growth came in at a seasonally-adjusted annualized rate (SAAR) of 3.4% quarter-over-quarter (Q/Q), notching year-over-year (Y/Y) growth of 3.0% through the third quarter of Should fourth quarter GDP growth come in at the median expectation of 2.9%, the U.S. would surpass 3.0% annual GDP growth in a calendar year for the first time since Housing remains a soft spot in the U.S. economy with both new and existing home sales struggling. Existing home sales fell 7% in November from a year earlier, the largest Y/Y decline since May Existing home prices have continued to grow, and although the growth rate has declined, home prices have increased at a higher rate than wages for 81 consecutive months. To add to affordability headwinds, mortgage rates, which began the year at 4.03% (30-year fixed), topped 5.20% in November before declining back below 5.00% to close the year. Oil prices declined sharply in the third quarter. West Texas Intermediate (WTI) crude prices hit a fouryear high of $76.41 per barrel to begin October before plummeting to $45 per barrel in December due to supply excesses and weak demand. Lower oil prices create significant headwinds for the Energy Sector, but also translate to lower fuel prices at the pump for consumers, creating a net benefit for the economy. The Bureau of Economic Analysis (BEA) measures corporate profits based upon the net income of corporations collected from corporate income tax returns and contained in the National Income and Product Accounts (NIPA). The metric differs from profits reflected in financial reports provided by corporations directly to the public and investors. According to the BEA, after-tax corporate profits were revised upward to 3.5% in the third quarter versus a preliminary report of 3.3% and second quarter growth of 3.0%. Worker productivity increased at 2.3% in the third quarter after a 3.0% increase in the second quarter, marking the first calendar year of productivity growth above 2.0% since Still, the Markit Purchasing Managers Index (PMI) for manufacturers, an indicator of economic health and confidence for the manufacturing and services sectors, dropped to 53.8 in December, its lowest level since September While a reading above 50 indicates more companies are growing than shrinking, the decline from 56.5 at the close of the second quarter bears watching moving forward. The U.S. consumer has driven the lion s share of growth since 2009 and remains healthy. Average hourly earnings were up 3.2% versus a year earlier, outpacing inflation which has hovered around 2%. Consumer confidence, although below its October peak, is still high. Household wealth (assets minus debt) stood at $109.4 trillion by the end of the third quarter, up about $6 trillion since the beginning of the year due predominantly to increased home and stock prices. Consumers did not hesitate to open their wallets this holiday season, spending over $850 billion (excluding automobiles) from November 1 December 24 according to Mastercard, up 5.1% versus the same period last year. Page 5

6 WALLINGTON PERSPECTIVE A Look Ahead U.S. economic growth for 2018 is seeded to be the best since Jobs have grown for 98 consecutive months and the unemployment rate of 3.7% is at a 49-year low. Real (inflation-adjusted) wages have been positive recently, as wage growth in the fourth quarter outpaced inflation. Both the manufacturing and services sectors grew in 2018, and worker productivity picked up in the second and third quarters. Still, both equities and fixed income markets seemed disconnected from a generally strong economy, as both struggled in the year. So what is next? Financial markets do not like uncertainty, and it is here in spades. Some of the known unknowns causing that uncertainty include the impact of higher wages on inflation; global trade tensions (particularly between the U.S. and China); slowing global economies (including the U.S., Europe, Japan, and especially China); the path of the Fed in raising interest rates and reducing its balance sheet; the potential actions of the European Central Bank; the political volatility emanating from Washington, D.C.; U.K. and Eurozone resolution of Brexit; and the amount of global debt and corporate debt outstanding. These are some of the major unknowns on investors minds as we begin the new year. Equities In 2019, equity investors will be largely focused on corporate profit margins and share buybacks. The fear is that profit margins may erode because of higher labor costs and other costs related to trade disputes and shortages. While earnings are still projected to grow in 2019, the estimated rate of growth has declined due not only to lower profit margins, but also lower revenue growth and an anticipated waning impact of 2017 corporate tax cuts. S&P 500 earnings are expected to increase 12% in the fourth quarter of 2018 over the same period a year ago, which is about half the average 25% growth rate of the first three quarters of Given even lower expected earnings growth of 8% in 2019, investors will be paying considerable attention to corporate guidance when quarterly results are reported. U.S. corporations returned a record $1.2 trillion to shareholders in 2018, $750 billion in share buybacks and $450 billion in dividends. Buybacks and dividends provided support for stocks, and positive returns in 2019 will likely depend heavily upon their continuity. Many of the buybacks were financed by cheap debt in the prolonged low interest rate environment maintained by the Fed. If the Fed continues to increase the fed funds rate and unwind its balance sheet, the higher interest rates (and thus higher cost of capital) will likely have a negative impact on buybacks. Global trade negotiations are another key item for investors as the year begins. Uncertainty still looms over trade conflicts, particularly between the U.S. and China. If not resolved by early March, existing tariffs on $250 billion of Chinese imports will increase from 10% to 25% and tariffs on an additional $200 billion of imports will be imposed. Even with a resolution on tariffs, cyber theft and forced sharing of intellectual property may be an even larger issue. While tariffs may be resolved in the shorter-term, the intellectual property conflict between the U.S. and China will likely continue for the foreseeable future. The S&P 500 finished the year on the precipice of a bear market, down 14.5% from its September peak. These uncertainties will have to be resolved in 2019 for the stock market to continue its nearly 10-year bull market run. No matter how they are resolved, 2019 should be a post-peak world for the global economies and financial markets. Slower U.S. growth has been foretold by lower oil and other industrial commodity prices, lower 10-year Treasury bond yields, and a flattening yield curve. Market P/E multiples usually will not expand with escalating uncertainty, so 2019 S&P 500 returns may depend to a large degree on earnings growth and dividends. The two stock market corrections in 2018 may be either adjusting for over-exuberance in 2017 and early 2018 or signaling an economic recession in Time will tell. Either way, 2019 is poised to be an interesting year for investors. Page 6

7 WALLINGTON PERSPECTIVE Fixed Income and Economy The major unknown moving forward is the Fed and its quantitative tightening (QT) policy how will they digest and react to a dynamic economic environment to reach the elusive neutral rate when there is no need to raise rates to dampen inflation pressures or to lower them to encourage companies to invest and hire and to incentivize consumers to spend more? One certainty is that the Fed appears to be more optimistic about future economic growth than the markets. It has a mandate to maintain full unemployment and moderate inflation, which have both been achieved to date. But Fed worries about inflation persist because of the tight labor market. And the Fed also worries about the ammunition it will have to respond in the event of another recession if interest rates remain low and its balance sheet remains large. Meanwhile, the markets are worried less about inflation and more about a slowing economy and possible recession. After maintaining near-zero rates from December 2008 through November 2015 to stimulate the economy through and after the Financial Crisis, the Fed has since raised rates nine times including four hikes in In addition, the Fed has begun reducing the $4.5 trillion bond portfolio it built as a result of the Great Recession and plans to continue doing so. However, Fed officials have recently pared back expected rate hikes from three to two in 2019 and one in 2020, and have also discussed potential deviance from the schedule to reduce the size of its bond portfolio. In October, Fed Chairman Powell said rates were a long way from neutral but in December noted rates were at the lower end of neutral. Market participants found this confusing, but it appears the neutral rate is between 2.75% and 3.25%. Still, uncertainty on Fed policy remains. Another issue on the minds of investors is in the $15 trillion U.S. Treasury market. U.S. government deficits are projected to reach $1 trillion annually by To fund those deficits, the supply of Treasury debt will have to increase. This increase in supply will be occurring in the face of waning demand. The Fed s bond portfolio reduction schedule calls for a decline of $3 trillion between 2017 and This is happening as foreign ownership of U.S. government securities is also on the decline; they now hold 41% of outstanding Treasury debt, their lowest share in 15 years and down from 50% as recently as China owns $1.1 trillion of U.S. Treasury debt and Japan $1.03 trillion, about $300 billion less than five years ago. The coming supply excess will need to be picked up by investors who may require higher rates to do so. In the end, the excess supply of Treasuries could very well depress prices and raise interest rates, making lending more expensive for all borrowers, the U.S. government included. Credit quality in the corporate fixed income markets is another key area of investor focus as the year begins. In the U.S., the amount of nonfinancial corporate bonds outstanding has grown from $3 trillion in 2008 to nearly $8 trillion today. About $6.8 trillion of these bonds are rated investment-grade. The rest are lower-quality high-yield (junk) bonds. The problem is $3 trillion of the investment-grade bonds are rated BBB, the lowest category of investment-grade. Should adverse economic conditions arise, many of these companies will be downgraded to the high-yield space, further increasing borrowing costs for their issuers. The newest big fixed-income product, the collateralized loan obligation (CLO), is another trend away from corporate credit quality. CLOs package low-quality levered loans into bonds much like the subprime mortgage-backed securities which became infamous during the Financial Crisis. There are now $1.3 trillion of these securities outstanding, most of which are owned in mutual funds or exchangetraded funds (ETFs). Should these funds experience losses due to increasing interest rates or deteriorating credit conditions, massive amounts of money could move out of them as investors sell, prompting widespread selling of the underlying securities within the funds. This presents a liquidity problem because corporate bonds can have limited liquidity, and the amount of capital dedicated to bond trading has been cut by 75% due to new capital requirements imposed on banks. Preservation of capital will be a high priority for bond investors going forward. In general, corporate bond quality is lower now than before the Financial Crisis. Page 7

8 WALLINGTON PERSPECTIVE Despite significant headwinds, the U.S. economy is still benefitting from a strong consumer. While housing affordability remains a constraint, lofty home prices joined near record-high stock prices to drive household wealth to nearly $110 trillion in December, its highest level on record. Low oil prices have hurt jobs and investment for many Energy Sector companies but have led to more money in consumers pockets via lower gas prices at the pump. Consumer confidence, while more an indicator of current economic conditions than future expectations, has been pushed to levels not seen since the turn of the 21 st century on the backs of low unemployment, rising income, and moderate inflation, prompting consumers to open their wallets. The consumer was the primary driver of economic growth in 2018 and in most quarters since While slower global growth, rising interest rates, labor market tightness, and political uncertainty may not predict a repeat of a strong 2018, the U.S. economy is expected to continue chugging along in Although no signals for a recession in 2019 exist yet, more economic uncertainty looms around Many economists are forecasting a recession in 2020; yet economists consensus forecasts are usually wrong. As we move further into 2019, the additional visibility on economic growth drivers will begin to provide a better framework by which these economists will either maintain their recessionary forecast for 2020, or at the very least, adjust their timing. Robert C. Klemkosky A Note to Investors Investing isn t about beating others at their game. It s about controlling yourself at your own game. ~ Jason Zweig The impact of global economic growth projections on risk assets was evident last year, especially in the fourth quarter. As we enter 2019, the significant amount of uncertainty we are facing will likely make it a very challenging year for many. Investors in any risk asset should be prepared for higher levels of volatility, and the emotions that can be elicited from significant swings in prices. Higher levels of volatility often serve to undermine long-term investment plans by causing investors to make inappropriate decisions, often at the worst possible time. Dalbar studies have shown just how fleeting success can be in the financial markets for many investors. From December 31, 1994 to December 31, 2014, Dalbar shows retirement plan participants averaged only 2.5% in annual returns, barely beating inflation and underperforming all other asset classes. Emotions make it tough, which is why a fundamentally disciplined approach to investing is so crucial long-term, especially in these times. Those who are able to overcome their emotions and focus on long-term goals and objectives give themselves a much greater chance to be successful. Those who instead chose to let volatility lead the way, something which is very easy to do as human beings, will find they are actually subjecting themselves to significantly more risk than they realize. Successful long-term investing has never been easy, and with the changes that have taken place in the financial markets eliminating many barriers to investor behavior, it is becoming even more challenging for those who have not predetermined their risk and return preferences and understand that volatility is the cost of higher returns. That cost can be mitigated significantly with the appropriate perspective on time horizon. Terence P. Weiss The information contained herein has been compiled from sources Wallington Asset Management, LLC believes to be reliable but no warranty, expressed or implied, is being made that the information is complete or accurate. Wallington Asset Management, LLC and its affiliates, employees and/or directors may have investments in positions associated with securities required to implement and maintain a particular investment strategy. Information presented is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities which may be mentioned herein. All securities are subject to price and yield change and subject to availability. Any recommendations or opinions expressed herein may be subject to change without notice. Past performance is not to be construed as a guarantee of future results. Wallington Asset Management, LLC does not render tax advice. All rights reserved. Any unauthorized use or any reproduction, modification or distribution of the materials is strictly prohibited. Page 8