As we begin 2019, we are excited about all this year has to oﬀer. However, our hearts continue to go out to those in California that were aﬀected by the ﬁres this November. The ﬁres were a harrowing and somber experience, the eﬀects of which will be felt for a long time. But they also serve as a reminder that we are part of an incredible community where neighbors and community members are willing to work together and help one another in times of need. As friends and families continue to recover and rebuild, please contact us if you need any assistance or if we can help answer any questions.
This fall Kris Gray, Principal, and Sarah Archer, Chief Investment Oﬃcer, had the privilege of traveling to New York for a thorough due diligence review of the management teams, all of whom are viewed globally as leaders in the private equity and alternative investment landscape. Kris and Sarah were given the opportunity to sit down face to face with representatives from ﬁrms like BlackRock (the largest asset manager), KKR (one of the most widely known and respected PE ﬁrms), and Blackstone (the largest owner of real estate) to discuss the current economic environment, market performance, investment strategies and new opportunities on the horizon. Our ﬁrm believes in having a strong purview into both the private and public markets, and our relationships in NYC provide incredible access to investments and information for our clients.
In December, Kris Gray joined other business leaders along with board members of the Association of Washington Business in private meetings with political leaders in Washington, D.C. In conversations with both Senators and Representatives from Washington state, Kris Johnson and Gary Chandler guided the discussions around trade policy, immigration, tax policy, and infrastructure. Having a presence in Washington, D.C. provides us and our clients with further insight on macroeconomic issues and tax policy changes that can beneﬁt businesses and individuals alike. A special highlight of the trip was attending a small bipartisan retirement party for Congressman David Reichert, a former sheriﬀ of King County who served seven terms as the U.S. Representative for Washington’s 8th Congressional District.
As another year comes to a close, we look back at what was an interesting year in both the economy and the markets. From an economic perspective, things are about as good as one could hope: unemployment is at its lowest point in nearly 50 years, wages are growing, manufacturing is expanding, corporate proﬁts are solid, and if this expansion continues through July 2019, it will be the longest expansionary period of any US economic cycle. But as we know, any good thing must eventually come to an end. The big question is, will 2019 be the year in which the economic, policy, and market risks materialize into a recession or bear market? On one hand, there are some compelling indicators that suggest the economy still has room to run, but there are also many reasons for caution and proof that the cycle is aging.
The current expansion is now 114 months old, making it the 2nd longest cycle in history. For perspective, the average length of an expansionary period is 67 months long1. Port-folio Manager for American Funds, Don O’Neal, describes it this way, “We are presumably late in the game, but there is always the possibility of extra innings.” What this cycle has in length, it doesn’t necessarily have in strength.
Real cumulative GDP growth has been signiﬁcantly less for the current cycle compared to cycles of the same length. This may mean that this expansion has more room to run, similar to a marathoner who has conserved their energy for the ﬁnal push of the race. Alternatively, it could mean that any recession we do see could be less severe. With the help of the Tax Cut and Jobs Act of 2017, GDP growth has accelerated in recent quarters. As of the last reading GDP growth stood at 3%1.Many expect GDP to return to the 2% pace that it averaged from 2010-2016 in upcoming quarters as the beneﬁts of the tax bill wear oﬀ.
The Federal Reserve has been watching inﬂation and other key readings to drive changes to interest rates. The Fed’s target inﬂation is 2%, and last quarter’s reading came in at 2.2%. This supported the Fed raising rates again in December to a target rate between 2.25-2.50%. This was the 4th hike in 2018 and the 9th since they started raising rates from a 0% ﬂoor in December 2015. Inﬂation has been driven, at least in part, by growing wages. In October, the year over year wage growth was 3.1%, the largest gain seen since 2009. Despite this wage pressure, corporate earnings have remained strong. Earnings are up 30% year over year, with the help of a favorable ﬁscal and regulatory environment. About 20% of that growth came from increased margin (less tax). Earnings growth is expected to moderate going forward and should land in the mid-single digit range.
After experiencing broad synchronized global growth in 2017, trendlines have led the US and international economies in diﬀerent directions. Developed countries have lost momentum and emerging market economies have been hurt by a strong dollar and weak commodity prices. As the Fed has marched forward in raising rates, other central banks have remained stagnant. Growth expectations were relatively high for the European and Japanese regions in 2018 but those expectations fell short, and investor conﬁdence fell with it. Populism and instability in France and Germany as well as uncertainty around the Brexit deal have also dampened the economic climate.
As we move into 2019, economic risks worth mentioning include: the trade war with China, Federal Reserve raising rates too quickly, and geopolitical uncertainty. To end the year, tariﬀs with China currently stand at $200B on exported goods, which some economists think could reduce GDP growth by 0.5%. If tariﬀs increase, the prospect of which has been threatened, the negative impact could intensify. A Fed policy mistake is also a possibility, yet remains unlikely as they have moved to a more neutral and patient stance. Despite the exceptional length of this cycle and the expectations for moderated corporate earnings, our expectation is continued expansion through the year and low recession risk in 2019.
2017 was marked by a comfortable and easy year in the market, where returns exceeded 20% and volatility stayed subdued. 2018 quickly changed the tone, with the ﬁrst of three separate 10% decreases starting at the end of January. Volatility returned with a vengeance and continued throughout the year. The 4th quarter was especially bumpy with a major drawback that wiped out the year’s gains. At the end of Q3 2018, the S&P 500 was up 8.9%. In the fourth quarter, however, it decreased -13.97%, dragging down the 2018 annual return to -5.1%. Other markets segments saw similar drawbacks. The MSCI EAFE Index, an index of international developed countries, was down -12.5% in Q4 (-13.8% YTD), and Emerging Markets fell -7.5% (-14.6% YTD).
Growth stocks were particularly aﬀected by the sell oﬀ, setting up value stocks to outperform during the quarter by about 2%. Leading the drawback in the growth sector were the popular FANG stocks (Facebook, Amazon, Netﬂix and Google), which saw signiﬁcant decreases from their respective highs. Amazon was down close to 30% as we neared the end of the year, down from its all-time highs seen in September. Facebook fell more than 40% peak to trough. Despite this pullback, Growth stocks did win over Value for the year, with Growth ending the year just barely negative and Value ending down -9%. Mid-Cap and Small Cap fared no better, with the Russell Mid Cap Index and Russell 2000 (small cap index) down -15.4% and -20.2%, respectively in Q4 (-9.1% and -11.0% respectively YTD).
Looking at the 10 major economic sectors, only one ended in (slightly) positive territory in Q4 with Utilities eking out a 0.8% return. All other sectors ended negative, with the majority down more than -10% for the year. Of the worst performers, Energy led the way, down -25.2% for the quarter, pulling the year’s return to -18.9%. Technology was down -17.5% in Q4, though just barely negative for the year. Healthcare, while down for the quarter, had a strong year relative to the other sectors, ending 2018 up 6.3%.
Looking abroad, markets didn’t fare much better, with the MSCI ACWI ex USA, a proxy for all markets outside the US, down -11.5% for the quarter and -14.2% for the year. Europe has struggled recently grappling with relatively weak earnings ﬁgures, weak economic growth, and political risks. China, on the other hand, has shown stronger than expected economic strength. This has helped steady Emerging Market companies and provide robust corporate earnings growth in the region. Last quarter, Emerging Markets proved to be more resilient than the rest of the world, only losing -7.5% for the quarter. Given US outperformance in this cycle, valuations of international equities are low relative to domestic equities, making international stocks “cheaper” by comparison. The PE ratio of the MSCI ACWI ex USA is at a modest 11.5x, well below its 20 year average of 14.2x.
Rising rates have made shorter-term U.S. bonds comparatively more attractive as a source of income. With short-term treasuries oﬀering almost as much yield as the 10-year note, investors have found been migrating to safer, more liquid investments. The yield curve continued to ﬂatten in the 4th quarter with yields on short to intermediate-term treasuries climbing slightly more than the long-term issues. Rising rates have put pressure on bond prices, though returns were mixed across ﬁxed income segments. In Q4, the Barclays US Aggregate Bond Index advanced 1.6%, but was essentially ﬂat for the year, up 0.01%. High Yield securities, which often follow the performance of equities, fell -4.2% in Q4, (down -1.5% YTD) and Investment Grade corporates fell -0.5% (down -3.7% YTD). Due to strong fundamentals and favorable supply/demand dynamics Munis grew by 1.5% in Q4 (1.0% YTD).
Despite heightened geopolitical risks, we expect the expansion to continue globally, albeit at a slower pace. The US economic cycle is aging and if growth remains positive through mid-2019, it will be the longest expansion in our history. We believe conditions remain favorable and the outlook is positive, but the pace of GDP growth will likely slow to 2% in 2019 vs. the 3% pace we experienced in 2018. Consumer spending will likely outpace capital spending at this stage in the economic cycle, which represents approximately two-thirds of overall GDP. We believe inﬂation will remain on a steady pace, and that the Federal Reserve will slow their tightening, with only 1-2 rate hikes expected this year. We expect a bipartisan infrastructure package will be announced and implemented prior to 2020 and has the potential to prolong the economic expansion. Due to the correction in Q4, we believe US equities are more attractively valued, and we believe 2019 is likely to end in positive territory on the S&P 500, but volatility will remain elevated. We expect to see technology, biotech, and energy recover ground and be strong performers. There are still compelling reasons to hold risk assets, but with increased rates holding ﬁxed income securities is becoming more valuable to provide a ballast for when economic growth slows. Due to attractive valuations in the emerging markets, we believe that investors will begin to increase their interest and we may see equity markets in Brazil and China outperform the US. We are less optimistic about international developed regions such as the Eurozone given the political uncertainty. Finally, we expect geopolitical tensions and hostile rhetoric to increase and lead to sharp market sell-oﬀs followed by recoveries as successful diplomatic negotiations ease tensions.
A reminder to have a focused, disciplined, long-term approach to investing is very important at this time to protect against common investor mistakes of market timing or fear-based reactions. A thoughtful, well-diversiﬁed approach, including alternative and defensive strategies, should help alleviate investor anxiety. Consider meeting with your advisor to review your current risk tolerance and ensure your investments and ﬁnancial strategies are meeting your short term and long-term goals.
Kristofer R. Gray, CFP®, CRPS, C(k)P®, MPA
Chief Investment Oﬃcer
Sources: 1) American Funds – US Economic Outlook; 2) BlackRock—Global Economic Outlook 2019; 3) BlackRock Benchmark Returns – December 2018; 4) JP Morgan Chase – Economic Update using Guide to the Markets – 1q19
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