January 11, 2019
Dear Valued Clients & Friends:
2018 Year-End Market Commentary
It is our profound pleasure and honor to work with all the individuals, families and institutions represented by the Compass Ion Advisors client base. You each mean a lot to us, and we are always striving to improve at exercising our core values. While we believe that these all have an impact on how we manage your investment portfolios, we feel that the following principles are particularly applicable:
- Transparency, and
Our investment committee, and our entire staff, seek to live up to these high standards every day, and we appreciate your continued trust. As we wrap up 2018 and begin 2019, we hope you find this commentary helpful.
The prior year of 2017 was a great period for investors due to:
- Positive returns in nearly every asset class,
- Historically low volatility in the stock markets, and
- Synchronized global growth.
The general consensus going into 2018 was:
- No U.S. recession,
- Increased volatility in the stock markets,
- Higher U.S. interest rates, and
- Modestly positive returns for stocks.
Three of those four prognostications turned out to be true. Equity market losses in the final three months of the year ruined the last prediction. This was particularly disappointing given that the S&P 500 had rebounded from a first quarter selloff and ended the third quarter with a 10.6% year-to-date return. As you can see below, after three quarters, despite the increased volatility, it looked like 2018 could be another strong year:
As the third quarter came to an end, the U.S. economy was growing at a rate above 3%, as measured by real U.S. GDP. Corporate earnings were growing at over 20% on an annual basis. What happened? We believe the following were the primary catalysts for the fourth quarter equity market decreases:
- Deteriorating Global Economic Data – During the third quarter, data from Europe, Japan and China indicated slower economic growth in those regions.
- Tightening U.S. Monetary Conditions – The Fed increased rates 4 times during 2018, with the December hike taking the Fed Funds target rate to 2.5%. In addition, the Fed fully transitioned from Quantitative Easing to Quantitative Tightening. The year ended with the Fed allowing roughly $50 billion per month ($600 billion on an annual basis) to roll off its balance sheet. As the Fed chooses not to reinvest these maturing dollars, this decreases overall liquidity in the economy as the private sector has to now absorb an increasing supply of U.S. Treasury bonds.
- U.S. / China Trade War – The impact here was primarily fear of continued escalation. However, some of the impact was more concrete including China’s economic slowdown plus U.S. companies publicly commenting about the negative impact on future earnings and disruptions in the supply chain (this affected technology companies in particular).
- Expectations of a U.S. Slowdown – Investor sentiment changed during the fourth quarter. Expectations spread that growth rates for U.S. corporate earnings, U.S. GDP growth, and capital investment would decrease in 2019. As notable technology companies began reporting disappointing results, these expectations took hold. Equity prices began to reflect a growing concern that a U.S. recession may be closer than was previously forecast.
- Inverted U.S. Yield Curve – This occurs when longer-term U.S. Treasury yields fall below shorter-term yields. Curve inversion has been a popular topic in the financial press because it often precedes an economic downturn. The U.S. yield curve did flatten throughout the year, and part of the curve (the 2-yr / 5-yr segment) did invert in December. Most market participants watch the 3-month / 10-year yield differential, which has proven to be a predictor of U.S. recessions, albeit an imperfect one. That yield spread, while not inverted, is historically tight and continues to be a concern.
Putting this all together, the market lowered its future growth expectations during the fourth quarter and began to realize that central banks will no longer support stock prices with easy monetary policy.
To keep things in perspective, the negative 2018 equity performance only gave back a portion of 2017’s positive returns, and at year-end the S&P 500 still had an annualized 5-year return of 8.5%.
The questions that investors must grapple with now are:
- Have equity markets discounted future growth too aggressively (i.e., are markets “oversold”) or is the current economic cycle coming to an end?
- Is the U.S. going to continue its market leadership position?
The table below provides returns for various investment sectors across the capital markets:
Diversified Portfolio Management
2018 proved to be a challenging environment for diversified portfolio management. In November, asset class performance was begging the question: Do I really need anything other than the S&P 500 and cash in my portfolio? After coming off its high in September, the S&P 500 bounced back from an October swoon and by November 7th was up 7% for the year. It looked like the index would finish a volatile year solidly positive.
At that time, global diversification looked particularly unhelpful, with both international developed and emerging markets lagging the U.S. U.S. small cap companies, which have historically outperformed their larger peers, were also underperforming both domestically and internationally. Bonds had not provided meaningful risk protection during market pull backs in either February or October.
For Compass Ion portfolios, where we actively seek to incorporate diversified portfolio positioning, performance relative to our risk benchmarks lagged a bit. In addition to global and small cap equity diversification, we also have allocations to various alternative fund strategies across our portfolios, most of which struggled through the year.
However, as the year ended, we began to see reversals in many of these trends. From November 7th to year end, the S&P lost over 10% of its value, with emerging market and international developed equities both outperforming by roughly 7% and 3% respectively. Towards the end of December, and continuing into early 2019 trading, we have started to see U.S. small cap begin to outperform U.S. large cap.
While these reversals in trends came too late in 2018 to erase all the performance drag experienced earlier in the year, we think it supports our longer-term view based on historic data that a more diversified approach to portfolio management provides more consistent, long-term, risk adjusted results.
While we believe the U.S. is currently experiencing a modest economic slowdown in tandem with other developed market economies and that trade tariffs are proving to be an increasing drag on global growth, we do not think we are at the end of the long running economic cycle or the secular bull market in stocks. We do think equities were oversold at the end of 2018 and noted some technical indications of “sell exhaustion” at year-end, which indicates that a bottom may be forming. There are strong signs that U.S. growth will slow during 2019 but stabilize around a 2% annual increase for the year – back to post-crisis trends. Below are our expectations for the coming year:
- No U.S. Recession in 2019 – We feel confident about 2019. We are less confident about 2020.
- The Fed will be Less Aggressive – We do not expect the Fed to be tone deaf to slower U.S. growth if inflation is close to its 2% target – something it has already started to signal. While we expect quantitative tightening to continue unabated, we expect a less aggressive path of additional Fed Funds rate hikes (1 or 2 this year) than previously predicted. We also anticipate China to increase their economic stimulus through a range of policies, which will provide some support to the market.
- Non-U.S. Equities will Outperform U.S. Equities – This is an uncomfortable view given that, with a few exceptions, U.S. equities have outperformed since the financial crisis. It has been well publicized that non-U.S. equities currently trade at a discount to U.S. equities (lower price to earnings ratios). Although there is some risk we may be early on this call, history has shown that market sectors with lower valuations tend to outperform those with higher valuations – particularly over longer time horizons.
- Equity Markets will Post Modest Positive Returns – 2019 will continue to be volatile, however we believe equity markets will, within a reasonable margin, recapture the losses experienced during 2018. Although there are many exogenous factors that could derail this prediction (e.g., trade war escalation and a deepening China slowdown), this is our base-case view.
Thank you for you continued trust in Compass Ion Advisors.
This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable. This presentation may not be construed as investment advice and does not give investment recommendations.
The securities presented may not be representative of the current or future investments for Compass Ion clients.
You should not assume that investments in the securities identified in this presentation or that recommendations made in the future were or will be profitable or will equal the performance of securities identified in this presentation.
Additional information, including advisory fees and expenses, is provided on Compass Ion’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Compass Ion does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The investment return and principal value of an investment will fluctuate so that an investor’s portfolio may be worth more or less than its original cost at any given time. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.
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