Market Monitor & Recap

Market Recap

4th Quarter Recap and Outlook-Septemer 30, 2018 to December 31, 2018

Recap

At the beginning of the year we expressed the notion that the performance of risk assets during the first two months of 2018 would act as a barometer for the year, a prognostication that was mostly proven correct. Throughout the last twelve months the global equity markets have been marked with significant volatility. The year started off with a bang as President Trump began to threaten major U.S trading partners with tariffs, which were quickly reciprocated onto U.S exports. Trump’s tough rhetoric coupled with the unwinding of large positions in volatility linked derivatives quickly culminated in a 10% correction in the S&P 500 during late January through early February. The S&P 500 subsequently rebounded, posting new all-time highs by August. However, this rally was short-lived, as the fear of slowing global growth accompanied by tighter monetary policy by central banks overcame investor optimism, sending the S&P 500 down nearly 20% from the peak to the trough. Due to heightened trade tensions between the U.S and various trading partners, last year was an especially rough year for international equities, the MSCI EAFE index underperformed the S&P 500 (-4.39%) by 8.9%, and emerging markets fared even worse underperforming by 10.1%.

Amid the volatile fourth quarter, energy and tech stocks were the worst performers. The 40% correction in crude oil, which was both a result of fading tensions with Saudi Arabia and growing concerns of slower global growth, sent the energy sector of the S&P 500 down nearly 24% for the quarter. Despite being the market darling over the last few years, the information technology sector has tended to be one of the worst performing sector of the S&P 500 during times of market stress. This time was no different, with technology stocks posting a 17% loss for the quarter.

We haven't seen such uncertainty surrounding an interest rate hike as we did in December when the Federal Reserve raised the Fed Funds rate by an additional 25 basis points. Historically the chance of an interest rate hike has all but been completely priced in by the market, yet the day before the meeting the Fed Funds futures market was only pricing a 68.3% chance of a hike. What this high level of uncertainty highlighted was the drastic divergence in views of monetary policy between the market and the Federal Reserve. As investors began to view the pace of recent rate hikes and the Federal Reserve’s expectations of future interest rates as burdensome to current levels of growth, and in the anticipation that the Federal Reserve will succumb to investor pressure and pause hikes, the market has quickly been reluctant to price in higher short-term rates going forward.

Outlook

It is our belief that stability will return to the U.S. equity market during the first quarter of 2019. Better trade relations between the United States and China, which we see happening following the January trade negotiations in Beijing, will perhaps be the largest contributing factor toward the stabilization of risk assets. In addition, with oil now above its one-year low of $42.53 and headed towards $50, investors should feel more comfortable taking on risk and financial conditions should normalize.

Based on our estimates, the U.S. economy will grow at 2.4% and inflation will continue to track above 2% over the next twelve months. Despite our sanguine outlook for the U.S economy, we believe that the performance of international equity markets will outperform U.S equities for the year. Due to their significant underperformance in 2018 the valuation metrics of international developed and Emerging market equities in particular are comparatively more attractive than those of U.S. equities. For example, the forward price to earnings multiple for emerging markets is 11.15x earnings compared to 15.2x earnings for the S&P 500. Into 2019, we expect quality stocks to outperform. Value may outperform growth as valuation plays a larger role in stock selection going forward. Conservative and high dividend stocks could lead as investors brace for an economic downturn in the next twelve to twenty-four months.

According to our analysis of monetary policy, the Federal Reserve will raise the Fed Funds rate. once during 2019. Though our expectation is below the Federal Reserve's own forecast of two rate hikes, it is still above the market's expectation of no hikes for the year, which we believe is an unlikely outcome considering the relative stability of recent economic data. By constructing a framework for fixed income investing based on the aforementioned expectation of one rate hike in 2019, we believe that we will be better positioned than the market for a shift higher in the front-end of the yield curve. It is our expectation that the yield curve flatten further throughout the year, with the potential for more points along the curve to become inverted. The spread between the two year and five year note turned negative in early December, and we see the potential for the inversion of the curve to extend out to the ten year segment by yearend. Corporate debt significantly underperformed both agency mortgage backed securities and U.S. Treasuries last year, a trend that we see continuing in 2019. In anticipation we have selectively trimmed our allocation to corporate debt, which we have reinvested into both agency mortgage backed securities and callable agency debentures. Despite our overall effort to trim our exposure to credit we will continue to reinvest some proceeds into corporate debt that offers relative value, but with a strong up in quality bias.

Media Perspective

A recent article from the Wall Street Journal, (Investors on Edge After Stocks' Biggest Yearly Loss Since 2008) - Stock investors are heading into the new year with a sense of wariness (By Akane Otani, Wall Street Journal)

Read More by Akane Otani, Wall Street Journal article at the Investors on Edge After Stocks' Biggest Yearly Loss Since 2008.

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