25 Jan Q4 2018 Investment Commentary
Jon Houk, CFP®, weighs in on the financial environment and critical market trends of Q4 2018.
Here are Jon’s year-end key takeaways:
• What stands out about 2018 is the breadth of negative returns across almost every asset class and financial market. 2018 was the worst year since the Great Recession of 2008 for the markets. It was a very challenging year for our globally diversified portfolios, driven by sharp declines in foreign stock markets and under-performance from some of our active managers.
• But as students of financial market history, we know the headwinds our portfolios have faced over the past year will eventually turn to tailwinds.Sticking to our process may feel uncomfortable at times, but it’s exactly what is necessary to achieve long-term success and avoid the pitfalls of “performance chasing” and emotionally-driven investing.
• Our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential scenarios. We are optimistic about their potential for strong performance in the years ahead as the headwinds and trends shift.
• Over the short term, if the current recession fears are overdone, we expect to generate strong overall and relative returns. Out-performance should come from our foreign equity positions, active managers, and flexible bond funds.
• On the other hand, if U.S. stocks slide into a full-fledged bear market, our portfolios have allocations to lower-risk fixed-income and alternative strategies that should hold up much better than stocks. We can then put this capital to work more aggressively at lower prices that imply much higher expected returns in the future.
• However, throughout our history, we’ve emphasized the importance of having a long-term perspective. As your time horizon lengthens, the range of reasonable expected outcomes narrows, the shorter-term cyclical spikes and dips are smoothed out, and the underlying fundamental/economic drivers of financial asset returns play out. Over the long term, we are highly confident of the benefits of owning a globally diversified portfolio.
• Successful investing is a process of consistently making sound, well-reasoned decisions over time and across market and economic cycles. We believe our diversified, fundamental, valuation-based investment approach meets this definition. As long as we continue to execute our approach with discipline and remain patient during the inevitable periods when it is out of favor, we have no doubt we will achieve successful and rewarding long-term results.
From a return perspective, 2018 could largely be considered the year that wasn’t. Despite a few halfhearted rallies leading into the closing day, global financial markets ended December with the worst annual returns since the Financial Crisis. Larger-cap U.S. stocks fell nearly 14% in the fourth quarter, wiping out year-to-date gains and ending down 4.5%. Smaller-cap stocks fared worse, falling 20% in the quarter and 11% for the year. Foreign stocks suffered through most of the year, with mid-double-digit year-end losses for both European and emerging-market stocks (despite their relative out-performance versus U.S. stocks in the fourth quarter).
In addition to the equity market declines, what stands out about 2018 is the breadth of negative returns across almost every type of asset class and financial market, whether bonds, equities, or commodities. Even core investment-grade bonds were in the red until the final weeks. It was extremely difficult to make money in the financial markets last year. In many ways, 2018 was a more difficult year in which to invest than 2008.
The lackluster performance of so many asset classes, culminating with the fourth quarter’s dramatic U.S. equity decline, is largely due to the uncertainty that prevailed throughout much of 2018. As we discussed in the third quarter newsletter, expectations for corporate earnings growth in the U.S. were exceedingly high and ultimately unsustainable. The subsequent downturn in U.S. equities had largely to do with those expectations falling to reasonable levels. Unsurprisingly, the catalysts for this adjustment came from a variety of risks that we have been highlighting all year long, such as U.S.-China trade tensions, political uncertainty in Europe, and a steadily hawkish Federal Reserve. The real question today is: have those expectations dropped low enough? Our best guess is that earnings-growth expectations will continue to be lowered for 2019, and that trend is actually very healthy for the markets from a long-term perspective.
It was a challenging year for our globally-diversified active portfolios, driven by sharp declines in international and emerging stock markets and under-performance from some of our active managers. In absolute terms, most investments were negative for the year.
However, our portfolio performance, particularly in the fourth quarter, also demonstrated the benefits of diversification, when our emerging market stocks and alternative investments performed better than U.S. equities.
A Consistent Focus
Throughout our history we’ve emphasized the importance of having a long-term perspective. With a long-term perspective comes the necessity of discipline and patience in sticking to our investment process and executing it consistently over time rather than being subject to swings in investor sentiment and market consensus, which more often than not detracts from returns.
While today’s headlines may be filled with distress signals and warnings of market weakness, it’s worth remembering that just one year ago those headlines boasted 20%-plus global equity gains and historically low market volatility. In fact, many investment strategists expected 2018 would bring a continuation of the synchronized global economic recovery. The sharp market pullbacks witnessed this past year only reinforce our view that no one can consistently predict short-term market moves.
Over the next year, the range of potential equity market outcomes is just as wide as it was going into 2018. Our approach and preparation remain the same. We construct and manage portfolios to meet longer-term return goals, which means steadfastly investing through multiple market cycles, not just the next 12 months. Given our current investments, we are confident our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential shorter-term scenarios.
If the current recession fears are overdone, we expect to generate strong overall returns with out-performance from our foreign equity positions, active managers, and flexible bond funds. On the other hand, if U.S. stocks slide into a full-fledged bear market, our portfolios have “dry powder” in the form of lower-risk fixed-income and alternative strategies that should hold up much better than stocks. In that situation, we would expect to put this capital to work more aggressively. As an example, we could increase our exposure to U.S. stocks at lower prices and valuations, which therefore imply much higher expected returns over a medium-term time horizon.
Speaking of U.S. stocks, in the period since the Financial Crisis, U.S. stocks have outrun all of their developed global counterparts, causing some investors to question the need to diversify outside the country. However, it should be particularly clear after this past quarter that that is not a sound long-term approach. In fact, the multiyear period of U.S. stock market out-performance versus the rest of the world is reaching an extreme level. We believe that the results of the past 10 years are not sustainable and that they won’t be repeated over the next several decades.
Even after their fourth-quarter declines, U.S. stocks are not cheap. However, many markets elsewhere are oversold, strengthening their appeal for long-term, value-seeking investors like ourselves. Europe is historically cheap, with a lot of the worries (e.g., Brexit, Italy’s political and debt concerns) likely already priced in. And the selloff in Asia has been particularly severe. Here again the market seems to be overreacting to potential risks (e.g., a slowdown in China) rather than reflecting the true value of emerging markets—a vast investment opportunity set that continues to expand at a faster rate compared to developed markets. Despite the risks we see over the short term, we have a high conviction that our investments outside the U.S. will earn significantly higher returns than U.S. stocks over the next five to ten years.
Our allocations to foreign stocks also provide our portfolios with diversification away from the U.S. dollar. After the dollar’s strong performance in the past several years and a U.S. budget deficit not seen outside recessions or war, we believe the U.S. dollar is a risk factor that investors would be prudent to diversify away from.
Successful investing is a process of consistently making sound, well-reasoned decisions over time and across market and economic cycles. Our goal is never to track or beat a particular benchmark from one year to the next, but rather to provide our clients with the optimal return for the environment we’re given and the risk profile of their particular strategy. Given this approach, it is normal, not unusual, for us to go through periods like 2018 where we will look out-of-sorts with the broader market. As we continue to execute our approach with discipline and patience during the inevitable periods when it is out-of-favor, we believe these efforts will generate successful and rewarding results for our clients over the long-term.
As always, we appreciate your trust in us and welcome your questions.
Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of October 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.