Oarsman Outlook: January 2019

Investors will not remember the final three months of 2018 fondly. In the worst quarterly performance since the Global Financial Crisis, most investment categories suffered substantial losses. Large-company U.S. stocks fell nearly 15%; small-company stocks plunged 20%. Overseas markets performed only slightly better, with developed markets declining around 12% and emerging markets off almost 8%. Crude oil swooned nearly 40%; gold was a lonely bright spot, gaining 7%. Benchmark bond yields dipped: the 10-year U.S. Treasury finished at 2.69%, compared to 3.06% at the end of September. Despite widening credit spreads, investment-grade bonds produced positive returns; lower-quality (high-yield) issues fell, however.

Among large-company U.S. stocks, relatively better performance came from the Consumer Staples, Health Care, and Utilities sectors; Capital Goods, Consumer Cyclical, Energy and Technology issues lagged. Value-oriented stocks outperformed their growth counterparts - albeit only marginally - for the first time in eight quarters.

Benchmark Performance - Equities

Benchmark Performance - Fixed Income

Review

Two-thousand-eighteen began with investors basking in the comfort of benign trends that had prevailed since late 2016: strong economic growth across much of the globe; surging corporate profits; calm inflation and a predictable interest-rate environment; and ebbing geo-political risks. January was one of the best months of the post-financial-crisis bull market, with nearly every asset category posting robust gains, paced by growth-oriented U.S. and emerging-market stocks. The resulting lofty valuations and ebullient investor sentiment meant it didn't take much to spoil the party. The remainder of the year saw two significant downturns that more than wiped out early gains: a violent but brief dip in February, sparked by inflation fears and rising bond yields; and the deeper, more drawn out fourth-quarter swoon, prompted by signs of faltering global growth. Volatility, largely absent the previous two years, returned to more normal levels: compared with just eleven in 2017, the S&P 500 recorded 64 daily moves (up or down) of greater than 1% (just above the historical mean of 59).

Most major asset categories turned in negative twelve-month results and, for the first time in at least 25 years, none provided a return greater than +2%. Non-U.S. and small-cap U.S. stocks finished the year down more than 10%. Average declines among U.S. large-caps were in the mid-single digits, but the value style trailed growth by a large margin (nearly six percentage points). Despite plummeting almost 25% in the fourth quarter, the mega-cap technology 'FAANG' group (Facebook, Amazon, Apple, Netflix and Google-parent Alphabet) managed a 12-month gain of almost 5%. Chinese stocks paced overseas declines, falling more than 25%; Indian and Brazilian stocks were rare gainers, rising some 5% and 15%, respectively (all figures in local-currency terms). Although the year's losses were the worst in a decade, we are heartened that the S&P 500's decline (less than 5%) was a mere fraction of its 2016-'17 cumulative gain (more than 35%) and truly puny in comparison with the +350% return since the March 2009 bottom.

Developments in the global economy were decidedly mixed. In the U.S., activity expanded at an accelerating pace: first-quarter GDP growth matched 2017's uninspiring pace of just 2.2%, while the final nine months likely averaged a stemmy 3.5%. Tax cuts and spending increases, accompanied by buoyant stock-market and real-estate values, boosted both consumer and business sentiment. The job market remained strong: employment gains totaled 2.6 million (the most since 2015); the unemployment rate dipped below 4%; wage gains accelerated. Inflation gauges rose modestly early in the year, but were in decline in the second half and remained at or below the 2% comfort zone. Despite some signs of slowing in interest-rate-sensitive sectors (e.g., real estate, autos), in many respects the American economy finished the year in its best shape in more than a decade.

In marked contrast, overseas economies fell short of strong 2017 performances. Growth in the European Union slowed from 2.5% to below 2%; Japan decelerated from 1.7% to below 1%. Most notable was a distinct softening in China, where a modest full-year slowing (probably less than half a percentage point, from 6.9% to around 6.5%) belied increasingly apparent late-year weakness. China's down-shift was largely the result of deliberate efforts to rein in local-government and financial-sector leverage, reduce inefficient industrial overcapacity and curb egregious environmental pollution. Nevertheless, a weakening real-estate market, the second major stock-market swoon in less than four years, and rising trade frictions have clearly dented both consumer and business confidence.

Steady domestic growth, tame inflation and calm financial markets (until recently) allowed the Federal Reserve to continue deliberately down the path to more normal (less accommodative) monetary policies. The U.S. central bank raised its short-term interest-rate target by a total of 100 basis points (to a range of 2.25% to 2.50%) and gradually reduced its holdings of bonds acquired since the financial crisis. The waxing and waning of global growth prospects, combined with a late-year flight-to-safety amid stock-market turmoil, caused considerable volatility in the bond markets. The 10-year Treasury yield, which began the year at 2.40%, traded as high as 3.24% early in the fourth quarter; as we write, it has fallen below 2.60% - a level not seen since last January. Diverging growth prospects and rising U.S. bond yields produced a largely unanticipated mid-year appreciation of the dollar, which gained around 8% against a basket of world currencies between April and August. Dollar strength pressured vulnerable emerging-market economies - notably Argentina and Turkey - and prompted (perhaps unfounded) fears of 'contagion' that pushed unrelated currencies and stock markets deep into the red.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1. Dividend Income (for three months this is the annual yield divided by four)
2. +/- Change in Earnings per Share* (average for S&P 500 companies)
3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the -13.5% S&P 500 total return?

Our read: Although year-ahead earnings gains have slowed to near zero, the improvement in valuation is noteworthy: 14% this quarter and nearly 25% year-to-date. As beginning valuation is a key determinant of prospective returns, this is a notably salutary development.

After a strong start, commodity-related investments succumbed to disappointing global growth, waning inflation and, in the case of oil, unexpected supply-side shocks. The broad commodity index dipped 13% on the year; crude oil fell 24%, following a roller-coaster path that saw a gain of more than 25% through early October followed by a near-40% plunge into year-end. Timber-oriented real-estate was one of the year's worst performing assets. Despite benefitting from a notable fourth-quarter flight-to-safety trade, gold was off 2% for the year.

Strong corporate profitability continued throughout 2018. Cumulative earnings for the companies in the S&P 500 Index increased more than 23% in the twelve months through September; the year-over-year gain is expected to tick up slightly in the October-December quarter (to be reported in coming weeks). Though slowing global growth has likely not been fully factored in, Wall Street analysts are currently penciling in further gains of around 10% for the year ahead.

Outlook

As the post-Global-Financial-Crisis economic expansion and bull market near their tenth anniversaries, heightened volatility combined with softening economic data have investors more attuned than usual to the possibility that an important inflection point is at hand. However, financial markets are notoriously sensitive to such perceived shifts: the Nobel laureate economist Paul Samuelson once famously quipped that the stock market had correctly predicted nine of the past five recessions. Nevertheless, recent developments are surely cause for heightened vigilance.

The U.S. economy possesses considerable momentum: despite recent moderation, both purchasing-managers surveys and the leading-indicator series have remained solidly in the expansion zone, and the most recent employment- and wage-growth reports were particularly robust. We expect some slowing as the boost provided by last year's fiscal stimulus begins to fade and higher interest rates exert their lagged impact. The strong dollar (by depressing export demand) and weak energy prices (by damping energy-sector capital spending) are additional headwinds. Perhaps more worrisome, the flattening yield curve (the difference between short- and longer-term interest rates), widening credit spreads, and downward drift in commodity prices could foretell a deeper malaise. Federal Reserve officials have recently indicated a heightened awareness of potential downside risks. Additional signs of weakness will likely prompt the central bank to pause - if not end - its policy-tightening campaign, which would undoubtedly lift spirits (as well as asset prices).

Other major economies will likely continue to underwhelm. We expect both Europe and Japan to muddle along, expanding at rates just below 2018's (around 1% in Japan, between 1.5% and 2% in Europe), though these would represent a slight acceleration compared to the most recent readings. The benefits of lower energy prices (unlike the U.S., these regions are large energy importers), accommodative monetary regimes and (in Europe) weak currencies, considerable scope for fiscal easing, and ebbing political uncertainty should offset slowing global demand.

Considerably greater concern attends China - clearly the biggest uncertainty facing investors today. Worries are manifold: a decelerating domestic economy and trade frictions cloud the near-term, while a broadening U.S./China geo-political rivalry looms beyond. We expect near-term growth and trade concerns to recede in coming months. It is hard to overstate the importance Chinese authorities place on maintaining growth; likewise their ability to make it happen - at least relative to other major economic powers. We believe Beijing will find a way to turn December's 90-day trade 'truce' into something more lasting. Meanwhile, both fiscal and monetary stimulus measures are in the pipeline (and will be augmented if incoming data disappoint), though they will work with the usual lag. Accordingly, we expect growth to pick up as the year progresses and would be surprised if the full-year figure comes in much shy of 6.5%. Longer-term worries are less tractable. It is becoming increasingly apparent that 'trade tensions' are just one aspect - or symptom? - of a fundamental clash of political-economic systems whose competing goals and visions will not easily accommodate each other and will likely dominate geo-politics for years (if not decades) to come. Steering this all-important relationship away from confrontation will require deft and creative diplomacy on both sides. (Here's hoping...)

Recent market volatility - and the investor anxiety it reflects - has centered on evolving views of U.S. monetary policy: investors seem to believe the likelihood of a 'policy error' is increasing - perhaps exponentially. Federal Reserve actions between 2015 and mid-2018 were highly predictable: officials clearly communicated their intent, absent a meaningful deterioration in economic data, to shrink the bank's balance sheet and raise interest rates toward a 'neutral' level that, though undefined, was universally believed to be at least 200 basis points (two percentage points) above the near-zero level that prevailed in mid-2015. Now that rates have been raised a cumulative 225 basis points, the future is much less certain: not only will the Fed be more 'data dependent' (i.e., unpredictable) but it will also be much more important that the Fed's view of 'neutral' approximates (an unknowable!) reality. This new environment seems likely to feature more pronounced volatility attending Fed meetings and communications (not to mention sniping from the White House).

The return of volatility and falling prices have resulted in meaningful improvements in both valuation and sentiment. As noted in the 'What's Changed?' box above, the combination of 20%+ profit gains and 5-15% price declines over the past twelve months have left U.S. stocks trading at valuations that are no longer much above historical norms. Meanwhile, the proportion of individual investors and investment newsletter writers who are 'bullish' has receded far below the decidedly frothy level of early 2018. Recent investment-fund flows - out of equities, into money-market funds - represent a fresh supply of 'dry powder' to buy stocks in the future, given the right catalyst. Accordingly, we believe prospective returns over the next several years are better than they have been since at least 2013. Nevertheless, heightened volatility and a murky economic outlook make for tricky near-term navigation. Depending on attending circumstances, a resumed sell-off could be an attractive opportunity to increase stock-market exposure, while sudden, steep gains might be cause to stand pat (or even lighten up on stocks) and hold cash - which, yielding nearly 2.5%, appears temptingly safe.

Although much has changed over the past twelve months, we detect a salutary symmetry. Last January, we noted investors seemed likely to extrapolate the unusually supportive environment that fueled robust returns in 2017, and suggested markets were primed for disappointment (and quite possibly sub-par returns). Today, we believe the drumbeat of market volatility, dour economic news and heightened political uncertainty have likely caused many to become overly pessimistic about the near-term outlook; arguably, the fourth-quarter declines already 'price in' a relatively gloomy future. Accordingly, any improvement in the data or resolution of uncertainties seems likely to result in positive investment results.

At the outset of the New Year we want to thank you for your continued support and encourage you to let us know what is on your mind. Please call or email any time.