February Market Commentary
As we look back on the market performance in 2018 it is helpful to note that worldwide, markets experienced more volatility than seen in many years. This does not come unexpectedly, with an aging bull market in the U.S., four interest rate increases by the Federal Reserve, an impending (and then realized) government shutdown, tariffs against international trading partners and subsequent trade wars. In December tax harvesting by fund managers to lock in gains and a “buyers strike” with few buyers in either equity or fixed income markets resulted in the market moving 10 times more than 1% in December – more than all of the rest of the year combined. The market in correction at -19.8% came close to a bear market (-20%). Christmas Eve was the worst selloff on the trading day before Christmas since December 23, 1933. Following this plunge, all three major indexes saw the strongest one-day gain since March 23, 2009, illustrating these wide market swings.
At the start of 2019, markets received a healthy reprieve from the fourth quarter carnage, but there are lurking risks, including equities have become technically overbought, U.S. economic growth has slowed due to tighter financial conditions last year, weak global growth and the after effects of the government shutdown. In addition, retail sales for December were weaker than expected, auto sales have declined and banks and other financial firms are showing more caution in providing capital to business. First quarter estimates are now in slight negative territory, with the subsequent two quarters in low single-digit territory – making the valuation case even less attractive.
In addition, risks are rising in the corporate bond market. The amount of corporate debt has surged over the past decade, with lower-rated issues making up a growing share of the market. Coupled with expectations that corporate profitability is expected to slow this year, both equity and fixed income markets are reacting more sensitively than ever to Federal Reserve commentary and efforts to raise rates and return to a more normal environment through quantitative tightening.
The lingering trade uncertainty, including ongoing and yet unresolved trade dispute with China and resulting tariffs, the still to be approved USMCA (United, Mexico, Canada Agreement) and increased auto tariffs in the European Union, clouds the economic forecast for 2019. The U.S. has a widening trade gap with China as illustrated in the following chart, but significant trade gaps exists with other countries as illustrated in this chart:
The rout in December was a good litmus test for investors following a remarkable slow and steady 10-year expansion to evaluate risk tolerance and asset allocation as well as, where appropriate, shift to higher credit quality corporate bonds or to pair existing exposure with higher-rated investments.
Market downturns are inevitable, but they offer extraordinary opportunities. To quote Warren Buffet from his most recent shareholder letter: “What investors need…is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. …if the businesses (we invest in) are successful (as we believe most will be) our investments will be successful as well…In America, equity investors have the wind at their back.”