2018 gave financial markets quite the rollercoaster ride, leaving equity investors feeling nauseated at times from the day to day volatility. When the dust settled, municipal bonds finished the year with positive gains while most asset classes were solidly in the red. Both international developed and emerging market equities posted double-digit losses in 2018 after outperforming US equities in 2017.
Valuations within these asset classes are attractive and fundamentals remain strong even as they experienced a challenging year.
International stocks were negatively impacted by Brexit uncertainty, fears of a trade war between the world’s two largest economies, and concern that the global economic recovery was slowing.
Emerging market stocks faced an additional challenge in the strengthening of the U.S. dollar. The chart left shows the depreciation of certain EM currencies against the U.S. Dollar through Q3 of 2018. The impact of an appreciating dollar is two-fold: it offsets local currency returns when converted back to U.S. dollars and increases the cost of debt for countries who have borrowed in U.S. dollars.
September provided a tempting point for investors to abandon global diversification and go “all in” on U.S. equities which were handily outperforming their international counterparts year-to-date.
Anyone who gave in to this siren’s call suffered a double dose of the painful decline in U.S. stocks that soon followed. The S&P 500 dropped 19.3% between 9/28/18 and Christmas Eve as prevailing market sentiment shifted to concern about lower corporate profits and fear that the Fed may be raising rates too quickly. Some would argue that a majority of the Q4 decline in U.S. equities can be attributed to investor fear that the Fed is pursuing an overly aggressive path of rate hikes. The idea at play here is that the Fed could prematurely stifle economic growth (and potentially cause a recession) by normalizing interest rates more quickly than the economy can handle.
Fed Chairman Jerome Powell recently stated that policymakers are not on a fixed path toward monetary policy normalization and will be patient to see how the economy evolves. If this holds true, Fed patience in 2019 will reduce one of the major headwinds that U.S. equities faced in Q4 of 2018. Let’s not forget that U.S. equity investors enjoyed nine consecutive years of positive total returns (including dividend payments) leading up to 2018. Market corrections are a healthy and necessary part of investing, not something that should trigger a knee-jerk reaction. In fact, market corrections provide savvy investors the opportunity to enhance long-term returns by purchasing assets at lower prices.
The sell-off in equities in Q4 reminded investors to appreciate the income and stability that bonds add to portfolios. Core bond holdings were mostly flat to slightly positive for the year as treasury yields exhibited intra-year volatility. The yield on the 10-Year Treasury began 2018 at 2.41%, jumped to over 3.2%, and ended the year at 2.68% as investors sought shelter from the decline in US stocks.
The yield curve flattened further, prompting headlines predicting an economic recession if the yield curve inverts. Since 1955 there have been nine recessions, each preceded by an inverted yield curve (defined as the yield on the 1-Year Treasury rising above the 10-Year Treasury). There was, however, one period (1967) when an inverted yield curve did not accurately predict a recession. The challenge is timing—recessions have occurred anywhere from one month to multiple years after a yield curve inversion. While no one can precisely predict recessions, we are keeping our eye on the shape of the yield curve along with other leading economic indicators.
The subject of inflation returned to conversations in 2018 when, during the month of May, core inflation reached 2% for the first time in six years. Two percent has become an important barometer for the market because the Fed has targeted 2% as an optimal level of inflation for the U.S. economy.
Professional investors have a dismal record of predicting inflation, which leads us to conclude a strategic allocation to inflation-related assets is the best form of protection. The tangible investment properties of real assets (real estate, commodities, MLPs) have a better track record of protecting portfolios against rising inflation than do stocks and bonds. Real assets experienced a down year in 2018 but should continue to add value to portfolios over time by providing inflation protection and a relatively low correlation to stocks and bonds.