Looking Forward to 2019 Following an Ugly End to 2018
2018 proved to be an extremely difficult year for investors, accentuated by steep declines experienced in stocks and risk assets during the 4th quarter. Bonds outperformed stocks for 2018, but also struggled during the year due to increased interest rates – the main bond index ended the year flat on a total return basis. This combination resulted in a nowhere to hide environment with conservative and aggressive portfolio allocations experiencing losses for 2018.
Often during periods of volatility and stress, portfolio diversification demonstrates its merit. Not so during 2018. Most every asset class struggled. Investors regularly allocate to dividend stocks, value stocks, small cap stocks, and international stocks to provide diversification. This hurt portfolios during 2018. The DJ US Dividend Index ended the year down over 5%. Value stocks declined more than the broad market with the Russell 1000 Value Index ending the year down over 8%. Small cap stocks also struggled, ending the year down more than 11%. International stocks declined more than 13%. 2018 represents the first year since the financial crisis where allocation investors experienced a meaningfully negative return on their investment assets for the calendar year.
Volatility has clearly returned to the markets and we anticipate volatility continuing for much of 2019. Uncertainty surrounding the US political environment, trade disputes, and the Fed, suggests further gyrations in the markets. However, volatile markets do not necessarily mean declining markets. We view 2019 with cautious optimism while recognizing there are several issues potentially derailing a relatively strong US economy and creating further downside for stocks.
Looking forward to 2019, there are several structural reasons we expect better returns compared to 2018:
- The Fed and Interest Rates We believe the Fed tightening had a negative impact on the markets during 2018. In our view, we now enter 2019 with the Fed likely to pause on further interest rate hikes until confirming the strength of US and global growth – helping both stocks and bonds.
- Bond Yields The Fed increased their target interest rates during 2018 and subsequently short, mid, and long-term market interest rates generally increased during the year. The combination of increased interest rates and larger credit spreads (driven by the risk-off environment in December 2018), means a vast majority of bond asset classes begin 2019 with more attractive yields.
- Stock Valuations Entering 2018, US companies expected to achieve considerable earnings growth as the impact of the business tax reduction legislation worked through the corporate earnings cycle. S&P 500 earnings increased approximately 20% during 2018. This, combined with the decline in stocks, means that stocks enter 2019 at more attractive valuations with both trailing price-to-earnings ratios and forward price-to-earnings ratios below averages over the last 20 years.
International stocks also enter 2019 at attractive valuations – although there continues to be uncertainty regarding the strength of the global economy outside of the US. We believe investors are being compensated for this risk, however, as overseas valuations are well below their averages over the past 25 years.
Risks and Conclusion
In aggregate, we anticipate stocks to remain volatile during 2019, but the Fed, interest rate levels, and stocks valuations present a more favorable outlook heading into 2019. Provided the US and worldwide economies do not experience a recession in 2019, we expect better portfolio returns compared to 2018 and a positive year for both stocks and bonds.
However, believe stocks and the economy could struggle if worldwide trade disputes lead to a decline in corporate earnings and the US appears headed into a recession. In this scenario, we expect long-term bonds to perform well and the Fed to consider lowering their target interest rates. At the present time, the US economy appears on solid footing, but there are many domestic and international risks to this outlook demonstrated by the substantial volatility currently experienced by financial markets.