If there was one theme that stood out in 2018 it was the return of volatility. Last year marked one of the wildest rides we have seen in nearly a decade and was quite a deviation from what we have experienced over the past two years. 2018 marked the first time since 2008 that the S&P 500 had a negative return and not to be outdone, the DOW and Nasdaq both landed in negative territory for the year. The S&P returned -4.38%, the DOW was off -5.63% and the Nasdaq was down -3.83%. Each of these indexes were positive going into the fourth quarter, but as investor sentiment weighed in and things like trade worries with China, Fed interest rates and BEXIT began to play out investors became more and more cautious and the market reacted sharply. In the fourth quarter the S&P lost nearly 15%. As we stated in our December letter we felt some of this was cause for concern, but for the most part it was an over reaction to economic uncertainty. This has borne itself in the first month of 2019. In January the S&P was up over 7.5% and the first few days of February has only continued this trend. So where does that leave us for 2019 and beyond?
Our CIO Thane Cleland had this to say:
“If Q4 estimates hold true, 2018 S&P 500 earnings will be up over 20% compared with 2017; a fantastic performance. When you combine 20+% earnings growth with -5% (losses in) stock prices, you get a steep decrease in valuation. The S&P 500 price-to-earnings multiple (P/E) fell 16% in 2018 landing at a very reasonable 14.2 times. This is a level below both the 5-year and the 10-year averages. This tells us the market is discounting more economic roadblocks in the future.”
In other words stocks are cheaper now than they have been. If all of the issues come to fruition, which we feel is doubtful, then we could see further declines and volatility, but if they don’t, again the more likely outcome, then this should prove to be a positive year in the overall economy and the markets.
Thane also shared what we view are the most important issues that could affect the markets in 2019.
1. BREXIT: “The UK is currently in an extremely difficult position. On March 29th they will no longer be in the European Union. The past two years have been spent on negotiations between UK Prime Minister Theresa May and the European Union to strike an agreement for the UK’s exit from the union. The proposed deal is not what the British people expected and in the view of many, leaves the UK in a worse position than staying in the union. The deal went to a vote of Parliament and was soundly defeated. Time is running short and options are deteriorating. PM May is trying to negotiate a better deal with the EU, but the EU is not inclined to listen. The UK can ask for an extension of the March 29th deadline, but ALL 28 members of the EU must agree and that is a very tall order. Lastly, the UK could take a second referendum to the people and see if they want to change their mind about leaving the EU. This seems the only likely way to avoid the economic disaster that would ensue if they leave without any deal. We get the feeling PM May is going down routes that she knows will fail and taking the clock down to the final seconds which will force the people of the UK to repeal their decision to leave the union two years ago. If that is true, it would likely produce a reversal and the best outcome for all parties involved. However, it is a dangerous game of chicken where failure would produce the worst possible outcome of a “no deal” exit. “
2. INTEREST RATES: “The US Federal Reserve has been on a predictable and well telegraphed campaign to normalize interest rates from the excessively stimulative policies that have been in place since 2008. When the cracks in our expected growth outlook showed up in late September/early October, there was significant chatter about skipping the expected December rate increase. President Trump took notice of the market sentiment and made several statements regarding his displeasure with Fed Chairman Jerome Powell and recommended a pause in the tightening process. Chairman Powell verbally assured the markets that the Fed Chair is a non-partisan position and only the Federal Reserve is responsible for monetary policy decisions. In early December, the fed raised the fed funds rate for the fourth and final time in 2018 and the markets reacted negatively in fear that the fed is getting too restrictive too quickly given the other headwinds our economy could face over the next several quarters. In January however chairman Powell stated that the Fed is now in more of a wait and see mode for 2019. The markets responded very positively to this news and was the largest contributor to the positive returns we saw in January. We expect the fed to raise rates in 2019, but at a slower pace and probably less than expected.”
3. CHINESE TRADE: “Far and away the most important issue facing short, intermediate, and long-term GDP growth prospects for the US and the rest of the world revolve around the growing trade war between the US and China. Both sides have been imposing an increasing number of tariffs on individual goods, but the real issue revolves around the theft of intellectual property and the circumvention of sanctions on third party governments. China has ignored the world’s patent laws for many years and most countries have turned their head to the issue because they are afraid of missing out on the world’s largest growth opportunity. China admits that learning from the west and copying our success is a preferred model for growing their economy into what could eventually become the biggest and most powerful in the world. The US has taken a stand against the disregard for international law and the consequences are yet to be determined for both sides. The trade war escalated exponentially on December 5th when Canada announced they had arrested Meng Wanzhou, the chief financial officer of the Chinese company Huawei Technologies. Huawei is the largest consumer electronics company in China (think of them as the Chinese version of Apple). Not only is Ms. Wanzhou the CFO of Huawei, she is the daughter of the founder and a bit of a celebrity. China has arrested two Canadian businessmen and sentenced to death a Canadian citizen convicted of a drug offense in China in retaliation for Canada’s actions. The US is seeking extradition to the United States so Ms. Wanzhou can face charges that Huawei has been stealing American telecommunications technology and lying about its relationship with its Iranian subsidiary. The Chinese parent company claimed that it had sold its Iranian division, when actually it had kept control and ownership of it. The two sides have agreed to a 90-day moratorium on any new sanctions or increasing any existing sanctions. That period is up on March 31st and little-to-no progress has been made on any fronts. This conflict has the potential to take significant growth out of the global GDP and is the most critical issue facing our economy. Stay tuned.”
Each of these has the potential to change the direction of the overall economy and the markets this year. Our general feeling is that Britain will not let the calendar roll over to April 1st with no plan in place, the Fed will use caution this year as it implements monetary policy and China and the US will come to some form of agreement for both the short and long term.
As we sum up expectations for 2019 we share this quote: “We’ve been in such a state of euphoria that even a return to moderate growth may feel like a recession.” We couldn’t agree more. Overall we expect the economy to return to more moderate grow. GDP should be between 2 and 2.5%, corporate earnings should grow close to 8% and we should continue to see unemployment remain at historic lows. All of these are very healthy numbers by themselves, it’s when compared to 2017 and 2018 they look small. As we return to more normal growth it will feel different, but we believe the outlook for 2019 is positive.
We do believe we are positioned well to weather short-term volatility and still achieve your long-term goals. As always if you have any questions about anything above we welcome your call.
Bryan and the Cascade Team