Quarterly Letter – First Quarter 2019

What a difference three months can make! Global equity markets made an about-face, registering sizeable gains to start the year. We attribute the sharp reversal to a marked shift in monetary policy and outlook by the Federal Reserve accompanied by a cessation in rate hikes; an issue that has been at the forefront of investors’ minds since last summer. Now that the Fed and investors are on friendly terms again, is a positive 2019 in the bag? There is a lot of year left, and as we assess investment markets and the global economy we believe there are significant factors at play that could positively or adversely impact market returns as we move through the remainder of the year. We examine these factors in our comments below.

U.S. Equity Markets
For those keeping score, the S&P 500 gained 13.6% in the first three months of 2019, recovering all of its prior quarter loss. The first quarter marked the best quarterly return and start to the year for this index since the first quarter of 2012. Not to be outdone, small-cap stocks also fared well with the Russell 2000 index gaining 14.6%. In our view, U.S. equity markets had become somewhat stretched in the late summer and early autumn of last year, as we noted in our third quarter letter that ‘investors will grapple with economic and market conditions that are less favorable than today.’ However, following a meaningful market sell-off going into year-end, we noted in our last letter that equity markets exited 2018 near ‘reasonable values.’ Over the past several months, inflation has decelerated and market interest rates have fallen; factors that lend validation to the recent equity market rally. As we move beyond the market celebration stirred by a pausing Federal Reserve, investors will likely turn their focus back to the nitty gritty of corporate earnings and economic data – looking for signs of stability or changing direction. To any extent these trends foster uncertainty, equity market volatility could increase in the months ahead.

International and Emerging Markets
Foreign equity markets also enjoyed strong moves to the upside during the first quarter as the MSCI EAFE Index gained 10.0% and the MSCI Emerging Markets Index trailed right behind with a gain of 9.9%. Although foreign stocks lagged U.S. stocks by a modest margin in the last quarter, it’s interesting to note that emerging market stocks outperformed both U.S. large and small-cap stocks during the market swoon and rebound of the past six months. We attribute the favorable buoyancy of emerging markets to lower valuation levels entering the downturn followed by signs of progress between the U.S., China and other countries regarding tariffs and the trade war. This issue has yet to be resolved, and presents a risk to both foreign and U.S. stocks if a final resolution does not come this year. Economic growth in developed Europe is expected to reach only 1.0% in 2019 while China has implemented stimulus measures in recent months to counter decelerating economic growth in their country. Over the past year, U.S. stocks have benefited from a reduction in corporate tax rates and positive economic growth trends relative to other developed countries. In spite of rising protectionism, we still live in a highly interconnected world and we’d view any significant global economic slowdown as a risk for both U.S. and foreign equities.

Bonds
Bonds have been anything but boring with practically all segments of the fixed income market showing positive returns during the first quarter. The upturn was led by two forces that don’t often converge during a late economic cycle; falling market interest rates and investor demand for bonds with higher credit risk. During the first quarter, the 10-year yield fell from 2.69% to 2.41%. Market interest rates, which peaked in October and November of last year, have fallen along with reduced expectations for further Fed rate hikes. The Fed confirmed this expectation at its most recent meeting when policy makers issued a revised forecast noting that economic growth appeared to be slowing, under the weight of the trade war, slowdowns in Europe and China and fading stimulus from U.S. tax cuts. The Fed now expects 2.1% GDP growth this year, down from its 2.3% forecast in December, and is no longer forecasting a rate hike in 2019. This shift in monetary policy not only pleased the stock market, but sent bond investors scurrying to buy longer-term bonds with the idea that interest rates may continue to fall. The current consensus view, as reflected by the Fed funds futures market, is that the next move by the Federal Reserve will be to cut rates as opposed to raising them, as was expected just months ago. Meanwhile, investors snapped up corporate debt in search of better yields, and companies eager to take advantage of relatively low borrowing costs have obliged, issuing new debt in substantial volumes. As it stands, corporate debt, relative to current GDP, is nearing record levels. This causes some apprehension as investment-grade corporate debt could swiftly be downgraded and re-priced to ‘below-grade’ status in a period of receding or negative economic growth. In our view, there is comparatively less economic and investment risk associated with high quality government bonds and bonds collateralized with tangible assets.

The Good, Bad And Not So Ugly
There’s no shortage of positive and less-than-positive data to support either a bullish or bearish view. Bulls can point to still high levels of corporate earnings, plentiful liquidity (cash) levels among banks, companies and investors in addition to strong employment and neutral monetary policy; factors that could support equity values and economic growth in the months and years ahead. Bears would counter that global growth is waning, manufacturing activity has slipped and the yield curve (the difference between short-term and longer-term U.S. Treasury yields) has flattened and inverted; factors portending past recessions. As we consider both sides, we remain cautiously optimistic that 2019 can be a favorable year for investors in an environment of positive, albeit slowing, economic growth. However, we caution that the economy and investment markets don’t always move in the same direction. After all, the mood of the market can be fickle, as the last six months have shown. As history so frequently demonstrates, disciplined and patient investors who have a sound financial and investment plan are those most rewarded over the long run.

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