Quarterly Letter – Fourth Quarter 2018

The old adage that ‘markets go up on an escalator and down on an elevator’ proved to be true in 2018. For much of the year, U.S. stocks shined and international and emerging market stocks languished as trade tariffs soured investor sentiment in foreign markets. However, sentiment for U.S. stocks also faded later in the year with increasing concerns over the direction of Federal Reserve policy and interest rates. We also can’t dismiss the notion that some profit taking was in order following sizeable market returns in recent years. As usual, the market faces a variety of risks that could adversely impact future market direction. That said, economic and financial conditions remain generally favorable and we believe most equity markets are currently trading near fair and reasonable values.

U.S. Equity Markets
Market volatility increased over the course of 2018 as the S&P 500 surrendered double-digit gains to exit the year with a return of -4.4%. The downturn in small-cap stocks was more severe with the Russell 2000 closing the year with a return of -11.0%. For the first time in more than a year, the quarterly return of U.S. equities lagged that of foreign stocks as the S&P 500 fell -13.5% and the Russell 2000 was down -20.2% in the fourth quarter. Still, the S&P 500 closed 2018 as the best relative performer among broad market indexes, which rendered a diversified investment approach less than ideal (more on that later). In our first quarterly letter of 2018 we noted that ‘the prospect of positive equity market returns in 2018 may be decided by a tug-of-war between the positives of a strong economy and growing corporate profits versus the headwinds of trade tariffs, various political risks and rising interest rates.’ As it turns out, investors exited the year giving greater weight to trade war and monetary policy concerns rather than solid earnings and positive economic trends that were realized over the course of the year.

International and Emerging Markets
After posting stellar returns in 2017, international and emerging market equities were derailed in 2018 by a strong U.S. dollar, trade tariffs, and signs of decelerating growth in parts of Europe and Asia. For the year, the MSCI EAFE experienced a negative return -13.8% and the MSCI Emerging Markets fell -14.6%. For the fourth quarter, MSCI EAFE was down -12.5% and MSCI Emerging Markets fell -7.5%. From a valuation standpoint, international and emerging market stocks are less expensive than U.S. equities and continue to reflect a valuable source of diversification for disciplined investors. We believe U.S. and foreign equity markets share similar fundamentals with economic and earnings growth expected to decelerate somewhat, but remain positive over the foreseeable future. The main risks that could impact international markets in 2019 are an escalating or unresolved trade war, budget disputes within the European Union (EU) and a disorderly ‘Brexit’ as the UK negotiates to leave the EU. On the flip side, foreign markets could outperform expectations if stable global economic conditions are met with any resolution to the trade war and tariffs, less aggressive monetary policy by the Federal Reserve and/or a weaker U.S. dollar.

Falling long-term market interest rates pushed bond prices generally higher during the fourth quarter in spite of the Federal Reserve implementing another 0.25% rate hike in December. Government and other high grade securities fared the best while widening credit spreads resulted in a headwind for sub-investment grade bonds.

The 10-year treasury rate fell from 3.05% at the end of the third quarter to 2.69% at year-end; a rather significant move lower during a period in which the Fed raised the discount rate. This dynamic has caused the shape of the yield curve to flatten, indicating a diminished range between short-term and long-term interest rates. In the past, a flattening yield curve has often (but not always) preceded decelerating economic growth or a recession within one to two years’ time. Although the domestic economy appears to be trending in a positive direction, the market is expressing concerns that continued tightening by the Federal Reserve could unduly threaten economic conditions over the coming year. At its latest meeting in December, the Fed indicated a reduced expectation for the number of rate hikes it plans to implement in 2019 from three or four hikes to only two. In our view, the Fed is adequately navigating the balance between keeping inflation in check and not allowing economic conditions to get too hot or cold.

Diversification – Still a good idea?
The media and many investors follow the Dow Jones Industrial Average or S&P 500 to gauge the direction and health of investment markets. This can cause some investor confusion in years when large U.S. stocks generate the best relative returns. Such was the case in 2018, sometimes causing investors to question portfolio returns that may have lagged these widely followed U.S. benchmarks. However, investment markets extend well beyond large-cap U.S. stocks and proper diversification is a durable, time-tested tenant. Over the past years and decades, it has been far more common for small-cap stocks and international or emerging market stocks to outperform the more commonly referenced blue-chip benchmarks. And bonds often serve the purpose of further reducing volatility while providing a level of return and income. Historically, adding these areas of exposure has resulted in lower volatility with often favorable returns over the long-run. We continue to believe that investors are well served by applying a diversified approach that adequately reflects their risk tolerance and long-term objectives.

From our vantage point, economic conditions in most parts of the globe remain positive with some pockets of deceleration. In the U.S., third quarter GDP registered at 3.5% and unemployment is trending near historic lows with wages on the rise and more job openings than job seekers. Price inflation was accelerating earlier this year, but based on recent data, appears to have subsided. This could allow the Fed to further soften its stance on monetary policy. We believe the economy and corporate earnings should remain on stable footing in 2019, but that markets will continue to experience volatility, perhaps swayed as much by investor sentiment as fundamentals. We continue to encourage clients and investors to remain disciplined in both favorable and challenging market environments. History has shown that a disciplined investment approach is predicated on individual circumstances and long-term objectives as opposed to near-term market gyrations. Remember that even challenging market periods offer silver linings; it allows us to reduce realized taxable gains through the process of ‘tax-loss harvesting’, put excess cash to work and rebalance portfolios in a way that takes advantage of market volatility. Like gardens, if managed properly, portfolios can benefit over the long-run from both sunny and rainy seasons.

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Confluence Wealth Management, LLC is a registered investment adviser with the United States Securities and Exchange Commission (SEC). Registration of an investment advisor does not imply any level of skill or training. As a registered investment advisor, Confluence Wealth Management is not engaged in the practice of law or tax preparation. As such, you are encouraged to consult with a CPA or tax professional about your individual situation prior to implementing any tax related strategies. See All Disclosures