Quarterly Letter – Fourth Quarter 2019

Investors had a lot to cheer for in 2019 as equity and bond markets generated returns well above their historic averages. The returns were impressive considering a year marked by several headwinds including a burgeoning trade war, flat corporate earnings, and signs of decelerating economic growth. However, the old investor adage that ‘the market climbs a wall of worry’ proved to be true in 2019. And investor sentiment was bolstered by a robust jobs market and wage growth, which supported high levels of consumer confidence and spending. Will the good times continue in 2020? We see reasons to be optimistic.

U.S. Equity Markets
Since 1950, the S&P 500 has experienced an average annual return of approximately 9.0% and over the past 20 years, the average return has been closer to 6.0%. Investors were treated to returns well above these averages as the S&P 500 returned 31.5% in 2019; the second-best calendar year return for this index in more than twenty years. Small-cap stocks also fared well in 2019 as the Russell 2000 generated an annual return of 25.5%. Following a significant market correction in late 2018, equity markets rebounded strongly through 2019 with only scant volatility. Rising equity values were fueled primary by valuation expansion in 2019 with corporate earnings registering only nominal growth. By year-end, U.S. equity markets were trading just over 10% higher than their average historic valuation level. However, we believe this premium may be warranted by below-average inflation and interest rates, which tends to support higher equity valuations.

International Markets
Foreign equity markets lagged the U.S. in 2019, but still provided impressive returns. The MSCI EAFE index, which reflects developed country stocks, gained 22.0% and the MSCI Emerging Markets index gained 18.4% for the year. The trade war seemed to impose a greater impact on foreign equity returns compared to the U.S. That said, with a phase I trade deal appearing likely, emerging market equities rallied during the fourth quarter, generating a return 11.8%. Besides the trade war, a strengthening U.S. dollar has also presented a headwind to international returns for U.S. investors. A strengthening U.S. dollar has shaved an average of about 1% from the MSCI EAFE index return for U.S. based investors in each of the past three years. There are signs this trend may be reversing as the U.S. dollar has weakened in recent months. A sustained reversal in the strength of the U.S. dollar would add to international returns for U.S. investors. Also, there are early signs that economic growth could improve in some parts of the globe over the coming year and we note that equity valuations are generally less expensive relative to U.S. equities.

After several years of meager returns, 2019 was a banner year for bond investors with returns in most bond segments exceeding midsingle digit returns. The favorable returns were generated by falling market interest rates and tightening credit spreads; two factors that don’t often coincide. Credit spreads shrunk from narrow to tight in 2019, reflecting an increasing acceptance of risk by bond investors.

Economic and Market Outlook
Most domestic and global economic trends remain positive. U.S. employment and hiring trends are still robust while wages are growing, and consumer confidence and spending remain strong. While the domestic economy has been most stable relative to other parts of the globe, there are signs of reaccelerating growth in some foreign markets. The overall U.S. economy remains healthy and the likelihood of a recession over the next year appears to be low. In 2020, domestic economic growth may moderate slightly with GDP expected to be near 2.0%. This environment should allow for at least mid-single digit corporate earnings growth. Most emerging market economies should experience economic growth exceeding 3.0% while some developed areas, such as Japan and parts of Europe, may experience tepid (sub 2.0%), but slightly better growth than 2019. Presuming steady economic conditions and stable interest rates, bond holders should expect diminishing (relative to 2019), but positive returns in 2020. The primary risk to this outlook would be an abrupt change in the economy, direction of interest rates, or the value of the U.S. dollar relative to other major currencies.

Following a year of low volatility, equity market volatility could increase in 2020 due to several factors including election-year rhetoric, a disconnect between market expectations and monetary policy, or an unexpected change in economic trends. With equity returns across the globe exceeding nearly everyone’s expectations in 2019, we expect returns in 2020 to moderate, but remain positive. There are several factors that could cause foreign and emerging markets returns to surpass the U.S. in 2020. These include a weakening U.S. dollar, fluctuations in relative global economic growth rates, and resolution to the trade war with a commensurate elimination of tariffs. If the current ‘goldilocks’ (not too hot or cold) economic environment is sustained, equity and bond investors could very well be smiling again in 2020.

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