Thoughts on the Market

December 20, 2018

It has been exactly one month since our last market commentary, and the market selloff has continued. In November, we described three overhangs that weighed on the market: global trade, Italian debt, and interest rates. Since that time, Italian debt has become less of a concern as the Italian government struck a budget deal with the EU. On the other hand, the remaining concerns over global trade and interest rates have intensified. Yesterday, the Federal Open Market Committee (FOMC) raised interest rates by 0.25% to 2.50%. This was anticipated by the market and not the source of the current market angst. The FOMC statement and forecasts that accompanied the hike is what further concerned market participants. Although the December hike was anticipated, investors wanted the FOMC to recognize the recent disappointing global economic data and equity market turmoil in their commentary. The statement fell short of that recognition, offering very little in terms of incremental macro concerns. The FOMC median forecast lowered the number of anticipated 2019 hikes from three to two. Market participants, however, are anticipating only one hike at most in 2019. The takeaway for investors is that the FOMC may be raising rates faster than the economy can handle, and it may inadvertently push us into an inverted yield curve (long-term interest rates below short-term interest rates), which historically has signaled an upcoming recession.

The concerns over trade have also grown in recent weeks. This is not only in terms of tariffs between the US and China, but also between the UK and EU. UK Prime Minister Theresa May survived a recent no-confidence vote, but failed to win over enough MPs to pass a deal defining the treaty with the EU governing future interactions between the two bodies in the areas of transportation, commerce, etc. The firmness of many MPs on a more pro-UK treaty makes a “hard-Brexit” more likely, as the two sides have only until March 29th to strike a deal. This concern may be contributing to businesses pulling back spending plans in the UK and EU. Management of FedEx highlighted this concern Tuesday, describing Europe as weakening “significantly” since September. While the economic data out of the US has remained solid, forward-looking indicators such as the yield curve and equity markets are signaling weaker US data ahead. There have also been negative headlines regarding a potential government shutdown in the US. While a government shutdown always sounds ominous, it is usually a non-event for the equity markets as recent shutdowns have not caused a fundamental change in the macro or micro economics of the US.

While there are definitely some fundamental reasons for this pullback, we still believe the shift in investor sentiment from overly positive to overly negative has been a major cause. Calendar timing is also not helping things for two reasons: (1) stocks that have fallen are vulnerable to end of year tax-loss selling, and (2) late-December is typically a time of low trade volumes and limited incremental news that can help change the existing gloomy market narrative. Selling for non-fundamental reasons is something that is difficult to endure, but also typically the most attractive time to be a buyer.

Since its peak on September 21st, the S&P 500 index has declined approximately 16%. Pullbacks of this degree are painful, but not unprecedented, even with no recession occurring. From November 2015 to February 2016, the S&P 500 declined over 13%; from May 2011 to October 2011, the S&P 500 declined nearly 20%. Subsequent to the bottom of the 2015 selloff, the S&P 500 is up over 30%, and since the bottom of the 2011 selloff, the S&P 500 is up over 120%. While it is true that we cannot predict the next recession, and therefore we must be open to the idea that one could be on the horizon, we also know that panic and market timing does not preserve money, but costs money over time. For this reason, it is important to maintain the investment strategy you have in place unless something significant has changed in your personal situation. We continue to believe that targeting a more aggressive risk level will produce higher long-term returns. While a number of our companies have declined considerably for a variety of macro and company-specific reasons, we see no reason to make wholesale changes to client portfolios. We use a variety of tools to check for underappreciated risk in companies held in your portfolios and remain confident that these companies have balance sheets that can withstand recessions and have competitive advantages to produce solid risk-adjusted returns over a long-term holding period.

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