2019 Quarter 4 Commentary
Quarterly Commentary“The stock market and economy are two different things.” - Milton Friedman
We hope all is well with you and your family and that you enjoyed the holiday season! The 4th quarter of the year turned out to be less volatile than the rest of 2019 and culminated in one of the best years for the stock market. Domestic equities returned +8.99% for the 4th quarter with growth-oriented stocks outperforming their value counterparts by more than +3%. This is the opposite of what we experienced in the 3rd quarter of 2019 when more defensive value stocks outperformed by approximately the same percentage. These sentiment shifts are common in volatile markets. The table below summarizes the performance of various domestic equity categories over the past 3- and 12-month periods.
The table below summarizes the performance of various domestic equity categories over the past 3- and 12-month periods.
The annual returns were below the equity returns in the U.S. but nevertheless significant: +21.94% and +20.40% for developed and emerging markets, respectively. This, again, reminds us about the benefits of global diversification.
The returns on domestic bonds were essentially flat in the 4th quarter of the year (+0.16%). This can be at least partially explained by the “risk-on” sentiment and stock market rallies around the world. The annual results, however, were the best for domestic bonds over the past ten years, +8.68% as measured by the Barclays U.S. Aggregate Bond Index. We continue to think of allocations to fixed income as a “buffer” in our clients’ portfolios. We would be cautious about any suggestions to increase the domestic bond allocation based on the performance results alone.
The Fed’s decision to reduce interest rates three times throughout the year had a significant positive impact on the domestic bond market. Prices of fixed income investments tend to move in the opposite direction of interest rate increases and decreases. Under our current expectations and economic conditions, there is only a 50% chance of an additional interest rate cut closer to the end of 2020. This gives us reasons to believe that domestic bond returns will be closer to the average we experienced over the past several years. The chart below summarizes the performance of the Barclays U.S. Aggregate bond index from 2009 to 2019.
Image Source: Morningstar
We continue to keep track of trade negotiations between the U.S. and China. These discussions were some of the main reasons for market volatility in 2019. The so-called “Phase 1” trade deal with China was announced in December 2019. As part of the agreement, China committed to increase imports of U.S. manufactured goods by $200 billion in 2020 and 2021. The list of agreed upon goods includes food, agricultural, seafood and energy products. The agreement also included provisions on intellectual property, technology transfer and currency policy. This is certainly a step in the right direction. It remains to be seen how the parties would actually implement this agreement. The chart below summarizes the U.S. exports to China including the agreed upon Phase 1 provisions.
Image Source: Morningstar
The U.S. economy is expected to continue its expansion in 2020, albeit at a lower rate than we experienced over the past two years. The consensus estimates for domestic GDP growth point to a range of between 1.80% and 2.20%. The target inflation rate remains at 2.00% with the Fed’s commitment to keep it at approximately this level. The reported unemployment rate is at a 50- year low of 3.5% (as of December 2019). These metrics visibly point out the maturity of the business cycle in the U.S (i.e. late-cycle expansion). The chart below summarizes the changes in the three economic indicators mentioned above.
Image Source: MBI Market Research Group, Department of Labor, Bureau of Labor Statistics
We expect the market volatility to remain at roughly the same level in 2020. Some of the “known” causes of market turbulence include trade negotiations, global military conflicts and the upcoming presidential election. There are, of course, many “unknown” events that may cause significant short-term market volatility. These occurrences are referred to as “black swan” events and cannot be predicted ahead of time, at least from the timing perspective. Given the state of our economy and current market conditions, we are cautiously optimistic about 2020. We remain alert and fully appreciate that we are in the eleventh year of the current stock market expansion.
We are going to rebalance most of the managed portfolio in January 2020. This will be completed as part of our semi-annual rebalancing process. We expect to reduce the allocation to equities and/or bring it closer to the targets per the investment policy of each client. We also believe that more frequent rebalancing of your portfolio in times of market volatility may benefit you from multiple perspectives. When the markets are down, we are frequently able to harvest losses for tax purposes and potentially deploy some of the excess fixed income to purchase equities at lower prices. When the opposite happens, we reduce the allocation to your stock holdings and increase your fixed income “buffer”. This creates a systematic process of selling high and buying low.
As a side note, we are reviewing the provisions of the recently passed “Setting Every Community Up for Retirement Enhancement (SECURE) Act” and how it will affect each of our clients. Some of the notable changes include the ability to postpone your required minimum distributions (RMD) to age 72 and limiting the “stretch” of the Inherited IRA distributions to ten (10) years. We will be discussing this with each of you at our next meeting.
Best wishes for a healthy and prosperous New Year and decade!