What a difference a year makes! In 2017 the U.S. stock market was continually setting new highs while volatility remained extremely low and for the first time ever the market rose every month. 2018 began with a high degree of optimism, but that suddenly changed and in the fourth quarter the focus of many investors shifted from the continuing strength in the fundamentals to apprehension about what might happen in the future.
2018 proved to be a very good year for the U.S. economy. Corporate profit growth was stronger than expected, employment trends are good, and contrary to the fears of many, inflation remains low. Many businesses benefited from lower tax rates, reduced regulatory pressures and a strong consumer. You would think that would be a positive backdrop for investments in common stocks. Instead, after setting a new high around the end of September, most stock prices sold off sharply during the fourth quarter.
The obvious question is what has changed? The economic expansion is now a year longer, but as we analyze the data, the probability of a recession in the next year or so seems very low. There has been a significant slowdown in the rate of growth in the United States and global growth has weakened as well. Even so, the outlook for corporate profits remains positive and we expect the expansion to continue. Throughout the year there was upward pressure on interest rates and in December the Fed raised rates for the fourth time in 2018 to 2.5 percent. This is the ninth increase since the Fed began raising rates from near-zero three years ago.
Investors are facing renewed apprehension about the possible impact on the economy as the Fed moves toward a normalization of monetary policy. Some are worried about the impact of the Fed engaging in an unwinding of its balance sheet at the same time it is nudging interest rates higher. Just as there were fears that quantitative easing would lead to inflationary pressures (it did not), now there is uncertainty about the impact on the economy and markets as the Fed effectively shifts to quantitative tightening. So far the Fed’s actions have been consistent with their congressional mandate to set a policy to promote maximum employment, stable prices and moderate long-term interest rates. Jerome H. Powell, the Federal Reserve chairman, says that the Fed will be patient going forward and will evaluate the health of the economy before moving ahead with any new interest rate increases.
Trade negotiations also remain a major uncertainty in the outlook for global growth, but we need to remember the goal is to lower tariffs, which would be a major positive. Weakness in China and Europe remain a concern, but the future prospects may not be as bad as feared.
With the mid-term elections behind us, we once again have a divided congress. So it seems unlikely that we will get any pro-growth legislation over the next couple of years. The government shutdown is symptomatic of the inability of congress and the administration to come together, but is unlikely to have a significant impact going forward.
The market collapse in December was unsettling, with inexplicable volatility that seemed to have little to do with the fundamentals, but instead was likely the result of computer driven trading. The subsequent rebound since Christmas has also surprised many. This is why Warren Buffett and Jeremy Seigel have often observed, stocks should be held for the long run. If the trading strategies using algorithms are here to stay, we should expect more volatility. Investors are encouraged to maintain the diversification in their portfolios and to stay the course.
A year ago most investments were selling at high valuations reflecting very good fundamentals. At year end almost all asset classes had come under pressure. With prices down, the expected return potential is now that much more attractive, as the current environment isn’t as bad as some suggest. Interest rates remain low, continuing to provide a challenge for fixed income investments. 2018 once again reminded us that the market movements are unpredictable, but that fact provides opportunities for investors.
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