In Client Letters

I had planned to write a short tribute to the passing of George H.W. Bush this quarter but given the turbulence in the markets during the 4th quarter of 2018, I felt the need to provide some context.  So, I moved my thoughts on our 41st President to the Responsible Investment Corner of this letter (yes, there is a connection!). 

The last time I titled one of my client letters “What Happened?” was in January 2013, a full six years ago.  At that time, I wrote about the unpredictability of the markets and surmised that few investors actually think back to the news they read, or the emotions they felt, at the beginning of any investment period of time.  At the beginning of 2012, the financial press was warning about a collapse of the euro currency, the implosion of Greece and Portugal and a dysfunctional U.S. government, while many political pundits suggested that there would be upheaval in Washington following yet another contentious Presidential campaign season.  Prominent Wall Street “gurus” predicted that U.S. stocks would fall in 2012…yet, the S&P 500 Index finished that year with a return of +16% and the MSCI EAFE Index (developed international stocks) earned nearly 18%!

Let’s think back to the beginning of 2018.  The U.S. and global economies were humming, corporate earnings were nearing all-time highs, the global stock markets had just finished an exceptional year.  To top off the optimism, our legislators had just passed a new tax bill that dramatically lowered corporate tax rates.  The Wall Street “experts” naturally assumed that 2018 would be another good year for the stock market…all else being equal, profits would be greatly expanded because corporations would pay less in tax.  Indeed, corporate profits continued to surge, yet the stock market lost value during this past year.  Many investors jumped on the stock bandwagon in last 2017 and early 2018, only to be disappointed.

So, what happened?  To start the year, volatility returned with a vengeance, after an unusually smooth 2017.  The first quarter of 2018 saw wide swings in both the stock and bond markets, as free trade, technology and low interest rates were all perceived to have been threatened (see my Q1 client letter).  After a couple of relatively calm quarters, the U.S. stock market experienced its second “correction” (losses of more than 10%) of 2018 during the fourth quarter.  By the end of the year, the stock market recorded its worst year since 2008 and the bond market experienced its second weakest return since 1999.  It was a rare year in which cash was the best performing asset class in the U.S.  The haze of negativity hanging over the markets is still primarily driven by the trade wars, political posturing, rising interest rates (the Fed raised rates four times in 2018), and now the uncertainty about the execution of Brexit.  The prevalence of index investing, momentum investing, and algorithmic trading has grown substantially over the years, perhaps exacerbating market swings, and that appears to have caused part of the mass selling last quarter.

Once again, as we enter the new year of 2019, you will get no market predictions from me.  I am hopeful that the trade wars and government shutdown will end soon, in which case I think the markets would respond positively.  Otherwise, volatility will continue to create anxiety and opportunity!

2018 Q4 Market Review

During the quarter, all broad stock market indexes lost value.  Large cap stocks lost less than small cap stocks and value stocks lost less than growth stocks, neither of which is a surprise during a quarter in which the market nearly entered “bear” territory.  Almost every sector in the U.S. stock market delivered a negative return.  The “best” performing sectors in the S&P 500 Index in Q4 included Utilities (+1.4%), Real Estate (-3.8%) and Consumer Staples (-5.2%).  The worst performing sectors during the quarter included Energy (-23.8%), Technology (-17.3%) and Industrials (-17.3%).

Non-U.S. developed, and emerging markets stocks continued their slide during the quarter.  During year, the “best” performing countries included Russia, Brazil and India.  Many regions around the globe struggled, including China and Germany.  U.S. tariffs and trade wars were to blame for much of the poor showing in the international markets.  The U.S. Dollar has strengthened relative to most other currencies this year, further detracting from returns for U.S. investors in international securities.

Most fixed income markets generated positive returns in Q4, which is more typical of a period in which the stock market experiences such large losses (unlike Q1 2018), which brought the calendar year performance to flat or slightly positive.  Even with a rising interest rate market in 2018, which is a headwind for bond prices, the advantages of holding bonds in a balanced portfolio came through again by the end of the year, as investors often move to the relative safety of bonds when the stock market falls.  The corporate and high yield sectors within the bond market produced negative total returns for the calendar year.  Cash (+1.8% calendar year return) yields rose throughout the year, as the Fed continued its path of rate hikes.

Here are the returns for select market indices for Q4 and calendar year 2018 (as stated in US Dollars):

Responsible Investment Corner

President George H.W. Bush passed from this Earth on November 30, 2018, which caused many citizens to yearn for the kind of civility and dedication that he brought to American politics.  Speakers at his funeral recalled the qualities of this man:  integrity, kindness, dignity, humor, empathy, loyalty, generosity, humility, and truth…all of which seem to be in short supply in today’s leaders.  In his inaugural speech, he referenced “a thousand points of light, of all the community organizations that are spread like stars throughout the Nation, doing good.”  He promised that all members of government would become involved in support of these organizations.  He recognized that is was important to give back to our community and that serving others enriches the giver’s soul.

Importantly, he was an advocate for environmental issues and the conservation and protection of our natural resources.  Many will not remember that his Administration passed the Global Change Research Act of 1990, which established the United States Global Change Research Program to study the effects of climate change and requires a special council to submit to the President and Congress, at least every four years, an assessment regarding the findings of the Program (the most recent 4th Assessment established that our economy, public health, national security, water supply, and other societal sectors are suffering because of climate change).  President Bush also signed into law the landmark 1990 Clean Air Act Amendment (to the original Clear Air Act, which was signed by President Nixon), which was designed to address three major threats to our environment:  acid rain, urban air pollution, and toxic air emissions.  He understood that there is no conflict between environmental progress and economic progress…indeed we need both to sustain ourselves as a nation and global society.

While current government policies have taken a step backward from many of the environmental and social aspirations of President Bush, the private sector has stepped forward to help fill the void.  Sustainable, Responsible and Impact (SRI) investing has seen massive growth over the past few years with positive social and environmental success stories.  Here’s an example of an investment made by one of the SRI funds that is held by some of our clients:

Xylem, Inc. is a leading water technology company, headquartered in Rye Brook, NY, that was recently ranked 7th in FORTUNE’s “Change the World” list of companies making a significant social impact through their core business strategy.1    Xylem helps its customers worldwide to transport, treat, test and efficiently use water in public utility, residential, commercial, agricultural and industrial settings.They also help cities cope with severe flooding and other water-related consequences of climate change.3  In addition, Xylem has a corporate citizenship and social investment program, Xylem Watermark, that seeks to provide and protect safe water resources around the world.

From organic farming to green bonds, there are many investment opportunities now available to investors that can achieve the “triple bottom line” of positive economic value, social responsibility and environmental impact.

This and That

  • Part of the market scare in Q4 was the fear of an “inverted yield curve,” in which long-maturity bond yields fall below short-maturity bond yields. Every past U.S. economic recession has been preceded by an inverted yield curve; however, a recession has not occurred every time there has been an inverted yield curve.  When recessions have occurred, they have been with a 14-month lag on average.4
  • The Green Bay Packers just hired Matt LeFleur to be their new head coach. He was an offensive coordinator (for the Tennessee Titans) prior to becoming named head coach for the Packers…just like Vince Lombardi, Mike Holmgren and Mike McCarthy.  Hopefully, he will enjoy similar success!
  • “In investing, what is comfortable is rarely profitable.” – Robert Arnott

Happy New Year!  Let’s try to make it a great 2019.

Gregory D. Wait, President
Falcons Rock Impact Investments, LLC

1 Green Century Funds investor letter, October 25, 2018
2 Wikipedia, January 10, 2019
3, 2018 Change the World list
4 JPMorgan Guide to the Markets, 1Q 2019, December 31, 2018