Looking Back on a Difficult Year

We have just come through one of the more difficult financial market in recent memory, and many clients and investors are wondering where we go from here. Throughout 2018, these communications had given no indication of pending doom, and there was no suggestion or forewarning of what we experienced through October, November and December. There was acknowledgement of the economic cycle being long in the tooth, but we agreed that time alone does not trigger a recession. We accepted that the debate between mid-cycle and late-cycle predictions did not need to be solved, partly because the two theories agreed that we were at least 12-18 months from any real economic contraction that would be detrimental to equity markets.

With 2018 behind us, has anything changed our perspective or our strategy going forward? The simple answer is no.

We first mentioned in the Q2 newsletter that over the past few years, a few select companies had been punished for either missing investor and analyst expectations or for publishing disappointing forward guidance. The markets marched higher through 2016, 2017 and 2018, with general optimism and prospects of further growth, setting increasingly higher expectations for company revenues and earnings. Late in the year, it seemed the pain of those few businesses deemed ‘not good enough’ started to spill over into the broader market and create doubts as to the strength of the economy. We even started to hear speculation of a near-term recession. The year ended with few asset classes or geographies showing positive returns. The chart below illustrates this using average returns in local currency terms for seven asset classes – Canadian equities, U.S. equities, EAFE – international equities, emerging markets equities, Canadian bonds, high yield bonds – U.S., and global bonds:

The outcome for 2018 was that the average return across these seven asset classes was (-5.8%), the highest return was +1.8% and the weakest return was (-14.6%). What started as losses for a few individual companies turned into the worst year for investors since the financial crisis of 2008.

Is there an explanation?

Short-term swings in the market can be difficult to explain. We had two significant shocks in October that acted as triggers to the declines. First, U.S. Federal Reserve Chair Jerome Powell publicly commented that interest rates were a long way from neutral. Higher interest rates, and the prospect of further increases, would cause higher consumer and corporate borrowing rates that would reduce spending and cut in to profits, respectively, eventually slowing the pace of economic growth. Second, U.S. initiated what looked to be a trade war with China. Both the U.S. and China started placing tariffs on more and more imported goods. If sustained, these tariffs would increase prices and eventually threaten the ability of the world’s two biggest countries to grow.

The combination of higher interest rates and biting tariffs meant investors started to price in an economic slowdown and even the next recession. However, this market volatility suggested there was a disconnect between what investors see – threats to economic growth – and what policymakers see – continued normal growth. The data shows general economic conditions remain sound in North America and globally, with limited signs of stress in financial systems. The measurable and monitored indicators were not showing any warning signs:

• increasing GDP growth
• U.S. unemployment near all-time lows
• consumer confidence relatively high
• rising government expenditures and spending
• interest rates and inflation trending higher, but controlled

The severity of investor’s reactions had a material impact on both the path of future interest rate hikes and trade negotiations between President Trump and President Xi Jinping. In October, 2018, the Fed fund futures were predicting four rate hikes in 2019. By January, 2019, the number of expected rate hikes was down to either one or zero. It is clear that the market has imposed limits on how much the Fed can raise rates. As well, China and the U.S. have recently agreed to hold off on applying tariffs to any additional goods while they work toward a new trade deal, setting March 2019 as a deadline. Both Trump, for re-election reasons, and Xi, for domestic economic reasons, are motivated to find common ground.

Most markets have cheered both developments, as the start of 2019 has seen moves higher from the lows of Christmas Eve.

Higher volatility is a reversion back to normal

Through the continued decline into year-end, it was important to recognize that stock prices fluctuate based on investor perception and emotion, while the underlying values of businesses are much more stable. This fluctuation, or volatility, felt like it was abnormal and as a result likely caused an overreaction than if it had happened at another time. We are coming out of a period – 2013 through 2017 – in which we saw very little fluctuation in market prices. The chart below is the annual volatility of the S&P500, dating back to 1982, shown as the percentage of days in each year in which the index range was greater than 1%.

Investors had been getting used to low volatility. In fact, 2017 had the fewest days of greater than 1% moves in the S&P500 in over 35 years.

Keeping perspective

We try to take much of the emotion out of the advice we provide our clients. These past several months are important reminders that we need to be prepared for short-term declines in financial markets so we don’t allow our decision making to affect long-term performance.

We should expect more normal levels of volatility over the intermediate term given the backdrop of the late economic cycle, evolving central bank monetary policies, trade uncertainty, and whatever other risks enter the psyche of global investors. We need to remain focused on the personal goals and objectives we have set and track our performance relative to those benchmarks instead of what the markets tell us to focus us.

Our strategy with clients has not materially changed with the events of 2018. We continue to diversify investments by asset class, industry and geography. We continue to own good companies with a history of growing their businesses and rewarding their shareholders. Declines in the price of a company’s shares do not necessarily reflect the value of those shares, and often present a compelling opportunity to purchase more. When necessary, we continue to hire the best investment managers with a track record of success within their sector or asset class. The noise and distraction of any further market volatility – whether from Brexit, Mueller, Washington dysfunction or trade negotiations – may require some getting used to. As this cycle further matures, we will continue to focus on the conditions of the economy to set our expectations for both equity and fixed income markets.

I believe that two out of ten years will be difficult years in the market. Predicting which will be the difficult ones is impossible, but we know looking back that 2018 was one. We need to experience years like this to benefit longer term as predicting when to ‘get in’ and when to 'get out’ has never consistently been done well. There are lessons to be learned from what we’ve come through, but there is also perspective to maintain to ensure we remain focused on what matters.

EdgePoint Investment Group Inc. recently published a paper titled ‘Show patience in a world of instant gratification’. The premise is in light of our growing obsession with things on-demand – same-day delivery, internet and wi-fi access, etc. – turning over underperforming investments in the short-term and replacing them with recent winners is not a successful strategy. We need to focus on our own goals and objectives and track progress using long-term measures. EdgePoint manages a global equity fund and is one of the best at what they do, in my opinion.  Even they have periods of losing money for investors. 2018 and 2011 were their only two years of negative performance since their inception in 2009. There was much more to gain over the past ten years than was lost in those two difficult ones.

Regards

Thank you for the trust and confidence you place in us to provide you with investment advice and wealth planning services. If there is anything we can assist with, or anything you would like to discuss, please feel free to contact me.