Recap of 2018 and the outlook for 2019
Happy New Year to all.
I hope that you were able to relax and recharge over the holidays and spend time with family and friends.
2018 was an interesting year for markets. It began with optimism driven by economic and earnings growth. The US economy, in particular, was humming, fueled by tax cuts. Your JCIC portfolios were well positioned and weathered the increased volatility and downturn in February and March and performed well to the end of the 3rd quarter. Volatility picked up again in October and sentiment began to turn more pessimistic. We had a respite in November but then in December a number of geopolitical issues, mostly around trade and a reduction in expectations for the rate of economic growth hit markets and they gathered speed to the downside. The pessimism also led people to look to move money from securities like equities and preferred shares into perceived safe-haven investments such as government bonds, thereby driving interest rates down. While we expect corrections to be a feature in the later stages of the long-running bull market, the recent correction was more severe than anticipated. In fact, last month was the worst performing December since 1931. Our investment returns for 2018 were hurt by the dramatic downturn in the 4th quarter.
Given the strength of the underlying fundamentals, we feel that this correction was overdone, and in fact, there has been a reasonable bounce back in the last 2 weeks. We continue to believe that equities offer the best return potential, followed by cash and short-term interest-bearing instruments and lastly bonds where we find both the current rates and the outlook less appealing.
What did we do in 2018? – We entered last year with an overweight position in equities and an underweight position in fixed income, using some preferred shares as a partial substitute for bonds. Given that we felt we were in the later stages of both the economic recovery and bull market we began the process of gradually de-risking the portfolios in the 2nd quarter. We reduced our equity exposure and raised cash by 3-5% across our Balanced, Growth and Income portfolios. We also began adding to our defensive positions, stocks like utilities as those presented more reasonable values following the market downturn that began in October. It is our intent to continue this gradual repositioning over several quarters, increasing cash and investment in less economically sensitive companies so as to be well positioned through the volatility we expect, as the current economic expansion runs its course.
Why was this correction more substantial? – There certainly was a confluence of negative factors that contributed to the market taking a more pessimistic view. There are several concerns; U.S.-China trade issues, Brexit, U.S. Federal Reserve management of interest rates, the unwinding of quantitative easing in the U.S. and Europe and now we can add the U.S. government shutdown and continued and substantial uncertainty caused by the leadership style of President Trump. All of these concerns have contributed to forecasts of a slower rate of GDP growth and a disruption of economic activity. Companies and markets hate uncertainty and we got lots of uncertainty in 2018. Faced with this, companies delay investment decisions as they wait to see how tariffs might affect their plans, purchases were accelerated and inventories built up in advance of announced tariffs. Now, these inventories are being sold, temporarily reducing new factory output. All of this gives a distorted picture of economic activity, making reading the economic tea leaves more difficult. Uncertainty leads to discounting in the markets for potential negative outcomes. These conditions are continuing in 2019. We cannot predict exactly when and what the final US-China trade deal or Brexit will be, but we know that these countries will continue to trade. They are economically tied to each other. Once the conditions are known the market will evaluate that and drive on. I am not saying that there is no risk to these scenarios, but we believe the downside risk has been priced into the markets so any reasonable settlement should lead to firmer market conditions. As economic data stabilizes, the market should price in a more realistic outlook, rather than the recent pessimistic view.
Where are we now and what’s next? – 2019 began with much pessimism. Equity valuations are now below historical averages and therefore represent good value, not sale candidates. While the rate of GDP growth has slowed, there is still decent growth globally and we expect that to translate to single digit earnings growth of in 2019. We believe the 4th Q downturn is a correction and not the beginning of a bear market. While the political headlines capture most of the attention we know these issues will have resolution and that brings us back to the economic fundamentals; GDP growth, strong employment, reasonable inflation, low interest rates, in short, good conditions for companies to operate. When we couple this with expected moderate earnings growth and lower than average valuation multiples we believe the case for owning shares in good companies is still compelling.
We have maintained our overweight position in equities which has enabled the portfolios to capture the recent uptick in markets. We monitor economic indicators and market data closely and over the next several quarters we will continue on our gradual path of de-risking the portfolios. This will be achieved by selling select equities on strength, adding shares of more defensive companies, building our cash positions and eventually looking for an opportunity to purchase bonds as they become more attractively priced.
We encourage you to get in touch if you have any questions and wish you and your families all the best for the New Year.
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