First Quarter 2019 Key Takeaways:

After posting their worst December since 1931, U.S. stocks surged to their best January since 1987, followed by further gains in February and March. Once again, the markets surprised the consensus and demonstrated the folly of trying to predict short-term performance. Investors who bailed out of stocks during the year-end selloff experienced severe whipsaw as the market rallied. Larger-cap U.S. stocks gained 13.6% for the quarter, placing it in the top decile of quarterly market returns since 1950. As a reminder, last year’s fourth quarter 14% drop was a bottom-decile dweller.

Foreign stocks also rebounded sharply in the first quarter. Developed international markets gained 10.6% and European stocks were up 10.9%. Emerging-market (EM) stocks rose 11.8%, after holding up much better than U.S. stocks on the downside in the fourth quarter of 2018.

Fixed-income markets were also strong: High-yield bonds gained 7.4%, floating-rate loans were up 4%, and investment-grade bonds rose 2.9%. The 10-year Treasury yield fell to 2.39% during March, its lowest level since December 2017.

Turning to alternative investments, our lower-risk alternative strategy fund generated positive returns that were better than core bonds but well below the soaring stock market. This is consistent with our performance expectations given their lower-risk and more-defensive positioning.

The market rebound was predominately due to a U-turn in Federal Reserve monetary policy. After hiking interest rates four times in 2018, Fed officials suddenly reversed course. They emphasized they would be “patient” and pause any further rate increases. Admittedly, there were other positives for the markets as well: The federal government shutdown ended in late January, signals from the U.S.-China trade talks turned more positive, and the likelihood of a “hard Brexit” seemed to wane.

It certainly feels better to see strongly positive portfolio performance this quarter compared to the losses in the fourth quarter of 2018. But just as we wouldn’t extrapolate last year’s losses when looking out over the coming years, it’s equally important to temper our expectations on the upside after this quarter’s strong rebound.

If monetary and fiscal stimulus around the globe extends the cycle for another few years, we have exposure to a wide range of investments that will particularly benefit. These include global equities, with an emphasis on developed international, European, and emerging-market stocks; and non-traditional fixed income funds.

On the other hand, if a recessionary bear market strikes, our holdings in core bonds, lower-risk tactical and alternative strategies should be beneficial to our portfolios. And we would then be in a position to tactically add back to riskier asset classes, such as U.S. stocks, at lower prices and higher prospective medium-term returns.

Market Recap

On the heels of their worst December since 1931, U.S. stocks opened 2019 by scoring their best quarter since the financial crisis. Larger-cap U.S. stocks gained 13.6%, placing the S&P 500 Index’s performance in the top decile of quarterly market returns since 1950. Not to be left behind, foreign equities, which were by far the most battered coming out of 2018, generated double-digit returns: emerging-market stocks rose 11.8%, while developed international stocks gained 10.6% and European equities gained 10.9%.

Fixed-income markets were also strongly positive. The 10-year Treasury yield fell to 2.39% during March, its lowest level since December 2017, after peaking at 3.24% late last year.

The market rebound was predominately due to a U-turn in Fed monetary policy. After hiking interest rates four times in 2018, including at their mid-December meeting, and indicating further tightening would occur in 2019, Fed officials suddenly reversed course. They emphasized they would be “patient” and pause any further rate increases. And—presto!—stocks are back at their highs of late last summer.

Admittedly, there were other positives for the markets as well: The federal government shutdown, which had started to weigh on sentiment, ended in late January; signals from the U.S.-China trade talks turned more positive; and the likelihood of a “hard Brexit” also seemed to wane.

Portfolio Attribution

Our portfolios generated strong performance for the first quarter, largely driven by their exposure to U.S., international, and emerging-market stocks.

Our actively managed tactical funds also had strong relative risk-adjusted returns. Their presence in our portfolios will provide some protection during a major market downturn.

Turning to our alternative investments, our allocation to lower-risk actively managed alternative funds had positive returns that were better than core bonds but well below the soaring stock market. This is consistent with our performance expectations for these strategies given their lower-risk and more-defensive positioning.

Market Outlook

The obvious question after experiencing such a rebound is, what’s next? It’s easy to be enamored with the U.S. equity market, especially when the Fed is playing its cards face up. However, the reality is the market rebound was due more to improving investor sentiment and risk appetite—caused largely by the shift in Fed monetary policy—than any meaningful improvements in underlying economic or business fundamentals.

From our vantage point, looking out over our longer-term investment horizon, seemingly little has changed after the roller coaster ride of the last six months. The first quarter of 2019 was certainly a nice respite from the losses of 2018, but we remain prepared for renewed market choppiness as the economic cycle gets later and later (and closer and closer to the inevitable downturn).

While the U.S. economy is still arguably the strongest market, growth expectations have been coming down. At its Federal Open Market Committee meeting on March 20, the Fed downgraded its median GDP growth estimate to just 2.1% for 2019 and 1.9% for 2020, citing the effects of economic slowdowns in China and Europe, fading stimulus from the 2017 Trump tax cuts, and ongoing uncertainty around Brexit and trade policy.

U.S. corporate earnings growth expectations also continue to decline. Consensus earnings-per-share growth estimates for the S&P 500 have dropped from 12% (as of 12/31/18) to just 4.1% as of mid-March. Even with the Fed now on hold, earnings growth will need to improve for stocks to appreciate meaningfully from current levels, given their sharp rebound in the first quarter and high valuations. Our annualized return expectations for U.S. stocks are in the low-single-digit range over the next five years.

On the other hand, there are a number of short-term scenarios that could see further equity gains, in particular in foreign markets. The Chinese government is once again trying to boost their economy via fiscal and monetary policy (including tax cuts, lower interest rates, and expanded bank lending). A revival in Chinese growth would have positive ripple effects across the global economy. It would benefit other emerging markets and Europe in particular, as China is a major importer of their goods. This foreign stimulus, combined with the Fed’s policy U-turn, may enable equity markets to extend their positive run for another few years. This outcome would certainly benefit our portfolio positions in developed international and emerging markets, among other riskier assets.

While we’d prefer to see global growth rebound with continued strong performance, we believe it is wise to be prepared (mentally, emotionally, and financially) for shorter-term downside and negative market surprises. If and when a recessionary bear market strikes, we will look to our holdings in core bonds as well as our tactical and alternative strategies to provide ballast to our portfolios and limit the impact of equity declines.

Any prolonged downturn will also likely present us with opportunities to tactically increase our exposure to riskier asset classes, such as U.S. stocks, at lower prices and higher prospective returns.

As always, we appreciate your trust and confidence in our investment discipline, and we work hard every day to continue to earn it.

Guardian Finanical Partners, LLC

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2018 Market Review

U.S. and global stocks dropped sharply in the last quarter, capping a year marked by turbulence and losses across most asset classes. Among investors’ worries are signs of a global economic slowdown, exacerbated by ongoing Federal Reserve monetary tightening, U.S.-China trade tensions, and political uncertainties in Europe (Brexit, Italy) and the United States.

After tumbling 7% in October and then stabilizing in November, U.S. stocks fell again in December as investors reacted negatively to the Fed’s language surrounding its 25-basis-point rate hike.  While the Fed’s updated forecast implied one fewer rate hike in 2019 than previously communicated (two instead of three), Fed chair Jerome Powell gave no indication it would ease up on its balance sheet reduction program (rolling off hundreds of billions of maturing assets purchased during quantitative easing), nor that a pause in rate hikes was imminent (although he didn’t rule it out).

Larger-cap U.S. stocks dropped 9% in December and fell 13.6% for the quarter (its worst quarter in seven years). For the year, U.S. stocks were down a more modest 4.5%. The negative year broke the S&P 500’s remarkable nine-year run of positive returns. Smaller-cap U.S. stocks fell more sharply, losing 20% in the fourth quarter and 11% for the year (iShares Russell 2000 ETF). Foreign stocks struggled as well, with developed international markets and emerging markets both down 14.8% (Vanguard FTSE Developed Markets ETF and Vanguard FTSE Emerging Markets ETF). However, their underperformance versus U.S. stocks came earlier in the year. In the fourth quarter, emerging-market (EM) stocks beat U.S. stocks by seven percentage points, while developed international stocks matched the U.S. market’s return.

In addition to the equity market declines, what stands out about 2018 is the breadth of negative returns across almost every type of asset class and financial market, whether bonds, equities, or commodities.

Core bonds, which typically perform well when stocks do poorly, had losses through November (Vanguard Total Bond Market Index). But a strong rally in Treasury bonds in December resulted in a flat return for the year.

Simply put, it was extremely difficult to make money in the financial markets last year.

Most investment strategists expected 2018 would bring a continuation of the synchronized global economic recovery. The sharp market pullbacks this year were contrary to the 2017 year-end consensus (just as 2017’s unusually strong returns were a surprise after a difficult 2016) and only reinforce our view that no one can consistently predict short-term market moves.

Key Drivers of Our 2018 Portfolio Performance

While we’d never predict what the stock market will do in any given year, U.S. stocks’ poor performance in 2018 wasn't a particular surprise to us. Our portfolios have been positioned for poor expected returns from U.S. stocks for a while. This is based on our “medium-term” (five- to 10-year) forward-looking analysis of valuations, normalized earnings growth, and dividend yield, across a range of scenarios we view as reasonably likely or plausible.

Our lower-risk liquid multi-alternative mutual fund had a slight loss. The risk-management and diversification benefits of the fund—which have been a drag on performance during the strong U.S. bull market run—were evident in the fourth quarter. While the S&P 500 dropped 19% from its late September high, our liquid multi-alternative fund posted only slight losses in the 2% range.

The multiyear period of U.S. stock market outperformance versus the rest of world is also reaching an extreme relative to history. We don’t believe this trend is sustainable either. The last 10 years’ performance is certainly not going to repeat over the next 10 years.  We don’t believe global equity investing is dead or destined to perennially underperform the U.S. market. And as noted above, during the market rout in the fourth quarter there were some glimmers that this cycle may be in the process of turning, with EM stocks outperforming the S&P 500 by seven percentage points and developed international stocks performing in line with U.S. stocks.

INVESTMENT OUTLOOK - MEDIUM TERM (5–10 YEARS)

As we look at the investment landscape over a 5–10 years, (closer to the length of a typical market cycle), our confidence in analyzing potential financial market returns increases meaningfully. This creates opportunities to tactically tilt our portfolio to asset classes and strategies where we believe the investment odds are strongly in our favor. We may also under-allocate to areas where the risk-return profile is very unattractive (high risk/low return) based on our analysis.

Presently, we have a high level of conviction that European and EM stocks will earn significantly higher returns than U.S. stocks over the medium term. This is reflected in our tactical portfolio allocations to these two markets. Also, because we expect returns to U.S. stocks and core bonds to be quite low over this time frame, we are under-allocated to those areas and are confident our positions in non-traditional bond funds and tactical and alternative strategies will prove beneficial as well.

Our base case expectation, using normalized earnings, suggests we can reasonably expect low single-digit annualized returns from U.S. stocks over the medium term. We also consider a more optimistic but less likely scenario that assumes S&P 500 sales growth and profit margins sustain near historically elevated levels. In this case, expected five-year returns would be in the high single to low double digits. We think this scenario is unlikely given the late stage of the current U.S. business cycle.

Closing Thoughts

The financial markets proved extremely challenging in 2018 across the board. A historically high percentage of markets posted losses for the year. Several stock markets and asset classes fell into official “bear market” territory, dropping more than 20% from their highs. Given our globally diversified approach, our portfolios were not immune. Having said that, in light of the multitude of macro risks (central bank tightening/QE unwinding, slowing global growth, ongoing U.S.-China trade tensions, widespread geopolitical uncertainties), coupled with unattractive U.S. stock market valuations and excessively optimistic earnings expectations, we weren’t surprised by the negative year.

If U.S. stocks slide into a full-fledged bear market, our portfolios have dry powder in the form of lower-risk fixed-income and multi-alternatives should hold up much better than stocks. We’d then expect to put this capital to work more aggressively; for example, by increasing our exposure to U.S. stocks at lower prices and valuations implying much higher expected returns over our medium-term horizon.

No one knows what 2019 will bring. The only certainty is the lack of certainty. But as discussed above, what we are confident about is our investment approach. With its strategic portfolio foundation and tactical flexibility, we believe it will be successful across market cycles.

We remain confident in our analysis and process, a critical part of what’s necessary to achieve long-term success and avoid the pitfalls of performance chasing and emotionally driven investing. We continue to execute our approach with discipline and remain patient during the inevitable periods when it is out of favor, we have no doubt we will continue to achieve successful and rewarding long-term results for our clients.

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