Another year is in the books! We trust you had a wonderful holiday and brought in the New Year with cheer.
A quick review of 2018 shows that the 2017 global equity rally continued into 2018 on the back of the U.S. corporate tax cut, deregulation, and solid global growth before reversing course in the fourth quarter. The lack of a trade agreement with China, an expectation of slower global economic growth, and a tighter monetary policy by the Federal Reserve all had a hand in the fourth-quarter equity sell-off.
During the fourth quarter, the Federal Reserve raised its benchmark federal funds rate for the fourth time in 2018 and indicated that it expects to raise it two times in 2019 and at least once in 2020. As we have mentioned in previous letters, these rate increases lead to higher corporate borrowing costs that will likely have a negative impact on earnings going forward, especially for companies with a debt-heavy capital structure. The Fed continues to reduce the size of its balance sheet by allowing a capped amount of Treasury and mortgage-backed securities to run off each month. This balance sheet reduction exacerbates tighter monetary conditions typically seen in a rising rate environment, as it further reduces liquidity in the financial system.
The U.S. stock market as measured by the S&P 500 Total Return Index declined by 4.38% for the year, while the bond market as measured by the Barclay’s Aggregate Bond Index rose .01%.
GDP grew at a solid rate of 3.4% in the third quarter of 2018 and is expected to be above 3% for the year. For 2019, estimates so far show a more modest growth rate of around 2%. Corporate earnings were very strong in 2018 but are also expected to grow at a less robust rate in 2019. The deceleration in expected earnings growth played a major role in the valuation reset that materialized in the form of the fourth-quarter equity sell-off.
The Federal Reserve’s actions will play a key role for the economy and corporate earnings in 2019. Some form of resolution to the U.S.-China tariff dispute would also benefit the U.S. and world economy.
As our clients know, we invest in companies with strong balance sheets, a history of earnings growth, and forward-looking leadership. We are confident that positioning our clients in these types of companies will allow them to capture significant upside during the course of a full economic cycle.
All of us at Gamble Jones wish you and your family a happy, healthy, and prosperous new year.
Gamble Jones Investment Counsel
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