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Quarterly Investment Review

A message from the Investment Management Team of Strategic Advisers LLC

By Brian Enyeart, CFA®,* President, Strategic Advisers LLC

Q4: Key Takeaways

  • GLOBAL STOCK WEAKNESS
    Despite a growing economy and strong corporate earnings, stocks broadly declined while bonds were flat as the market struggled to digest several key concerns in the final months of the year.
  • U.S. ECONOMY MATURING
    The U.S. economy continued to mature, with positive economic growth leading to strong employment and consumer trends, as well as higher interest rates.
  • STOCK VALUATIONS REASONABLE AND EARNINGS OUTLOOK REMAINS POSITIVE
    Stock valuations are close to long‐term averages while the 2019 corporate earnings outlook is positive.

Stocks declined while bonds were flat

In the final months of 2018, stocks declined in the U.S., despite positive economic growth and strong corporate earnings. In particular, uncertainty regarding several concerns drove volatility higher in the final months of 2018, including:

  • the pace of future interest rate hikes
  • a slowing Chinese economy
  • ongoing trade negotiations

International stocks also had positive corporate earnings. However, a stronger U.S. dollar, and slowing economic growth in Europe and China, weighed on returns.

Lastly, despite modestly higher interest rates driven by positive economic growth and strong employment trends, investment‐grade bonds were flat for the year, outpacing stocks for the first time since 2011.

U.S. business cycle showing signs of maturity

Even as the United States continues to experience positive economic expansion, we are seeing some signs of a maturing business cycle, including:

  • positive but slower corporate earnings growth
  • rising wages for workers
  • higher interest rates

During the later phase of an economic cycle, it is common for markets to struggle given increasing uncertainty about the pace of growth and the influence of fiscal policy and overseas growth. This is why after several years of historic market calm, we anticipate higher volatility, as well as positive, but lower, investment returns for stocks and bonds. As a result, we continue to have a modest tilt toward stocks over bonds within most client accounts. However, we have reduced our allocation to stocks in recent months. This has helped to reduce the level of risk in client accounts, and aligned them closer to their long‐term asset allocation mix.

Domestic stocks down 5.3%1

Stock markets in the U.S. declined 14.4% during the fourth quarter. For 2018, U.S. stocks were down 5.3%, finishing in negative territory for the first time since 2008. Small‐ and mid‐sized company stocks underperformed larger company stocks for the quarter and the full‐year period. This reflected investors’ preference for the perceived safety of large, more resilient companies.

For much of the year, growth areas of the market and companies with strong corporate earnings, particularly within the technology and consumer discretionary sectors, posted double‐digit gains. However, these gains were eroded in the final months of the year given rising uncertainty regarding future economic growth and the level of corporate earnings. During this time, more defensive investments, such as certain consumer staples and utilities, rose in value.

For most client accounts, we have less emphasis in these defensive areas, given our view of a growing U.S. economy, as well as their high valuations relative to other types of stocks. We continue to emphasize growth‐oriented stocks in most client accounts. We also favor quality companies that have healthy balance sheets and a more consistent earnings outlook.

International stocks declined 14.0%2

International stocks outperformed U.S. stocks during the fourth quarter but lagged for the year, finishing down 14.0%. While most major economies continued to grow, a marked slowdown in the pace of growth in key regions such as China weighed on returns.

Despite recent performance challenges, we still believe that international stocks play an important role in your managed account:

  • In the short term, corporate earnings of international stocks are projected to be positive in 2019.
  • Their valuations remain reasonable when compared to domestic stocks.
  • We continue to believe they provide diversification benefits. While U.S. stocks outpaced international stocks in seven of the last ten years, international stocks outpaced U.S. stocks in ten of the past twenty calendar years.

Today, within international stock funds, we continue to favor companies with growing earnings. Recently however, we have slightly decreased our tilt towards growth and increased our exposure to value‐oriented stocks, including those in the financials and materials sectors.

Bonds flat for the year

Despite modestly higher interest rates, which can negatively impact bond prices, investment‐grade bonds finished the year flat, returning 0.0%.3 After spending much of the year with slightly negative returns, they rose over the final months of the year. Investors sought the safety and yield that these higher quality bonds, and in particular U.S. Treasuries, can offer. More risk‐oriented bond investments, such as high yield, fell 2.3%.4 High yield bonds were driven lower by:

  • falling oil prices
  • investor concerns about corporate creditworthiness
  • higher interest rates

Meanwhile, short‐term bonds gained 1.9%5 during the year, providing stability to client accounts.

In December, we modestly increased investment‐grade bond fund holdings in most Portfolio Advisory Services client accounts. We reduced exposure to high‐yield bond investments. As the U.S. economy matures, investment grade bonds can help provide stability during periods of market volatility.

Importance of remaining focused on your financial goals

Higher market volatility can be difficult for investors. Some may even be tempted to abandon their financial plan, and move their investments out of the market. Yet straying from a financial plan can lead to missing out on future financial gains. After all, stocks have been through numerous declines and several recessions over the years. Yet over the long‐run, they have delivered better returns than bonds or short‐term investments. Therefore, we believe that maintaining discipline and sticking to a financial plan can reward investors over the long‐run.

Updates on Tax-Sensitive Accounts

  • Weaker stock returns and higher volatility provided opportunities to harvest losses to help offset future gains. We also periodically rebalanced client accounts as needed, by selling bonds and buying stocks.
  • (Given the maturing U.S. economy, during the fourth quarter, we began reducing exposure to stock investments and increasing bond exposure in tax‐sensitive accounts. However, we continue to have a modest emphasis on stocks over bonds in most client accounts. Earlier this year, we also removed our exposure to convertible bonds as valuations became less attractive.)
  • (Investment‐grade municipal bonds6 returned 1.7% for the quarter and 1.3% for the year. Performance was broadly helped by three factors:)
  1. lower issuance due to 2017 tax reform
  2. (increased inflows due to a flight to quality in the final months of the year)
  3. (healthy tax receipts as state and local economies grew)

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