- Revised expectations for forward U.S. economic growth created volatility across the financial markets.
- Large capitalization technology stocks looked expensive and crowded to us during the third quarter, but recent declines and still healthy fundamentals have created attractive entry points.
- During the fourth quarter we saw some intriguing opportunities, reduced cash levels in our portfolio and added several new names.
Market Overview and Outlook
The U.S. stock market experienced a difficult fourth quarter, falling -13.5%, and had its first down year since 2008 with a total return of -4.4%. The market came within a hair of technically being labeled a bear market (down 20% from the peak) before bouncing significantly after Christmas. Volatility, as measured by the VIX index, increased from near historical lows in 2017 to about average in 2018. Investors were dealing with various issues in 2018, including fears of a trade war with China, turmoil in the White House, weakness in international economic numbers and Federal Reserve policy that is perhaps more backward looking.
Revised expectations for forward U.S. economic growth created volatility across the financial markets. Yields on the 10-year U.S. Treasury fell from a high of 3.23% on November 8 to a low of 2.68% at year-end. The short-end of the yield curve inverted the last week of 2018 and again the first week of 2019. The 2-year to 10-year Treasury spread narrowed to only 12 basis points in early December, the tightest since 2008. An inverted yield curve has historically proved to be a reasonably good predictor of recessions. Oil prices peaked north of $75 in early October but cratered to the mid-$40s by year-end. Coming into the fourth quarter, oil markets had been anticipating shortages caused by new Iranian sanctions. Instead, the sanctions had little impact and weaker global economic results reduced demand expectations. The U.S. dollar increased from 1.16 Euros to 1.145 during the quarter, making a new high for the year but still trading within a narrow range.
The best performers in the fourth quarter were low-risk or defensive stocks. The strongest groups were the utilities, consumer staples and health care sectors, while the cyclical energy, materials, industrials and consumer discretionary lagged. For the year, the defensive utilities and health care sectors did well, but strong earnings growth enabled consumer discretionary and technology stocks to report gains as well. Large capitalization stocks significantly outperformed small, while highly leveraged companies and those with credit problems were among the weakest stocks in the market.
U.S. economic news started the quarter very strong but ended more mixed. While the U.S. consumer did well, manufacturing experienced some softness to close out 2018. Retail sales were outstanding, posting one of the best Christmas seasons in years. Car sales were steady above 17 million (seasonally adjusted annual rate), although results were boosted by high fleet sales. Housing slowed slightly but continued to grow. Unemployment claims bottomed for the cycle in September at 205,000 before rising to 231,000 by December — still a very low number. Job creation was terrific in December at 312,000 and average hourly wage growth picked up to 3.2%. Employment is the best single indicator of the health of the U.S. economy but tends to lag at the onset of a recession.
"We need to be mindful of credit problems and Federal Reserve policy."
The market was very concerned about the combined impact of Chinese trade friction, international slowing and Federal Reserve policy on the manufacturing economy. The December ISM fell sharply from 59.3 to 54.1 — still indicative of a growing economy, but the third-sharpest decline in the indicator in 20 years. We are most likely witnessing a growth slowdown from red hot conditions last summer, but we need to be mindful of credit problems and Federal Reserve policy. The BAA spread, a key indicator of credit stress, decisively broke out during the fourth quarter and is now above the average for the business cycle. Real interest rates of just above zero are not likely to retard the economy per se, but the narrow yield curve must be watched. The current Federal Reserve balance sheet reduction of $50 billion per month is a clear headwind, as is the decline in the money supply we saw in 2018.
Large capitalization technology stocks looked expensive and crowded to us during the third quarter, but recent declines and still healthy fundamentals have created attractive entry points. The big cap pharmaceutical stocks looked very interesting six months ago. Even after their strong fourth-quarter performance, a couple of the names still look intriguing but overall the group looks fairly valued to us. We would continue to avoid the utilities, which sell at record relative valuations despite poor revenue outlooks and deteriorating allowed returns. We are generally wary of the materials sector but are interested in companies that benefit from lower raw material costs.
We were quite nervous about the market a quarter ago, but at least from a valuation standpoint we feel better now. During the fourth quarter we saw some intriguing opportunities, reduced cash levels in our portfolio and added several new names. That said, we continue to feel that a conservative stance is most appropriate at this time. We are late in the economic cycle. Growth in 2019 will be significantly lower than last year even if the Federal Reserve is able to engineer a soft landing. The Appreciation strategy of owning large, high-quality stocks is well-suited for today’s market, offering upside participation if the economy remains robust and preserving capital should a trade war erupt or should the Fed’s tightening result in an inverted yield curve.
The ClearBridge Appreciation Strategy had a negative return during the fourth quarter of 2018, outperforming the Strategy’s S&P 500 Index benchmark.
On an absolute basis, the Strategy had gains in three sectors in which it was invested during the quarter (out of 11 sectors total). The main contributors to the Strategy’s performance were the real estate, consumer staples and utilities sectors. The main detractors were the IT and financials sectors.
In relative terms, the Strategy outperformed its benchmark impacted by stock selection and sector allocation. In particular, stock selection in the communication services, financials, health care and consumer staples sectors added the most to relative performance. The Strategy’s cash position also helped. Conversely, an underweight to the utilities sector dragged on relative performance during the quarter.
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Merck, American Tower, Procter & Gamble, CME Group and Aetna. The greatest detractors from absolute returns were positions in Apple, Microsoft, Raytheon, Home Depot and JPMorgan Chase.
During the quarter, we established positions in Amazon.com, W.W. Grainger, CVS, and salesforce.com. We closed positions in Ameren, Broadcom, Fastenal and Citigroup. Our shares of Aetna were converted to shares of CVS following CVS’s acquisition of Aetna and were retained.