Filbrandt Reports

Market Update: Changing Expectations

Volume 19, Issue 1

Executive Summary:

In this Market Update, you will learn:

  • Why market returns in 2018 were flat to down despite positive economic indicators
  • Our expectation on near-term Federal  Reserve interest rate hikes
  • Our outlook for the U.S. economy’s growth rate in 2019

In 2018, the economy grew at the fastest clip of the bull market. Sales, profits and wages were up. Unemployment fell to the lowest rate in over 60 years. Inflation was under control. Yet market returns in most major asset classes ended flat to down. How could this be?

Changing expectations is the biggest factor. Going into the year, stock valuations were high by historical standards, but reasonable given the robust outlook for the economy. Tax cuts were expected to fuel growth. The synchronized global economy was propelling record profits. To some, the biggest risk was the possibility that the economy would grow too quickly.

Today, investors are adjusting their expectations for a world with trade disputes and slowing economic growth. As a result, stock valuations have pulled back to average levels in the U.S. and to depressed levels in various foreign markets.

The Federal Reserve also appears to be adjusting its expectations, as they now say that interest rates are “approaching neutral.” Market fears of more aggressive rate hikes appear to have been exaggerated. Now, most economists are expecting one or two rate hikes in 2019 compared to prior estimates of three to four.

At Filbrandt Wealth Management, we believed the probability of a slowing economy was more likely than the over-heating scenario and adjusted our portfolios accordingly early in 2018. After a solid first half of the year, market prices are now reflecting this new environment.

Economic growth will be slower, still healthy

Looking forward into 2019, we expect that the economy will grow at a slower, but still healthy rate of 2 to 2.5 percent. The probability of a recession remains low, however, as leading economic indicators continue to improve. Much of the impact of the interest rate increases is behind us, which should allow bond markets to generate positive rates of return. The most popular bond benchmarks have never had two consecutive years of negative returns. Stock valuations are also now poised for better long-term returns, especially in foreign markets. Balanced portfolios of stocks and bonds should produce average returns between 5 to 6 percent over the next several years, a slight increase from prior estimates. Overall, we maintain a constructive five-year outlook, but recognize that short-term volatility has normalized and risks of a slowing economy are real.

A slowing economy combined with rising wages could put a crimp on corporate profits. When the growth rate of profits declines more than expected, stocks usually react quickly to the downside and overshoot fair valuations. Earnings growth estimates for 2019 are currently being revised from 11 percent to around 8 percent, so much of the deceleration seems to be priced into the market.

Investors’ appetite for risk is a bit of an unknown. Recently, momentum-driven stocks have been exchanged for more defensive blue-chip holdings, and high-yield bonds are being replaced with high quality bonds. Stocks could decline further in coming months if this desire for safety continues to grow. In such an event, we will take advantage of the attractive valuations by rebalancing portfolios back to their respective allocation targets – i.e. we will be buying stocks. As Warren Buffet says, “Buy when others are fearful.” Rebalancing has always been a key tenet of our philosophy, but could become even more critical during periods of heightened volatility.

Finally, market conditions will continually change, but our process remains committed to achieving clients’ long-term goals. We thank you for another year of trusting us with your financial security and wish you a very prosperous 2019.

Volume 19, Issue 1

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