fourth quarter summary 2018 - diversifiedtrust.com

2018FOURTH QUARTER SUMMARY

2FOURTH QUARTER SUMMARY 2018 | DIVERSIFIED TRUST COMPANYFOURTH QUARTER SUMMARY 2018 | DIVERSIFIED TRUST COMPANY

Summary• In many respects, 2018 was the year that nothing worked. The Federal

Reserve raised interest rates four times throughout the year, placing a lot of pressure on bond returns. Concerns late in the year that the Fed would overtighten then caused a correction in risky assets. That left cash as the only major asset class to generate a meaningfully positive return. With nearly every asset declining in price, it was a difficult year for diversification to deliver much cushion to portfolios.

• We have benefitted from a “Goldilocks” environment for the past few years: supportive fiscal and monetary policy, low inflation and coordinated global growth. The Fed’s tightening has unwound that narrative somewhat, leading to a return of volatility to financial markets.

• The biggest risk to the market is that the Fed oversteps. The market’s reaction to hawkish rhetoric from the Fed during the fourth quarter showed just how concerned investors are that the Fed will hike too aggressively and cause a recession.

• If the Fed can keep from being too aggressive, we believe that there are still opportunities. The economy remains strong. And even though we are in the later stages of this expansion, history has shown that we can still enjoy more growth from where we stand today.

3FOURTH QUARTER SUMMARY 2018 | DIVERSIFIED TRUST COMPANY

What a difference a year makes! 2017 saw robust returns from nearly every

asset class with historically low levels of volatility. The S&P 500 returned a

robust 22%, and international equities were up over 27%. Yet, here we are at

the end of 2018 with sagging equity markets, and only short-to-medium term

fixed income able to post positive returns. U.S. equities sold off by 14% in the

fourth quarter alone! What happened?


Not surprisingly, a year in which nothing worked was a difficult environment for diversified portfolios. While this

has happened in the past, history shows that 2018 was something of an outlier.

Since both stocks and bonds suffered in this environment, we also had a very small spread in returns across asset classes. The top performing asset (cash), returned only +1.87%, while the worst (international equities) was -14.2%, a spread of just over 16%. That made 2018 only the second year in the last 40 that saw a spread of less than 20% between the best and worst performing asset classes.

Not surprisingly, a year in which nothing worked was a difficult environment for diversified portfolios. While this has happened in the past, history shows that 2018 was something of an outlier.

Goldilocks is Gone – But there’s Still Hope

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A TOUGH YEAR FOR DIVERSIFICATIONWith the Fed sounding convicted about raising rates, 2018 presented a challenging environment for fixed income

assets (bonds were flat for the year). And with investors concerned about the Fed overtightening in the latter

part of the year, risk assets fell as well. The result? A historically bad year for investors where almost nothing

worked, and what did work did not work well. Of the eight major asset classes (large cap, small cap, international

equities, core bonds, long-term bonds, commodities, REITs and cash), only cash and bonds (up just +0.01%!)

were able to eke out positive returns for the year. Most years - even in 2008 - there are more asset classes that are

able to generate positive returns.

Since both stocks and bonds suffered in this environment, we also had a very small spread in returns across

asset classes. The top performing asset (cash), returned only +1.8%, while the worst (international equities) was

-14.2%, a spread of just over 16%. That made 2018 only the second year in the last 40 that saw a spread of less

than 20% between the best and worst performing asset classes.

Since both stocks and bonds suffered in this environment, we also had a very small spread in returns across asset classes. The top performing asset (cash), returned only +1.87%, while the worst (international equities) was -14.2%, a spread of just over 16%. That made 2018 only the second year in the last 40 that saw a spread of less than 20% between the best and worst performing asset classes.

Not surprisingly, a year in which nothing worked was a difficult environment for diversified portfolios. While this has happened in the past, history shows that 2018 was something of an outlier.

Goldilocks is Gone – But there’s Still Hope

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Source: FactSet & Ned Davis Research

Source: FactSet & Ned Davis Research


GOLDILOCKS IS GONE – BUT THERE’S STILL HOPEWe as investors have been spoiled over the past few years. A combination of very accommodative central

banks, synchronized global economic growth, contained inflation, and robust corporate profits led to a period

of unprecedented low volatility during all of 2017 and much of 2018. The CBOE’s Volatility Index (VIX) barely

went above 15 during all of 2017 and moved only marginally higher during most of the first nine months of

2018. During this time, equity markets steadily advanced.

Central banks have been the leaders of this low-volatility regime. Extremely low bond yields have helped

shareholders in two ways. First, they have allowed companies to borrow very cheaply. Not surprisingly, many

companies are now carrying higher debt loads than they have historically, but with a comfortable level of

interest coverage given the drastically lower rates. Many businesses took advantage of this debt to buy back

shares, improving earnings per share numbers and consequently boosting their share prices. As a result, both

stocks and bonds have been able to generate positive returns.

A combination of very accommodative central banks, synchronized global

economic growth, contained inflation, and robust corporate profits led to a

period of unprecedented low volatility during all of 2017 and much of 2018.

We as investors have been spoiled over the past few years. A combination of very accommodative central banks, synchronized global economic growth, contained inflation, and robust profit growth led to a period of unprecedented low volatility during all of 2017 and much of 2018. The CBOE’s Volatility Index (VIX) barely went above 15 during all of 2017 and moved only marginally higher during most of the first nine months of 2018. During this time, equity markets steadily advanced.

Central banks have been the leaders of this low-volatility regime. Extremely low bond yields have helped shareholders in two ways. First, they have allowed companies to borrow very cheaply. Not surprisingly, many companies are now carrying higher debt loads than they have historically, but with a comfortable level of interest coverage given the drastically lower rates. Many businesses took advantage of this debt to buy back shares, improving earnings per share numbers and consequently boosting their share prices. As a result, both stocks and bonds have been able to generate positive returns.

Second, extremely low yields, especially zero or near-zero cash yields, lead investors to move further out on the risk curve in search of return. Commentary from central bankers that they will do “whatever it takes” (ECB President Mario Draghi in 2013) or that the “stance of monetary policy remains accommodative” (in the Fed statements following the Financial Crisis all the way until 2018) only further incentivizes risk-taking behavior. We have benefitted from this market support for years now. Even with their losses in 2018, U.S. equities have compounded at double digit rates since the market bottom in 2009.

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CBOE VIX IndexCBOE VIX Index

Source: FactSet & UBS


Second, extremely low yields, especially zero or near-zero cash yields, lead investors to move further out on

the risk curve in search of return. Commentary from central bankers that they will do “whatever it takes” (ECB

President Mario Draghi in 2013) or that the “stance of monetary policy remains accommodative” (in the Fed

statements following the Financial Crisis all the way until 2018) only further incentivizes risk-taking behavior.

We have benefitted from this market support for years now. Even with their losses in 2018, U.S. equities have

compounded at double digit rates since the market bottom in 2009.

This “Goldilocks” narrative of “just right” market conditions finally began to break down somewhat in late

2018, and not surprisingly the Fed was at the center of the gyrations. The start of elevated market volatility

can be traced back to Fed Chairman Jerome Powell’s hawkish comments in early October about the Fed

Funds Rate still being “a long way from neutral.” This led to an immediate selloff in equity markets. The Fed

subsequently backed off their guidance for four more rate hikes in 2019, but when Powell and the rest of the

Fed continued to talk about raising rates, risk assets sold off.


IT’S ALL ABOUT THE ECONOMYWhile markets have been screaming at the Fed for three months that they are being too aggressive in raising rates,

the economy has continued to grow, albeit at a slightly slower rate. A look at the data says that the real economy is

still performing well. Although the expansion is a bit slower than it was during the past few years, it is still strongly

positive at over 2% real GDP growth. A number of other “hard data” indicators remain strong. Corporate profits

continue to rise (even when you strip out the impact of tax reform). Unemployment is still below 4%, and the

economy added well over 300,000 jobs in December – hardly a softening in the labor market. The tight job market

has pushed wage growth a bit higher, putting more money into consumers’ pockets. This is reflected in still-strong

consumer confidence numbers and the robust sales retailers did during the Christmas season. The higher wages

have helped households to spend, but thus far the increase has stayed low enough not to be inflationary.

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Sources: FactSet


So, if the economic data all looks pretty good, what’s the issue? Tariffs and rhetoric around trade policy have

begun to take their toll on global growth. International trade is still growing, but at the slowest rate in several years.

Numerous corporations have cited uncertainty around trade policy as a reason for postponing capital investment.

Prices of many household items are starting to get more expensive as the impact of tariffs work their way through

supply chains. This is undoubtedly having a negative impact upon growth. Surveys of Purchasing Managers at

companies across the globe have indicated that the expansion is slowing a bit, but with most readings still north of

50 things are still growing, albeit at a slower rate.

Continued economic expansion is key for us as investors. Large and sustained equity declines (25% or more over

a period of at least a year) tend to come only in periods of recession; unfortunately, sharp drawdowns are not

uncommon during bull markets. Including the most recent market decline, we have experienced 5 corrections

of 10% or more in the last 8 years alone. Fortunately, those large declines have been very transient since the

underlying economy remained strong. As the issue causing concern for the market was addressed, equities could

resume their upward climb. While the recent pullback was a bit steeper than the past couple of corrections, they are

all in the same ballpark.

postponing capital investment. Prices of many household items are starting to get more expensive as the impact of tariffs work their way through supply chains. This is undoubtedly having a negative impact upon growth globally. Surveys of purchasing managers at companies across the globe have indicated that the expansion is slowing a bit, but with most readings still north of 50 things are still growing, albeit at a slower rate.

Continued economic expansion is key for us as investors. Large and sustained equity declines (25% or more over a period of at least a year) tend to come only in periods of recession; unfortunately sharp drawdowns are not uncommon during bull markets. Including the most recent market decline, we have experienced 5 corrections of 10% or more in the last 8 years alone. Fortunately, those large declines have been very transient since the underlying economy remained strong. As the issue causing concern for the market was addressed, equities could resume their upward climb. While the recent pullback was a bit steeper than the past couple corrections, they are all in the same ballpark.

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Purchasers Managers Index

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PMI less than 50 =

Contraction

Purchase Managers Index

Tariffs and rhetoric around trade policy have begun to take

their toll on global growth.

Source: FactSet


S&P 500 Drawdowns*

With the economy performing reasonably well, we believe the real risk comes from the Fed. Chairman Powell

has been focused for some time now on “normalizing” rates. After the debt-fueled housing bubble led to the

financial crisis in 2008, the Fed has been very cognizant of not being overly stimulative and creating a new bubble.

Compound that with the extraordinary policies following the crisis (zero interest rates for seven years and several

rounds of quantitative easing), and it is understandable that the Fed would want to try and unwind things a bit,

both to prevent the economy from overheating, and in order to provide dry powder for the next downturn.

Starting with their first rate hike in late 2015, the market has had little tolerance for the Fed’s desire to move rates

rapidly higher. Each time the Fed has attempted to tighten faster than the market believes is prudent, equities sell

off sharply, and invariably the Fed pulls back a bit. This latest cycle has been no different. As we discussed earlier,

the recent sell off began in early October on Fed Chairman Powell’s hawkish statements about raising rates. The

Fed’s unwillingness to meaningfully walk back these comments over the subsequent months only increased the

concern amongst investors that the Fed was about to make a policy error and overtighten. This was compounded

when the Fed made its decision to raise rates by 25 basis points in December. While the hike was fully expected

by the market, the Fed held firm to its intent to raise rates, indicating that they expected to do so two more times

in 2019.

*As of mid January | Source: FactSet


Such a move is about as close as markets can come to screaming at the Fed that they are making a big mistake. Equities falling further into the end of the year didn’t send a positive message either.

This appears to have finally resonated with Powell. On January 4th, he attended a round table discussion in Atlanta with former Fed Chairs Yellen and Bernanke. Yellen pointedly stated that “I don’t think that expansions just die of old age. Two things usually end them. One is financial imbalances and the other is the Fed, and usually when the Fed ends a[n] … expansion, it’s because inflation has gotten out of control and the Fed needs to tighten to bring it down.” Bernanke followed with “as Janet says, expansions don’t die of old age. I’d like to say they get murdered, instead.”

While both Bernanke and Yellen both thought that the Fed wasn’t causing a recession currently, this exchange clearly put the spotlight on Powell. During his prepared remarks, he stated that “we’re always prepared to shift the stance of policy and to shift it significantly if necessary… we will be prepared to adjust policy quickly and flexibly, and to use all of our tools to support the economy, should that be appropriate, to keep the expansion on track, to keep the labor markets strong and to keep… inflation near 2 percent.” This was exactly what the market wanted to hear. Within minutes of his appearance on stage, equities began to rally and the yield curve began to normalize. Finally the Fed’s rhetoric and the market’s expectations appear to be in line with each other. Market expectations are now for generally flat rates for all of 2019, with a slight chance of a cut in 2020.

Hikes Priced in Over the Next 12-Months

Such a move is about as close as markets can come to screaming at the Fed that they are making a big mistake.

Equities falling further into the end of the year didn’t send a positive message either.

This appears to have finally resonated with Powell. On January 4th, he attended a round table discussion in Atlanta

with former Fed Chairs Yellen and Bernanke. Yellen pointedly stated that “I don’t think that expansions just die of

old age. Two things usually end them. One is financial imbalances, and the other is the Fed, and usually when the Fed

ends a[n] … expansion, it’s because inflation has gotten out of control, and the Fed needs to tighten to bring it down.”

Bernanke followed with “as Janet says, expansions don’t die of old age. I’d like to say they get murdered, instead.”

While both Bernanke and Yellen thought that the Fed wasn’t currently causing a recession, this exchange clearly

put the spotlight on Powell. During his prepared remarks, he stated that “we’re always prepared to shift the stance

of policy and to shift it significantly if necessary… we will be prepared to adjust policy quickly and flexibly, and to use

all of our tools to support the economy, should that be appropriate, to keep the expansion on track, to keep the labor

markets strong and to keep… inflation near 2 percent.” This was exactly what the market wanted to hear. Within

minutes of his appearance on stage, equities began to rally, and the yield curve began to normalize. Finally the

Fed’s rhetoric and the market’s expectations appear to be in line with each other. Market expectations are now for

generally flat rates for all of 2019, with a slight chance of a cut in 2020.

By that point, after equities had already sold off by more than 15%, bond markets had priced in flat rates for the

year, and by early 2019 actually priced in a chance of a cut in 2019 instead! This was quite the about-face from mid-

September, when 3.6 hikes (December + 2.5 more) were priced into bond rates.

Source: Bloomberg, Bianco Research


Where Does this Leave Us?

We are unmistakably in the latter innings of this economic cycle. But, as Chairman Yellen noted above, expansions don’t die of old age. And while there is increasing evidence that growth is plateauing, we can still enjoy a period of steady expansion during this part of the cycle. Inflation and wage growth remain contained, consumer confidence is high, unemployment low, and earnings are still growing – barring some sort of exogenous event, usually these indicators take some time to begin rolling over before a recession begins. And, as shown in the chart above, bond markets also usually start pricing in Fed rate cuts in advance of equity market tops.

Households are the “swing voter” when it comes to the economy – with near full employment they have been the engine driving growth. With over 70% of our GDP now coming from services, we need individuals to remain confident and, most importantly, spending. Shrinking 401(k) balances and negative news about world trade, an inverted yield curve, etc. could erode that conviction. We will be watching consumer confidence, and other fundamental indicators, very closely in coming months. Even if we should see economic data erode, we would argue that the recent declines have led some bad news to be priced into equities.

This has us reluctant to get our portfolios too conservative at this point. We as investors want risky assets in our portfolios when we have a reasonable expectation of getting paid for taking that risk. While the Goldilocks period may be coming to a close, there are still opportunities available. As long as the Fed

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This has us reluctant to get our portfolios too conservative at this point. We as investors want risky assets in our

portfolios when we have a reasonable expectation of getting paid for taking that risk. While the Goldilocks period

may be coming to a close, there are still opportunities available. As long as the Fed does not attempt to force

additional rate hikes upon an unwilling market, we believe that this remains an environment in which stocks can do

well. Non-U.S. equities remain attractively valued. And even though 2018 was a historically bad year for diversified

portfolios, that diversification is what should help us to mitigate potential losses when the inevitable downturn

finally comes.

WHERE DOES THIS LEAVE US?We are unmistakably in the latter innings of this economic cycle. But, as Chairman Yellen noted above, expansions

don’t die of old age. And while there is increasing evidence that growth is plateauing, we can still enjoy a period of

steady expansion during this part of the cycle. Inflation and wage growth remain contained, consumer confidence

is high, unemployment low, and earnings are still growing – barring some sort of exogenous event. Usually, these

indicators take some time to begin rolling over before a recession begins. And, as shown in the chart on the

previous page, bond markets also usually start pricing in Fed rate cuts in advance of equity market tops.

Households are the “swing voter” when it comes to the economy – with near full employment they have been

the engine driving growth. With over 70% of our GDP now coming from services, we need individuals to remain

confident and, most importantly, spending. Shrinking 401(k) balances and negative news about world trade,

an inverted yield curve, etc. could erode that conviction. We will be watching consumer confidence and other

fundamental indicators very closely in coming months. Even if we should see economic data erode, we would argue

that the recent declines have led some bad news to be priced into equities. PE Ratios have come down across the

board – Emerging Markets are now cheaper than they have been since 2014.

Source: FactSet


INVESTMENT TEAMWILLIAM T. SPITZ, CFA FOUNDER AND DIRECTOR

R. SAMUEL FRAUNDORF, CFA, CPA CHIEF INVESTMENT OFFICER

JASON P. LIOON, CFA DEPUTY CHIEF INVESTMENT OFFICER

JEFFREY S. BUCK, CFA PRINCIPAL

SELDEN S. FRISBEE, II PRINCIPAL

F. KNEELAND GAMMILL, CFA PRINCIPAL

THOMAS H. HUSSEY PRINCIPAL

CAROL B. WOMACK PRINCIPAL

JAMES S. GILLILAND, JR. SENIOR VICE PRESIDENT

MAX H. ROWLAND VICE PRESIDENT

JASON R. WHEAT, CFA VICE PRESIDENT

ALEX ELDER, PhD ANALYST

Important notes and dIsclosures

This Quarterly Summary is being made available for educational purposes only, and should

not be used for any other purpose. Certain information contained herein concerning

economic trends and performance is based on or derived from information provided by

independent third-party sources. Diversified Trust Company, Inc. believes that the sources

from which such information has been obtained are reliable; however, it cannot guarantee

the accuracy of such information and has not independently verified the accuracy or

completeness of such information or the assumptions on which such information is based.

Opinions expressed in these materials are current only as of the date appearing herein and

are subject to change without notice. The information herein is presented for illustration

and discussion purposes only and is not intended to be, nor should it be construed as,

investment advice or an offer to sell, or a solicitation of an offer to buy securities or any type

of description. Nothing in these materials is intended to be tax or legal advice, and clients are

urged to consult with their own legal advisors in this regard.


ATLANTA

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Phone: 770.226.5333

■

GREENSBORO

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Phone: 336.217.0151

■

MEMPHIS

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Phone: 901.761.7979

■

NASHVILLE

3102 West End Avenue, Suite 600 Nashville, TN 37203

Phone: 615.386.7302

DIVERSIFIEDTRUST.COM

fourth quarter summary 2018 - diversifiedtrust.com

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