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Thomas R. Kiley
Chief Executive Officer
Great Lakes Advisors

U.S. equities suffered through a very poor fourth quarter, despite a good underlying economy and continued strong profitability. The broader market, represented by the S&P 500, dropped 13.5% in the quarter, resulting in a loss of 4.4% for the full year. The S&P lost more than 9% in December alone—its biggest monthly loss since February 2009.

Global markets, which had been weak most of the year, continued their slide. Emerging market indices were down 9% in the quarter and closed 17% lower for the year. International equities (ex-U.S.) fell more than 12% in the quarter and almost 17% for all of 2018. Brazil was the best performing market in 2018, recovering strongly at year-end after the election of Social Liberal Party leader Jair Bolsonaro. At the other end of the spectrum, continued tumult in Turkey drove that market down more than 40%. Europe was particularly weak, declining almost 20%, with European banks down almost 30%. Recall that just one year ago most global equity indices were at, or near, all-time high levels.

Crude oil prices plummeted 37% in the fourth quarter, closing at $45.81, about 20% lower than the prior year. Despite many opinions to the contrary, OPEC and U.S. shale producers were more than capable of making up for dwindling supplies coming out of Venezuela and Iraq. Slower global growth, with a focus on the Chinese economy, also pushed prices lower. Energy stocks in the U.S. fell more than 18% in the year.

The yield on the 10-year U.S. Treasury Note, which touched 3.25% in early November, closed the year at 2.68%, up 35 basis points from the prior year’s close. The Federal Reserve surprised no one with its deliberate increases in the Federal Funds Rate in 2018, but faces intense scrutiny in 2019 with many questioning whether it will continue to raise short-term rates despite growing concerns of economic weakness.

Market Outlook
The ferocity with which global equity markets declined in the fourth quarter, and in particular in December, is only explained clearly with hindsight. It should come as no surprise that very few equity investors foresaw such a volatile and violent downturn. After all, at least on the surface, economic conditions, at least in the U.S., look rather benign.

Start with the basic building blocks. Interest rates remain historically low, and the U.S. economy is in rather healthy shape. GDP grew at more than 3% in the first nine months of the year, and is expected to have grown somewhere between 2.5% and 3% in the fourth quarter. Inflation appears to be well under control, though some manufacturers report modest inflationary pressures in input prices. Lastly, employment is also quite healthy, with joblessness below 4%, wages finally growing a bit better than the 2%-2.5% rate of the last several years, and many companies finding it difficult to fill certain skilled positions. In fact, on January 4th, the Labor Department reported a very strong nonfarm payroll number for December; perhaps more important, average hourly earnings rose 3.2% over last year.

However, there has been an undercurrent brewing for the last several months, and a deeper dive exposes storm clouds that have gathered on the horizon. Global economies showed signs of weakening throughout much of 2018, most notably in China. Despite the strong December payroll report, a widely-followed report published in early January from the Institute for Supply Management (ISM) suggested manufacturing orders fell precipitously in December, with the index showing its largest one-month decline in the last ten years. Further analysis suggests recent strength in GDP may have been businesses building inventories in front of expected tariff increases, a one-time impact that does not portend future growth. The “sugar high” the U.S. economy enjoyed as a result of the Trump tax cut has about run its course, having had only a minor effect on capital investment. The looming threat of a “trade war” with China and potentially other U.S. trading partners has hung over investors’ heads for the last several months and caused their economies to slow. Increasingly, both fixed income and equity investors are concerned with the impact of the U.S. Treasury coming to market in 2019 to fund government deficits that will approach or exceed $1 trillion.

The mid-term elections held few surprises, but investors collectively wonder what the Democratic resurgence will mean—both in terms of policy, and in terms of the Presidency. We seem to have withstood the known unknowns of the Trump Presidency, but fret over the political unknowns which lie ahead.

To this political uncertainty, we add the usual rate hiking cycle of the Federal Reserve Board late in an economic expansion. All cycles are unique, and the Fed typically does not execute perfectly in attempting to allow a moderate expansion with little price pressure. This cycle is unique in at least two ways: The Fed is raising rates from a very low level, and it has embarked on the hikes with little sign of above-target inflation.

Washington, D.C. is right in the bullseye if we are looking for the cause of the withering confidence, lack of visibility, and increased volatility. As a result we find ourselves in an interesting position. We have a lot of confidence in the U.S. economy, and its ability to quickly adapt to changing circumstances. As we have said in the past, we are not “market timers” nor macroeconomic forecasters, and we do not have a specific economic forecast for 2019. The recent market sell-off has provided opportunities to buy very good businesses at more attractive prices, including many that we already own. While our short-term results have been unsatisfying, we believe the longer-term value inherent in our holdings is better than it has been in some time. Hopefully our political leaders will work to restore stability in the U.S. and around the world, which would be a positive development for global economic growth.



This commentary is provided courtesy of our affiliate, Great Lakes Advisors. This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. No mention of particular securities should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities.