The fourth quarter of 2018 saw U.S. equities decline materially, with especially steep falls in December. During the fourth quarter the equity market as measured by the S&P 500 generated a total return of -13.5%, bringing full year S&P returns to -4.4%. While disappointing, these results need to be seen in the context of a broader and much more severe downturn in global equity markets. Developed international markets finished the year down more than 13% while emerging markets were down almost 15% for the year. Fixed income markets were also challenged by rising rates and widening credit concerns. Against this backdrop of uncertainty, as we would expect, U.S. Treasuries provided an offset and produced positive returns due to a strong rally in December.

The fourth quarter was characterized by significant volatility, reflecting a fierce debate about the economic growth rate and what the correct multiple should be for that growth. Anticipating these concerns, we focused our portfolio over the past year on higher quality companies and reduced our exposure to cyclicals and companies with more levered balance sheets, thereby positioning the portfolio to better handle volatile markets.

Nine years into a bull market, it is not surprising to see the market undergo a correction. While unnerving, corrections result in a more favorable repricing of equities, and, as long as fundamentals do not meaningfully deteriorate, provide the opportunity to add to existing positions or initiate new positions at lower prices. During the fourth quarter, investors clearly focused on potential negatives and began to price in the possibility of recession. The narrative focused first on the Trump administration’s recent trade threats, particularly against China, which have had a tangible, negative impact on their economy and have hurt sentiment here. Recent global economic data have also shown weakness, with slowing growth in China and Europe—including the bellwether German economy.

Adding potency to this argument, the yield curve inverted briefly late in the fourth quarter. Yield curve inversion has typically been regarded as a precursor of recessions, even those that ultimately failed to materialize. Said another way, inverted yield curves have predicted “seven out of the last five recessions”. In the current case, we think the yield curve is indicating unease with the recent rate hike in the face of slower growth rather than a recession or actual economic contraction in the near term.

We believe that the global economy has experienced a synchronized slowing of growth that is likely to continue for the foreseeable future. This is supported by many positive indicators that reflect economic strength: unemployment of 3.9% continues to improve even as the labor participation rate expands; wages are growing at 3.2% versus last year; inflation is coming in under 2%; and GDP continues to grow at 3.4%. These data lead many market participants to believe the expansion will continue through at least 2019 and 2020. Moreover, interest rates are still low from a historical standpoint and the benefits of tax cuts and a business-friendly regulatory environment should continue to benefit domestic equities.

Since this debate about growth versus contraction is not entirely new, what exactly prompted markets to sell off in the quarter? Two issues seem to have sparked recent volatility: the continued escalation and uncertainty around the U.S./China trade dispute and actions by the Federal Reserve (the Fed), specifically rate hikes based on continued stability and economic data.

First, threats by the Trump administration to impose trade sanctions and tariffs on China have erupted into a full-blown trade war. The U.S. has imposed tariffs on $250 billion in Chinese goods and has threatened tariffs on substantially more. China has responded with tariffs on $110 billion of U.S. goods. Negotiations continue, but the outcome remains uncertain. Trade wars do two things: raise costs to the importing nation and create uncertainty. Inflation has been very tame for most of the recovery here, and we are monitoring for signs of increased inflation. Uncertainty can lead businesses to defer investments as management teams contemplate a more uncertain world with potential new tariffs and changing consumer behavior. As the trade war escalated, the markets began to factor in its potential impact on corporate profits and hence stock prices. Stay tuned.