January 2019 Market Commentary

The S&P 500 enjoyed its best January performance in 30-years, driven by a number of policy announcements and economic news including (1) the Fed’s signaling that their tightening cycle is near an end; (2) increasing hope that a satisfactory agreement between the U.S. and China regarding trade policy can be reached before March; and (3) stronger than expected job creation and wage growth. While the S&P 500 suffered its largest monthly loss since 2009 in December, the index actually began rallying the day after Christmas and is now up more than 15% since its December lows. U.S. Treasury yields fell during the month on expectations of slower inflation and reassessment of the Fed’s future interest rate policy, helping bonds finish the month higher.

The following table contains a summary of January and year-to-date market performance:

Index January YTD Index January YTD
S&P 500 (Total Return) +8.01% +8.01% All Country World Index (Net) +7.90% +7.90%
MSCI EAFE (Net) +6.57% +6.57% Barclays Aggregate +1.06% +1.06%
MSCI Emerging Markets (Net) +8.77% +8.77% 60/40 Blend* +5.16% +5.16%

* 60% All Country World Index/40% Barclays Aggregate

Statements by the Fed throughout January contributed significantly to the market’s change in sentiment and subsequent equity market rally. On January 4th, the Fed Chairman Powell stated that the Fed will be “patient” as the economy evolves. Powell noted that the market has been focused on risks that are “well ahead of the data,” but that the Fed is listening carefully to the market’s concerns and is prepared to be flexible with policy. He also added that the Fed will be ready to readjust their balance sheet policy as economic circumstances require. The S&P 500 rallied over 3% that day. On January 29th, the Fed made a number of statements the market took to be dovish. The Fed downgraded their economic assessment, noting that market-based measures of inflation had moved lower. They also removed the “roughly balanced” description of risks from its outlook, and scrapped guidance for “further gradual increases.” And finally, the Fed not only reiterated an earlier statement about balance sheet flexibility, but went a step further and indicated that they would end quantitative tightening with a bigger balance sheet.

Equity markets took the Fed’s guidance as a sign that the central bank would not undertake policies that might catalyze a recession, allowing the economic cycle to continue its upward aim at becoming the longest expansion in history (July ’19). Bond markets treated the Fed’s actions differently. Slower growth and lower expected inflation both raise the attractiveness of Treasury bonds, driving their prices higher and yields lower. The 10-year U.S. Treasury bond yield fell to 2.6%, down from 3.2% the beginning of November.

On trade policy, a number of statements by the Trump administration over the month raised investor
sentiment that an agreement would be reached before the March 1 deadline that would result in 25% tariffs.
In the middle of the month it was reported that Treasury Secretary Mnuchin had discussed lowering tariffs as
an olive branch and in response to a report that China offered to increase agricultural and energy imports
from the U.S. over the next 6-years to close the trade cap. The S&P 500 rallied 1.3% that day. As the month
wore on, the administration backed away from those reports and emphasized instead the need for regular
reviews of Chinese compliance in meeting import targets. January ended with stories of high-level talks with
senior Chinese negotiators here in the U.S., including (1) Chinese proposals for structural reforms providing
protection of intellectual property and investment access, and (2) the expectation that President Trump and
Chinese President Xi would meet personally in February before the March 1 deadline. The S&P 500 closed
nearly 1.5% higher on the news.

Economic news was mixed with investor concerns over falling manufacturing and weakening consumer
sentiment alleviated by strong jobs and wage reports. January opened with the news that the December ISM
Manufacturing index fell from 59 to 54, its biggest fall since 2008 on declining export orders. As for
consumers, the “current conditions” component of the Consumer Confidence Index was largely unchanged
in January but the “expectations” component fell sharply as respondents reacted negatively to the fourth
quarter market sell-off and government shutdown. Whatever concerns those reports raised, however, were
overshadowed by the December and January job creation and wage growth announcements. January began
with the announcement that employers had created 312,000 jobs in December versus expectations of
180,000. That was followed up with the end of January announcement that 304,000 jobs were created in the
month. What’s more, strong job growth is fueling a positive trend in wages (+3.2% year-over-year), outpacing
inflation (+1.8%) over the same period.

On the earnings front, as the fourth quarter results roll in (~50% reported), the S&P 500 is on pace for yet
another double-digit growth rate (~12%), beating consensus expectations to boot. While the results are much
weaker than the +20% earnings growth experienced in the first three quarters of 2018, stock prices are rallying
more than earlier this year on positive results. One explanation is that the volatile Q4 sell-off lowered
expectations too much versus the strength of fundamentals. Expected 2019 earnings growth has fallen from
12% back in September to just under 8% today.

The rally in equity prices was not limited to the U.S. Emerging market equities were the best performing asset
class for the month while non-U.S. developed markets also produced strong performance. Emerging market
equities were driven higher by many of the same factors as U.S. equities: the apparent end of the Fed’s
tightening cycle as well as improved sentiment over the expected outcome of trade negotiations. The Fed’s
announcement signaled to investors a likely end (or at least a pause) to the dollar’s appreciation which has
been a drag on emerging market performance. Economic data from the EU continues to weaken, largely due
to softening exports over uncertainty about the outcome of Brexit, U.S-China and U.S.–EU auto and steel trade
negotiations. Despite economic weakness and policy uncertainty, non-U.S. developed market equities rallied in January. Prices surged over ECB policy statements supportive of growth, and rising confidence that
successful solutions to policy conflicts will support a growth tailwind.

Caprock continues to believe the U.S. and Chinese policy makers will reach an agreement that reduces the
risk of a global slowdown; the costs of not doing so are too high. Any evidence that a growth-sustaining
solution is unlikely would lead Caprock to recommend a tactical rebalance that reduces exposure to risk
assets (such as global equities) sooner than would otherwise be the case at this stage of the market cycle.
However, a successful resolution to policy risks combined with continued economic momentum could propel
equity markets higher from current levels.

Regardless of the outcome, the upside opportunity relative to the downside risk is becoming increasingly less
attractive and markets are becoming more volatile. Historically in this kind of environment, regularly
rebalancing to target weights has proved to be a capital preserving strategy by selling into rising markets and
adding to positions after prices have fallen. As a result, Caprock continues to believe rebalancing to target
allocations remains a smart discipline at this stage of the market cycle.

This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but Caprock makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.