2018 was a challenging year for markets, marked by four Fed rate hikes in the U.S. and a host of geopolitical issues which raised fears around the end of the economic expansion. Volatility aggressively came back after being fairly suppressed in 2017, due to escalating U.S.-China trade tensions, Brexit negotiations (or lack thereof), an Italian budget stalemate, and potential default issues in Turkey and Argentina, among other contributors. Globally, reduced market liquidity raised investor fears, as central banks tightened to normalize rates from extremely low levels. Oil prices swung widely in both directions, before finishing in negative territory for the year. The year closed with a U.S. government shutdown due to a stalemate over border-wall funding.
However, it wasn’t all bad news. Inflation remained benign, the labor market tight, credit generally good, business and consumer confidence high, and corporate earnings solid. The volatility in 2018 helped reset equity valuations and might just be what the markets needed to recalibrate and help extend the current economic cycle. All in, the macro backdrop remains positive and provides a good setup going into 2019.
Equities were challenged
U.S. equities posted their first negative annual return since 2008, with the S&P 500 ending the year down 4%. Global equities fared worse with the MSCI ACWI falling 9% in 2018. Emerging markets reversed course from strong 2017 gains and reported an annual loss of 15%, pressured by escalating geopolitical issues, a rising dollar, Chinese growth fears and trade conflicts, and higher U.S. interest rates.
Volatility came back
Volatility escalated in 2018, with the average annual VIX level climbing from 11.1x in 2017 to 16.6x in 2018, as markets were no longer able to shrug off the mounting uncertainty from higher rates, global political instability, U.S.-China trade tensions, a slowing global economy, and worries about enriched valuations.
10-year Treasury rallied
The 10-year U.S. Treasury yield ended the year up 28 basis points. After peaking at 3.23% in early November, the 10-year Treasury yield settled at 2.68% by year-end, due to the strong risk-off sentiment which prompted a year-end rally in U.S. Treasuries.
Oil prices slid
Crude oil prices traded in both bear and bull market territories during the year. After a relatively stable rise to $76 per barrel (up 30% from the start of the year), WTI crude oil sold off sharply and ultimately ended the year down 25%, as sentiment shifted from concerns of a supply shortfall to fears of a demand slowdown.
Source: Morningstar Direct, Bloomberg as of 12/31/18. U.S. equities represented by S&P 500 Index, emerging market equities represented by MSCI Emerging Markets Index, global equities represented by MSCI All Country World Index, and oil prices represented by WTI crude oil.
What can investors expect in the year ahead?
While the global economy is still relatively healthy, it is currently being led by the U.S., which is expected to slow towards trend in 2019. However, strong U.S. consumer and business spending may put a floor under slowing growth and help curtail odds of a U.S. recession in 2019. Still investors should brace themselves for a more turbulent ride, as continued geopolitical issues, slowing economic growth, and monetary and fiscal policy uncertainty pressure markets.
1. Narrowing of global divergence
In contrast to 2017’s global synchronized growth and upside surprise, 2018 saw global divergence and downside surprise. This divergence was characterized by strength in the U.S. and weakness in the rest of the world. In 2019, U.S. economic growth is expected to moderate closer to potential, as the boost provided by fiscal stimulus in 2018 begins to fade.
2. Fed remains a wild card
After raising rates four times in 2018, and nine times since the normalization path began in December 2015, the Fed funds target rate range stands between 2.25%-2.5%. Given the slightly more dovish tone the Fed has taken recently, the Fed is now expected to raise rates twice in 2019 (down from previous estimates of three) and once in 2020, which would put the peak rate for the cycle at 3.1% versus 3.4%. With inflation at the Fed’s target level, the Fed has more incentive to pause its tightening, and market watchers are eagerly waiting to see if it will. Other downside risks at this point include the autopilot roll-off of the Fed’s balance sheet, which may need to be revisited at some point in the upcoming year.
3. More bumps in the equity road
After muted volatility in 2017, equity markets saw an ample amount in 2018, which challenged global equity markets, especially later in the year amid rising geopolitical issues and higher rates. Investors will likely see more volatility in 2019, due to continued geopolitical uncertainty, higher rates, and slower economic growth. On a positive note, markets repriced significantly in 2018, providing a better valuation starting point. Given expectations for healthy corporate earnings growth (albeit much lower than 2018’s standout rates due to the waning impact of U.S. tax cuts), U.S. equities could record gains in the low- to mid-single digits.
4. Pockets of opportunities in secular growth assets
While most asset classes have some sensitivity to the economic cycle, pockets of opportunity can be found in less cyclically sensitive areas. For instance, while most of the financial services sector is cyclical in nature, select secular growth opportunities can be found in the electronic and mobile payments space. Many disruptive payments companies offer long runways of organic growth, a unique value proposition to both consumers and businesses, and fundamentals and growth profiles that are better insulated against the economic cycle. Health care is another area that is often viewed favorably at this point in the economic cycle, given that its organic growth and revenue are more dependent on innovation cycles in the space versus the economic cycle. Selectivity and caution will be crucial when seeking out secular growth opportunities.
2018 offered few places for investors to hide with most asset classes posting losses for the year, and late-cycle risk factors are expected to rise in 2019. Given the current landscape, conditions could get worse before they get better. For U.S.-based investors, cash will look increasingly attractive in this environment. But things could get better as the year rolls on, and investors should watch for inflection points that could turn things more bullish. The key signposts would include a pause in the Fed’s tightening cycle, a weakening of the U.S. dollar, more decisive stimulus from China, signs of a bottom in global growth, and evidence that earnings growth is hanging tough.
Data Sources: Morningstar Direct, Bloomberg as of 12/31/18.
The MSCI All Country World Index is a market capitalization-weighted index designed to provide a broad measure of equity market performance throughout the world. The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices in 23 emerging economies and is designed to measure equity market performance in global emerging markets. The S&P 500 Index is a market-weighted index of 500 of the largest U.S. stocks in a variety of industry sectors. The VIX is a measure of the implied volatility of S&P 500 Index options. Often referred to as a fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30-day period. West Texas Intermediate (WTI) crude oil, also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. An investment cannot be made directly in an index. Past performance is no guarantee of future results.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice.
Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
1015665-00001-00 Ed. 01/2019