2018 Year-End Market Commentary and 2019 Market Outlook
Benjamin Lavine, CFA, CAIA
Data Source: Bloomberg
- The fourth quarter started poorly with ‘risk-off’ positioning across global markets. Global equities dropped following negative headlines surrounding Federal Reserve tightening, China slowdown, and ongoing trade disputes between the U.S. and China.
- The prospect of more trade tariffs (and perhaps general political uncertainty), as well as tighter financial conditions brought on by higher interest rates (at the start of the quarter) and widening credit spreads seem to drive a pull-back in appetite for future capital spending.
- The MSCI All-Country World Index (ACWI) dropped 12.8% for the quarter. The U.S. (S&P 500) and Japan (MSCI Japan) equity markets led the markets lower, returning -13.5% and -14.2%, respectively, while MSCI Europe was down 12.7%.
- MSCI Emerging Markets outperformed developed markets, returning -7.5% despite concerns over a worsening global economic environment and tightening financial conditions.
- In December, what started as a lingering concern over the impact from U.S./China trade disputes accelerated into a larger concern over Federal Reserve tightening and its impact on global economies. Cyclical risk assets sold off as investors sought safe havens such as low volatility sectors (utilities, telecom, real estate), U.S. Treasuries, and precious metals.
- U.S. small caps underperformed large caps for the quarter. The S&P 600 Index dropped 20.1% for the quarter versus -13.5% for the S&P 500. S&P Pure Value and Growth were in line with each other dropping 16.6% and 16.9%, respectively.
- Among risk factors, defensive, interest-rate sensitive factors such as MSCI U.S. Minimum Volatility and High Dividend outperformed Value, Quality, and Momentum.
- The drop in U.S. Treasury Yields contributed to a strong quarter for the Bloomberg Barclays U.S. Aggregate Bond Index, which returned 1.6%. Suffering from widening credit spreads, U.S. High Yield dropped 4.5% for the quarter.
- The health of the U.S. credit markets deteriorated due to concerns over Fed interest rate policies and high-profile downgrades/bankruptcies (i.e. credit rating downgrade of GE and Sears bankruptcy).
- Rather than responding positively to dovish Fed comments following the December meeting and a possible détente in the U.S. / China trade conflict, credit markets appear to be pricing in a more adverse economic backdrop for risk assets.
- The commodity complex suffered as oil prices plunged from $76/barrel (early October) to the mid-$40/barrel range. Some commentators attributed the sharp sell-off in oil prices to technical selling pressures from hedge funds, but the sell-off in oil was not entirely due to technical reasons as global supply (North American shale production, easing of Iran sanctions) had finally caught up with demand.
Year-to-Date 2018 Highlights:
- After starting off strong in January, global equity markets failed to keep up their strong 2017 performance; MSCI ACWI dropped 9.4% in 2018.
- International diversification did not pay off in 2018 as the U.S. market (S&P 500) led all major regional indices, having only dropped 4.4% versus -12.9% for MSCI Japan, -14.6% for MSCI Emerging Markets, and -14.9% for MSCI Europe.
- Within U.S. equities, small caps and value undperformed large caps and growth respectively. S&P 600 Index dropped 8.5% vs. -4.4% for the S&P 500; and S&P Pure Value returned -12.0% vs -4.2% for Pure Growth.
- Interest rate-sensitive and defensive growth sectors such as health care, utilities, and consumer discretionary led major U.S. sectors while economically-sensitive cyclical sectors such as industrials, materials, and energy lagged.
- After a rocky start, U.S. Fixed Income (Bloomberg Barclays U.S. Aggregate Bond Index) finished the year flat, while U.S. High Yield dropped 2.1% after having led all major fixed income segments throughout most of the year.
- Through the third quarter, the S&P GSCI Commodities Index was up 15% but then plunged in the fourth quarter, wrapping up 2018 with a -13.8% return. Precious metals ended the year with a -3.6% return.
- As we exit 2018, one thing is clear: there is a disconnect between the angst signaled by the financial markets versus positive U.S. economic data and the Fed’s economic outlook for 2019.
- The path for U.S. earnings growth looks less certain and less certainty typically results in a higher risk premium demanded by investors. Hence, we would expect U.S. stocks to track earnings growth but would not expect a higher valuation paid for that earnings growth.
- Growth momentum stocks (i.e. the FAANGs) may continue to enjoy premium valuations in an environment of scarce growth, but overall valuations for equity and fixed income credit risk are more attractive following the steep 4Q2018 sell-off.
- The risk regime that characterized low market volatility and complacency throughout 2017 and early 2018 shifted to one of greater uncertainty; and expectations of more turbulence ahead as the market waits on bated breath as to whether this extended cycle will fall into recession.
- Going forward, market pricing may push risk premiums into extreme complacency or fear over the short-run, but current market prices reflect a more balanced view of risk and reward.
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By: Benjamin Lavine