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Expert Perspective

News, research and market insights from our team of experts.

Investment e.Perspective

Current Issue | January 07, 2019

2018 Market Review: Taking the Punch Bowl Away

By: Marcos Nogués, Chief Investment Officer & Oxford Investment Fellow


A combination of deteriorating news flow and a shift in economic policy contributed to an environment of rising volatility in 2018. In February, global equity markets suffered a price correction which proved to be the “shot over the bow” that presaged a spike in volatility late in the year.

Cash was the only place to hide as nearly all major market index returns were negative in 2018. Energy and financial sectors led US equities lower. Emerging markets equities held up relatively well during a tumultuous Q4, but declined nearly 15% during the year as a strong US dollar continued to be a headwind. Rising interest rates led to modest declines in most US bond markets, while a collapse in oil prices introduced renewed weakness within resource equities. Wild stock market gyrations in the last few weeks of 2018 left investors wondering, what caused this change in market dynamics?

Headline Risks
To be sure, there was no shortage of fear-inducing headlines during the year. The Mueller investigation into Russian election interference proceeded with relentless determination. Global trade tensions and nationalist policies advanced in the US and abroad. Tariffs imposed among major trading partners began to take a bite out of global economic activity. Concerns about intellectual property theft and currency manipulation created a growing rift with China. The announced US military withdrawal from Syria was welcomed by Russia even as a renewed threat of nuclear proliferation has heightened tensions with our old Cold War rival. To top it off, partisan bickering in Congress couldn’t avoid a partial government shutdown during the holidays, which continues today.

Although this dizzying news-flow may have affected sentiment on the margin, the real story affecting markets in 2018 was about tightening financial conditions.

Full Capacity
A strong economy has led the Federal Reserve to tap the breaks on accommodative monetary policy, causing yields to rise and financial conditions to tighten. The output gap has closed and the US economy is running at (or beyond) full capacity with an unemployment rate at multi-decade lows. In response, the Federal Open Market Committee (FOMC) raised the Fed Funds rate four times in 2018 and allowed its balance sheet to decline by $420 billion through bond maturity run-off. This interest rate normalization process has been a contributing factor to recent volatility for a market used to the extraordinary monetary policy enacted following the Great Recession.

Liquidity has also been declining abroad. The European Central Bank has signaled a shift in strategy by ending their quantitative easing program and possibly raising rates in late 2019. In addition, European policy is clouded by stress in the Italian financial system and complications in Brexit negotiations. Financial conditions in the emerging markets have also been tighter as a result of rising global yields, especially in countries with large amounts of foreign currency debt.

Tighter liquidity conditions, which reverberated through the financial system in the form of lower bond prices, also took a toll on equity valuations. The trailing 12-month price-earnings ratio for the S&P 500 declined by more than 20% to 17x in 2018.

Outlook
During volatile times, it is important to keep a cool head and focus on long-term fundamentals. When we invest in stocks, we are buying their stream of future earnings. Of course the valuation at which we buy and eventually sell the earnings stream (the P/E ratio) matters a great deal, but more important for long term investors is the growth of those earnings during the period the stocks are held. And this is where we find some comfort.

The US economy is performing well and the probability of a recession in 2019 remains reasonably low. The unemployment rate is at the lowest level in 48 years and wages are rising just over 3% with core inflation around 2%. This should bode well for consumption, which represents more than two thirds of economic growth. In addition, the corporate sector remains healthy. Earnings growth will likely reach an impressive 20% year-over-year in Q4 and is likely to grow further in 2019, albeit at a slower pace. The Tax and Jobs Act of 2017 will continue to have a positive impact on capital investment, which in turn should grow our capital stock and boost productivity.

Looking abroad, emerging market equities (MSCI EM) trade at a meaningful valuation discount to US and international developed markets, as measured by trailing 12-month price-earnings ratios in the chart below. While valuations are not particularly useful as market timing tools, we believe this discount adequately compensates long-term investors that can look past current challenges and negative sentiment.

Source: Morningstar

If there is a silver lining from 2018, expected future returns are now higher than they were at the end of 2017. Higher yields increase returns for bond investors. Money market funds finally pay interest again. Equity market valuations offer a more attractive entry point. We also continue to utilize Niche Growth Strategies as a complement to traditional markets to potentially enhance risk-adjusted portfolio returns.

With the Presidential Twitter account fully active, a split Congress and other countries jockeying for position on the global stage, there is no doubt headline risk will continue in 2019. Smart investors should avoid overreacting to the noise and focus on the underlying economic factors. On this front, the data still suggests continued growth if only at a slower pace.

The above commentary represents the opinions of the author as of 1.7.19 and are subject to change at any time due to market or economic conditions or other factors.