In 2018, the markets reminded us once again how random and unpredictable one year can be. Whereas we sailed through 2017 with not a single day where the markets fluctuated more than 2%, 2018 was an entirely different story. Despite an outlook that was relatively positive coming into the new year, with the U.S. economy on solid footing and corporate profits still growing, a number of issues arose that created a disconnect between the performance of the real economy and the financial markets.
As a result, volatility in the equity markets spiked to levels we have not seen in years, with U.S. equity markets as measured by the S&P 500 declining 4% for the year. It seems like a distant memory that the S&P 500 was up double-digits as late as September, only to sell off dramatically in the final months of the year. Markets outside the U.S. performed much worse, with equities as measured by the MSCI World Index declining 14% for the year. Some of the bigger issues concerning investors were the following:
Trade tensions this year escalate
Protectionism resulted in a rise in trade tensions between the U.S. and several major trading partners. With the re-write of NAFTA in 2018, tensions between the U.S., Mexico and Canada abated.
However, trade tensions with China escalated throughout the year as the U.S. sought better agreements on fair trade, market access and intellectual property rights. This ongoing conflict and lack of clarity around the issue weighed on the markets as investors tried to figure out how this might affect global growth and corporate profits going forward. A further escalation of tensions will likely be a drag on global growth.
The Federal Reserve raised interest rates four times in 2018 while signaling two more hikes in 2019. To many investors, the rate hikes seem unjustified and too much to take in the face of expectations of slowing global growth and lackluster inflationary pressures. Higher interest rates have the effect of crimping corporate profits and also put pressure on stock market multiples. Concerns about the cost of servicing rising corporate debt began to surface as well.
Changes in government cause concerns
With Democrats winning control of the House of Representatives after the mid-term elections, we now have a divided Congress. This has caused concern about gridlock, with the current government shutdown evidence of such concerns. Should the relationship between the Senate and the House — as well as the relationship between Democratic leadership and the White House — become more adversarial; this could threaten the markets and increase volatility.
Worldwide, we saw the wave of populism and protectionism impacting economies and the markets outside the U.S. To point, the tense negotiations between the UK and the EU over Brexit created uncertainty and volatility, and put downward pressure on the European markets in 2018.
Will we see a recession this upcoming year?
As we look ahead to 2019, here are the main themes we see emerging: The U.S. economy maintained solid momentum over the past year, benefiting from the tailwinds of tax cuts, strong employment and strong consumer confidence. However, the country’s economy is expected to cool off in 2019. Some are calling for recession as early as this year, and many are saying it will be 2020. What we do know is that predicting recessions is difficult business, so we will go with the idea that recession will eventually come, but current economic data supports the theme that the economy may be down but not out in the coming year. This should provide some support for the financial markets.
We expect equity market volatility will be with us for the foreseeable future and return to more historic levels. We believe this will be the case as equity prices re-adjust in the face of uncertainty surrounding Fed policy, political events and slowing global growth. The recent bout of volatility has felt very uncomfortable, but in reality it is closer to normal when we look at the market from a longer-term perspective. The chart to the right reminds us that market dips and volatility are more the norm compared to the market tranquility we have experienced in the years leading up to 2018. History has shown that back-to-back down years for the stock market are not very common, so a rebound is likely if you believe in history, particularly if we see a more dovish stance from the Federal Reserve. In terms of valuations, U.S. equities are now less richly priced and are trading at multiples closer to historical averages after the recent market pullback.
We do agree that U.S. equities look more attractive now based on current valuations; however, we believe caution is warranted. Current valuations may still be too high for what the markets can deliver in the years ahead, especially if earnings decelerate from their current pace and margins tighten from current cyclical peaks.
Global and portfolio diversifications are key factors
The dispersion between U.S. and global equity returns is likely to narrow as profit growth in the U.S. slows. Emerging markets did poorly in 2018 primarily due to rising rates in the U.S., a stronger dollar and trade war concerns. Should these forces reverse course, we could see an improvement in these markets. Global diversification will be a key factor going forward as we now see many non-U.S. developed and emerging market assets trading at valuations less lofty than what we find in the U.S.
Taking the longer view, we expect market returns will be more subdued compared to what we have experienced historically. A higher starting point from a valuation standpoint, elevated profit margins, a lower interest rate environment and slower global economic growth all point toward lower returns going forward. Based on these factors, investors should prepare accordingly. We believe a diversified portfolio is as important now as ever. It will be beneficial to focus on quality investments and to diversify globally looking outside the U.S. for opportunities that will help portfolios ride out the volatility and generate good risk-adjusted returns. Undoubtedly the best advice we can give is to always have a planned strategy and stick to that strategy unless there are some compelling reasons to change.