Lessons from 2018 and what to expect of 2019

After the stellar act of 2017, we did anticipate greater financial market volatility and lower returns this year, just not quite this bad. At the time of writing, global equity, commodity, sovereign and credit indices are all posting negative year-to-date performances in USD terms – despite a pretty solid macro landscape and still strong earnings growth.

Why such a disconnect between markets and fundamentals? A number of factors contrived to dampen financial returns in 2018. Fiscal stimulus boosted US growth and inflation more than initially expected, causing a significant repricing of the US interest rate curve. A higher dollar cost of capital is, and always has been, a natural stress factor for the global economy and markets. Asset valuations had to adjust to this cost and idiosyncratic risks in specific emerging markets (highly indebted Argentina and Turkey in particular) then fuelled volatility.

Political risks added to investor discomfort. The trade dispute between the US and China, uncertainty around the US mid-term elections, complicated Brexit negotiations and the Italy-European Union (EU) budgetary tug of war all contributed to making the investment environment challenging.
 

Finally, the Eurozone’s economic momentum of 2017 proved unsustainable. Although the broad picture remains healthy, growth moderated throughout this year because of temporary factors, such as the new emission standards in the car industry (which mostly hurt the German economy), as well as structural issues, notably weaker external demand due to US import tariffs.

Can we look forward to a healthier 2019?

Despite some slowdown in activity, we expect the overall picture to remain relatively supportive next year, with growth exceeding long-run potential in all the main economic blocs – and no major accident. Put differently, we do not foresee a US recession, a hard landing in China or a dismantling of the Eurozone. This is not to say, however, that the investment skies are cloudless.

2018 demonstrated that rising US yields are not always easy for markets to digest, even if they are an entirely predictable consequence of a sound economy, one that is growing above its potential and closing the output gap. This source of volatility will likely remain with us next year, as monetary tightening continues in the US (at least until the neutral level is reached – see chart 1, page 04) and gets under way elsewhere, for instance in the Eurozone.

Trade tensions, with their ability to undermine confidence and markets, could also make a virulent comeback, unless the US and China turn the 90-day “cease fire” agreed at the recent G20 summit into a longer-term compromise. And political risk is unlikely to disappear from the radar – although an important lesson from 2018 is that headlines are often worse than the underlying developments.
 

But while China should continue to suffer from trade tensions, policy easing measures and past currency depreciation will provide some macro stability, both domestically and across the emerging markets more broadly. And one of our important expectations for 2019 is that the US should lose some of its economic outperformance versus the Eurozone. With the effects of US fiscal stimulus likely to wane just as the headwinds facing European economies drop, growth levels on either side of the Atlantic should start to converge by the end of next year (see chart 2, page 04).

All told, as we look to the new year, we feel that a neutral, but not risk averse, portfolio positioning remains appropriate. Investment discipline and strengthened risk management are, however, key at this stage of the cycle, with asset quality and liquidity being the foremost considerations. As such, we favour equities over high beta¹ fixed income segments, maintain above-average cash holdings and are starting to opportunistically reduce our long-held underweight in sovereign bonds.

¹ Beta is a measure of the volatility, or systematic risk, of an asset relative to the overall market. It reflects how that asset’s returns tend to respond to market swings.