2018: The Return of Volatility
If 2017 was the year of low volatility and universally rising asset prices, then 2018 might well be considered its malevolent twin. The past year marked the return of volatility and falling asset prices to financial markets.
All major equity indices were down for the year:
- S&P 500 (US Large Cap): -4.4%
- Russell 2000 (US Small Cap): -11.0%
- MSCI EAFE (Developed International): -13.8%
- MSCI EM (Emerging International): -14.6%
Regarding volatility, the standard deviation on the S&P 500 – a measure of the market’s risk – was 15.3% in 2018, almost 4 times higher than the benign 3.9% of 2017. In comparison, the 10-year average standard deviation on the S&P 500 is 13.6%, which provides some perspective to the fact that 2017 was more of an anomaly than 2018, and gives investors a sobering reminder that annual returns on risk assets are far from linear. As always, volatility can be either good or bad depending on what one does with it. These pronounced sell-offs and run-ups can provide profitable entry and exit points for the rational and opportunistic investor.
Notably, the negative returns prevailed despite local economic data repeatedly surprising on the upside:
- Q2 and Q3 GDP growth was up 4.2% and 3.4% respectively, driven largely by tax cuts.
- The US added 2.6 million jobs in 2018, up from 2.2 million in 2017. This resulted in the unemployment rate dropping to 3.7%, its lowest level since December 1969.
- Corporate profitability continued to surge, with S&P 500 companies generating an expected $162 of combined operating earnings, up 23% year over year.
Despite the strong economic data, the market pullback was based primarily on a few key factors:
- Recession concerns: After a 10-year bull market following the Great Recession, market participants have become jittery at any sign of negative data, interpreting the data as the start of the next recession. Typically, market bears will closely watch for yield curve inversion (when short term interest rates are higher than long term rates), which has been a leading indicator in 5 of the last 5 recessions. The spread on 10-year Treasuries over 2-year Treasuries is the proxy for yield curve inversion and has slowly been trending towards the negative (0.21% at the end of December 2018 versus 0.51% a year earlier and 1.25% a year before that).
- Interest rates: The Federal Reserve raised interest rates four times in 2018 – 1.00% in aggregate – which has slowed lending growth and made cash and bonds more attractive to risk averse investors.
- Global growth: Fears of slowing global growth due to trade wars, as well as question marks over future corporate earnings growth due to the effects of tariffs on company input costs.
2019: Defense First, with Selective Opportunistic Offense
We expect 2019 to be categorized by positive, yet slowing, economic growth. Look for $170-$175 in earnings from the S&P 500, for a 4.5% – 7.5% growth rate over 2018. GDP growth to come in around 2.5% now that lower tax rates are baked into historical numbers. Political uncertainty and the adverse effects of an ongoing government shutdown will continue to be a drag on sentiment.
If inflation remains in check and the Federal Reserve sees no signals of the economy overheating, expect two more rate hikes in 2019. This means we’re close to the end of the rising rate environment, which should bode well for fixed income and real estate income securities.
Our positioning for 2019 is that volatility will likely continue and that we are indeed late in the economic cycle, with a recession becoming more likely in the next 12-24 months as the yield curve approaches inversion. We believe it’s time to position our portfolios more defensively to limit downside exposure, while selectively taking advantage of opportunities that present themselves in choice markets:
- Lower exposure and weightings to riskier assets like small cap and growth stocks.
- Extend bond duration and increase allocation to real estate income considering the Federal Reserve has signaled it is unlikely to aggressively raise rates without due cause.
- We favor large cap stocks over small cap, value over growth, consumer staples, utilities and healthcare over more cyclical sectors like materials and consumer discretionary.
- Increase cash on hand for opportunistic buying when choice markets and sectors sell off.
- International equities appear enticing on a valuation basis, but look for catalysts for growth and returns in strategic international markets.