2019 Global Investment Outlook – 1st quarter insights
2019 Global Investment Outlook – 1st quarter insights
When markets fall, commentators look for who’s to blame; we see four villains in this particular drama. The good news: they have been identified, at least for now, although we wouldn’t rule out a twist in the plot before the end of the show. The bad news: they have not yet been conclusively defeated to allow viewers to relax.
The four villains
Risks that have been building throughout 2018 manifested themselves in a sharp decline in markets in the final quarter of 2018.
We have been highlighting four areas of concern:
1. Central banks
A few editions ago, we described the central bankers as super heroes that saved financial markets by cutting interest rates and engaging in Quantitative Easing (QE) to push down the yields on government bonds and force investors into riskier assets. We mulled whether they would turn into market villains as they began to raise rates and reverse QE, thereby tightening monetary policy. President Trump certainly considers them as such, recently tweeting that “the only problem our economy has is the Fed”.
The Federal Reserve certainly spooked markets in December. Having raised rates, it stated that it would continue to increase interest rates despite slowing growth as wage pressures continue to build in the US. However, a sharp decline in the stock market may focus the minds of Fed members; historically, every time the stock market has fallen 20%, the Federal Reserve has eased monetary policy. This is important for equity markets as the chart below illustrates the effect of interest rate policy on stock market returns. The chart shows the returns from equity markets when the average central bank around the world is either raising or cutting interest rates.
Valuations play a vital, if unexciting role in this drama. Although price to earnings ratios will never steal the show, history shows that the price you pay for an asset is the largest driver of future returns. There’s good news here: 2018 saw earnings grow and prices fall. The combination of these two factors saw a marked improvement in the valuation of equity markets around the world. Although we continue to expect disappointing returns from America, the world’s largest stock market, other markets’ valuations are looking more reasonable and, in some areas, downright cheap. However, that assumes that earnings don’t fall sharply, which typically only happens in a recession.
3. Recession risks
Spotting oncoming recessions is notoriously difficult, prompting the queen to ask why no one had spotted the great recession of 2008. There are several reasons for this: firstly, recessions are often triggered by different factors so no single indicator can “predict” a recession. Secondly, almost no one wants a recession to occur, and most people are optimists, so they prefer to focus on positive news. Finally, some of the best indicators of recession come from the market itself but few people would want to fill the awkward silence following the queen’s question with “the bond market spotted the recession”. Even though it did.
We therefore acknowledge that spotting an oncoming recession is difficult, but approach the puzzle with an open mind, after all, recessions are like forest fires: a necessary evil. In any event, the world hasn’t figured out a way to avoid them, so we need to watch out for them. We use a range of indicators that have warned of prior recessions, using both economic data and signals from markets. None have a crystal ball, but when taken in combination they help to navigate a slowdown.
Recessions cause damage to equity investors on two fronts: firstly, a recession causes corporate earnings to fall, on average by 25% since the second world war. Secondly, valuations also contract during recessions so the total fall in equity values is closer to 35%. The chart below maps all the major US equity market falls since 1900, showing the peak to trough decline in prices and the number of trading days to complete the fall.
The last, perhaps most unpredictable actor in our production is Brexit; this has already been a long saga and looks set to drag on further. Whilst we follow every twist and turn, rather like an Agatha Christie novel, we know that we aren’t going to be sure of the outcome until the end. Until then, with this, as with every uncertainty that we face, we think that the benefits of a diversified approach are most valuable when times are uncertain.
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