The beginning of the year is often the time when investment strategists opine on the outlook for the year ahead. But 2018 proved, once again, how futile such short-term forecasts can be. Following 2017’s impressive worldwide equity returns, investors in early 2018 were encouraged by ongoing global economic growth and robust US earnings momentum. At that time, who would have guessed that 2018 would prove to be a year when most risk assets posted negative returns? Although last year’s markets were unusual in many regards, they affirmed some of the evergreen tenets of investing.
Sentiment can change quickly. Markets always look ahead; stock prices, for example, reflect expectations for future earnings growth, interest rates, and other market factors. Even though they tend to be forward looking, the speed at which expectations change still feels like a whipsaw at times. Consider the tariff issues that first surfaced last spring.
Initially, the focus was on the direct impact of tariffs. US stocks performed well through September—both in absolute terms and relative to non-US securities—as the direct effects of tariffs were expected to be modest. Then attention shifted to the broader issue: The widespread global growth of recent decades, which had been spurred by open trade, could be significantly disrupted by tariff wars. Even with S&P 500 earnings growing at a 20%+ pace in 2018 (fueled in part by the reduction in US corporate tax rates), expectations for future earnings dimmed when US companies began blaming protectionism for rising input costs and softening sales to foreign markets. And while the US economy was quite healthy, investors began fearing that an economic slowdown, and perhaps a recession, was looming. By December, sentiment was further eroded by fears that ongoing Fed tightening could curtail economic growth, leading to a dramatic year-end sell-off in which US stocks fell at twice the pace of already-battered non-US stocks.
The lesson for long-term investors? Consistently predicting when sentiment shifts will occur is almost impossible, but when the market moves over-aggressively in one direction, as it did in December, it will eventually correct. That’s why having the right long-term asset allocation, and sticking with it, is always the best advice.
Interest rates don’t move according to a play book. In recent years, the Fed adopted an increasingly transparent policy to communicate its intent, and the amount of analysts’ commentary about the outlook for interest rates has been staggering. Nonetheless, 2018 demonstrated that movements of interest rates across the yield curve are affected by investor expectations and preferences as well as by policy actions. In other words, interest rates are not monolithic; short, intermediate, and long-term rates can move in different directions and/or at a different pace.
In 2018, the Fed raised short-term rates at a faster pace than most had expected. But long-term rates did not move in parallel, and, in fact, declined later in the year as concerns about economic growth became the central focus. The flattening yield curve and the potential for an inverted curve fueled worry about a looming recession.
But the lesson here is that bets on the direction of interest rates can disappoint. In January 2019, markets were calmed by Fed comments that low inflation would allow the committee to be patient rather than remain on a set path for rate hikes. Markets interpreted that as a dovish comment, but what it really means is that Fed decisions will hinge upon incoming data. Given the underlying strength of the US economy, we currently expect the Fed to raise rates twice in 2019, but futures markets are no longer pricing in any rate hikes. As such, ongoing surprises and volatility are likely.
Geographic diversification still matters. Returns from US stocks have outpaced those from non-US stocks over the past decade, making it easy for US investors to have a home bias. That view was validated in 2018, when the S&P fell 4.4% while the broad non-US index declined by more than three times that amount, over 14%. But we know from history that geographic return patterns trade places. Today, the prices of non-US stocks embed significant pessimism; at the end of 2018, the price to forward earnings ratio for developed international markets was only 11.9x and for emerging markets, 10.6x, while the US market was trading at 14.5x. Such valuation gaps eventually attract investor dollars. In fact, we saw some signs of that late last year, and even in the first few weeks of this year, non-US stocks have outperformed.
Illiquid investments provide important diversification benefits. 2018 was highly unusual in that returns on nearly all publicly traded major asset classes were flat to down. But less liquid alternatives—private credit, private equity, mortgage-related debt, and some hedge funds—were generally positive. For long-term investors, these illiquid alternatives form an important part of an asset allocation. Their historical long-term returns are attractive; they offer differentiated return streams that have a lower correlation to returns on stocks and bonds; and the less liquid nature of these assets means that they are not vulnerable to the irrational redemption stampedes that can occur when investor sentiment shifts to highly negative.
What does this mean for markets looking ahead?
The markets are now in a period of transition; we are referring to it as “Shifting Sands.” We expect global economic growth to slow in 2019, but not enter a recession. In the US, interest rates are beginning to normalize, and the withdrawal of monetary stimulus will be a contributing factor to expected returns on both stocks and bonds that are lower and more volatile than in the recent past. Modest returns on global stocks (which we forecast to be around 7.5% over the next decade), will be affected in the near term by decelerating earnings growth as well as tighter financial conditions. On the positive side, the global stock sell-off in 2018 pushed returns for many geographies and industry groups down 20% or more, into so-called correction territory. This means that even if there is no growth in corporate earnings in 2019, equity valuations look reasonable relative to history, providing more room for error than we’ve seen in recent years.
Tying 2019 back to what we saw in 2018:
- Expect sentiment to continue to swing and equity volatility to remain high. Investors will be examining every earnings release and data point to try to extrapolate future trends, and there is likely to be overreaction on both the downside and the upside. Overlapping geopolitical issues, including Brexit, trade issues, slowing growth in China, and political strife in Washington, will also keep investors on edge, and may dominate market psychology from time to time.
- Bond returns should be modest but solid, as we have already come quite a way through the tightening cycle. Inflation is the wild card here: If inflation rises above the Fed’s 2% target, the committee may raise short-term rates more aggressively than the market currently expects.
- Valuations in non-US equity markets are very attractive, increasing the likelihood that exposure to these markets will improve the risk/return trade-offs in a portfolio.
- Illiquid assets will remain important diversifiers. This will be especially true if higher volatility causes investors to withdraw from publicly traded risk assets, pushing prices of those liquid securities below levels justified by their fundamentals.
In this environment, maintaining a commitment to a long-term investment plan will be more important than ever. That’s a lesson that rings true, time and again.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.