At first glance, 2018 was a year to forget for investors in virtually all asset classes. It was the year in which the longest US equity bull market on record, seemingly came to an end. It was a year where markets were heavily influenced by geopolitics and central banks. The only certainty in global financial markets in 2018, was that there would be volatility, and lots of it.
Across the board, global equity markets were down for the year. The FTSE 100 lost 12% over the year, with the FTSE 250 down 15%. In the US, the S&P 500 was down by 6% and the tech heavy Nasdaq lost 5%. Some of the biggest falls came in Asia, with the Japanese Nikkei 225 down by almost 15%, whilst the Chinese Shanghai CSI 300 fell a whopping 26%, and the Hong Kong Hang Seng index finished the year nearly 14% lower. Europe fared no better, with the S&P Euro 350 index falling by 13%, the Italian FTSE MIB index losing 16% and the German DAX down by a gigantic 18%. Emerging markets didn’t escape the sell off either, with the MSCI Emerging Market index down 16% for the year. Almost without exception, 2018 was a disastrous year for global equity markets.
Over the course of the year, there was a never-ending stream of geopolitical headlines for investors to contend with. Some were predictable and recurring themes from 2017, but there were also new developments too.
In Europe, Brexit took centre stage, and with both sides unable to agree a clear and mutually beneficial way forward, markets were rattled and drifted downwards as the uncertainty increased, with flows out of UK equity funds totalling $9 billion in the year to 19th December. Towards the end of the year, Germany – for so long the economic powerhouse of the Euro Area – began to show signs of strain. The German economy shrank by 0.2% in the third quarter of the year - to bring annual economic growth down to just 1.1% for the year to the end of September – in part caused by a worrying decline in car sales, blamed on stringent new emissions regulations.
Attention in Europe was once again on Italy, with the third largest Euro Area economy still smaller than it was in 2008, and perennially teetering on the brink of recession. Italian government debt is the second highest (as a % of GDP) in Europe, after only Greece, and the nations banks hold one quarter ($500 billion) of the total non-performing loans in Europe. An unstable coalition government has brought yet more uncertainty, and spent part of the year at loggerheads with the ECB over its heavy spending plans. Although this spat was eventually resolved, the Italian situation continues to depress other European markets that are fearful of contagion. Italian market worries were most evident in the bond markets, where the spread between the Italian and German 10 year government bonds, widened to the highest level since 2013, highlighting the perceived risk differential between the two countries' debts. The French Yellow Vests protests did nothing to assuage European markets, with the French CAC 40 index down 15% from late September. Economic growth in the Euro Area fell to 1.6% for the year to the end of September, but on the plus side an unemployment reading of 8.1% was the lowest since the global financial crisis. The Euro and the Pound both finished the year down against most major currencies
As has been the case for so long now, the US market was once again driving global market performance. The US market began the year where it had left off in 2017, with the Nasdaq and S&P 500 both up by 7% by the end of January, buoyed by Trump tax cuts, announced at the end of 2017. Despite heightened levels of market volatility, US and most global markets were up or close to up by the midpoint of the year. Indeed, there was a period when all looked well with global markets and the world economy. Asset prices weren’t cheap by historical standards for sure, but economic fundamentals were sound. The US economy was widely described as being in a ‘goldilocks’ state. Even at the end of the year, annual US economic growth is seen coming in at 3% – the highest growth rate in a decade – with inflation of around 2.2%. The US unemployment figure in November was the lowest since 1969, at 3.7%.
But in a strange paradox, it was arguably the strength of the US economy and subsequent actions of the US Federal Reserve that caused the market sell off, which has affected all areas of the market. In the face of such strong economic growth, investors and the Fed, both became wary of the likelihood of higher levels of inflation. To combat such inflation, the Fed talked about and began to raise interest rates, raising them 4 times over the course of the year, from 1.5% at the start of the year, to 2.5% by the end. This higher interest rate environment had the effect of increasing the yield on longer term US credit. In effect, market participants – guided by the Fed – thought that interest rates would continue to rise into the future. But higher interest rates make riskier assets – such as stocks – less attractive. As the 10 year US Treasury yield flirted with the psychologically significant 3% level, investors began to pour out of the US stock market in their droves, with the sell off spilling over into most global markets.
Towards the end of the year, when the Fed raised interest rates for the 4th and final time of the year, in the face of growing stock market headwinds, the market reacted by sending the yield on the 10 year Treasury lower. The yield had peaked at 3.24% in early November, but by the end of the year, it had fallen back down to 2.73%. The market believed that the Fed was raising interest rates too quickly, and would in turn negatively impact future economic performance. The opposing movements of the short and long term Treasury yields (short term yields increasing and long term yields decreasing), reduced the yield gap to the lowest level since 2007, shortly before the global financial crisis. The yield curve has not yet inverted but it is perilously close to doing so. An inverted yield curve is a remarkably good indicator of an upcoming recession. Every US recession of the last 60 years has been preceded by an inverted yield curve, with only one false positive. The flattening of the yield curve is a sign that we are late in the economic cycle and suggests that market confidence is low. In turn, this has fed through into global stock markets, which have started to discount asset prices, fearing lower future economic growth or even recession.
Another significant change in the markets in 2018 was the reduction in the size of central banks’ balance sheets. Since 2008, over $12 trillion has been injected into the global economy via quantitive easing. This increase in liquidity proved to be the perfect backdrop for rising asset prices. But the Fed is now unwinding its bond holdings – which peaked at $4.5 trillion in 2014 - to the tune of around $50 billion per month. The simultaneous reduction in the US balance sheet and increase in interest rates has strengthened the US Dollar, with the greenback up 4% for the year, against a weighted basket of currencies - despite another US government shutdown at the end of the year.
The ECB has signalled that next year, it won’t be adding to the €2.5 trillion in assets, that are already sat on its balance sheet. But the Bank of England and the Bank of Japan, show no signs of ending their asset buying programmes, even if the Japanese have at least recently started to reduce the amount they are buying. The Japanese Yen is in fact one of the best performing currencies of the year, up 11% against the Dollar and 8% against the Euro.
This general move away from quantitive easing and towards quantitive tightening, is unprecedented and has no doubt contributed to both the volatility and downward trajectory of global markets in 2018. There is simply less liquidity in the system, and so asset prices have been pushed down. In the year to 19th December, the total flow out of US equity funds was $31 billion. World markets have had their most volatile year since 2015, with the CBOE Volatility index surging more than 100% in 2018. In addition to a reduction in liquidity, this increase in volatility has also been blamed on trading algorithms and high frequency trading, which seem to amplify both gains and losses.
Besides a higher rate environment, global markets also had to contend with US protectionism and an American – Chinese trade war. Over the course of the year, the US administration has imposed 3 rounds of tariff hikes on Chinese goods, affecting annual trade
worth more than $250 billion. Naturally, China responded in kind, imposing its own tariff hikes on American goods, affecting annual trade worth more than $110 billion. Chinese economic growth has been slowing for some time now, with growth of 6.5% in the year to the end of September, being the lowest in almost a decade. With Chinese growth being such a disproportionately large contributor to global growth, a trade war involving the two largest economies is clearly a negative for global markets, and weighed heavily on global market sentiment. Peak to trough, the Chinese CSI 300 index was down by more than 30% in 2018.
But beyond the trade war, there are wider worries over China. Since the financial crisis in 2008, China has been making huge investments to help stimulate its economy, with total debt nearly doubling between 2008 and 2018, to over 315% of GDP. It is the combination of this vast build up of debt, the opacity of China’s banking system and the lack of a developed financial market structure, that worries investors.
In the oil markets, the combination of an increase in the supply of oil and concerns over the strength of the global economy, was enough to make Brent Crude finish the year at $53 p/b, nearly 20% down for the year, despite being at $86 in early October. Gold fared better, but still fell 2% over the year. The yellow metal’s status as a haven asset, was found wanting in a higher interest rate environment. Silver fell even further, down 11% for the year. Even bonds performed poorly, ending the year with very negligible returns at best, with the S&P Aggregate Bond index up less than 1% and the S&P High Yield Index down by 2%. Bitcoin – which enjoyed a spectacular and well documented rise in 2017 – finished the year down 72%, at just $3,742.
But despite the headline losses, across virtually all asset classes, there were a few bright spots and it was possible to achieve a positive return in the markets – if you knew where to look. The main Indian, Brazilian & Russian indexes all finished the year higher than they started, up 4%, 12% and 9% respectively. The FANG+ index – including Facebook, Amazon, Apple, Netflix and Google – was up by nearly 3%. Amazon, Netflix and Microsoft finished the year higher, up 27%, 33% and 20% respectively. Facebook lost nearly 28%, largely on the back of data sharing issues and increasing calls for regulation. Despite 74% of stocks on the FTSE 100 losing value, there were still some notable gainers. Ocado finished the year up over 100%, and Pearson was up by 27%. Notable FTSE 100 fallers were British American Tobacco, down 49%, and Royal Mail, down 40%. In the US, the list of big losers included the likes of General Electric and Kraft Heinz, losing 61% and 44% respectively.
2018 was a year in which timing the markets was more important than time in the markets. To make any sort of reasonable return, it was essential to be out of the markets or to have reduced holdings by early October at the latest. From the start of the year through to early October, the S&P 500 was up by 9%. Whilst from the start of the year through to the end of August, the Nasdaq was up by 15%. The performance of investments showed the importance of having a well-diversified portfolio, avoiding too much exposure to any one market. To illustrate this point, the MSCI All Country World index fell by 9% over the year, which is less than most developed equity markets.
The performance of global markets in 2018, was typical of those seen before, in the latter stages of an economic cycle. The US equity bull market has been the longest in history – with asset prices rising since early 2009 - and put simply, asset prices can’t keep going up forever. Although each year brings new geopolitical issues for investors to contend with, the myriad of different factors in 2018 was both unprecedented and unpredictable. This year’s geopolitical factors may or may not have been enough to bring down markets on their own, but when combined with seismic shifts in monetary conditions, the result was a significant deterioration in investor sentiment and in turn asset prices. The equity falls of 2018 are the largest seen since the financial crisis 10 years ago. Global markets are now signalling that there is an increased likelihood of recessions occurring throughout the world. But despite that, the falls that we have seen, present attractive entry points for investors with long investment horizons, and in some cases, falls may be somewhat overdone, even in the short term.
GCIS - Commercial Intelligence - Market Intelligence
This does not constitute investment advice. Past performance is not a guide to future performance. The value of investments can fall as well as rise.