Investors won’t remember 2018 with any fondness. But it wasn’t nearly as bad as the headlines would have you believe. We believe the world economy is in fair shape and a Brexit deal won't be too painful for the UK.
Review of 2018: Most markets were down
If this is indeed the season to be jolly, it seems investors missed the memo. 2018 will be a losing year for most asset classes. On 5 February, the Dow Jones 30 had the largest one-day fall in its history (-1175 points), in April the US 10-year Treasury yield reached 3% for the first time in almost five years, and, at the time of writing, the S&P 500 is enduring its worst fourth quarter since 2008.
The return of volatility
Back in January, investors were excited because growth was strong across the world. The S&P 500 began the year with six consecutive highs and it looked as though nothing could go wrong.
Then everything changed. Global equities plunged by 9% over two weeks in early February, and fell by another 10% in October. Most markets have been much jumpier and more erratic this year than in super-quiet 2017.
As shown in the graph below, though, this rise in volatility looks like a return to normal – and doesn’t particularly worry us. Indeed, equity volatility in 2018 has been slightly below its long term average.
It’s clear that investors became far more cautious as the year progressed. In some cases, the caution is warranted. For example, the huge tech stocks known as the FAANGs (Facebook, Amazon, Apple, Netflix and Google) plunged between June and November 2018, as their valuations returned to more realistic levels. In other cases, interesting assets were unfairly punished, creating potential buying opportunities. Emerging Market equities and European dividends are two recent examples.
What about the fundamentals? In our view, there was little change through the year. The world economy is growing at a healthy 3.6%, according to the International Monetary Fund (IMF). Europe and the US are slowing, but are in fair shape. In both the US and UK, unemployment has fallen, inflation is stable and wages are rising. Global earnings per share growth in 2018 will be an impressive 16%.
For all the talk of rate hikes, there were only four by major Western central banks through the year (three in the US, one in the UK, none in Europe), and monetary policy in both regions remains loose. Rates are trending up, as they should, but are far from worrying.
Some commentators claim that weak equity markets in 2018 reflected fragile and slowing global growth and company earnings, blaming factors such as interest rate hikes, the US-China trade dispute, Brexit and Eurozone politics. We are not convinced. We think that the world economy is in good shape.
It’s hard to know why large numbers of investors across the world suddenly began selling. Big computer-driven traders probably played a part in this, unrelated to any economic or financial fundamentals.
Investors won’t remember 2018 with any fondness. But it wasn’t nearly as bad as the headlines would have you believe.
The world economy is growing at a healthy 3.6%, according to the International Monetary Fund (IMF).
The year ahead: Goldilocks economy, risks exaggerated
2018 was tough for financial markets. We think 2019 will be far more normal – and perhaps even boring, in a positive kind of way. The world economy is in fair shape and the risks that the media is shouting about are widely exaggerated.
In our experience, economic reality – the reality of company sales, employment, government spending, domestic and foreign trade – is remarkably stable over time. It’s like a supertanker in motion that can’t be diverted easily.
By contrast, investors are far more erratic. You can view investor sentiment as cycling around the economic fundamentals, as depicted in the graph above. Sometimes investors are overly optimistic (greedy), as seen in January 2018; sometimes they’re too pessimistic (fearful), as in February 2016. We think this familiar cycle is in action at the moment, and that investors are too pessimistic (see Review of 2018).
Our goal as investment managers is to focus on the long term and not get caught up in these cycles of investor greed or fear. We expect investor sentiment and markets to recover in 2019 and are positioned accordingly – slightly overweight equities, with a bias towards the US, and negative on bonds and credit.
The big picture
Begin with global growth. The world economy is slowing a little, but should grow comfortably through 2019-20. We don’t see the big danger signs that might destabilise it, e.g. soaring interest rates or a financial crisis. China’s growth is easing, as it should, but is unlikely to crash anytime soon.
World inflation is running at around 2.7%, and is under control. It’s not far from the 2% target in the US and UK, and even Japan might be clawing out of its deflationary mire. Interest rates are normalising in the US, which is healthy, and are set to rise in most countries in 2019.
Putting the story together, we think the world economy is in a ‘Goldilocks’ phase – neither too hot nor too cold. Goldilocks is usually good for companies: we expect global earnings per share to rise in 2019 and 2020.
So why are investors worried? We think they’re focusing on risks and threats that have been exaggerated. These include US recession, trade wars and the UK political situation.
Three risks that don’t worry us too much
The big question for global growth is the US, since US recessions have often been associated with equity crashes in the past. Some commentators fear recession in 2019. We are not overly worried. The US is currently growing at around 2.5%. From these levels it normally takes at least two years for growth to turn negative. Moreover, the usual imbalances associated with recession – soaring inflation, housing crunch, commodity price shock – are largely absent. We think that a US recession is unlikely before late 2020, at the earliest.
What about trade wars? So far, tariffs have been implemented on about 2.5% of world imports, corresponding to less than 0.6% of world GDP. They’re certainly a negative for growth, but on a tiny scale to date. While they could get much worse, we think the US and China will reach some compromise that won’t harm their economies (and their people) too much.
“We think a deal will materialise that won’t be too painful for the UK.”
What about the UK? Brexit is a shambles and we do worry that the UK could end up with a ‘No Deal’ – which, actually, would be a terrible deal – in March 2019. But it’s in the interests of both the UK and the EU to reach a broadly sensible outcome. We think a deal will materialise that’s not too painful for the UK.
And the possibility of a Corbyn government? We think Mr Corbyn’s bark is worse than his bite. If he came to power he’d be so constrained by the range of views within his party, by business pressures and by economic constraints, that he would not be able to do much that would derail the UK’s financial markets.
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