April 2018 - Two-Sided Risk Emerges
Updated: Jul 10, 2018
The behavior of financial markets throughout the first quarter of 2018 stands in marked contrast to that which prevailed in 2017. The so-called "Goldilocks" environment characterized by low bond yields, benign inflation and ample liquidity has been replaced by a more volatile regime and the emergence of two-sided risk in which risky assets can both rise, and fall. Indeed, in the first quarter of 2018, global equity markets recorded their first quarterly decline since 2016 as per the MSCI All-Country World Index which fell 0.85%. This came despite still strong global economic growth and expectations for another year of robust earnings growth which we believe will lead to another year of equity market outperformance over bonds. That said, we think the transition into an environment characterized by higher volatility, shifting correlations and slightly tighter financial conditions is likely to persist. The change in market conditions can readily be seen across asset class performances as both stocks and bonds delivered negative returns over the quarter. A "60/40" portfolio comprised of a 60% allocation to the S&P 500 and a 40% allocation to the Barclays U.S. Treasury Index would have returned -0.9% over the quarter, its worst performance since the third quarter of 2015. Over the last three months, bonds yields and stock prices moved in opposite directions, reducing the diversification benefits of bonds and leading to lower returns across balanced portfolios.
Within equities, the S&P 500 ended the quarter down 0.8%, ending a streak of nine quarters of positive performance. Weakness across high-tech growth stocks as a result of regulatory risk and concerns surrounding data protection further weighed on investor sentiment as the "FANG" stocks (Facebook, Amazon, Netflix, Google) ended the quarter down 10% from their highs. In Europe, the benchmark Eurostoxx 50 fell 3.7% to be down 8.5% from its January 2018 high while Japan's Nikkei 225 finished the quarter down 5.4%. Emerging market equities fared somewhat better, with the MSCI Emerging Markets Index up 1.4% as a weaker U.S. Dollar helped support returns.
Within fixed income, higher yields and wider spreads weighed on both sovereign and corporate bonds. The U.S. 10-year Treasury bond lost 4% over the quarter as its yield increased 33 basis points to 2.76%. Within credit, U.S. investment grade credit shed 2.2% as the losses from duration were furthered by an 18 basis point widening in credit spreads according to ICE-Bank of America Bond Indices. Down the capital structure, U.S. high-yield fared better given its shorter duration and spread cushion and finished the quarter down 0.31% according to ICE-Bank of America Bond Indices. It is noteworthy that despite the weakness across equity markets, U.S. high-yield remained fairly stable with spreads at 372 basis points, 49 basis points above their low 10-year low recorded in January 2018.
The weaker performance across asset classes can be attributed to a range of factors, both fundamental and technical. While it is nearly impossible to identify any single factor with total certainty, we have identified four main drivers which we believe are responsible for the market's performance over the first quarter. While we acknowledge their detrimental impact on markets over the last three months, we do not believe they are formidable enough to push this bull market off the cliff and expect to see equity markets move higher over the year.
The first is the path of interest rates. While core government bond yields are not high in absolute terms (there is still $3.7 trillion in bonds with negative yields), we believe the market has transitioned to a period where the path of least resistance is for bond yields to move higher rather than lower. This represents a material departure from the last few years in which quantitative easing programs from the world's systemically important central banks drove bond yields to record lows. The point of maximum policy accommodation is likely behind us meaning there will be less buying by global central banks at a time when issuance is expected to increase, namely from the U.S. in order to fund its fiscal deficit which could reach $1 trillion over the next decade. While higher interest rates are not intrinsically negative for equity markets, the transition to a different regime where earnings are discounted at higher rates means a period of repricing for equity markets and low, if not negative returns, across government bond markets.
Second, rising inflation expectations are exacerbating some of the pain across risk markets. The first quarter of 2018 saw U.S. 10-year inflation expectations break above 2% for the first time since 2014 while readings also increased across the eurozone and Japan. The channel through which this impacts risk sentiment is the scope for more aggressive tightening cycles by global central banks should inflation move meaningfully higher. So far this is not our base case. In the U.S., investor expectations for future rate hikes are in line with the Federal Reserve at three for 2018. This diverges in 2019 as the Fed forecasts another three while the market expects only one. Central bank policy in the eurozone and Japan is also likely to remain accommodative through the course of the year though the prospect for slightly tighter policy has increased given forward market-based measures of inflation.
Third, while outright global economic activity remains robust, there has been a slight deceleration in momentum. Citibank Economic Surprise Indices turned lower across developed and emerging markets over the first quarter and moved into negative territory in the eurozone which we attribute to the especially strong momentum which the eurozone experienced in 2017. Nevertheless, in the short-term, equity markets tend to trade according to the second derivative of growth; the change in momentum is often more impactful than the absolute level of growth.
Fourth, geopolitical risks look more global than local as the probability of trade wars increased over the quarter following the imposition of tariffs on steel and aluminium by the U.S. A slowdown in trade would significantly weigh on global capital expenditure and emerging market exports. While the impact to growth is difficult to measure at this point, protectionism which is met with retaliatory tariffs would negatively impact our forecasts for future growth.
Notwithstanding the aforementioned drivers, it is important to acknowledge that the synchronized global expansion amid strong earnings growth which underpinned our outlook going into 2018 remains intact. Of the 28 countries monitored by Bloomberg, all have manufacturing PMIs that were in expansionary territory in February 2018. The median forecast for 2018 real global GDP growth stands at 3.8% according to estimates compiled by Bloomberg. In the U.S., the Conference Board's Leading Economic Indicator remains strong at 6.5, its highest level since 2014 suggesting the probability of recession over the next twelve months remains very low. At the same time, initial jobless claims fell to a 45-year low while sentiment readings remain strong. Growth momentum in Europe has fallen more significantly, possibly given the impact of a stronger euro on exports, though we still expect above-trend growth for 2018. In China, growth has moderated given a slowdown in credit expansion though manufacturing activity remains robust with a PMI at 51.5 while the services sector PMI remains strong at 54.6.
While fundamentals remain encouraging, we believe the market is undergoing a shift as it transitions into a period of less liquidity, higher rates and a slowdown in the momentum of growth. Risk assets have responded in kind. Still, it is important for equity market participants to remember that corrections regularly take place within bull markets. Since the Second World War, there have been twenty-two bull market corrections (defined as a +10% decline). The market fell 13% on average and it took just four months to recover. On this basis, we continue to advocate a strategic long position in equities given our belief in the underlying fundamental picture. with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.