The final quarter of the year has seen warning signs in markets, and things could become more serious since few asset classes are delivering positive returns year to date.
The US stock market has begun to falter and, in stark contrast to much of 2018 and 2017, volatility has also picked up significantly.
While investors have been rewarded for simply being exposed to markets in recent years, 2018 has not been so straightforward.
We suspect 2019 will require an even more discerning eye and the ability to draw from a wide variety of tools to both protect capital and deliver returns, especially if tightening financial conditions and slowing growth present themselves in a meaningful way.
This year the US economy performed strongly, as GDP growth continued to accelerate until the second quarter of this year, having done so for a total of eight consecutive quarters.
Performance of selected US stocks vs MSCI World ex US index in the past 12 months
While the acceleration stopped in the third quarter, relative economic outperformance continues, despite indications of a slowdown from the OECD’s leading indicator. The Federal Reserve has been raising interest rates slowly, inflation is under control, and the US dollar has remained resilient.
Emerging headwinds
However, while a more granular analysis reveals these conditions helped to drive US performance, they dragged on performance in the rest of the world, particularly for emerging markets with high levels of US dollar debt and large current account deficits.
But this only tells part of the story. Simply looking at the top-line S&P 500 performance, which reached all-time highs in September, it would have been tempting to assume that all was well.
The primary contributor to this was the technology sector’s strong performance and outsize market share, despite interest rate sensitive sectors such as homebuilders and car makers struggling, well before the ‘Faang’ stocks (Facebook, Apple, Amazon, Netflix and Google) were hit in October. Even the US was not as robust as it looked at first glance.
Key points
• The US stock market has begun to falter.
• Next year is not expected to show the same growth as 2018.
• Political uncertainty is likely to continue into 2019.
Turning to 2019, recent global growth downgrades by both the International Monetary Fund and the OECD are an obvious headwind, and this may require policymakers to once again intervene to get global growth back on track.
But this is a tall order. On the fiscal policy side, the US tax cuts helped to drive outperformance, but the benefits are fading and the stimulus must be funded.
In terms of monetary policy, the European Central Bank and the Fed are still unwinding the easy money that has supported markets for nearly a decade. While the ECB is most likely hoping it has not left it too late, the Fed’s rhetoric has softened, emphasising a return to “data dependency”.
Since this may have temporarily assuaged investors’ fears over the Fed tightening too fast, there are still some slightly worrying signs coming out of credit markets, with the US high-yield market starting to show signs of stress, and a worrying amount of investment-grade issuers in both the US and Europe on the cusp of ‘junk’ status. Further deterioration here would be worrying, even if the Fed pauses.
Trump’s unpredictability
Political uncertainty is also likely to continue into 2019, with President Donald Trump’s unpredictability almost the only guaranteed outcome for policy in the US.
While the G20 meeting between Mr Trump and China’s Xi Jinping produced a temporary reprieve from further tariffs, there is still little certainty in the medium to long term.
In Europe, Brexit continues to worry investors both in the UK and on the continent, the Italian budget dispute is still ongoing, while regional stalwart Germany posted its worst period of quarterly output since 2013.
Of course, this all paints a bleak picture for the new year. But as always, there is a chance of upside surprises.
While not intuitively a positive for markets, a slowdown in the US economy may be welcomed by non-US markets. This could bring a slowdown in the Fed’s tightening cycle and result in lower US rates and a weaker US dollar, which would serve to remove some of the traditional headwinds for the rest of the world.
One area we are watching closely if this plays out is emerging markets, which were hit especially hard in 2018, and some countries are already benefiting from the recent plunge in the oil price.
A serious stimulus commitment out of China would also result in an upside surprise for investors, especially given the world’s second-largest economy’s significant growth slowdown in recent months.
Hedging
For now, we are maintaining a cautious stance, which includes reduced exposure to technology and a bias towards value managers in the US. Hedges will also be a key driver of performance, and we think a healthy allocation to traditional hedges like gold will serve us well.
Beaten-up areas of the market, such as emerging markets, may also outperform. However, we are focused on value-oriented rather than growth-biased managers, and believe that emerging market debt may offer an equally attractive opportunity to equities.
Getting currency exposure right will also be important, and we have our eyes on the Japanese yen, especially given a potentially overvalued US dollar.
The past year has been a difficult one for investors, and 2019 is not shaping up to be any easier.
Of increasing importance will be high levels of selectivity in allocating to risk assets, and leveraging a wide range of instruments and global assets to both add value, but perhaps more importantly at this juncture, protect capital.
Bill McQuaker is portfolio manager of Fidelity's multi-asset open funds
