By Richard Turnill, BlackRock’s Global Chief Investment Strategist.
- We draw three lessons from 2018, a year in which navigating markets has been tough amid trade frictions, rising rates and some sharp turns.
- Equities fell, as weaker-than-expected economic data sparked growth slowdown fears. The UK’s Theresa May won a party confidence vote.
- The Federal Reserve is expected to raise rates this week, and any signs about its future tightening path – and a possible pause – will be in focus.
Three investing lessons from 2018
Navigating markets in 2018 has been tough. Returns in many bond, equity and credit markets globally verge on finishing the year in negative territory. We find uncertainty around trade, together with higher interest rates, has been a major drag on stocks, offsetting solid earnings growth. The lesson, one of three from 2018: Geopolitics matter.
Chart of the week
Global equity valuations and market attention to geopolitical risks, 2016-2018
We had warned markets were vulnerable to temporary drawdowns in 2018 if tough U.S. trade talk turned into actions. Yet the magnitude of the impact of geopolitics on markets has surprised us. This effect on stocks is reflected in the decline in valuations in the chart above. It corresponds with a rise in market attention to the risk of global trade tensions throughout 2018 and with market concern about geopolitical risk overall remaining at a historically elevated level. This is reflected in our BlackRock Geopolitical Risk Indicators. Geopolitical risks beyond the U.S.-China trade relationship have also played a role this year in European markets and in many emerging markets (EM), where the risks have been more local.
Adapting to rising rates and building portfolio resilience
We find trade frictions are more baked into asset prices than a year ago. Yet we expect the vagaries of U.S. trade policy changes to cast a shadow over markets. Another geopolitical risk causing us worry: the risk of fragmentation in Europe. Overall, we expect further market sensitivity to geopolitical risks in 2019 as global growth slows: We find the impact of geopolitical shocks on global markets tends to be more acute and long-lasting when the economy is weakening. See our BlackRock geopolitical risk dashboard.
Our second lesson from 2018: Rising short-term yields have made cash a viable alternative to riskier assets for U.S.-dollar-funded investors and have exposed markets with weak fundamentals. Two-year U.S. Treasury yields are now more than three times their average over the post-crisis period. Rising rates hit EM assets much harder than we expected this year and led to a wide dispersion in EM returns. We see many EM assets offering better compensation for risk as we head into 2019, with the Fed likely pausing its quarterly pace of hikes amid slowing growth and contained inflation. But EM countries with large external liabilities are vulnerable to any greater-than-expected Fed tightening.
The final lesson: Build portfolio resilience. Broad market drawdowns have become more frequent in 2018 as volatility has risen from the doldrums of 2017. Many market segments have fallen sharply, from financial stocks and crypto currencies to perceived safe-havens such as telecom stocks. We would be wary of assets seeing sharp price rises that are disconnected from fundamentals. We prefer a barbell approach: exposures to government debt as a portfolio buffer on one side and allocations to assets offering attractive risk/return prospects such as quality and EM stocks on the other. This includes steering away from assets with limited upside if things go right, but hefty downside if things go wrong. We see European equities and European sovereign bonds falling into this category. Read more in our 2019 Global investment outlook. The Weekly commentary will resume on Jan. 7. Happy holidays.
Week in Review
- Global equity markets fell, as disappointing economic data from Japan, China and Europe sparked global growth slowdown fears, and concerns around trade frictions and European politics added to the macro uncertainty. China’s November retail sales and industrial production came in lower than expected, as did eurozone December flash PMIs. U.S. retail sales beat expectations.
- Britain’s Prime Minister Theresa May won a leadership challenge within the UK’s Conservative party, ensuring she won’t face a similar no-confidence vote for another year. Yet May then failed to win concessions from the EU that could have made the UK Parliament more likely to pass her Brexit withdrawal-agreement proposal. The British pound was volatile.
- Italian government bond yields declined on a more meaningful-than-expected reduction of the planned Italian budget deficit, though it may not be enough to avoid an “excessive deficit procedure” from the European Council. The European Central Bank confirmed it will end its net asset purchases in December, and clarified that it will continue with reinvestments until at least after its first rate hike.
U.S. housing starts, building permits
Fed’s Federal Open Market Committee (FOMC) statement, U.S. current account, existing home sales; Japan balance of trade
Bank of Japan statement; Bank of England summary
Japan consumer price inflation; U.S. PCE; eurozone consumer confidence flash; China’s Central Economic Work Conference (expected Dec. 19-21, President Xi Jinping speech expected)
Markets currently price in a roughly 75% probability that the FOMC will raise interest rates by a quarter percentage point this week. Any signs about the Fed’s path ahead will be in focus, with the Fed’s “dot plot” suggesting the median policy maker expects three hikes. We view two rate increases next year as more likely, while markets are currently pricing in only one. We see the FOMC pausing its quarterly pace of hikes in 2019 amid slowing growth and inflation. U.S. rates are en route to neutral – the level at which monetary policy neither stimulates nor restricts growth – and we see the Fed becoming more cautious as neutral nears.