Commenting on short-term market movements is usually a futile task. One should focus on longer-term macro trends.
Since 2018 was the first significant yearly stock market loss since the Financial Crisis in 2008, and December 2018 was the worst December stock market performance since the Great Depression of 1929, I felt compelled to comment on current market gyrations and provide an outlook for 2019 and beyond.
Back to Normal:
2018 proved to be a difficult one for the market, with S&P 500 down 6.2 percent, which is only the second yearly loss in a decade. December proved quite painful, with the index down by 9 percent
To put this into a larger perspective, the S&P 500 had been going straight up since bottoming in March 2009. There has been 10 years of gains and close to 180 percent return, with very little downside volatility. Clearly, the market needed a breather.
The gains were greatly supported by the Federal Reserve’s zero interest rate policy (ZIRP) and quantitative easing (QE), which were put in place to supply money and liquidity to the financial markets and avert another crisis. There is much debate about whether the Fed and other central banks kept monetary policy too loose for much longer than needed, creating an overextended position in riskier asset classes.
During 2018, the Fed raised interest rates four times and began to shrink its balance sheet. As a result, the fuel that the stock market enjoyed from QE and easy monetary policy was no longer a tailwind, but a headwind. Individual company fundamentals will be increasingly more important than perhaps at any other time in the past 10 years as the Fed normalizes monetary policy.
As a result, volatility is rising again. By historical measures, volatility has been unusually low for many years due to extremely accommodative monetary policies. However, as the chart below shows, recently higher volatility levels are not extreme by historical standards— if anything, the “extreme” was the low-volatility period we had been experiencing in recent years.
What is causing this renewed bout of volatility?
- Normalization of Monetary Policy – As the Fed normalizes interest rates and overall monetary policy, it will continue to add fuel to the volatility fire. Usually the early cycle of rate hikes is positive for the market, as it shows confidence that the overall economy is strengthening. However, as rates continue to rise, they eventually become a headwind to stock prices because higher rates means lower present value of discounted cash flows, which negatively impacts stock prices.
- Uncertain policies coming from Washington – From trade wars to border disputes, the market is spooked by the unpredictable behavior coming from Washington. The political uncertainty has definitely been a contributing factor to overall market volatility. Trade policy uncertainty is now starting to negatively impact corporate earnings and business outlooks despite the tailwinds from tax cuts. The market hates uncertainty and short-term volatility will continue to be elevated so long as these issues remain unresolved.
- Paradox of Growth – We could very well experience a tug-of-war between a volatile stock market and an economy that continues to experience strong growth. As the economic slack created by the Financial Crisis continues to be filled and as the economy reaches full employment, the potential risk of wage inflation increases. Unlike other periods in history, inflation has remained subdued due to continued strong productivity growth, the exportation of cheaper labor abroad, technology advancements and efficiency gains. The Fed has a dual role of maintaining full employment and controlling inflation and is just now getting back to a more neutral monetary policy after years of QE. All of these factors lead to higher economic and market uncertainty and increased volatility.
What does this mean?
Our outlook for 2019 is positive for the economy. Consumers and businesses remain buoyant and over time, the markets will grow in line with overall economic activity. A lot of the recent volatility is due to lower growth concerns, but so far, we have not seen evidence of this in the U.S. economic data, which remains robust. China has been slowing for quite some time, but at some point in 2019 we could see their government try to stimulate their economy once again.
We are negative on bonds, as we expect long-term interest rates to resume an upward trend like we saw earlier in 2018. As rates continue to rise, the headwinds for bond investors will be significant. We have an entire generation of bond investors that have never had to deal with a bear market in bonds. This would be particularly difficult for prices of longer-duration bonds, and especially bond mutual funds and bond ETFs, which do not have maturity dates that provide some clarity on the return of capital to their investors. Shorter-duration and hedged fixed-income strategies will make a lot more sense in a rising rate environment since parts of the yield curve could remain flat or inverted for some time if the Fed continues to raise short-term interest rates.
The good news is that the plumbing of the economy is working well, with few signs of the excesses or irresponsible lending that occurred before the Financial Crisis. As we have seen, debt market crises are much harder to successfully resolve compared to bear markets in stocks.
In short, we see the current bout of stock market volatility as primarily an adjustment to a normalization of monetary policy, which is a result of a new phase of economic growth; and secondarily, a reaction to a number of other short-term political uncertainties that are likely to be clarified in the coming months. With the normalization of monetary policy, we are effectively removing the “training wheels” the Fed put in place during the Financial Crisis. Honestly, it is a welcomed sign.
How to take advantage?
This type of environment is quite positive for illiquid asset classes, as managers tend to have a longer-term view and are sheltered from day-to-day movements. I do worry about some large IPOs (particularly in the tech space) that are scheduled to come to market. If volatility persists, we could see delays in some key offerings.
As extreme volatility quiets down and the markets return to normal, underlying fundamentals will dictate performance again — welcomed news indeed. Additionally, we remain quite positive on venture development, as demand for early-stage funding continues at an all-time high and the opportunity to identify disruptive technologies within research institutions is an untapped opportunity.
Future performance will require skill rather than indexing. Stock/company/technology selection will matter again. Underlying fundamentals will rule again. Alpha generation will be back in the vocabulary of investors.