2018 was an interesting and volatile year for capital markets to say the least. US Equities posted their first negative calendar year return (S&P 500 declined 4.4%) after 9 consecutive years of positive performance. It was a bumpy ride to get there, as the S&P 500 experienced two separate 10% drawdowns, something that has happened only 1 other time in the index’s history. According to Barron’s: “In only one year — 1990 — did the market have two 10%-plus corrections, and in retrospect that marked the beginning of the great 1990s bull. (The year 1997 had a 9.6% decline and a 10.8% drop, while 2011 registered a 9.8% pullback in addition to its 19.4% correction.”
In global equities, both developed international and emerging markets (measured by the MSCI EAFE & MSCI EM indices, respectively) peaked in January, and proceeded to enter bear markets (>20%+ decline from peak) in the 4th quarter. While the pain wasn’t felt in US equities until the 4th quarter, equities across the globe were contracting for the majority of 2018. This bear market in global equities is best highlighted by looking at the 2018 performance of the top 20 individual countries in terms of market capitalization, which are listed in the chart below. The US posted the 4th best return among those countries, while the average return was -11.8%, and the median return was -13.0%. As you can see, the contraction in equities in 2018 was global and widespread.
Taking a closer look at US equities, they peaked on September 20th and briefly entered bear market territory with a 20% drawdown through December 24th before rebounding slightly to end the year. The 4th quarter was the worst quarterly performance in the US since 2008, which came somewhat of a surprise given the positive earnings and economic data:
- In the 3rd quarter, S&P 500 companies posted their highest year over year earnings growth in 8 years (+32%) and profit margins reached their all-time highs of 12.1%
- The 4th quarter is on pace to be the 5th consecutive quarter of double-digit earnings growth
- Unemployment ended the year near its all-time low at 3.9%
- Inflation has been hovering right near the Fed’s target of 2%
So why the sharp drop in US Equities despite all the positive economic data? Was it a healthy correction due to valuations stretching too high after 9 years of positive performance? Or is it an indication that a global economic slowdown could have a negative impact on the US and potentially cause a recession? There is a case to be made for either outcome, but no way to know for sure. The continued strong economic data gives me reason to believe that a recession in the near term is unlikely, but it will be important to watch for any slowdown in earnings or uptick in unexpected inflation.
One item of note in looking at the Q4 drawdown in US Equities, was the asset classes that historically have provided some downside protection when equities fall – Treasuries (TLT), Corporate Bonds (AGG), Gold (GLD) – ALL posted positive performance in Q4. While these exposures didn’t insulate a portfolio from the all the damage in equities, they certainly highlight the benefits of diversification when faced with such uncertainty over where markets are going.
Q4 2018 Performance: S&P 500, TLT, AGG, & GLD:
Another important thing to keep in mind is the context of what has happened the last 10 years in the US and abroad. Below is a chart that reflects the 10-year cumulative performance through 12/31/2018 for the S&P 500, the MSCI EAFE, and MSCI Emerging Markets indices.
10-year Cumulative performance: S&P 500, MSCI EAFE, MSCI Emerging Markets:
The amount that US equities have advanced since 2008 as well as the outperformance in the US relative to global equities is significant. US biased portfolios have been rewarded the last 10 years, but now more than ever there is a strong case to be diversified globally. If you’re a believer that investment performance is mean-reverting and that a truly diversified portfolio includes international exposures, then it shouldn’t come as a surprise that many firms are overweight developed international and emerging markets entering 2019.
So where will equities go from here? The appropriate answer to this question should always be: “we don’t know for sure”. At the end of 2016, many strategists and forecasts said that we were “late cycle” or in the “9th inning” of the economic expansion that began in 2008, and that equity valuations were higher than their historical averages. The S&P 500 went on to post an annual return of 21.8% in 2017 with 12 consecutive positive monthly returns for the calendar year, something the index has never done since its inception.
If anything the last two years highlight two things: the difficulty in forecasting market returns, and the importance of remaining invested in a diversified allocation that’s aligned with your portfolio objectives.
Andrew Gibson, CFA
Vice President / Investment Officer
The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.