Last year was an extraordinary one for markets with strong returns and rock-bottom volatility (vol) across most asset classes. The market environment in 2018 has returned to a more “normal” mix of lower returns and higher volatility. This reflects rising economic uncertainty and less room for growth to exceed expectations.
The chart below illustrates this reduced reward for risk, one of the three investing themes in our Q2 2018 Global Investment outlook. It shows how a hypothetical global portfolio of 60% equities and 40% bonds would have seen its Sharpe ratio, a measure of returns over cash relative to realized volatility, plummet this year (see the orange dot) from 2017 peaks. A key reason: a hefty rise in equity volatility back to more “normal” levels. Volatility was unusually low in 2017, even in the context of low-vol regimes we have seen since 1980. The recent plunge in the Sharpe ratio also comes amid more muted asset returns and rising U.S. cash rates–a product of the Federal Reserve’s gradual monetary tightening.
The euro-zone example
What explains the shifting market backdrop? We see two key factors. First, economic uncertainty has risen as U.S. stimulus and trade policy actions have broadened the range of possible outcomes compared with 2017. Second, we see less scope for growth outside the U.S. to beat expectations. This is reflected in our BlackRock Growth GPS, which points to above-trend global growth in 2018 but shows consensus having caught up with or even overtaken our own measure. Europe provides a good example. Growth expectations there have likely overshot after last year’s unexpectedly strong data. Our GPS suggests the euro-zone should experience decent above-trend growth in the coming year. Temporary factors, such as an inventory unwind, may explain some of the region’s recent disappointing economic data. Yet consensus estimates look too high and may need to revert to more realistic levels, we find.
A bumpy road ahead
This points to a bumpy road ahead for markets, especially when combined with elevated geopolitical risks and slowly rising inflation. Yet we do not believe lower returns and higher short-term volatility spell the end of the equity bull market, now in its ninth year. Nor do we see warning signs, such as a widespread buildup in leverage, that would signal the end of the expansionary cycle. We see synchronized global growth with room to run providing a solid foundation for equities. We see higher interest rates ahead, but plentiful global savings should keep yield rises moderate–even amid rising U.S. bond issuance.
We prefer to take risk in equities over credit. We see market returns being driven by earnings growth, dividends and coupons, rather than rising valuations. This, too, is a return to normal. We prefer equity markets with higher earnings growth, such as the U.S. and emerging markets (EM). In fixed income, we prefer EM debt and short-duration U.S. bonds. The latter’s recent yield increases reflect anticipated Fed hikes and make for an attractive risk/reward trade-off.