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.
Here are lessons we draw from 2018
1. Geopolitics matter.
We had warned markets were vulnerable to temporary draw-downs 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.
2. 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.
3. Build portfolio resilience.
Broad market draw-downs 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.