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January 2019

Five lessons from 2018

2018 was painful for most investors, a year that forced them to learn (or re-learn) a number of important lessons.

No hiding place in 2018

Diversification was not a winning strategy in 2018. The vast majority of regional stock markets and industry sectors that make up the MSCI World Index ended in the red last year, as did US Treasuries and corporate bond indices. Global government bonds would have done the same had it not been for a sharp December rally. Indeed, for US dollar-based investors, all major asset classes finished underwater, leaving US cash as the best performing asset class for the first time since before 1986 (see chart).

A tough year for investors

Total return % in USD and local currency

Asset return

Source: Thomson ReutersDatastream, Pictet Asset Management. Currency impact equals the appreciation of the local currency vs USD. Data covering period 31.12.2017-31.12.2018

A risk parity portfolio – one in which 75 per cent of assets are invested in global bonds (JPM Global Government Bonds in local currency) and the balance in global equities (MSCI World) – would have fallen in value by 1 per cent by year-end. That’s the first time such a portfolio has suffered a loss since 2008, and, before that, 1994.

Central bank stimulus matters...

What goes up must come down? Quantitative easing by global central banks has pushed up asset prices since the financial crisis, resulting in a record-breaking bull run in global stocks. But in 2018, and for the first time in 10 years, the world’s major monetary authorities have turned net sellers of financial assets: their stimulus has fallen to USD600 billion in 2018 from USD2.6 trillion in the previous year.1

Our analysis shows that the withdrawal of liquidity has already started to weigh on price-earnings multiples.

Looking ahead, we expect excess liquidity to keep falling. This would likely prompt a 10 per cent drop in the valuation of global equities on a price earnings basis (see chart)2.

where liquidity goes, equities follow

G3 excess liquidity and global equities trailing price-to-earnings ratio

Liquidity impact on equities chart

Source: Thomson Reuters Datastream, Pictet Asset Management. Data covering period 30.04.1982-29.03.2019 (estimated).

…and so does geopolitics

All politics may be local, but then again, so are earthquakes. 2018 reminded us that political tremors can travel a long, long way. One of US President Donald Trump’s main populist platforms was his argument that the US gets a raw deal from its trade partners, particularly China. Using his executive powers, he imposed substantial tariffs while threatening even bigger ones. So far, global trade has been relatively resilient. Manufacturers or consumers have managed to absorb the costs or, alternatively, to find new customers or new suppliers.

But for how long can the real global economy remain immune is questionable. Trade wars have already had a big impact on business sentiment. Take the export orders component of the global purchasing managers’ index. Having hit 55.7 in February, its highest point since 2011, PMI export orders dropped to 50.6 in October, which is barely in expansion territory – a slump that’s likely to have been driven by global trade tensions (see chart).

What is more, trade isn’t an issue that’s likely to go away soon. That is because at its heart is the tug of war for global supremacy between the US and China, something that will play out over years to come.
exporting worries

Global economic activity (PMI) vs export orders

Global economic activity (PMI) vs export orders

World PMI based on 34 manufacturing PMIs, GDP-weighted. Export orders based on 22 PMIs, GDP-weighted. Source: Thomson Reuters Datastream. Data as of 30.11.2018.

A stronger US dollar is always bad news for emerging markets

Emerging markets looked good on paper at the start of 2018: strong economic growth, low inflation, recovering commodity prices, attractive valuations… But one fly found its way into the ointment: the US dollar.

Dollar drag
MSCI EM total return in local currency relative to MSCI World; Fed trade-weighted USD
EM equities vs dollar chart

Rebased to 01.01.2018. Source: Thomson Reuters Datastream. Data covering period 29.12.2017-30.11.2018.

The greenback climbed some 8 per cent against a trade-weighted basket of currencies. For emerging markets that proved a sharp blow, raising fears of higher costs of servicing dollar-denominated debt and rising prices for foreign goods. As a result, total returns on developing market equities, in dollar terms, lagged the global benchmark by around 7 per cent (see chart).

Going into 2019, there are grounds to expect that the dollar will reverse course, as US growth slows, Fed tightening loses some steam and fiscal stimulus effect fades. High valuations and very bullish sentiment are additional headwinds. However, whichever way the wind blows, it seems likely that returns from emerging markets will remain closely tied to the path of the greenback.

Never under-estimate Europe's ability to disappoint

Emerging markets weren’t the only region to disappoint. The poor performance of European stocks – a consensus long last January – proved that the region’s troubles are far from over. Italy was the chief cause for concern, both politically and economically. While the Italian government clashed with Brussels over plans for an expansionary budget, the country’s economy stagnated, dragging down growth for the euro zone as a whole. The yield spread between 10-year Italian sovereign bonds and their German peers climbed above 300 basis points in the autumn – the highest since July 2013. That, in turn, pegged back European equities (see chart). In both local and US dollar terms, European equities hit an all-time low relative to their US peers in December.
yielding problems for stocks
MSCI EMU total return in local currency relative to MSCI World; 10-year yield spread between Italian BTPs and German bunds, basis points
European equities vs bond yields chart

Source: Thomson Reuters Datastream. Data covering period 01.01.2018-30.11.2018.