A summary of Q4 2018: Be careful what you wish for

9 min read 4 Jan 19

Summary: The last quarter of 2018 saw some significant equity weakness, which came in two bouts:

In October, price weakness emerged in response to rising rate expectations in the US. However, any investors hoping that an abatement of those pressures would support equity markets were to be disappointed.

The easing of rate pressures has instead been associated with more negative sentiment toward equity markets, not less. Longer-term rate expectations have declined only against a backdrop of renewed growth concerns.

The fact that this has taken place even as the policy rate has increased means that the yield curve flattened, including the much discussed inversion at shorter maturities:

On a global level, the US market was one of the worst performers in December, reversing the story for much of 2018. Among major markets, only Japan did worse, a function of the sharp appreciation in the Yen in that month.

Diversification was hard to come by, but it is worth noting the outperformance of the Mexican market, reflecting the idiosyncratic behaviour of Mexican assets that I discussed last month.

An imperfect storm

A number of reasons have been put forward to explain this more recent growth pessimism. December’s equity price declines have been put down to variety of factors, including slowing economic data, declining global liquidity, ongoing trade concerns, and the threat of US policy error against this backdrop.

Often when such a range of possible causes are put forward it is described as a ‘perfect storm’ (see for example, herehereherehereherehere, and here for mentions since the start of October). This is not just because the phrase is a cliché often used by commentators; it is also reflective of confusion over just what is driving markets.

When a wide range different rationalisations are put forward for price moves it might be that all are indeed valid. Or it could be that commentary is clutching at straws to explain moves that have no obvious direct cause.

December certainly felt that way, with the US market seeing significant intraday swings (resembling the environment I commented on in Q1 last year) and ‘gapping behaviour,’ often unrelated to news flow. What seemed like a plausible story for price moves one day was often inconsistent with what followed.

I wish it could be Christmas every day?

Such apparently confusing price action can elicit dangerous responses in investors. One is to believe that markets (or at least those who have just sold) ‘know something’ you don’t’. Perhaps all those bear arguments about QE bubbles are right? Maybe algorithms have changed markets? Maybe all global profits and growth data are illusory?

As always, this could well be the case – but be wary of changing your mind just because markets are causing you stress.

The opposite temptation is to dismiss market moves as simply the product of the holiday season. Commentators still refer to the ‘Santa Claus rally’ (as discussed here in 2016). Maybe calendar year motivations impact decision making, or perhaps low volumes make for a more chaotic price determination mechanism. It is certainly the case that volumes tend to be lower in December:

However – like all rules of thumb in markets – even if true, there is little chance of profiting from it consistently (the chances of such widespread commonplace not being arbitraged away seem very slim). In fact, as Winton have shown, there is little or no evidence for seasonal trends in being meaningful. If anything, December is the least volatile month historically.

Perhaps the main opportunity the Christmas period provides for investors who celebrate it is that being out of the office diverts attention from the type of short term price moves that can pollute our decision making.

The information in commodities

To some extent, the attention on equity markets distracted from the equally sharp declines in the oil price in the fourth quarter. Both oil and copper have fallen materially in the second half of the year.

What is interesting in the phase is how the nature of commentary differs from the obsessive attention on commodities as a global growth indicator in early 2016. We have commented before on how this attention varies over time:

This is not to say that we should be more or less worried about commodities today than we were then (though there are more compelling arguments that a falling oil price seems more likely to be a drag than a boost for the US economy than it once was). It simply highlights the fact that we should be wary of becoming obsessed by the issue of the day (or ignoring those issues that get less coverage).

The process by which investors (and especially commentators) choose where to focus their attention could well have a significant behavioural element: perhaps there are more ‘interesting stories today’ or, having experienced an oil price collapse, we are less afraid of it than we once were.

Looking ahead

The first few days of 2019 have been in keeping with the equity volatility that ended 2018. The US saw the worst two-session start to the year since 2000 and Asia the worst start since 2016 . Should moves persist we can expect articles arguing that ‘when a calendar year starts like x, it normally means annual returns are y.’ These should of course be ignored, as should our tendency to extrapolate the recent past. The weakness at the start of 2016 ultimately set equity investors up for good returns, while the optimism that greeted the start of 2018 is now dead and buried.

The history of markets is for the expectations of the consensus to be confounded again and again. For investors (to use my own lazy cliché) the best bet is to expect surprise in the year ahead, and the best way to negotiate whatever twists and turns may come is to maintain a disciplined investment approach.

By Stuart Canning

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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