Putting 2018 in Perspective

4 February 2019

Despite a strong start to the year, capital markets finished 2018 with an intense bout of volatility and risk aversion.

Broad-based selloffs in the fourth quarter erased gains accumulated across most asset classes earlier in the year and pushed equity markets into negative territory for the year. Exhibit 1 depicts the extent of this selloff — with risk assets trending steadily down during the fourth quarter, having few places to hide.

Exhibit 1: Fourth Quarter Returns

Chart 1: Fourth Quarter Returns

Daily data from 1 October 2018 to 31 December 2018. Past performance is not a reliable indicator of future results. Sources: MSCI, Bloomberg Indices, Bloomberg. MSCI World Index (net total return, USD), MSCI Emerging Markets index (net total return, USD), Bloomberg Commodity Index (total return, USD), and Bloomberg Barclays US Corporate High Yield Index (total return, USD)

Exhibit 2 illustrates the tumult, as measured by the so-called fear index — Chicago Board of Options Exchange Volatility Index (VIX) — which surged to 25 from 12 over the fourth quarter, exemplifying the market’s forward-looking volatility expectations.

Exhibit 2: Volatility Spikes to End the Year

Chart 2: Volatility Spikes to End the Year

As at 31 December 2018. Month-end values are used. Sources: CBOE, Bloomberg

“The Worst December since the Great Depression”

The year concluded with attempts by the financial press to portray the market downturn as one for the ages. The most notable of these reports centred on the S&P 500 Index, which represents U.S. companies with large market capitalisations, registering the “worst December since the Great Depression.”1 Global equity indexes were hit similarly, with the MSCI World Index registering its worst December on record (dating back to 1970), as shown in Exhibit 3.

Ex 3: MSCI World Index Performance in December

Chart 3: MSCI World Index Performance in December

MSCI World Index, gross total return USD. As at 31 December 2018. Data series extends from 1970 to 2018. Source: Bloomberg, MSCI. Past performance is not a reliable indicator of future results.

Full-year 2018 returns were much less extreme than December’s performance, and by no means historically extraordinary.

Headlines making these claims failed to convey necessary context for understanding the December (and fourth-quarter) plunge — grossly overselling the extent of the market decline.

Global equities (as measured by the MSCI World Index) were actually performing above average heading into the fourth quarter before volatility struck in October. As Exhibit 4 demonstrates, performance was much less extreme for the full calendar year than during December and the fourth quarter, and by no means historically extraordinary.

Ex 4: MSCI World Index Calendar Year Performance

Chart 4: MSCI World Index Calendar Year Performance

MSCI World Index, gross total return USD. As at 31 December 2018. Data series extends from 1970 to 2018. Source: Bloomberg, MSCI. Past performance is not a reliable indicator of future results

In fact, when limiting our focus to monthly returns since the turn of the century, the most recent December decline appears unlikely but not unprecedented (with a standard deviation2 of 1.4, assuming an annual volatility of 20.5% based on our latest Capital Market Assumptions). Since 2000, there have been 13 months with softer total returns — they just happened to not be Decembers.

The Outlier That Was 2017

The dislocation at the end of 2018 may have felt particularly outsized because it occurred amid an unusually long period of volatility. Looking back to Exhibit 2, it’s plain to see that expected volatility measures escalated in the fourth quarter to the highest sustained levels in several years. But in a longer-term context, this was not abnormal. Year-end volatility was nowhere near that of the financial crisis of 2008 or dotcom crash in 2000; it was more akin to the minor market correction we saw at the start of 2016.

This point is illustrated in Exhibit 5, which shows the number of daily one-percent price declines in each of the past thirty years. There was a large jump in single-day declines from 2017 to 2018, but the outlier was not the instability of 2018 — it was the notable calm of 2017. Last year’s turbulence was more of a return to normal equity-market behaviour than a sign of looming crisis. And while many of its one-percent-decline days occurred in the fourth quarter, such clustering is not unusual. Since 2000, there have been nine other quarters with at least as many one-percent-decline days.

Exhibit 5: One-Day Losses Greater Than One Percent

chart 5: One-Day Losses Greater Than One Percent

MSCI World Index, gross total return USD. As at 31 December 2018. Past performance is not a reliable indicator of future results. Source: Bloomberg, MSCI, SEI

“The Time to Buy Is When There’s Blood in the Streets”

Baron Rothschild, 18th century British nobleman and member of the legendary Rothschild family banking dynasty, reportedly said, “The time to buy is when there’s blood in the streets.”3 No, we do not see last quarter’s weakness as a sign of equity prices haemorrhaging to the point of recession, drowning Wall Street with figurative blood. However, in light of the recent volatility, this quote is a good reminder that investors can be best served by maintaining a thoughtful investment strategy — which might include capitalising on opportunities during a downturn — rather than letting emotions drive decision-making.

Market selloffs are often called corrections for a reason: When prices “correct,” they’re pulling back from overpriced or inflated levels to more moderate values that are less likely to swell into a bubble that eventually bursts. Even with the recent earnings boom over the past few years, equity multiples continued to climb as price increases far surpassed earnings growth. Meanwhile, investment-grade and high-yield credit spreads both remained historically tight, offering investors minimal compensation (by historical standards) for taking on extra risk. As we see in Exhibits 6 and 7, the fourth quarter of 2018 served as a release valve of sorts, allowing risk-asset valuations across capital markets to settle at more moderate levels — and, as equity valuations pulled back, credit spreads neared their 10-year averages.

Ex 6: MSCI World Index Price Levels

Chart 6: Ex 6: MSCI World Index Price Levels at Different Price-to-Forward Earnings Ratios

Monthly data from January 1996 through December 2018. Implied prices are calculated using forward earnings times forward P/Es. Past performance is not a reliable indicator of future results. Sources: MSCI, Factset, SEI

Exhibit 7: Credit Spreads

Chart 7: Credit Spreads

As at 31 December 2018. Past performance is not a reliable indicator of future results. Source: Bloomberg Indices, Bloomberg. Month-end values are used. High Yield represented by Bloomberg Barclays US Corporate High Yield Index. Investment Grade represented by Bloomberg Barclays US Corporate Index.

Looking forward, we are beginning to see mixed signals about where we are in the economic cycle; we still expect the global economy to continue expanding in 2019, albeit at a moderating pace. The challenging conditions seen in the final quarter of 2018 can prey on investors’ emotions. But the global economy is not exactly in dire straits, and we believe most markets have now corrected to more attractive valuation levels.

Our confidence is increasing that risk assets bottomed in late December. The sheer ferocity of the recent correction is reminiscent of other times in the past eight years when stocks sold down hard, only to turn around and hit new highs. Expected MSCI World Index earnings growth for 2019 remain in the mid-single-digits as of late January, leading us to believe that — barring a collapse in multiples or a major black swan event — 2019 may be another solid year.

We believe investors can be best served by maintaining a thoughtful investment strategy — which might include capitalising on opportunities during a downturn, rather than letting emotions drive decision-making.

Putting 2018 in Perspective: Keeping a Strategic Mindset

While examining the volatile capital markets of 2018 can provide useful insight, it is important to maintain perspective and remember to keep in mind the broader historical context. We believe that any reactionary, wholesale changes to a long-term game plan are not only ineffective, but potentially harmful, to an investor’s ability to achieve long-term goals. In our view, strategic allocations should be considered a permanent — or at least durable — core positioning designed to help produce well-diversified, efficient portfolios. These allocations can be tailored to an investor’s ability (including time horizon) and willingness to take risk (if applicable), with the ultimate goal of meeting long-term investment objectives.

In our December 2018 paper, The global bull market: Is it time to get out?4, we examined how timing the market successfully requires, at a minimum, two well-timed decisions (when to exit and when to re-enter), both of which pose risks to meeting long-term investment objectives if poorly timed. That being said, there is a meaningful degree of activity occurring under the hood in many of our solutions as we believe that prudent active management can improve a strategy’s results. Sub-advisors in SEI’s actively managed strategies engage in active security selection and seek to exploit excess return sources, such as value, momentum and stability characteristics (factors); in some cases, our portfolio managers implement active tilts among these factors; and our Portfolio Strategies Group engages in active (or tactical) asset allocation. Tactical allocation positions can be thought of as temporary, as we expect them to be unwound at some point. These changes are marginal adjustments, implemented in a way that avoids overwhelming the strategic characteristics of a portfolio, but are still expected to enhance the return of a strategic portfolio or lower its risk at the margins.

Legal Note

1 See CNBC.com on December 17, 2018; CNN.com on December 18, 2018; and Marketplace.org on December 25, 2018, for example.
2 Standard deviation is a statistical measure of historical volatility. A statistical measure of the distance a quantity is likely to lie from its average value. It is applied to the annual rate of return of an investment, to measure the investment’s volatility (risk). Standard deviation is synonymous with volatility, in that the greater the standard deviation the more volatile an investment’s return will be. A standard deviation of zero would mean an investment has a return rate that never varies.
3 “Buying when blood is in the streets.” February 2011. Mackintosh, James. Financial Times.
4 “The global bull market: Is it time to get out?” December 2018. Patten, Art. SEI.

Glossary of Financial Terms

Black swan event: A black swan event is an occurrence  that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. 

Factors: Factors, or risk factors, are characteristics of securities (such as momentum,  stability or value) that can be periodically under- or over-priced, resulting in temporarily larger or smaller risk premiums.

Forward price-to-earnings ratio: The forward price-to-earnings ratio is the ratio of a company’s share price to its expected earnings over the next 12 months, which can be used to help determine whether a stock is undervalued or overvalued.

Momentum: Momentum securities are those whose prices are expected to keep moving in the same direction (either up or down) and are not likely to change direction in the short-term.

Option-adjusted spreads: Option-adjusted spreads estimate the difference in yield between a security or collection of securities and comparable Treasurys after removing the effects of any special features, such as provisions that allow an issuer to call a security before maturity.

Stability: Stability securities exhibit lower risk and higher quality, and can benefit from the power of long-term compounding as a result of the investors tendency to misprice lower risk.

Value: Value securities are those that are considered to be cheap and are trading for less than they are worth.

Index Definitions

The Bloomberg Barclays U.S. Corporate  Index is a broad-based benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market. 

The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. 

The Bloomberg Commodity Index reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight- caps are applied at the commodity, sector and group level for diversification. 

The Chicago Board Options Exchange Volatility Index (VIX) tracks the expected volatility in the S&P 500  Index  over the next 30 days. A higher number indicates  greater  volatility.

The MSCI Emerging Markets Index is a free float-adjusted market-capitalization-weighted index designed to measure the performance of global emerging-market equities. 

The MSCI World Index is a free float-adjusted market- capitalization-weighted  index designed to measure the equity market performance of developed markets. 

The S&P 500 Index is a capitalization-weighted  index made up of 500 widely  held U.S. large-cap  companies.

Legal Note

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