It has been an interesting first half of 2018. Over the last several weeks we have had many discussions with our clients regarding the markets, their portfolios, and our strategies.
Tremendous earnings growth coupled with almost no price appreciation has provided some long-awaited opportunities. The earnings growth has allowed us to “grow into” last year’s relatively expensive market.
Having said that, we still see a lot of risk out there and will remain prudent by keeping a balance between our exposure to risk and our potential for returns. We have counseled clients for years that we are comfortable missing the first 10% and the last 10% of a rally, while making the 80% in between. We believe this remains as important as ever in our current market.
We have summarized the 5 most relevant risks to the market and have provided commentary on each.
Geopolitical risk remains the top risk for investors this year.
A notable slowdown in global growth combined with escalating trade conflicts has weighed on stock market performance in the first half of 2018.
While geopolitics remains high on our list of risks, it is worth nothing that the threat of military conflict with North Korea, considered a big risk by many at the beginning of the year, de-escalated quickly. In fact, one year ago President Trump threatened North Korea with “fire and fury like the world has never seen.” In response, North Korea announced its plan to fire missiles at Guam. Ultimately, there was no military action and tensions cooled. In a similar way, the second half of the year might see a de-escalation of trade conflicts, as world leaders negotiate away from a potential trade war.
Chasing returns remains a predictable investor behavior and a top risk for the rest of 2018. Without the aid of advice and a financial plan, retail investors often tend to chase returns. As stock market returns rise, there is in-flow of investor dollars into the market. Typically this signals a time for us to be defensively positioned as retail investors are most often wrong when attempting to time the market.
Rising interest rates also remain a risk this year. Should central banks be forced to raise interest rates more quickly than expected, markets could suffer. More of the world’s central banks are hiking rates more in 2018 than at any other time in the past six years. Inflation has jumped in 2018 to a year-over-year pace of 2.9% after ending 2017 at 2.1%. This rapid increase in rates runs the risk of an inverted yield curve which has historically been a reliable indicator of global recessions and bear markets. While this time may be different given the unprecedented intervention by the central banks over the last decade, it is something we are watching closely.
A sharp and sustained rise in the value of the U.S. dollar poses a risk to global investors in 2018. The value of the U.S. dollar rose sharply in April after falling steadily in 2017. A continued rise in the dollar could act as a drag on the dollar-based returns of non-U.S. investments. As with most foreign investments, our investment in Thornburg International Value has suffered for precisely this reason. The dollar’s move higher may also escalate trade tensions if other countries weaken their currencies to win a trade advantage against U.S.-based competitors. A result could be tighter global financial conditions which could contribute to slowed growth and financial stressors.
The fading global economic momentum this year was not unexpected but could pose a risk to investors if deceleration continues and momentum fails to stabilize. The economies of Europe and Japan are expected to slow this year to a more sustainable pace of growth after above average growth in 2017. China also continues to see its economic momentum fade. The pace of these slowdowns caught many economists by surprise in the first half of the year as the economic data widely missed economists’ expectations. Based on the global composite purchasing managers index (PMI), global economic deceleration appears to have stabilized. Reflecting steady and solid global growth for much of 2017, the global PMI jumped late in the year and then slowed sharply in early 2018. The global PMI has stabilized following the drop, but the risk of a renewed decline cannot be ruled out. Global economic volatility has seen an uptick in 2018.
Downgraded risks from our top five
We have noted frequently that the chase for yield led investors to increasingly turn to exploiting the spread between public and private assets, known as the liquidity premium. This fueled a boom in private assets that aren’t traded in public markets such as private equity, private debt, commercial real estate, and direct lending. This posed a potential liquidity issue and was a concern for us. Given some changes in the markets, we are now downgrading this risk from the top five. There are few signs that a downturn in these assets that could spill over into publicly traded stocks or bonds.
We will close with a reminder of two key takeaways from the beginning of the year that still hold true in our estimation: A global recession would be a big risk for stocks. While the global economic cycle is aging, we don’t foresee a global recession in 2018—although that risk may rise in 2019. Whether or not these surprises come to pass, a new year almost always brings surprises of one form or another. Having a well-balanced, diversified portfolio and being prepared with a plan in the event of an unexpected outcome is key to successful investing.
David B. Miller
Managing Partner | Chief Investment Officer Director of Investments David.firstname.lastname@example.org
Mallen M. Urso
Mallen.Urso@auctuswa.com | Investment Advisory