Despite rallying aggressively in the year’s last trading sessions, equity indices finished December down sharply (the MSCI AC World index in dollar terms fell by 7.2%), thus putting the finishing touches on their worst year since 2008, with an 11.2% loss.
The steepest market losses among large developed economies in December were by Japan (-10.5% by the Nikkei 225), due to a run-up in the yen, and the US (-9.2% by the S&P 500), which had been holding up better until then. European indices fell by a little less than these in December (-5.4% by the EuroSTOXX 50), but more so over the course of the entire year. Likewise, emerging markets underperformed steeply in 2018, but lost just 2.9% in December (based on the MSCI Emerging Markets index in US dollar terms).
Worldwide, energy, technology and financials stocks underperformed in December, while sectors exposed to shifts in bond yields, such as utilities, listed real estate and telecommunications, were boosted by the rather sharp pull-back in yields, especially in the US.
Exhibit 1: A year to forget for equities (date as of 31/12/2018)
Behind this decline, the usual suspects
There were various causes of market jitters in December, and these were exacerbated by the traditionally low year-end transaction volumes. As had been the case since the start of the quarter, political factors and concerns over global growth combined to push equity prices down and volatility up.
Investors were kept on edge by developments in trade talks between China and the US after the leaders of the two countries met in early December on the sidelines of the G20 summit. Donald Trump and Xi Jinping decided that a trade agreement should be reached by 1 March. However, this “truce” came with new skirmishes followed by signs of goodwill from both sides but without any actual commitments being made. Although new Sino-US meetings are planned for early 2019, it’s mainly the lack of visibility on this issue that has rattled equity markets.
In the US, the stand-off between the Trump administration and the House of Representatives on funding the construction of a wall at the Mexican border led to a new partial government shutdown.
On the economic front, disappointing indicators in China in recent weeks (on exports, retail sales, manufacturing output and activity surveys) undermined investor morale, as did monetary policy decisions by the European Central Bank and the US Federal Reserve, which were deemed a little too “hawkish” (despite the softer language from Mario Draghi and Jerome Powell) at a time when global growth is showing signs of slowing. Falling oil prices (with WTI crude down by 10.8%, to under USD 50 per barrel in mid-December) is due more to supply-side issues than demand-side ones. The market was not swayed by the output reduction agreement between OPEC and its allies, while US production continued to rise. Lastly, the political situation in Europe remained unclear, especially in the UK, where Brexit scenarios were thrown into disarray by Theresa May’s decision to postpone the vote on the deal she had reached with the European Union. In Italy, however, the government’s latest decisions reassured investors, although some tensions remain within the coalition.
Exhibit 2: Rising volatility
Remember: new relaxation of long-term yields in the eurozone
Eurozone government bonds tracked US markets upward in December. The 10-year Bund yield slipped below 0.25% on several occasions to a low since mid-2017. It ended the month down by 7bp, at 0.24%.
The Italian BTP rallied, with the 10-year yield receding by almost 50bp to a low since early September, at 2.74%. The spread with German yields of the same maturity narrowed to 250bp (from 290bp at end-November), a low since late September, in reaction to the budget agreement between the Italian government and the European Commission. The Five-Star Movement and The League agreed to adjustments in their two main campaign promises (a citizen’s income and pension reform). By postponing these measures, Giuseppe Conte’s government will save enough money to bring the budget deficit down to 2.04% of GDP (vs. an initial proposal of 2.4%), assuming GDP growth of 1.0%, in line with the Commission’s figures. The Parliament approved this version of the budget late in the month, which spared Italy the opening of a procedure for excessive deficit, with which had been threatened after some tough bargaining with its European partners. As a result, late-year BTP auctions were well received.
The 10-year OAT yield rose slightly on the month (+3bp to 0.71%), in contrast to yields on other eurozone markets. In France, investors looked askance at the government’s response to the “yellow vest” movement, which will require an increase in public spending, at a time when the GDP growth outlook was revised downward. During the first half of December, the spread with German yields of the same maturity hit 48bp, a high since early May 2017. However, the European Commission quickly added that the budget deficit (expected to reach 3.2% in 2019) would be “tolerated” and that it would not review the draft French budget.
Exhibit 3: Italian BTPs rallied in December
Happy New Year 2019? Let’s keep our fingers crossed
The least one can say is that 2018 ended with a bang on the financial markets. Total returns were wiped out within three months, with equity indices and commodities closing out the year sharply down, while government bonds managed to eke out some gains despite the normalisation of G4 central bank monetary policies.
No doubt political and geopolitical factors were the cause of investor nervousness, with the markets veering sharply upward and downward in December, but they were not the only cause. Yes, the political environment is hard to read – whether it’s the Trump administration’s protectionist measures, the Brexit process, or the rise of non-traditional parties in Europe and several emerging economies – but there are more fundamental factors at play in the rocky performance on the equity markets and the rebound in volatility late in the year after it being very low in 2017.
Concerns over the sustainability of global economic growth rose in December against a backdrop of a slowdown in China and persistent disappointments in the eurozone. Meanwhile, the Fed’s monetary policy is no longer expansionist and could become restrictive in the coming months, while the ECB closed out its net asset purchases in December and is even thinking about raising its key rates next autumn. In 2018, investors mourned the exceptional circumstances that had characterised 2017 (strong growth, abundant liquidity and modest inflation) and sent risky assets sharply up. In 2019, they will have to be on their toes in dealing with this new phase in the global economy that will likely see growth becoming weaker, but still higher than potential, liquidity receding, and the prospect of higher bond yields.