Key Themes From Our 2019 Capital Markets Forecast

The last ten years in capital markets have been anomalous in many ways. Gains in global equities have exceeded the gains in the worldwide economy, as measured by gross domestic product (GDP), since the onset of the bull market almost ten years ago. To some degree, this is an unfair comparison; it is often the case that returns in equity bull markets outpace GDP and wage growth since investors are willing to pay more for an earnings stream when growth prospects are more optimistic, a phenomenon known as equity multiple expansion. However, multiple expansion has been even more pronounced during this recovery. Equally as anomalous, market performance has substantially rewarded one asset class: U.S. equities. What this may mean going forward is the subject of a deeper discussion later in this piece, but suffice it to say when diversification fails investors over a large swath of time, it is atypical.

Early last year, we projected volatility to increase in 2018, coming off a strong 2017 which featured the lowest volatility on record for the MSCI All Country World Index (ACWI) and the second-lowest volatility in the past 100 years for the S&P 500 index. This turned out to be a prescient call. Volatility of 15.3% and 13.5% in 2018 represent the largest standard deviation in the S&P 500 and MSCI ACWI, respectively, since 2011. The choppiness has rattled investors, if for no other reason than instability following a period of abnormally low volatility typically feels more unsettling. This is evidenced by weakness during 2018 in almost all assets outside of cash, a mirror image of the strong results in 2017. The silver lining to a year like 2018 is the performance of the economy exceeding the gains of the equity markets. While this may serve as a painful adjustment in the short-term, it has historically proven to be a necessary breather for longer-term health in the equity markets.

All of this begs the question of where to from here, for both the economy and the markets. To answer that we need to assess: 1) from where have we come, 2) where are we now, and 3) where are we going? Per our investment process, our goal is to understand what we are seeing in the context of historical data and to use this information to assess the likelihood of what will come next. There are compelling quantitative and qualitative reasons to argue the economy, and thus the stock market, has more room to run despite the worst December in nearly 100 years.

There are, however, no assurances, especially given the length of the bull market and our belief that volatility is here to stay for the foreseeable future, particularly when taken into historical perspective. Looking at Cboe Volatility Index® (VIX) data going back to 1990, we find there are instances of bullish price action with a VIX above 20. From the middle of 1997 through the end of the bull market three years later, the VIX was routinely over 20. With a current market which has spent the bulk of the last seven years under 20 (the first three years of the bull market were spent whittling down volatility from bear market highs), this is a feeling to which investors are not accustomed. This leaves us with two important points: 1) because volatility has been abnormally low by historical norms, volatility could still be low by historical standards even as it moves higher, and 2) higher volatility does not preclude equity markets from rising further.

This analysis may seem to contradict our recent decision to reduce exposure to equities across all strategies. However, history is replete with examples of corrections within bull markets which lack depth and duration but during which it is still optimal to reduce risk, including as recently as late 2015 and early 2016. The idea of repositioning risk within our portfolios during market turbulence does not mean we are expecting a repeat of the last two bear markets. In fact, history demonstrates that years in which the equity markets have taken a breather while the real economy continued to chug along (e.g., 2018), have not occurred near the tops of market cycles. Instead, they have taken place in the middle of market cycles, as equity valuations readjust and set the stage for another leg in an underlying bull market. Two notable recent cases of this are 1984 and 1994. The obvious counterpoint to 2018 serving as a repeat of 1984 and 1994 is they occurred only a few years removed from respective recessions, whereas the current market is almost 10 years removed from the recession that ended in June 2009.

We believe the length of a recovery is less significant than its magnitude. Age, in and of itself, is not necessarily the determination, but rather what comes with age. This is a key point when reconciling where we actually may be in the business cycle and in a corresponding bull market/bear market cycle. It is crucial to comprehend the dynamics of a typical business cycle and to understand why this one may be different.

In addition to supplying strategy ranges and expected returns, this year’s Forecast will focus on the nature of the economic cycle, analysis of our current positioning within the cycle, and implications for economic growth and capital markets expectations. We continue to expect public market returns to be relatively anemic over the next seven years. However, we are more optimistic than at this time last year despite a litany of investor worries, including central bank policy, trade, rising interest rates, yield curve inversion, and potential inflation. Our optimism primarily relates to improved equity valuations and higher interest rates. The incremental uptick in optimism will likely be met with higher volatility, which is to be expected as the economic cycle ages.

Increased volatility should lift the equity risk premium, thus compensating investors more for taking on risk. Across our strategies, higher equity risk premiums increase our ability to maximize equity exposure given a lower probability of breaching drawdown targets. Additionally, higher projected rates from Fixed Income should allow our strategies to be more effective in maintaining goals when equities go out of favor. For capital markets, an increase in alpha (i.e., the active return on an investment) is to be expected from both active managers and active rebalancing after a long period of underperformance relative to passive strategies.