Investment Outlook for January 2019
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Investment Outlook for January 2019

After a remarkable stock market year, characterized by both a record-breaking performance during the first nine months and extreme volatility during the fourth quarter, investors might be wondering whether volatility will reverse to the long term mean from now on, or whether one should incorporate the recent heightened uncertainty into this year’s performance expectations. In other words: Is high volatility here to stay?

Overall, 2018 will probably be described by historians as concluding one of the most favourable nine-year periods of economic expansion for advanced economies, but a number of commentators had been warning since the end of the first quarter last year that one possibly should not project positive trends into the future without allowing for a number of existing and potential threats. Geo-politics is an obvious source of uncertainty and last year’s instability in the Middle East, some Asian countries and Latin America continued to feed geo-political risk perceptions. At the start of 2019, one should probably add a number of European countries (France, Italy and possibly Germany) and even the USA, to this list.

President Donald Trump played his part in keeping politics in the foreground of investors’ risk perceptions by repeating his attacks on the Fed on Christmas eve, accusing the central bank of not understanding the market (although this is difficult to believe from such a veteran trader) stating that the Fed doesn’t "have a feel for the Market," and "the only problem our economy has is the Fed." Trump had been complaining for months about the Fed’s policy, obviously with potential poor voter feedback in mind, ahead of crucial elections for Congress. Some sources suggest that the president had been contemplating firing Fed Chairman Powell because of recent stock market losses that he attributes to monetary tightening. The Treasury Secretary does not seem to agree and quoted Trump as follows: "I never suggested firing Chairman Jay Powell, nor do I believe I have the right to do so."

Away from the daily political “noise” it is reassuring to note that fundamental economic trends do not point towards an imminent recession over the next few months. Consumer spending continues to drive the US economy and is not showing any signs of a slow-down: Retail sales increased by 5% in the period from November 1 to Christmas (according to Spending Pulse which records both on-line and store sales) with online sales jumping by 19%.

If erratic economic trends are not the main source for market volatility then which factor can logically explain the financial volatility witnessed over the last few months? Not for the first time in history the main suspects can be summarized as “traders” in various incarnations (program trading, quant-driven hedge funds, various ETFs, passive formulas, etc) although the statistical evidence for this notion is not very strong. The recent consensus on Wall Street seems to be that most trades come from “machines” and the sudden and sharp declines of various indices are seen as a reflection of a “new normal” in trading. This new normal trading practice also saw unexpected positive jumps recently which erased some of the draw-downs (most notably on Boxing Day when both the S&P and NASDAQ jumped by 5%) although there is still some distance to go to wipe out the declines suffered by investors since the start of the fourth quarter last year.

Equity market volatility has moved to the upper end of the historic range although it has not broken any records: the VIX index (measuring implied expectations of US stock market volatility) reached 30 on December 27.

graph 02 outlook

Source: Bloomberg – VIX Index

The equity risk premium (judging by the so-called Implied ERP) has not moved significantly in the last year, and according to NYU’s Damodaran the implied ERP in the USA stood at 5.29 % at the start of December (the historical range is 3.5 % to 5.5%) suggesting that the US equity market is presently neither over-bought nor over-sold. Historic patterns and recent fundamental economic trends suggest that, contrary to what financial headlines sometimes imply, there are no compelling economic reasons why holdings of global equities should be reduced: the higher projected returns from reduced current valuations have been kept in balance by somewhat reduced cash flow (and dividend) projections.

Neither recent economic or corporate cash flow trends, nor changes in equity risk premia provide a satisfactory explanation for last year’s spike in equity volatility across sectors and around the globe. Although a period of heightened volatility can be distressing for investors, long-term equity holders can be assured that there is no logical reason or empirical evidence to assume that the cash flow discounting nature of equity markets has fundamentally been altered in recent months. So far there also does not seem any compelling reason to assume that heightened volatility has become a structural feature of equity markets worldwide.

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The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Fund Management Limited. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.