Global equities had a challenging year in 2018, experiencing their steepest decline since the onset of the financial crisis in 2008 as doubts emerged about the sustainability of the economic recovery.
Last year also marked the return of volatility after a relatively calm 2017, with markets swinging sharply at several key points during the year and for different reasons. This culminated in December, as steep drops in U.S. equities were swiftly followed by the largest one‑day points rise in history. The MSCI AC World Index traded in a 20% range from peak to trough during 2018 before ending the year almost 9% lower.
The market conditions conspired to make 2018 a difficult year for active managers, with investors crowding into a small number of perceived safe haven stocks, such as Netflix and Amazon.
The U.S. market outperformed the rest of the world, supported by tax cut stimulus, but the S&P500 Index still ended the year 4.4% lower on a total return basis – its first reversal in a decade. The reduced risk appetite hit cyclical sectors hardest, with energy, materials and industrials stocks all underperforming. The largest sector, technology, was also the most volatile, as a 20% gain in the first nine months of the year was all but erased in the fourth quarter.
Europe was among the biggest laggards in 2018, as a host of regional issues – ranging from Britain’s departure from the EU to budget turmoil in Italy and protests in France – merged with global concerns about slowing growth and trade disputes. The MSCI Europe Index ended the year 14.3% lower, with auto companies and banks hardest hit.
Meanwhile, China‑related issues dominated the narrative in emerging markets, with external pressures including a trade dispute with the U.S. compounding domestic policy challenges, resulting in a near 19% drop in the MSCI China index.
More broadly, the MSCI Emerging Markets Index posted a 14.2% decline in U.S. Dollar terms, with slower corporate earnings growth and currency depreciations taking a toll on Brazil, Russia and India.
At a department level, the Internal Equities Department was confronted by the same macroeconomic and stylistic headwinds facing many active managers in 2018. While the Department has an inherent bias towards smaller and mid‑cap stocks, it was mega‑cap growth stocks that performed best early in the year before being replaced by large‑cap defensive stocks.
Among other initiatives in 2019, the Internal Equities Department will explore the possibility of creating sub mandates within some regional and country portfolios to capture specific opportunities.
In the External Equities Department, meanwhile, judicious manager selection and a sharp focus on its target markets helped to offset the impact of the challenging market conditions. The Department’s strategy typically involves targeting less efficient markets and identifying quality managers who can produce high levels of excess returns within acceptable risk parameters. To this end, it introduced a new single country mandate for Canada during 2018 and appointed a respected manager to lead its efforts in capturing local opportunities.
Looking ahead, the External Equities Department is considering complementing its current pool of managers with new strategies that target modestly lower returns over time, with lower risk – an approach aimed at further enhancing its ability to generate consistent excess returns.
During 2019, the Department will also explore the possibility of creating additional single country portfolios where it believes opportunities exist.
The Indexed Funds Department received approval in late 2018 to implement new enhanced indexation strategies. These innovative strategies are aimed at building on the Department’s success in recovering costs and generating added value while adhering to ADIA guidelines. The Department is also collaborating with other stakeholders to investigate alternative index solutions in areas such as ESG.
Heading into 2019, equity markets appear finely poised. After the selloff in 2018, valuations began the year at what some would consider attractive levels relative to expected earnings. Despite a sharp recovery in the early months of 2019, doubts remain about the sustainability of earnings growth at a time of record high profit margins and signs of a slowing global economy.
The result is an environment that will likely remain highly sensitised to economic growth signals. Geopolitical events are also expected to play a continued role in driving sentiment, and volatility.
In the U.S., equity valuations remain within historical norms even after their gains in early 2019, although with profit margins at record highs they remain vulnerable to negative surprises. Investors will be watching closely for any sign that fund flows are shifting away from mega large‑cap stocks to small and mid‑cap companies, where valuations are relatively more attractive. Such a move, which some consider overdue based on historical precedent, would mark a return to more supportive conditions for active managers than those experienced in 2018.
In Europe, markets will be driven by many of the same factors as those across the Atlantic, in addition to a number of significant regional political events.
Meanwhile, the performance of emerging markets will remain heavily correlated to global growth and the outcome of trade disputes, even though valuations are relatively attractive at the stage. If, as expected, growth slows only modestly then these markets appear well placed to recover some of the losses experienced in 2018. Any slowdown in the pace of monetary tightening in the U.S., and subsequent weakening in the U.S. Dollar, could also provide much needed support.
Over the longer term, we remain confident about the relative prospects of emerging markets – particularly China and India – versus the developed world, and this will be reflected in the emphasis we place on these markets.