2018 Year-End Review
Capital markets experienced heightened volatility toward the end of 2018 as investor sentiment shifted. Concerns over global growth, ongoing trade wars, higher U.S. interest rates, and corporate profit trends resulted in a sharp sell-off of many risk assets as the fourth quarter unfolded. U.S. equities posted gains for most of the year, with the Russell 3000 Index reaching a year-to-date (YTD) cumulative high of 11.3% on September 20th. However, a 14.8% drop from that all-time high caused the Index to end the year at a 5.2% decline.
Most asset classes (aside from cash) posted negative absolute returns for the year, although high quality fixed income protected capital in the fourth quarter with interest rates rallying sharply amidst slowing growth expectations.
U.S. Treasury yields rose across the curve through most of the first nine months of 2018 due to Fed policy rate hikes, slowing Fed purchases, and heavier Treasury issuance. As a result of higher government spending and tax reform, U.S. T-bill issuance rose 21% year-over-year (YOY) and total Treasury issuance grew approximately 8%. In early November, the 10-year U.S. Treasury yield reached a calendar year high of 3.24%—up 78 bps from the start of the year. However, as concerns about economic growth intensified, the 10-year yield fell sharply and ended the year at 2.69%—up only 23 bps for the year. In this environment, the yield curve flattened as the yield on the three-month T-bill rose 106 bps to 2.45%, moving in parallel to the Fed’s four policy rate hikes during the year. The spread between the 2-year and 10-year Treasury fell 37 bps, to 0.18%. In total return terms, U.S. Treasuries at the front-end of the curve rose 1.8% and outperformed those in the intermediate (+1.4%) and long-end of the curve (−1.8%).
While many consider a flattening yield curve a sign of expectations for a slow economic environment in the future, a more foreboding omen is an inversion of the curve—when short-term rates are higher than longer-term rates. Inversions have generally preceded recessions by 18-24 months. In early December, the spread between 3-year and 5-year Treasuries went negative. Although most market-watchers focus on the spread between the 2-year and 10-year Treasuries, this was the first time that any part of the yield curve inverted in the past 10 years.
Credit markets were impacted by these macro developments. In addition, although investment-grade corporate issuance fell 18% YOY, it was still a robust $1.3 trillion. Issuance trends in the below-investment-grade space were also significant, with the leveraged loan market rising to $1.3 trillion. This was the first time the leveraged loan market equaled the size of the high yield bond market. Below-investment-grade spreads widened by 180 bps, to over 500 bps, and investment-grade spreads rose 60 bps, to 150 bps. However, total return losses in the credit markets were less severe than broad equities. In 2018, investment-grade corporates fell 2.5%, high yield declined 2.1%, and leveraged loans gained approximately 0.6% mostly because their coupons reset higher when rates rise.
The U.S. dollar (USD) reacted favorably to domestic fiscal stimulus and to Fed rate hikes. The Dollar Spot Index, a measure of the strength in the USD versus six developed market counterparts, rose 4.4% for the year. The USD appreciated against all developed market currencies aside from the Japanese yen, which appreciated 2.7% against the greenback. The dollar’s gain against emerging markets (EM) currencies was even more dramatic. Some EM weakness was idiosyncratic in nature, most notably the 50% fall in the Argentine peso and the 29% depreciation in the Turkish lira. Collectively, there were only two EM currencies that appreciated against the USD: the Thai baht (+0.1%) and the Ukrainian hryvnia (+1.3%).
Calendar year 2018 marked the first year since the financial crisis in 2008 that the Russell 3000 Index or S&P 500 Index posted a loss. Based on closing values, the Russell 3000 Index declined 19.8% from its high on September 20th to its low on December 24th, narrowly avoiding the 20% peak-to-trough decline that would signal the start of a bear market. Market strength through the first nine months of the year was driven by growth-oriented stocks, particularly within the health care, consumer discretionary, and IT sectors. During the fourth quarter, value stocks meaningfully outperformed their growth counterparts and traditionally more defensive-oriented sectors provided some downside protection. However, the Russell 3000 Growth Index (−2.1%) still bested the Russell 3000 Value Index (−8.6%) by more than 600 bps. Led by Merck (+39%) and Pfizer (+24%), health care (+5.2%) was the Index’s best performer. Utilities (+4.5%) and IT (+3.2%) followed, with the latter generating a gain mostly on the strength of Microsoft (+20%).
Non-U.S. developed markets, as measured by the MSCI EAFE Index, were down 13.8% for the year, underperforming their U.S counterparts. Every country represented in the benchmark was down on the year—Finland (−3.4%) was the top performer—as a number of macro and geopolitical issues weighed on returns. European markets were jolted early in the year following a populist victory in the Italian election. Brexit turmoil continued, hampering returns in the U.K. and continental Europe. Germany (−22.2%), Europe’s largest economy, posted a sizable loss as the country experienced its first quarterly GDP contraction since 2015. European banks as a group lost roughly one-quarter of their value in 2018—the worst performance for the industry since 2011. Japan, the largest component of the MSCI EAFE Index at approximately one-fourth of assets, fell 12.9% despite the Nikkei 225 Index achieving an all-time high earlier in the year. The Nikkei’s gains were erased late in the year as global trade tensions weighed on a number of Japan’s export-oriented companies.
Emerging markets, as measured by the MSCI EM Index, posted a similar mid-teens decline; however, most of the 2018 sell-off occurred earlier in the year, as macroeconomic concerns and trade discussions began to escalate. In mid-September, we published an Investment Perspective, Navigating Emerging Markets Volatility, in which we highlighted the key drivers of the sharp sell-off in EM through September 14th, including fears of a slowdown in global growth, heightening trade tensions, and rising U.S. interest rates. In the piece, we reaffirmed our support of EM equity exposure in a well-diversified portfolio and advocated clients take advantage of the pullback to rebalance into weakness. From September 14th to year-end, EM equity (−5.5%) was more insulated from the broad U.S. (−14.3%) and non-U.S. developed market (−10.7%) declines. For the full year, it was particularly challenging for EM growth stocks, with tech-oriented Chinese companies Baidu (−32%), Tencent (−21%), and Alibaba (−21%) among those struggling. Representing close to 30% of the benchmark, China (−18.8%) weighed on results. Brazil (−0.5%) held up reasonably well despite sizable losses suffered earlier in the year amidst a breakout of civil unrest and political uncertainty. Brazilian equities rallied to close 2018, as markets responded favorably to the election of President Jair Bolsonaro.
Hedge funds finished 2018 in negative territory, but protected capital well in equity market drawdowns on a relative basis. The S&P 500 lost roughly 22% in February, March, October, and December, while the HFRI Fund Weighted Composite fell approximately 8%. However, upside capture during the stronger months of the year remained below the historical average. For long/short equity funds, alpha generation was low on the long and short sides, leading to relatively low dispersion between the best and worst performing funds.
Hedge funds started the year with bullish posture but reduced exposure following the market sell-off in February/March. The long/short ratio neared a recent high of 1.8 early in the year as the pullback provided an opportunity for funds to lean into positions. Gross and net exposures
began the year at historically high levels of approximately 195% and 60%, respectively, before hedge funds de-grossed significantly in October and November, reaching lows of 177% and 41% in November. This level of de-grossing was the most extreme in recent history.
The growth/value dynamic impacted hedge funds meaningfully in 2018. Growth investors had a strong tailwind throughout much of the year, while value struggled. Hedge funds’ gross and net exposures to technology have been at near peak levels since 2010. At the end of the second quarter, Morgan Stanley Prime Brokerage reported that funds had 38.9% net exposure to IT, which was in the 98% percentile since 2010. In the second half of the year, technology exposure declined significantly, while health care exposure increased. Through mid-October, technology and internet retail companies contributed 4.1% of the S&P 500’s 5.1% return before correcting significantly later in the year. The flattening yield curve hurt financials, further hindering value funds and eliminating meaningful protection for classic value investors.
Event-driven and credit-related managers with more limited equity exposure tended to outperform their more exposed peers. Merger and acquisition (M&A) activity provided a steady stream of tradable opportunities for arbitrageurs, and many managers were able to generate considerable profits from credit positions in Puerto Rico and South Africa’s Steinhoff. Cracks began to emerge in the credit market late in the year due to a number of the excesses of the last few years such as high leverage and weak covenants, but not to the point where distressed managers could put meaningful capital to work. Distressed managers have indicated they are prepared to be aggressive if the sell-off continues and companies begin to face stress next year. Event equities were a mixed bag, but there were a handful of sizable detractors. Among the largest was Caesars Entertainment, which had been one of the top contributors to results in 2017 after it emerged from bankruptcy. Caesars’ earnings failed to meet expectations and the company remains highly leveraged, which weighed on shares in 2018 (−46.3%). Many event-driven managers also held California utility PG&E, which plummeted more than 48% in the fourth quarter due to potential liability from the devastating wildfires in the state. However, pending legislation in California may help to alleviate PG&E’s ultimate liability. Merger-arbitrage was a generally profitable strategy in 2018, with many generating sizable gains from positions in 21st Century Fox and Britain’s Sky Plc amid bidding wars for the companies in the third quarter. Other major deals that contributed to returns in the year included AT&T/Time Warner, CVS/Aetna, Takeda/Shire, and Cigna/Express Scripts. Trade tensions with China led to the ultimate collapse of the Qualcomm/NXP Semiconductors merger, which hurt returns for many event-driven managers.
Most public real asset segments endured a difficult year, particularly in the fourth quarter. Global REITs declined 4.7% for the year, with the U.K. falling 18.1% in USD amidst increasing concern around the possibility of a hard Brexit. U.S. REITs (−3.9%) and Asian REITs (−0.9% in USD) each had negative absolute returns, but outperformed broader equity markets. Despite the specter of rising interest rates, property fundamentals and capital interest in real estate markets remained resilient overall. As was the case with other real assets segments, there was a continuing divide between public and private valuations driving significant M&A, including multiple take-privates by Blackstone and Brookfield. Private equity real estate had another strong fundraising year at more than $100 billion. While year-end returns are not yet available, private value-add and opportunistic funds returned 10.1% for the one-year ended September 30, 2018.
Public energy-related investments were particularly challenged in the year. Oil prices declined by more than 35% in the fourth quarter, driven by supply and demand projections and macro headlines. U.S. shale production increases surprised to the upside. Organization of the Petroleum Exporting Countries (OPEC) pledged cuts to support higher prices, but the timing and clarity on the impact did not flow through to prices. Trade war and global growth fears dropped longer-term demand forecasts. After rallying in the first half of the year, resource equities traded sharply down with oil prices in the second half. While final marks are not yet available, private natural resources appeared on track to outperform the public markets again in 2018, having delivered an 11% one-year return as of September 30th. Given the continuing increase in U.S. energy production and the need for new energy infrastructure, the opportunity set for private investment appears strong.
Oil dominated much of the commodity headlines, but is less than 20% of the Bloomberg Commodity Index, which declined 11.2% during the year. The energy category (−12.7%) was a laggard, but industrial metals declined 19.4%. Industrial metals tend to trade with sensitivity to China and global growth projections and the trade war impact was felt acutely in this category. Precious metals declined less (−4.5%) as gold resumed its role in the fourth quarter as a safe haven. Gold was one of the few positive assets in the fourth quarter, with spot prices increasing by 7.3%.
Amid this backdrop, the traditional 70/30 portfolio—70% domestic equities (S&P 500)/30% fixed income (Bloomberg Barclays Aggregate)—fell 2.8% in 2018. This mix outpaced the 7.0% decline of a more broadly diversified portfolio, which incorporates non-U.S. developed and EM equities, private equity, real assets, hedge funds, and non-U.S. bonds. Diversified portfolios were hurt by EM equity exposure relative to domestic, as well as natural resource stock and commodity exposure. Generally, hedge funds protected capital relative to the broad equity market declines, particularly in the fourth quarter sell-off. Traditional hedges, such as U.S. Treasuries, U.S. TIPS, and non-U.S. sovereign debt posted negative absolute returns, but insulated portfolios from the equity market decline. While year-end marks are not yet available, early indications are that private capital investments will be additive for diversified structures in aggregate.