The past two years have been characterized by unusually high equity returns and low volatility. Cyclical stocks have also significantly outperformed defensive ones. But how long can this last?
The current bull market in global equities is now well into its ninth year, making it one of the longest up-cycles on record. As US equity valuations recently matched 1929 levels, many investors have started wondering if this bull market could be on its last legs. Indeed, the last two years have been characterized by a combination of extremely favorable circumstances, that hardly seem sustainable.
Global equity markets have posted annual returns at levels that were almost twice the historical average. From 30 June 2016 to 30 June 2018, the broad MSCI AC World and MSCI EM Indices achieved annualized returns of around 15% and 16%, respectively. This is almost twice the expected and historical global average of 8% per year.
Of course, there were significant differences between the markets. Chinese stocks fared especially well, helped by the solid performance of index heavyweights Alibaba and Tencent. Meanwhile, European markets lagged somewhat, most notably non-euro markets such as the UK and Switzerland. But, overall, the rise in global equities has been relatively broad-based.
At the same time, the level of market volatility has been only about half the historical average. In the 24 months between July 2016 and June 2018, the volatility of the MSCI World has averaged approximately 8%, which is low by any standard. At the end of 2017, the one-month rolling volatility even fell below 4%. Such a low level of volatility is normally associated with bond markets.
Historically, market volatility has been closer to 15% on average, although periods with substantially lower or higher volatility have been known to occur. Given that market volatility historically tends to revert to the mean, we think an extended period of extremely low volatility is improbable. From this perspective, the recent jump in market volatility in early February and late March 2018 could be a sign of a new period of higher volatility ahead.
Another important feature of the recent market environment is that cyclical growth stocks have significantly outperformed defensive stocks, which is not unusual in the final stages of a strong bull market. The most significant turnaround in the current bull market happened in July 2016, when cyclical sectors started to outperform defensive sectors by a wide margin.
This trend of cyclical stocks outperforming defensive, high-dividend ones has been quite consistent over the last two years. As a result, both the minimum volatility and high dividend factors have lagged the market by quite a wide margin, both in developed and emerging markets. Given these trends, it should come as no surprise that momentum has worked well, especially over the past 12 months.
Timing the short-term direction of markets and factors is always a daunting task. But, given the strong performance seen in global equity markets over the past couple of years, returns are likely to be significantly lower and more in line with long-term averages going forward. And conversely, volatility levels are expected to rise substantially.
In this context, investors who subscribe to the ‘back to normal’ view might want to look forward instead of looking in the rear-view mirror, and make sure their equity positions are consistent with their own long-term expectations.