2018 vs. 2020: (Financial) history doesn’t repeat itself

On the heels of a sparkling performance last year, equity markets entered the new decade with a full head of steam. The price performance exhibits striking parallels with the period from the start of 2017 through early 2018, but there are also some essential differences.

 

“History doesn’t repeat itself, but it does rhyme.” This aphorism, mistakenly often attributed to Mark Twain, applies with reliable regularity not just to economic history, but also to financial markets, where the price evolution of assets or financial variables – be it stocks, currencies or interest rates – recurrently exhibits sharp parallels with earlier times. In such instances, there’s an inclination to project current developments into the future along the lines of the historical “pattern” – until that no longer works. And by then at the latest, it emerges that correlation in fact does not imply causation and that price trajectories that seem to look alike usually actually germinate from entirely different underlying fundamentals.

 

Today, around six weeks into the new investment year, investors are facing a renewed temptation to tinker and reason using a historical template comparing the performance of the US equity market over the last 14 months with its performance during the years 2017 and 2018. Back then, like today, the S&P 500 stock index of the 500 largest US companies initially embarked on a robust rally, rising more than 20%. The upsurge continued unabated, and even accelerated exponentially in some market segments, into early 2018 until February of that year, when a steep correction set in. The more than 10% plunge within a span of just two weeks caught many investors on the wrong foot at that time, especially those who had grown accustomed to the steady ascent and had been speculating that volatility would stay low. If the price-performance analogy between the 2017/2018 and 2019/2020 episodes were to hold true, one could expect stock prices to turn downward these days.

 

The price evolution of assets or financial variables recurrently exhibits sharp parallels with earlier times.

 

Volatility on the equity markets indeed picked up noticeably at the start of February. It was triggered by the outbreak of the nCoV-2019 coronavirus in China, which is currently stoking economic fears among investors. Will history repeat itself this time? In the present example as well, we think it is unlikely to because the underlying macroeconomic conditions are much different today than they were at the start of 2018. Back in those days, the US Federal Reserve, for instance, had already been more than two years into the process of gradually raising its policy rate, and since autumn 2017 it had been shrinking its balance sheet (quantitative tightening) to slowly but steadily drain liquidity from the financial markets. The Fed’s tightening monetary policy caused market interest rates to rise across the entire yield curve. The yield on two-year US Treasury notes, for example, quadrupled from 0.5% in mid-2016 to 2% in January 2018. Market interest rates in 2019, in contrast, were in a continual downtrend with intermittent interruptions. The Fed made three quarter-point cuts to its policy rate last year and for a few months now has been buying short- and long-term Treasury bonds in an effort to provide US banks with ample liquidity and to suppress long-term interest rates. So, unlike the situation in 2017/2018, stocks at present are not facing a monetary-policy headwind this time around.

 

 

An itinerary for 2020, or not?

Different underlying conditions imply different outlooks

S&P 500 index, US 2-year yield and volatility index (VIX) in 2017/2018 and 2019/2020

 

And we are also at a different point today with regard to economic growth around the world. In early 2018, to cite an example, the global purchasing managers’ index, a key indicator of business sentiment among corporate executives, hit a seven-year high of 54.4 points, signaling a state of near-euphoria and at the same time marking a cyclical peak from which things practically could only head downward going forward, which is exactly what happened. Today, two years later, we are faced with an almost inverse situation: leading economic indicators are signaling a stabilization at a low level and should tend to pick up further. This would give equity markets added support. One unknown in this context is the impact of the epidemic in China. If the negative scenario doesn’t materialize and the public health crisis is brought under control, the impact on global economic growth should remain reasonably contained. And even in China, a weak first quarter is likely to be followed by a rebound in the quarters thereafter that will make up for some of the lost growth, in part because the government of China will reach for its all-purpose tool: economic stimulus through monetary and fiscal policy.

The medium-term outlook for stocks thus remains constructive. A reprise of the year 2018, which wreaked double-digit share-price losses on equity investors in the final reckoning, is less probable today due to the favorable underlying conditions that currently prevail. The near-term picture, though, looks different because February 2020 and February 2018 do have at least one thing in common, namely investor sentiment. In the wake of a weeks- and months-long uptrend, investor sentiment today is somewhere between bullish and downright euphoric. That sentiment reading implies limited potential for an immediate resumption of share-price advances. The upshot here is that history once again won’t repeat itself, and if it happens to rhyme, it will only do so rudimentarily. Stock-market volatility may remain elevated in the near term, but the equities asset class continues to ride a longer-term tailwind.

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