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In a typical year, financial markets are a mixed bag. Some are up and others are down, but this didn’t happen last year. 2018 has been difficult for investors with cash outperforming both bonds and equities for the first time since 1993. In fact, 89% of asset classes worldwide handed investors losses, more than any year going back to 1901 as the outlook for economic growth and corporate profits was dampened by rising trade tensions and interest rates. All of which have left investors with few safe places to put their money.

Before running for the hills in panic, there are a few things worth considering. First, while bad things occur all the time in the markets, the damage is usually localized to sectors. Second, when turmoil is more widespread the main question is whether this disruption is temporary or systemic. In the case of the U.S., its economy is in a sweet spot: growth is strong; unemployment is below 4% (near 50 year lows) and business and consumer surveys are healthy. The underlying conditions remain sound, just a little less upbeat versus the high level of comfort as stocks churned higher in 2017. While Canada’s growth is expected to slow marginally over the next two years, the economy should still prosper after the new North American trade agreement makes the future more certain and oil prices begin to stabilize. Canada’s central bank is taking a break from raising interest rates and the pause could be protracted as a weaker economy will curb inflation and the need for caution.

International growth could slow sharply over the next year or so. There has been a slowdown in Europe already which is likely to persist. Europe does not seem to have learned from the last series of crises and could come under renewed stress as the continent is being battered by Brexit, uncertainty about German leadership and the rise of populism in Italy. Coupled with the European central banks decision to press ahead with plans to normalize policy and end quantitative easing, the outlook is becoming murky once again. The U.K. economy could meaningfully slow down this year as the Brexit uncertainty will not subside anytime soon.

Across Asia the picture is similar. Japan remains stable despite the expected easing of the prolonged low interest rate policy. Still, the sales tax hike in October 2019 is looming and could be highly disruptive to growth as it has done in the past. The slowdown in Australia’s housing market will likely restrain consumer spending despite anticipated stability in interest rates. The U.S./China trade war has already taken a toll on large chunks of the global economy as China is growing at its slowest rate in nearly a decade. There are also continued worries about the health of emerging markets outside of China.

Most of the world’s equity market pain occurred over the last three months. It’s likely that the markets are going too far in pricing in bad news which could potentially lead to a rally as investors buy oversold equities. In Canada, equities were down 10.1% for the fourth quarter and 8.9% for the year. The U.S. actually gained 4.4% last year in Canadian dollar terms (all percentages are in Canadian dollar terms), but lost 8.1% over the last three months. International equities dropped 4.6% in 2018 and 7.1% in the fourth quarter, paced by Europe’s 7.7% decline. Canadian bonds gained 1.4% for the year, with all of that occurring in the last three months 1.8% gain. As mentioned, cash was the big winner yielding 1.7% annualized for the last three months of the year.

Global economies are set to undergo a slowdown in 2019 but that does not necessarily mean further pain. Certainly, more volatility could be in store as headlines whipsaw markets so investors should be alert to signs of market stress. However, there appears to be little to indicate a continued equity market downturn. Fundamental economic conditions remain relatively strong and while political fragmentation and international trade woes are concerning, they likely cannot by themselves nullify the upside potential of the markets.

The breadth of the underperformance encompasses virtually all assets classes and 2018 could be rated as one of the worst years in history for investors. In Canada, despite the economy being far from worrisome and at near full employment, the equity market had a challenging year. The sectors that form the backbone of the S&P/TSX index, Financials and Energy, dragged the index to an 8.9% loss on the year; its worst performance in a decade.

In 2018 all but two sectors of the Canadian equity market were in negative territory and most of the drop occurred in the erratic fourth quarter. The Energy sector was the worst performer with a 28.6% plunge in value on a total return basis over the year It was followed by the Consumer Discretionary sector which fell 17.7% and Financials which declined 12.5%.

Canada’s oil price discount, which is the difference between the Canadian oil benchmark the Western Canadian Select (WCS) and its American counterpart West Texas Intermediate (WTI), has been historically impacted by heavy oil but spread to light oil and was becoming costly for producers. During October the dollar amount of the discount was estimated to be about $50 million per day, or more than US$52 per barrel. It’s no wonder that the returns for the energy sector were very poor. As for Financials, despite rising rates and reassurance from credit rating agencies such as Fitch, investors continue to be wary.

On the positive side, the Consumer Staples sector returned a marginal 0.7% for the year while the most positive contributor was Information Technology which rose 11.7%. In early 2018 Health Care, and in particular marijuana stocks, skyrocketed but over the course of the year investors grew more cautious as the sustainability of their valuations began to be questioned. The subsequent correction was swift and severe for marijuana stocks which caused the Health Care sector to post a negative return.

With growth taking a breather in major economies around the world during 2018, some analysts have predicted that global growth has peaked and a few have even made recessionary calls citing the flattening and then temporary inversion of the U.S. yield curve. The inversion in December was the first occurrence in a decade. Our view is that rather than a recession, the synchronized global growth that the world experienced a few years ago will be slower in 2019. Pockets of deceleration will still exist and weigh negatively on global momentum. But overall growth, although subdued, is likely to be decent. That argument seems especially compelling for Canada with an economy that faced many headwinds in 2018 including NAFTA, the bear market in Energy and numerous geopolitical issues.

The Canadian FTSE TMX Universe Bond Index gained 1.8% in the fourth quarter of 2018 and was up 1.4% for the year. Over the course of 2018 the Bank of Canada raised rates in July and again in October, bringing the Canadian interest rate benchmark to 1.75%. In the U.S., the Federal Reserve increased its benchmark interest rate in December. It was the fourth quarter-point rate hike in 2018 and pushed the target range to 2.25% to 2.5%. The recent increase was the ninth rate rise since the U.S. began raising rates in December of 2015.

The most recent Canadian rate increase was announced on October 24 in a Bank of Canada statement and confirmed that that the bank felt comfortable with the economic outlook now that politicians in Canada, Mexico and the U.S. had agreed on the revised trade agreement. That evidence suggested that Canadian households were adjusting to higher borrowing costs. The central bank’s policymakers raised their outlook for business investment and exports, which suggests that the economy is becoming less reliant on debt-fuelled spending and the housing market.

In December the U.S. Federal Reserve announced a widely expected quarter-point increase in its benchmark interest rate and signaled that it plans to continue raising rates this year. The decision to raise rates for the fifth consecutive quarter, by a unanimous vote of the Federal Open Market Committee, amounted to a rejection of the view that the Fed should hold off raising rates in order to help prop up the economy in hopes of increasing employment and wage gains. The statement made no mention of turbulence in the financial markets, however Fed Chairman Jerome Powell did say that the central bank is very close to the range of neutral-rate estimates, a sign that the central bank may back off its plans to normalize interest rates this year as the outlook for growth has increasingly migrated to one that includes a mid-cycle slowdown.

Canada’s economy is growing somewhat faster than the Bank of Canada predicted a few months ago and “vulnerabilities” from elevated levels of household debt are “edging lower,” according to their statement. Policymakers reiterated that interest rates must rise and offered a more definitive notion of where it wants to go. Additionally, the statement notes “Governing Council agrees that the policy interest rate will need to rise to a neutral stance to achieve the inflation target.” The Bank of Canada’s Governor Stephen Poloz has talked about returning interest rates to a level that economists associate with normal, a place where the cost of money is neither stimulating expansion nor curbing growth. The central bank estimates that the “neutral” interest rate is something between 2.5% and 3.5%. The statement confirmed that the pace of interest-rate increases will be determined by “how the economy is adjusting to higher interest rates, given the elevated level of household debt” and “global trade policy developments.” The resolution of the North American trade dispute is a relief but the central bank expressed heightened concern of the U.S. trade war with China.

The Standard & Poor’s 500 index lost 13.5% in U.S. dollar terms over the fourth quarter and in Canadian dollar terms the index has fallen 8.1%. For 2018 as a whole the U.S. equity benchmark dropped 4.4% in U.S. dollar terms but was up 4.4% in Canadian dollars as the loonie came under pressure. The S&P 500 share index hit a rough patch which was not all that surprising given that we were in the tenth year of a bull market and economic expansion. Global financial market volatility picked up in 2018 and is pointing to an expectation among some investors that deterioration in global macro conditions is increasingly likely. That suggests the outlook analysis for 2019 should be more about assessing whether underlying economic conditions allow for an extension of the global business cycle. The U.S. may well enter a cyclical slowdown in 2019 and, if so, a key question is whether the Federal Reserve can successfully engineer a soft landing for the U.S. economy. Back in September most Fed officials had predicted at least three rate increases over the course of 2019 but following the December rate announcement they are now predicting the central bank would raise rates no more than twice this year. The mention of any rate increase at all sent markets into a tailspin as many investors hoped that the Federal Reserve was closer to the end of its hiking cycle.

A stronger economy tends to push up interest rates, which in turn puts downward pressure on stock prices. In late December the U.S. Bureau of Economic Analysis confirmed that real gross domestic product (GDP) increased at an annual rate of 3.4% in the third quarter of 2018 according to its third estimate. The very healthy real GDP number in the third quarter reflected positive contributions from personal consumption expenditures, private inventory investment and non-residential fixed investment. However headwinds, including restrictive trade policies and tighter financial conditions, are gathering. This should lead to a classic cyclical slowdown in 2019. For 2020, the current consensus forecast suggests a soft landing.

Given the sell-off in expensively priced tech shares in October and the trend to higher interest rates, it’s not surprising that warning signals began to flash for some traders. In December retail outflows picked up, unlike in the October sell-off, as mutual funds were cashed in and stocks in e-trade accounts were sold which would indicate that relatively inexperienced investors headed for the sidelines. The volatility indicators such as the VIX index don’t yet suggest the big money is ready to be swept off the table. It’s not the summer of 2008.

During 2017 synchronized global growth and prevalent calm were main reasons for bullishness. However, last year volatility returned to the global markets in a very big way indicating expectations of ominous signs appearing on the horizon. While several early warning signs are starting to flash, none are consistent with an imminent collapse in world growth. The pace of growth is shifting to a lower gear, which is consistent with late cycle dynamics and should not choke off growth, despite less supportive monetary policy.

The European economy enjoyed its strongest performance for a decade in 2017 but cooled off in 2018. Quite simply, Europe’s economy disappointed and lingering concerns remain. At first sight, alarm bells should be ringing, however the slowdown in Europe can be explained in large part by the disruption to the auto sector caused by the rollout of new emissions tests. Growth in much of Central and Eastern Europe has chugged along at a decent pace. Of course, there are issues: the winding down of the central bank’s asset purchase program and the potential for rising interest rates; the U.K. stumbling toward agreement with the European Union over Brexit; trade tensions and the challenges posed by Italy’s acute fiscal difficulties. Europe is fundamentally solid and while growth is moderate, it is not anywhere close to a recession.

Economically, Japan is in decent condition. Consumers are enjoying a historically tight labour market, while company margins are buoyant and cash balances are high. Japan is dead set on raising its consumption tax again. The last time Japan pursued this course the economy fell into a recession. Though economic conditions are stronger today, a tax increase will still likely lead to slower growth. The disruption should be temporary as the central bank remains accommodative.

On paper, the Chinese economy looks fine. Officially its economy grew 6.5% for 2018. But beneath the surface, China’s economy has slowed in recent months and gauging the magnitude of the slowdown is difficult. Consumers and businesses are losing confidence. Car sales have plunged. The housing market is stumbling. However, China could successfully withstand the negative impact of U.S. tariffs and stimulate the private sector by ramping up an assortment of government led spending initiatives to bail out its economy as it has done in the past.

Emerging Markets are highly sensitive to global market conditions and many countries, such as Brazil, Argentina, Turkey and South Africa face unique headwinds that could be inflamed by the impact of developed market interest rate decisions and a stronger U.S. dollar. A sharp rise in inflation could be triggered if international interest rates are hiked significantly, which would likely hurt those countries, companies and sectors that operate with high leverage and have delicate liquidity needs. As well, there are several upcoming elections that have the potential to disrupt major markets like India, Indonesia and Argentina.

Last year was not kind to international stocks as they declined 12.5% in the fourth quarter and 13.4% for the year (all returns are in U.S. dollar terms). Europe, by a very small margin, was the worst culprit falling 13.0% in the quarter and 17.3% for the year. Not to be outdone, Asian stocks as a group declined by 11.5% during the last three months and 15.0% for the year. Surprisingly, Emerging Market stocks appear to have suffered most of their declines earlier in the year, as they were only down 7.4% in the quarter, but had a big annual decline of 14.2%.

Inflection points in global business cycles always generate volatility; still a recession in 2019 is not inevitable. However risks, especially those in the economic policy arena, remain high. While trade war fears have been prominent, their actual impact has been milder as the various tariffs imposed so far only cover 2% of world trade. So, while the business cycle is full of twists and turns, slower growth is still growing.