Equity markets are off to a roaring start in 2019, with the magnitude of returns receiving some impressive framing — the first quarter was the best quarter for the S&P 500 Index since the third quarter of 2009, and it was the best quarterly start to a year since 1998.
This follows a fourth quarter of 2018 that was characterized by extremes of its own when the S&P 500 Index sold off to bear market levels (down -20%) intraquarter, and it marked the worst December for equity markets since 1931.
With these back-to-back quarters of extremes, it’s not surprising that style and factor leadership in the equity markets shifted substantially in the first quarter:
Most striking was an abrupt change in investor risk appetite as higher beta stocks outperformed strongly for most of the early part of 2019. Part of the first quarter rally could be expected given the oversold conditions late in the fourth quarter; however, the predominant impetus was the abrupt change in Federal Reserve policy that many investors interpreted as an end to their tightening bias and rising rates.
Investors interpreted the Federal Reserve policy shift as a near-term reduction of recession risk, which would bode well for equities. But what does the policy shift say about the longer-term implications of rates and investor risk appetite?
Investor risk perception at any point in time may not be a good reflection of reality at either the market or individual stock level.
Market valuations reflect current investor expectation of risk and opportunity; but they may be over- or under-reacting to risk. In the current environment, the perception of the end of Federal Reserve tightening has also led to a rally in bonds and falling yields. At lower yields, bonds are less attractive, which could lead investors to stretch for returns through equities and other riskier asset classes.
With equity valuations approaching levels that preceded the fourth quarter sell-off, investors may be losing sight of important underlying risks to the equity market, including weak global growth, a trending decline of the global Purchasing Managers’ Index (PMI), waning fiscal stimulus impact in the U.S. and slowing earnings growth.
Similarly, at the stock level, risks can also go unrecognized for varying periods of time. A common disconnect is for lower quality stocks to rise beyond their intrinsic value in speculative markets, where their risks are not fully discounted.
Sustainability risks may also lie hidden in the background. Consider, for example, what recently happened to Pacific Gas and Electric Company (PG&E).
It is appropriate that markets reacted to the news of PG&E’s liability, of course. But what these gyrations don’t say is that the wildfire risk that confronts the company is not new.
California comes off in almost all the climate models as becoming hotter and drier, and it’s a state that has a long history of severe wildfire. This puts a lot of assets at risk, including assets such as hundreds of miles of transmission and distribution wires. The wildfire risk also creates significant liabilities. Anytime there’s high danger of forest fires, any ignition source can set off a fire that burns thousands of acres and anything occupying those acres. As an operator of a lot of potentially spark-producing equipment and assets in fire-prone terrain, PG&E’s potential wildfire liability was already growing.
In short, knowledge of sustainability-related challenges should help us better identify hidden risks. Markets react to news and events, as well as financial information contained in required filings. But sustainability assessment gives us additional insight into risks that don’t show up in the news — except, of course, until after the event.
Interestingly, while the Federal Reserve’s interest rate policy shift was the dominant news during the quarter, we also learned that the Federal Reserve has begun to consider climate risks in making policy. According to a March economic letter, “for the Fed, the volatility induced by climate change and the efforts to adapt to new conditions and to limit or mitigate climate change are also increasingly relevant considerations.”
Increased risk awareness began to creep back into the market in March as beta backed off the leadership it established in the first two months of 2019. After such a swift and dramatic expansion of market price-to-earnings (P/E) valuations early this year, there are signs that market participants may be taking a longer-term focus as equity risks are coming into better view.
For those of us attuned to the evolving maps of climate change risks, we know there are many physical risks beyond wildfire liability in California. Below is a small sampling, and to learn more, read our article: How Climate Change Affects Financial Performance.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
One cannot invest directly in an index.