The turbulent conditions that have hampered markets in 2018 show little sign of easing next year, according to research that suggests indicators are pointing to a bear market in 2019. 
Concerns such as the US/China trade war, the Federal Reserve’s rate-hiking plans and falling bond yields have led to renewed volatility in equity markets this year and two significant sell-offs have bruised investors.
FE Analytics shows that the MSCI World index posted a 22.40 per cent total return (in US dollar terms) during 2017, with volatility of just 2.88 per cent. In 2018 to date, the index has made a 1.20 per cent loss while volatility has jumped to 14.85 per cent.
MSCI World volatility by calendar year in dollar terms
Source: FE Analytics
Global research group CrossBorder Capital warns that these turbulent conditions could face investors for many months to come.
“Skidding levels of global liquidity, sky-high investors’ risk appetite readings and flattening yield curves warned us a year ago that world markets would suffer badly as 2018 unfolded,” the group added.
These factors formed part of a model that the firm uses to estimate the probability of the single event of a bear market in global equities, which it defines as a 15 per cent or larger fall in the MSCI World index in the coming 12 months, measured in US dollars.
One year ago, the model was registering readings in excess of 90 per cent and it does not carry much better news today.
“Looking into 2019, and try as we might, there is not much positive change that makes us any more optimistic,” CrossBorder Capital said.
“The bear’s grip will continue. True bear markets typically suffer 30 to 50 per cent price falls and we should remember that the Wall Street decline has been seriously lagging other markets until now.”
Four factors are assessed in the group’s model. It argues that bear market odds rise significantly when: central banks run tight liquidity policies, starving markets of new credit; the term structure of interest rates is flat, indicating low term premia and high demand among investors and banks for ‘safe’ assets; risk appetite among global investors’ is elevated and vulnerable to fall; and speculative cross-border flows to emerging markets are extended and likely to reverse.
CrossBorder Capital said these four factors – the first two of which measure the flow of liquidity while the other two reflect investors’ risk appetite and prevailing risk pricing respectively – show a “strong statistical significance” when combined in a probit model framework and tend to improve prediction of future market turning points by 35-40 per cent.
12-month ahead probability of global equity bear market: 1981-2019
Source: CrossBorder Capital
The above chart shows CrossBorder Capital’s probability assessment of a future bear market, with the orange line indicating the estimated probability based on the above four factors while the grey bands highlight actual bear markets.
“According to the data, the bear market in world equities is set to continue into 2019,” the group surmised.
Explaining why the outlook is so poor, the global research group noted that global liquidity conditions “have been hammered lower” over the past 15 months. This is down to the fact that central banks – and especially the US Federal Reserve – have substantially shrunk their balance sheets as they ease back on the emergency measures put in place after the global financial crisis.
These low liquidity conditions also explain the contribution of the second indicator: bond term premia have fallen because they justify the shift of insurance companies, pension funds, banks and the like into the safety of long-term bonds, thereby forcing down their yields.
When it comes to investors’ risk appetite, CrossBorder Capital pointed out that this often reaches high extreme levels in equity and credit markets in the months leading up to their peak. The firm’s monitor of risk appetite stood at 49 points (out of 50) earlier in 2018 but has recently fallen to just 10.
Looking at the last of the four indicators, peaks and troughs in speculative cross-border capital flows, notably to emerging markets, also tend pre-date turning points in equity prices. The latest data shows that such speculative activity remains at pronounced levels while cross-border flows remain decent.
Global liquidity index and cross-border capital flows to emerging markets
Source: CrossBorder Capital, US Federal Reserve, People’s Bank of China, Bank of Japan, ECB, Bank of England, IMF
“Adding up these factors, tight central bank liquidity and flat yield curves significantly raise the odds of an equity bear market, while moderate risk appetite readings and a similarly average pace of cross-border flows are not yet sufficiently weak to indicate a coming market rebound,” the firm concluded.
“In other words, investors’ risk appetite needs to fall further and speculators need to give up or policymakers need to flood markets with cash.”
Looking at past findings from the firm’s model, it noted that to end the bear market that struck after the bursting of the dotcom bubble, CrossBorder Capital’s world risk appetite index plunged to -44.1 and central bank liquidity index rocketed to 83.4.
After the 2008 financial crisis, risk appetite bottomed at an index of -65.1 in early 2009 and world central bank liquidity reached a “whopping” index reading of 93.6 to end that bear market.
“Today, the probit model concludes that there needs to be more ‘blood on the streets’ before we can begin to look forward to better market prospects,” the research group warned.
“The economic news has yet to darken meaningfully and, if history is any guide, we may still only be halfway through this correction. We are sorry to be so downbeat, but short-to-mid duration government bonds seem to us a compelling place to hide.”