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MARKET KNOW-HOW

MARKET KNOW-HOW

The Synchronized Expansion
00:00 / 12:31
The Synchronized Expansion

The Synchronized Expansion


The economic expansion has deepened and synchronized around the globe, with the participation of more than 98%1 of world economies. The inputs are broad, including improving labor markets, accommodative monetary policy, supportive financial conditions, favorable sentiment, and the potential for fiscal impulses. Taken together, these inputs suggest the global expansion should persist.

Even so, markets remain vulnerable to shocks of volatility, and late-cycle dynamics reinforce the need for realistic expectations. We expect meaningfully lower annualized returns from risk assets due to market and policy realities such as full valuations, legislative bottlenecks, and diminishing excess economic capacity. Each of these factors serves to heighten our commitment to strategic portfolio design.

Our key views:

  • Elevated US equity valuations create a rationale for moving beyond beta and beyond borders
  • Political risk continues to loom over markets, even as events in Europe have retreated from the headlines
  • Greater equity market return dispersion creates a target-rich environment for skilled active managers

1. Source: GSAM

Overview


Market


Growth

Global growth has both broadened and deepened in the most synchronized recovery since 2010. Manufacturing and US labor appear particularly strong.

Inflation

Inflationary impulses have paused, particularly in Europe. Diminishing excess capacity has supported prices in the US, while Sterling weakness has buttressed UK prices.

Monetary Policy

Divergent policy remains a global theme. The Federal Reserve’s efforts to neutralize its policy stance contrasts with more expansive commitment in Europe and Japan.

Politics

The possibility of pro-cyclical US policy has continued to intrigue markets, but the news cycle of near-constant controversy and legislative bottlenecks are blocking meaningful initiatives.

Risk

Politics remains dominant, followed by the pace of US rate hikes, Brexit turbulence, stability of Chinese currency and growth, lofty valuations, and structurally diminished market liquidity.

The Trend Is Your Friend


2017Q3_EMEA_Macro1-final-r2-digital

Source: Haver, Markit, and GSAM. Analysis as of May 2017. Table shows headline readings for Composite (weighted aggregation of manufacturing and services sectors) Purchasing Managers Indices. PMI surveys based on questionnaire responses from panels of senior purchasing executives (or similar). Respondents are asked to state whether business conditions for a number of variables have improved, deteriorated or stayed the same compared with the previous month, as well as to provide reasons for any changes. A reading of over 50 indicates expansion; a reading of less than 50 indicates contraction. 12m Δ represents the change since the reading 12 months prior to this document, i.e. May 2016. Developed Markets and Emerging Markets refer to GDP-weighted categories for regional PMIs as categorized by Haver. BRIC is an acronym that refers to Brazil, Russia, India and China, which are all grouped in a similar stage of economic development. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this document.

Key Takeaway


We see increasing evidence of economic synchronization across both advanced and emerging markets. Global growth data suggests the expansion could continue for another couple of years.

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Overview


Market


Equities

We continue to favor equities, but with modest return potential on account of valuations. Earnings growth is likely to be the primary driver of returns, favoring ex-US equity markets.

Rates

We expect the trend of higher rates to resume, driven by monetary policy evolution, global growth, and reduced excess capacity. Government debt may be a less effective hedge.

Credit

Tight spreads and higher leverage reflect late-cycle conditions, leaving us wary of investment-grade and high-yield beta, but confident in security selection.

Currency

Despite recent weakness, Dollar risk may be to the upside given central bank divergence. Sterling is likely tethered to UK politics. Global growth could drive emerging market currencies.

Volatility

Low volatility reflects the strong macro backdrop, but cannot insulate investors from exogenous shocks, especially any potential fallout from political risk in Washington and Europe.

It's Been A Good Run (If Uneven)


2017Q3_Markets1-final-r2-digital-01

Source: Barclays Live, Bloomberg, and GSAM. Analysis from January 1, 2009 to May 31, 2017. Chart shows total cumulative returns for asset classes. US Equities represent the
S&P 500 Index, European High Yield Bonds represents the Bloomberg Barclays Pan-Euro High Yield Index, Global Equities represents the MSCI World Index, European Equities
represents the Stoxx Europe 600 Index, US High Yield Bonds represents the Bloomberg Barclays High Yield Corporate Bond Index, Japan Equities represents the TOPIX Index,
Emerging Market Equities represent the MSCI Emerging Markets Index, German Bunds represents the German subset of the Bloomberg Barclays Aggregate Government Index,
US Inv. Grade Bonds represents the Bloomberg Barclays US Corporate Bond Index, US Treasury Bonds represents the Bloomberg Barclays US Aggregate Treasury Index, Gold is
represented by the Gold Spot Price $/oz, European Inv. Grade Bonds represents the Bloomberg Barclays Investment Grade European Corporate Bond Index, and Japan Government
Bonds represents the Bloomberg Barclays Japan Aggregate Government Bond Index. Past performance does not guarantee future results, which may vary.

Key Takeaway


We believe the macro backdrop remains supportive of risk assets, although full valuation and politics may limit near-term upside and intensify tail risk. We favor equities over credit, credit over sovereign debt, and emerging markets over developed markets.

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The Know
The recovery is global

Growth has gained momentum internationally, broadening out the US-led recovery.

The current macroeconomic backdrop is supportive of continued positive international momentum.

Developed economies have seen improvement in a number of economic indicators, led by manufacturing. We believe this trend, alongside the steady expansion in the consumer and labor sectors, suggests a robust global developed investing environment.


Source: GSAM.


The How
Watch the bottom line

Historically, earnings outside the US have improved more rapidly when growth rates have risen.

For every dollar in sales growth, the benefit to earnings has been greater outside the US.

In Europe and Japan, fixed costs tend to be a higher share of total costs than in other markets. This has caused Europe and Japan to historically see more earnings upside when sales have strengthened but also more earnings weakness when sales have weakened. Given our expectations for improving global growth, Europe and Japan seem particularly well positioned.


Source: Datastream, Goldman Sachs Global Investment Research, and GSAM.

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The Know
The European economic recovery has strengthened

A broadening and deepening positive momentum is evident.

Broader and deeper macro improvements suggest a more resilient recovery.

In July 2012 the ECB assured the market that it would do “whatever it takes” to preserve the euro, and the markets believed it. While weak core inflation dynamics still call for monetary accommodation, over the last five years the economy has made meaningful progress in many areas, which in our view supports procyclical deployment and risky assets.


Source: ECB, Bloomberg, Markit, Haver, Macrobond and GSAM.


The How
Follow the cycle

The changing macro environment is more supportive for equities compared to the recent past.

As policy uncertainty diminishes, the market is re-focusing on the economic cycle.

European equities are now entering the expansion phase of the cycle, driven by improvements in growth prospects. At a more micro level, this has started to translate into a convincing improvement in earnings dynamics. In line with ECB policies, European bond yields remain near historic lows, making the case for European equities even more compelling.


Source: GSAM.

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The Know
High valuations, modest historical returns

We think investors should temper their US equity return expectations.

Rich equity valuations such as today’s have often presaged returns of less than 10%

Following periods of top-quartile valuations, the S&P 500 Index has delivered single-digit or negative returns 99% of the time. In nearly a fifth of instances (17%), returns were negative. High valuations have often persisted for years at a time, elongating the timeframe for modest equity returns.


Source: Bloomberg, Robert Shiller, and GSAM.


The How
Know your alternatives

In periods of lower equity returns, alternative strategies’ performance has been attractive.

Historically, alternative strategies have been similar to equities in periods of muted returns, with less than half the volatility (standard deviation).

We believe we are entering a favorable environment for alternative strategies. During periods when equity market returns registered in single-digit or negative territory, these strategies outperformed the S&P 500 on a risk-adjusted basis. In light of high equity valuations and the potential for lower returns, we see the case for a fresh look at alternative strategies.


Source: Bloomberg and GSAM.

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The Know
Rate levels matter

Fixed income valuations today are more sensitive to changes in interest rates than in the past.

As interest rates begin to creep higher, investors may need to be more nimble than in the past.

Falling developed world interest rates since 2008 have caused the average coupon of outstanding government debt securities to fall markedly, while the average maturity has lengthened. As rates decline and maturity increases, so does duration.1 In today’s low-rate environment, valuations have become much more sensitive to any adjustment in interest rates.


Source: Barclays and GSAM.


The How
Bond markets are entering a new phase

After years of low, stable, and declining interest rates, the future is less certain.

Relative value strategies may help to transform a challenging fixed income environment into return generating opportunities.

Rate divergence, not only in policy rates but more importantly on the back end of the curve creates challenges for traditional long-only fixed income investors, particularly today given the higher levels of duration. Nevertheless, this also creates opportunities for strategies that can take advantage of relative price changes.


Source: Bloomberg and GSAM.

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The Know
Emerging market flows have picked up

In the past, EM inflows have been supportive of both equity and debt performance.

We believe the improving macro backdrop has been supportive of emerging market flows and returns.

The recent uptick in emerging markets equity (EME) and debt (EMD) inflows follows an extended period of easier financial conditions and improved corporate earnings. In the past, such periods of strong inflows have helped drive performance. EME and EMD returns rose an average of 3.0% and 0.9%, respectively, during months with inflows greater than $5 billion.


Source: Bloomberg, the Institute of International Finance (IIF), and GSAM.


The How
Potential for growth and income

We think EM earnings and yields warrant attention in today’s market environment.

EM equity and debt investments stack up favorably vs. other major regions when measured by yield and earnings growth expectations.

For equities, we expect the recent positive emerging markets earnings growth trends to continue driving performance, and is reflected in forward-looking expectations. In a low-rate environment, dollardenominated EMD yields stand out versus US investment grade bonds, US aggregate bonds, and global bonds.


Source: Bloomberg, Goldman Sachs Global Investment Research (GIR), and GSAM.

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The Know
Indian growth is now globally significant

The world’s third largest economy will be a key driver of the future global expansion.

India is set to be one of the key drivers of global growth.

EMs have consistently recorded faster economic growth than DMs in every year since the turn of the century1. While much of that historical outperformance is attributable to the rise of China, the future path of the global economy looks likely to be influenced heavily also by India’s rapid expansion. Already the world’s third largest economy, its contribution is set to increase in the coming decades.


Source: OECD and GSAM.


The How
Indian equities have outperformed the Indian economy

Strong growth in India has helped drive strong equity market returns.

Indian corporates have been successful in turning economic growth into equity returns.

India has delivered the highest net total equity market returns over the past 15 years of any G7 or BRIC economy. Double-digit annualized growth has generated higher returns for equity investors. Since the Taper Tantrum in 2013, India is witnessing an impressive macroeconomic improvement that may continue to be supportive of potential equity returns over the long term.


Source: Haver, Bloomberg, and GSAM.

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