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Investment Strategy

GSAM Quarterly 3Q17
Investment Strategy

Strong global earnings, receding political risk and overly-negative sentiment on the “Trump trade” leave us positive on equities.

US: Market sentiment on Trumponomics has swung too far in the other direction, resulting in an almost full unwinding of the “Trump trade.” With expectations so low, we think US equities now have upside potential on reform as any incremental progress on reform could be a positive surprise. We see attractive opportunities in specific sectors such as Financials, which can reap significant benefits from clearer and more effective implementation of existing regulatory legislation.

Europe: We are finally seeing a much-awaited earnings rebound, led by cyclicals. Q1 earnings results were the best in 3 years and consensus estimates have seen year-to-date upgrades, a departure from the persistent downgrades of previous years. Fading political risk in Europe (see “Will it Last”) should be supportive for corporate confidence, in turn boosting investment, M&A and earnings growth. Rising valuations and increasing investor positioning suggest growing recognition of these tailwinds, but significant potential remains for an earnings-driven recovery.

Japan: We are encouraged by continued progress on economic and corporate reform in Japan. Japanese companies have lagged companies in other DM countries with respect to returns on capital, but are catching up. Valuations remain attractive—while valuations have increased, Japanese equities are cheaper than many other developed markets.

EM: We remain constructive on the strong fundamentals for EM equities. EM economic growth premium to DM continues to widen and inflationary pressures are moderating, supporting the earnings rebound. We are constructive on the EM consumer, due to improving macro conditions, particularly in Asia. Following years of underperformance versus DM, EM trades at an attractive discount.

Retail: The improving macroeconomic backdrop—cyclically low unemployment, accelerating wage growth and a surge in consumer confidence—has not yet translated to better retail sales or consumer price inflation. In fact, Q1 was the weakest quarter for retail since the recession, with the slowdown broadening out from mall-based retailers. Margins are under pressure as e-commerce penetration accelerates and e-tailers price aggressively to expand, acting as a deflationary force. The shifting environment creates differentiation between “winners” and “losers.”

Media: Media is another sector facing deflationary pressure from technological disruption, where selectivity is important. With the rapid expansion of online platforms and new entrants offering innovative services and significantly lower consumer pricing, cable networks are being hard hit by accelerating cord-cutting, unbundling and “skinny bundling.”

Earnings forecasts are positive across all major regions

Outlook_17Q3_Ex7

Source: Factset. As of June 2017.

WHAT WE’RE WATCHING

Elevated valuations make equities more vulnerable to a moderation in growth on the one hand or a sharper-than-expected rise in bond yields on the other. These risks support our case for dynamism despite the broadly positive backdrop (see “Time for Dynamism, Not Long Term De-risking”).

The global earnings recovery this year remains a key pillar of our constructive view. We see significant potential in Europe, where earnings remain over 40% below their pre-crisis peak, and in EM, where the earnings cycle is finally turning after years of underperformance compared to DM.


After several years of disappointing growth and inflation, combined with massive central bank intervention, we think fixed income markets are complacent. In our view, US rates are too low for the projected policy tightening, and we think markets are underestimating the effects of Fed balance sheet reduction and global tapering of QE.

We expect more US rate hikes relative to other major markets

Outlook_17Q3_Ex8

Source: Bloomberg, GSAM Forecasts. As of June 2017.

Neutral on spread risk, focus on tactical and relative value

In government bonds, we are negative on the US but see relative value opportunities. Our conviction that US growth will lead to higher inflation has declined, but we think the market is significantly underestimating the Fed’s likely tightening path. In other economies, we think the market is overestimating central bank tightening. For example, the market is pricing in more rate hikes in Canada than the US, despite lower inflation and softer wage growth in Canada and the renewed weakness in oil. We think these differences create relative value opportunities.

We are roughly neutral on spread risk. We are cautious on assets most exposed to Fed tightening, including mortgage-backed securities (MBS) and corporate credit. We see more value in securitized credit sectors including non-agency MBS and AAA-rated collateralized loan obligations.

Emerging markets offer opportunities but external debt appears overpriced. We are positive on EM fundamentals and see opportunity, notably in EM corporate debt. In external debt, we think value is less attractive after a strong rally year-to-date, but we recognize that reforms have occurred in EM and we continue to find opportunities for security selection. We are watching closely for any indications that China is not able to reduce leverage without disrupting growth.

 

WHAT WE’RE WATCHING

Risks include a more aggressive Fed, which could drive dollar strength and tighten financial conditions. In this scenario we see a potential spillover of volatility from agency mortgages to credit. An uptick in wage growth could create upside risks to inflation.

Across fixed income markets, our highest conviction views are based on the likelihood that the Fed will continue to tighten policy based on steady growth and tight labor markets, while inflation and central bank policy rates in other economies are likely to remain relatively low.