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Goldman Sachs Asset Management Statement on the Russia-Ukraine War. Read it here.    

February 18, 2022 | GSAM Connect

Diversification and Alpha-Hunting to Rule Investment Decisions

Market Observations from Multi-Asset Solutions

The start of 2022 was notable for the absence of the January effect—the tendency for stock prices to rise in the first month of the year. Over the month, US Small Cap sold off nearly 10%1, registering the second worst January since 1980, and US Large Cap sold off more than 5%, the fourth worst showing in more than four decades. As a result, valuations have improved, especially in the technology sector and late stage venture capital. Broad equity factors have undergone material repricing with value outperforming growth across market capitalizations, led by energy and financials.

Equity selloffs—especially in sectors with higher interest rate sensitivity—reflect investor concerns about the increasingly hawkish stance that central banks are adopting. The market is now pricing in more than six 25-basis-point hikes in the US federal funds rate in 2022. But despite the near term challenges, markets appear sanguine about the longer-term outlook. The 20-year to 30-year part of the US Treasury curve remains stubbornly flat to slightly inverted, signaling a likely return to low inflation and at- or below-trend growth over the long run. Five-year-forward of 10-year Treasuries are still trading around 2.4%, 5y5y inflation breakevens are trading around 2.1%, and the breakeven curve is still deeply inverted. Put another way: the market environment remains moderately constructive for risk assets.

Corporations still have access to easy financing at low rates and defaults have remained low as well, helping to mask any increased idiosyncratic credit risk. Still, the VIX, the “fear gauge” for the S&P 500, has been elevated, having closed at 31.96 on Jan. 26 as the selloff intensified and credit spreads widened. Equity dispersion is increasing as the earnings season progresses, with markets forced to absorb the impact of macro uncertainties along with the steady flow of beats and misses at the company level.

EXHIBIT 1: Volatility Spikes in January

Source: Bloomberg, Goldman Sachs Asset Management

 

Outlook

Despite the market’s expectation of a more aggressive Fed rate hike cycle, there is still uncertainty about the likely path of inflation and whether Fed hikes will weigh on economic growth. 

The effectiveness of using monetary tightening to curb inflation depends not only on the magnitude of policy actions but also the underlying cause of price increases. In a demand-driven inflationary environment, where the economy overheats and prices rise, higher interest rates can help dampen price pressures as economic activity cools down.

But that is not the inflationary environment we are facing today. Present inflationary pressures are being driven chiefly by supply-chain bottlenecks that emerged as a result of the pandemic, and pass-through of higher energy prices that built throughout 2021 due to OPEC production cuts and ongoing underinvestment in the fossil fuel sector. In this environment, tightening monetary policy via rate hikes is likely to be less effective in curbing inflation and may actually disproportionally weigh on economic growth. This is particularly so now that the boost the economy received from extraordinary policy accommodation is fading and growth showing signs of slowing toward trend. We expect price pressures to fade—independently of monetary policy—once the pandemic turns into an endemic and supply chain bottlenecks are resolved. If central banks raise rates significantly in the meantime, they may end up cooling growth more than inflation.

Against this macroeconomic backdrop, we view the current market environment as one of the most uncertain since the financial crisis. It is unprecedented in the sense that we have not experienced similar levels of inflation since the late 1970s, when the combination of energy crises, unanchored expectations and policy missteps led to double-digit inflation in the US. Even then, we were not facing broad-based shipment delays reaching far beyond commodities and raw materials. The complexity and interconnectedness of manufacturing today makes it even harder to predict the future.

To be sure, the Federal Reserve today is better equipped to enhance the transparency of monetary policy decisions and keep inflation expectations stable, thanks to the Flexible Average Inflation Targeting framework. But today’s problem is essentially rooted in public health and won’t have its trajectory fully determined by traditional tools of economic policies and political negotiations.

Equity selloffs, rising rates and a flattening yield curve suggest markets are pricing in at least some probability of recession. But while we’re watching these signals closely, we believe the probability of a recession over the next 12 months remains low. In our view, it would take a significant increase in debt levels and a meaningful deterioration in earnings for any slowdown in economic growth to result in recession.

As pointed out in our 2022 outlook, household credit has been declining since the GFC, and savings rate has returned to its pre-pandemic level as higher portions of disposable income are now allocated towards consumption; corporate debt-to-profit ratio is currently near the lower end of historical range and has now fallen back to pre-pandemic levels. Net leverage for S&P 500 companies has also returned to pre-pandemic levels and cash holdings have continued to build, with the highest share in information technology. In our view, debt in the economy will have to increase materially from current levels and earnings to deteriorate significantly for any slowdown in economic growth to result in a recession.

Investment Implications

With higher rates, lower valuations and wider dispersion in markets, we believe alpha hunters are likely headed into a potentially fruitful investment season. In our view, achieving attractive returns for a given level of risk in this environment favors well-diversified portfolios.

The recent market selloff has created investment opportunities in equity markets, including:

European and Growth Equities: On the public markets side, we like European stocks more than US stocks due to their more cyclical nature. Similarly, international growth equities appear likely to outperform their US counterparts.

Chinese Equities: Within emerging-markets, we think Chinese equities may be poised for a rebound. Performance last year was hampered by regulatory headwinds, property sector default and the country’s economic slowdown—and the selloff has continued so far in 2022. That has caused valuations to cheapen further, making Chinese equities look more attractive.

In addition, the People’s Bank of China continues to ease monetary policy as Chinese inflation remains low. This should be supportive of growth and contrasts sharply with the actions of major developed market central banks that have telegraphed plans to withdraw monetary accommodation. With economic stability being high on the administration’s priorities, and potentially more stimulus measures to come ahead of the Party Congress later in the year, Chinese assets may look attractive again. Overall, increased equity dispersion both at the regional level and the company level suggest a more favorable backdrop for alpha strategies over beta exposures.

EXHIBIT 2: Inflation: China vs. US

Source: Bloomberg, Goldman Sachs Asset Management

 

On the Fixed Income side, tailwinds from spread compression are fading as the economy transitions from early- to mid-cycle. As such, we believe diversified portfolios optimized for carry and roll-down are likely to result in superior performance. Last year, US corporate bankruptcies were at their lowest level in more than a decade and the number of bankruptcies with more than $1 billion in liabilities were less than 1/3 of their level a year ago2.

This year, the selloff in credit so far has been more prominent at the higher end of the quality spectrum, with BB outperforming B and CCC by more than 1%3. This suggests that markets are more concerned about rising yields rather than growth or default rates. Going forward, “fallen angel” companies—those downgraded from investment-grade to speculative grade status during the pandemic—have an incentive to maintain conservative balance sheets. Also, tailwinds from strong commodity prices are expected to continue for the energy sector. Overall, credit fundamentals are likely to hold up well so long as economic growth remains positive and defaults are low, although from a total return perspective, the drag from duration should be watched closely amid central bank tightening.

On Commodities, we believe there is further upside potential for oil. Structurally, commodity markets are facing supply shortage and currently trading in backwardation, indicating that investors are willing to pay a higher premium for immediate delivery. The latest EIA figures also point to declining stocks of crude oil, which hover around the lower end of the 5-year range. Over the near term, we see several other catalysts adding support to the upside momentum, including geopolitical tensions between the U.S. and Iran and between Russia and Ukraine.

In private markets, we are monitoring potential opportunities in early-stage venture capital, where valuations are attractive compared to late-stage venture and pre-IPOs. With inflation elevated, companies with pricing power and more growth exposure than their relevant markets may be poised for strong performance.

Concluding Remarks

Uncertainties related to inflation and the Fed’s policy actions are likely to remain top of mind for investors, and portfolio diversification is becoming all the more important for investors to navigate through this volatile environment. Currently, a recession in the next 12 months is not our base case scenario, but we will continue to monitor developments closely as incoming data and central bank policy evolve in the coming weeks and months.

 

Diversification does not protect an investor from market risk and does not ensure a profit.

1Total return as of 1/31/2022.

2Source: S&P Global Market Intelligence

3As of 2/4/2022. Source: ICE BofA.

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