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MARKET KNOW-HOW

MARKET KNOW-HOW

Pro-growth, Pro-equity, Pro-reality
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Pro-growth, Pro-equity, Pro-reality

Pro-growth, Pro-equity, Pro-reality


We expect the global expansion to continue in 2018, and so we remain optimistic about the forward path for risk assets. We describe the core of our view as pro-growth and pro-equity. At the same time, a risk-managed, dynamic approach to investing strikes us as more relevant than ever. We are equally pro-reality, with an environment of exceptionally low volatility masking a rising set of potential vulnerabilities. We remain cautious towards pure beta, both globally and across asset classes.

Our key views:

  • Pro-growth: The breadth of participation across global economies has deepened. From housing to consumption to manufacturing and services, economic momentum has become more comprehensive. Nearly all world economies—99% on a GDP-weighted basis—have enjoyed positive growth, with 56% accelerating over the last twelve months.
  • Pro-equity: The favorable operating environment has translated into very strong earnings growth across global equity markets. Above-trend growth and fiscal impulses may promote mid-teen earnings growth that could advance the market even in the absence of further multiple expansion. 
  • Pro-reality: The acceleration in macro data has likely peaked, and with it, easier-to-beat earnings comparisons. Late-cycle conditions such as tight credit spreads, full valuations, and monetary policy normalization are likely to promote more idiosyncratic outcomes in the near-term and more moderate results in the long-term.

Overview


Market


Growth

Above-trend developed markets (DM) growth may decelerate but persist. Current recession risk remains low as economies enjoy easy financial conditions and potential fiscal impulses.

Inflation

Diminished spare capacity across many advanced economies may support prices longer-term. Any inflation adjustments are likely to be gradual and country-specific.

Monetary Policy

Evolving Federal Reserve (Fed) policy is unlikely to weigh on DM growth. Structural adjustments may leave emerging markets more resilient than in prior hiking cycles.

Politics

Uncertainty may reemerge as looming US mid-term elections may reamplify partisanship. Italian elections, Brexit developments, and North Korea also possess disruptive clout.

Risk

Investors may be too focused on the downside. While there is no lack of headline risks, contained inflation likely keeps the most significant risk (the Fed) in check.

Pro-Growth


Source: GSAM. As of November 2017. Potential gross domestic product (GDP) represents an estimate of the output that an economy could produce with its capital and labor resources operating at full capacity. Current Inflation Target represents an explicit target inflation rate that a central bank strives to achieve. The charts above show the current measure for both figures for each country, remaining static in 2018–19 for illustrative purposes. In the case of the US, for example, our growth forecasts are above our current estimate of potential GDP (1.9%), reflecting our expectation for stronger demand that in turn may contribute to rising inflation. Current Potential GDP: US: 1.9%, Eurozone: 0.7%, UK: 1.6%, Japan: 0.5%, China: 5.4%. Current Inflation Target: US: 2.0%, Eurozone: 2.0%, UK: 2.0%, Japan: 2.0%, China: 3.0%. 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.

Key Takeaway


As late-cycle optimists, we believe that global macro data reflects the health and durability of the current economic cycle. Nascent signs of inflation suggest central banks should be patient as monetary policy normalizes.

View Less

Overview


Market


Equities

Equities remain our preferred asset class, particularly emerging markets. Our enthusiasm is tempered by full valuations and markets heavily reliant on higher earnings.

Rates

US rates appear exposed to transitioning monetary policy, a pick-up in term premium, and shrinking spare capacity. Any move higher should be contained by limited inflationary impulses.

Credit

Tight spreads and higher leverage moderate our credit return expectations. Still, interest coverage is solid and default risk appears to have cleared recent commodity uncertainty.

Currency

Euro and USD markets are likely to be dominated by interest rate differentials with a slight bias to USD strength near term. Sterling may be tethered to Brexit results and EM could outperform.

Volatility

Low volatility may persist, reflecting strong macro underpinnings. However, high valuation heightens vulnerability to any exogenous shock or shift in the operating environment.

Pro-Equity, Pro-Reality


Source: GSAM. As of November 2017. 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.

Key Takeaway


We believe macro synchronicity supports risk assets, especially ex-US. Earnings should dominate equity returns, while in our view, fixed income returns are limited due to tight credit spreads, higher risk premia, and transitioning central bank policies.

VIEW LESS DISCLOSURE
The Know
Sell high, buy low?

Waiting for lower valuations potentially results in a long game of wait-and-see

Valuation in our view is a poor metric for investors seeking to “time” the market.

Investors employing a strategy of selling equities at high valuations (e.g. 90th percentile) with the intention of buying back at “cheaper” levels might have to wait a long time to re-enter the market. In February 1998, the last time the 90th percentile was breached, an investor who sold could have been out of the market for as long as 100 months.


Source: Bloomberg and GSAM.


The How
Cashing out can be costly

Long-term market exposure has often beaten valuation-based timing strategies

A “sell high, buy low” valuation strategy historically has under-performed.

If valuations remain elevated—as they often have in the past—investors may miss returns waiting on the sidelines. A strategy that sells S&P 500 equities at the top decile of valuations and re-enters at the 50th percentile historically has underperformed a buy-and-hold strategy by 100 basis points on an annualized basis.


Source: Bloomberg and GSAM.

VIEW LESS DISCLOSURE
The Know
Emerging markets trade trends

Individual emerging market economies are increasingly exporting to each other

Emerging markets (EM) countries’ exports to each other have been trending higher for decades.

Although emerging market economies remain connected to the global economy, trade dependencies between individual emerging markets—such as China and Brazil—are growing amongst each other. Since 1996, intra-EM trade has doubled.


Source: International Monetary Fund (IMF) Direction of Trade Statistics (DOTS) and GSAM.


The How
EM earnings return

Earnings growth expectations have begun to rise for the second consecutive year

EM in 2017 broke a six-year trend in negative earnings growth revisions.

Although S&P 500 profit margins have surpassed their pre-global financial crisis peak, EM margins have been both improving and have room to expand. We see the potential sustainability of this trend as supportive of a strategic allocation to EM.


Top Chart Source: Datastream, MSCI, and GSAM. Bottom Chart Source: FactSet and GSAM.

The Know
Stocks Beyond borders

International developed equity markets turned in a strong 2017

In developed international markets, individual country returns have varied widely over time.

Economic fundamentals have broadly improved across EAFE markets, fueling a synchronized global expansion. Alongside stronger GDP growth, increasing earnings momentum has contributed to solid equity returns across Europe and Japan. We believe that the trend of upward earnings revisions may continue.


Source: Bloomberg and GSAM.


The How
Security selection matters

Looking beyond country-level returns reveals additional opportunities for selectivity

The sizeable return differential between the MSCI EAFE’s top and bottom performers, in our view, suggests a selective approach to international equity investing.

Security returns across international developed markets can be sorted by quartiles. In 2017, the MSCI EAFE’s top quartile outperformed the broad index by at least 7 percentage points (pp) and the bottom quartile underperformed by at least 21 pp.


Source: Bloomberg and GSAM.

The Know
To each his own

Different stages of the economic cycle point to diverging policy prescriptions.

We expect monetary policy to continue diverging globally in 2018.

We believe today’s ultra-low yield environment exacerbates the challenges for traditional fixed income investors. As the chart shows, many economies differ in proximity to their stated inflation goals and current spare capacity levels. The degree of policy divergence, in our view, suggests the need for flexibility.


Source: GSAM.


The How
Flexible strategies for traditional challenges.

Selloffs are a normal investment experience, but today’s potential impact is above normal.

In today’s low-rate environment, valuations have become more sensitive to any adjustment in interest rates.

Irrespective of central bank policies, investor should be wary of corrections and beware of the losses they could likely incur with a “hands-off” investment approach. Duration has abundantly increased in recent years, making even small increases in interest rates potentially harmful for bond portfolios. Flexibility is increasingly key.


Source: Bloomberg and GSAM.

The Know
There are alternatives to variability

Predicting category leadership in alternative strategies has been challenging

Hedge fund sub-strategy leaders and laggards change frequently.

Historically, examining category averages in alternative strategies, there has been minimal persistence in returns for the typical single-strategy alternative investment. Investors who select single-strategies based on the recent past may experience inconsistent outcomes.


Source: Bloomberg, HFR Database, and GSAM.


The How
Harness the power of diversification

Manager diversification may reduce the impact of outliers

Increasing the number of managers in a portfolio may reduce the impact of extreme returns.

Many investors fear alternative investments based on their observations of individual Hedge Funds (HF). However, we believe that a diversified portfolio of HF may offer attractive return and risk characteristics with more consistency. As the chart shows, the historical performance of single manager funds is widely dispersed, while that of funds of HF is tightly packed.


Source: Bloomberg, HFR Database, and GSAM.

The Know
Millennials matter

The largest generation is poised to dominate income and spending growth

The growth in Millennials’ income and spending marks an important demographic transition

There are 2.3 billion Millennials around the world, making them the largest population cohort. Entering their prime earning years, Millennials' aggregate income level has already surpassed Generation X, and is expected to surpass Baby Boomers in 2018. Earnings growth is likely to mean spending growth, with Millennials’ cumulative spending projected to increase by 17% over the next 5 years.


Source: BLS, World Bank, Euromonitor, Goldman Sachs Investment Research, and GSAM.


The How
Demand-driven disruption

‘Going digital’ illustrates how Millennial consumption transforms the economy.

Investors should remain cognizant of disruption as it spreads.

E-commerce is familiar to all of us, but it still represents only 9% of global retail sales in 2017. Opportunities for digital disruption remain vast. We believe investors can no longer outperform solely through superior knowledge about an industry. Security selection that is conscious of disruptive trends may be more critical as demographic and technology changes continue to unfold.


Source: comScore, DOC, Haver Analytics, Goldman Sachs Investment Research, and GSAM.

Stay Informed and Be Ahead of the Curve


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