Investors today face a market of pressure points. These markers of sensitivity include the pace of economic growth, the ongoing withdrawal of monetary policy accommodation, escalating trade tensions, and geopolitical risk. Each of these can drive episodic volatility. While markets may come under pressure in 2019, we are both confident in the continued global expansion and cautiously optimistic of late-cycle conditions.
Among the reasons we remain constructive despite these pressure points: none appears to possess the muscle to initiate a recession on its own. Together, they magnify sensitivities emerging in the system, which is why they bear close watch. As the year unfolds, we believe that macroeconomic fundamentals and the evolving market environment will remain supportive of risk assets. Now is the time for investors to stay focused on a commitment to risk management and strategic portfolio design.
Consequently, we would emphasize:
The current US economic recovery is likely to become the longest in history in 2019. Yet a smörgåsbord of leverage- and valuation-based indicators still points to few current imbalances in the economy. While the economy is probably closer to the end of this cycle than the beginning, financial excesses appear to be contained.
The increased velocity of volatility in 2018 has left investors unsettled. However, pockets of episodic volatility are the norm, while the sheer absence of volatility experienced in 2017 is the exception. For example, investors have experienced more than 60 days of 1% or more S&P 500 price moves in the average year, but saw just eight of those in 2017.
The outperformance of US large-cap growth stocks versus value has been unprecedented by some metrics.
The length of growth or value outperformance can vary across periods, making it difficult to time investment decisions for the two styles. The current length of growth outperformance has exceeded its long-term median length by a factor of four. At 21 months, growth dominance today is twice as long as the period during the dot-com bubble. At the same time, growth valuation continues to be stretched at its highest level ever.
Source: Bloomberg and GSAM.
Growth’s remarkable run may have created an unintended overweight.
Over recent years, rolling returns for US large-cap growth stocks have surpassed value stocks by a wide enough margin that an equally-weighted starting allocation to growth and value would have drifted to a markedly imbalanced allocation today. In our view, investors should be aware of any such imbalances, and should prepare their portfolios in the event of a regime change in growth-versus-value performance trends.
Source: Bloomberg and GSAM.
Top Section Notes: As of November 30, 2018. For illustrative purposes only. Valuations are represented by 12-month forward price-to-earnings (P/E) ratios. The length of outperformance is characterized by consecutive number of rolling 3-month periods where growth outperforms value. ‘Current’ reflects the rolling 3-month return period from December 2016 to November 2018. The most recent outperformance period by the Russell 1000 Growth relative to the Russell 1000 Value index is December 2016 to October 2018. The 'dot-com' bubble refers to the rapid rise in US equity valuations, roughly from 1995 to 2000, fueled by investments in internet-based companies. Bottom Section Notes: As of November 30, 2018. Chart shows the relative portfolio weights of an illustrative portfolio that started with equal allocation to US large-cap value and growth equities. US large-cap value and growth equities are represented by the Russell 1000 Value and the Russell 1000 Growth indices, respectively. The illustrative portfolio weights are based on rolling 2-year returns of the two indices. These illustrative results do not reflect any GSAM product and are being shown for informational purposes only. No representation is made that an investor will achieve results similar to those shown. The performance results are based on historical performance of the indices used. The result will vary based on market conditions and your allocation. Past performance does not guarantee future results, which may vary.
A stronger dollar, country crises, and geopolitical headlines help explain challenged 2018 performance.
We believe that 2018 EM underperformance has been driven primarily by the trifecta of a stronger US dollar, idiosyncratic country risk, and Sino-US trade tensions. Performance may make a comeback as these conditions, which are likely temporary, start to unwind. Additionally, EM companies have limited revenue exposure to the US, which suggests that this headwind may not represent long-term structural risk.
Source: Bloomberg, FactSet, and GSAM.
Earnings growth in emerging markets remains stronger than in developed markets.
History tells us that over the long term, earnings growth is the predominant driver of returns in EM economies. We estimate that 2019 EM earnings growth will beat developed markets. In addition, EM valuations are lower than in developed markets. We believe this backdrop of attractive valuations and higher earnings growth may be supportive for EM market performance.
Source: Bloomberg, FactSet, and GSAM.
Top Section Notes: As of November 30, 2018. The top chart shows the performance of an illustrative emerging market currency basket against the US dollar. The illustrative emerging
market currency basket equal-weighted the 24 countries (Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan,
Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates) in the MSCI Emerging Markets (EM) Index. Past performance does not
guarantee future results, which may vary. For illustrative purposes only. GROWTH OF $100: A graphical measurement of a portfolio's gross return that simulates the performance
of an initial investment of $100 over the given time period. The example provided does not reflect the deduction of investment advisory fees and expenses which would reduce an
investor's return. Bottom Section Notes: As of November 30, 2018. Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock
and the estimates are calculated by market capitalization weighting each constituent within the index. Forward price-to-earnings (P/E) ratio measures current share price relative to
next 12 month EPS forecasts. Investments in foreign securities entail special risks such as currency, political, economic, and market risks. Emerging markets securities may be less
liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability. All indices are defined in the end notes
for both charts.
Sitting on the sidelines can mean missing out on gains even if investors succeed at the task of avoiding losses.
Some of the strongest equity market returns have come within days of a market bottom. We are wary of investors' tendency toward loss aversion, which may lead to missing out on gains while trying to time the market. Investors are rarely able to achieve perfect timing— even if they miss drawdowns, they may still fail to benefit from rebounds. We advocate for a riskaware approach and maintaining a strategic allocation.
Source: Bloomberg and GSAM.
Long-term strategic market exposure has often beaten market timing strategies.
Liquid alternatives, in our view, can be a valuable late-cycle diversifier and counterbalancing asset for periods of heightened episodic volatility. Historically, as the economic cycle turns, investors who have held liquid alternatives have seen smaller losses than those who held only equities, while still participating in the subsequent recovery. In our view, alternatives offer an efficient solution for investors to de-risk yet remain invested.
Source: Bloomberg and GSAM.
Top Section Notes: As of November 2018. Chart shows the average 5-year total return of the MSCI World Index from the last three economic cycles’ market bottoms (March 9, 2009, October 9, 2002, and September 28, 1990). ‘Stay Invested’ means remaining invested in the MSCI World Index at the market trough and on average the total return equaled 139% from the market bottom. The ‘gained’ proportion of total return represents the proportion of the full potential return of staying invested. The ‘missed’ proportion of total return represents the average amount of return that an investor missed out on by being uninvested for the given period versus staying invested through the market trough. ‘Invest 2 Days After Bottom’ means being uninvested for the first two days after the market trough, then being fully invested in the MSCI World Index. ‘Invest 1 Month After Bottom’ means being uninvested for the 21 trading days following the market trough, then being fully invested in the MSCI World Index. Bottom Section Notes: As of November 2018. Chart shows the average monthly growth of a $100 investment made one year before an average economic cycle market bottom (March 2009, October 2002, and September 1990) in both the MSCI World Index and the HFRI Fund of Funds Index (HFRIFOF), a common index for liquid alternatives. The analysis uses data from October 1988 to March 2011 for the MSCI World Index and from January 1990 to March 2011 for the HFRIFOF, the earliest available data through 24 months after the most recent recession. GROWTH OF $100: A graphical measurement of a portfolio's gross return that simulates the performance of an initial investment of $100 over the given time period. The example provided does not reflect the deduction of investment advisory fees and expenses which would reduce an investor's return. Investments in Liquid Alternative Funds expose investors to risks that have the potential to result in losses. These strategies involve risks that may not be present in more traditional (e.g., equity or fixed income) mutual funds. Past performance does not guarantee future results, which may vary.
Staying exposed to locally sourced revenues could pay off—small firms could fare better than globalized large caps.
In our view, a highly uncertain global landscape could increase the attractiveness of small caps, which derive a larger proportion of revenues locally. These stocks should have a lower sensitivity to the dangers of a potentially escalating trade war, geopolitical concerns, Brexit, and Italianinduced risk.
Source: Haver and GSAM.
Historically global small caps have delivered significantly higher returns with a superior Sharpe ratio.
Over the long term, global small caps have flexed their muscles by delivering significantly higher returns without bearing substantially higher risks. Especially in highly uncertain times, the higher domestic revenue exposure of these companies could be more protected from external risks. In addition, still-healthy domestic consumption trends should be supportive.
Source: FactSet, Bloomberg and GSAM.
Top Section Notes: As of November 30, 2018. The Baker, Bloom & Davis Economic Policy Uncertainty Index is a non-financial metric that can be used to gauge the underlying level of economic policy uncertainty on a country level, by exploiting the informational content of national newspapers. The Global Economic Policy Uncertainty Index has been constructed by weighting and rescaling the single-country indices (Australia, Brazil, Canada, China, France, Germany, India, Italy, Japan, Netherlands, Russia, Spain, Korea, UK, and US) by their share of global GDP and rebasing the series as of January 2001. The chart uses a 3-month rolling average to smooth the data. Bottom Section Notes: As of November 30, 2018. Analysis is from January 2001, inception date of the MSCI World Small Cap index, to November 2018. Risk-free rate assumed to be 2.25% in the Sharpe ratio computation. Annualized returns and Sharpe ratios are computed using the MSCI World Index and the MSCI World Small Cap Index. Domestic direct revenue exposure values are based on FactSet's proprietary algorithm, and represent the proportion of each index with revenue streams that are primarily domestic oriented. The global aggregate figure is derived using market cap weights of the US, European, and Japanese indices. US is represented by the S&P 500 and Russell 2000 indices, Europe by the MSCI Europe and MSCI Europe Small Cap indices, and Japan by the MSCI Japan and MSCI Japan Small Cap indices. Past performance does not guarantee future results, which may vary.
Moving into the mainstream, with direct lending leading the way.
Since the early 2000s, private credit has rapidly matured into an established asset class, with the expansion of direct lending being most pronounced. Today, the direct lending market equals the convertible bond market in size, and is a quarter of the size of high yield. Direct lending refers to loans to small and medium-sized enterprises (SMEs). In comparison to larger-sized loans, we believe the lower middle market offers a more attractive supply/demand balance for lenders.
Source: Preqin, JP Morgan, BofA ML, Bloomberg, and GSAM.
Private credit can act as an effective diversifier, even to common credit asset classes.
As we move into the later stages of the economic cycle, investors are increasingly adopting private credit as a strategic portfolio component for income generation, return enhancement, and potential diversification benefits. As the chart shows, from a portfolio standpoint, private credit can be a powerful complement to traditional fixed income strategies. By giving investors access to differentiated sources of return, direct lending’s long term cross asset correlation figures remain contained.
Source: Bloomberg and GSAM.
Top Section Notes: As of November 30, 2018. The market size of direct lending refers to the sum of assets under management of direct lending funds and US Business Development Corporations (BDCs). The market size of the global high yield market refers to the BofA ML Global HY Index. The market size of the global bank loans market refers to the sum of the Credit Suisse Leveraged Loan Index and Credit Suisse Western European Leveraged Loan Index. The market size of the Emerging Market Debt refers to the JP Morgan EMBI Global Diversified Index. The size of the global convertible bond market refers to the Bloomberg Barclays Global Convertibles Composite Index. Bottom Section Notes: As of November 30, 2018. Analysis is from September 2004, inception date, to November 2018. Direct lending is represented by the Wells Fargo Business Development Index. Global Equity refers to the MSCI World Index. Global Government Fixed Income refers to the FTSE World Government Bond Index. Global HY refers to the Bloomberg Barclays Global High Yield Index. Europe HY refers to the Bloomberg Barclays Pan-European High Yield Index. Euro corporates refers to the Bloomberg Barclays Euro Corporate Index. Global bank loans refers to the CS Leveraged Loan Index. EMD Local refers to the JP Morgan GBI-EM Global Diversified Index. Global convertibles refers to the ICE BofAML Global Convertibles Index.
Environmental, Social and Governance investing (ESG) looks and feels like traditional investing.
A popular misconception about ESG is that ESG investment principles come at the expense of returns. In our view, such a belief is misguided. We believe that integrating ESG principles into investment strategies does not necessitate more risk or lower returns. A well-crafted portfolio that uses a disciplined process and quantitative investment rigor has the potential to deliver both social and economic outperformance over time. ESG investing strategies are really just a new manifestation of investing—one where investors may both do good and potentially do well.
Source: Bloomberg, MSCI, and GSAM.
ESG investing can be integrated in investment processes to create portfolios.
ESG represents a lens for managers to examine conventional assets to create portfolios with both embedded impact and market-rate returns. Hence, it can be weaved into the portfolio construction process as it requires the same rigor and discipline as traditional investing. Investors can integrate ESG and impact investing as a fundamental part of investing across various asset classes.
Top Section Notes: As of November 30, 2018. Beta refers to the volatility of the ACWI ESG Index in relation to the broad MSCI ACWI Index. Past performance does not guarantee future results, which may vary. Bottom Section Notes: As of November 30, 2018. The chart shows a core, satellite, and alternatives illustrative asset allocation framework in which ESG could be integrated. Image for illustrative purposes only.
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