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2019: Edition 1


Pressure Points

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:

  • Revisiting the balance between growth and value style weights
  • Emerging markets strike us as poised for a comeback
  • Deploying alternatives to manage a riskier market landscape.

Volatility: A Return to Normalcy

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.

Source: Bloomberg and GSAM.
The Know
Growth spurt

The outperformance of US large-cap growth stocks versus value has been unprecedented by some metrics.

Peak Growth

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.

The How
Balancing act

Growth’s remarkable run may have created an unintended overweight.

Growth Drift

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.

The Know
Navigating EM headwinds

A stronger dollar, country crises, and geopolitical headlines help explain challenged 2018 performance.

A Series of Unfortunate Events

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.

The How
Leaning against the wind

Earnings growth in emerging markets remains stronger than in developed markets.

Growing Up Cheap

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.

The Know
A two-way street

Sitting on the sidelines can mean missing out on gains even if investors succeed at the task of avoiding losses.

Missing the Bottom, Missing the Bounce

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.

The How
Gearing up for a bumpy ride

Long-term strategic market exposure has often beaten market timing strategies.

Know Your Alternatives

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.

The Know
Policy risk ahead

Staying exposed to locally sourced revenues could pay off—small firms could fare better than globalized large caps.

Economic Policy Uncertainty Is on the Rise

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.

The How
Small, but tough

Historically global small caps have delivered significantly higher returns with a superior Sharpe ratio.

Stronger Returns Globally, Higher Share of Revenues Sourced Locally

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.

The Know
The rise of private credit

Moving into the mainstream, with direct lending leading the way.

A Market That Can No Longer Be Ignored in Diversified Allocations

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.

The How
Same, same, but different

Private credit can act as an effective diversifier, even to common credit asset classes.

Direct Lending Has Low Correlation to Numerous 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.

The Know
Doing good and doing well

Environmental, Social and Governance investing (ESG) looks and feels like traditional investing.

ESG Has Generated Similar Returns and Risk

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.

The How
ESG as a lens

ESG investing can be integrated in investment processes to create portfolios.

ESG as an Integrated Component of Portfolio Construction

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.

Source: GSAM.


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