Late-cycle expansions are often associated with elevated equity valuations, tight credit spreads, and financial excesses. These conditions can create vulnerability even when the operating environment is sound. History also demonstrates that late-cycle equity returns can be robust, rewarding a disciplined approach.
In our view, 2018 is unfolding much like a performer walking a tightrope. Risk is considerable, but manageable, and best addressed by balance, agility, and focus.
Our key views:
Global growth should remain solid as the synchronized expansion continues, but the pace is likely to moderate amid tightening monetary policy and financial conditions.
A likely source of volatility, inflation remains highly regional, with US readings gradually firming, Europe subdued, and emerging markets mixed, but Chinese inflation likely to rise.
In 2018, we expect: four hikes by the Federal Reserve, two by the Bank of England, the end of quantitative easing by the European Central Bank, and the Bank of Japan to still be on hold.
US fiscal expansion may lower recession risk in the near-term, but emerging tariff rhetoric and the potential for targeted retaliation introduce new systemic risk.
Late-cycle factors such as higher rates and earnings growth deceleration may be amplified by limited fiscal/monetary options. The potential for a trade war also remains top of mind.
Source: Goldman Sachs Global Investment Research, National Bureau of Economic Research, and GSAM. As of March 2018. The chart shows quarterly data from January 1984 to March 2018, the latest available data, of the unconditional probability of a US and Euro area recession over the next 8 quarters. 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. Please see additional disclosures at the end of this document.
We expect further global expansion with relatively low recession risk, contained financial imbalances, and a gradual firming of inflation. Central banks are likely to remain patient as monetary policy normalizes.
Cyclical overheating often shows up in the form of financial excess rather than in inflation. We find the consumer and banking system to be in significantly better shape versus pre-crisis financial imbalances, valuations, and risk appetite. Government debt, on the other hand, is on a concerning trajectory.
The deviation from central bank targets has gradually declined as wage and commodity price inflation have moved higher, a trend we expect to persist. Consequently, the list of central banks gearing up to raise rates may broaden in 2018. Easy financial conditions are likely to provide some cushion to market sentiment.
Top Section Notes: Valuation percentiles are based on the time period between 1990 and March 2018. 'Q4 2006' represents 1 year prior to the 2007–2008 Financial Crisis. ‘Financial Imbalances’ is a category that includes: Households/Consumers (personal saving, mortgage, and non-mortgage debt), Nonfinancial Business (corporate debt and interest expenses, debt to assets, and debt to GDP), Financial Business (bank equity ratios, financial sector liabilities, leverage, and loan-to-deposit ratios), and Government (debt/GDP and deficit/GDP for federal, state, and local governments). ‘Valuations/risk appetite’ is a category that includes: Housing (price-to-rent and price-to-income, house prices, mortgage spreads, lending standards, and credit scores), Commercial Real Estate (commercial cap rates, commercial real estate prices, collateralized mortgage bond spreads, and lending standards), Consumer Credit (credit card interest rates, personal loans, auto loan originations, credit card loans, and other consumer loans), Business Credit (corporate debt spreads, commercial and industrial lending standards, and high yield debt issuance), and Equity Market (valuations, equity risk premiums, and volatility). Indicators are shown as percentiles relative to the entire period. The center of the web indicates lower imbalance or risk, while the outer edge indicates higher. Bottom Section Notes: Most recent deviation is based on December 2017 inflation. Central Banks include: Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ), Bank of Canada (BoC), and Bank of England (BoE).
The current operating environment remains favorable for earnings. Equities are our preferred asset class, particularly those in ex-US markets that are more levered to global expansion.
US rates appear vulnerable to transitioning monetary policy, a pick-up in term premium, and increased Treasury supply. Forward pricing appears to lag Federal Reserve communications.
Tax reform was a tailwind for credit, potentially elongating the cycle. Still, we remain cautious on credit beta as tight spreads and higher leverage moderate our return expectations.
Euro and USD markets are likely to be dominated by differentials in interest rates, economic growth, and current accounts, with trade policy also joining the mix.
Elevated valuation, rising rates, and policy uncertainty may heighten equity sensitivity to exogenous shocks and shifts in the operating environment.
Source: Bloomberg, Goldman Sachs Global Investment Research, and GSAM. Data as of March 31, 2018. ‘Multiple expansion’ refers to the change in the ratio of price to the next 12 months of forecasted earnings per share, and is a measure of how expensive an asset class is. The chart shows a decomposition of each year’s total return contributors. 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. Please see additional disclosures at the end of this document. Past performance does not guarantee future results, which may vary.
We believe the synchronized global macro backdrop provides an attractive operating environment for risk assets, though the market appears increasingly vulnerable to bouts of volatility and adjustment.
Since September 2017, longerterm interest rates have been trending higher as the impact of economic momentum, fiscal stimulus, and monetary tightening have unfolded. In our view, longer-term global rates still have room to move higher and narrow the gap between current yield and implied fair value.
Potential increases in longerterm rates may prompt the next concern—the level at which correlations between stock prices and bond yields turn negative. We believe equity pressure may result if the 10-year Treasury approaches 3.4%– 3.8%. Multiple factors, including speed, magnitude, and the catalyst of higher rates may also impact correlations.
Top Section Notes: ‘Current yield’ is as of March 31, 2018 and ‘Fair Value’ is as of February 16, 2018 for US, Germany, Japan and UK, Switzerland, latest available. ‘Fair Value’ is derived from the Goldman Sachs Global Investment Research (GIR) Fair Value model. Fair Value is the yield based on GIR economists’ outlook for growth and inflation, and the expected stance of monetary policy. The ‘Below Fair Value (bps)’ represents the difference between today’s nominal interest rates on sovereign securities with maturities of 10 years and their respective Fair Values. Past performance does not guarantee future results, which may vary. Bottom Section Notes: ‘Current’ as of March 31, 2018. The equilibrium rate is the federal funds rate that neither stimulates nor restrains economic growth. This rate was calculated by reducing the long-run equilibrium nominal rate by 1.5 percentage points, in line with the shift in the Federal Reserve’s projections since 2012.
Rising corporate earnings may normalize expensive markets—lower prices are not a requirement.
Near the 90th percentile of historical valuation, US equities may seem primed for lower forward valuations. But investors who sell expecting a better entry point may miss out on strong earnings momentum. We believe that rising earnings, rather than price declines, can be the primary driver of normalizing valuation.
Source: Bloomberg and GSAM.
Should equity returns moderate, Buy-Write strategies may benefit.
As valuation contracts from elevated levels (our base case over the next few years), markets may see moderate, but positive returns. This is potentially an ideal backdrop for buy-write strategies in which investors maintain broad equity exposure, but forego a portion of potential equity upside in exchange for additional returns in the form of distributions from call option premiums.
Source: Bloomberg and GSAM.
Top Section Notes: Analysis from January 1954 to March 2018. Chart shows the valuation percentile and earnings per share for the S&P 500 Index. Forward P/E refers to the current index price divided by the next 12 months’ forecasted earnings per share. Valuation percentiles indicate which percent rank P/E ratios fall into as compared to history, when all historical valuations are ranked. The two periods highlighted refer to the most recent during which the S&P 500 traded above the 90th percentile: March 1992 to October 1994, and December 1997 to May 2006. Bottom Section Notes: Analysis from March 2006, common inception, to March 2018, latest available. The ‘BuyWrite index’ refers to the CBOE S&P 500 2% OTM BuyWrite Index (BXY). This index is not necessarily reflective of all Buy-write strategies. Returns show the magnitude of relative performance between the BXY index and the S&P 500, e.g. a negative return means underperformance. A ‘Buy-write strategy’ refers to an investment that receives call premiums on an underlying equity position to generate income. Writing an option refers to selling an option. An option is the right, but not the obligation, to buy or sell a particular security. Buy-write strategy maximum loss is equal to full value of shares minus the premium collected from the options. Please note that Buy-write strategies are not appropriate for all investors and are not riskless investments, so investors can lose money. In a rising market, due to limited upside participation, Buy-write strategies could significantly underperform the market. Returns are daily total returns gross of dividends. '% of time BuyWrite Index has Historically Outperformed S&P 500 Index' is calculated by looking at the frequency of time the 12 month subsequent returns were greater than the same period return for the S&P 500 Index. Past performance does not guarantee future results, which may vary.
Major countries around the world find themselves in varying stages of economic, credit, and monetary policy cycles.
The global economy, credit, and central banks are all subject to cycles. Currently, the cycle in the US is farther along from an economic, credit and central bank perspective. Other major markets remain in earlier, more expansionary stages, providing support for earnings growth absent a US slowdown.
Global economic growth provides a supportive backdrop for international profit margins.
Global growth may remain abovetrend, which historically has supported earnings growth outside the US. For every dollar of sales growth, the earnings benefit has been greater internationally. These markets are more levered to global growth, via higher operational leverage, a broader revenue mix, and a significant financial sector representation.
Source: Datastream, MSCI, and GSAM.
Top Section Notes: As of March 2018. For illustrative purposes only. Bottom Section Notes: As of March 2018. Analysis is from January 2005 to March 2018. Net profit margin used in the analysis refers to the next twelve months’ net profit margin. Net profit margin is defined as net income / total revenues. ‘Pre-Financial Crisis Peak’ refers to the highest net profit margin between 2005 and 2007. ‘Current’ refers to March 2018.
When growth in emerging markets outstrips developed markets, equity returns have tended to follow suit.
A widening growth differential between EM and developed markets (DM) has been conducive to historical EM equity outperformance. Today, IMF forecasts suggest a widening growth differential which may be more than temporary. We believe EM equities stand near the beginning of a cyclical performance uptick relative to DM.
Source: Haver, Bloomberg, Factset, International Monetary Fund (IMF), and GSAM.
A trend higher in interest rates has often favored EM assets.
During the last three US rate-hike cycles, EM equities have not only withstood the increases, but also delivered strong performance. With the backing of strong macro conditions, EM equities may exhibit similar resilience in this cycle.
Source: Bloomberg, Federal Reserve, and GSAM.
Top Section Notes: As of March 2018. "EM-DM growth differential” shows the percentage point difference in real GDP growth rates between the IMF’s estimates for Developed Markets (DM) growth versus Emerging Markets (EM) growth using data from the latest World Economic Outlook. ‘EM growth’ takes the country weights from the MSCI EM index and applies them to the IMF’s individual country forecasts. Post-2017 weights are assumed to be constant. 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. Past performance does not guarantee future results, which may vary. Bottom Section Notes: As of March 2018. Chart shows the performance of the MSCI Emerging Markets Total Return Index and the S&P 500 Total Return Index during the three most recent Federal Reserve rate hike periods. ‘US Fed Rate Hike’ refers to the change in the level of the Federal Open Market Committee’s (FOMC) target fed funds rate, as defined by the Federal Reserve.
Interest rate risk is at historic highs and equity volatility’s unexpected spikes may persist.
The Bloomberg Barclays US Aggregate Bond Index’s duration has trended to an all-time high, indicating that sensitivity to rising interest rates has increased. In addition, equity volatility, as measured by the VIX index, has recently begun to surge.
Source: Barclays Live, Bloomberg, and GSAM.
Diversified liquid alternatives have historically exhibited favorable features relative to stocks and bonds.
The last two equity drawdowns highlighted the low beta benefits of alternative investments, which fell less than half as much as equities. Similarly, the last two large rate increases demonstrated the benefits of the low correlation of alternative investments, which posted positive returns while bond returns were in negative territory.
Source: Bloomberg and GSAM.
Top Section Notes: As of March 2018. Top chart shows the monthly data of the Bloomberg Barclays US Aggregate Bond Index’s duration from August 2008 to March 2018. Bottom chart shows the daily CBOE Volatility Index (VIX) from August 31, 2008 to March 29, 2018. Bottom Section Notes: ‘Diversified Liquid Alternatives’ represents the HFRI Fund of Funds Composite Index. ‘Recent US Equity Drawdowns’ refer to the last two periods when the S&P 500 Index was down by more than 10% as of March 2018. ‘Recent US 10-Yr T-Note Yield Spikes’ refers to the last two periods when the US 10-Yr T-Note Yield increased more than 300 basis points within a two month period. Past performance does not guarantee future results, which may vary.
The municipal bond market has delivered less volatility than US government bonds.
With the onset of higher longer-term interest rates unfolding since September 2017, we find that diversified municipal bond portfolios, including those with broad allocations to credit and term structure, have produced less volatility than similar duration US Treasuries.
Source: Barclays Live and GSAM.
The power of muni diversification can be unlocked in a mutual fund structure.
In a universe of 50,000+ securities, the median number of holdings in separately managed muni accounts is only 30, compared to 217 for the median mutual fund. Historically, the more diverse portfolios have outperformed identically benchmarked SMAs, particularly during rate tightening cycles.
Source: Federal Reserve, Barclays Live, Morningstar, eVestment, and GSAM.
Top Section Notes: As of March 2018. Analysis is from April 1997, common inception, to March 2018, latest available. Volatility is the annualized standard deviation of monthly returns. Duration is the average duration of each index. ‘Treasury’ refers to the Bloomberg Barclays US Treasury Index. ‘High Yield Muni Agg’ (HYM) refers to the Bloomberg Barclays High Yield Municipal Bonds Index. ‘Muni Short’ (SM) refers to the Bloomberg Barclays 3 Year Municipal Bond Index. ‘Muni Agg’ (MA) refers to the Bloomberg Barclays Municipal Bond Index. ‘Blended Muni Portfolios’ refers to hypothetical portfolios with allocations between HYM, SM, and MA. Please see end notes for additional information on allocations for these hypothetical portfolios. Bottom Section Notes: For illustrative purposes only. Chart compares the current rate hike cycle (December 2015 to March 2018, latest available) to the prior rate hike cycle (June 2004–June 2006). ‘Muni Mutual Funds’ refers to the funds listed in Morningstar that are benchmarked to the ‘Bloomberg Barclays Municipal TR USD’. ‘Muni Separately Managed Accounts (SMA)’ refers to the eVestment universe of accounts that are benchmarked to the ‘Bloomberg Barclays US Municipals’. Total returns are average annualized performance (net of fees). Average SMA fees are 42bps, and reflect all available data reported by SMAs benchmarked to the Bloomberg Barclays US Municipals category. Average Muni Mutual Fund fees are 78bps, as defined by Morningstar for net expense ratio. Please see end notes for material differences between Mutual Funds and Separately Managed Accounts. 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. Diversification does not protect an investor from market risk and does not ensure a profit. Please see end notes for additional definitions. Past performance does not guarantee future results, which may vary.
Managers who can find signals in the noise may enjoy a competitive advantage.
Big data is about more than computers and zettabytes. Extracting actionable insights requires skilled managers to harness advanced analytics and processing technologies. As the rate of data generated increases exponentially, we believe a judicious blend of human judgment and computer-led analytics will become an essential tool in uncovering investment insight.
Source: International Data Corporation (IDC), IBM, and GSAM
Technology plus human expertise can lead to more informed investment decisions.
Natural language processing (NLP) technologies use computers to boil down vast amounts of text into themes and insights that humans could not otherwise discover on their own. Subtle relationships between companies or trends can be uncovered. While data-driven technologies can convey timely and informed inputs, it is the successful pairing of technology with human judgment that will be key.
Top Section Notes: As of March 2018. Data based on an IBM report published in 2013 and an IDC report published in 2014. For illustrative purposes only. Bottom Section Notes: As of March 2018. The chart shows that Natural Language Processing, which is a form of big data analytics, can potentially analyze vast amounts of text in a short span of time. For illustrative purposes only.
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