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MARKET KNOW-HOW
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Edition 1 of 3

MARKET KNOW-HOW

Pro-growth, Pro-equity, Pro-reality

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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.

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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.

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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.

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The Know
Sit tight

These strategies warrant a fresh look as investors enter the ninth year of the bull market

Buy-Write strategies have consistently lower volatility than the S&P 500 over the last 10 years.

Moderate returns and larger draw-downs have often historically followed elevated equity valuation periods. Investors who de-risked were at risk of waiting for years to re-enter at lower valuations. However, Buy-Write strategies, which seek to generate income by receiving call premiums, provided lower volatility across various market environments.


Source: Bloomberg and GSAM


The How
Faster recoveries

During equity bear markets, Buy-Write strategies’ smaller draw-downs resulted in speedier recoveries

The lower-volatility characteristics of Buy-Write strategies have exerted an influence on returns.

Historically, Buy-Write strategies' relative outperformance on the downside has coincided with faster recoveries. Over time, these strategies have provided similar returns, with lower volatility. Buy-Write strategies outperformed the S&P 500 by an annualized 4.5% in the past three equity drawdowns, which resulted in a one year faster recovery.


Source: Bloomberg and GSAM.

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The Know
Single stocks, singular shocks

Over-concentration in an individual company creates a risk of amplified losses

Average losses are greater for a single stock than for the index as a whole.

Historically, over-concentration exposes the portfolio to greater downside risk, without increasing long-term average returns. A one standard deviation loss for the S&P 500 Index is -9%, but the same one standard deviation loss is -22% for an average S&P 500 single stock.


Source: Bloomberg, Morningstar, and GSAM.


The How
Life comes at you fast

It may take years to build wealth, but a fraction of that time to destroy it

Six notable corporate collapses destroyed 18 years of wealth creation in only 2 years.

Investors tend to stick to what they know, but this may come at substantial cost. Behavioral biases such as familiarity and overconfidence can lead to volatile single-stock concentration, at a time when disruptive forces increase the potential for unpredictable losses.


Source: Bloomberg and GSAM.

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The Know
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.

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The Know
Trade in places

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.

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The Know
Measuring up

The municipal bond market has delivered more yield at equivalent credit and maturity levels

Across most maturities and credit, municipal bonds (munis) have outpaced their taxable equivalents.

Despite 2017’s stronger demand and weaker supply, munis have provided more attractive combinations of tax-equivalent yields (TEY) than taxable bonds, even when applying a personal tax rate of 35%. As shown, AAA-rated munis may have enhanced yields vs. virtually all Treasury maturities, as well as down most of the corporate credit spectrum.


Source: Barclays Live and GSAM.


The How
Endless possibilities

A little credit and term structure may go a long way

Munis may provide diverse opportunities to build a better portfolio.

For many municipal investors, benchmarking to the municipal aggregate bond index is a starting point. However, modest enhancements to a portfolio’s term structure and credit exposure may provide combinations of either higher TEY, lower volatility, or both. For instance, a little short duration for liquidity and credit for income may go a long way in generating improved risk-adjusted yield.


Source: Barclays Live and GSAM.

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