We hope that you, your family, and your community are moving past the worst of the health and economic consequences of COVID-19. Our thoughts are with you during this period of recovery.
Ascertaining a medical solution has rightly remained the dominant focus of global policymakers, though the economic backdrop has fortunately evolved from one of aggressive shuttering to one of cautious normalization. Economic evidence suggests that through relatively low-cost face masks and targeted physical distancing measures, economies can recuperate while vaccines and treatments are developed.
From an investment perspective, we find that this unprecedented moment validates the lessons of strategic discipline, risk management, and quality. As we enter the US election season, the skills acquired from navigating recent volatility should prove useful yet again.
The remainder of this edition of the Market Know-How will focus on summarizing our macro expectations and providing a framework for breaking out.
We estimate that global real GDP will fall  -3.3% in 2020. This year saw the sharpest and shortest recession since at least WWII. In fact, for the US, the National Bureau of Economic Research documents that no recession has lasted fewer than six months in a database that covers cycles back to the mid-1800s. As we look into 2021, the recovery may be stronger in select non-US markets experiencing less economic drag from the COVID-19 resurgence.
The scientific name of the new strain of coronavirus is SARS-CoV-2. In people, the disease caused by the virus is called COVID-19, with common symptoms of fever, fatigue, and respiratory stress. In markets, the symptoms appear to be volatility and velocity. When compared to a composite of prior bear markets, the 2020 equity plunge and near instantaneous reversal are unparalleled. While the deluge of monetary and fiscal policy has sustained the recovery amidst a collapse in global earnings, the handoff between policy and fundamentals will likely prove volatile.
Top Section Notes: Goldman Sachs Global Investment Research, National Bureau of Economic Research, and GSAM. As of August 6, 2020. 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. Bottom Section Notes: Bloomberg and GSAM. As of July 31, 2020. Analysis shows the daily performance of bear markets based on the MSCI World Index for the year prior and following a bear market trough. ‘Bear market’ refers to a drawdown from peak to trough of 20% or greater. ‘Average’ refers to the average market performance across bear markets since 1969. ‘Current’ refers to the most recent bear market with the trough in March 2020. Past performance does not guarantee future results, which may vary.
COVID-19 has reset the global economy, requiring a new investing framework.
The Coronacrisis is a generational event that stands to transform how economies function. To navigate the shifting environment, investors need to adapt to a new framework consisting of three overlapping phases: preservation, consolidation, and innovation. Preservation is key in periods of high uncertainty, as companies focus on funding and survival. Consolidation depends on business strategy, not circumstance. Lastly, innovation creates the potential for both massive disruption and superior returns. Successfully managing through these phases potentially lies in the ability to identify sustainable competitive advantages emerging out of the crisis.
Source: Goldman Sachs Global Investment Research and GSAM.
COVID-19 accelerated secular trends already underway.
In parallel, this pandemic has also exacerbated key investment challenges, ushering in a world of episodic volatility, lower yields, and scarcer growth. To better cope with volatility, we believe that balance sheet strength and competitive positioning remain vital in this recovery. To combat yield compression, cash flow enhancers may be effective in providing diversified income growth. And as the number of faster-growing companies continues to decline in major markets, we believe the opportunity set is becoming more idiosyncratic and global. The post-COVID world may mean investing without borders.
Source: Datastream, I/B/E/S, Goldman Sachs Global Investment Research, and GSAM.
Top Section Notes: As of July 31, 2020. For illustrative purposes only. ‘Coronacrisis’ refers to the COVID-19 pandemic. Bottom Section Notes: As of July 31, 2020. Chart shows the rolling 6-month average of companies in the MSCI World Index by sales growth band from January 2000 to July 2020. 'Sales growth’ is measured by annualized forward consensus expectations of next three-year sales growth. ‘Low growth’ refers to companies with annualized sales growth less than 4%. ‘High growth’ refers to companies with annualized sales growth greater than 8%. International securities entail special risks such as currency, political, economic, and market risks. Past performance does not guarantee future results, which may vary.
Sector composition of the top-performing companies today reflects shifting growth dynamics.
Attractive equity returns of the last few years have reflected shifting demographics, social preferences, and consumer behaviors that translate into powerful earnings growth. While the US technology sector has been well-positioned for these trends, the US market’s compositional advantage has begun to shrink as global economies invest in more profitable industries. Additionally, the market’s willingness to pay a premium for more consistent profitability may extend to areas such as Med-tech, Fin-tech, Ed-tech, Green-tech, and Environmental, Social, and Governance (ESG), which could begin to balance out the global opportunity set.
Source: Bloomberg and GSAM.
Strong performance has not been limited to the US.
The top-performing companies remain well-represented in the global landscape, despite overwhelming US performance. Of the top 50 performing stocks each year, on average, more than 75% have been domiciled outside of the US over the last decade. Even in the Coronacrisis, where macro and market conditions have been challenged, global opportunities have remained plentiful. So far this year, 92% have been domiciled internationally. Investors who can identify high-quality companies with strong balance sheets, earnings potential, and profit margins may benefit from expanding their portfolios’ borders.
Source: Bloomberg and GSAM.
Top Section Notes: As of July 31, 2020. Charts show the proportion of the top performing 50 stocks in the MSCI ACWI Index based on sector composition. 'Cons. Discret.' refers to consumer discretionary. 'Comm. Services' refers to communication services. 'Cons. Staples' refers to consumer staples. Bottom Section Notes: As of July 31, 2020. Chart shows the proportion of the top performing 50 stocks in the MSCI ACWI Index by region of domicile (US or international). ‘Coronacrisis’ refers to the COVID-19 pandemic. Past performance does not guarantee future results, which may vary. International securities entail special risks such as currency, political, economic, and market risks.
Growth today is different from growth yesterday.
Recent months of equity performance have shown an unusual dynamic of growth dominance during periods of significant market volatility. Historically, this has occurred only 41% of the time. In our view, this rotation in outperformance can be explained by the evolving characteristics of growth companies. They tend to be 1) more defensive because of balance sheet strength and ample liquidity, and 2) more insulated from negative earnings revisions due to less cyclical business models. We believe the outperformance of growth will likely persist given modest GDP growth, low inflation, and single-digit earnings growth potential.
Source: Bloomberg and GSAM.
Attractive growth sector tilts exist outside of large cap equity.
The growth opportunity is expansive as you move down in market capitalization. The index composition of small- and mid-cap growth stocks is heavily weighted toward information tech and healthcare, which comprise ~60% of the index. Even within growth sectors, these companies are tilted toward industries most transformed by the digital revolution, including semiconductors in tech and biotech in healthcare. We think the next decade ahead will increasingly be disrupted by technology. Small- and mid-cap growth stocks are poised to benefit from this secular trend as they are both innovative and nimble in evolving business strategies.
Source: Bloomberg and GSAM.
Top Section Notes: As of July 31, 2020. Chart shows outperformance of the Russell 2500 Growth and Value style indices relative to the Russell 2500 Index during periods where the Russell 2500 Index declines on a trailing three-month basis. Bottom Section Notes: As of July 31, 2020. Chart shows the relative sector weights of Russell 2500 Growth Index versus the Russell 2500 Value Index. ‘Comm. Services’ refers to communication services. ‘Cons. Staples’ refers to consumer staples. ‘Cons. Discret.’ refers to consumer discretionary. Past performance does not guarantee future results, which may vary.
Depressed yields are likely to persist in the near-term.
In the first half of 2020, markets hit a number of records: the Treasury curve dipped below 1%, short term interest rates effectively moved to zero, and the municipal market experienced the lowest yield levels in history. In this environment, investors may hesitate to take on duration when a recovery in rates could pose headwinds to bond prices. However we believe interest rate sensitivity is often overestimated in municipal bonds, especially when moving down the credit spectrum.
Source: Bloomberg, Thomson Reuters MMD, and GSAM.
Rate sensitivity impacts municipal debt differently.
There are a plethora of factors beyond interest rates that may influence the pricing of municipal debt, especially in an economic recovery. A macro rebound can push rates higher and expose municipals to greater rate sensitivity. Yet offsetting this impact is a stronger revenue backdrop that may narrow credit spreads and improve fundamentals. We think this counterbalancing feature has helped drive the stark historical disconnect between realized and option-adjusted duration. This dynamic is even more accentuated in credit, which may provide an attractive approach to generating tax-free income while reducing realized duration risk.
Source: Bloomberg and GSAM.
Top Section Notes: As of July 31, 2020. Chart shows Municipal Market Data (MMD) yields from December 2017 to July 2020 for the 5-Year, 10-Year, and 30-Year tenors. Bottom Section Notes: As of July 31, 2020. ‘Option-Adjusted Duration (OAD)’ is a measure of the sensitivity of bond price to interest rate changes, assuming that the expected cash flows of the bond may change with interest rates. ‘Realized Duration’ refers to the actual price sensitivity of a bond based on historical market-based data. ‘Muni HY’ refers to the Bloomberg Barclays Municipal Bond: High Yield Total Return Index. ‘Muni Agg” refers to the Bloomberg Barclays Municipal Bond Total Return Index. ‘Muni Short’ refers to the Bloomberg Barclays Municipal Bond: Muni Short (1-5) Total Return Index. Past performance does not guarantee future results, which may vary. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this page.
The characteristics of core fixed income have evolved over time.
Over the past decade, investment grade fixed income has changed from both a characteristic and composition perspective. The Bloomberg Barclays US Aggregate Bond Index has lower yields, higher duration, and more exposure to Treasuries relative to 10 years ago. As such, investors who rely on a passive investment strategy may unintentionally take on more interest rate exposure as well as lower yields. We believe there are ample opportunities to boost income and seek more attractive risk-adjusted returns by diversifying into high quality spread sectors of the core fixed income market.
Source: Bloomberg Barclays and GSAM.
Not all fixed income is created equal.
When it comes to fixed income, investors are often tethered to the Bloomberg Barclays US Aggregate Bond Index. However, not all bonds are created equal, even within the same core fixed income space. Sub-sectors have a wide range of characteristics across yield, volatility, return, and correlation to equities. In today’s yield-challenged environment, we believe selectivity is critical not only within the benchmark, but also across the entire investment grade universe. A dynamic approach in core fixed income may allow investors to fully capitalize on the benefits in their portfolios.
Source: Bloomberg and GSAM.
Top Section Notes: As of July 31, 2020. Chart shows sector weights of the Bloomberg Barclays US Aggregate Bond Index components by market value. ‘US Treasury’ refers to the US Treasury component. ‘Securitized’ refers to the securitized component, including mortgage-backed securities, asset-backed securities, and commercial mortgage-backed securities. ‘Corporate’ refers to the corporate component. ‘Government-Related’ refers to the government-related component. The composition of the Bloomberg Barclays US Aggregate Bond Index may not add up to 100 due to rounding. ‘Duration’ is a measure of a bond's price sensitivity to changes in interest rates. ‘Option-adjusted spread (OAS)’ refers to the spread between a bond and its risk-free rate, after accounting for embedded options. ‘Yield’ is measured by yield-to-worst, which is the lowest yield an investor can expect when investing in a callable bond. Past performance does not guarantee future results, which may vary. Bottom Section Notes: As of July 31, 2020. ‘Volatility’ is measured by standard deviation. Analysis based on monthly performance over the past 10 years. Aggregate’ refers to the Bloomberg Barclays US Aggregate Bond Index. ‘Agency’ refers to the Bloomberg Barclays US Agency Index. ‘Corp A’ refers to the Bloomberg Barclays A Corporate Index. ‘Corp Aa’ refers to the Bloomberg Barclays Aa Corporate Index. ‘Corp Aaa’ refers to the Bloomberg Barclays Aaa Corporate Index. ‘Corp Baa’ refers to the Bloomberg Barclays Baa Corporate Index. ‘Corporate’ refers to the Bloomberg Barclays US Corporate Investment Grade Index. ‘MBS’ refers to the Bloomberg Barclays US Mortgage Backed Securities (MBS) Index. ‘Securitized’ refers to the Bloomberg Barclays US Securitized Bond Index. ‘Treasury’ refers to the Bloomberg Barclays US Treasury Index. ‘Treasury 1-3Yr’ refers to the Bloomberg Barclays US Treasury: 1-3 Year Index. ‘Treasury 7-10Yr’ refers to the Bloomberg Barclays US Treasury: 7-10 Year Index. Past correlations are not indicative of future correlations, which may vary.
The US middle market represents a vibrant capital base and addressable market opportunity.
The US middle market is made up of the “businesses next door” that are the backbone of the economy. These companies range from $10-$100 million in annual EBITDA and have strong growth potential, but are often underserved by traditional providers of capital such as banks and the public markets. Instead, their funding often comes from local banks and private markets. In our view, today’s tailwinds of targeted fiscal stimulus, renewed investment in domestic supply chains, and the longer-term trend of companies staying private longer, all make the middle market an attractive opportunity for investors.
Source: US Chamber of Commerce, National Center for the Middle Market, and GSAM.
Private debt may deliver a unique source of income and volatility hedge.
Middle market direct lending has held advantages over other public fixed income markets resulting in stronger risk-adjusted returns. In the post-COVID world, these aspects of the private market may be particularly attractive. Bilateral negotiations can result in better terms (e.g. enhanced due diligence, higher credit spreads, and tighter debt covenants). Relatively conservative capital structures and longer deployment horizons can lead to lower default rates and less fluctuations in yield. As such, direct lending can be an interesting source of returns for investors seeking to manage portfolio volatility. Imperative though is partnering with companies with healthy balance sheets and sustainable cash flows.
Source: Bloomberg and GSAM.
Top Section Notes: As of March 31, 2020, latest available data. ‘Middle market’ refers to the sample of companies with revenue between $10 million and $1 billion, as surveyed on a quarterly basis by the National Center for the Middle Market (NCMM). ‘Sales growth’ refers to the year-over-year change in the Middle Market Indicator (MMI) 12-month projected gross sales revenue and is reported by the NCMM. Bottom Section Notes: As of June 30, 2020. Analysis based on quarterly returns from September 2004, earliest common inception, to present. ‘Direct Lending’ refers to the Cliffwater Direct Lending Index, which measures the unlevered, gross of fee performance of US middle market corporate loans. ‘High yield’ refers to the Bloomberg Barclays US High Yield Index. ‘Investment Grade’ refers to the Bloomberg Barclays US Aggregate Bond Index. ‘Leveraged loans’ refers to the S&P/LSTA Leveraged Loan Index. ‘Volatility’ is measured by standard deviation. ‘Return per Unit of Volatility’ is calculated by taking a ratio of annualized return divided by annualized volatility. Investment grade bonds are corporate or municipal bonds with low to medium level of default risk. Traditionally, these bonds offer lower yields given their healthier credit profile. Investment grade bonds have credit ratings between AAA and BBB- based on the Standard & Poor (S&P) rating. High yield bonds are corporate or municipal bonds with a higher level of default risk relative to their investment grade counterparts. Given the riskier credit profile of high yield bonds, investors are generally compensated with higher yields. Leveraged loans are floating rate loans with below investment grade rating made by banks to companies. Leveraged loans typically fall higher in the capital structure relative to high yield bonds. Historically, leveraged loans have offered higher recovery rates in the case of a default. Direct lending is a form of corporate debt provision in which lenders other than banks make loans to companies. The borrowers are usually small and medium enterprises while the lenders may be wealthy individuals or asset management firms. Direct lending debt is typically structured as floating rate loans with below investment grade credit rating. Floating rate debt reacts to interest rate changes in a similar manner to fixed rate debt, although typically to a lesser degree. Typical features of this asset include strong loan collateral and reasonable leverage, but can also be less liquid than public fixed income instruments. There is limited ability to trade these loans on the public market due to the fact that issuers are generally small and consequently not well-known. Credit and default risk is higher for direct lending strategies compared to traditional broad market fixed income strategies given that the focus in direct lending strategies is on below-investment-grade issuers. Investors are typically compensated through credit risk and illiquidity premiums. Past performance does not guarantee future results, which may vary. Investments in fixed income securities are subject to credit, liquidity, and interest rate risk.
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