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2021: Edition 2

MARKET KNOW-HOW | 2021: Edition 2

Faster, Higher, Stronger

Market Know How- John Tousley

Although COVID-19 may mean that this year’s delayed Olympic Games in Tokyo will be like none that has gone before, one constant will be the Olympic motto: Faster, Higher, Stronger. It is a motto that is also apposite for current market conditions.

Some of the moves in fixed income markets this year— such as the sell-off in Treasuries—have been faster than anything we have seen in recent years, and bond markets may remain in a state of flux for the remainder of 2021.
As a consequence, core fixed income allocations require risk-aware active management, and security selection in credit markets may become an increasingly differentiated source of returns.

Despite the sell-off in bond markets, global equities remain resilient and continue to grind higher. In our view, that dynamic is likely to remain intact as the earnings recovery becomes the key driver of returns as economies re-open.

And, of course, the moves in both bond and equity markets reflect stronger economic fundamentals with global activity set to surpass pre-pandemic levels this year.

This edition of the Market Know-How will focus on summarizing our macro expectations and providing
a framework for positioning over the rest of 2021.

We emphasize:

  • Investing sustainably in an increasingly disrupted world.
  • Moving down in market cap, out in geographic exposure, and forward in diversity.
  • Focusing on high-quality fixed income as a key to risk management irrespective of interest rate levels.

Macro & Market Views

Global Growth

Growth looks set to be strong across the board this year, in our view. Massive fiscal stimulus, historically low interest rates, and a huge war-chest of pandemic-induced household savings provide a confluence of tailwinds. Much of that growth will be a catch-up from the damage caused in 2020, and we expect the strong resurgence to continue well beyond pre-pandemic levels and throughout 2022. Even so, we anticipate a high degree of growth variability across regions dependent on vaccine rollout, policy support, and GDP composition.

Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of April 12, 2021.
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The Know
The fast lane

A small- and mid- (SMID) cap race to becoming a top revenue grower

Broadening US Market Leadership

Market performance over the past five years has increasingly rewarded efficient businesses with high growth potential. Large US companies with rich balance sheets, significant market share, and economies of scale have attracted the lion’s share of investor dollars. Yet a closer look at performance tells us that US SMID-cap has become equally competitive today. Across every sector, US SMID-cap companies represent 78% or more of top decile revenue growers in the all-cap Russell 3000 Index. We believe this trend will gain momentum as tech transformation continues to unlock innovation for smaller, more nimble players of the US equity market.

Source: Bloomberg and Goldman Sachs Asset Management.

The How
The way forward

Megatrends are redefining the investment landscape

Identifying Specific Investment Opportunities

Finding high-growth US public companies may increasingly come from investing in themes accelerated by COVID-19: new age communication, consumer preferences, health care, information technology, and sustainable industry. We believe portfolio implementation of these themes will require careful company selection that may be better achieved through SMID-cap investing. Unlike US large cap, US SMID-cap is home to a greater variety of companies operating in distinct business verticals across a sector’s value chain. Greater precision in identifying the right company for the right investment idea may open doors to unique, differentiated revenue streams in the future.

Source: Goldman Sachs Asset Management.

The Know
Macro matters

Economic growth may influence equity performance

Economic Growth and Equity Market Returns

Investors often question how their views on economic growth should inform how they choose to invest in developed and emerging markets. Economic theory suggests that growth influences equity markets in stages: 1) higher corporate profit growth, which leads to 2) higher EPS growth, which finally translates into 3) an increase in stock prices. While such a progression makes intuitive sense, in practice we do not see a particularly strong statistical relationship. Historical data shows that a country’s real GDP has some positive, but not meaningful, degree of explanatory power on equity market performance.

Source: Bloomberg and Goldman Sachs Asset Management.

The How
Micro matters more

Most performance comes from stocks, not countries.

Active Outperformance

We believe that outperformance in international developed equities and emerging market equities comes less from country beta, and more from security selection. Data shows that since 2010, a significant proportion of international fund managers have delivered returns in excess of their passive counterparts when compared to US large cap managers. The magnitude of this outperformance is also pronounced for international fund managers, with emerging market and foreign large cap managers outperforming the median passive fund by 3.8pp and 2.3pp, respectively.

Source: Morningstar and Goldman Sachs Asset Management.

The Know
Why diversify?

Companies with material female representation have generated stronger returns than the benchmark

Companies with Female Leaders have Outperformed

We believe that incorporating diverse perspectives drives better corporate outcomes. Data suggest that higher representation of female employees, managers, and executives all coincide with stronger performance. In 2020, for the first time, every S&P 500 company board had female representation. More importantly, a quarter of companies had boards where women filled at least one-third of the seats. This level is significant—it is where women are more than just a token voice, but have a meaningful presence at the table. Over the last three years, companies with top quartile female board representation (>33%), outperformed the broader index by 25pp. Adjusting for sectors and size makes the argument for diversification even stronger.

Source: Bloomberg and Goldman Sachs Asset Management.

The How
Outperformance, she wrote

Diversification in portfolio management has also improved outcomes

Funds with Female Investors have Outperformed

Investment managers with more gender diversity have also outperformed over time. Here too, adding one woman does not necessarily move the needle. However, when more than 33% of a portfolio management team is female, outperformance has been significant in the US large cap equity space. In this highly competitive market for active managers, diversity clearly has an edge. Female PMs have also outperformed from a risk-adjusted perspective, with all-female teams generating a 21% higher Sharpe ratio versus teams with no women over the last three years. Even so, female-managed funds are the minority today. Teams with more than 33% female PMs make up only 10% of all US large cap mutual funds and 9% of assets under management.

Source: Morningstar and Goldman Sachs Asset Management.

The Know
Eggs in many baskets

Diversification across asset classes is stronger than within them

Core Fixed Income is a Key Diversifier Across Assets

Over the last 30 years, correlations within asset classes steadily climbed as markets became more globalized: equities have tended to move with other equities, and bonds with other bonds. In order for investors to diversify effectively, we believe they need to allocate across multiple asset classes. The core of a balanced portfolio relies on developed market equities and investment-grade bonds, but investors may also consider fixed income diversifiers, alternatives, and commodities. We believe a well-rounded portfolio may be the best defense in times of volatility, as well as the best offense to identify global opportunities.

Source: Goldman Sachs Global Investment Research, Global Financial Data, and Goldman Sachs Asset Management.

The How
Sunny side up

Core fixed income has been steady in bouts of equity volatility

Strength in Stability

In a multi-asset portfolio, the core ballast over time has been a high-quality fixed income allocation. Not every year will be as volatile as 2020, but in most years equity markets have experienced some bouts of uncertainty. Since 2000, the average annual return of the S&P 500 Index has been nearly +8%, but the average maximum annual drawdown has been more than -16%. It is in these periods of volatility where core fixed income has shown its strength, returning on average +2% over the same periods of maximum equity drawdown. Similar to home construction, we believe a high-quality fixed income foundation is key to a well-designed portfolio.

Source: Bloomberg and Goldman Sachs Asset Management.

The Know
Keep it private

A cyclical asset offering inflation protection

Risk-Adjusted Performance By Market Environment

As global rates continue to hover at historically low levels, private credit markets may offer attractive opportunities to boost long-term risk-adjusted returns relative to traditional fixed income assets. Private credit solutions are often constructed with a floating rate structure, which may be an effective hedge against the risks of inflation and rising rates. Additionally, given private credit’s pro-cyclical nature, it may be well positioned in an environment of rising growth and inflation. A stimulus-driven economic rebound that ultimately leads to improving earnings, tight spreads, and fewer defaults, may also provide a meaningful tailwind.

Source: Cliffwater and Goldman Sachs Asset Management.

The How
Funding private assets

Matching the characteristics of the funding source to those of the private asset

Illustrative Private Credit Funding Sources

Investors seeking to add private assets to their existing portfolio may question how to size and fund their exposure. We believe that investors should attempt to match the characteristics of the funding source to those of the private asset being added. For example, private credit shares similar characteristics to public credit, such as high yield bonds and bank loans, as well as to public equity. Within a private credit sub-strategy, such as direct lending, the proportions of funding sources may vary based on the attributes of the sub-strategy. Consequently, we believe in proportionally funding the sub-strategy’s exposure from public credit and public equity markets (if private equity is not available).

Source: Goldman Sachs Asset Management.

The Know
The taxman cometh

Rates are likely to revert higher in coming years

Tax Rates are Below Average

Given record-high public debt levels and relatively low tax rates, we think taxes are more likely to move higher than lower over the next decade. Investments may be one such target area. Currently, long-term capital gains and qualified dividends are taxed at a maximum rate of 20%, along with an additional 3.8pp on investment income. If Congress does raise taxes on capital gains and dividends, we believe a rate around 28% may become the new ceiling—the same level President Reagan and a divided Congress agreed to in the Tax Reform Act of 1986.

Source: Wolters Kluwer Tax & Accounting and Goldman Sachs Asset Management.

The How
A penny saved

Loss harvesting can be even more beneficial in higher tax regimes

Tax Savings Go Above Average

An increase in the capital gains rate may cause a short-term momentum reversal and valuation re-rating in equity markets, but more significantly it may lead investors to be more prescriptive about long-term asset location. For example, tax loss harvesting in equity portfolios may become even more advantageous as investors strategically realize losses to offset their capital gains. In low-tax environments (15-20%), loss harvesting has added 4.1pp on average to after-tax annualized total returns. In higher-tax regimes (>28-35%), loss harvesting has added more than double that, with 8.6pp of tax savings on average.

Source: Bloomberg and Goldman Sachs Asset Management.


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