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2023: Edition 1

MARKET KNOW-HOW | 2023: Edition 1

Point Break

Market Know-How 1Q2023: Point Break

Inflation continues to be the dominant global concern, even in a world of complex geopolitical dynamics that include military conflict in Ukraine, territorial flexing by China, and entrenched societal polarization. We expect the evolution of inflation and commensurate central bank responses to remain the prevailing theme in 2023. While waiting for the wave to break, however, investors must learn to surf.

Given the interplay between inflation and monetary policy, many see a recession as a natural byproduct of tighter financial conditions. History credibly informs such a view, but a US recession may not be a forgone conclusion given a healthy financial system, strong labor demand, and robust private sector. In the Euro area and the UK, heightened sensitivity to external energy supply makes a recession probable, if not already in progress.

The adjustment to a higher inflationary regime has been painful, with the traditional 60 / 40 portfolio delivering historically poor returns in 2022.1 Even so, we think the opportunity set has been reset, with fixed income reasserting itself as a critical driver of diversification and cash flow.

In this edition of the Market Know-How, we explore how investors may navigate the ongoing period of inflation adjustment with emphasis on:

  • Adjusting equity exposure in seeking to reflect renewed cross-asset competition by focusing on quality, profitability, and idiosyncratic positioning. In fixed income, add duration to address reinvestment risk.
  • Monetizing elevated market volatility and stock dispersion to help improve after-tax performance via direct indexing.
  • Diversifying existing exposure with alternative investments to potentially access unique sources of returns.

Macro & Market Views

Global Growth

The global economy is likely to grow below trend in 2023 as major central banks continue to tame inflation by normalizing demand. In Europe, competing tensions between fiscal easing—to buffer the pain of rising energy costs—and monetary tightening will likely determine the duration and magnitude of its recession. In the US, we believe the path to lower inflation will require right-sizing labor demand and reducing wage growth. Though progress has been made, more restrictive financial conditions may be necessary to help address an overheated economy.

Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of November 30, 2022. “Real GDP” refers to Gross Domestic Product adjusted for inflation, year-over-year. 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.
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Duration: Reinvestment Risk

Convergence, then Divergence

US yields have risen substantially in the past year amid tighter monetary policy. However, we anticipate they may peak as we approach the end of the current Fed hiking cycle. While the 2-Year US Treasury yield has historically tracked the 10-Year yield around the end of prior hiking cycles, the two have diverged in the periods that followed. We believe such a divergence may underscore a nearing challenge for investors: reinvestment risk, particularly on the shorter end of the yield curve. For investors seeking income generation, we believe the relatively stickier yields achieved by extending duration will provide a more durable source of cash flow going forward.

Source: Bloomberg and Goldman Sachs Asset Management.

Duration: Looking Long

Strong Fixed Income Performance Following the Last Fed Hike

We recognize that the risk of additional rate hikes may steer investors towards the front end of the curve. Still, that may not always be the case, and the transition may be abrupt. Specifically, at the 24-month mark following the past three Fed hiking cycles, the Bloomberg US Aggregate Bond Index has averaged a yield over double that of the shorter duration index. Additionally, higher starting yields may make any further rate spikes less painful. These future yield advantages are similarly powerful for munis, where we also observe supportive fundamentals. As the calendar flips forward, investors may find attractive yields when adding on duration, across both municipal and taxable bonds.

Source: Bloomberg and Goldman Sachs Asset Management.

Direct Indexing: Monetizing the Market Volatility

Tax Breaks

Exploiting losses is sometimes easier than building gains. Though the rapid rise in interest rates and the slowing growth backdrop have driven equities lower in 2022, we believe direct indexing may stand to benefit from market volatility. Direct indexing involves purchasing the underlying shares of an index, rather than owning an index fund. This investment strategy prioritizes tax-loss harvesting, which builds tax savings through capital losses while attempting to keep tracking error tight to the benchmark. Tax-loss harvesting works not only in down years but also in up years, historically, as individual constituents can still see intra-year declines. In fact, over the last decade, at least one-fifth of underlying S&P 500 companies have fallen  -10% or greater at any given point each year.

Source: Bloomberg and Goldman Sachs Asset Management.

Direct Indexing: More Than Tax-Alpha

Death and Tax-Loss Harvesting

The tax-alpha achieved from harvesting losses is, in our view, a compelling feature of direct indexing, but it's not the only one. We see a variety of other potential benefits that come with building a war chest of capital losses, including the ability to liquidate concentrated stock positions, reduce active risk in portfolios, and help offset significant taxable events such as the sale of a business or real estate. Additionally, owning individual securities instead of an index fund allows investors to achieve these potential benefits while expressing preferences, such as sector tilts. The power of direct indexing extends beyond reducing investors’ tax bills, making this strategy attractive to those seeking to express individual customization.

Source: Goldman Sachs Asset Management.

Secondaries: Primer on Secondaries

Public Equity, Direct Private Equity, Secondaries

With public market returns challenged, many investors now look to private market alternatives, including secondaries, for enhanced risk-adjusted returns. Secondaries provide exposure to partially—or fully-funded portfolio interests by 1) acquiring assets from limited partners seeking liquidity and 2) providing liquidity to general partners. This ability to access prior vintages may be particularly attractive to investors looking to grow their private market allocations. Additionally, secondaries have historically delivered similar returns to direct private equity with less volatility. With many institutional investors looking to rebalance their portfolios via the secondary market, supply is poised to increase, potentially spurring greater discounts than usual.

Source: Cambridge Associates, Bloomberg, and Goldman Sachs Asset Management.

Secondaries: Smoothing Out the Risks

Getting a Head Start on the J-Curve

Secondaries investing can help manage risks across strategies and managers, providing investors with broader access to private markets. By purchasing into a known pool of assets—that may have a greater number of underlying holdings than in a direct private equity fund—investors potentially have both more transparency and less concentration risk. Also, the secondaries J-curve, or the cash flows throughout the fund lifetime, may allow for faster distributions and greater capital efficiency compared to the direct private equity J-curve. Lastly, investors can access secondaries in an array of asset classes, from private equity to real estate and infrastructure.

Source: Goldman Sachs Asset Management.


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