The economic expansion has deepened and synchronized around the globe, with the participation of more than 98%1 of world economies. The inputs are broad, including improving labor markets, accommodative monetary policy, supportive financial conditions, favorable sentiment, and the potential for fiscal impulses. Taken together, these inputs suggest the global expansion should persist.
Even so, markets remain vulnerable to shocks of volatility, and late-cycle dynamics reinforce the need for realistic expectations. We expect meaningfully lower annualized returns from risk assets due to market and policy realities such as full valuations, legislative bottlenecks, and diminishing excess economic capacity. Each of these factors serves to heighten our commitment to strategic portfolio design.
Our key views:
1. Source: GSAM
Global growth has both broadened and deepened in the most synchronized recovery since 2010. Manufacturing and US labor appear particularly strong.
Inflationary impulses have paused, particularly in Europe. Diminishing excess capacity has supported prices in the US, while Sterling weakness has buttressed UK prices.
Divergent policy remains a global theme. The Federal Reserve’s efforts to neutralize its policy stance contrasts with more expansive commitment in Europe and Japan.
The possibility of pro-cyclical US policy has continued to intrigue markets, but the news cycle of near-constant controversy and legislative bottlenecks are blocking meaningful initiatives.
Politics remains dominant, followed by the pace of US rate hikes, Brexit turbulence, stability of Chinese currency and growth, lofty valuations, and structurally diminished market liquidity.
Source: Haver, Markit, and GSAM. Analysis as of May 2017. Table shows headline readings for Composite (weighted aggregation of manufacturing and services sectors) Purchasing Managers Indices. PMI surveys based on questionnaire responses from panels of senior purchasing executives (or similar). Respondents are asked to state whether business conditions for a number of variables have improved, deteriorated or stayed the same compared with the previous month, as well as to provide reasons for any changes. A reading of over 50 indicates expansion; a reading of less than 50 indicates contraction. 12m Δ represents the change since the reading 12 months prior to this document, i.e. May 2016. Developed Markets and Emerging Markets refer to GDP-weighted categories for regional PMIs as categorized by Haver. BRIC is an acronym that refers to Brazil, Russia, India and China, which are all grouped in a similar stage of economic development. 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 see increasing evidence of economic synchronization across both advanced and emerging markets. Global growth data suggests the expansion could continue for another couple of years.
As the US expansion approaches triple digits (as measured in months), we see more of the same as we look ahead. One way to frame the economic outlook is to model the probability of recession over the next 2 years. Long-term averages suggest a 31% recession probability, leaving a more than two-thirds chance that the current US expansion becomes the longest on record.
The sustainability of economic growth is often governed by the availability of labor and manufacturing capacity. We believe medium-term recession risk is rising in the US as resource utilization pushes above potential and pressures wages higher. We see global advanced and emerging markets forging slightly more runway in the form of additional productive capacity.
Top Chart Notes: As of May 31, 2017. The chart shows quarterly data of the unconditional probability of a US recession in the next 9 quarters from January 1981 to March 2017, the latest available data. The lines show the amount of time from current levels (31%) it has historically taken to enter a recession, as defined by the National Bureau of Economic Research. 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. Bottom Chart Notes: Analysis uses annual data from 2000 to 2016, the largest available data series. The output gap is the difference between actual and potential Gross Domestic Product (GDP) and is estimated based on measurements of spare capacity in the economy. The US output gap is calculated using the Federal Reserve Board of Governors’ potential GDP estimates from the FRB/US Model package. The World ex-US output gap is calculated using a real GDP-weighted average of output gap across the 32 Organisation for Economic Co-operation and Development (OECD) countries, for which data is available, excluding the United States. Past performance does not guarantee future results, which may vary. Please see additional disclosures at the end of this document.
We continue to favor equities, but with modest return potential on account of valuations. Earnings growth is likely to be the primary driver of returns, favoring ex-US equity markets.
We expect the trend of higher rates to resume, driven by monetary policy evolution, global growth, and reduced excess capacity. Government debt may be a less effective hedge.
Tight spreads and higher leverage reflect late-cycle conditions, leaving us wary of investment-grade and high-yield beta, but confident in security selection.
Despite recent weakness, Dollar risk may be to the upside given central bank divergence. Sterling is likely tethered to UK politics. Global growth could drive emerging market currencies.
Low volatility reflects the strong macro backdrop, but cannot insulate investors from exogenous shocks, especially any potential fallout from political risk in Washington and Europe.
Source: Barclays Live, Bloomberg, and GSAM. Analysis from January 1, 2009 to May 31, 2017. Chart shows total cumulative returns for asset classes. US Equities represent the
S&P 500 Index, European High Yield Bonds represents the Bloomberg Barclays Pan-Euro High Yield Index, Global Equities represents the MSCI World Index, European Equities
represents the Stoxx Europe 600 Index, US High Yield Bonds represents the Bloomberg Barclays High Yield Corporate Bond Index, Japan Equities represents the TOPIX Index,
Emerging Market Equities represent the MSCI Emerging Markets Index, German Bunds represents the German subset of the Bloomberg Barclays Aggregate Government Index,
US Inv. Grade Bonds represents the Bloomberg Barclays US Corporate Bond Index, US Treasury Bonds represents the Bloomberg Barclays US Aggregate Treasury Index, Gold is
represented by the Gold Spot Price $/oz, European Inv. Grade Bonds represents the Bloomberg Barclays Investment Grade European Corporate Bond Index, and Japan Government
Bonds represents the Bloomberg Barclays Japan Aggregate Government Bond Index. Past performance does not guarantee future results, which may vary.
We believe the macro backdrop remains supportive of risk assets, although full valuation and politics may limit near-term upside and intensify tail risk. We favor equities over credit, credit over sovereign debt, and emerging markets over developed markets.
Decomposing US equity return drivers since the Global Financial Crisis reveals distinct periods of earnings growth dominance and multiple expansion. Earnings power once again appears primed to drive equity markets. Especially in Europe, Japan, and Emerging Markets, we anticipate strong earnings to revalidate the merits of global equity diversification.
Volatility currently remains anchored at the extreme lower end of historical experience, reflecting the market’s confidence in global macro conditions. Still, we believe drawdown management remains important: 1) markets remain vulnerable to exogenous shocks, 2) high valuations increase the potential magnitude of drawdowns, and 3) volatility is generally a lagging indicator.
Top Chart Notes: Analysis as of June 28, 2017. Chart shows S&P 500 Index performance and trailing 12 month earnings per share. The first period is from December 31, 2008 to December 31, 2011 and is characterized as an earnings driven return environment because S&P 500 earnings growth was the primary driver of returns. The second period is from December 31, 2011 to December 31, 2016 and is characterized by a multiple expansion (price-to-earnings growth) driven return environment. The 2017–2019 estimates are S&P 500 Index price and earnings per share forecasts from Goldman Sachs Global Investment Research. 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. Diversification does not protect an investor from market risk and does not ensure a profit. Past performance does not guarantee future results, which may vary. Bottom Chart Notes: As of May 31, 2017. Chart shows annualized 30-day rolling volatility (standard deviation) of the S&P 500 Index and labels various different market events that occurred when volatility moved significantly higher. These events are illustrative examples. Past performance does not guarantee future results, which may vary.
We think investors should temper their US equity return expectations.
Following periods of top-quartile valuations, the S&P 500 Index has delivered single-digit or negative returns 99% of the time. In nearly a fifth of instances (17%), returns were negative. High valuations have often persisted for years at a time, elongating the timeframe for modest equity returns.
Source: Bloomberg, Robert Shiller, and GSAM.
In periods of lower equity returns, alternative strategies’ performance has been attractive.
We believe we are entering a favorable environment for alternative strategies. During periods when equity market returns registered in single-digit or negative territory, these strategies outperformed the S&P 500 on a risk-adjusted basis. In light of high equity valuations and the potential for lower returns, we see the case for a fresh look at alternative strategies.
Source: Bloomberg and GSAM.
Top Section Notes: As of May 31, 2017. Subsequent 10 Year Annualized S&P 500 Returns and S&P 500 valuation percentile levels for the cyclically-adjusted price-to-earnings (CAPE) ratio are calculated from December 30, 1927, the inception of the S&P 500 Price Index. The shaded area reflects the top-quartile (75–100%). Bottom Section Notes: As of May 31, 2017. Analysis from January 1990 to May 2017. This time period is the longest common time period of the S&P 500 Index and HFRI Fund of Funds Index (inception is January 1990). Chart shows 10 year subsequent average returns, volatility and Sharpe Ratio of the S&P 500 Index (S&P 500) and the HFRI Fund of Funds Index (Alternative Strategies). Sharpe Ratio is a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment. Volatility is measured by standard deviation. Investments in Alternatives expose investors to risks that have the potential to result in losses. These strategies involve risks that may not be present in more traditional (e.g., equity or fixed income) asset classes. Past performance does not guarantee future results, which may vary.
Growth has gained momentum internationally, broadening out the US-led recovery.
Developed economies have seen improvement in a number of economic indicators, led by manufacturing. We believe this trend, alongside the steady expansion in the consumer and labor sectors, suggests a robust global developed investing environment.
Historically, earnings outside the US have improved more rapidly when growth rates have risen.
In Europe and Japan, fixed costs tend to be a higher share of total costs than in other markets. This has caused Europe and Japan to historically see more earnings upside when sales have strengthened but also more earnings weakness when sales have weakened. Given our expectations for improving global growth, Europe and Japan seem particularly well positioned.
Source: Datastream, Goldman Sachs Global Investment Research, and GSAM.
Top Section Notes: GSAM as of May 31, 2017. The GSAM Current Activity Indicator (CAI) is a measure of current economic activity that can be interpreted as the growth signal in the main high-frequency indicators for each economy. The Global CAI aggregates individual country-level CAIs into a global composite. Global Gross Domestic Product (GDP) is reported as percentage year-over-year change with each country weighted by its respective market capitalization. Bottom Section Notes: Analysis is from 1996 to 2016, the latest available. The earnings growth to sales growth ratio shows the median Earnings Before Interest and Taxes (EBIT) and Net Profit to Sales Growth ratio from 1996 to current. Both ratios are a measure of profit margins and operating profitability growth as a ratio of revenue growth. A higher profit margin indicates companies are profitable because operating expenses have grown at a slower rate relative to total revenue growth. Please see end disclosures for additional information. Past performance does not guarantee future results, which may vary.
We see a pronounced underweight in many client portfolios.
Investors are overweight US large caps by an average of 14 percentage points relative to our 70:30% PRISM™ strategic asset allocation. We see a case for greater diversification through international small caps, particularly at a time of lofty US equity valuations.
Source: GSAM PRISM™.
International small caps may be well positioned to benefit from the global economic expansion.
International small caps’ exposure is 70% cyclical by sector and includes a relatively high degree (55%) of domestic revenue drivers. These domestically-oriented companies in the past have also been better positioned than international large caps during periods when broad international equity markets have outperformed the US.
Source: FactSet, Bloomberg, and GSAM.
Top Section Notes: GSAM PRISM™ is a registered trademark of GSAM. Average PRISM™ Client Portfolio is represented by looking at the average allocation of a GSAM PRISM™
Client Portfolio. Portfolio allocation represents the average percent allocation to the respective asset class across over 2800 financial advisors. The illustrative 70:30% PRISM™ Strategic Asset Allocation Portfolio is composed of 70% (Core Equity and Diversifiers) and 30% Core Fixed Income. Diversifiers are defined as non-traditional asset classes. Please see page 8 for the list of diversifiers and additional disclosures. These allocations are based on asset class views of GSAM Portfolio Strategy. International Small Cap is defined as small cap stocks in Europe, Japan, and other developed markets. Bottom Section Notes: As of May 31, 2017. Cyclical sectors are sectors that tend to perform best during business cycle peaks, and include: Consumer Discretionary, Industrials, Energy, and Information Technology. Domestic exposure represents the proportion of each index with revenue streams that are primarily domestic oriented. The chart shows 12 month rolling returns of the S&P 500 Total Return Index (US Large Cap), the MSCI EAFE Total Return Index (International Large Cap), and the MSCI EAFE Small Cap Total Return Index (International Small Cap) drawn only from periods where the MSCI EAFE Total Return Index outperformed the S&P 500 Total Return Index from December 31, 1998, common inception, to May 31, 2017. Investments in foreign securities entail special risks such as currency, political, economic, and market risks. Please see end disclosures for additional information. Past performance does not guarantee future results, which may vary.
In the past, EM inflows have been supportive of both equity and debt performance.
The recent uptick in emerging markets equity (EME) and debt (EMD) inflows follows an extended period of easier financial conditions and improved corporate earnings. In the past, such periods of strong inflows have helped drive performance. EME and EMD returns rose an average of 3.0% and 0.9%, respectively, during months with inflows greater than $5 billion.
Source: Bloomberg, the Institute of International Finance (IIF), and GSAM.
We think EM earnings and yields warrant attention in today’s market environment.
For equities, we expect the recent positive emerging markets earnings growth trends to continue driving performance, and is reflected in forward-looking expectations. In a low-rate environment, dollar-denominated EMD yields stand out versus US investment grade bonds, US aggregate bonds, and global bonds.
Source: Bloomberg, Goldman Sachs Global Investment Research (GIR), and GSAM.
Top Section Notes: As of June 1, 2017. Chart includes readings up to June 1, 2017. Flows for April and May are IIF preliminary estimates for emerging market debt (EMD) and emerging market equity (EME) portfolio flows. Average monthly returns are calculated for January 2005 to June 2017, for months when IIF EM Equity flows are greater than $5 billion and for months where flows are less than $5 billion. This threshold was selected as representative of the average EM equity and debt flows during months of inflows and outflows respectively. Bottom Section Notes: As of June 28, 2017. Top Chart: Equity Earnings Growth Expectations is the simple average of the fiscal year 2017 GIR forecasted earnings per share (EPS) growth and the fiscal year 2018 forecasted EPS growth. Bottom Chart: Yield is represented by Yield to Worst (YTW), as of June 28, 2017. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. Investments in foreign securities entail special risks such as currency, political, economic, and market risks. Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability. All indices are defined in the end notes for both charts. Please see page 8 for additional chart disclosures. Past performance does not guarantee future results, which may vary.
Municipal bond investors are focused on US tax policy outcomes.
Often underutilized by investors, the breadth of the municipal market potentially provides compelling opportunities to enhance tax equivalent yields (TEY) through the diversification of term structure and credit.
Source: Barclays Live, Bloomberg, Moody’s, US Department of Treasury, and GSAM.
Adding credit and term structure diversification to a muni portfolio may improve outcomes.
In the table to the left, we introduce high quality short duration muni bonds and high yield muni bonds to match key metrics of a static municipal benchmark. We find that simple adjustments to a core muni bond portfolio can potentially generate a meaningful increase in income, a reduction in interest rate sensitivity, or both.
Source: Bloomberg, Barclays Live, and GSAM.
Top Section Notes: As of May 31, 2017. The chart shows Tax-Equivalent Yield curves which show comparable yields of tax-free municipal bonds by adjusting for tax-free earnings of municipal bonds. The hypothetical 35% tax rate reflects presidential administration tax proposals. Goldman Sachs does not provide accounting, tax, or legal advice.
Bottom Section Notes: As of May 31, 2017. Chart shows several illustrative municipal portfolios which represent what a typical portfolio that matches the historical tax-equivalent yield, duration, or volatility of the Bloomberg Barclays Muni Aggregate Index respectively might potentially look like. Volatility is the annualized standard deviation of daily returns from 1997 to 2017. Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Tax-Equivalent Yield, Duration, Volatility, and Average Credit are portfolio weighted averages of index data. 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 page 8 for additional definitions on both the top and bottom chart. Past performance does not guarantee future results, which may vary.
We believe a deep bench of funds for a given asset class can help investors ensure they have backup options.
One method we use to test product depth is the “80, 2” screen. A category may fail this screen if 80% or more of exchange-traded fund (ETF) assets under management are concentrated in two or fewer ETFs. National municipal bonds and emerging market debt are two areas that provide limited fallback options.
Source: GSAM Strategic Advisory Solutions/Portfolio Strategy and Morningstar.
We think investors should be open to a range of fund types; no fund structure can serve every purpose.
Applying our fallback rules as well as historical performance, we see a case for building portfolios with ETFs where the product offerings are extensive, such as in large cap US equities. We also see a case for mutual funds where ETF coverage is less extensive and where mutual fund managers historically have outperformed, such as in foreign large cap stocks and high yield bonds.
Source: GSAM Strategic Advisory Solutions/Portfolio Strategy and Morningstar.
Top Section Notes: Charts as of August 31, 2016. For illustrative purposes only. The asset class categories refer to the following Morningstar Categories: Infrastructure, Muni National Interm (US Munis), Emerging Markets Bond (EM Debt USD), Bank Loan (Bank Loans), EM Local-Currency Bond (Local EM Debt), Foreign Small/Mid Blend (Int’l Small Cap), Real Estate (US REITs), Small Blend (US Small Cap), EM Equity, Energy Limited Partnership (MLPs), High Yield Bond (High Yield), Global Real Estate (Int’l REITs), Foreign Large Blend (Foreign Large Caps), Large Blend (US Large Cap), Commodities Broad Basket (Commodities). Bottom Section: The Illustrative 70:30% Long Only Taxable Portfolio (composed of 70% equities and 30% fixed income) is sourced from GSAM PRISM™ Strategic Advisory Solutions. The figures shown in the pie represent allocations to this Illustrative 70:30% Long Only Taxable Portfolio. “Mutual Fund Historical Outperformance” and “ETFs Historical Outperformance” vehicle type was determined by looking at historical performance on rolling 3-year performance (net of fees) for mutual funds against the largest ETF in their respective category. For example, the case to allocate 15% to ETFs instead of MFs in US Large Cap is based on ETFs historical outperformance in this category. “ETFs Underdeveloped” refers to asset classes that did not pass the top chart concentration screen, and lack product depth (less than 10 ETFs or less than $10B in assets). For example, the case to allocate 37% to MFs instead of ETFs in US Munis, Local EM Debt and Int’l Small Cap is based on the high concentration of ETFs along with a lack of product depth, in these categories. Please see end disclosures for additional information.
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