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Edition 3


Bring the Noise

Episodic volatility has picked up. Markets are abuzz with trade tensions, geopolitical missteps, populism, and pockets of stressed liquidity. Much of it amounts to noise. The operating environment remains on solid footing. Fully 97%
of global economies are expanding, central banks are slowly removing policy accommodation, financial imbalances are limited, and the current US fiscal boost is strong.

We believe the backstretch of 2018 should remain supportive of risk assets, particularly equities, though the rapid speed at which sentiment can change calls for a strategic commitment to risk management. Equally, we accept the signaling power of a flattening US yield curve, but would caution not to over-interpret curve implications at this point. In short, market conditions are highly consistent with late-cycle characteristics.

Consequently, we would emphasize:

  • Stick to the plan. A strong earnings cycle should persist.
  • The time to prepare portfolios for episodic volatility is now. Shifts in the volatility regime can happen quickly.
  • Alternative asset classes may reemerge as essential diversifiers, should equity and fixed income return correlations stay positive.

If markets bring the noise, a focus on idiosyncratic positioning can differentiate portfolios from pure market beta.




Global growth may have peaked amid policy transitioning, tighter financial conditions, and trade uncertainty. Even so, data as they stand are healthy, with low global recession risk.


The global inflation pickup remains gradual and country-specific. While excess capacity has generally contained global prices, tariffs may introduce a statistical wrinkle in the data.

Monetary Policy

Transitioning central bank policy will be top of mind as markets discount reaction functions and terminal levels. We expect a gradual data-centric approach towards normalization.


Markets appear to be trading with a higher beta to policy. Consequently, trade policy and Brexit negotiations may intensify swings in market sentiment and investment activity.


Late-cycle factors such as higher rates and earnings growth deceleration may be amplified by limited fiscal/monetary options. Trade, politics, and populism also feature prominently.

Election Pop and Volatility Drop

Source: GSAM. As of August 2018. S&P 500 Average Return is the path of the S&P 500 Index before and after historical midterm elections (i.e. the midterm elections are the
starting point of the analysis to determine the average pre- and post-election S&P 500 path), using the averages of weekly returns in order to generate that path. The midterm
elections analyzed were: 1994, 1998, 2002, 2006, 2010, and 2014. Average VIX refers to the average weekly absolute value of the CBOE Volatility Index (VIX) to generate a path
before and after those same midterm elections. The analysis uses S&P 500 and VIX data from May 27, 1994 to April 24, 2015. For example, the S&P 500 average return four weeks
before the midterm elections was 5.2% lower than that of the midterm week. The average VIX level four weeks before the midterm elections was 24.0. Past performance does
not guarantee future results, which may vary.

Key Takeaway

Although global growth may have peaked, conditions for continued global expansion remain intact, offsetting trade, policy and related macro uncertainties.

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Improving valuation reflects a persistently strong earnings cycle. We expect earnings growth to support equities but taper down from the policy-induced gains of 2018.


We believe the technical impact from quantitative tightening should drive global rates higher, potentially reducing the effectiveness of government debt as a hedge.


Fundamentals look good-to-very-good, though tight spreads, higher duration, and higher leverage temper our return expectations. Idiosyncratic positioning remains key.


Dollar pressure may ease, as above-trend global growth differentials narrow, and the pace of higher relative US interest rates slows.


We expect trend volatility to remain below normal, but the frequency and magnitude of episodic dislocations to increase as technology and speed replace capital in trading.

Earnings Growth has Reigned in Equity Valuation

Source: Bloomberg, Barclays Live, and GSAM. As of July 31, 2018. Valuation percentile of equity asset classes refers to the forward Price-to-Earnings ratio of each asset class as a percentile of the asset class’ historical Price-to-Earnings ratio based on the past 10 years from June 2018. Forward Price-to-Earnings ratio is a common valuation metric representing the current price as a multiple of the next twelve months of earnings per share of that asset class. For fixed income asset classes, global valuation percentile refers to spreads as a percentile of historical spreads for each asset class. Global refers to the MSCI World Index. US refers to the S&P 500 Index. Euro area refers to the Euro Stoxx 50 Index. UK refers to the FTSE 100 Index. Investment Grade refers to the Bloomberg Barclays Global Aggregate Corporate Index. High Yield refers to the Bloomberg Barclays Global High Yield Index. Emerging Market Debt ($) refers to the Bloomberg Barclays EM USD Aggregate Index. China refers to the MSCI China Index. Emerging Market refers to the MSCI Emerging Market Index. Past performance does not guarantee future results, which may vary.

Key Takeaway

Late-cycle markets tend to be supportive of risk assets like equities and commodities, though volatility may increase as markets digest the level, speed, and shape of rates.

The Know
Municipal bonds: less rate sensitive than you think.

Realized duration has been historically lower than duration “on paper.”

Munis’ realized duration—the actual response to changes in rates—has often been lower than the stated option-adjusted duration (OAD).

In today’s rising rate environment, we believe that an understanding of muni rate sensitivity is critical. The difference between OAD and realized duration is also found among credit securities broadly. Munis, for example, trade at an average beta of 0.7 to OAD, implying that they are less sensitive to interest rates than is often assumed.

Source: Bloomberg Barclays and GSAM.

The How
Less is more.

Rate sensitivity may be further reduced by rethinking muni term structure and credit exposure.

Muni diversification may enhance yields while managing rate risk.

We believe that with munis’ features such as callability, credit profile and liquidity, realized duration is a more accurate and essential measure of interest rate sensitivity. By incorporating credit and term structure, investors may amplify the reduction in realized duration and improve tax-equivalent yields relative to the Bloomberg Barclays Municipal Bond Index.

Source: Bloomberg Barclays and GSAM.

The Know
Rethink diversification.

Today, stocks and bonds are less useful diversifiers of one another than they have been in the past.

Stocks’ and bonds’ ability to offset each other has varied over time— potentially important context for strategic portfolio construction.

The forty year decline in long-term interest rates coincided with several multi-year equity bull markets, during which returns were simultaneously positive for both asset classes. Going forward we believe that rising rates could pressure bond and equity returns alike, potentially necessitating broader and more effective sources of diversification.

Source: GSAM.

The How
Differentiated diversification.

Liquid alternatives could potentially be an offset for stocks and bonds.

Historically, alternatives have outperformed stocks and bonds 72% of the time when both of these asset classes’ returns were negative.

We believe that macro fundamentals support rising rates over time-a direct headwind to fixed income returns. Additionally, the speed and slope of rate increases may create a headwind for equities. As a result, stock and bond returns could be potentially challenged,
simultaneously-strengthening the case for alternatives.

Source: GSAM.

The Know
Staying private.

More growth-oriented companies are delaying their entry into public markets compared to the past.

Shifting industry dynamics have enabled emerging growth companies (EGC) to strategically defer initial public offerings (IPO).

Supportive economic growth, plentiful private funding, strong end-investor demand, and regulatory shifts have made it easier for EGCs to stay private longer, with greater flexibility in timing their IPOs. Consequently, the private equity cohort has many established companies with outstanding management, solid revenue growth and profitability.

Source: Dow Jones VentureSource and GSAM.

The How
The private opportunity.

As the number of US listed companies drops, the private marketplace has expanded rapidly.

The private market represents a relatively untapped landscape for many investors.

Investors are increasingly adopting private markets as a strategic portfolio component for the potential diversification and total return benefits across equities, credit, real estate, special situations, and geographies. Environmental, Social and Governance (ESG) and impact investing is also seeing development as investors align their portfolios with social and environmental objectives.

Source: World Bank, PitchBook, and GSAM.

The Know
Investing for impact.

The ESG and impact investing spectrum has broadened and evolved over time.

We believe that it is time to rethink ESG and impact investing, which have moved into the mainstream.

Popular misconceptions about Environmental, Social and Governance (ESG) and impact investing include: 1) the space is a niche investment subsector, and 2) ESG investment principles may come at the expense of returns. In our view, these premises are fundamentally not true.

Source: GSAM.

The How
Investing with a cause.

Impact investing requires the same discipline and rigor as traditional investing.

There are many distinct ESG investment strategies employing tools to analyze a fast-growing universe of ESG data.

An effective ESG investing program, in our view, requires a focus on material, data-driven metrics. When executed with the same discipline and rigor as traditional investing, ESG data can drive analysis, insights, and potential returns.

Source: Bloomberg, Goldman Sachs Global Investment Research, and GSAM.

The Know
Emerging exodus.

Trade concerns have sparked a flight from emerging market assets despite their solid fundamentals.

Outflows from emerging market (EM) debt and equity have accelerated as trade war fears have picked up.

EM fundamentals remain strong, and the favorable economic growth differential versus developed markets remains intact. Investors have nevertheless sold EM first and asked questions later amid volleys between the US and China.

Source: National Sources, Bloomberg, the Institute of International Finance (IIF), and GSAM.

The How
Trading places.

EM economic activity is largely regional in nature, which is an important context for trade concerns.

US-related activity accounts for only 8% of total revenue exposure for EM companies.

Despite the emergence of globally relevant companies and brands, EM revenues remain largely among EM countries. We believe market volatility may reveal the periodic disconnect between sentiment or fund flows, and fundamentals.

Source: FactSet and GSAM.

The Know
Chart your course.

Investing is a journey and a destination—there are many paths to pursuing investment objectives.

Top performing managers exhibit varying amounts of risk.

A manager’s deviation from a specified benchmark can be quantified as tracking error, which differs widely even among the top performers. The magnitude of this variation has important implications for selecting managers. Diversifying among your managers may help to reduce risk relative to the benchmark—sizing matters.

Source: Morningstar Direct and GSAM.

The How
A tailored fit.

Sizing risk over capital means matching risk allocation to investment conviction.

We believe investors should seek to optimize the balance of risk among managers they have hired.

As an example, in our view, a 50/50 capital blend rarely reflects a 50/50 balance of risk. This approach may inadvertently overweight one manager’s risk-taking over another’s. The approach we favor is sizing according to risk by allocating according to tracking error.

Source: Morningstar Direct and GSAM.


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