We expect the global expansion to continue in 2018, and so we remain optimistic about the forward path for risk assets. We describe the core of our view as pro-growth and pro-equity. At the same time, a risk-managed, dynamic approach to investing strikes us as more relevant than ever. We are equally pro-reality, with an environment of exceptionally low volatility masking a rising set of potential vulnerabilities. We remain cautious towards pure beta, both globally and across asset classes.
Our key views:
Above-trend developed markets (DM) growth may decelerate but persist. Current recession risk remains low as economies enjoy easy financial conditions and potential fiscal impulses.
Diminished spare capacity across many advanced economies may support prices longer-term. Any inflation adjustments are likely to be gradual and country-specific.
Evolving Federal Reserve (Fed) policy is unlikely to weigh on DM growth. Structural adjustments may leave emerging markets more resilient than in prior hiking cycles.
Uncertainty may reemerge as looming US mid-term elections may reamplify partisanship. Italian elections, Brexit developments, and North Korea also possess disruptive clout.
Investors may be too focused on the downside. While there is no lack of headline risks, contained inflation likely keeps the most significant risk (the Fed) in check.
Source: GSAM. As of November 2017. Potential gross domestic product (GDP) represents an estimate of the output that an economy could produce with its capital and labor resources operating at full capacity. Current Inflation Target represents an explicit target inflation rate that a central bank strives to achieve. The charts above show the current measure for both figures for each country, remaining static in 2018–19 for illustrative purposes. In the case of the US, for example, our growth forecasts are above our current estimate of potential GDP (1.9%), reflecting our expectation for stronger demand that in turn may contribute to rising inflation. Current Potential GDP: US: 1.9%, Eurozone: 0.7%, UK: 1.6%, Japan: 0.5%, China: 5.4%. Current Inflation Target: US: 2.0%, Eurozone: 2.0%, UK: 2.0%, Japan: 2.0%, China: 3.0%. 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.
As late-cycle optimists, we believe that global macro data reflects the health and durability of the current economic cycle. Nascent signs of inflation suggest central banks should be patient as monetary policy normalizes.
In the last 40 years, economic cycles have become longer, as central banks more aggressively targeted inflation, macro volatility declined, and macro-prudential policies improved financial system stability. This “Great Moderation” has allowed central banks to err on the side of caution and potentially elongate the economic cycle.
As economic cycles age, a central bank’s role as a counter-cyclical force often becomes more pronounced. While the risk of a steeper trajectory for Fed policy exists, this time may be different. Given the weakness of inflation and the anchoring of inflation expectations in most developed economies, policy makers have less clear motives to act as aggressively as in the past.
Top Section Notes: Analysis as of December 2017. Expansion refers to the period during a business cycle when the economy moves from a trough to a peak. Bottom Section Notes: As of December 31, 2017. The Federal Funds Rate (Fed Funds Rate) is the short-term interest rate targeted by the Federal Reserve’s Federal Open Market Committee (FOMC) as part of its monetary policy. The graph shows the past five Fed Funds Rate hikes and cumulative change during the corresponding periods.
Equities remain our preferred asset class, particularly emerging markets. Our enthusiasm is tempered by full valuations and markets heavily reliant on higher earnings.
US rates appear exposed to transitioning monetary policy, a pick-up in term premium, and shrinking spare capacity. Any move higher should be contained by limited inflationary impulses.
Tight spreads and higher leverage moderate our credit return expectations. Still, interest coverage is solid and default risk appears to have cleared recent commodity uncertainty.
Euro and USD markets are likely to be dominated by interest rate differentials with a slight bias to USD strength near term. Sterling may be tethered to Brexit results and EM could outperform.
Low volatility may persist, reflecting strong macro underpinnings. However, high valuation heightens vulnerability to any exogenous shock or shift in the operating environment.
Source: GSAM. As of November 2017. 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.
We believe macro synchronicity supports risk assets, especially ex-US. Earnings should dominate equity returns, while in our view, fixed income returns are limited due to tight credit spreads, higher risk premia, and transitioning central bank policies.
Valuations have expanded across most assets as record price levels reflect an improving operating environment. While high valuations are rarely the trigger for market corrections, they do leave equities exposed to de-rating should growth expectations deteriorate or rates spike. While neither outcome is our expectation, strategic preparedness is warranted.
The interpretive power of valuation significantly improves as investment horizons lengthen. In the short run, expensive markets tend to stay expensive and provide poor tactical insight. While today’s full market valuation tells us little about what to expect in 2018, it may serve as a critical 5+ year guidepost.
Top Section Notes: Bloomberg, Barclays Live, and GSAM. As of December 31, 2017. 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 on a monthly basis. 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. Japan refers to the TOPIX Index. Global Investment Grade refers to Global Investment Grade Corporate Credit measured by the Bloomberg Barclays Global Aggregate Corporate Index. Global High Yield refers to the Bloomberg Barclays Global High Yield Index. Emerging Market Debt refers to the Bloomberg Barclays Emerging Markets 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. Bottom Section Notes: As of December 31, 2017. Valuation refers to Cyclically Adjusted Price-to-Earnings (CAPE) ratio. Strength of relationship between S&P 500 CAPE ratios and S&P 500 returns is measured by the R-squared statistic, which ranges from 0 to 1, or from weakest to strongest explanatory power.
Waiting for lower valuations potentially results in a long game of wait-and-see
Investors employing a strategy of selling equities at high valuations (e.g. 90th percentile) with the intention of buying back at “cheaper” levels might have to wait a long time to re-enter the market. In February 1998, the last time the 90th percentile was breached, an investor who sold could have been out of the market for as long as 100 months.
Source: Bloomberg and GSAM.
Long-term market exposure has often beaten valuation-based timing strategies
If valuations remain elevated—as they often have in the past—investors may miss returns waiting on the sidelines. A strategy that sells S&P 500 equities at the top decile of valuations and re-enters at the 50th percentile historically has underperformed a buy-and-hold strategy by 100 basis points on an annualized basis.
Source: Bloomberg and GSAM.
Top Section Notes: As of December 31, 2017. Analysis is from January 1954 to December 2017, earliest and latest available years for data, respectively. Chart shows the number of months an investor would have remained uninvested had they sold out of the S&P 500 Total Return Index after the two instances when the Index reached the 90th percentile of valuations, waiting to buy back in at the 70th, 60th, and 50th percentiles, respectively. Valuation percentiles are based on the S&P 500’s forward 12-month price-to-earnings (P/E) ratio. Past performance does not guarantee future results, which may vary. Bottom Section Notes: As of December 31, 2017. Analysis is from January 1954 to December 2017, earliest and latest available years for data, respectively. Chart shows the growth of $100 of an Illustrative strategy that sold the S&P 500 Total Return Index when valuations were above its 90th percentile in March 1992 and February 1998, and each time repurchased at lower percentiles, compared to the growth of $100 of an Illustrative buy-and-hold strategy that stayed invested for the same period of time. Federal capital gains taxes are taken into account for the “sell high, buy low” strategy using the applicable historical rate, and a 1-3 Month T-Bill return is applied to the cash when not invested in the S&P 500. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.
These strategies warrant a fresh look as investors enter the ninth year of the bull market
Moderate returns and larger draw-downs have often historically followed elevated equity valuation periods. Investors who de-risked were at risk of waiting for years to re-enter at lower valuations. However, Buy-Write strategies, which seek to generate income by receiving call premiums, provided lower volatility across various market environments.
Source: Bloomberg and GSAM
During equity bear markets, Buy-Write strategies’ smaller draw-downs resulted in speedier recoveries
Historically, Buy-Write strategies' relative outperformance on the downside has coincided with faster recoveries. Over time, these strategies have provided similar returns, with lower volatility. Buy-Write strategies outperformed the S&P 500 by an annualized 4.5% in the past three equity drawdowns, which resulted in a one year faster recovery.
Source: Bloomberg and GSAM.
Top Section Notes: Analysis from December 31, 2007 to December 31, 2017. A Buy-Write strategy refers to an investment that receives call premium on an underlying equity position to generate income. Writing an option refers to selling an option. An option is the right, but not the obligation, to buy or sell a particular security. Buy-Write uses the CBOE S&P 500 2% OTM Buy-Write Index as a benchmark and is not necessarily reflective of all Buy-Write strategies. Chart shows the difference between the 12-month trailing volatility (standard deviation) of the CBOE S&P 500 2% OTM Buy-Write Index and the S&P 500 Index. Past performance does not guarantee future results, which may vary. Bottom Section Notes: Analysis from October 31, 2007 to December 31, 2017. The three S&P 500 drawdown periods analyzed are defined as the last three major S&P 500 Index drawdowns. These periods are the Financial Crisis (October 2007–March 2009), European Debt Crisis (April 2012–June 2012), and Chinese Bear Market (July 2015–February 2016). ‘Time to Recover Loss’ is defined as the number of months to recover the initial investment following the drawdown period defined above. Past performance does not guarantee future results, which may vary. Please note that Buy-Write strategies are not appropriate for all investors and are not riskless investments, so investors can lose money. In a rising market, due to limited upside participation, buy-write strategies could significantly underperform the market.
Over-concentration in an individual company creates a risk of amplified losses
Historically, over-concentration exposes the portfolio to greater downside risk, without increasing long-term average returns. A one standard deviation loss for the S&P 500 Index is -9%, but the same one standard deviation loss is -22% for an average S&P 500 single stock.
Source: Bloomberg, Morningstar, and GSAM.
It may take years to build wealth, but a fraction of that time to destroy it
Investors tend to stick to what they know, but this may come at substantial cost. Behavioral biases such as familiarity and overconfidence can lead to volatile single-stock concentration, at a time when disruptive forces increase the potential for unpredictable losses.
Source: Bloomberg and GSAM.
Top Section Notes: As of December 31, 2017. Returns have been normalized to standard normal distribution curves, a distribution commonly used in stock market analysis, and is for illustrative purposes only. Returns are annualized monthly total returns for the S&P 500 Index and average annual returns for a typical single stock in the index. Total returns were taken from the largest available data set. Returns were drawn from January 1928 to August 2017 for the S&P 500 Index, and 1980 to 2016 for single stocks. The number of single stock return data varies year to year and is limited by data availability. Standard deviation is a measure of historical risk, and is calculated by taking the range of deviation from the average. Bottom Section Notes: As of December 31, 2017. All companies listed here have been delisted from an exchange and declared bankruptcy. Max stock price is the maximum value of the stock price or its peak value. Stock price collapse is defined as the point where a stock loses 99% of its max value. Past performance does not guarantee future results, which may vary.
International developed equity markets turned in a strong 2017
Economic fundamentals have broadly improved across EAFE markets, fueling a synchronized global expansion. Alongside stronger GDP growth, increasing earnings momentum has contributed to solid equity returns across Europe and Japan. We believe that the trend of upward earnings revisions may continue.
Source: Bloomberg and GSAM.
Looking beyond country-level returns reveals additional opportunities for selectivity
Security returns across international developed markets can be sorted by quartiles. In 2017, the MSCI EAFE’s top quartile outperformed the broad index by at least 7 percentage points (pp) and the bottom quartile underperformed by at least 21 pp.
Source: Bloomberg and GSAM.
Top Section Notes: As of December 31, 2017. This example is for illustrative purposes only. EAFE represents the MSCI EAFE Index, which captures large and mid-cap representation across developed market countries. Japan, UK, France, Germany, and Switzerland are represented by their respective gross price return MSCI country indices in USD. Diversification does not protect an investor from market risks and does not ensure a profit. Past performance does not guarantee future results, which may vary. Bottom Section Notes: As of December 31, 2017. A percentile refers to a percentage position in the data considered. International securities entail special risks such as currency, political, economic, and market risks.
Individual emerging market economies are increasingly exporting to each other
Although emerging market economies remain connected to the global economy, trade dependencies between individual emerging markets—such as China and Brazil—are growing amongst each other. Since 1996, intra-EM trade has doubled.
Source: International Monetary Fund (IMF) Direction of Trade Statistics (DOTS) and GSAM.
Earnings growth expectations have begun to rise for the second consecutive year
Although S&P 500 profit margins have surpassed their pre-global financial crisis peak, EM margins have been both improving and have room to expand. We see the potential sustainability of this trend as supportive of a strategic allocation to EM.
Top Chart Source: Datastream, MSCI, and GSAM. Bottom Chart Source: FactSet and GSAM.
Top Section Notes: As of December 2016. Exports refers to Free on Board, provided by the International Monetary Fund (IMF). Free on Board means the seller's obligation to deliver is fulfilled when the goods have passed over the ship's rail at the named port of shipment. Emerging Markets refers to the 24 countries in the MSCI Emerging Markets Index. Bottom Section Notes: Top Chart: As of November 2017. The MSCI Emerging Market Earnings Per Share (EPS) growth forecast revisions represent analyst revisions to consensus earnings growth forecasts and the trajectory of revisions across time in US Dollars. Bottom Chart: ‘Pre-Financial Crisis’ refers to January 2007 and ‘Current’ refers to November 2017. Past performance does not guarantee future results, which may vary. 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.
The municipal bond market has delivered more yield at equivalent credit and maturity levels
Despite 2017’s stronger demand and weaker supply, munis have provided more attractive combinations of tax-equivalent yields (TEY) than taxable bonds, even when applying a personal tax rate of 35%. As shown, AAA-rated munis may have enhanced yields vs. virtually all Treasury maturities, as well as down most of the corporate credit spectrum.
Source: Barclays Live and GSAM.
A little credit and term structure may go a long way
For many municipal investors, benchmarking to the municipal aggregate bond index is a starting point. However, modest enhancements to a portfolio’s term structure and credit exposure may provide combinations of either higher TEY, lower volatility, or both. For instance, a little short duration for liquidity and credit for income may go a long way in generating improved risk-adjusted yield.
Source: Barclays Live and GSAM.
Top Section Notes: As of December 31, 2017. Top Chart: 'Excess Muni Tax-Equivalent Yield vs. US Treasury Yield', is the difference between the tax-free AAA- rated subset of the Bloomberg Barclays Muni Aggregate (Muni Agg) Index yield and its comparable maturity US Treasury Index yield. 'US Treasury Yield' is the yield of the Bloomberg Barclays US Treasury index. Bottom Chart: 'IG Corp Yield' is the yield of the Bloomberg Barclays Investment Grade Corporate index, grouped by credit quality. 'Excess Muni Tax-Equivalent Yield vs. IG Corp Yield' is the difference between the tax-free Muni Agg yield and its comparable credit quality IG corp yield. Credit ratings (AAA, AA, A, BAA) refer to credit quality subsets of the Bloomberg Barclays Muni Aggregate Index. Goldman Sachs does not provide accounting, tax, or legal advice. The hypothetical 35% tax rate reflects presidential administration tax proposals, which are subject to change. All yields quoted are yield to worst. Bottom Section Notes: As of November 30, 2017. Chart shows illustrative portfolios with different combinations of Muni Agg (MA) Index, Muni Short (SM) and Muni HY (HYM) indices, with at least 50% allocation to MA Index. Three examples are highlighted to show what a typical portfolio allocation might look like if the portfolio has the same TEY (Yield-Matched) as the MA Index, same volatility (Volatility-Matched) as the MA Index, or a combination of both. Volatility is the annualized standard deviation of daily returns from 1997 to 2017. 'Tax-Equivalent Yield' and 'Volatility' 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 end notes for additional definitions. Past performance does not guarantee future results, which may vary.
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