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2019: Edition 2

MARKET KNOW-HOW | 2019: Edition 2

Game of (Un)Knowns

A stabilizing macro backdrop, convergent growth, and late-cycle opportunity: each is a reason we do not see winter coming for investors. We believe that strategy will be key—we remain pro-expansion, yet pro-reality, attuned to the evolution of late-cycle conditions.

Here are the knowns: the global economy has transitioned from above-trend to near-trend growth, the expansion has continued, and looking ahead we see activity stabilizing. The US expansion is on track to notch its 121st month in June, which would be the longest expansion in history. Accordingly, absent clearer signs of a long-lasting deterioration in fundamentals, we believe the evolving market environment remains supportive of risky assets. On the back of a solid operating environment, credit performance should remain stable.

The unknowns bear close watch, though as the season progresses we expect more conclusions on several key concerns: an uncertain Brexit process, turbulent trade policy, and the possibility of further populist
shocks in election outcomes. Investors, in our view, should prepare for emergent risks even as they seek to capitalize on opportunity.

Consequently, we would emphasize:

  • Pro-risk asset classes—emerging markets may be well-positioned for a comeback
  • A focus on risk allocation over capital allocation, leading to a strategic commitment to alternative investments
  • Income in both public and private markets, which may help build an additional buffer against short-term volatility.

Macro & Market Views

Global policy uncertainty has been elevated...

Geopolitical shifts, trade negotiations, evolving monetary and fiscal policies, volatile oil prices, and ubiquitous media coverage are all forces contributing to elevated global economic policy uncertainty. On the margin, we believe these uncertainties should moderate through 2019, though the political echo chamber is likely to mask progress.

Source: Economic Policy Uncertainty and GSAM.

Top Section Notes: As of March 31, 2019. Bottom Section Notes: As of March 31, 2019. Chart shows the ideological spectrum of Democrats (blue, left) and Republicans (orange, right) in Congress based on their voting history. The political ideology scores represent how economically liberal or conservative a party is on the scale of -1 (very liberal) to +1 (very conservative). For example, the median economic ideology is more liberal for Democrats and is more conservative for Republicans in 2018 compared to 1968. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this page.

The Know
Muni momentum.

Voracious municipal bond demand has been met with limited supply growth.

Municipal Bonds are Relatively Scarce

The technical backdrop for the municipal (muni) market has solid long-term underpinnings. The size and supply of munis have remained relatively steady while Treasury and corporate debt markets have experienced dramatic expansions. Demand for municipal securities has increased and may continue to grow as select provisions of the Tax Cuts and Jobs Act, including limitation on SALT deductions, are realized.

Source: SIFMA and GSAM.

The How
Less is more.

More security selection is possible within lower-rated muni bonds, which may also benefit from wider spreads.

Increasing Opportunity Set in Lower Credit Ratings

In the wake of the global financial crisis, the collapse of monoline insurers resulted in structural changes, such as the realignment of municipal credit ratings. Just as the opportunity set broadened across muni credit, option-adjusted spreads became more dispersed, indicating that spreads were increasingly driven by CUSIP-specific fundamentals and covenants. We believe that investing across the muni spectrum may allow investors to more fully benefit from an increasingly idiosyncratic market.

Source: Barclays POINT and GSAM.

The Know
Clipping coupons.

Yields across a range of asset classes today may provide a significant buffer against potential price losses.

Point Break

In the current benign rate environment, the coupon income from credit asset classes is looking particularly attractive. We estimate that yields could rise by a further ~1% before the offsetting price reduction would reduce returns in various credit sectors to breakeven. For example, rates or spreads would need to rise more than 197 basis points to generate negative returns in US High Yield.

Source: Bloomberg Barclays and GSAM.

The How
Rare potential.

The large rate moves that would be required to offset this substantial income have been exceedingly rare.

Smooth Moves

The present difference between the current and breakeven yields for several sectors is so wide that it has historically been breached just a handful of times. For example, the 197 basis point move in US HY yields has occurred in just 2% of 12-month periods. Given our expectation for stabilizing global growth, contained inflation, and dovish central bank policy, we consider the likelihood of such moves to be particularly slim.

Source: Bloomberg Barclays and GSAM.

The Know
Sector dissector.

The impact of sector composition on growth-versus-value return differentials can be quite large.

Growth and Value, Sector Selector

The sector composition of large-cap growth indices has been famously dominated by the information technology sector, while value has historically tilted toward financials. Each of those sectors today represents more than 25% of the respective index. In our view, a tactical bias to either growth or value should be informed by underlying sector views. In fact, roughly 70% of the growth-versus-value return differential is attributable to the sector allocation effect.

Source: Bloomberg and GSAM.

The How
Late-cycle value.

Style investors have often benefited from taking stock of Federal Reserve interest rate moves.

A Short History, but a Good One

We believe that today’s late-cycle conditions may benefit the sectors contained in value-tilted positions. Value sectors have historically outperformed the S&P 500 in the 12-month period immediately following a cycle’s last Federal Reserve (Fed) rate increase by at least two percentage points. If markets are correct that the data-dependent, increasingly dovish Fed has concluded its rate hikes, investors may benefit from revisiting large-cap value and its key underlying sectors.

Source: Goldman Sachs Global Investment Research and GSAM.

The Know
Emerging opportunities.

We see emerging markets poised for a comeback as global macro conditions converge.

Convergence Ahead: Favorable Environment for Emerging Markets

US economic growth may converge with the rest of the world, "catching down.” We expect exceptional 2018 US earnings growth to normalize closer to the global trend, and EM earnings to catch up. Additionally, we expect a weakening US dollar, which would also be supportive of EM assets.

Source: International Monetary Fund (IMF), FactSet, Goldman Sachs Global Investment Research, and GSAM.

The How
Weighty decisions.

Many investors are structurally underweight EM, and thus may not fully benefit from EM growth prospects.

Underallocation to EM Assets: Potential Missed Opportunity

Portfolios we’ve examined through GSAM PRISM™ are systematically underweight EM equity, debt in US dollar and in local currency by an average of 3.8 percentage points (pp), 1.7pp, and 2.7pp, respectively, relative to our strategic asset allocation. We think that portfolios with higher EM allocations could enjoy enhanced risk-adjusted returns, particularly at a time of softening developed market fundamentals and US convergence.

Source: GSAM.

The Know
Coming of age.

Private equity has been generating more value, attracting more interest, and becoming more accessible to investors.

Private Market Evolution

The private equity (PE) universe has expanded rapidly in recent decades, and is creating more value for companies and their investors. A favorable funding environment has enabled companies to strategically delay public offerings. Individual investors’ barriers to entry have shrunk as asset managers have lowered minimum net worth and investment requirements. We believe this evolution has enhanced the asset class’ attractiveness.

Source: Preqin, CB Insights, and GSAM.

The How
Diversifying private equity.

Investing across managers, funds, and vintages in our view is key to improving client outcomes.

Risk and Return by Private Equity Strategy

Diversifying vintage years enables exposure to different stages of the PE investment cycle. Diversifying across strategies enables access to buyout, distressed, growth, and venture investments. Each strategy comes with unique risk and return tradeoffs; single-strategy performance may be highly variable. A diversified approach, in our view, may mitigate risk and help transform PE into a core allocation.

Source: Preqin and GSAM.


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