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2020: Edition 3

MARKET KNOW-HOW | 2020: Edition 3

Breaking Out from the Outbreak

Market-Know How Edition 3 - Breaking Out from the Outbreak

We hope that you, your family, and your community are moving past the worst of the health and economic consequences of COVID-19. Our thoughts are with you during this period of recovery.

Ascertaining a medical solution has rightly remained the dominant focus of global policymakers, though the economic backdrop has fortunately evolved from one of aggressive shuttering to one of cautious normalization. Economic evidence suggests that through relatively low-cost face masks and targeted physical distancing measures, economies can recuperate while vaccines and treatments are developed.

From an investment perspective, we find that this unprecedented moment validates the lessons of strategic discipline, risk management, and quality. As we enter the US election season, the skills acquired from navigating recent volatility should prove useful yet again.

The remainder of this edition of the Market Know-How will focus on summarizing our macro expectations and providing a framework for breaking out.

We emphasize:

  • Alpha-oriented, bottom-up strategies that can identify disruptions in the competitive landscape. Recovery is likely to be non-linear and discriminant.
  • Broadening global exposure to expand the alpha opportunity set borne from COVID-19 disruption.
  • Balanced exposure to value/cyclicals as they may provide brief, yet powerful, episodes of outperformance. However, the macro landscape remains growth-biased in our view.
  • Commitment to a high quality core bond allocation to buffer equity volatility rather than avoiding it.

Macro & Market Views

Global Growth

We estimate that global real GDP will fall  -3.3% in 2020. This year saw the sharpest and shortest recession since at least WWII. In fact, for the US, the National Bureau of Economic Research documents that no recession has lasted fewer than six months in a database that covers cycles back to the mid-1800s. As we look into 2021, the recovery may be stronger in select non-US markets experiencing less economic drag from the COVID-19 resurgence.

Source: Goldman Sachs Global Investment Research, National Bureau of Economic Research, and GSAM. As of August 6, 2020.
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The Know
From the great reset.

COVID-19 has reset the global economy, requiring a new investing framework.

Three Phase Framework

The Coronacrisis is a generational event that stands to transform how economies function. To navigate the shifting environment, investors need to adapt to a new framework consisting of three overlapping phases: preservation, consolidation, and innovation. Preservation is key in periods of high uncertainty, as companies focus on funding and survival. Consolidation depends on business strategy, not circumstance. Lastly, innovation creates the potential for both massive disruption and superior returns. Successfully managing through these phases potentially lies in the ability to identify sustainable competitive advantages emerging out of the crisis.

Source: Goldman Sachs Global Investment Research and GSAM.

The How
To the alpha bet.

COVID-19 accelerated secular trends already underway.

Focus on Idiosyncrasy

In parallel, this pandemic has also exacerbated key investment challenges, ushering in a world of episodic volatility, lower yields, and scarcer growth. To better cope with volatility, we believe that balance sheet strength and competitive positioning remain vital in this recovery. To combat yield compression, cash flow enhancers may be effective in providing diversified income growth. And as the number of faster-growing companies continues to decline in major markets, we believe the opportunity set is becoming more idiosyncratic and global. The post-COVID world may mean investing without borders.

Source: Datastream, I/B/E/S, Goldman Sachs Global Investment Research, and GSAM.

The Know
Change in leadership.

Sector composition of the top-performing companies today reflects shifting growth dynamics.

Top Companies Concentrated in Tech and Health Care

Attractive equity returns of the last few years have reflected shifting demographics, social preferences, and consumer behaviors that translate into powerful earnings growth. While the US technology sector has been well-positioned for these trends, the US market’s compositional advantage has begun to shrink as global economies invest in more profitable industries. Additionally, the market’s willingness to pay a premium for more consistent profitability may extend to areas such as Med-tech, Fin-tech, Ed-tech, Green-tech, and Environmental, Social, and Governance (ESG), which could begin to balance out the global opportunity set.

Source: Bloomberg and GSAM.

The How
Consistent global opportunity.

Strong performance has not been limited to the US.

Top Companies Concentrated Internationally

The top-performing companies remain well-represented in the global landscape, despite overwhelming US performance. Of the top 50 performing stocks each year, on average, more than 75% have been domiciled outside of the US over the last decade. Even in the Coronacrisis, where macro and market conditions have been challenged, global opportunities have remained plentiful. So far this year, 92% have been domiciled internationally. Investors who can identify high-quality companies with strong balance sheets, earnings potential, and profit margins may benefit from expanding their portfolios’ borders.

Source: Bloomberg and GSAM.

The Know
When defense is offense.

Growth today is different from growth yesterday.

Up When Down

Recent months of equity performance have shown an unusual dynamic of growth dominance during periods of significant market volatility. Historically, this has occurred only 41% of the time. In our view, this rotation in outperformance can be explained by the evolving characteristics of growth companies. They tend to be 1) more defensive because of balance sheet strength and ample liquidity, and 2) more insulated from negative earnings revisions due to less cyclical business models. We believe the outperformance of growth will likely persist given modest GDP growth, low inflation, and single-digit earnings growth potential.

Source: Bloomberg and GSAM.

The How
Growing down.

Attractive growth sector tilts exist outside of large cap equity.

Time to Move Down

The growth opportunity is expansive as you move down in market capitalization. The index composition of small- and mid-cap growth stocks is heavily weighted toward information tech and healthcare, which comprise ~60% of the index. Even within growth sectors, these companies are tilted toward industries most transformed by the digital revolution, including semiconductors in tech and biotech in healthcare. We think the next decade ahead will increasingly be disrupted by technology. Small- and mid-cap growth stocks are poised to benefit from this secular trend as they are both innovative and nimble in evolving business strategies.

Source: Bloomberg and GSAM.

The Know
Lower for longer.

Depressed yields are likely to persist in the near-term.

Lingering Lower

In the first half of 2020, markets hit a number of records: the Treasury curve dipped below 1%, short term interest rates effectively moved to zero, and the municipal market experienced the lowest yield levels in history. In this environment, investors may hesitate to take on duration when a recovery in rates could pose headwinds to bond prices. However we believe interest rate sensitivity is often overestimated in municipal bonds, especially when moving down the credit spectrum.

Source: Bloomberg, Thomson Reuters MMD, and GSAM.

The How
Give munis some credit.

Rate sensitivity impacts municipal debt differently.

Don’t Fear, Duration Impact Is Barely Here

There are a plethora of factors beyond interest rates that may influence the pricing of municipal debt, especially in an economic recovery. A macro rebound can push rates higher and expose municipals to greater rate sensitivity. Yet offsetting this impact is a stronger revenue backdrop that may narrow credit spreads and improve fundamentals. We think this counterbalancing feature has helped drive the stark historical disconnect between realized and option-adjusted duration. This dynamic is even more accentuated in credit, which may provide an attractive approach to generating tax-free income while reducing realized duration risk.

Source: Bloomberg and GSAM.

The Know
Then and now.

The characteristics of core fixed income have evolved over time.

Changes in US Core Fixed Income Landscape

Over the past decade, investment grade fixed income has changed from both a characteristic and composition perspective. The Bloomberg Barclays US Aggregate Bond Index has lower yields, higher duration, and more exposure to Treasuries relative to 10 years ago. As such, investors who rely on a passive investment strategy may unintentionally take on more interest rate exposure as well as lower yields. We believe there are ample opportunities to boost income and seek more attractive risk-adjusted returns by diversifying into high quality spread sectors of the core fixed income market.

Source: Bloomberg Barclays and GSAM.

The How
Similar, but different.

Not all fixed income is created equal.

Variety and Diversity in the US Aggregate Investment Grade Universe

When it comes to fixed income, investors are often tethered to the Bloomberg Barclays US Aggregate Bond Index. However, not all bonds are created equal, even within the same core fixed income space. Sub-sectors have a wide range of characteristics across yield, volatility, return, and correlation to equities. In today’s yield-challenged environment, we believe selectivity is critical not only within the benchmark, but also across the entire investment grade universe. A dynamic approach in core fixed income may allow investors to fully capitalize on the benefits in their portfolios.

Source: Bloomberg and GSAM.

The Know
Meet in the middle.

The US middle market represents a vibrant capital base and addressable market opportunity.

Strong and Sizeable

The US middle market is made up of the “businesses next door” that are the backbone of the economy. These companies range from $10-$100 million in annual EBITDA and have strong growth potential, but are often underserved by traditional providers of capital such as banks and the public markets. Instead, their funding often comes from local banks and private markets. In our view, today’s tailwinds of targeted fiscal stimulus, renewed investment in domestic supply chains, and the longer-term trend of companies staying private longer, all make the middle market an attractive opportunity for investors.

Source: US Chamber of Commerce, National Center for the Middle Market, and GSAM.

The How
Be direct.

Private debt may deliver a unique source of income and volatility hedge.

Middle Market Credit Potential

Middle market direct lending has held advantages over other public fixed income markets resulting in stronger risk-adjusted returns. In the post-COVID world, these aspects of the private market may be particularly attractive. Bilateral negotiations can result in better terms (e.g. enhanced due diligence, higher credit spreads, and tighter debt covenants). Relatively conservative capital structures and longer deployment horizons can lead to lower default rates and less fluctuations in yield. As such, direct lending can be an interesting source of returns for investors seeking to manage portfolio volatility. Imperative though is partnering with companies with healthy balance sheets and sustainable cash flows.

Source: Bloomberg and GSAM.


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