Do low expected returns and the maturation of the economic cycle mean it’s time to de-risk?
We think de-risking would be premature, unless it meets investors’ strategic goals.
We acknowledge that the cycle is maturing and absolute valuations of many asset classes are high. At the same time, US equities—to take one key example—have offered an attractive risk-reward proposition even in the later stages of the economic cycle, though investors should be prepared for volatility. This is important context for the (correct) observation that US equity valuations stand near the top historical decile and are expensive by many measures.
Risk/Reward in Equities Still Worthwhile Towards End of Expansion
Source: Haver Analytics, GSAM Global Portfolio Solutions. Real return is the return after adjusting for inflation. As of December 2016. Shows returns for economic expansions ending Jan. 1967, Feb. 1974, May 1979, July 1989, June 1995, Sept. 2000 and Jan. 2008.
The cycle still has room to run, in our view.
The economic expansion is in late stages by some metrics, but remains mid-cycle by others. Two examples that indicate a mid-cycle environment include capacity utilization in the manufacturing sector and the current gap between actual and potential unemployment in the US versus previous cycles. Both measures suggest that utilization rates are more in line with what is seen in the middle of the expansion phase rather than at the end. Our central scenario is for the expansion to carry on for another couple of years.
US Employment and Capacity Utilization Show Room for Continued Expansion
Source: Haver Analytics, GSAM Global Portfolio Solutions. As of December 2016.
The market continues to signal return potential for equities.
The equity risk premium measures the market-implied return expectations for owning stocks versus a “risk-free” asset. We note that the current equity risk premium (ERP) remains above the longrun average, and is somewhat higher than our estimated ERP given current macroeconomic conditions. We view this signal as a counterweight to elevated valuations.
The Risk Premium Offered by Equities is Above Historical Norms
Source: Haver Analytics, Robert Shiller data, GSAM Global Portfolio Solutions. As of December 2016. The market implied ERP is based on a 1-stage dividend discount model and cyclically adjusted earnings. The macro benchmarked ERP is GSAM’s estimate of the fair level of the ERP given prevailing macro conditions.
Is this a slow-growth cyclical recovery or is the economy stuck in “secular stagnation”?
We believe 2017 will look increasingly normal.
With growth broadening out to more countries and inflationary pressures building in the US, we think the economy will feel increasingly normal in 2017. This should push the market in the direction of our view. Namely, that we are in a slow but cyclical recovery, where interest rates should rise over time, rather than “secular stagnation,” where rates could stay at super low levels on a more structural basis.
Remarkably Steady Global Growth
Source: Haver Analytics, GSAM Global Portfolio Solutions.
“Secular Stagnation” concerns were driven by temporary factors…
Our conviction in the cyclical recovery is strengthened by our view that the factors which made “secular stagnation” a particularly powerful story in 2016 were cyclical rather than structural: the disinflationary impact from the fall in oil prices and the weakness in macro data in the beginning of the year, followed by the rise in political uncertainty after the UK referendum.
Current Employment Recovery Consistent with Previous Cycles
Source: Haver Analytics, GSAM Global Portfolio Solutions. Represents the median improvement from peak during past recoveries from 1954–2007.
…whereas economic performance has been better than is often acknowledged.
Our conviction is further strengthened by the fact that global growth in the postcrisis environment has been in line with the experience in the 1980s and 1990s. Even in the US where nominal growth has been weak, improvements in the labor market have been in line with past recoveries.
If expected returns on traditional assets are low, where do we see opportunities?
We see opportunities in alternatives, emerging markets and dynamic asset allocation.
We think de-risking would be premature with developed economies likely to continue growing (albeit slowly) and emerging market growth improving as Russia and Brazil rebound from recession (see our growth forecasts). Equities may benefit from recent earnings improvements and market expectations of fiscal spending and de-regulation, but this is balanced by the potential for rising bond yields and political uncertainty. As a result, we think return prospects for traditional equity and fixed income assets are low and alternative sources of return may offer more opportunity.
Our focus on sources of return beyond traditional exposures begins with alternative investment strategies and alternative risk premia. Examples include lower-beta strategies within equity long/short and macro strategies that look for opportunities across multiple asset classes. We see these exposures as improving diversification and as useful tools in the pursuit of attractive risk-adjusted returns.
Increased Dispersion within Equity Markets Can Create Opportunity
Source: GSAM. Quarterly data through September 2016. Dispersion score is a measure of the difference between the price of the top 25% and bottom 75% of equities in each market.
Emerging market assets have room for recovery.
In our view, emerging market underperformance versus developed markets from 2011 until the beginning of 2016 was driven by excessive valuations, economic pressures from imbalances, slowing growth and high investor expectations. Progress on these fronts created attractive opportunities across emerging market equities and fixed income. Despite possible policy shocks from the incoming US administration, the initial conditions supporting emerging market assets in 2016 remain in place. These include continued demand for high yielding assets, a cyclical uplift from improving emerging market growth, improved currency reserve coverage and supportive valuations.
Emerging markets also offer many investment dimensions: importers versus exporters, consumption-driven versus investment-driven economies, state-owned versus private companies and local currency versus external currency fixed income. We think this diversity provides fertile ground for security selection and diversification.
We believe a more dynamic approach can add value.
We expect a series of transitions to play an important role in shaping our investment views in 2017. As these transitions play out, we will be looking at a variety of signposts to measure the investment implications.
Equities, corporate bonds and emerging market assets could each trade in a wide range, where temporary volatility causes periods of weakness followed by recoveries. Such an environment increases the opportunities for tactical asset allocation and more dynamic investment management. We believe this approach will be critical in the context of overall valuations.
We also think active security selection is both attractive and more meaningful to portfolio returns in an environment of more modest returns on major asset classes. From a macro perspective, we think the transitions from monetary to fiscal policy and from globalism to populism should lead to more differentiation and divergence in fundamentals. While valuations may be elevated at the asset class level, dispersion within asset classes is elevated, providing potential opportunity to seek returns via security selection.