In the 12 months ending March 31, the S&P 500 delivered the 3rd best return on record. Historically, the period following such a surge has retained its strength. In past instances of major equity market drawdowns (>30%), returns in the second year of recovery have averaged nearly 20%. We think the macro backdrop is still highly supportive for risk assets, with momentum from the vaccine- and policy-fueled economic normalization likely pulling returns forward. The opportunity cost of not being invested is high, but there are valid market concerns about: 1) taxes, 2) rates, 3) inflation, and 4) prices. As such, we think investors should build a strategic, front-footed approach to today’s market environment.
Source: Bloomberg and Goldman Sachs Asset Management. As of May 20, 2021. Past performance does not guarantee future results, which may vary.
1) Taxes: Likely going higher
With massive fiscal spending, record-high public debt levels, and relatively low tax rates, we think taxes are more likely to move higher than lower over the next decade for both corporates and high earners. We expect higher tax rates would elicit a temporary market response, but not create a sustainable shift in the opportunity set. On the corporate front, we think a tax increase to 25% would represent a 3% reduction in 2022 S&P 500 EPS, but ultimately still see record earnings ($193) as fundamentals drive corporate profitability more than taxes. From an individual perspective, we have seen that the market impact around tax hikes has historically been short-lived.
For investors concerned about tax implications, we would consider a more prescriptive approach to long-term asset location strategies. For example, tax loss harvesting in equity portfolios may become even more advantageous as investors strategically realize losses to offset their capital gains. In fixed income, the tax-advantaged income in municipal bonds may become more attractive. And across assets, an ETF wrapper may make more sense.
2) Rates: Measured steepening in the yield curve
Rising Treasury yields and a steeper curve have been reflective of the economic normalization and the cyclical recovery. We expect the yield curve to steepen further as long rates reflect sustained growth momentum and Federal Reserve tapering starting in 2022, but short rates remain anchored by central banks’ collective patience regarding inflation and liftoff. We expect the 10-year yield to rise to 2.1% by year-end 2022, which may pose a headwind near-term for long duration assets but enrich alpha opportunities across asset classes. In fixed income, there are more options for carry and roll. In equities, higher yields can still be supportive so long as rising rates occur gradually and alongside better growth.
Even so, we see tactical value in taking duration down in fixed income. Short duration fixed income reduces rate sensitivity, while still creating value at the sector, term structure, and spread level, and with lower volatility from each. In past periods of rising rates, short duration has been a ballast. During the 2013 Taper Tantrum and the last Fed hiking cycle, the 1-3 year portion of the US Aggregate bond Index returned 0.29% and 1.05%, respectively, while both the full market US Aggregate and US Treasury Indexes lost more than 300bps. Adding high-quality spread sectors can also potentially offer attractive yield opportunities with better risk-adjusted returns.
Periods of higher rates have also historically portended well for value-style and down-in-cap equities, with coinciding growth providing a strong tailwind. Additionally, for value stocks, shorter duration cash flows are less sensitive to interest rates and discount factors, and some sectors such as financials may benefit from a steeper curve. The small-cap premium has also proven valuable in times of rising rates when traditional equity premia is compressed.
3) Inflation: Firming for now
Firmer price measures have been influenced recently by transitory factors related to COVID-19, including low base effects and supply disruptions. As these temporary pressures roll off, we expect Core PCE to remain near ~2.0% as the statistical composition of inflation measurements limit sustained breakouts. Upside risks include faster-than-expected full employment, pent-up household consumption, and high fiscal multipliers from infrastructure spending. But ultimately, we think that despite higher levels, prices will remain supportive of risk assets and are unlikely to pull Federal Reserve policy forward.
If we were to see inflation move sustainably higher, real assets may continue to outperform. We see strong potential in real estate and commodity markets especially, as they have both suffered from structural underinvestment in capex and supply over the past few years, and are meeting an influx in demand. But equities have also historically done well in inflationary environments, ultimately beating inflation 100% of the time when held for 15 years or more. Equities with a high beta to the economic recovery and to commodity prices may do especially well, including those in emerging markets.
4) Prices: Higher valuations, higher risks
Today’s elevated equity valuations may raise correction risk, but can also be justified by the macro recovery and policy support. Absent renewed recessionary factors, we do not expect any sharp re-pricing of risk assets, and would be buyers of any short term weakness. Importantly, we find strong statistical support that equities can stay expensive for extended periods of time, particularly with relatively low rates and high corporate profitability. For example, the S&P 500 has traded at top quintile cyclically-adjusted price-to-earnings ratio for the last ten years, and returned more than 250% in that period. Moreover, economic expansions have historically been good for equity markets, with positive returns nearly 90% of the time.
To address price risk in US equity markets, investors may consider revisiting their core fixed income ballast. For instance, since 2000 the average maximum annual drawdown in the S&P 500 has been more than -16%, even as the average annual return has been nearly +8%. In these same periods, core fixed income has shown its strength, returning on average +2% during equity drawdowns.
Investors may also want to look abroad for equity opportunities at more attractive prices, in our view. For example, 2021 emerging market earnings are expected to be 40% higher than in the US, but emerging market equities are trading at a 40% valuation discount. International developed markets are also catching up in their recovery. Selectivity among all of these markets may help identify pockets of relative value.
 Source: Bloomberg. As of May 31, 2021
Source: Goldman Sachs Asset Management. As of May 20, 2021. For illustrative purposes only.