Valuations across all asset classes are near record highs, limiting room for further upside and making asset prices more vulnerable to negative news or sentiment. (Exhibit 4)
After nearly two years of developed market (DM) policy rates trending lower and currently hovering at all time lows, interest rates will likely rise in 2022. At the same time, bond buying by major central banks is set to fall. Low interest rates have supported higher public and private equity valuations while quantitative easing (QE) has tightened spreads for many fixed income securities. Easy monetary policy has also contributed to strong corporate earnings and margins, which now have less room for improvement. Policy normalization may not immediately reverse these trends, but it leaves less room for asset prices to move higher and potentially chips away at valuation support. (Exhibit 5)
Being positioned on the right side of inflation and disruption will be critical to outperformance. We believe recent trends such as growth versus value, the US versus the rest of the world and the technology sector versus diversified exposure are likely to be less pronounced than in the previous cycle as technological innovation spreads across industries and regions. At the same time, low commodity prices, which contributed to lower earnings and valuations for commodity oriented companies in recent years, have risen significantly. As a result, we expect a modest level of overall earnings growth that is more balanced across regions and sectors. We believe this environment will have a higher dispersion of returns driven by companies that are able to benefit from or withstand an inflationary environment and that have secular growth drivers.
Exhibit 4: Expensive valuations after the bull market in every major asset class, similar to the Golden 1920s and 1950s
Source: Robert Shiller, Datastream, Goldman Sachs Global Investment Research. As of November 17, 2021.
Exhibit 5: EPS GS top-down forecasts
Source: STOXX, Goldman Sachs Global Investment Research. As of December 13, 2021.
Weighing risk versus reward favors alpha strategies. The ability to generate alpha becomes even more important in a lower-return environment as alpha will comprise a greater portion of an investor's total returns.
Alpha strategies have the ability to pick securities or assets across an opportunity set that can span all sectors and regions around the world, potentially adding the benefit of diversification to a portfolio.
In addition to these offensive benefits, active security selection also offers defensive benefits by managing risks. For example, we believe market cap-weighted passive indices leave investors overexposed to various risks: five stocks contribute about 23% of the market cap of the S&P 500, state owned enterprises account for roughly 18% of the MSCI EM Index and about a third of companies in the US small cap universe are unprofitable.
Being active across asset classes may be critical in this environment, though it requires focus on manager and strategy selection. For some investors taking a very long-term view and recognizing that beta returns over the past few years have been above average, active strategies with a moderate amount of alpha generation may help them achieve long-term goals, without necessarily adding a high degree of marginal risk.
Investors who need to continue to generate higher levels of return could consider taking more risk, potentially through long-term, less liquid alternative investments that are driven by factors less correlated to market beta, such as private secondary offerings and more complex opportunities in the private markets.
We prefer strategies with a wide opportunity set, such as absolute return strategies in the alternatives universe, unconstrained fixed income strategies, or global and thematic strategies within public equities. These strategies can benefit from security specific opportunities and regional differences in valuations, as well as changes in broader market conditions such as growth, interest rates or inflation. Pairing private and public investments can take advantage of differentials in valuation, growth opportunities or access.
The secular shift toward alternatives is likely to continue as investors look for asset classes and strategies that may offer higher returns than public markets. A combination of skilled managers and fewer constraints allow hedge funds and private market strategies to take advantage of alpha opportunities across many time horizons and transaction types. Hedge funds can further amplify their alpha generation ability with shorting.