Goldman Sachs 2018 Midyear Outlook: (Un)Steady as She Goes

  • In our 2018 Outlook, we discussed six steady factors supporting the outlook: 1) economic growth; 2) equity markets; 3) strong, relatively steady and broad-based earnings growth; 4) regime shift in inflation volatility; 5) low probability of recession; 6) disdain for this rally
  • Also highlighted six unsteady factors threatening the outlook: 1) domestic politics; 2) rise of populism; 3) terrorism; 4) increasing threat of cyberattacks; 5) rising geopolitical tensions; 6) bitcoin and the unsteady cryptocurrency mania
  • While data on the global economy and financial markets continues to point to a “steady as she goes” outlook, the increase in geopolitical tensions between US and China, the rise of radical populist parties in countries such as Italy and Mexico, and deteriorating geopolitics in the Middle East, where a third of the world’s oil is produced, have contributed to an increase in market volatility, weak returns in certain equity and currency markets, and heightened unease among investors
  • Against this backdrop, assets have continued to flow out of US equities and into bonds, reflecting the persistent disdain for the US equity rally
  • Also seen inflows into developed and emerging market equities – surprising given the uncertain impact of the election results in Italy and Mexico, depreciating emerging market currencies, and declining developed and emerging market equities
  • News of the unsteady factors will dominate the airwaves for the foreseeable future. However, at this time, we can invest client assets only on the basis of fundamental long-term drivers of equity markets embodied by the steady factors
  • Halfway through 2018, there has been many improvement in many of the steady factors
  • We have raised 2018 growth forecasts for the two largest economies in the world: US growth rate was raised by 0.2% to 2.8% and China increased by 0.3% to 6.8%; Japan, Brazil, UK and Russia were revised down
    • Netting out these revisions, our 2018 global growth forecast remains unchanged at 3.4%
  • Current activity indicators imply that the likelihood of a US recession in 2018 is close to zero. Over the next 12 months, through mid-2019, the probability of a recession remains at about 10%
  • Favorable financial conditions, rising building permit trends and increases in the Conference Board Leading Economic Index suggest a reduced risk of recession
  • This has been offset by cyclical factors, such as a very strong labor market and improving wages, that reduces slack in the economy
    • While a strong labor market and improving wages are good for the economy in the short term, they also increase the prospects of higher inflation and a faster pace of interest rate hikes by the Fed – which in turn increase the odds of a recession
  • Favorable economic backdrop, fiscal stimulus, easy monetary policy, higher oil prices and muted inflation provided a significant boost to corporate earnings across the globe in the first quarter of 2018
    • Earnings growth estimate for 2018 remains unchanged at 16%
  • Popullar group of FAANGs has now been replaced by FANGMAN: Facebook, Apple, Netflix, Google, Microsoft, Amazon, and Nvidia
    • These stocks are forecast to grow 2018 earnings by 21.7%
    • While FANGMAN stocks represent about 17% of S&P 500 market cap, they account for only 10% of earnings
  • Even with our base case of some multiple contraction this year and next, we expect US equities to provide a total return of about 7% in 2018 and about 5% in 2019
    • Equities have traded at higher multiples in periods of low and stable inflation. While current valuations may seem high when compared to long-term medians, they are substantially less so when compared to the median levels seen since April 1996, when the US entered a period of low and stable inflation. US equities are about 13% overvalued when factoring in the current inflation regime
    • While Treasury yields have increased and are close to the midpoint of our 2018 range of 3%, we do not believe they have increased to a level that will derail this bull market. Historically, 10-year Treasury yields have averaged about 5% before negatively impacting equities. About 90% of S&P 500 debt is fixed and only 10% matures each year. Thus, it will take a number of years of higher interest rates before the aggregate interest expense of US companies meaningfully increases. In the current economic and inflation environment, interest rates closer to 4% may become a limiting factor, but at this point we are far from that level
    • Ongoing economic growth has overwhelmingly favored positive equity returns in the past, with high odds of positive returns and low odds of large losses. Only one quarter of US bear markets have occurred during expansions. Equity returns have remained favorable until about 5 months prior to the onset of an economic contraction, highlighting the penalty for prematurely exiting the market in the absence of elevated recession risk
  • US household debt as a % of disposable income has decreased substantially since the peak levels seen in the GFC. It has decreased from above 130% to 103%, and the debt service ratio is at two-decade lows as a result of low debt levels and low interest rates
    • Portion of the population with FICO scores below 650 has decreased from 35% in 2010 to 30% in 2017
    • Less favorably, we have seen a small increase in 90-day delinquency rates in auto loans and credit card loans among subprime borrowers
  • While the Trump administration Tax Cuts and Jobs Act of 2017 and the Consolidated Appropriations Act of 2018 have provided a boost to economic growth in 2018 and are expected to continue to do so in 2019, they have also increased the budget deficit from 3.5% of GDP in 2017 to 4% in 2018, and to an expected 5.2% by 2019
  • The problem with introducing a fiscal boost at a time of economic strength is twofold:
    • When the US economy inevitably falls into a recession sometime in the future, the deficit will have to expand even further from its already wide levels
    • We are approaching a time when mandatory spending is projected to increase due to Social Security, Medicare, Medicaid, and income-support programs
  • Debt-to-GDP is projected to rise from its current level of 76% to between 96% and 105%. While the US can fund its budget deficit and debt levels given its global reserve currency status, no one knows the tipping point at which debt levels become unsustainable
    • It is estimated the tipping point to be somewhere between 160% and 180% of GDP
  • Forecasters assign a 60% probability that the Democrats will win a majority in the House of Representatives, but only a 30% probability that they will win the Senate
    • It is not clear whether a divided government is unfavorable for US equities
    • US equities have lagged when the US government has been divided between Republicans and Democrats, compared with periods of united government
  • We continue to recommend a strategic overweight to US equities, implying an underweight to EAFE and emerging market equities. Tactically, we remain a greater allocation to US assets through US banks, US high yield bonds, US MLPs and the USD, and a smaller allocation to EAFE equities

Goldman Sachs 2018 Midyear Outlook: (Un)Steady as She Goes, July 2018

Image Source: Goldman Sachs Investment Strategy Group