After last week's warning by Ray Dalio that a 100 bps rise in yields could lead to trillions in cross-asset losses, it was Goldman's turn to pick up the bearish torch with a note in which it warned that stock markets are set for volatility in the remainder of the year as a result of potential "growth shocks" which continue to loom until year-end as political risks remain elevated, given the upcoming US presidential elections and Italian referendum, and the UK government’s plan to trigger Article 50 by March 2017.
The report by GS managing direct Christian Mueller-Glissmann comes at the same time that Goldman's chief economist David Kostin was similarly dour on the upcoming Q3 earnings season which begins this week, "warning that 4 out of 5 factors suggest disappointing results ahead", as per the following table:
Looking at the market, Glissman was more focused on the continued drift higher in rates, and said that “we have more potential for shocks right now” telling Bloomberg that “we have a slight tilt to be a bit more defensive, and tilt towards Asia and emerging markets relative to more developed markets. We are a bit more bearish on Europe and the U.S into year-end.”
The Goldman strategist is concerned by high U.S., valuations, saying that current levels can precipitate significant drops in the event of shocks. That’s the case particularly in the absence of sustainable profit growth to support prices. The S&P 500 trades at more than 18 times estimated earnings, compared with a 15.6 average for the past five years.
“Equities are a tough asset to own without a clear, positive trend in growth,” Mueller-Glissmann said. “It’s tough to deal with these equity draw-downs because there are very few places to hide except for cash.”
And indeed, as he writes in his latest note, "we stay defensive in our asset allocation and keep our OW Cash for 3m. We stay inclined to keep cash reserves in case shocks create more attractive entry points. We remain UW Bonds and maintain our 2% target for US 10-year yields by year-end: we expect a more gradual move from here but the risk of ‘rate shocks’ remains elevated due to uncertainty over the BoJ and ECB’s QE programmes, and the timing of the next Fed rate hike given US data recently. We stay OW Credit and N Equities (both 3m and 12m), although 12m forecast returns suggest investors should rotate from credit to equities. We think the case for credit vs. equities has weakened relative to previously."
In terms of his modest bearish downside, Mueller-Glissmann, he predicts that the S&P 500 Index and the Stoxx Europe 600 Index will each drop by about 2 percent by December. These days that is called an aggressive bearish forecast.
Among the key points discussed is that the outperformance of credit is now over, if only for the time being:
Following the strong performance of credit YTD, in particular high yield and EM, and with equities lagging, we look at relative value and risk in credit and equities in a Q&A format. Credit has performed strongly due to (1) search for yield without a material growth pick-up, and (2) attractive credit valuations after pressure from falling commodity prices, US recession risk fears, and EM and China growth fears. With headwinds fading, spreads have declined sharply but further large declines appear unlikely. Current credit spreads leave less of a buffer for ‘growth shocks’ than previously and US credit fundamentals continue to deteriorate. Rising rates may also act as a drag on total returns, making it necessary to hedge duration risk.
Does that mean that Goldman is switching out of bonds and into stocks?
On the surface, valuations for equities appear more attractive than for credit, as equity risk premia are high, both relative to credit spreads and relative to their history. However, estimating equity risk premia is difficult due to the low level of bond yields and uncertainty on LT growth prospects: high dividend yields (and low bond yields) could just signal lower growth. Until we see a sustained pick-up in growth, we think equities will be stuck in their ‘fat and flat’ range: low positive returns but continued risk of drawdowns. To unlock the ERP and drive outperformance of equities vs. bonds and credit, we need moresigns of a ‘reflation’ scenario. Until then, we still prefer credit to equity.
However, as Goldman admits, "being defensive is not easy given that many ‘safe assets’, such as gold, are already expensive and could suffer from rising rates." Furthermore, in the rush for year end window dressing by hedge funds, it is likely that TINA will be the primary consideration as hedge funds scramble into high beta, "growth" positions.
Still, "cross-asset diversification is more difficult as bonds may not hedge ‘growth shocks’ as well as they have previously, given that they are expensive, inflation is picking up and monetary policy could turn less supportive. Moreover, while the BoJ may be able to reduce rate volatility for JGBs by yield targeting, this could reduce the ability of bonds to buffer ‘growth shocks’ and drive more volatility in other assets, such as equities and FX." More details:
Goldman also notes the risk of substantial upcoming drawdowns, not only amid the hedge fund community, but the volatility targeting entities such as risk-parity funds, a topic we touched upon last week. As Goldman adds, "this is a risky dynamic for multi-asset investors; as we highlighted in the previous issue of GOAL,equity/bond correlations have been positive since the summer. Large drawdowns in multi-asset portfolios are either because of large equity drawdowns or because of combined equity/bond sell-offs, which tend to particularly affect risk parity and vol target investors. Risk parity and vol target portfolios appear at risk right now because (1) as a result of the low volatility across assets, they have likely increased risk during the summer, e.g., in riskier assets such as the S&P 500 and MSCI EM, and (2) within equities, they tend to be weighted towards low vol stocks and more defensive bond proxies."
Those types of stocks are particularly vulnerable to both ‘real rate shocks’ and also a procyclical increase in bond yields; indeed, as Exhibit 3 shows, since September such stocks have regularly underperformed the market during risk-off periods. We continue to like puts on bond proxy sectors, such as Utilities, Telecoms and Staples, in particular in Europe where implied volatility is at a discount to the market. Similarly, investors could hedge gold downside via put options, given that it is also vulnerable to higher yields – current 3-month implied volatility, at 14.2, is at the 11th percentile compared with the last 10 years (see Cross-asset Volatility Overview in Exhibit 55 below). Note: Put buyers risk losing the entire premium paid if the underlying closes above the strike price at expiration.
Summarizing GOldman's current stance:
We remain Neutral Equities on a 3- and 12-month basis. Equities have lagged credit YTD and on a 12-month horizon forecast returns are higher for equities than for credit. We remain Overweight MSCI Asia ex Japan and continue to like HSCEI calls. We still expect ‘fat and flat’ returns for equities this year and, as a result, we stay neutral in our asset allocation. With elevated equity valuations, in part due to the very low level of rates but lack of earnings growth YTD, we believe the potential for a sustained upward trend has been limited and equities are both vulnerable to ‘growth’ and ‘rate’ shocks. Growth has been resilient YTD and the prospect of fiscal easing has raised reflation hopes. Low positioning in equities coupled with a short ‘Goldilocks’ phase (anchored rates and better growth) has supported equities during the summer. But we still think that ‘fat and flat’ remains the most likely outcome until the end of the year.