Goldman: "We Have Entered The Slowdown Phase", But Stocks Don't Care

Under normal circumstances, we would say it is strange, if ironic, that the same day the S&P is trading just shy of an all time high 2,400 again, Goldman comes out with a note warning that "global growth momentum appears to be slowing. The ISM has likely peaked, and the US labor market has tightened further. We appear to be in the “slowdown” phase." It goes without saying that circumstances are anything but normal, and that if the US economy is in a slowdown phase after a quarter in which GDP rose 0.7%, we would hate to see what an all out contraction would look like.

Sarcasm aside, echoing some of the confusion voiced by Bank of America earlier today, Goldman notes that "so far equities and credit are holding up well relative to historical slowdown phases, while other assets (USD, commodities and Treasuries) are underperforming relative to history." 

Why the disconnect? Goldman suggests that even though the economy has peaked, "Historically, slowdowns have not necessarily been bad for risky assets, unless a recession results."

Wait, isn't that what markets do: they discount the future? The answer here, obviously, is not under central planning when the market's only reaction function to any move lower is to buy the dip (see: "Bank Of America: "These Markets Are Very Weird"). However, it would not be politically correct for Goldman to admit that the market's primary function, anticipating and reaction to the future, no longer works, so it provides some other ideas, claiming that "some asset prices, primarily the Treasury term structure and US HY spreads, tend to reflect recession risk early, while equity momentum tends to fade. The ISM and the unemployment rate also appear to give some advance warning.

But first things first: why has Goldman, which traditionally was the biggest economic cheerleader, thrown in the towel? The answer:

In our view, the US is in the late cycle. While US growth remains above trend, we think growth momentum has likely peaked (Exhibit 1) and the US is at or near full employment. The ISM manufacturing index recently decelerated from 57.7 in February to 54.8 in April, and we think we are in the “slowdown” phase of the ISM cycle.  In our previous two GOAL reports we showed that, as the level of the ISM slows down from a peak, on average equity returns fall and equity volatility begins to pick up. However, we also argued that these shifts can take time. Our US economists’ model of recession risk suggests that, although US recession risk is rising, over the next nine quarters it is still near the unconditional historical average (Exhibit 2), which suggests a more muted risk asset slowdown in the near- to mid-term, as opposed to a sharp contraction."

All else equal, when even the company which runs the White House warns that growth has peaked (in a sub 1% GDP quarter), perhaps it is time to get nervous. Perhaps it is, but not for stocks, because as Goldman notes further down in its analysis, "this time equities have outperformed their history while other assets have lagged.We think this is largely because of positive growth data, favourable positioning and a good Q1 earnings season, and also because expensive valuations in government bonds make them an unattractive alternative. In addition, strong policy expectations that had been in place have largely retreated, resulting in less upward pressure on inflation, yields and the dollar, in our view. Less coupon income this time relative to history has also been a headwind to government bond returns, with yields almost half what they have been on average in slowdown phases since 1990 (4.1%). We have negative return expectations for duration from here.

While we have shown that we can expect equity returns to moderate in the ISM slowdown phase, what can we expect from other asset classes? Exhibit 3 plots the average monthly returns of different asset classes during these phases since 1990, along with current performance in this slowdown cycle so far. Historically, government bonds have tended to do best in this phase, followed closely by equities and then US high yield, with commodity and USD returns more muted.

And yet this time around, the equity outperformance is staggering, almost as if stocks are totally oblivious of any potential recessionary risks on the horizon.

So with equities clearly ignoring the risk of a recession as a result of the current slowdown, is there any particular asset class investors should keep an eye on during a "slowdown phase"? According to Goldman, performance has varied materially;

"Exhibit 4 plots the realised return distribution of each asset. Return distributions have historically been most concentrated for fixed income, especially US high yield, which usually has the benefit of low volatility due to a negative correlation between spreads and government yields. However, the equity return distribution reflects significantly more variation, with substantial positive and negative tails. In our view, this reflects the material uncertainty about long-term growth that is characteristic of the slowdown phase as the market assesses the depth of the slowdown. The centralised distribution of USD spot returns in slowdown is consistent with our FX team’s view of less strong USD momentum right now."


The commodity return distribution is perhaps the most startling, though, with no distinct concentration at any point. We think this suggests that the range of outcomes for the commodities asset class in an ISM slowdown phase is broad, and largely depends on the interplay of the underlying economic, cyclical and commodity fundamental pictures, as our commodities team has argued. They expect backwardation to occur in the oil market based on the idea that there is less spare capacity globally at this phase in the economic cycle.

There is another potential explanation why this time the slowdown phase is being discounted, or rather ignored: not every slowdown leads to a recession:

"the fact that risk assets have held up so well is not actually that unusual, as Exhibit 4 suggests. Indeed, positive returns have resulted the majority of the time. As a result, we think a key question for investors during the slowdown phase is whether there are cross-asset market indicators that signal when risk positioning should be scaled back. In our view, what ultimately leads to negative returns in risk assets and outperformance of safe havens is a pick-up in recession risk. We think the slope of the government bond term structure and US high yield spreads tend to reflect this recession risk early, while equities’ momentum normally fades."

To illustrate, Exhibit 5 plots the median historical performance of the S&P 500 during slowdown phases, split by whether the slowdown led to a recession or not. By the end of slowdown, the performance  differential is roughly a correction (10%), and this is even before any contraction phase based on the ISM. Exhibit 5 also shows that it takes some time for equities to digest what slowdown means, with the market relatively flat for the majority of the slowdown phase, regardless of whether a recession follows or not. Only towards the end of slowdown does market performance diverge, on average.We think this is also consistent with how the S&P 500 is trading right now.

Goldman then reveals what may be the most interesting finding:

"This highlights that equities do not tend to show material negative returns in the slowdown phase in advance of a recession. Rather, positive momentum in equities fails to pick up. To illustrate, Exhibit 6 plots the average price path of the S&P 500 prior to and after recession periods. In advance of a recession the only signal, on average, is that positive equity momentum fades, as material negative price momentum does not tend to appear until equities are already in the recession."

In other words, one doesn't even need the Fed to break the market: stocks tend to be naive enough on their own, refusing to see an upcoming iceberg until it has already hit (the December 2007 recession being the best example: it was not until long after, that stocks finally crashed).

And then there is Trump's own budget, which as we showed earlier today, forecasts there will be no recession for the next decade, implying that if correct, the duration of the current business cycle would be the longest on record by nearly 100%, stretching to roughly 20 years.

Maybe stocks are right: maybe this time it is different, the business cycle is dead, and there really won't be a recession for years and years if ever...


All of the above, of course, ignores the real reason why stocks refuse to drop: the Fed (and Trump) "Puts" discussed by BofA earlier, according to which "US equity sell-offs have seemingly become embraced as alpha (i.e., buy-the-dip) opportunities instead of being feared as bona fide risk-off events, as the central bank put has become a self-fulfilling prophecy." What's the point of selling if other ETFs, algos and quants will simply use that as a catalyst to buy, ignoring any and all economic data.

Lastly, with the Fed eager to step in with hints of more QE or rate cuts the second there is even a modest selloff, it is difficult to see what, if anything (except a Chinese crash of course), can end this arrangement.