"Where To From Here": Why Goldman's Client Are Confused

Badk in early February, after the great volatility explosion which sent the VIX to 50, killed the XIV ETF and which we now know was precipitated by the market's misreading of the sharp January rising average hourly earnings print (which just as we said at the time, was due to a drop in the workweek and little else as the latest BLS data revisions confirmed), Goldman's clients wanted to know one thing: "how much worse will it get?" In response, Goldman's chief equity strategist David Kostin answered "not much", and indeed so far he has been proven correct as not only is the Nasdaq back to all time highs, but the S&P has recouped virtually all of its 10% correction.

One month later, with the market once again soaring, things are even more confusing because while the vol scare may have come and gone for now, two other risks remain, namely rising interest rates and the escalating trade conflict, both of which according to Goldman "have ended the “Goldilocks” environment of 2017." And yet, as Citi lamented overnight, the markets remain oblivious.

Adding to this, a somewhat puzzled Kostin writes in his latest Weekly Kickstart, that "with 10-year Treasury yields now at 2.9% and new tariffs on steel and aluminum formally ordered this week, the ratio of return/realized volatility has declined from 3.3 in 2017 (22% / 7%) to 0.3 YTD. The S&P 500 nonetheless remains in positive territory."

This confusion appears to be spreading, and has in turn prompted Goldman's clients to ask, "where to from here?"

Kostin's answer is two-fold, first focusing on the move higher in rates, and why there may be less to it than some bears insist:

Interest rates present a more substantial risk to equity valuations than they do to earnings. Because corporate borrow costs are historically low and interest coverage is still elevated, we estimate that a 100 bp increase in 10-year Treasury yields would reduce S&P 500 return on equity (“ROE”), excluding Financials, by less than 50 bp (from a current level of 19%). Financial earnings benefit from high rates, so the overall impact on S&P 500 profitability is  surprisingly small.

The speed of rising interest rates poses a more immediate risk to equities than does the level of rates. This week we published an analysis of the relationship between bond yields, corporate growth, and equity valuations. One key observation from our analysis was that S&P 500 prices typically stop increasing when rates rise more quickly than a standard deviation in a month (currently equating to a rise in Treasury yields of roughly 20 bp), and equity prices decline when yields rise by more than two standard deviations (40 bp). This relationship has held true during the last 50 years irrespective of whether rising yields were driven by inflation or real rates.

The level of Treasury yields eventually also matters for equities, even if the change occurs gradually. Our dividend discount model framework suggests that 10-year Treasury yields above 4% – which would require substantial Fed tightening from current levels and/or inflation expectations well above the 2% target – would outweigh any potential reduction in the equity risk premium (“ERP”), and therefore lead to lower equity valuations.

Incremental medium-term growth needed to offset change in bond yields and ERP

Concluding the rates discussion, Kostin reminds clients that Goldman economists expect 10-year Treasury yields to gradually rise to 3.25% by the end of 2018 and 3.6% by the end of 2019.

"The combination of eight Fed rate hikes by the end of 2019, rising inflation expectations, and a higher term premium will lift the yield curve."

Unless, of course, the move is not a gradual, linear levitation but a sharp, staccato spike a la the Taper Tantrum, in which case all bets are off.

What one can also highlight here, is that after an initial scare following the sharp move to just shy of 3.0% a month ago, equities have indeed eased back, and now interpret any gradual increases in the 10Y rate as a neutral, if not benign development. The question of course, is what happens once 3.0% is breached and whether what has been a moderate selloff re-accelerates, once again slamming risk assets.

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Which brings us to the second, and more material recent development, which is proving to be a bigger source of confusion for Goldman clients, namely the growing trade conflict and why do stocks refuse to go down as a result? 

As a reminder, the steel and aluminum tariffs signed by President Trump this week will go into effect on March 23. The order also exempts Canada and Mexico as leverage during the Nafta negotiations, and leaves open the possibility for other country and product exemptions.

From a fundamental perspective, and echoing what Barclays said two weeks ago, Goldman reiterates that these tariffs should have a de minimis effect on aggregate US economic and earnings growth. In fact, together the steel and aluminum industries account for just 0.1% of national employment and 1% of industrial production. In aggregate, Kostin notes that "these commodity inputs equate to just 1% of total US private industry gross output (i.e., revenues), meaning even significantly higher steel and aluminum input costs would have a limited impact on aggregate US corporate profits."

That said, as Goldman cautioned one week ago, downstream users of the metals including autos and machinery stocks will likely face margin pressures from higher domestic input prices. In general, industries with high material intensity and low margins (the bottom right of Exhibit 2) face the highest risk from rising commodity costs, whether due to tariffs or other causes.

And if a direct threat to the US economy as a result of Trump's trade war is - as of now - nonexistant, what is the danger? Here Kostin once again echoes Barclays, and writes that the larger threat to corporate earnings and equity valuations is the potential for escalating trade conflict in response to these tariffs.

Our economists believe retaliation by US trading partners is likely, particularly in the form of tariffs on US metals, luxury consumer goods, and agriculture. Our commodity analysts highlight soybean exports as particularly vulnerable to retaliation from China. In addition, the upcoming release of the US Section 301 investigation regarding intellectual property may lead to further conflict with China, potentially jeopardizing US corporate sales to and supply chains in China.

And here a paradox: just like Citi's Matt King continues to rage against the market's seemingly infinite complacency when faced with shrinking central bank balance sheets, prompting him to ask "we know what central banks are doing... why are we so slow to price that in?", so the advent of a trade war has so far prompted nothing more than a yawn from investors, who appear convinced that there is no threat to risk assets as a result of potential trade war escalation. Here's Goldman:

Although equity prices have moved in reaction to the proposed metals tariffs, investors do not appear concerned about escalating trade conflict. Firms that our analysts have highlighted as vulnerable to rising steel and aluminum  input costs have underperformed the Industrials sector by more than 300 bp in the last two weeks. However, the share prices of agriculture firms, luxury consumer companies, and TMT firms with high imported COGS have generally demonstrated no signs of concern (see Exhibit 3).

Even more bizarre is that contrary to conventional wisdom, "baskets of US stocks with the largest international sales in general and specific exposure to Europe and China have all outperformed the S&P 500 in recent weeks" (see Exhibit 4), almost as if the market is rewarding those companies that are on the front line of the trade war

Finally, Goldman claims that the outperformance of the domestic-facing Russell 2000 over the S&P 500 by 300 bp this month, is not due to trade concerns, but rather "positioning and earlier underperformance appear more likely causes."

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So, going back to the original question posed by Goldman clients, "where to from here", the answer appears to be more of the same, with new S&P all time highs imminent.

Here, Kostin underscores that despite the sharp VIX moves, the rising rates, and trade conflict, "strong economic and earnings growth should continue to lift US equity prices during 2018. Our economists’ Current Activity Indicator signals a 4.8% current pace of US economic activity, and consensus expects that next month S&P 500 firms will report year/year EPS growth of 17% in 1Q."

This "strong growth environment" helps explain the return of the honey badger market which is ignoring any potentially adverse news, as well as the resilience of equity prices and investor sentiment.

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Looking forward, Kostin believes that the S&P 500 will rise a further 4% by year end to 2850 "on the strength of earnings growth rather than P/E multiple expansion."

It's not all good news: "uncertainty surrounding interest rates and trade conflict suggests that the return and volatility environment will look more like it has in recent weeks than during the “Goldilocks” environment of 2017."

But the biggest winner of the recent market moves is none other than Donald Trump, who - due to luck or otherwise - managed to not only broaden his populist appeal by launching a (very limited) trade war (which so far excludes Canada and Mexico) and at the same time, has not only kept his favorite metric of the success of his presidency - the stock market - from crashing, but at this pace, stocks appear on track to make new all time highs in the coming days.