Market Know-How 3Q 2024
Arrival
The past is a foreign country. They do things differently there. Investors yearning for a return to the market conditions of yesteryear often bide their time on the sidelines, as many struggle to take action in a new—both economically and (geo)politically—investment landscape.
The post-GFC era of low inflation, low interest rates, and low market volatility has been replaced by a more fluid paradigm characterized by sticky inflation, higher-for-longer rates, and frequent bouts of episodic market volatility. This is what ‘normal’ now looks like and, while the certainties of the recent past have been superseded by a less predictable environment, it is replete with investment opportunities.
The prospect of a prolonged period of stubborn inflation implies higher-for-even-longer interest rates, which has created an abundance of yield opportunities for income-hungry bond investors. The regional-, sector-, and company-dispersion of outcomes in equity markets is likely to broaden, placing a premium on judicious risk management, but creating meaningful potential upside for long-term investors allocating to themes of secular growth.
In this edition of the Market Know-How, we visit three high conviction strategies for those ready to embark by:
- Using tax-advantaged SMAs to leverage ideal market conditions for efficient equity tax management.
- Transitioning to multi-sector fixed income to secure sustainable cashflow and hedging benefits from active spread and duration flexibility.
- Participating in the differentiated features and potential benefits of private credit to address interest rate concerns.
Source: Goldman Sachs Asset Management. As of June 11, 2024. “GFC” refers to Global Financial Crisis. “SMA” refers to Separately Managed Account. “Fed” refers to the Federal Reserve. “Spread” refers to the difference in yield between bonds of a similar maturity but with different credit quality. “Duration” refers to a bond price’s sensitivity to a change in interest rates. Diversification does not protect an investor from market risk and does not ensure a profit. There is no guarantee that objectives will be met. Views and opinions are current as of March 29, 2024, and may be subject to change. They should not be construed as investment advice. The portfolio risk management process includes an effort to monitor and manage risk but does not imply low risk. Goldman Sachs does not provide accounting, tax, or legal advice. Please see addition al disclosures at the end of this page.
Macro Views
We expect resilient global growth and disinflationary progress to continue, amidst regional nuances. This divergence will likely lead to varied monetary policies globally, with some regions potentially advancing more quickly than others. Growth should be supported by strong real household incomes, a rebound in manufacturing activity, and gradually less restrictive monetary policy, in our view.
Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of May 28, 2024. “We” refers to Goldman Sachs Asset Management. “Fed” refers to Federal Reserve. “ECB” refers to European Central Bank. “BoE” refers to Bank of England. “A” refers to actual. “E” refers to expected. The economic and market forecasts presented herein are for informational purposes as of the date of this page. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this page. Past performance does not predict future returns and does not guarantee future results, which may vary.
Inconsistent progress on disinflation across major economies has paved the way for a potential decoupling amongst key central banks, in our view. The ECB has already begun to ease rates and the BoE appears to be gearing up for a first cut, while a more cautious approach from the Fed may be the likely scenario, with key inflation and labor prints this summer top of mind.
Inflation has come down in a slow and steady fashion, albeit with regional discrepancies. Despite a hotter start to the year than consensus anticipated, we expect US core PCE inflation to remain relatively flat in the near-term behind further rebalancing in the auto, housing rental, and labor markets. Disinflation progress in the Euro Area and the UK has remained broadly on track, while in Japan, we expect core CPI to linger above the BoJ’s 2% target until mid-2025.
Republicans have a clear path to flipping the Senate, whereas both the House and White House are toss-ups, in our view. The economy remains top of mind for voters, highlighting the likely impact that upcoming inflation and labor market data will have on the election outcome. The makeup of Congress should provide further clarity on how the next administration will tackle expiring income tax provisions in 2025.
Our base case scenario in the US is an ongoing soft landing, but we acknowledge that tail risks have increased. We see a possible scenario in which growth remains resilient, preventing further disinflationary progress and delaying Fed rate cuts. We also see a small probability of inflation reaccelerating, in which the Fed must keep rates at current levels through the end of the year.
Government debt sustainability has once again entered the spotlight as interest rates have returned to their 250-year averages and will likely remain higher-for-longer. The US is not alone, with most G7 countries also experiencing elevated debt levels. Higher costs of servicing debt, political gridlock, and rising government expenses alongside aging populations serve as headwinds to global efforts toward improving debt sustainability.
Growth in 1Q came in above consensus expectations, and momentum has remained solid since. Underlying components of the figure were more mixed, with growth being driven by strong exports and manufacturing but showing weakness in areas like consumption and property. While the Chinese government is stepping up its efforts to accelerate fiscal support and stabilize the housing market, it is unlikely to be enough to arrest house price declines, pointing at potentially slower growth in the remainder of the year.
Market Views
Equity and bond investors must prepare for more dispersion in a higher rate world. Short-term opportunities may emerge as central banks embark on policy rate normalization at different speeds and timing, with higher terminal rates as the likely endpoint. This structural shift may require more active selection, greater geographical diversification, and non-traditional risk diversifiers in portfolios.
Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of June 11, 2024. “We” refers to Goldman Sachs Asset Management. “DM” refers to developed markets. “EM” refers to emerging markets. “EBITDA” refers to earnings before interest, taxes, depreciation, and amortization. “EUR IG” refers to European investment grade . Diversification does not protect an investor from market risk and does not ensure a profit. The economic and market forecasts presented herein are for informational purposes as of the date of this page. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this page. Past performance does not predict future returns and does not guarantee future results, which may vary.
A resilient macro backdrop across DM economies continues to support our constructive view on equities, though upside potential remains limited due to elevated valuations. In the near-term, we believe higher-for-longer interest rates through the remainder of the year will underscore investor focus on earnings growth and margin expansion. However, as the timeline for monetary policy decisions diverges across DM economies, we believe a regional broadening across equity markets in the long-term is likely.
A higher cost of capital and lagging investor confidence in US small caps have pushed down valuations, providing potentially attractive entry points. In addition to stable growth as a backdrop for a lower risk differential for small caps, we believe mega-cap concentration and stretched valuations may also serve as tailwinds. Globally, we find that small caps tend to outperform as sentiment and activity data improve. With a rising number of unprofitable small-cap companies, we remain focused on fundamentals and selectivity.
Chinese equities remain exposed to geopolitical risks despite a potential recovery in macro conditions and strength building on a company-specific level. Recent strength in other emerging markets has been driven by optimistic growth and global disinflation progress, though we see some markets with stretched valuations limiting upside, evident among some Indian equities.
Skepticism towards disinflation progress has persisted in 1H 2024 across most major economies, leading to a flattening yield curve, though we expect steepening to pick up again through the end of the year along with elevated market volatility. Divergence in the rate cutting timeline may also cause more pronounced interest rate declines in Europe than the US, a trend we expect to continue given the stronger growth outlook in the US.
Investors seeking tax-exempt income at higher yields may find attractive opportunities in munis, particularly in high-yield allocations. We see demand for munis potentially increasing as tax cuts are expected to expire towards the end of next year and investor expectations for rate cuts have been pushed back. As a result, this heightened demand will likely offset much of the supply influx we’ve seen and continue to expect this year, especially after last year’s historically low issuance.
We believe credit spreads are likely to remain tight, as resilient fundamentals and balanced supply-demand dynamics continue to support a healthy outlook. Risks skew to slight upticks in defaults and debt-to-EBITDA ratios across borrowers, though a positive macro backdrop may limit downside. We see opportunities in EUR IG due to cheaper valuations giving way to potentially attractive yields.
Implementation Solutions
Tax-Advantaged Equity SMAs
Consistency is Key: Investors often analyze portfolio holdings toward the end of a calendar year, seeking loss harvesting opportunities to offset realized capital gains. While a prudent exercise, we believe it neglects opportunities that present themselves throughout the entirety of the year. A closer look at the last decade demonstrates this rationale. Since 2014, an average of just 22% of S&P 500 stocks traded at a loss of at least -10% on the first trading day of December in each calendar year. Meanwhile, when looking throughout the year, an average of 55% of stocks traded at the same loss on any given trading day. A consistent approach to loss harvesting through the use of tax-advantaged equity SMAs provides a better opportunity to maximize savings and generate alpha, in our view.
Source: Bloomberg and Goldman Sachs Asset Management.
Challenging Conventional Wisdom: Conventional wisdom might suggest that US large-cap returns are maximized when equities are purchased at cheap valuations. We find however that forward returns of the S&P 500 remain quite strong even when capital is deployed at all-time index highs. For investors looking to efficiently allocate today, we believe that doing so through strategies that loss harvest throughout the year enhances after-tax outcomes even further. This is demonstrated by the fact that a significant portion of index constituents trade at sizeable losses shortly after new peaks are reached. In the last decade, an average of 70% of S&P 500 companies have seen their stock prices fall by -5% within the twelve months following an index high, while the index itself has averaged a 9.3% annual return following all-time highs since 1950.
Source: Bloomberg and Goldman Sachs Asset Management.
As of June 10, 2024. Please see additional disclosures at the end of this page. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this page There is no guarantee that objectives will be met. Past performance does not predict future returns and does not guarantee future results, which may vary.
Multi-Sector Fixed Income
Unpredictable Circumstances: Performance leadership amongst fixed income sectors has fluctuated in recent years due to dramatic swings in macro conditions. A unique feature of 2024, however, has been episodic and pronounced rate volatility, in our view. We expect this to remain the case in the second half of this year due to 1) bumpy disinflation, 2) rate cut uncertainty, 3) the US presidential election, and 4) geopolitical tensions. In such an environment, portfolio flexibility is paramount, and we believe that investors may benefit from prioritizing income while managing risk. Investors may be able to strike this balance in areas like securitized credit, where relative valuations remain attractive, demand is increasing, and risk-adjusted carry continues to be strong, in our view.
Source: Barclays and Goldman Sachs Asset Management.
Confronting Uncertainty: The dynamic in today’s fixed income environment, characterized by fluctuating rate volatility and historically tight spreads, underscores the structural advantages of employing an active approach, particularly one that can be flexible, utilizing cross-sectional positioning to potentially optimize geographic and sector exposures. Over the past five years, +48% of active fixed income managers have outperformed their passive counterparts, with a significant proportion of outperformers doing so with lower volatility. With less restrictive monetary policy on the medium-term horizon, investors looking to capture additional income, diversify their portfolios, and reduce duration risk, may benefit from utilizing an active multi-sector strategy.
Source: Morningstar and Goldman Sachs Asset Management.
As of May 31, 2024. “US 3m Treasury” refers to a 3 Month US Treasury Bill index. “US ABS” refers a US Asset Backed Security index. “US MBS” refers to a US Mortgage Backed Security index. “US 10yr Treasury” refers to a 10 Year US Treasury Note index. “US HY Corp” refers to a US High Yield Corporate Bond index. “US IG Corp” refers to a US Investment Grade Bond index. Please see additional disclosures at the end of this page. Diversification does not protect an investor from market risk and does not ensure a profit. Past performance does not predict future returns and does not guarantee future results, which may vary. There is no guarantee that objectives will be met. For illustrative purposes only.
Private Credit
Financing Flexibility: As interest rates have remained higher for longer and economic growth has slowed, companies who have tapped private markets for debt financing may become more burdened by the floating rate structure of their outstanding debt. Fortunately, this concern can be addressed through flexible loan features offered to borrowers via private credit. Lenders often boast deep access to company records and a bilateral relationship with their borrowers, affording them the potential to recognize early signs of distress and quickly implement workouts such as pricing amendments, sponsor infusions, and pay-in-kind structures to avoid a covenant breach before it occurs. As such, default rates of private companies have remained around 2%, while those across the leveraged loan market have trended beyond 6%.
Source: Proskauer, GS Global Investment Research, and Goldman Sachs Asset Management.
Loyalty Points: The floating rate structure of loans provided by private lenders may be a concern as central bank rate cuts appear to be on the horizon, in our view. With that said, attractive yield spreads, upwards of 800bps in recent years, have kept return targets competitive. Even if falling rates amplify the incentive for public debt, demand for private credit may remain relatively inelastic due to the pricing certainty, flexible loan structures, and close lender relationships offered to borrowers. In past periods leading up to Federal Reserve rate cuts, private credit provided annual outperformance of 330bps relative to high yield bonds and 670bps relative to the leveraged loan market. Resilient performance before and after interest rate cuts demonstrates the attractiveness of the asset class despite its floating rate nature.
Source: Cliffwater, Bloomberg, and Goldman Sachs Asset Management.
As of June 11, 2024. Top Right Section Notes: As of March 31, 2024. Chart shows the default rates of private companies broken in to $25mm --$49mm and >$50mm EBITDA, compared to default rates of public companies in the leveraged loan market. “EBITDA” refers to earnings before interest, taxes, depreciation and amortization. Bottom Section Notes: As of June 1 0, 2024. Bottom Right Chart shows the median 12 Month forward returns of different loan markets beginning from 3 months prior to Fed rate cuts. Yield spreads upwards of 800bps refers to the spread over the floating rate base of private loans . Please see additional disclosures at the end of this page. Past performance does not predict future returns and does not guarantee future results, which may vary. There is no guarantee that objectives will be met. For illustrative purposes only.
