Goldman Sachs Portfolio Strategy Research’s “US Weekly Kickstart” of March 28th highlighted how the flattening of the yield curve led to a major change in investor sentiment last week, and resulted in one of the largest weekly losses for hedge funds since 2001. A proprietary index serving as a proxy for long-short hedge fund performance developed by Goldman Sachs was down more than 3% last week.

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GS analysts David J. Kostin et al. offer an overview of their projections for the next few quarters. “Our rates strategists expect the curve to flatten further in 2Q but over the medium term both higher rates and a flatter curve are positive for equity performance. We expect a Rate Sensitive portfolio of stocks <GSTHUSTY> to outperform the S&P 500 (INDEXSP:.INX) and for cyclical areas to outperform defensives as growth improves and interest rates rise.”

Hedge fund: Hump-shaped yield curve

The GS analysts argue the Fed will continue to taper very gradually, with no increase in the fed funds rate until early 2016. This will cause the yield curve to assume the classic bell-curve shape. “Our interest rate strategists continue to think the front end of the US Treasury curve will move higher during 2Q as US economic activity rebounds. They expect the US yield curve to become more “hump shaped” as the fed funds rate remains unchanged until early 2016 while longer dated yields are more fairly priced. This outlook suggests that equity investors should follow a “flattening” rather than the “rising” playbook from the past 12 months.”

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Hedge fund: Remain bullish on earnings and equities

Kostin and colleagues do not see the see a gradually increasing interest rate scenario as a problem. In fact, they are forecasting strong earnings growth for the next couple of years.  “Our top-down EPS forecasts of $116 and $125 for 2014 and 2015 both reflect 8% growth. Bottom-up consensus forecasts a 9% increase in 2014 to $118, and 11% increase in 2015 to $131.”

Given that greater earnings typically lead to higher share prices, it’s not surprising that Goldman is also bullish on equities, and is projecting 2015 as a very strong year for the S&P 500. “With the close of 1Q we roll forward our 12-month S&P 500 (INDEXSP:.INX) price target to 1950 in 1Q 2015. Our 2014 year-end price target remains 1900, 3% above current levels, and our year-end 2015 target remains unchanged at 2100.”

As mentioned above, over the short term, GS expects rate-sensitive stocks to continue to outperform.