Reflation has been seen as the gold standard for whether the U.S. economy is in recovery mode, and most analysts expect it to heat up as the year goes on. Oil prices have been a hot topic as well, and it’s easy to see why because they’ve been closely correlated with most risky assets as well. In fact, cross-asset correlations in general have been quite high this year so far.

Cross-asset correlations to remain high

Goldman Sachs analyst Christian Mueller-Glissmann and team note that oil prices rallied, partially due to relief in China and the weakening of the U.S. dollar following the Fed’s dovish comments after its meeting. However, they warn that the recent rally might defeat itself as oil supply may be cut and prices remain at the high end of their $25 to $45 per barrel projection for this year. They expect the second quarter to bring continued volatility in oil prices.

When the second half of the year arrives, they expect reflation will continue to continue being one of the most important cross-asset drivers as reflation has already begun in the U.S. They believe oil prices will finally stabilize toward the end of this year, which they suggest could reduce the cross-asset correlations they’ve noted with oil prices.

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However, they caution that equities could have a difficult time breaking out of their “fat and flat” range because stock prices have become elevated and the growth and inflation mix is worse than expected.

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Looking across the major asset classes, they prefer credit because they believe it’s “already discounting a poor growth outlook and credit spreads could help buffer higher yields, especially in US HY credit.”

Cash upgraded to Overweight

The Goldman Sachs team has upgraded cash to Overweight over three months as cash should help investors benefit from the high volatility that has been observed this year and that they expect to continue. They note that because of the high correlations across assets, it’s become extremely difficult to diversify. In a similar way, they said diversifying rate shock risk is difficult as well.

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As a result, they suggest a “portfolio of DM risk-off currencies” and continue to prefer the U.S. dollar even though the Fed remains dovish. They also suggest hedging for lower oil prices and “other event risk” in the second quarter.

They’re still Underweight commodities over three months and Neutral over 12 months as they expect the asset will become more attractive as the market makes adjustments to supply. But until those adjustments occur, they see a risk for the rally to defeat itself because cuts in supply could be delayed.

Focusing on reflation in the U.S.

The Goldman team notes that the closer the correlation between risky assets and oil prices has become, the greater the concerns about deflation and “secular stagnation” have become. This is especially true since the disappointments in both growth and inflation following the GFC. They note that since 2013, consensus estimates for inflation in the G7 have been pushed sharply lower along with expectations for growth and oil prices. They said that the current levels indicate that there’s a very poor macroeconomic outlook for risky assets especially.

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Over the long term, they said expectations for inflation have tumbled along with oil prices as both the 10-year breakeven inflation forecast for the U.S. and the survey from the University of Michigan have dropped. In order to relieve the pessimism about inflation and growth and help weaken the correlations with oil prices, the Goldman team thinks sustained reflation and growth in the U.S.—possibly in Europe and Japan as well—must occur.

They note that falling expectations for inflation run counter to the data suggesting that reflation is occurring in the U.S. They go further by suggesting that even though the data continues to improve, there’s a risk that there could be yet another growth and deflation scare as a result of sharp declines in oil prices and possible shocks from various directions, particularly in Europe or the U.S. China growth and currency devaluation also remain concerns.