The summer Goldilocks rally has reversed, bringing with it an odd bond and stock market correlation, a Goldman Sachs report noted. As a result, risk parity funds were hard hit and, with bond prices potentially rising into the year end, the long end of the yield curve could see more pressure while the short end will continue to be “anchored” by central banks. Goldman’s September 15 Portfolio Strategy Report called for raising cash but at the same time upgraded stocks slightly.
Goldman – Watch out for shocks as stocks upgraded on “less negative returns”
Due to “risk of shocks” Goldman recommends remaining defensive and advocates an overweight position in cash. “We still prefer credit to equity due to better asymmetry of returns,” the report said, pointing to better upside potential for credit than stocks.
With the bias towards credit, the report from Christian Mueller-Glissmann, Ian Wright, Alessio Rizzi and Peter Oppenheimer nonetheless moved higher its equities rating. Equities were upgraded to Neutral on the basis of optimism regarding fiscal easing and long-term growth expectations.
On the basis of Goldman’s equity strategists now forecasting “less negative returns,” the overall portfolio recommendation is expecting “fat and flat” performance. “Risks are still skewed to the downside in the near-term, in our view, owing to more bullish positioning and the fading ‘Goldilocks’ backdrop.”
If you are an equity investor, the report is much like a doctor saying you no longer have terminal cancer but that malignant tumor will eventually turn negative. Just give it time.
Bonds have increased sensitivity
Much like Bridgewater Associates noting increased sensitivity in the bond market, as reported Saturday by ValueWalk, the Goldman report takes this tact as well.
“For bonds, the beta to US 10-year yields is the most negative since the mid-1990s: this is a technical effect, as in a negative rates world most bonds increasingly resemble zero-coupon bonds,” the report observed.
What might matter for investors is the rate of change in bond yields, another point made by Ray Dalio in his recent report on increasing bond market sensitivity. Dalio warned about the Fed raising too quickly and Goldman has similar concerns.
“While equity investors also fear higher rates, they are not necessarily negative for equities and risky assets more broadly; this will depend on the speed and driver of rate increases,” the report said. There are even situations where higher rates can help stocks.
With anchored inflation and low bond yields, rises in yields have tended to reflect better growth, supporting equity performance as investors lower the required equity risk premium. However, for this virtuous relationship to hold, growth needs to pick up alongside yields and rate volatility should be low. If bond yields increase too rapidly, such as during the ‘taper tantrum’ in May 2013 and the ‘Bund tantrum’ in April 2015, equities tend to struggle, at least initially.
Elevated valuations and fragility in the near term stock market headwinds
For stock investors, a headwind is likely to be “elevated valuations” with the market appearing “fragile to shocks near term.” Such shocks could emanate “from the resumption of the Fed rate hike cycle and a strong Dollar, and increasing political uncertainty into the US elections.”
Goldman is not just underweight US stocks, but European stocks remain a question mark. “Due to elevated political uncertainty (from Brexit and the Italian referendum) and uncertainty on ECB policies,” stocks could find difficulty ahead. “A ‘no’ vote in the Italian referendum (a 40% probability, in our view) could put pressure on Italian risky assets, in particular banks, and increase political uncertainty in Italy and the Euro area.”
The report was neutral on commodities, as they appear reliant on global monetary easing, a difficult probability path given the abnormally low (and negative) rates around the developed world.