Goldman Sachs Asset Management 2018 Investment Outlook

Weathering Heights

• We expect the global expansion to continue through 2018 though at a moderating pace
• This would make US expansion the 2^nd longest on record and closing in fast on the record-long expansion in the 1990s
• Continue to prefer equities over credit and credit over rates
• Our read of the economic data suggests that economic and market cycle has yet to fully mature
• We are now about a month away from the S&P 500 breaking a 66-year record of the longest stretch without a drawdown of at least 5%
• Even though we expect new peaks from here, pace of return is likely to be much more moderate; also expect meaningful drawdowns along the way
• Risk 1: A moderation in the pace of global expansion
  • Would not position for this moderation before more tangible signs show up in data but we do anticipate that slower growth will be accompanied by higher volatility
  • Emerging Markets, outside of China, are a bright spot and we expect EM economies to outperform in 2018
• Risk 2: Central bank tightening starting to matter
  • We believe the Fed will need to continue to tighten policy to avoid more serious overheating
  • In Europe, QE is likely to provide ongoing support for the economy but we would expect the very long-end of the curve to continue to rise
  • Bearish on duration and see government bonds as the most misvalued asset
  • Analysis suggests that equity markets should be able to withstand 10-year US yields rising to around 3% without triggering a more sustained sell-off
• Risk 3: China fears
  • Continue to believe that China can avoid a hard landing in the next few years but a moderation in policy support following the recent Party Congress is more likely than not
  • If less favorable external environment were to cause a moderation in growth, perception could quickly swing again, exposing still large debt levels and an expanding fiscal deficit
• Other risks: Geopolitics, Trump policies and upside surprises

Macro Outlook Summary

• Growth: Expect the global expansion to continue but at a moderate pace; in the US, this is due to a lack of spare capacity; in Europe, the monetary and fiscal factors supporting growth are becoming less powerful and, in China, policymakers might rebalance their focus somewhat away from growth and towards addressing imbalances after the 2017 party congress; EM economies are a bright spot and we expect the EM vs DM growth gap to continue to widen
• Inflation: We think the main impact of inflation on asset prices will run through monetary policy and given the tightness of the US labor market, we think the inflation bar is fairly low for policy tightening to continue; in Europe, we expect inflation to be more muted
• Monetary policy: Expect the tightening of monetary policy to start to matter in 2018; expect the main impact to come through a significantly faster pace of Fed hiking than the market is expecting; this will lead to pressures on bonds and there is significant risk that it could be a source of temporary broader market volatility
• Politics: Expectations for Trump’s ability to implement his policies are so low that we think there is room for surprises; deterioration in US trade policy is a risk; North Korea and geopolitical risks more broadly remain a factor but are not something we would position for at this point; in Europe, we expect Brexit to have muted spillovers to the Eurozone

Investment Themes

• US is at risk of overheating from easy financial conditions
  • Since 1970, US unemployment rate has only been below the current level of 4.1% for 11 months, or less than 2% of the time
  • Whereas improvements in the labor market typically flatten out towards the end of the cycle, they have accelerated in 2017
  • So far, we see no signs of a slowdown but think that is very likely to happen in 2018 due to more forceful tightening by the Fed, external events or unpredictable shocks
• Whereas tighter financial conditions in Europe could slow growth
  • Financial conditions have tightened somewhat due to the appreciation in euro and the rise in longer-term interest rates
  • Growth is likely to remain strong enough for unemployment rate to continue falling but pace of growth likely to moderate in 2018
• Imbalances remain the main concern in China
  • Imbalances are large and even though the build-up in debt has eased in 2017, the IMF’s measure of the augmented fiscal deficit has continued to widen
  • China’s economic policy needs to gradually shift its focus from growth to lowering imbalances
  • Rebalancing would be good for the long term but weaker data out of China is likely to be a source of market volatility in the near term
• Government bonds are the misvalued asset
  • Since early 2016, we see the Fed as being behind the curve. As a result, we are bearish on bonds and think a sell-off could arise as the Fed hikes faster than the market expects
  • Bonds could also come under pressure if the market starts to require an unusually high risk premium for longer maturities given the risk of inflation in an environment of unusually easy monetary policy and a tight labor market
• Credit spreads in line with the macro environment
  • Corporate credit spreads are low but broadly consistent with strong fundamentals
  • Risk is that we are approaching the point in the cycle when fundamental support for credit spreads have historically started to turn
• Equities on the cheap side
  • On an absolute basis, equity valuations are high, particularly in the US
  • However, we estimate that equities are on the cheap side relative to macro conditions
  • Current levels of S&P 500 and 10-year yield imply a large equity risk premium compared to the average level; we expect this gap to close mostly due to higher bond yields, with room for 10-year yields to rise to around 3% without the need for a sustained equity sell-off
• Limited impact of the wind down in QE with rate changes being the main story and the market impact temporary outside of bonds
  • Flow of central bank asset purchases has already peaked and the stock of assets on central bank balance sheets will likely peak in 2018
  • Our main concern has been Italy where a combination of 1) internal political challenges, 2) reduced ECB buying of Italian bonds and 3) questions around long-term debt sustainability could drive Italian bond yields higher
  • ECB is now set to continue QE through at least September and Italy has decided on a new electoral law that should limit the impact of anti-establishment parties
  • Even if the QE wind down has limited impact, the US needs tighter financial conditions to avoid a more dangerous level of overheating
    • We believe the Fed will eventually hike policy rates enough to generate that outcome
  • Market expectations for rate hikes are unrealistically low in our view and we think the risk of broader market volatility due to a faster-than-expected pace of rate hikes is high
  • Outside of bonds, impact of more tightening in the US than elsewhere is most likely to be felt in currencies
  • With the US economy at or near full capacity, we expect inflation to resume its upward trend in 2018
  • Over the longer term, we think the market impact of Fed rate hikes will be limited to higher bond yields
  • Dollar strength versus other DM currencies could last longer but even this should eventually mean-revert as the ECB moves towards the exit and the Bank of Japan eventually does the same
• Disrupting now: Retailers…how to survive in the Amazon
  • Believe retailers will need to focus on building omni-channels and in-store customer experiences as prerequisites for survival while pursuing a differentiated supply chain and scaling advantages in order to thrive
• Next up in 2018: Consumer staples…the next shoe to drop
  • Consumer staples are likely to be the next target of e-commerce disintermediation
  • E-commerce has changed consumption patterns by creating an online “endless shelf” to foster niche brands; in addition, e-commerce is spawning growth in private labels through voice-assisted devices as well as mining proprietary data to draw traffic, removing the consumer data advantage of traditional players
  • Number of Smart Homes is expected to double in North America and triple in Europe between 2016 and 2019, helping to propel the velocity of digitalizing and collecting consumer information
• In the next decade: Autos…the next Retail?
  • The 5% new sales penetration rate of electric vehicles matches that of Retail e-commerce in 2007, and IHS Markit forecasts it to increase to 35% by 2030
  • Over the next 10 years, growth of hybrid and electric vehicles could unleash a wave of disruption across the auto and industrial markets, similar to what e-commerce did in the consumer sector in the last 10 years
  • “Pure plays” are pricing in extremely high valuations even under a blue sky scenario and we see more value in downstream parts, such as semiconductors and automation components
• On the horizon: Emerging Technology in Emerging Markets
  • Lack of incumbent technology and infrastructure in many EM countries has reduced any barrier to disruption
  • With 86% of the world’s millennials residing in the EM world, the subsequently higher e-commerce penetration rates in EM have created opportunities across the supply-chain

Investment Strategy – Equities

• In the US, we believe small cap companies are well positioned to benefit from domestically-oriented and pro-growth policy, and could see a boost should there be further progress on tax reform given their higher effective corporate tax rates compared to larger cap companies
• Value-oriented sectors have the potential to outperform in periods of economic recovery, while trading at a significant discount to growth sectors
• We also like companies that invest in their future growth through capex and R&D, rather than focusing on shareholder returns
• We believe the focus on disruption in the retail sector has led the market to become overly pessimistic on retail real estate whose performance has significantly lagged other REIT sectors in 2017 due to market discounting without regard to quality
• We are especially constructive on EM equities, where the macroeconomic fundamentals are supportive and valuations are attractive
• EM economic growth premium to DM continues to widen and the recovery is broad-based across EM countries
• We are also positive on Japanese equities, where corporate fundamentals have been recovering over the last 20 years, as evidenced by high cash levels, low debt levels, improving profit margins and a rising return on equity
  • Corporate governance reforms are also resulting in more shareholder friendly actions
  • Despite improving fundamentals, valuations remain attractive relative to other DM equities and their price-to-book ratio is cheapest relative to the US since the GFC

Investment Strategy – Fixed Income

• Neutral on spread risk, focused on relative value across rates and currencies
• Central bank policies: converging in direction, diverging in pace
  • Inflation remains low considering current unemployment and growth rates, although transitory factors have contributed to positive inflation surprises in Europe and negative surprises in US inflation
  • Unemployment rate for DM countries is nearing pre-crisis levels
  • We still expect the Fed to lead in its hiking cycle, but as more economies are faced with tight labor markets and risk of overheating, we expect to see more central banks prepare for, kick-start or re-start their rate hiking cycles
  • This creates relative value opportunities across developed government bond and currency markets
• Corporate credit: tighter spreads, less upside potential
  • Mix of healthy growth, low inflation, revived commodity prices and contained volatility has compressed corporate credit spreads to multi-year tights
  • In 2018, think these supportive factors are likely to fade somewhat and give way to concerns around high levels of leverage, low levels of interest coverage and extended valuations
  • Tax reform remains a tentative tailwind but insufficient to sway our cautious view on credit at this stage
• Exposure to assets geared to growth still makes sense
  • Global growth environment, real rate differentials and relative valuations continue to favor exposure to EM currencies versus the dollar
  • Fundamentals have improved in many EM countries, as reflected by a decline in current account deficits
  • While we expect Chinese growth to moderate, we expect some offset from improving growth in commodity-oriented EM countries

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