Goldman Sachs Group Inc is already preparing for 2017. In a note to clients, a team led by Chief Credit Strategist Charles Himmelberg released its Top 10 market themes for next year.
“High growth, higher risk, slightly higher returns,” is how the strategists view the year ahead — and it’s clear that their outlook has been heavily influenced by the pending regime change in Washington, D.C. Here’s a brief summary of each of the ten themes Goldman sees as forming the backdrop for investing in 2017.
Expected returns: only slightly higher
Relative to its 2016 forecasts, the team says owners of financial assets can reasonably able to expect more upside — but stress that these returns will still likely remain low. “The best improvement in the opportunity in global equities is in Asia ex-Japan, where we forecast returns of 12.5 per cent (versus 3.8 per cent for 2016),” the strategists write.
“At the other end of the equity spectrum, in Japan we are forecasting declines of -3.7 per cent on the Topix (versus 5.2 per cent for 2016).”
US fiscal policy: a pro-growth agenda
President-elect Donald Trump’s focus on infrastructure spending during his victory speech — rather than trade protectionism or immigration restrictions — catalysed the risk-on sentiment that’s pervaded markets, according to Himmelberg.
“Markets are starved for growth. This is plainly visible in the eagerness with which markets seized on Trump’s growth-focused message,” he writes. “It is also visible in the speed with which the market’s narrative on the economic outlook under Trump has shifted from ‘uncertainty’ to ‘growth’.”
Fiscal stimulus in the US will help reflate the economy, and stands a good chance of passing through Congress, the team reckons.
US trade policy: concerns are likely overdone
Goldman doesn’t see an imminent trade war on the horizon, and expects any renegotiation of agreements currently in place (like NAFTA) to focus on attempts to improve the prospects for the US manufacturing sector.
“We think the popular media narrative on the downside risk of a trade war is overstated,” the strategist writes. “Our tentative view is that Trump’s use of punitive tariffs will be just as pragmatic as President Obama’s, albeit more vocal.”
Emerging markets risk: ‘Trump tantrum’ is temporary
Emerging market assets have been crushed since the election, as the rise in Treasury yields has reduced the need to reach for yield overseas, and the potential for protectionist trade policies threatens to curtail growth opportunities.
Investors are voting with their feet, heading out of EM equity and bond exchange-traded funds in droves. But Goldman doesn’t see a continuation of the EM rout as a theme for the year ahead.
“We have consistently found that when stronger US growth accompanies higher US rates, EM assets can prosper, especially EM equities and spreads,” writes Himmelberg.
Trump and trade: hedge with RMB
The president-elect has blasted China as a currency manipulator. Lately, Beijing has done more to keep its currency artificially high than weaken it, using its hoard of foreign reserves to defend the yuan. Managed depreciation has been the order of the day for the Chinese yuan: the surprise devaluation in August 2015 roiled financial markets, and Goldman’s team expects this to continue in 2017.
“Our forecasts ($/CNY at 7.30 in 12 months) call for a depreciation that is well beyond forward market pricing, thereby implying positive gains even accounting for the negative carry,” the strategist writes. “And beyond the usual reasons for wanting to hedge exposure to ‘China risk,’ we think it will also hedge the risk of a ‘Trump trade tantrum’.”
Monetary policy: focusing the toolkit on credit creation
To Goldman, the Bank of Japan’s move to yield curve control is the canary in the coal mine for a new swath of policy innovations “that target the intermediary cost of supplying short-term bank credit rather than the market cost of borrowing via long-term public debt.”
Focusing on that element of the transmission mechanism and moving towards measures like “funding for lending” schemes, they argue, is what will have the most impact on real economic activity, chiefly investment.
Better-targeted monetary stimulus could help avoid some negative side effects associated with quantitative easing and negative rates that inhibit credit creation, Goldman argues.
Corporate revenue growth recession: signs of inflection
For years, S&P 500 companies have exceeded analysts’ expectations on the bottom-line more often than the top line during quarterly earnings seasons, as a combination of cost-cutting and shrinking share count, rather than soaring sales, fuelled the growth in earnings per share.
However, the strategists “expect 2017 to confirm that the US corporate sector has emerged from its recent ‘revenue recession’.”
A firming global economy and recovery in oil prices from their February lows significantly buoys the outlook for revenue growth stateside. “For 2017, our US Portfolio Strategy team expects that modest improvements in the macroeconomic backdrop will help lift S&P 500 operating EPS by 10 per cent to $116 and they have a year-end S&P 500 target of 2200,” writes Himmelberg.
Inflation: moving higher across developed markets
Market-based measures of inflation expectations in the US have spiked since the election, as traders bet that Donald Trump will be the inflation president.
“What seems clear to us, as argued above, is that economic issues, notably tax cuts, infrastructure spending and defence spending, are high on the agenda — a recipe for reflation,” writes Goldman’s team. “We are forecasting large boosts to public spending in Japan, China, the US, and Europe, which should fuel inflationary pressures in those economies.”
The strategists think central bankers in developed nations will be willing to tolerate an overshoot in inflation should that arise, since price pressures have been below their targets for an extended period of time.
The next credit cycle: kinder and gentler
While commodity-sensitive segments of the credit market have suffered pain in 2016, there hasn’t been much in the way of contagion. Goldman’s team expects more of the same in 2017, with the credit cycle not making a turn for the worse.
“Regardless of the state of balance sheet fundamentals, recessions lead to a meaningful acceleration in defaults while expansions keep defaults low. We expect the same playbook in this cycle,” they write. “The strong ‘business cycle’ component in the behaviour of high yield defaults, and our view that US recession risk remains low in 2017, leave us comfortable with the view that the inflection point is unlikely to materialise next year, despite the weak state of corporate balance-sheets.”
The ‘Yellen Call’ 2.0: now with ‘contingent knock-in’
At this time last year, Goldman’s team argued that conventional wisdom surrounding the Federal Reserve — that it would work to keep financial assets aloft by easing policy in response to any market turbulence — was moving in the opposite direction. Now, an easing of financial conditions would enable the central bank to withdraw policy more expeditiously, ultimately capping the valuation of financial assets.
“For 2017, this intuition seems as relevant as ever, especially given that President-elect Trump has promised a material fiscal stimulus,” writes Himmelberg. “A ‘contingent knock-in’ has been added to the ‘Yellen Call’ — that is, conditional on a large fiscal stimulus in 2017, the FOMC will be obliged to respond more aggressively to an easing of financial conditions, all else equal.”
However, Goldman cautions that it’s no sure bet that financial conditions will ease in the year ahead, noting the recent rise in bond yields and the US dollar.
