After numerous warnings from Goldman strategist David Kostin that stocks are expensive, most recently over the weekend when he wrote that "investors will soon capitulate on their expectation of upside to 2017 EPS forecasts as they face the reality that the accretive impact from tax reform will not occur until 2018" and that "revisions to consensus EPS forecasts during the past few months have been negative for both 2017 and 2018" moments ago Goldman officially downagred equities.
Warning that as a result of rising drawdown risk, a function of the "interplay of the cycle and rates", with "growth momentum nearing its peak and rates increasing further with a hawkish Fed, the asymmetry for equities is turning increasingly negative."
This also means more vulnerability to potential shocks, e.g., from European politics, US policy, commodities and China. The increase in risk appetite in recent months and strong positioning by systematic investors such as CTAs and risk parity funds increases ‘vol of vol’ risk, i.e., the potential for a sharp correction.
As a result, "given the asymmetry for equities is getting worse, we downgrade equities to Neutral for 3m. Nonetheless, after what Goldman believes will be an initial flush, stocks will rebound again, and as a result "we remain Overweight for 12m and still see c.5% total return, which is high compared to other assets."
Here are the highlights from the just released report:
Equity drawdown risk – is the trend still your friend?
- Equities had strong risk-adjusted returns in the last 12 n months, trending up with low volatility. The S&P 500 has now increased for more than a year without a 10% drawdown and has had 67 consecutive trading days with 1-month realised volatility below 10%. In fact realised 1-month S&P 500 volatility is at 6.83%, which is the 7th percentile since 1928.
- Equity valuations are at their cycle highs and nearing Tech Bubble levels but realised volatility is close to multi-year lows. Investors are increasingly wondering how long this gap can last and if equities will continue their low volatility uptrend. High equity valuations alone are not a reason for drawdowns in the short term, if they reflect stable or improving macro conditions; but they indicate elevated drawdown risk. Current low volatility signals a strong macro backdrop and little reason to worry – but volatility is often a lagging signal.
- Risk appetite has picked up again after moderating at the beginning of the year from very high levels in mid-December (Exhibit 1). In our last GOAL report we argued that bullish sentiment and positioning did not have to signal a near-term pullback was imminent, as long as there are no major disappointments. Since then equities have rallied as global growth has accelerated further and several macro indicators have reached new cycle highs (e.g., US jobless claims recently fell to 44-year lows, our global leading indicator (GLI) accelerated to a new 6-year high and our current activity indicator points to global growth of 4%). Macro data has also remained positive relative to expectations, as indicated by our global macro surprise index (MAP) being near a 6-year high as well. The strong performance of the S&P 500 has been closely linked to macro surprises, with it somewhat lagging the better data YTD.
- Worse asymmetry for equities – interplay of growth and rates key. However, after the ‘reflation rally’ in the last 12 months the question is if equities can go further, given returns have been primarily driven by valuation as opposed to earnings growth, valuation are even more elevated and the economy is moving more late cycle. Higher valuations increase equity drawdown risk. Current low volatility still signals a strong macro backdrop but it is often a lagging signal. The interplay of growth and rates is key to support equity valuations from here – a slowing cycle makes equities more vulnerable to higher rates and also shocks, e.g. from European politics, US policy, commodities or China. Rising rates do not have to weigh on valuations as long as they are accompanied by better growth and more optimism. However, equity/bond correlations are likely to turn positive if rates move too high too fast, e.g., in the event of a policy shock
- We continue to see more potential for repricing of the Fed rate hike cycle. Better growth and higher inflation are likely met with increasing hawkishness from the Fed and this might in turn weigh on sentiment (see Global Markets Daily: Sentiment at risk from a hawkish hike, March 14, 2017). Our Economists expect the three rates hikes in 2017 to come in March, June and September meetings (vs. March, September and December previously) and expect a tapered balance sheet normalisation to begin in 4Q17 vs. 2H18 previously. Fears of an unwind of the Fed balance sheet and changes to the ECB and BOJ’s policies on QE and negative rates could put further upward pressure on longer-dated yields, in particular real yields. It is much easier for equities to digest a repricing of rates through breakeven inflation from very low levels than a sustained increase in real yields, which could weigh more on valuations. While global growth continues to be strong we already see early indications of the peak in growth momentum, especially outside the US. For DM new data surprises relative to our CAI suggest it is slowing.
- Downgrade equities to Neutral 3m - remain pro-risk for 12m. Given the asymmetry for equities is getting worse, we downgrade equities to Neutral for 3m; we remain Overweight for 12m as we still forecast c.5% total returns in local currency, c.2% in USD, which is high compared to other assets. There is also potential for some relief rally in the event of a market-friendly outcome in the French elections, especially for European equities. With current low volatility we recommend investors replace equity positions with calls (for details see the trade section below). Within equities we move to Neutral across regions over 3m as dispersion of return forecasts is low and over 12m Overweight all regions besides the S&P 500, which stays Underweight. While rising US rates should benefit Europe and Japan (also as a result of weaker FX) they should become a headwind in the US, where valuations are highest. We upgrade MXAPJ given growth momentum is strong and relatively low valuations. Trump protectionism, rising rates and slowing China data are risks but strong growth in the region should be able to digest these.
- Big trees fall hard - high valuations usually mean larger drawdowns. High equity valuations indicate poor asymmetry of LT returns and increase latent risk and the potential size of a drawdown. Exhibit 21 shows that from high levels of valuation equity drawdowns are usually larger over the subsequent 3-5 years. From very low levels of valuation there is usually good asymmetry as equities have likely been through a bear market and are recovering – if equity valuations are in the bottom quartile, the maximum drawdown over the coming years tends to be lower. However, again results for near-term drawdown risk are more mixed; e.g., over 3-12 months, high valuations had poor predictive power for drawdowns.
- Owing to the different valuation regimes and cycles since 1928 the relationship is not perfect. The bursting of the Tech Bubble led to a smaller drawdown than the Great Depression despite starting at a higher valuation. Also, in the stagflation of the 80s equity valuations stayed very low for long periods, and while this turned out to be a buying signal eventually, equities had several large drawdowns before that point.
It still remains to be seen just how big the upcoming drawdown - from the current near all-time-high valuations - will be...