Having pointed out the gathering storm in VIX ETPs, raised concerns of a "reasonably high probability" of a large drop in stocks, and explained how complacently short-term risk is being priced, Goldman's portfolio strategy team have unleashed a dramatic warning. Shifting to an oveweight cash position for the next 3 months, Goldman warns "we downgrade equities to Neutral over 12 months on growth and valuation concerns. Until we see sustained earnings growth, equities do not look attractive, especially on a risk-adjusted basis."
Markets have been calmer and cross-asset correlations with oil have fallen since our last GOAL on March 21. Declines in bond yields, owing to a continued dovish Fed, a weaker dollar and stronger commodity prices, have been the key cross-asset moves. This has lifted bond and credit returns, but equities have not benefited much.
Global earnings growth revisions have been negative and equity valuations remain high, with the equity risk premium a less useful predictor of returns owing to uncertainty over trend growth and normalisation of bond yields. We stick with our ‘fat and flat’ view for equities. After the rebound from the trough on February 11, and with the S&P 500 at the upper end of its recent range, we downgrade equities to Neutral over a 12-month horizon, in line with our 3-month view.
Until we see sustained signals of growth recovery, we do not feel comfortable taking equity risk, particularly as valuations are near peak levels.
Our equity strategists have become more defensive, owing to heightened drawdown risk and growth scarcity. While we see some upside to equities in local currency (particularly Japan), we expect the dollar to strengthen, resulting in poor USD returns over the next 12 months (Exhibit 1).
We prefer to implement the divergence theme via FX rather than equities; equities are generally more volatile than FX and, while the equity/FX correlation for Europe and Japan remains negative, it has increased recently (Exhibit 2).
For Europe, equity/FX correlations could become even less negative as political risks in Europe intensify.
We also move to Neutral across equity regions on a 12- month basis (in line with our 3-month basis) alongside these effects.
Risks abound, OW cash allocation still appears sound
- Given we do not see much value across asset classes and we see a variety of cross-asset risks, we remain Overweight cash near term.
- We believe the market’s dovish pricing of the Fed increases rate shock risk, in which case both equity and bonds could sell off.
- We are also not convinced the EM rally is sustainable, which could weigh on commodities, in particular metals.
- China growth concerns could also come back into focus, as we think the support from policy will fade during 2H2016.
- Finally, we continue to see elevated European political risk with uncertainty around the UK’s upcoming EU referendum.
Lost and found: Five conviction themes for a ‘fat and flat’ market
We highlight five conviction cross-asset themes for this volatile but trendless market. Generally, our focus is shifting to carry strategies across assets and relative value opportunities. We continue to prefer credit to equity, despite the strong rally in credit, with the potential for further spread compression high, in our view. We see some attractive carry opportunities in EM FX, credit and dividends. The main remaining directional conviction view we have is a continued upward trend in US inflation; once this trend becomes more established, we think there is potential for sector and style rotation within equities. On the relative value side, we continue to favour oil vs. metals in equity and credit.
This 'asset allocation' call from Goldman confirms their colleague David Kostin's warnings:
He also hinted that with 80% of fund managers underperforming their benchmark, the probability of irrational capital allocations increases, and as a result there is a "reasonably high probability" of a large drop (or "drawdown" as a sudden plunge is called in polite circles) in the S&P500 ahead of his year-end 2100 price target.
Of course, while we tend to agree with Goldman, one glance at the following "pessimistic" chart explains...