gs - goal - adventures in wonderland
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Global Strategy ReportTRANSCRIPT
October 21, 2014
GOAL- Global Strategy Paper No. 16
Portfolio Strategy Research
Adventures in Wonderland Through the looking glass: Scenarios for a post-crisis world
Seven years after the start of the financial crisis, economic and financial conditions remain far from
normal. In the ‘Wonderland’ of near-zero interest rates, many of the traditional relationships that have
governed the way in which markets and cycles evolve have broken; the value of historical analysis
has weakened.
There are three main paths from here, in our view: a ‘secular stagnation’ scenario, a ‘sustained
moderation’ and a ‘normalisation’ based on a new global growth engine (driven by restructuring, the
US energy revolution and/or a major consumption shift in China). The first is broadly better for bonds
than equities, while the second is better for equities than bonds. ‘Normalisation’ would be very good
for equities and negative for bonds.
A stagnation scenario would keep bond yields lower for longer. Financials would likely underperform
alongside domestically focused companies, particularly in Europe. In a moderation scenario, we
would expect the scarcity of growth and income to drive returns. Growth stocks would likely re-rate
further, while companies with reasonable yields and dividend growth prospects should perform well.
‘Normalisation’ would be best for equities and benefit cyclicals and financials in particular.
Markets seem to be pricing in a growing probability of stagnation, particularly in Europe. Conditions
do not have to improve much to imply reasonable returns in equities. If, as we expect, growth
expectations stabilise, the perception of a ‘risky’ asset might shift to fixed income given that risk
premia are so low and yields have overshot fundamentals, in our view.
We see sustained moderation as the most likely scenario for the global market, with moderate
stagnation in Europe. Equities should continue to outperform bonds, but with much lower absolute
returns than enjoyed since 2010. This global ‘moderation’ may continue for some years. It is likely to
end as a result of either: (1) the bursting of a bond bubble as interest rates finally start to rise; or (2)
significant further valuation expansion of equities (reducing long-term returns).
Despite the recent spike, the trend of volatility is likely to remain low given macro stability and
regulation – volatility tends to be affected by recent experience, but is also related to valuations. With
low macro volatility, it is unlikely that market volatility will rise significantly and in a sustained way
until valuations become stretched.
Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.
Peter Oppenheimer
+44(20)7552-5782 [email protected] Goldman Sachs International
The Goldman Sachs Group, Inc. Global Investment Research
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Table of content
Adventures in Wonderland … Investing through the looking glass 3
Where to from here? 7
What outcomes are the markets discounting? 10
What works under different outcomes? 18
The implications of low volumes and volatility 30
Postscript: Anatomy of the crisis 32
Disclosure Appendix 37
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Adventures in Wonderland … Investing through the looking glass
“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,“ said the Cat.
“I don’t much care where –“ said Alice.
“Then it doesn’t matter which way you go,“ said the Cat.
“– so long as I get SOMEWHERE,“ Alice added as an explanation.
“Oh, you’re sure to do that,“ said the Cat, “if you only walk long enough.“
(Alice’s Adventures in Wonderland, Chapter 6, Lewis Carroll)
Alice in Wonderland was confused. In that strange world, nothing seemed to make sense.
Investors today face a similar sense of the unfamiliar. In the unusual world of zero interest
rates and low growth, many of the rules and relationships that typically drive the way in
which markets move no longer seem to apply – equity markets have often fallen alongside
lower bond yields, while some of the strongest markets have been in the areas with the
weakest activity.
Alice in Wonderland, faced with a fork in the road, couldn’t decide which route to take;
investors are facing a similar dilemma. Markets and economies have recovered a great
deal from the crisis that has overshadowed the market over the past half-decade, but it is
far from clear what the route is from here. Do we return to ‘normal’ but with the risks of
rates rising sharply, or do we not have normal growth but benefit from permanently lower
rates? Questions about what ‘normal’ really looks like, how we get there and what happens
along the way are ever more pressing as some central banks get close to monetary exit. It
is the nature of the next phase of the economic and market development that we focus on
in this paper.
The weakest of recoveries
While economic conditions have improved since the dark days of the crisis, they have done
so very slowly. From that perspective, conditions remain anything but ‘normal’. Discussions frequently revolve around the question of how this new cycle will evolve.
But the reality is that it is likely to remain very different from anything we have seen
before. The temptation to look to historical comparisons to help inform how markets
will evolve and what appropriate valuations are for assets is unlikely to be fruitful
since there are no appropriate analogies.
What makes the current world very different from the past is the combined impact of the
crisis and the regulatory changes that have followed, coupled with rapid and highly
disruptive technological developments. Seven years after the start of the crisis, growth
continues to lag previous recoveries quite sharply and deflationary forces remain ever
present. As Exhibit 1 shows, even in the US (which has been out of recession for five years),
growth is tracking below equivalent points in past economic recoveries.
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Exhibit 1: US GDP growth continues to track below equivalent points in past recoveries
Source: Haver Analytics, Goldman Sachs Global Investment Research.
For other economies, the lack of growth has been even more striking. Of course, part of the
reason that growth has been so tepid is that the economic downturn has been exacerbated
by the financial crisis. The US housing crash and credit crunch have had a bigger effect on
activity than ‘normal’ recessions, and their impact has been amplified further around the
world by the banking and sovereign crisis in Europe. But even in comparison to previous
major banking/financial crises (the ‘big 5’ historically), growth rates have been unusually
lacklustre in this cycle, particularly in Europe.
Exhibit 2: Current Euro area recovery subdued relative to other regions and history *Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992)
Source: Haver Analytics, Goldman Sachs Global Investment Research.
Rather than spending time on the economic factors that have driven such lacklustre growth,
it is the financial market developments that we are most concerned with here. Despite this
anaemic recovery, in the financial ‘Wonderland’ of close to zero interest rates, asset
prices have staged remarkable recoveries. As Exhibit 3 shows, equities globally have
generated annualised returns of around 20% since their lows in 2009, but fixed income
markets have also remained very strong. This is all the more so given the very low levels of
inflation, which mean the recoveries in real terms are very strong.
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27
1953195719601969197319801981199020012007
Index to quarter before recession
86889092949698
100102104106108110112114116
-12 -8 -4 0 4 8 12 16 20 24
Level GDPIndex
Euro area
UKUSAll OECD CountriesBig 5 Historical Banking Crises* (ave.)
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Exhibit 3: Annualised total returns for equities, bonds and credit from 2009
Source: Bloomberg, Datastream, Goldman Sachs Global Investment Research.
Ten of the best … dramatic adjustments in financial markets:
There are many examples of significant and historic shifts in pricing across asset prices
that have occurred during the past several years. Here are just a few:
"Curiouser and curiouser!"
Since the low in the global equity market on March 9, 2009, the MSCI The World index
has risen roughly 180% in total return terms, generating an annualised return of a
remarkable 20%.
2013 was one of the strongest years on record for the equity markets. The US
managed a price return of 30% and the Sharpe Ratio of the S&P 500 ranked in the 98th
percentile since 1962.
Perhaps even more striking is that bond markets have continued to perform strongly.
Since the 2009 low in equities, the JP Morgan GBI global bond index has risen 24%.
Despite the ongoing European crisis and economic stagnation, the Stoxx 600, for
example, has managed a 14% annualised return since its relative trough in 2012. In
Spain and Italy, it has been 22% and 17%, respectively.
But, given the scale of the downturn during the Great Recession, the Europe Stoxx 600
is still roughly 20% below where it was in 2000.
Profits are unlikely to revert to their 2007 levels until 2017. The FTSE 100 is still at
levels seen in 1997.
EM markets have also been weak; despite the extraordinary growth of China, the China
onshore market is still 60% below its peak in 2007.
The collapse in government bond yields has triggered a historic search for yield. A
fixed income fund with 30% US treasuries would need 50% of its assets invested below
BBB to generate a 4% return – an all-time high.
The German Bund market has an equivalent ‘P/E’ of roughly 120x and the Iboxx
corporate bond index an equivalent P/E of 65x.
Over 60% of companies in the Stoxx 600 index have a dividend yield above the iBoxx
credit yield; less than a fifth of companies used to be in this position.
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Equities Credit Government bonds
%
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What do we make of all these records? Has the market, like the famous hare in Alice’s
Wonderland, gone mad? Does it represent a series of unstable and unsustainable bubbles?
And most importantly, where can markets go from here? These are the topics we turn to next.
2015; the fork in the road
In 2012, when we wrote The Long Good Buy, the case for equities (March 21, 2012), we
argued that equity markets were entering the best prospective period of returns for a
generation. While this part of our view has worked well, our expectation that bond
yields would generally rise and result in a significant rotation of asset return leadership
away from bonds to equities has not materialised. Instead, bond yields have generally
continued falling (albeit punctuated by short-lived sell-offs). Overall, equities have
outperformed, but equities and bonds have cycled through various phases of relative
performance as investors switch between hopes of recovery and fears of
stagnation/deflation (Exhibit 4).
Exhibit 4: US equities and bond yields since 2013
Source: Datastream, Goldman Sachs Global Investment Research.
Investors continue to analyse how a recovery to historical normality might be achieved and
when it might arrive. As growth expectations pick up, bond yields tend to rise alongside
equity markets. But these periods have not been sustained. They continue to be followed
by phases when the growth cycle weakens again – we are currently in one of these phases.
Each time this happens, investors get more worried about the limits to policy support.
As Exhibit 4 shows, for example, the period from September through to the end of 2013
was marked by rising bond yields and rising equity prices (a positive correlation between
bond yields and equity prices). As 1Q14 growth disappointed, interest rate expectations
reversed and equity prices fell alongside falling bond yields (again a positive correlation
between yields and equity prices). The start of this year through to the summer
experienced a combination of gradually rising equity prices and gradually falling bond
yields, both with low volatility (a negative correlation between yields and equity prices).
The most recent stage, starting in September, takes us back to the start of the year – global
growth indicators are slowing again (with particular concerns over Europe) and bond yields
are falling alongside lower equities.
The swings in sentiment related to growth and correlation with bonds have been
sharp, but in reality very little has changed. While consensus expectations for global
growth in 2014 were 3.7% at the start of this year, they have now fallen back to
2.1
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Sep-13 Dec-13 Mar-14 Jun-14 Sep-14
S&P 500
10 year US yield (RHS)
Equities riseBond yields rise
Equities fallBond yields fall
Equities riseBond yields fall
%
Equities fall Bond yields fall as grow th expectations decline
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around 3%. This is the same growth rate achieved in 2013 and 2012. The backdrop
remains one of sub-par growth, low inflation and low interest rates.
In this context, we are now entering an important phase as investors once again question
the type of recovery that we are likely to see while markets are adjusting to valuations that
are consistent with these expectations. Views are split: some believe that lower bond yields
tell us that any recovery is going to be sub-par at best and the risks of deflation are high,
while others believe that bond and equity markets have gone too far in pricing this as the
likely outcome and see opportunities, particularly in equities. Our view fits with the
second interpretation. While growth is likely to remain weak globally, the recent price
action in both bonds and equities has priced too high a deterioration in macro
fundamentals than we think likely.
Where to from here?
In our minds, there are three very different near-term paths that economies and markets
can now follow, and that imply very different outcomes for financial markets:
Path 1 – ‘Secular Stagnation’:
Growth remains well below the previous trend and inflation and rates stay low.
Equities achieve a low return (although in areas with low valuations, it is still likely to
be reasonable in real terms). Volatility stays low.
Path 2 – ‘Great Moderation’:
Growth recovers, but is not strong enough to raise inflation pressures; technological
innovation also keeps a lid on inflation. Interest rates rise but very slowly. It is not a
‘normal’ cycle since rates inflation remains subdued, but there is at least sufficient
growth to generate profit expansion.
Equities outperform bonds. Volatility stays low. Bonds become the ‘riskier’ asset.
Path 3 – ‘Normalisation’ – a new growth engine: this is the more positive route that
markets may take. It is possible that longer-term growth is enhanced but technology keeps
a lid on inflation and the trade-off between growth and rates becomes more favourable for
risky assets. Any new strong secular drive for growth is unlikely to have an impact in the
near term, but there are various potential drivers. The stronger growth could come,
perhaps, from:
major structural reforms in places like India and Europe;
the impact of the US energy revolution; and
a significant growth driver from Chinese consumption.
In truth, the outcome may also vary by region. The US, for example, looks much more
likely to achieve a moderation than, say, Europe. Already, Europe is following a
stagnation path from an economic perspective. But even here, this need not be bad for
investors. What matters is not so much the outcome, but the outcome relative to
expectations. As we show later (see chapter titled What outcomes are the markets
discounting?), this scenario is largely priced in for Europe.
Of the three, a return to ‘normal’ – triggered by a major new growth engine – would clearly
be the most positive for equities and the most negative for bonds. But it is also the least
likely, in our view, at least in the nearer term.
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Of the other two, the moderation scenario is the more positive for equity holders in absolute
terms and, barring sharp rises in interest rates or exogenous shocks, it could still last for a
long time. It is unlikely to be very negative for bond holders while inflation stays low,
central banks remain accommodative and regulation results in many ‘non-economic’
buyers. However, there are factors, both positive and negative, that may ultimately come
into play over the next few years and could also result in quite different outcomes.
Great Moderation … leading to:
There are probably two possible medium/long-term scenarios that are likely to stem from a
Great Moderation (path 2).
Outcome 1 – Equity re-rating. A long period of stable growth and low inflation
encourages significant rises in equity valuations and, eventually, very low returns for a
long time thereafter. In this outcome, good near-term returns in equities (relative to
other asset classes) gradually push valuations up to levels that imply low long-term
returns, just as with other asset classes. The performance in equities may be enhanced
by further margin rises as technology constrains the returns to labour. While this
extends the bull market in equities, it implies that very low returns become much more
likely over the longer run.
Outcome 2 – Bond bubble bursts. Lower-for-longer inflation and accommodative
policy could push bond and credit yields down further, creating a bubble. When an
adjustment in interest rates finally happens, it may trigger a more aggressive bear
market in bonds and credit; equities could also fall sharply. The risks here are
significant given the extraordinarily low risk premia priced into fixed income
markets. Just as with equities in the late 1990s, fixed income assets have been
increasingly priced on a relative basis (against ever lower yielding government
bonds). There is a growing gap risk across fixed income – and a real danger that when
the risk-free rate adjusts, liquidity across fixed income will disappear.
Moderation is our central view
In our view, a continued moderation with low volatility and low volumes is the most
likely outcome, particularly for the US. While the probability of a stagnation outcome is
much higher in Europe (and already appears to be under way), this seems to be priced
into the markets already (see next section, What outcomes are the markets discounting?).
From a global perspective too, moderation is the more likely outcome, in our view.
Our global return forecasts are consistent with this. We expect equities to outperform
bonds as they have done since the relative lows in 2010, but to demonstrate much lower
aggregate returns moving forward.
In the following exhibit, we show for each starting year the relative total real return
between equities and bonds (using US data) for the next ten years. Using our forecast, we
can project the relative ten-year holding period from 2006. The recovery in the relative
performance of equities versus bonds looks set to continue, but we doubt that we will get
back to the large ex-post risk premia achieved in the 1950s or early 1990s.
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Exhibit 5: Annualised excess return of equities vs. bonds over 10-year holding period in US
Source: Robert Shiller Data, Bloomberg, Goldman Sachs Global Investment Research
In our view, if we are wrong in expecting the great moderation path to dominate markets
over the next year, then the next most likely outcome is probably the derailing of the
moderation path as a result of a sharper re-rating of equities as investors are gradually
forced up the yield curve.
The next most likely exit from moderation would likely come from a rise in bond yields.
While equities would likely outperform in this scenario, at least over the medium term, it
would likely trigger higher volatility and a setback in prices across the major asset classes.
The risks to the bond market here may not stem purely from higher inflation coming
through (as in 1994 for example), but perhaps from central banks being seen to be behind
the curve as forward inflation expectations rise. Anything that pushes long rates higher
may result in enhanced ‘gap risk’ heightened by a lack of liquidity. This may become
particularly strong in the credit market.
Exhibit 6 explains the possible scenarios we will see from here. A broader description of
the stages of the crisis to date can be found in the postscript at the end of this piece.
-10%
-5%
0%
5%
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25%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Annualized excess return 10-year holding periods GS returnforecasts
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Exhibit 6: The road to recovery Scenarios for the markets
Source: Goldman Sachs Global Investment Research.
What outcomes are the markets discounting?
To assess how markets are likely to perform over the medium term, it is helpful to try
to understand what kind of outcome is already priced. While there is no perfect way
of assessing this, most measures would suggest that there has been a meaningful
decline in long-term inflation and growth expectations priced into both fixed income
and equity markets. The shifts in expectations are reflected in important moves in the
market’s required return or risk premiums.
Equities remain the only major asset class continuing to offer a high risk premium.
Put another way, the rewards for taking risk in the fixed income and credit markets
are very low. Equities, meanwhile, are implying very low future growth rates under
more normalised risk premium assumptions.
Risk premia and required returns
While it is difficult to estimate what markets are discounting without making several
assumptions, a simple look at valuations and returns gives us some sense of the risk
premium that investors are being offered.
Of course, one problem with these cross-market comparisons is that we are making
comparisons with assets of varying maturity, ranging from very short on cash, five-year for
credit, ten-year for bonds and theoretically infinity for equities. Nonetheless, these
comparisons are at least consistent over history and they yield interesting results.
Financial Crisis
• Oct 2007 – Mar 2009 Phase I: US housing / banks
• Equities underperform bonds
• Feb 2011 – June 2012 Phase II: European banks / sovereign
• Equities underperform bonds
• Europe underperforms US
• May 2013 – Mar 2014 Phase III: EM
• EM underperforms DM
Option I: Secular Stagnation
• Low returns
• Equities underperform bonds
• Low volatility
• Equity valuations rise
• Bonds underperform equities
• Low volatility
• Equities rise
• Bonds fall
Option III: New Growth Engine
Leading to...
Cross Roads to Recovery
Option II: Great Moderation
• Bonds collapse
• Equities fall (low returns)
Bond Bubble Bursts
• Equities rise
• Bonds stable
Equity Re-rating
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Using the real cost of equity as a measure of expected equity returns (in Europe as an
example) suggests that this has actually remained quite stable since the financial crisis, at
around 6% per annum. What is most striking is the fall in the market’s ‘expected returns’ in
competing asset classes. For example, for government bonds, the real yield (yield minus
inflation expectations) has fallen from around 6% in the early 2000s to close to zero today
and there has been a similar shift in credit (here we use an estimate of the credit risk
premium, plus the real government bond yield). Meanwhile, the real expected return on
cash has collapsed from around 4% to -2%.
Clearly, these shifts reflect the severity of the crisis to a large extent and, of course, the
impact of monetary policy. But the reality is that the market seems to demand a stable
and high yield in equities whatever the real yield in the fixed income market. This, in
turn, is a reflection of the loss of confidence in long-term growth at the very least,
and perhaps the high probability put on a long-run stagnation scenario. This is also
reflected in the varying levels of risk premia across equity markets. For example, in the
case of the US, where growth expectations are higher, we estimate the ERP has fallen to
5.2%. By contrast, in the case of Europe, where investors remain more sceptical about
recovery prospects, the ERP is around 8.2%.
Exhibit 7: Implied real total return for equities remains high versus other asset classes in US Expected inflation based on five-year historical average; credit is BAA non-fin; cash is US Fed
Fund target
Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research.
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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Equity Credit 10y Bonds Cash
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Expectations in bonds
Looking at bonds in isolation shows a clear shift downwards in risk premia. The obvious
observation is that bond yields have fallen in many cases to record lows.
Exhibit 8: US bond yield near historic lows
Source: Robert Shiller data, Goldman Sachs Global Investment Research.
As a result of these declines, and also reflecting current strong corporate balance sheets,
credit spreads have collapsed.
Exhibit 9: Collapsing credit spreads
Source: Datastream, Goldman Sachs Global Investment Research
What is extraordinary about the movement in bond yields is the length of time for which
they have been falling and, as a result, the huge returns that they have generated. The
declines in bond yields of course did not start with the recent financial crisis and resulting
Great Recession. Yields peaked in the early 1980s alongside inflation and have been falling
ever since. While most of the declines in bond yields through the 1980s and 1990s can be
ascribed to falling inflation expectations, the more recent declines also reflect some decline
in longer-run growth expectations too.
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Barclays Investment Grade Barclays High Yield
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The persistence of the declines in bond yields has resulted in a remarkably strong bull
market, with most government bond markets delivering equity-like returns for 30 years. As
Exhibit 10 shows, total real returns in US government bonds over ten-year holding
periods were around 8% following the peak of inflation in the 1980s; while these have
faded over time, they have remained between 3% and 4% over ten-year holding
periods up to the present. This is an achievement only matched (although not for such a
prolonged timescale) by the period around the Great Depression.
Exhibit 10: Annualised real total return of US bonds over ten-year holding period
Source: Robert Shiller Data, Bloomberg, Goldman Sachs Global Investment Research.
The shifting expectations of future growth and inflation can be reflected in the market-
implied ‘neutral rate’. As Francesco Garzarelli and team have shown (Macro Rates Analyst:
The passing of the baton, September 18, 2014), expectations for the neutral rate have fallen
in both the US and Europe.
Exhibit 11: US neutral rate now at around 3.75%... Survey forecast for USD short rates 5-to-10 years in the future
Exhibit 12: …while the neutral rate of the Euro area is
between 3.0% and 3.25% GS estimate of EUR short rates 5-to-10 years into the future
based on long-run GDP and CPI Consensus forecasts
Source: Blue Chip Financial Forecasts, Goldman Sachs Global Investment Research.
Source: Consensus Economics, Goldman Sachs Global Investment Research.
-8%
-6%
-4%
-2%
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1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Annualized real return 10-year holding period
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Survey long-run neutralrate
Fitted long-run neutral rate
%
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Long-run neutral rate estimated from growthand inflation surveyFitted long-run neutral rate
%
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But equally interesting is that the decline in longer-dated bond yields in both the US and
the Euro area has been much greater than the decline in neutral rate expectations. This
term premium is measured as the difference between the 5-year 5-year US treasury yield
and survey-based expectations of three-month rates 5-10 years in the future. This fall in the
‘term premium’ has been particularly sharp in Europe and reflects the combination of weak
cyclical data (particularly in Europe), policy easing and forward guidance, but also declines
in long-run growth expectations (for further details, see Macro Rates Analyst: The passing
of the baton, September 18, 2014).
Importantly, in terms of expectations, even factoring in the downgrades to the
European economic outlook, the end-2014 ‘fair values’ for 10-year yields that we
obtain through our Sudoku model are substantially higher than what the market is
discounting. As our bond strategy team argues, all told, US 10-year Treasuries are
approaching very stretched levels relative to the macro outlook.
Exhibit 13: The US 5-year 5-year forward term premium
is close to the levels of 2004-06… Survey based, fitted survey based and Kim-wright model
estimates
Exhibit 14: …while in the Euro area, the term premium is
at historic lows GS estimate of the Euro area term premium
Source: Federal Reserve Board, Blue Chip Financial Forecasts, Goldman Sachs Global Investment Research.
Source: Consensus Economics, Goldman Sachs Global Investment Research.
Expectations in equities
Since long-term growth and inflation expectations seem to have fallen in the bond markets,
it would be logical that they have fallen in the equity markets too. But just how much have
they come down? This is a difficult question to answer with confidence because it is hard to
disaggregate the relative shifts between growth expectations and the risk premium.
For example, we can try to back out these variables from a multi-stage discount model (we
do this using GSDDM) – for details, see Strategy Espresso: What the markets are
discounting and what cyclicals are telling us, October 15, 2014. If we fix the long-run
growth rate in the model and input differing bond yields, then we can infer the required
ERP. On the other hand, we can assume that the ERP doesn’t change but the long-run
growth expectations do. This is important since it follows that if the future rate of profit
growth is lower than many models assume, then the implied equity risk premium would be
lower and the relative valuation of equities less attractive than it might at first appear.
-2
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85 90 95 00 05 10 15
Survey based TP
Fitted survey based TP
Kim & Wright TP
%
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94 96 98 00 02 04 06 08 10 12 14
Fitted 5y5y Germany term premium
%
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Goldman Sachs Global Investment Research 15
In our DDM, we are already using quite conservative assumptions about growth.
Specifically, in Europe for example, we assume 7% pa real growth in the first five years,
during which the market re-converges to average ROE. This is a particularly mild recovery
by historical standards, owing to the relatively high starting level of margins. We then
assume 2.5% real growth of profits for the next 15 years which, although in excess of trend
growth in Europe, is not excessive in our view given the exposure of European companies
to faster growing regions in the rest of the world. Both the overall compound growth rate
from current levels (3.9%) and the long-run growth rate that we use in our assumptions
(2.5%) are well below the 5.1% trend real growth rate of earnings achieved in Europe over
the past 30 years. The reason we employ these more conservative forward estimates is that
we see margins being less of a driver in the future than in the past; we estimate that
margin expansion has contributed roughly half (2.4 percentage points) of the 5.1% real
earnings growth rate over that period (see GOAL Strategy Paper No 12: Profit Pathology,
April 4, 2014). Historically, sales grew by only 2.8%, which is still above the growth
rate that we assume moving forward.
Using valuations to back out implied growth
Using our DDM methodology, we can back out implied growth assuming the risk premium
is fixed.
Exhibit 15 does just this for Europe (Stoxx 600). It shows the evolution of the future rate of
growth assuming a fixed 3.5% ERP. Despite the recent improvement, the implied real rate
of growth consistent with this level of equity risk premium remains substantially
negative (around -4%) and clearly pricing in some form of long-run stagnation, which
we think is too extreme. Of course, it may be that the risk premium never returns to the
levels seen on average historically, or that it takes a very long time to. But even if we
assume the ERP does not revert to long-run averages of around 3.5% but converges to a
long-run average of, say 5%, the market is still implying 0% pa earnings growth over
the next 20 years. The stagnation scenario, while not fully priced, does appear to be
reflected to some degree in current market valuations.
Exhibit 15: Implied rate of growth with a constant ERP in Europe
STOXX Europe 600
Source: Datastream, Goldman Sachs Global Investment Research.
-8
-6
-4
-2
0
2
4
6
8
10
90 92 94 96 98 00 02 04 06 08 10 12 14
%
Implied Growth
Historical real EPS 5.1%
0% EPS growth. Consistentwith 5.6% ERP
Implied EPS growth at 3.5% ERP
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 16
Another way of showing this is to look at the actual movements of the equity market
through this year alongside the shifts in the risk-free rate. Using our DDM, we can see what
impact the fall in the bond yield should have had on equity prices assuming the risk
premium and growth had not changed.
Since the beginning of the year, bond yields have fallen by over 100 bp in Europe – and
have also fallen in most other regions too. Using our DDM model, we can estimate that if
nothing else had changed since then, the market should be 18% higher than it is
currently, with a fair value level of almost 410. Instead, it has gone almost nowhere.
There can be only two explanations: either the ERP has risen by about 90 bp, fully
offsetting the decline in yield, or investors have offset the fall in the risk-free rate with a
decline in their assumptions about long-term growth.
We estimate that to offset the lower bond yields that we have seen (with no change
in the risk premium), growth assumptions would have needed to fall 125 bp relative
to our baseline assumption (from 2.5% real growth per annum to 1.25%). Of course,
it’s also possible that there has been a deterioration of growth expectations and a rise in
the ERP (owing to Russia/Ukraine tensions) and there are infinite combinations.
The details of these sensitivities are illustrated in the matrix below, which shows the fair
value of the market for different levels of yields and long-term growth. At the beginning of
the year, the SXXP was around 319 at the intersection of a 2.3% bond yield and 2.5% real
long-term growth expectations. All else equal, the fall in bond yields should have resulted
in a move of the fair value to the left of this sensitivity matrix. But the current value of the
market is more consistent with a level of growth that would be around zero. This would be
a radical decline compared with the historical level of earnings growth, which has been
about 5.0% per annum in real terms (partly driven by higher margins, as explained above).
Exhibit 16: Sensitivity of the fair value to growth and bond yield Stoxx Europe 600
Source: Goldman Sachs Global Investment Research.
As a further cross-check, it is interesting to look at the performance of cyclical sectors
versus more economically defensive ones. In recent weeks, cyclicals have underperformed
in most markets. In Europe, cyclicals’ relative performance leads industrial production
growth by about three to six months – the correlation between the two over the last 20
years has been around 60% with a six-month lead for equities. At the moment, the move
down in cyclical sectors implies a further deterioration in Euro area IP growth, with
the region seeing production fall by around 2%-3% year-on-year over the next few
months. Industrial output is more volatile than aggregate demand, but that is still a
significant deterioration compared with where we are now and with what our economists
forecast. Euro area IP growth is forecast by our economists to trough at -0.2% in 1Q2015
and then to rise modestly to just over 2% by 4Q2015.
Risk free rate0.6% 0.8% 1.1% 1.3% 1.6% 1.8% 2.1% 2.3% 2.6% 2.8% 3.1%
-0.3% 353 331 312 295 279 264 251 239 228 218 209
0.1% 366 343 323 305 288 273 259 247 235 225 215
0.4% 379 355 334 315 298 282 268 255 242 231 221
0.7% 393 368 346 326 308 291 276 263 250 238 228
1.0% 408 382 358 337 319 301 286 271 258 246 235
1.3% 423 396 371 349 330 311 295 280 266 254 242
1.6% 439 410 385 362 341 322 305 289 275 262 249
1.9% 455 425 399 375 353 333 315 299 284 270 257
2.2% 472 441 413 388 365 345 326 309 293 279 265
2.5% 490 458 429 402 378 357 337 319 303 288 274
2.8% 509 475 445 417 392 369 349 330 313 297 283Re
al L
ong
Te
rm G
row
th
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 17
Exhibit 17: Cyclicals already signaling a significant further downturn in industrial output Premium/(discount on 12m forward P/E and Euro area IP YoY growth
Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research.
Whatever the precise combination of declining long-run growth and rising risk premia, it is
clear that investors have priced in a much more negative long-run fundamental
backdrop, particularly for equity markets in Europe – although the same can be said,
we think, to varying degrees, across equity markets more broadly.
The requirement for equities to generate a high and stable yield even as the real yield on
competing assets falls is quite extreme by historical comparison. A very tangible way of
illustrating this is in Exhibit 18, which shows a record proportion of companies in Europe
that now have a dividend yield above the corporate bond yield.
Exhibit 18: Percentage of European companies with div. yields > corp. bond yields
Source: Datastream, Goldman Sachs Global Investment Research
-20
-15
-10
-5
0
5
10
15
20
25
-30
-25
-20
-15
-10
-5
0
5
10
15
20
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Cyclicals vs. Defensives PE
Change in IP growth vs. last year (RHS)
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
% of companies with DY>CY Average
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 18
We are not making these points to suggest that the equity market is very cheap – of course,
part of the reason these apparent anomalies exist is because bond yields are so low. In
reality, if growth does indeed improve into the future, a lower ERP would be likely offset in
part by higher bond yields. But it does suggest to us that in the case of Europe, the market
is pricing a high probability of stagnation (or worse) and investors continue to demand an
unusually high risk premium to compensate for this risk.
In the case of China and other parts of Asia, this also appears to be true. Only in the US are
valuations at a level, given how high profits are, that suggests a return to growth
‘normality’ is really priced in.
In our view, it is because the market is pricing a high probability of a stagnation outcome
that the opportunity for investors remains good in major equity markets. Economic and
profit conditions don’t need to improve much in order for equity markets to generate a
reasonable real return and one well in advance of other major competing asset classes.
What works under different outcomes?
Many of the discussions we have had recently with investors have been on the themes and
styles that should work moving forward. When the macro environment globally was poor
and Europe was in crisis, many momentum strategies worked for a long time. Just as an
underweight in banks in Japan would have been sufficient for a long-only manager to
outperform the index through much of the post-crisis period in the 1990s, a similar pattern
unfolded in Europe post 2010. Equally, the scarcity of growth led to small caps generally
outperforming large and US growth stocks enjoying significant outperformance.
Much of this changed in the first quarter of this year, when there was a dramatic reversal of
many dominant momentum strategies. Since then, narrow stock dispersion and, until
recently, low volatility have made it much harder to add alpha for many investors. Moving
forward, the outlook is further muddied by the spread of the possible future outcomes.
In this section, we look to see if there are any pointers we can take from previous periods.
What works in ‘stagnation?’
When most people think of stagnation, they think of Japan, but in our view this is not a
particularly good example to look at as a guide to the market overall. Japan was very
overvalued when the stagnation started in the 1990s, a far cry from what we are
seeing in most markets today.
In their report From the ‘Great Recession’ to the ‘Great Stagnation’? (Global economics
weekly, September 28, 2011), Jose Ursua and team looked at the prevalence of stagnations
globally. They showed that episodes of stagnation are more common than many imagine,
and identified 93 episodes since 1800, 24% occurring over the past decade. While equity
returns tended to be low during these episodes, they were on average much better than
those during Japan’s stagnation of the 1990s. Exhibit 19 shows that average real equity
returns were 5% (with Japan the outlier). Nonetheless, average inflation during previous
stagnations has been higher than we are seeing today and the current situation in this
regard is more similar to Japan’s experience. Consequently, some of the lessons from
Japan’s stagnation may be relevant for us today.
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 19
Exhibit 19: Japan’s 1990s episode (O) vs. long-lasting stagnation average ( ) historical
average (+), and post-WWII average (x)
Source: Goldman Sachs Global Investment Research, Barro-Urusa (2009), Ursua (2011).
Accepting the dangers of looking for past templates, there are a couple of themes that did
work in Japan through the stagnation and are likely to be relevant in the current
environment if stagnation evolves.
1) Global exporters outperformed domestically exposed stocks in general; this of course
reflected weak domestic demand and was not primarily a function of currency – the
yen was generally strong through most of this period.
Exhibit 20: Exporters strongly outperformed domestically exposed stocks in Japan
through the 1990s
Source: Datastream, Goldman Sachs Global Investment Research.
50
100
150
200
250
300
350
400
85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
Exporters versus the TOPIX
Exporters versus the Domestic Sector
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 20
2) Banks underperformed.
Exhibit 21: Banks underperformed the Japan market in the 1990s
Source: Datastream, Goldman Sachs Global Investment Research
The underperformance of banks was both a function of the banking crisis and of the
ongoing weakness in the economy.
Under similar circumstances, we might see patterns play out in a similar way – global
companies would tend to do better, even more so perhaps in the case of Europe, as we
expect the euro to decline over the medium term (reaching parity against the US$ by end
2017). Banks may struggle under the prospects of poor loan growth, although in this case
the similarities are less clear. Balance sheet restructuring in Europe has been swifter than it
was in Japan and policies aimed at kick-starting bank lending are more forceful. It is also
likely that pure yield plays would perform quite well; interestingly, there was a clear pattern
of ‘value’ outperformance in Japan during its stagnation. We think the reason for this is
that the overall market remained very expensive – perhaps a less obvious point of
comparison to today. Nonetheless, if confidence about future growth and pricing falls
sufficiently, value becomes the most obvious measure of potential and we think this is a
theme that would likely be repeated if deflation and stagnation set in.
Exhibit 22: During the stagnation in Japan, there was a clear pattern of value outperformance MSCI Japan Value, MSCI Japan Growth and MSCI Japan indices
Source: Datastream, Goldman Sachs Global Investment Research.
20
40
60
80
100
120
140
160
180
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Banks versus the TOPIX
80
130
180
230
280
330
380
430
480
530
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Japan Value versus Japan Growth Japan Value versus Japan Market
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 21
What works in the Great Moderation
In this environment, we would expect volatility to remain low. In addition, there are two
important features for investors:
1) Income is scarce
2) Growth is scarce
Finding growth
Given the slow recovery of most economies, even since the end of the Great Recession it
has been difficult to find growth.
This scarcity of economic growth has taken its toll on the corporate sector too. While the
damage has not been evident so much in financial losses (at least outside the banking
sector), it has had an impact on investment behaviour and, with it, confidence in future
growth. Rather than spend money on an uncertain macro future, companies have been
hoarding cash.
Exhibit 23: Cash balances of European companies are highSTOXX Europe 600 ex financials cash-to-asset ratio
Exhibit 24: Cyclicals especially appear cash rich Pure cash-to-asset rates (STOXX Europe 600 sector groups)
Source: Factset, Worldscope, Goldman Sachs Global Investment Research.
Source: Factset, Worldscope, Goldman Sachs Global Investment Research.
With less investment and lower economic activity has come less growth in earnings.
The proportion of companies in Europe, for example, generating annual earnings growth
above 10% has fallen sharply, and those generating annual sales growth above 10%
have reached a multi-year low. Little wonder that ‘growth’ has become highly prized.
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
10.5%
11.0%
11.5%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Pure cash
Cash & equivalents (RHS)
2%
3%
4%
5%
6%
7%
8%
9%
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Cyclicals
Defensive
Commodity
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 22
Exhibit 25: Proportion of STOXX 600 companies with FY3/FY2 growth >10% has fallen for
both sales and earnings Based on FY3/FY2 consensus earnings and sales growth
Source: I/B/E/S via Datastream, Goldman Sachs Global Investment Research.
In the case of the US, companies investing for growth are now clearly outperforming (see
Exhibit 26), but this is in an environment where the economy is growing and ROE is at a
high. It also follows a long period in which companies have bought back stock and also
raised dividends.
Exhibit 26: The market is rewarding growth strategies
Performance of S&P companies based on their use of cash
Source: Goldman Sachs Global Investment Research.
10%
20%
30%
40%
50%
60%
70%
80%
90%
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Proportion of companies with >10% earnings growth
Proportion of companies with >10% sales growth
Average porportion of co. with >10% earnings growth
Average porportion of co. with >10% sales growth
92
94
96
98
100
102
104
106
Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14
Inde
xed
perf
orm
ance
Buybacks
Dividends
CapExLong/short performance of S&P 500 quintiles based on use of cash
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 23
In Europe’s case, the depth of the recession, coupled with an existential crisis of the euro,
meant that it has been only since fairly recently that investors would pay any premium for
growth again. Through much of the crisis, investors preferred to hide in relatively ‘safe’
and defensive parts of the market. If growth was rewarded at all, it was mainly top-line
growth that tends to be more stable and predictable. Many of these kinds of companies
moved to a large premium valuation during the depth of the crisis and have reverted to
significant premiums in the drawdown of the past several weeks. In most markets, and
even in the case of Europe where stagnation has largely been priced, more expensive
defensive companies may start to underperform more cyclical global companies.
The scarcity of income
While growth may be scarce, income appears even harder to find. In effect, we live in a
world with a zero, if not negative, risk-free rate. German real bond yields, for example, are
close to zero on 10-year maturities.
Exhibit 27: The collapsing German ‘risk-free’ rate…
…now negative in real terms on 10-year maturities
Source: Datastream, Goldman Sachs Global Investment Research.
Yield attracts very high valuations
It is understandable that in a zero rate world, anything with a higher yield becomes highly
prized, particularly when this environment is coupled with low volatility and low inflation
expectations. But the extent of the re-rating is remarkable. The effective multiple for
government bonds (1/BY for 10-year German government bond) is roughly 120x.
-2
-1
0
1
2
3
4
5
6
7
8
9
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
Germany Real Bond Yield
-1 standard deviation
Average
+1 standard deviation
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 24
Exhibit 28: The “effective multiple” is extremely high for government bonds… 1/BY for 10-year German bonds and 12m-forward P/E for STOXX 600
Source: Datastream, Goldman Sachs Global Investment Research.
For corporate credit, at 65x, the ‘multiple’ is at its highest since 1999, from when we
have data.
Exhibit 29: …as well as for corporate credit
1/BY for iBOXX Europe Corporates and 12m-forward P/E for STOXX 600
Source: Datastream, Goldman Sachs Global Investment Research.
5
25
45
65
85
105
125
145
165
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
Germany 10-year 1/BY STOXX Europe 600 NTM PE
Average Germany 10-year 1/BY
5
15
25
35
45
55
65
75
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
IBOXX Eur Corporates 1/BY STOXX Europe 600 NTM PE
Average iBOXX Eur Corporates 1/BY
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 25
As bond yields have collapsed and credit spreads narrowed, investors are struggling
to meet income requirements without moving significantly up the risk curve. Hugo
Scott-Gall and team illustrate that in order for a credit fund to generate a 4% return in the
US, the proportion they would need to invest in HY credit would be high.
Exhibit 30: US HY holding needed in portfolio % of portfolio required in high yield corp. bonds to achieve weighted yield of 4%, if various
levels are put in US government bonds
Source: Datastream, Goldman Sachs Global Investment Research.
Another way of thinking about this is to look at the proportion of fixed income and equity
that would be needed in a mixed portfolio to generate a 4% return. Exhibit 31 shows that
even with as high as 30% in government bonds, we would need to combine this with a
portfolio of around 30% of equities to generate the required return. When we do this
exercise in Europe, we find that even 100% of the remainder invested in HY credit would
not be sufficient to generate a 4% return.
Exhibit 31: US equity holding needed in portfolio % of portfolio required in equities to achieve weighted yield of 4%, if various levels are put in US
government bonds; equity return based on cost of equity
Source: Datastream, Goldman Sachs Global Investment Research.
0%
10%
20%
30%
40%
50%
60%
70%
80%
Jan
-09
Ap
r-09
Jul-0
9
Oct
-09
Jan
-10
Ap
r-10
Jul-1
0
Oct
-10
Jan
-11
Ap
r-11
Jul-1
1
Oct
-11
Jan
-12
Ap
r-12
Jul-1
2
Oct
-12
Jan
-13
Ap
r-13
Jul-1
3
Oct
-13
Jan
-14
Ap
r-14
Jul-1
4
Oct
-14
5% 10% 20% 30%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Jan
-09
Ap
r-09
Jul-0
9
Oct
-09
Jan
-10
Ap
r-10
Jul-1
0
Oct
-10
Jan
-11
Ap
r-11
Jul-1
1
Oct
-11
Jan
-12
Ap
r-12
Jul-1
2
Oct
-12
Jan
-13
Ap
r-13
Jul-1
3
Oct
-13
Jan
-14
Ap
r-14
Jul-1
4
Oct
-14
5% 10% 20% 30%
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 26
If interest rates and inflation stay low, income and cash distribution within the equity
market are likely to remain attractive to investors. In recent months, stocks in the highest
quartile of dividend yield have outperformed the market. Of note, these stocks did not
outperform during the worst part of the crisis in Europe. They were considered to be ‘value
traps’ with dividends vulnerable to cuts; during this phase, consumer staples did much better,
boosted by stable sales growth expectations and high EM exposure (at that time a perceived
attraction). Since 2013, however, high dividend yield stocks in Europe have outperformed the
index. Growth expectations have fallen and bond yields have come down commensurately.
Exhibit 32: Relative performance of high-yield equities
Source: I/B/E/S via Datastream, Goldman Sachs Global Investment Research.
It is mainly lower bond yields that have been the driver for the outperformance, as shown
in Exhibit 33.
Exhibit 33: High yield equities tend to perform better as BY fall
Source: I/B/E/S via Datastream, Goldman Sachs Global Investment Research.
95
100
105
110
115
120
125
Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14
Europe
US
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.095
100
105
110
115
120
125
130
Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14
Europe 1Q dividend yield vs. STOXX Europe 600
German 10 year bond yield (RHS, inverted)
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 27
Looking ahead, we would expect the focus on pure yield to shift to one that captures
both yield and growth. For this reason, we favour our basket of companies that have
a reasonable yield but sufficient free cash flow growth and low enough debt to be
able to sustain dividend growth. For details on this basket, Bloomberg ticker
GSSTHIDY, see Strategy Matters: Tracking the uses of cash: Europe’s equity income
opportunity, August 4, 2014.
What works in the normalisation/growth engine?
While we see this as the least likely outcome in the near term, it would tend to result in a
much more pro-growth and risk-on performance distribution. From where markets are
currently, the most obvious reversal would be of cyclical companies, which, particularly
recently, have underperformed the markets quite sharply in most regions.
Exhibit 34: Cyclicals have underperformed quite sharply
Cyclicals: Media, general retailers, travel, leisure goods, chemicals, basic resources,
construction & materials, industrial goods & services, autos & parts;
Defensives: Food & beverages, tobacco, health care, food & drug retail, utilities
Source: Datastream, Goldman Sachs Global Investment Research.
One aspect of a new global growth driver would likely be a steepening yield curve. As Exhibit
35 shows, the relationship between cyclicals versus defensive sectors against the slope of the
yield curve (shown here in Europe) is quite strong. Of course, much would ultimately depend
on what the source of the better growth is. This might have an important impact on
geographical allocations. Major supply-side reform success in Europe or a large China
consumer growth increase might benefit Europe more than the US. On the other hand, if the
global engine comes from a US energy revolution, it might benefit the US more to begin with.
86
91
96
101
106
Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14
US Europe
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 28
Exhibit 35: Cyclicals have de-rated as the yield curve has flattened and investors have
preferred longer-duration growth/defensives Premium/(discount) on 12-month forward P/E and 10Y minus 2Y German gov bond yield
Source: I/B/E/S via Datastream, Goldman Sachs Global Investment Research.
Nonetheless, anything that has a meaningful impact on longer-term global growth
assumptions would both lengthen equity expectations and help bring down the equity risk
premium (ERP).
Understandably, the willingness to pay for growth depends very much on risk
appetite. We find that the premium paid for visible premium top-line growth tends to
rise in a more uncertain world, and the premium for more cyclical growth tends to
rise when investors are more confident. This of course makes sense. We can see this by
comparing the ERP to the average P/E of companies with high expected sales growth
relative to those with high expected earnings growth.
Improving growth, a turn in inflation and a fall in the ERP would all tend to support
the valuations of more cyclical growth areas of the market. Historically, the premium of
companies with high-quality stable growth (in the top bands for sales growth) relative to
companies with more margin-driven or cyclical growth catch-up has followed the ERP
(Exhibit 36). We think that as the ERP gradually normalises, the premium paid for more
cyclically driven growth companies should increase relative to the more defensive names.
0
0.5
1
1.5
2
2.5
3
-30
-25
-20
-15
-10
-5
0
5
10
15
20
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Cyclicals vs. Defensives PE
Slope of the yield curve (RHS)*
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 29
Exhibit 36: The premium for companies with high-quality stable growth relative to
companies with cyclical margin-driven growth should decrease as the ERP normalises Relative P/E of high sales growth (>8% FY3 growth) vs. high earnings growth (>12.5% FY3
growth) companies
Source: I/B/E/S via Datastream, Goldman Sachs Global Investment Research.
The other major beneficiary of such a shift in growth expectations would likely be the
financials. These would probably benefit from both the steeper yield curve and improved
lending growth prospects. Insurance companies would meanwhile benefit from the likely
higher bond yields and falling liabilities.
As we see it, a new growth cycle that shifts expectations back towards
‘normalisation’ would mainly benefit:
Cyclicals versus defensives;
Companies with high expected earnings growth relative to those with stable top-
line growth; and
Financials.
-1
1
3
5
7
9
11
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1.4
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
P/E high sales vs. high earnings growth
Pan Europe ERP (RHS, inverted)
Macrobenchmarked ERP forecasts
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 30
The implications of low volumes and volatility
Our central scenario of moderation and recovery implies that volatility remains low for some
time. True, it has risen sharply very recently in the growth scare since September, but the
underlying trend is likely to remain low. Charles Himmelberg has argued (see Top of Mind,
Volatility: Lower for longer?, June 25, 2014) that the current low economic volatility is a
continuation of the “Great Moderation” in economic growth that prevailed from the mid-1980s
until the GFC, largely owing to the establishment of credible monetary policy. In his view,
current low asset volatility is incentivising a build-up in leverage, but regulation post the GFC
has “muzzled the financial accelerator” that amplified problems in the past, substantially
slowing the process this time around. In short, the credit cycle will play out, but not any time
soon – another reason to think that this cycle may be less ‘normal’ than those in the past.
Exhibit 37: Resumption of the “Great Moderation” % change in volatility from 1970-1984 period
Source: Goldman Sachs Global Investment Research.
In our Global Strategy Paper No. 1, Monitoring Risks: Valuation vs. Volatility part 1, October
17, 2011), we looked into the drivers of volatility and the signs that may indicate a change.
Exhibit 38: Periods of low volatility are not uncommon, but when volatility rises it tends to
do so quickly
Source: Datastream, Goldman Sachs Global Investment Research.
-100
-90
-80
-70
-60
-50
-40
-30
-20
-10
0S&P 500 10-Yr UST 1-Yr UST PCE Inflation
PCE CoreInflation
Fed NationalActivity Index
PrivateSector Emp.
Growth
2011-2014
1985-2006
Volatilities of growth, inflation rates, and equity returns have all fallen from their pre-85 levels, and have fallen further during the post-crisis period.
90
110
130
150
170
190
0
0.1
0.2
0.3
0.4
0.5
65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
Log scale, Indexed (Jan 1965=100)Realized volatility
S&P 500 (RHS)
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 31
As Exhibit 39 shows, periods of low volatility are not uncommon and they can last for long
periods, but in general, when volatility finally rises it does so quite quickly.
What are the signals that volatility may shift? Looking at historical regimes, we note two in
particular: recent volatility and valuation. The relationship between realised volatility over
the next two months plotted against current realised six-month volatility and current
dividend yield is shown in Exhibits 39 and 40. Over these short-term periods, it is clear that
there is a good positive relationship between current realised volatility and two-month future
volatility, but no relationship between current dividend yield and two-month future volatility.
Exhibit 39: Volatility is well correlated with near-term
future volatility… 2-month realised volatility plotted against the 6-month
realised volatility at the beginning of the 2-month period
Exhibit 40: …whereas the dividend yield is not 2-month realised volatility plotted against the trailing
dividend yield at the beginning of the 2-month period
Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research.
Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research.
Exhibit 41, however, extends the horizon and shows the realised volatility over the six-
month window from one year into the future to 18 months into the future, plotted against
current six-month realised volatility. The charts show that current realised volatility has
much less influence over longer-term risks. A regression line would still show a small
positive relationship between the two variables, but it is clearly non-linear, with all the
highest volatility episodes following periods of low rather than high realised volatility – in
other words, volatility spikes do tend to follow periods of low volatility.
In terms of signals, the current dividend yield gives a much better picture than
realised volatility over longer-term risks. A regression would show a negative
relationship with an R-squared more than twice as high as the R-squared for the
relationship of this future volatility with current realised volatility. The negative relationship
points in the same direction as the outliers in the scatter plot in Exhibit 42. Since 1973, six-
month realised volatility has never been above 22% when the dividend yield 18 months
earlier was above 3.3%.
The key observation here is that in the moderation scenario, a large spike in volatility
is unlikely to occur before the moderation has given way to some kind of significant
rise in equity valuations. While this is possible, if not likely in time, it may be many
months or years before we get there.
y = 0.5958x + 0.0503R² = 0.28
0%
10%
20%
30%
40%
50%
60%
70%
80%
0% 10% 20% 30% 40% 50%
2 m
. rea
lised
vol
. 2 m
onth
s le
ad
6 months realised vol
y = -0.0055x + 0.15R² = 0.0064
0%
10%
20%
30%
40%
50%
60%
70%
80%
1 3 5 7
2 m
. rea
lised
vol
.2 m
onth
s le
ad
Div Yld (%)
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 32
Exhibit 41: High volatility does not capture latent risks of
future volatility… 6-month realised volatility plotted against 6-month realised
volatility 18 months earlier
Exhibit 42: …whereas stretched valuations do 6-month realised volatility plotted against trailing dividend
yield 18 months earlier
Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research.
Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research.
Postscript: Anatomy of the crisis
This section is a description of how the crisis unfolded and how the epicenter shifted
from the US to Europe and then to EM. Understanding the causes of the crisis and
how it was priced helps us to put in context where markets are now.
The financial crisis itself has really evolved in three separate but related phases. Each
ended with an aggressive policy intervention and a sharp rebound in risky assets that
soon faded as another wave of the crisis hit. The three main phases can be described as:
Phase 1: US housing market and credit crunch (Oct 2007-March 2009) For equities globally as an asset class, this was the worst phase of the crisis; what started as a
US housing market correction culminated in the collapse of Lehman, a global credit crunch
and a deep global recession. Equities sharply underperformed other asset classes and
bonds performed strongly as policy rates were cut aggressively. The US equity market fell
nearly 40% from its peak and many other equities markets suffered worse still.
Exhibit 43: Phase 1: The US housing market Total return from October 2007 to March 2009
Source: Bloomberg, Datastream, Goldman Sachs Global Investment Research.
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
0% 10% 20% 30% 40% 50%
6 m
. rea
lised
vol
. 18
mon
ths
lead
6 months realised vol
High vol has occurred afterperiods of low vol 18 months earlier
Periods of high vol have beenfollowed by periods of low vol
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
1 3 5 7
6 m
. rea
lised
vol
. 18
mth
s le
ad
Div Yld (%)
Stretched valuations signal latent risk of volatility 18 months later
Attractive valuations have alwaysbeen followed by moderate volatility 18 months later
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
Government bonds Credit Commodities Equities
The crisis
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 33
All major equity markets fell together.
Exhibit 44: US equities and equity markets worldwide fell significantly
Source: Datastream, Goldman Sachs Global Investment Research.
As often is the case, it is difficult to assess the key trigger for the market rebound. This is
often related to the Geithner announcement that the Treasury could use $100 billion from
the Troubled Asset Relief Program (TARP), together with new capital from private
investors, in order to generate $500 billion in purchasing power to buy toxic loans and
assets. It was also announced that the scheme could potentially expand to $1 trillion over
time (without needing approval from congress). But this announcement came on March 23
– the market had already rebounded from March 9. Also important was the announcement
by Vikram Pandit, the CEO of Citibank, that the bank had been profitable in the first two
months of 2009 and was enjoying its best quarterly performance since 2007.
Whatever the specific trigger, the rebound in equities from this stage of the crisis was fast and
furious; the DJIA rebounded more than 20% over just three weeks. From its low on March 9, the
S&P 500 was up 30% by mid-May, over 60% by the end of the year and had risen 100% in less
than a year. As Exhibit 46 shows, the US and global markets all rallied strongly.
Exhibit 45: Global equity markets recovered from their low on March 9, 2009 Indexed March 2009=100
Source: Datastream, Goldman Sachs Global Investment Research.
30
40
50
60
70
80
90
100
110
120
Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09
Index (Oct-07=100)
S&P 500 STOXX 600 MSCI EM
90
100
110
120
130
140
150
160
170
Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09
S&P 500 MSCI The World
Index(Mar-09=100)
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 34
Phase 2: The European phase (February 2011-June 2012)
Equities bounced back sharply from the post-Lehman lows. But the European leg of the
crisis soon took centre stage. Equities underperformed in this period while government
bonds outperformed sharply and credit rebounded.
Exhibit 46: Equities underperformed in the European phase of the crisis
Source: Bloomberg, Datastream, Goldman Sachs Global Investment Research.
Within equities, the picture was more nuanced. The US equity market outperformed other
regions by far. Europe performed poorly and entered a new bear market while the ‘periphery’
in particular underperformed. In this phase of the crisis, equities outperformed bonds overall,
but there was significant geographic dispersion, with Europe falling most sharply. The
Eurostoxx 50 fell 29.9% from October 2009 (post the Lehman recovery) to June 2012.
Again, the recovery cannot be pinpointed to a specific factor, but is often attributed to the
comments by ECB chairman Draghi to ‘do whatever it takes’ to save the euro on July 26,
2012, followed by the swift and explicit backing of President Sarkozy and Chancellor Merkel.
The recovery again was initially sharp. The Eurostoxx 50 rose 45.1% between June 2012
and 2014, with Spain, the most heavily hit during the worst of the crisis, up 68.3%.
Exhibit 47: European markets underperformed global equities significantly in the
“European phase” of the crisis
Source: Datastream, Goldman Sachs Global Investment Research.
-15
-10
-5
0
5
10
15
20
25
Government bonds Credit Equities Commodities
60
65
70
75
80
85
90
95
100
105
Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12
Index (Feb-11=100) Eurostoxx 50 MSCI the World
The recovery
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 35
Exhibit 48: US market outperformed significantly S&P 500 relative performance vs MSCI EM and STOXX 600
Exhibit 49: Periphery significantly underperformed the
STOXX 600 Average of MIB and IBEX relative perf vs STOXX 600
Source: Datastream, Goldman Sachs Global Investment Research.
Source: Datastream, Goldman Sachs Global Investment Research.
Much of the recovery in equity markets, particularly in the periphery, can be attributed to
the collapse in sovereign spreads. This allowed the ERP to fall from very elevated levels
and triggered a sharp re-rating in valuation. We have yet to see any meaningful recovery in
either Euro area economic activity or European profits, but the falls in the risk premium
from historic highs were sufficient to propel the markets higher.
Phase 3: The EM phase (May 2013-March 2014) It is difficult to be specific about an EM phase, as the underperformance of EM began
slowly and has been quite long-lasting. From their absolute relative peak in October 2010
(following years of outperformance), EMs had underperformed DMs by 39% up until the
recent low in March 2014. However, this long phase can be split into two parts.
The first was the period between October 2010 and May 2013. This was a period of
underperformance largely driven by the China GDP slowdown. During this period, the EM
index underperformed DM by 24% in dollar terms. However, this was relative
underperformance in a period of generally rising equity markets.
The second phase, which is perhaps more specifically an EM-focused period of weakness,
was from May 2013 through to March 2014. This includes the ‘taper tantrum’ episode and
the rise in US rate expectations that fuelled serious concerns about EM economies with
significant external liabilities. Over this period, EMs underperformed DM by 20%.
Exhibit 50: EM underperformed DMs by more than 20% in
phase 3 …
Exhibit 51: … although EM rebounded somewhat in the
spring of 2014
Source: Datastream, Goldman Sachs Global Investment Research.
Source: Datastream, Goldman Sachs Global Investment Research.
90
95
100
105
110
115
120
125
Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12
S&P 500 vs MSCI EM
S&P 500 vs STOXX 600
Index(Feb-09=100)
50
60
70
80
90
100
110
120
Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12
Periphery vs STOXX 600
Index(Feb-09=100)
75
80
85
90
95
100
105
May-2013 Aug-2013 Nov-2013 Feb-2014
EM vs DM
78
80
82
84
86
88
90
Mar-2014 May-2014 Jul-2014 Sep-2014
EM vs DM
October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 36
Equity basket disclosure
The Securities Division of the firm may have been consulted as to the various components of the baskets of securities discussed in this report prior to
their launch; however, none of this research, the conclusions expressed herein, nor the timing of this report was shared with the Securities Division.
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October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 37
Disclosure Appendix
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October 21, 2014 GOAL - Global Strategy Paper
Goldman Sachs Global Investment Research 38
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