Nathalie Salman | Getty Images
Goldman Sachs strategists expect a “baby bear” market in bonds next year, with a mild move higher in interest rates due to a better economy, subdued global inflation and the lack of central bank policy easing.
In a sweeping outlook for 2020, the firm’s strategists say they do not expect a “go-go global growth environment that would sink the Dollar or result in a major bear market for bonds.” Risk assets, such as stocks, should see “decent returns.”
“We are optimistic about US growth, but the mature business cycle limits the possible upside beyond the very near term. There are also plenty of risks, including the trade war and the possibility that the next Congress will reverse the 2017 US corporate tax cut,” they wrote in a report.
They said a major difference between this year and next will be that the Fed and other major central banks should keep policy unchanged and “markets will need to learn to fly on their own.” In the U.S., the Federal Reserve cut interest rates three times in 2019, and the strategists estimated that central bank easing lifted U.S. equities by about 20% in 2019. The gain in the S&P 500 is just about 24% year to date.
“We expect moderately better economic and earnings growth, and therefore decent risky asset returns” across regions, they wrote.
The markets have recently priced out several risks, including Brexit and the trade war, but have not yet priced in better growth. The strategists expect upside in a variety of “cyclically sensitive assets, including emerging market equities and breakeven inflation in the bond market, and expect cyclical sectors to outperform in equities and credit.”
Their approach to investments in 2020 is to “watch your footing.” For instance, buy corporate debt but hedge by pairing it with lower-risk mortgages and stay away from lowest-rated junk bonds.
The strategists do not expect Chinese policymakers to provide a big stimulus to their economy, but they instead will try to stop the deceleration. For Europe, the strategists have low confidence for much of a rebound.
“So although we are cautiously optimistic on the global economy, we forecast only moderately higher 10-year Treasury yields next year, targeting a rebound to 2.25%, mostly skewed toward the second half of 2020,” they wrote. The 10-year was at 1.76% Friday.
The strategists said the move higher is essentially a “baby bear” market in bonds. “With the Fed on hold and inflation unlikely to take off, we would discourage positioning for a major bear market in US rates next year, even with somewhat better growth,” they wrote. The case for shorting European and U.K debt is more compelling.
“Directionally, we think the UK offers the most attractive shorts in G10, given a likely rebound in activity and resolution to the Brexit impasse after the [U.K.] election, plus the prospect for more expansionary fiscal policy,” they said.
Election uncertainty
Investors will also focus on the U.S. election, which carries its own risks. “Barring a unified government led by Democrats, US tax policy would likely remain unchanged at least through 2023. But if the majority shifts in the senate, our US portfolio strategists expect that every 1 percentage point change in the effective corporate tax rate would lead to a roughly 1% change in S&P 500 EPS.”
If policy uncertainty rises substantially, that could result in a decline in earnings expectations and the forward price to earnings ratio on the S&P 500 could decline by one to two multiple points, they added. Sectors that are most vulnerable to legislation, such as health care, would face headwinds.
They see the potential for cyclical stocks versus defensives to continue to gain momentum in the near to medium term in the U.S. and in emerging markets. They recommend stocks with large valuation discounts, such as the financials, industrials and consumer discretionary. Emerging market cyclicals have become more appealing because of improving earnings sentiment and attractive valuations.
As for corporate earnings, they expect to see a rebound in earnings but flatter profit growth.
Earnings growth of 1% in 2019 is down sharply from 23% in 2018, while net leverage on corporate balance sheets continues to rise and is approaching levels from the late 1990s.
In terms of corporate debt, Goldman recommends underweight allocation on high yield debt, but keeps overweight and neutral allocations on corporates, rated B and BB. Goldman strategists like strong balance sheet companies over longer horizons, as they see potential for tail risks from near record corporate leverage and slower earnings growth.
“The growth reacceleration that our economists envision is certainly a welcome development from a sentiment standpoint, not least because it would further reduce recession concerns,” the strategists wrote.
However, they do not see better growth resulting in a revival in low quality assets. High-quality assets will continue to be more attractive even at a premium as “an insurance policy against an unexpected turn in what is generally perceived to be an aging cycle.”