Fresh off a “successful” effort to sink the Nasdaq with a single, scary-sounding note that basically suggested FAAMG stocks could very well be caught in a similar dynamic as that which many suspect is allowing (no, “forcing”) programmatic strats to lever up (i.e. low vol creating a self-feeding loop that begets still higher prices, still more buying, and still lower vol), Goldman is back on Friday evening with their weekly “kickstart” piece which features conversations they’ve been having with clients.
The theme is familiar: equities are benefiting from a “Goldilocks” environment where the econ backdrop is just good enough to keep everyone confident in the sustainability of the rally and just tepid enough to keep the Fed from getting too aggressive.
Basically this mirrors Deutsche’s assessment which suggests that it’s not so much that stocks are cheap to bonds and therefore can keep rising, but that bonds “are expensive to equities and by staying expensive can allow equities to become even more expensive.”
But as you’ll read below, Goldman thinks this is unsustainable because either inflation catches up to an economy at full employment putting upward pressure on wages and downward pressure on margins, or inflation remains subdued and the economy eventually catches down to the deflationary reality being telegraphed by lower long-term rates.
Goldilocks and the three hikes
Next week the FOMC will hike the fed funds rate for the second time this year. With the unemployment rate at 4.3%, fed funds futures are currently pricing a nearly 100% likelihood of a 25 basis point hike at the FOMC meeting next Wednesday, in line with our economists’ expectations.
Our economists’ outlook mirrors the Fed’s “dot plot” in forecasting one additional tightening in 2H. Our economists expect the Fed will announce the start of balance sheet normalization in September, with the third hike of the year at the December FOMC meeting, followed by four hikes during 2018.
The market, in contrast, currently prices only a 50% probability of another hike by year-end and just two more hikes in total through 2019. Investors have lowered their expectations for Fed tightening as economic data releases suggest that the pace of growth and inflation peaked earlier this year. Our economists’ Current Activity Indicator shows a 3.0% current pace of economic growth, roughly a full percentage point slower than the peak pace in February. At the same time, core PCE inflation fell by 25 bp to 1.5%, 10-year breakeven inflation slipped back below 1.8%, and investors have tempered their earlier hopes for fiscal stimulus out of Washington, DC.
The unexpected mix of healthy growth and declining rates represents a Goldilocks scenario for US equities. Growth data has certainly not been too cold, supporting S&P 500 EPS growth of 14% in 1Q and consensus expectations for 11% growth in both 2017 and 2018. Nor have conditions run too hot and caused the rise in rates that we expected would constrain equity valuations this year. Instead, the economic backdrop has proven just right.
However, just like in the fairy tale, this perfect scenario is unlikely to last. With the economy at full employment, an easy Fed risks the possibility that wage pressures build and weigh on corporate profit margins. Our base case is that above-trend economic growth will eventually push inflation higher, prompt an accelerated pace of Fed tightening, and lead to higher bond yields that will reduce equity valuations. As the cycle matures, we expect US equity prices will continue to rise, but we think that the trajectory of price gains will be slower than the pace of earnings growth as monetary policy and valuation multiples each normalize.
Conversely, if the current market outlook for low rates and inflation is proven correct, it will likely accompany a significant slowdown in the pace of economic growth. This scenario is potentially less friendly for equities given the negative earnings revisions that likely would result from a weakening economic environment.
The S&P 500 sits at a record high of 2432, up 10% YTD, but signals below the surface of the market suggest equity investors believe the pace of economic growth may be slowing. Our Dual Beta basket (ticker: GSTHBETA) of stocks from each sector with the highest combined sensitivity to the US economy and equity market has underperformed by 360 bp since the start of February (4% vs. 8%). At the same time, Cyclical industries have underperformed Defensives by 460 bp (5% vs. 10%).
The outperformance of NDX, “FAAMG” (FB, AAPL, AMZN, MSFT, and GOOGL) and other growth stocks also supports the idea of decelerating economic growth. As we explored in our report earlier this week, growth stocks typically outperform when there is a scarcity of economic growth. This cycle’s prolonged length and slow economic growth help explain why value stocks have underperformed growth stocks to such a large extent during recent years and YTD in 2017.
Perhaps most remarkable is the outperformance of stocks with strong balance sheets alongside a rallying equity market and extremely easy financial conditions. Falling rates, tight credit spreads, a slipping USD, and high equity prices have brought the Goldman Sachs Financial Conditions Index to its lowest level in two years. Nonetheless, our basket of S&P 500 firms with Strong Balance Sheets (GSTHSBAL) has outperformed our Weak Balance Sheet basket (GSTHWBAL) by 520 bp during the last six months. Strong balance sheet outperformance in a 10%+ equity market rally is rare; occurring in only 5% of six-month stretches in the last 30 years. One notable episode was in 2000, at the Tech Bubble peak.
Looking forward, investors should focus on stocks with a fast pace of growth (Information Technology) and the potential for acceleration in growth (Financials). If the current economic “Goldilocks” environment persists, Technology and other growth stocks should continue to outperform, despite today’s price declines. However, if investors recalibrate expectations for inflation and Fed policy to match the growth optimism suggested by the S&P 500 level, higher rates should lead to Financials sector outperformance.
Upcoming regulatory changes could also provide catalysts for Financials outperformance. CCAR (“stress test”) results on June 28 could mark an inflection in bank capital returns, Thursday’s House passage sends the Financial Choice Act next to the Senate, and President Trump is reportedly preparing to name three picks for the Fed, including the vice chairman of bank supervision.