If you ask BofA’s Michael Hartnett, the S&P is “more likely” to drop to 3,400 over the next six months than it is to rally all the way up to 4,400.
Those are arbitrary numbers, of course, but the point is just to say if you’re weighing the chances of US equities tacking on another double-digit gain versus the chances of a technical correction, Hartnett thinks the odds are skewed in favor of the latter.
The S&P closed at a record Friday thanks to an afternoon surge. In some sense, it’s comforting that momentum seems to have waned recently — maybe “melt-up” isn’t the right adjective after all. On the other hand, we’re sitting at something of an inflection point on the macro front. Due to the experimental character of the current fiscal-monetary policy conjuncture, it’s not clear what’s next.
For Goldman, there are four possible macro scenarios with a chance of prevailing over the next several months. The bank sketched them out in a new asset allocation piece.
Echoing the notion that a correction is at least more likely from elevated levels of risk appetite than it would be otherwise, Christian Mueller-Glissmann noted that the bank’s Risk Appetite Indicator “has been above 1 since the end of January indicat[ing] a worse asymmetry to add risk and increased vulnerability to negative growth and rate shocks.”
As the figure on the right (from Goldman) shows, “the likelihood of very strong S&P 500 returns (>10% over 3 months) is usually lower from high RAI levels.” That said, the bank also noted that “the risk of very large equity drawdowns (>10%) is usually lower [too] because there is likely a strong macro backdrop that has boosted risk appetite, similar to the COVID-19 recovery.”
In order to better contextualize the discussion, Goldman worked through an exercise that will be familiar to anyone accustomed to how they parse their gauge of risk appetite. They regularly break the indicator down to find out what’s in the driver’s seat, as it were.
“As the reflation rotation accelerated, the gap between the first two RAI principal components PC1 (‘growth optimism’) and PC2 (‘search yield’) has grown – this has been a drag for long-duration assets in particular, such as Nasdaq, China A-Shares and Gold,” Mueller-Glissmann said, noting that “markets have shifted from fading deflation risk to pricing more of an inflation overshoot, especially near term.”
The good news is, Goldman suggested that a kind of Goldilocks scenario is the most likely. Or at least for the next few months. Specifically, the bank “us[ed] cross-asset sensitivities to changes for RAI principal components,” in order generate four potential scenarios.
The first posits an acceleration of the reflation narrative. As growth optimism continues to build, equities outperform bonds, ex-US equities, cyclicals & value continue to do well, and small-caps best big-cap US tech. Commodities keep rallying, while bonds and gold lag. That’s consistent with the notion that balanced portfolios would be better served by increasing their allocation to commodities, perhaps at the expense of bonds.
Last month, JPMorgan wrote that multi-asset portfolios could be at risk in a world where bonds can no longer be relied upon as a hedge given the low level of yields and high “tantrum” risk.
At a recent quant conference, JPMorgan’s investors expressed palpable concern about inflation risk. Asked about possible hedging strategies, “42% of participants answered by including commodities, 32% by increasing equities, and only 26% [saw] a solution in interest rate products,” a note out last month read. In the course of making the case for a new commodities supercylce, JPMorgan said it “expect[s] multi-asset portfolios to add commodity and commodity equity exposure to hedge inflation.”
Read more: JPMorgan Sees New Commodity Supercycle
In Goldman’s “Goldilocks” scenario, growth optimism remains buoyant, or at least doesn’t fade, while worries about premature monetary tightening wane.
In that environment, the bank said US and emerging market shares should do well, growth stocks would be under less pressure, the Nasdaq could stabilize and perhaps outperform small-caps, while “bonds are less of a drag and 60/40 and risk parity portfolios perform well.” The VIX, meanwhile, would fall in what I’ll call the “new Goldilocks.”
The bank also posited two unfavorable scenarios, the first being a continuation (or acceleration) of the rate shock, with an emphasis on rising real yields. There’s no escape in that scenario, save perhaps short-dated credit. Gold would “decline sharply,” Goldman noted.
Another risk scenario is a new growth shock. Based on reader feedback, that seems to be a real worry among some investors, especially as vaccine rollout in Europe continues to lag the US and virus variants proliferate. In a growth scare, bonds would obviously outperform, followed by gold. “Equities would have a larger drawdown, led by cyclicals and commodities, the VIX would spike and, depending on the growth shock, likely more than in a rate shock,” Goldman remarked.
For their part, Goldman is optimistic, albeit with a tinge of caution.
The bank expects the reflation narrative to gather more steam in the near-term, where that means Q2. After that, Mueller-Glissmann said “a transition to a ‘Goldilocks’ scenario into year-end” is “most consistent with our current forecasts.”
The title of the piece is itself instructive. “Remain pro-risk but watch your tail,” the header reads.