Positive returns this year for equities, says Goldman Sachs

Equities are in favor with Goldman Sachs Asset Management it reveals in its 2018 mid-year outlook: A better balance of risks, which notes the balance of risks for markets has improved, indicating positive news on growth going forward.

‘Equities remain our preferred asset class for 2018, and after the sell-off the tactical outlook has improved. We expect moderate but positive returns for the year, as equities will likely need to digest higher bond yields as the year progresses,’ write the report authors.

Goldman Sachs estimates that US equities ‘can absorb’ a 10-year US treasury yield of roughly 3.5 percent before a sustained sell-off, as implied by the equity risk premium.

‘However, history has shown that rising rates alone are a poor indicator of subsequent equity returns,’ according to the report. ‘US equities were able to generate double-digit positive returns over the subsequent 12 months in all but one hiking cycle since 1988. The driver of higher rates is important – equities may perform well to the extent that higher rates reflect strong economic growth prospects, as is the case in the current cycle.’

The report goes on to observe that the normalization of rates and rising cost of capital reinforce a ‘Darwinistic framework’ where strong companies thrive and the weak perish, increasing the dispersion among companies and sectors.

‘For large cap equities, much of the earnings recovery since the financial crisis has been driven by cost-cutting and margins growth, rather than revenue growth. With rising cost pressures, pricing power will become an increasingly important differentiator of future success. The increased dispersion between winners and losers reinforces the importance of active management,’ write the authors.

Goldman Sachs also notes that US small-cap equities look increasingly attractive. ‘Small caps have performed well in rising rate regimes as they are more levered to better growth prospects and are less sensitive to interest rates due to smaller dividends on average.

‘Higher domestic exposure also allows small caps to benefit more from tax cuts, while being relatively insulated from the negative impact of potential tariffs and trade tensions. Operating margins for small caps remain well below pre-crisis peaks in contrast to the new highs reached by large-cap companies, providing room for improvement.’

On the emerging market front, accelerating emerging market economic growth is expected to exceed developed market economies in the next few years, notes the report.

Emerging markets are expected to contribute over 70 percent of global GDP growth between 2015 and 2025, and Goldman Sachs estimates that as 1.2 bn people in emerging markets rise into middle and high-income classes over this 10-year period, real consumption should more than double.

‘This shift is evident in the changing composition of emerging market equity markets towards the information technology and consumer sectors. Supportive macro fundamentals have revived emerging market earnings growth, which has outpaced developed markets, while valuations are at a 20-25 percent discount.’