investment management division · 2014-02-06 · investment management probability of loss at...
TRANSCRIPT
Investment Management Division
Recent Market Downdraft:
Within Sight of the Summit or Past the Peak?
February 6, 2014
Investment Strategy Group
Investment
Management
Division
-4.9%-4.5%
-6.5%
-12.5%
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
12/31 1/7 1/14 1/21 1/28 2/4
To
tal R
etu
rn
S&P 500 Euro Stoxx 50 (Local)
EM Equities (USD) TOPIX
Not a Great Start to 2014
Source: Investment Strategy Group, Bloomberg. 1
2014 Asset Class Performance Year-to-Date (Through February 4th)
The 5-13% declines across the major equity markets year-to-date have raised concerns that the S&P 500 has peaked.
US Nonfarm
payrolls (1/10)
Disappointing
HSBC China Flash
PMI & Argentine
peso devalued
(1/23)
January FOMC
meeting (1/28-1/29)
Investment
Management
Division
0
500
1000
1500
2000
Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13
Is This Another “Lehman Moment” or a Confluence of
Disappointing Headlines?
Source: Investment Strategy Group, Bloomberg. 2
S&P 500 Price Level Since its March 2009 Trough
We have now seen 13 unique downdrafts of 5% or greater since the S&P 500’s trough in 2009.
Investment
Management
Division Probability of Loss at Current Valuations
3 Source: Investment Strategy Group, Datastream, Bloomberg.
The unconditional probability of a 5% decline and a 10% decline during a year is 95% and 57%, respectively.
These probabilities increase when the starting valuations are high.
2. S&P 500 Price Level in 2011
1050
1100
1150
1200
1250
1300
1350
1400
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov DecS
&P
50
0 P
ric
e L
eve
l Full Year: 0.0%
Beginning to Trough: -12.6%
Peak to Trough: -19.4%
A
C
B
1. Probability of Loss in S&P 500 When Valuations Are High (1945–2013)
Definitions
Loss defined as…
A. Return from
Beginning to End
of Year
B. Return from
Beginning of
Year to Trough
C. Return from
Peak to Trough
within a Year
-5% 29% 56% 100%
-10% 24% 37% 63%
-15% 19% 28% 40%
-20% 13% 23% 26%
Investment
Management
Division Has our Assessment of the Risks Changed?
Source: Investment Strategy Group. 4
Six risks highlighted in our 2014 Outlook:
The US stalls into a recession.
The complete exit from QE by the Federal Reserve is more disruptive than expected.
The Eurozone sovereign debt crisis bubbles over.
Confidence in the impact of Japan’s “Three Arrows” dissipates.
One or more key emerging market countries experience a hard landing.
Geopolitical hotspots result in military engagement, temporary or otherwise.
Investment
Management
Division
Several Key US Data Releases Have Disappointed Recently,
But Recession Risk Remains Low (and Unchanged)
5 Source: Investment Strategy Group, Bloomberg, Goldman Sachs Global Investment Research, Macroeconomic Advisers.
GS US Economics Research and Macroeconomic Advisers note that weather has likely played a role in the
disappointing economic data—including December nonfarm payrolls, the Institute for Supply Management’s
(ISM) January data as well as auto sales.
We expect US growth of 2.25–3.25% in 2014, 0.9% faster than 2013.
We do not currently see signs of excesses in the private sector such as those that have historically preceded
recessions.
Recent US Economic Data Releases
Release Type Indicator Period Actual Prior
Real Activity US GDP %QoQ Dec-13 3.2 4.1
US Nonfarm Payrolls (Thousands) Dec-13 74 241
US Unemployment Rate (%) Dec-13 6.7 7.0
US U Michigan Consumer Confidence Jan-14 F 81.2 82.5
US Conference Board Consumer Confidence Jan-14 80.7 77.5
US ISM Manufacturing Jan-14 51.3 56.5
US Empire Manufacturing Survey Jan-14 12.5 2.2
US ISM Non-Manufacturing Jan-14 54.0 53.0
US Housing Starts (%MoM) Dec-13 -9.8 23.1
US NAHB Housing Market Index Jan-14 56.0 57.0
Auto Sales (million units, annual rate) Feb-14 15.2 15.3
Labor Market
Leading Indicators
Housing Market
Consumer Spending
Investment
Management
Division Monetary Policy is Unlikely to Cause a Recession in 2014
6 Source: Investment Strategy Group, Federal Reserve, Stephen K. McNees [then Fed economist], “The 1990-91 Recession in Historical Perspective,” New England
Economic Review, January/February 1992.
1. Federal Reserve Tapering is Not the Same as Tightening
Beginning
of Fed
Tightening
S&P 500
Peak
Recession
Begins
2. Sequence of Fed Tightening, S&P 500 Peaks and Recessions
(Based on 8 Historical Tightening Cycles that Led to Recession)
+18 Months +10 Months
+28 Months
As discussed during our January 15th call, monetary policy tightening has been a trigger of past US recessions.
“Tapering” is not the same as tightening. The Federal Reserve’s balance sheet continues to grow even as it tapers.
We do not expect the Fed to begin tightening until Q3 2015. The historical sequence of Fed tightening and the
beginning of the subsequent recession would suggest that the next recession will not begin until late 2017.
“Nothing that we did today was intended to reduce
accommodation…”
“…I do want to reiterate that this is not intended to
be a tightening”
– Former Fed Chairman Ben Bernanke Regarding the Start
of Tapering (December 18, 2013)
Investment
Management
Division Somewhat Positive News Out of the Eurozone
7 Source: Investment Strategy Group, Bloomberg.
1. Eurozone Data Releases – Through February 5, 2014
The Eurozone economy represents 17% of global GDP and recent data releases point to continued economic
improvement.
Moreover, the incremental yields on peripheral 10-year sovereign bonds remain contained.
We expect Eurozone growth of 0.25–1.25% in 2014, 1.1% faster than 2013.
2. Incremental Yields on Peripheral 10-Year Sovereign Bonds
0
500
1000
1500
2000
2500
3000
3500
4000
0
100
200
300
400
500
600
700
10 11 12 13 14
Sp
rea
d o
ve
r G
erm
an
Bu
nd
(b
ps
)
Sp
rea
d o
ve
r G
erm
an
Bu
nd
(b
ps
)
France
Italy
Spain
Greece (right)
Indicator Period Actual Prior
EZ PMI Manufacturing Jan-14 54.0 52.7
EZ PMI Services Jan-14 51.6 51.0
EZ Markit Composite PMI Jan-14 52.9 52.1
EZ Consumer Confidence Jan-14 -11.7 -15.4
EZ Industrial Production (%MoM) Nov-13 1.8 0.8
EZ Retail Sales (%MoM) Dec-13 -1.6 0.9
SP GDP %QoQ Non-Ann. Dec-13 0.3 0.1
EZ Unemployment Rate (%) Dec-13 12.0 12.0
EZ Inflation Flash Estimate %YoY Jan-14 0.7 0.8
EZ Core Inflation %YoY Jan-14 0.8 0.7
Investment
Management
Division Confidence in Abenomics Has Somewhat Dissipated
8 Source: Investment Strategy Group, Datastream, The Wall Street Journal.
1. TOPIX Price Index 2. Approval Ratings for Prime Minister Abe’s Cabinet Have Fallen
69
6058
55
5048
0%
10%
20%
30%
40%
50%
60%
70%
80%
Japan News Network NHK (National Broadcaster) Kyodo NewsA
be
Ap
pro
va
l Ra
tin
g
Prior Measure December
600
700
800
900
1000
1100
1200
1300
1400
Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13
Pri
ce
Le
ve
l
Introduction of Abenomics:+77%
Recent Decline:-13%
The precipitous decline in the TOPIX may be related to the upcoming consumption tax increase, insufficient yen
depreciation, and/or lower approval ratings for Prime Minister Abe’s cabinet.
The real impact of the Japanese economy on the US economy is negligible.
If Japan’s confidence in Abenomics deteriorates further, it is likely that the Bank of Japan increases quantitative
easing.
Investment
Management
Division
Has our Assessment of a Hard Landing in Emerging
Markets Changed?
China: Manufacturing PMIs
Source: Investment Strategy Group, Datastream.
Disappointing headlines about China in early 2014 raised concerns about:
– A growth slowdown following the official PMI dipping to a six-month low and the HSBC PMI falling below 50
(a level consistent with slowing growth).
– The solvency of China’s shadow banking system:
• China Credit Trust offered to restructure the $500 mn Credit Equals Gold Trust, preventing a default on
January 31st. The Chairman of ICBC had said earlier that it would not compensate investors for losses.
• We estimate $874 bn worth of trust products will mature in 2014.
9
46
47
48
49
50
51
52
53
54
55
2011 2012 2013 2014
Ch
ina
: M
an
ufa
ctu
rin
g P
MIs
NBS PMI HSBC PMI
Expansion
Contraction
Investment
Management
Division Negative Headlines in Other Emerging Markets
Source: Investment Strategy Group, Bloomberg.
Emerging markets also had a confluence of disappointing developments in early 2014:
– Escalating violence in Ukraine and Thailand.
– Intensification of the dispute over corruption and influence peddling in Turkey as Prime Minister Erdogan
reassigned many of the prosecutors and police involved in a probe.
– Significant currency depreciation in Argentina, Turkey, Russia and South Africa.
10
1. 2014 YTD EM Currency Returns (%) – Through February 5, 2014 2. Protest in Turkey
-18%
-16%
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
20
14
YT
D S
po
t R
etu
rn
Investment
Management
Division Emerging Market Growth Could be Slower in 2014
Policy Rates of EM Countries (%, GDP Weighted)
Source: Investment Strategy Group, Bloomberg.
In response to the market disruption, central banks in Turkey, South Africa, India and Brazil raised interest rates.
Higher interest rates could erode the already meager 0.3% pick up in emerging market growth that we expect in 2014.
As such, emerging market growth may slow below our current forecast of 5.1%.
11
3.8%
4.0%
4.2%
4.4%
4.6%
4.8%
5.0%
5.2%
5.4%
5.6%
Jan-10 Sep-10 May-11 Jan-12 Sep-12 May-13 Jan-14 Sep-14
Po
lic
y R
ate
(G
DP
We
igh
ted
)
EM Policy Rate Projected on 2/5/2014 Projected on 12/31/2013
Investment
Management
Division US Exposure to Lower Emerging Market Growth is Minimal
US Exposures to Emerging Markets
* Argentina, Brazil, India, Indonesia, Russia, South Africa and Turkey.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research.
5.0
5.5 5.5
0.7
1.9
1.0
0%
1%
2%
3%
4%
5%
6%
7%
Exports(% US GDP)
Banks' Asset Exposures(% Total US Bank Assets)
Corporate Profits(% Total US Corporate Profits)
All EM Most Affected Countries*
The exposure of the US to a downdraft in emerging markets is relatively small.
According to the IMF, the impact of a 1% shock to Chinese growth on the Eurozone and the US is negligible (less
than 0.04% and 0.025%, respectively).
Despite generally higher GDP growth rates in emerging markets, the US remains the engine of global growth.
12
Investment
Management
Division Why This is Not a Repeat of the Asian Crisis
13
Emerging Markets: Improvements Over the Last 20 Years
(1) Using data for the EMBI Index before January 1, 1998, and data for the EMBI Global Diversified Index thereafter.
Source: Investment Strategy Group, Datastream, IMF, national sources.
A full-blown, 1990s-style emerging market crisis is not our base case given improvements in their macro backdrop:
– The fall in inflation from almost 100% to 6% due to more inflation targeting and flexible exchange rates.
– The drastic reduction in the share of external debt as a share of total emerging market debt.
– The extra firepower from a fourfold rise in foreign reserves as a share of GDP (even excluding the reserves of
China and the oil-producing Arab countries of the Persian Gulf, emerging market reserves rose almost threefold).
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Inflation(%YoY)
External Debt(%Total Debt)
1994/95 Now
Increased macro stability Lower vulnerability More firepower
Foreign Reserves(%GDP)
EM ex-
China/GCC
Investment
Management
Division Emerging Markets Will Remain a Key Topic
A fundamental reassessment of emerging markets is underway.
Returns were not as attractive as expected, economic growth
rates were not as sustainable as imagined, and countries were not
as stable as believed.
Investors are becoming more aware of the intransigence of the
deep structural fault lines in most of these countries.
Risks to some of these countries have increased substantially
relative to the 2003-07 Goldilocks period, and uncertainty is
much higher. A limited reduction in the long-term strategic
allocation to emerging markets is warranted.
It is too early to overweight emerging markets, as they are not
yet attractive enough relative to the US from a valuation
perspective.
14
Investment
Management
Division Emerging Markets Are Only Moderately Undervalued
15
1. Normalized Emerging Market Equity Valuations1 – Through February 2014 2. Deviation of EM Currencies from Fair Value2 – Through February 5, 2014
(1) Based on monthly data for Price/Forward Earnings, Price/Book Value, Price/Cash Flow, Price/Sales, Price/Earnings-to-Growth Ratio, Dividend Yield and Return on Equity.
(2) Average deviation of the currencies in the EM Local Debt index from three fair value metrics: GSDEER, 5YMA and FEER.
Source: Investment Strategy Group, Bloomberg, Datastream, GS Global Investment Research, I/B/E/S, MSCI, PIIE
Emerging market equity valuations are not attractive enough relative to their own history or compared to US equities
to warrant a tactical tilt at this time. The most undervalued segments include Chinese banks and Russian energy.
Emerging market currencies are also only moderately cheap.
-20%
-15%
-10%
-5%
0%
5%
10%
08 09 10 11 12 13 14A
ve
rag
e o
f 5
YM
A, G
SD
EE
R a
nd
FE
ER
Mis
alig
nm
en
ts
-0.4-0.4
-0.1
-0.6
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Since 1994 Since 2003 Since 1994 Since 2003
No
rma
lize
d C
om
po
sit
e V
alu
ati
on
EM Less Attractive
Valuation vs. Own History Discount vs. US Equities
Investment
Management
Division Geopolitical Risks Remain Contained
Source: Investment Strategy Group 16
Despite a diplomatic flare up between China and Japan, the risk of military conflagration has not risen in early 2014.
Congressional pressure for further sanctions on Iran de-escalated as the interim nuclear deal went into effect.
However, countries accounting for about 25% of EM GDP, including all of the “fragile five,” face major elections in
2014. We expect above-average levels of policy uncertainty to drive market volatility in emerging markets.
“China will spend more on defense than Britain, Germany and France combined.”
– IHS, Feb 2014
“Hillary Clinton Opposes New Iran Sanctions.”
– LA Times, Feb 2, 2014
“[Japanese PM] Abe explicitly compared the tensions between China and Japan
now to the rivalry between Britain and Germany in the years before the first world
war, remarking that it was a ‘similar situation.’”
– Financial Times, Jan 22, 2014
Investment
Management
Division
The Market Impact From the US Debt Ceiling Negotiations
is Likely to be Limited
US Stock Market Performance Around Fiscal Deadlines (S&P 500)
Source: Investment Strategy Group, Datastream.
The US Treasury has warned Congress that the debt ceiling needs to be raised before the end of the month.
Declining Presidential and Congressional approval ratings, the upcoming midterm elections, the troubled Obamacare
rollout and the unpopularity of the October government shutdown suggest a compromise will be reached.
Equity markets have been far more sanguine in the face of policy uncertainty since the debt ceiling debate in the
summer of 2011.
17
80
85
90
95
100
105
110
-20 -18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20
S&
P 5
00
Le
ve
l (D
ea
dlin
e -
20
da
ys
= 1
00
)
Days to/from Fiscal Deadline
To 8/2/2011 (Debt Limit) To 12/31/2012 (Fiscal Cliff)
To 3/1/2013 (Sequester) To 10/17/2013 (Debt Limit)
Jul 22 2011-Aug 8 2011
(16.8%)
Investment
Management
Division
18 (1) Adjusted for large pension-related gains / losses in the telecom sector in Q4 of 2012 and 2013.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Capital IQ.
Nearly 2/3rds of companies exceeded revenue expectations in the 4th quarter of 2013, above the 10-year average.
Consensus earnings estimates have risen around 2% since the start of reporting.
S&P 500 operating margins are approaching new all-time highs, having reversed the majority of late 2012’s atypical
operating items and pension-related adjustments.
In turn, the annualized run rate of operating earnings accelerated in the fourth quarter to around $113, near the mid-
point of our $111-116 range for 2014.
US Equity Fundamentals Remain Supportive
1. S&P 500 Operating Margin (Rolling 4 Quarters) 2. S&P 500 Quarterly Operating Earnings (Annualized)1
$97
$102
$96$98
$103
$105$108
$113
$60
$70
$80
$90
$100
$110
$120
Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013
An
nu
alized
Qu
art
erl
y E
arn
ing
s
8.4
8.6
8.8
9.0
9.2
9.4
10 11 12 13
Investment
Management
Division
13%
11%
10%
8%
6% 6% 6%7%
5%
0.2%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0%
2%
4%
6%
8%
10%
12%
14%
1 2 3 4 5 6 7 8 9 10
5 Year Annualized Price Return (LHS)
Percent of Outcomes with Positive Returns (RHS)
More ExpensiveLess Expensive
Current Decile
Valuation
US Equities’ Overvaluation Has Moderated Somewhat
19
Note: Each decile contains five valuation metrics, beginning in September 1945. The current decile is based on an average difference from each decile’s threshold
across the following five valuation metrics: price/trend earnings, price/peak earnings, price/trailing 12m earnings, Shiller CAPE, and price/10-yr average earnings.
Source: Investment Strategy Group, Datastream, Robert Shiller.
Following the recent decline, US equities now stand at the 80th percentile of their historical valuations, compared to
the 90th percentile at the beginning of 2014.
Today’s valuation level has preceded positive price returns over the subsequent five years almost 80% of the time
historically, with an average annual price return of 7%.
US Equity Price Returns from Each Valuation Decile
Investment
Management
Division US Equities: Prospective Returns Have Improved
20 Source: Investment Strategy Group.
ISG End 2014 U.S. Equity Scenarios
We continue to expect S&P 500 earnings growth of 3-7% in 2014.
– S&P 500 Q4 earnings releases and commentary do not suggest that earnings will be weaker than expected.
– While global risks have intensified, we remain comfortable with our 2014 base case economic scenario.
The potential upside to our year-end 2014 central case price target range is now 6-10% on a total return basis,
up from 0-5% at the beginning of 2014.
We continue to believe that being underweight US equities poses a greater risk of underperformance than
remaining invested at one’s strategic allocation.
Good Case Central Case Bad Case
Probability 25% 60% 15%
S&P 500 Operating EPS $121 $111 - 116 ≤ $90
S&P 500 Reported EPS $115 $105 - 110 ≤ $72
S&P 500 Trend EPS $90 $90 ≤ $90
S&P 500 Price to Trend Reported Earnings 21 - 23x 18 - 21x 11 - 14x
S&P 500 Fundamental Valuation Range 1,890 - 2,070 1,620 - 1,900 1,260 - 1,350
S&P 500 Price Target 2,000 1,825 - 1,900 1,350
Investment
Management
Division Key Takeaways
21
Investors’ focus on different risk factors ebbs and flows.
The market has recently focused more on the “negatives” from emerging markets and ignored
their limited impact on the US and the Eurozone.
The market has also ignored:
– Improving European economic data
– Better than expected S&P 500 earnings
– Comments from the Federal Reserve that tapering is not tightening
Our key recommendation is to stay fully invested in US equities, but also highlight that
history shows that when starting valuations are high, the probability of at least one 5%
downdraft is 100% per year and the probability of at least one 10% downdraft is 63%.
Investment
Management
Division Important Information
22
Investment Strategy Group. The Investment Strategy Group (ISG) is focused on asset allocation strategy formation and market analysis for Private Wealth Management.
Any information that references ISG, including their model portfolios, represents the views of ISG, is not research and is not a product of Global Investment Research. If
shown, ISG Model Portfolios are provided for illustrative purposes only. Your actual asset allocation may look significantly different based on your particular circumstances
and risk tolerance.
Forecasts. Economic and market forecasts presented herein reflect our judgment as of the date of this material and are subject to change without notice. These forecasts
are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has
no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.
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below and, in certain cases, earlier in this presentation. Additional information regarding risks may be available in the materials provided in connection with specific
investments. You should not enter into a transaction or make an investment unless you understand the terms of the transaction or investment and the nature and extent of
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abrupt changes in price. Commodity prices are volatile because they respond to many unpredictable factors including weather, labor strikes, inflation, foreign exchange
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conditions, the potential difficulty of repatriating funds or enforcing contractual or other legal rights, and the small size of the securities markets in such countries coupled
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http://theocc.com/publications/risks/riskstoc.pdf. A secondary market may not be available for all options. Transaction costs may be significant in option strategies that
require multiple purchases and sales of options, such as spreads. When purchasing long options an investor may lose their entire investment and when selling
uncovered options the risk of loss is potentially unlimited.
Investment
Management
Division
23
Important Information
• Real Estate. Investments in real estate involve additional risks not typically associated with other asset classes, such as sensitivities to temporary or permanent
reductions in property values for the geographic region(s) represented. Real estate investments (both through public and private markets) are also subject to changes in
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