While the Covid-19 pandemic and economic lockdown is likely to lead to one of the worst economic downturns since the 1930s, it hasn’t been a typical recession because it was not caused by economic or market factors.
Goldman Sachs’ chief global equity strategist Peter Oppenheimer said the current recession is an ‘event-driven’’ bear market, where an exogenous and unanticipated event causes a valuation adjustment.
While the recent rally in equities – driven largely by technology stocks – has started to lose momentum, the strategist believes equity returns are still likely to outperform bond returns, and outlined 10 reasons why the bull market will continue.
The first reason he gave was that it is likely markets have entered a new investment cycle, which usually begins in a recession as investors start to anticipate a recovery.
“We appear to be in the early stages of a new bull market,” he explained. This ‘hope’ phase, said Oppenheimer, is typically the strongest part of the cycle and is what investors have been witnessing this year.
He added: “That said, as we transition from the initial ‘hope’ phase to a more sustainable ‘growth’ phase, it would not be unusual for the market to experience a near-term setback if the animal spirits unleashed in the ‘hope’ phase prove to have been too optimistic.”
The strategist said during the ‘growth’ phase markets usually experience a de-rating of valuations and exhibit much lower returns, which is consistent with Goldman Sachs “modest” 12-month price targets.
Typical phases of the cycle
Source: Goldman Sachs Global Investment Research
A second reason he believes the bull market will continue is that as vaccines become more likely, the economic recovery “looks more durable”.
“A vaccine would accelerate the recovery starting in Q1 2021, particularly in the consumer areas that are highly sensitive to mobility,” he said.
He also said current aggressive policy support isn’t likely to change in the event of a vaccine, as authorities will likely allow economies to run hot to establish the economic recovery, pushing risk assets and equities higher.
“Also, even without a vaccine, so far the death toll from the recent virus spike has not risen,” the Goldman Sachs strategist added, “suggesting that the rise in cases is either related to more testing or is occurring in younger, less vulnerable cohorts, in which case it points to evidence of society better protecting vulnerable groups.”
The third reason he gave for a likely continuation of the bull market was the upward revisions to economic forecasts and earnings. He said this is typically what is seen in the early stages of recovery from a bear market, and that upward revisions could well drive equity markets higher.
The fourth reason he noted was the firm’s bear market indicator pointing to a low risk (44 per cent) of another bear market. The indicator uses variables including valuation, yield curve, growth momentum, inflation, private-sector balance and unemployment.
“While these high valuations – the main factor preventing the indicator from falling further and in the 93rd percentile – could limit long-term returns for investors, it is more likely than not that this cycle is only in its early stages and has plenty of time to run,” Oppenheimer said.
He revealed that the indicator points to double-digit returns over the next five years, but that a lot has already been achieved since the March low.
The fifth reason he pointed to was the aggressive policy support, which have substantially reduced the tail risk for investors. The monetary support provides what he describes as a central bank ‘put’ – the belief that central banks will provide as much liquidity as is required – while also extending forward guidance on zero interest rates. Whilst fiscal support provides a government ‘put’ – the belief that governments will step in with up-scaled programmes to prevent another imminent economic downturn.
“Together these policies significantly reduce the left tail risk to equity holders, justifying a fall in the equity risk premium,” Oppenheimer added.
The sixth reason for a continuation of the bull market was Oppenheimer’s belief that the equity risk premium has room to fall from current elevated levels.
A new economic cycle is emerging, he said, which – with moderate growth, inflation and interest rates – could be as long as the last and reduce the risk of recession and lead to equity risk premium falling.
The seventh reason he outlined was the long-term decline in nominal interest rates, which have supported and will continue to support risk assets. He said economic activity could falter and inflation expectations fall, pushing real rates higher, but for now he believes a continued environment of negative real rates will continue to help push up equity valuations.
The eighth reason outlined by the strategist was the inflation ‘protection’ that equities provide in a portfolio.
Equities, which suffered in the inflationary period of the 1970s when margins contracted, did better than bonds because “their revenues are linked to nominal GDP; as inflation accelerates so, at least, should nominal sales”, he said.
“While significant rises in inflation are not likely in the near-to-medium term and, at any rate, would be a negative drag on equities, equity markets can offer a much more effective hedge against unexpected price increases,” Oppenheimer explained.
Inflation leading to an increase in nominal S&P 500 sales
Source: BLS, Haver Analytics, Compustat, Goldman Sachs Investment Research
He also said equities are likely to outperform in an environment where bond yields rise from extreme lows currently.
The ninth reason for a continuation of this bull market, Oppenheimer said was the fact that equities continue to look cheap relative to corporate debt, particularly for companies with strong balance sheets. He noted that 60 per cent of US companies and 80 per cent of European companies have dividend yields above the average corporate bond yield.
The strategist said it was plausible companies could see their dividend yields fall – which would drive multiples and returns higher.
He highlighted that the largest US tech companies pay low dividends and pay very close to nothing on debt, making it easy for them to raise funds very cheaply to channel back into investing for the future growth.
“If dividend yields continue to fall as investors increasingly search for defensive and predictable yield, then these stocks could re-rate further, driving broader equity indices higher,” Oppenheimer said.
The final reason for the continuation of the bull market, according to the Goldman Sachs strategist, was the acceleration of the digital revolution.
“From payments to online shopping, the transition is forcing rapid adjustment in the composition of the stock market and in the way that companies are responding,” he said. “Much of this involves the acceleration of digitalisation of companies in the non-technology space which, itself, has benefited technology companies.”
He said while there is a risk the whole market would correct if the economy slows and these stocks fall, many of these companies are highly cash-generative and have strong balance sheets, and they are seen as defensive, possibly outperforming even in a market correction.
“Unless interest rates rise meaningfully – which would risk a de-rating of longer-duration stocks both on an absolute and relative basis – this sector of the market is likely to remain dominant for some time to come, and we remain overweight in every region,” Oppenheimer finished.