Unlike Goldman’s cross asset strategists, whose six Top Trade recommendations for 2016 have gotten destroyed three weeks into the year, with half of them already stopped out as we showed yesterday, the bank’s chief equity strategist David Kostin has been notably more accurate in his predictions, with his conservative 2015 year end target of 2000 on the S&P almost exactly where the stock market ended.
Since then stocks have taken a sharp leg lower, with the S&P dropping as much as 15% from its all time high, half the average post-war recession drawdown.
Which has forced Goldman’s clients to ask some very simple questions, starting with: “just what is going on”, and more importantly “what does the market know that they don’t:
Despite the generally positive US economic data, the sudden fall in asset prices has investors focused on the potential for a US recession. Clients understandably point to the stock market as a cause for concern, and wonder what the market has come to know in early 2016 that they do not.
Kostin responds:
A long few weeks ago, at the end of 2015, client conversations centered on the limited set of opportunities in an expensive stock market. With the median S&P 500 stock trading at a forward P/E of 17x – ranking in the 94th historical percentile – clients were reluctant to add exposure to equities, but almost universally expressed a desire to buy the market 10% lower.
So where are the buyers? According to Goldman’s clients these are the 5 biggest risks facing anyone will to BTFD:
- who is brave enough to catch a proverbial falling knife?;
- US industrial activity is contracting and the consumer will soon follow, dragging the broad economy into recession;
- the plunge in crude increases financial stress on Energy firms, and will lead to further cuts in capex and a profit downturn across many industries;
- China’s economy is slowing and the RMB will soon be devalued, exporting deflation and prompting the Fed to halt its tightening path, unsettling investors; and
- share prices need to fall further to offer an attractive risk-adjusted return given heightened economic and market risks.
According to Kostin the biggest risks remain energy and China, where Goldman’s own GDP ‘estimator’ shows just 4.5% growth, 230 bps below the official number…
Energy and China have been the two sources of negative macro news in 2016. Most visibly, WTI crude plummeted by 20% to below $30/barrel from $37 at the start of the year as global equities tumbled and Treasury yields dipped below 2%. Crude oil has now declined by 31% in 12 months and trades 70% below its local peak of $107 in mid-2014.
In China, the government reported 4Q GDP growth of 6.8%. However, during the same time period our China CAI (Current Activity Indicator) expanded at an average of just 4.5%, 230 bp slower than the official measure. Earlier this week our December CAI reading suggested China economic growth has decelerated to just 4.2%.
… even as the US economy has stubbornly refused to enter an all out recession (despite the clear manufacturing contraction):
In contrast, our MAP index of US economic surprises stands at roughly the same level as in early December when the S&P 500 stood at 2100.Broadly speaking, the industrial side of the US economy has continued to disappoint, with the ISM manufacturing index falling for six consecutive months to its current level of 48.2. Meanwhile, employment and services data have signaled economic health, with job creation averaging 284k during the past three months, lifting the full-year 2015 total to 2.7 million. Personal income is growing and consumer sentiment remains healthy. Although it has declined from mid-2015 highs, the ISM nonmanufacturing index remains deep in expansion territory at 55.3. Our economists expect US GDP growth will accelerate from its tortoise-like pace of around 1% in 4Q as headwinds from the inventory cycle, financial conditions, and oil prices fade.
So what does Goldman expect will happen in the coming year?
We continue to believe that a US recession is unlikely in 2016 and that the S&P 500 will rise to 2100 by year-end. Our economists expect that US GDP will grow at 2% this year as the Fed hikes rates four times. They estimate that risks to the US economy from a further slowdown in China are limited, and that the negative effects of lower oil prices will be offset by benefits to the consumer (see Global Economics Analyst, Jan. 15, 2016).
Our S&P 500 EPS estimate of $117 assumes US GDP growth of 2%. Every 100 bp shift in GDP growth impacts EPS by $5 per share. Our 2016 EPS growth forecast is 11%. However, EPS growth for S&P 500 ex-Energy will equal only 5% (see page 24 for EPS growth by sector).
The downdraft in equities YTD clearly reveals that investors believe a recession is more likely than we expect. The S&P 500 P/E has contracted by 6%. Cyclicals have underperformed Defensives by 422 bp YTD, as Telecom Services, Utilities, and Consumer Staples have led the market. Fed funds futures are pricing just over one hike in 2016.
Of course, prolonged market weakness in itself has the potential to weigh on growth, providing another example of financial market reflexivity. Even if the correction in equity prices was unwarranted based on economic fundamentals, the sell-off may become a self-fulfilling prophecy if lower share prices and increased volatility weigh on consumer spending and corporate investment.
Will Goldman be right, and will the US economy bounce back despite a hard landing in China, despite SWFs liquidating assets (up to $4 trillion in total), despite a new round of European bank tremors, despite increasing anti-austerity tensions in Europe’s periphery, and despite headwinds from a tightening Fed? Not even Kostin knows the answer, which is why he provides to scenarios how to trade the US: one assuming a recession, and assuming no recession.
For investors who do not expect a US recession, the current S&P 500 correction provides a buying opportunity. At the start of the year we forecast the index would rise by just 3% in 2016. Following the correction the prospective price return is now 10% (total return of 12% with dividends).
For investors concerned about a recession in 2016, our recommended strategies of strong balance sheets and domestic sales exposure should deliver relative outperformance even in the event of an economic downturn. These qualities have outperformed recently, with long/short basket trades returning 131 bp and 413 bp YTD, respectively. We believe these strategies should continue to generate strong returns given the trends of relative US economic strength, a rising US dollar, high corporate leverage, and oil-exacerbated credit market weakness.
