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Goldman Explains 'The Road To Recovery' In 1 Simple Chart

In Goldman Sachs' view, there are three very different near-term paths that economies and markets can now follow, and that imply very different outcomes for financial markets:

 

 

Through the looking glass: Scenarios for a post-crisis world

Seven years after the start of the financial crisis, economic and financial conditions remain far from normal. In the ‘Wonderland’ of near-zero interest rates, many of the traditional relationships that have governed the way in which markets and cycles evolve have broken; the value of historical analysis has weakened.

There are three main paths from here, in our view: a ‘secular stagnation’ scenario, a ‘sustained moderation’ and a ‘normalisation’ based on a new global growth engine (driven by restructuring, the US energy revolution and/or a major consumption shift in China). The first is broadly better for bonds than equities, while the second is better for equities than bonds. ‘Normalisation’ would be very good for equities and negative for bonds.

Path 1 – ‘Secular Stagnation’:

Growth remains well below the previous trend and inflation and rates stay low.

Equities achieve a low return (although in areas with low valuations, it is still likely to be reasonable in real terms). Volatility stays low.

Path 2 – ‘Great Moderation’:

Growth recovers, but is not strong enough to raise inflation pressures; technological innovation also keeps a lid on inflation. Interest rates rise but very slowly. It is not a ‘normal’ cycle since rates inflation remains subdued, but there is at least sufficient growth to generate profit expansion.

Equities outperform bonds. Volatility stays low. Bonds become the ‘riskier’ asset.

Path 3 – ‘Normalisation’ – a new growth engine:

This is the more positive route that markets may take. It is possible that longer-term growth is enhanced but technology keeps a lid on inflation and the trade-off between growth and rates becomes more favourable for risky assets. Any new strong secular drive for growth is unlikely to have an impact in the near term, but there are various potential drivers. The stronger growth could come, perhaps, from:

  • major structural reforms in places like India and Europe;
  • the impact of the US energy revolution; and
  • a significant growth driver from Chinese consumption.

In truth, the outcome may also vary by region. The US, for example, looks much more likely to achieve a moderation than, say, Europe. Already, Europe is following a stagnation path from an economic perspective. But even here, this need not be bad for investors. What matters is not so much the outcome, but the outcome relative to expectations. This scenario is largely priced in for Europe. Of the three, a return to ‘normal’ – triggered by a major new growth engine – would clearly be the most positive for equities and the most negative for bonds. But it is also the least likely, in our view, at least in the nearer term.

Of the other two, the moderation scenario is the more positive for equity holders in absolute terms and, barring sharp rises in interest rates or exogenous shocks, it could still last for a long time. It is unlikely to be very negative for bond holders while inflation stays low, central banks remain accommodative and regulation results in many ‘non-economic’ buyers. However, there are factors, both positive and negative, that may ultimately come into play over the next few years and could also result in quite different outcomes.

Great Moderation...  leading to:

There are probably two possible medium/long-term scenarios that are likely to stem from a Great Moderation (path 2).

Outcome 1 – Equity re-rating. A long period of stable growth and low inflation encourages significant rises in equity valuations and, eventually, very low returns for a long time thereafter. In this outcome, good near-term returns in equities (relative to other asset classes) gradually push valuations up to levels that imply low long-term returns, just as with other asset classes. The performance in equities may be enhanced by further margin rises as technology constrains the returns to labour. While this extends the bull market in equities, it implies that very low returns become much more likely over the longer run.

 

Outcome 2 – Bond bubble bursts. Lower-for-longer inflation and accommodative policy could push bond and credit yields down further, creating a bubble. When an adjustment in interest rates finally happens, it may trigger a more aggressive bear market in bonds and credit; equities could also fall sharply. The risks here are significant given the extraordinarily low risk premia priced into fixed income markets. Just as with equities in the late 1990s, fixed income assets have been increasingly priced on a relative basis (against ever lower yielding government bonds). There is a growing gap risk across fixed income – and a real danger that when the risk-free rate adjusts, liquidity across fixed income will disappear.

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Moderation is Goldman's base case but they realize the Fed is now entirely boxed-in.

In our view, if we are wrong in expecting the great moderation path to dominate markets over the next year, then the next most likely outcome is probably the derailing of the moderation path as a result of a sharper re-rating of equities as investors are gradually  forced up the yield curve.

 

The next most likely exit from moderation would likely come from a rise in bond yields. While equities would likely outperform in this scenario, at least over the medium term, it  would likely trigger higher volatility and a setback in prices across the major asset classes. The risks to the bond market here may not stem purely from higher inflation coming through (as in 1994 for example), but perhaps from central banks being seen to be behind the curve as forward inflation expectations rise. Anything that pushes long rates higher may result in enhanced ‘gap risk’ heightened by a lack of liquidity. This may become particularly strong in the credit market.

In other words, the Fed is desperate for higher yields to signalize a recovery and higher terminal rate, but it can't afford it as it would lead to bond market dislocations.

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Source: Goldman Sachs' Peter Oppenheimer