DISSECTING THE MARKET DISCONNECT

ISSUE 80 | July 11, 2019 | 6:20 PM EDTEquityResearchGlobal Macro Research

Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.

The Goldman Sachs Group, Inc.

Amid growth uncertainty, inflation disappointments and dovish central bank shifts, the typical correlation between equities and bonds—that sees equities fall when bond yields decline—has broken down. How to interpret this apparent disconnect and what it’s telling us about growth and future asset performance is Top of Mind. We speak with Bridgewater’s Ray Dalio, who thinks recent price action makes sense given the Fed’s easier stance, but that limits on further monetary policy easing—among other political and geopolitical factors—will ultimately bring about a major negative shift in growth and markets. GS strategists agree that there’s no disconnect in markets because under the surface risky assets have reflected growth concerns—

not just bonds. But GS Chief Economist Jan Hatzius argues that the bond market is too concerned about growth, and perhaps not concerned enough about the direction of Fed policy, with the costs of easing now potentially outweighing the benefits. We share our views on how to position here (focus on “up in quality” for now), as does Dalio (diversify!).

To the extent that there is some difference of view between bond market and equity market investors—with the bond market more pessimistic about growth than the stock market—I would side a bit more with the stock market. That’s because it seems to me that the growth outlook, while clearly not as strong as in 2017/2018, is still pretty decent.

- Jan Hatzius

“

When the Fed shifted to a much easier stance, it made sense that both interest rates fell—which was good for bonds—and stock prices rose. But the power to do this is limited. Think of central banks cutting interest rates and purchasing financial assets (QE) as shooting doses of stimulants into their economies and markets. There is now only a limited amount of stimulant left in the bottle, and the sooner we use it, the sooner it will run out.

- Ray Dalio

“

INTERVIEWS WITH: Ray Dalio, Founder and Co-CIO, Bridgewater Associates

Jan Hatzius, Chief Economist, Goldman Sachs

Praveen Korapaty, Chief Interest Rates Strategist, Goldman Sachs

BREAKING DOWN BOND MARKET PRICING William Marshall and David Mericle, GS Macro Research

LOWER RATES MAY NOT MEAN HIGHER STOCKS David Kostin, GS US Equity Strategy Research

CARRY AND QUALITY OVER “BETA” Lotfi Karoui and Caesar Maasry, GS Markets Research

THE BEARISH BULL MARKET IN EVERYTHING Christian Mueller-Glissmann, GS Multi-Asset Strategy Research

IS NEGATIVE-YIELDING DEBT SUSTAINABLE? George Cole, GS Europe Markets Research

WHAT’S INSIDE

of

Allison Nathan | allison.nathan@gs.com

TOP MIND

David Groman | david.groman@gs.com

...AND MORE

Note: The following is a redacted version of the original report published July 11, 2019 [26 pgs].

30

35

40

45

50

55

60

65

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Manufacturing Survey Tracker

ISM Manufacturing Index

-30

-20

-10

0

10

20

30

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Large manufacturers

Large nonmanufacturers

Small manufacturers

Small nonmanufacturers

Corp outlook

2019Q3

-2

-1

0

1

2

3

4

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

GDP

Potential Growth

New Forecast

Old Forecast

-8

-6

-4

-2

0

2

4

6

8

15 16 17 18 19

More central banks easing

The stock-bond disconnect 10-year US Treasury yield, %; S&P 500, index (rhs)

1.8

2

2.2

2.4

2.6

2.8

3

3.2

3.4

Apr-18 Oct-18 Apr-19 Oct-19

2000

2200

2400

2600

2800

3000S&P 500(rhs)

US 10y Yield

Rising odds of recession cuts Market-implied probability of policy actions over the next 12 months, %

Moving in tandem 10-year US inflation breakeven, %; probability Fed does not cut by ≥100bp, % (rhs)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Oct-18 Dec-18 Feb-19 Apr-19 Jun-19

≥ 100bp of cuts25 to 75bp of cutsNo ChangeHike

30%

40%

50%

60%

70%

80%

90%

100%

1.6

1.7

1.7

1.8

1.8

1.9

1.9

2.0

2.0

Jan-19 Feb-19 Mar-19 Apr-19 May-19 Jun-19 Jul-19

10y Inflation Breakeven

Probability that Fed does not cut by ≥100bp (rhs)

02468

10

12

14

16

18

Pan

ic o

f 1837

follo

wed

b

y

dep

ressio

n

('37-'

43);

key

cau

ses w

ere

restr

icti

ve

len

din

g

po

licie

s in

G

reat

Bri

tain

,

declin

e in

co

tto

n p

rices,

sp

ecu

lati

ve

len

din

g

1842:

6.6

%

1792:

4.7

%

1798:

8.1

% 1821:

4.6

%1835:

4.0

%

1861:

6.6

%

Pan

ic o

f 1857

follo

wed

b

y

dep

ressio

n

('57-'

60);

key

cau

ses w

ere

declin

ing

in

tern

ati

on

al

eco

no

my,

failu

re o

f a

larg

e U

S b

an

k,

an

d d

ow

ntu

rn

in t

he r

ailro

ad

ind

ustr

y

US

Civ

ilW

ar

(1860-1

865);

US

fo

rced

off

of

the g

old

sta

nd

ard

1864:

5.3

%

Go

ld

cra

sh

1869:

4.2

%

1932:

4.3

%

Gre

at

Dep

ressio

n('

29-'

41)

WW

II (

'39-'

45)

1945:

1.7

%

WW

I

('14-'

18)

1915:

3.7

%

US

ab

rog

ati

on

o

f B

rett

on

Wo

od

s

1971:

5.5

%

1981:

15.8

%

Fed

Ch

air

man

V

olc

ker

incre

ased

th

e

fed

fu

nd

s r

ate

to

a p

eak o

f 20%

in

1981 t

o g

et

do

ub

le-d

igit

in

flati

on

un

der

co

ntr

ol

1984:

13.9

%

Vo

lcker

hik

ed

rate

s t

o

restr

ain

th

eeco

no

mic

re

co

very

an

d e

nsu

re

inflati

on

w

ou

ld r

em

ain

lo

w

2n

d o

il s

ho

ck a

nd

Ira

n

ho

sta

ge c

risis

('79-'

80)

1st

oil s

ho

ck

('73-'

74)

Lo

win

po

licy-r

ate

cycle

1986:

7.0

%

Lo

win

po

licy-

rate

cycle

fo

llo

win

g '9

1

recessio

n

1993:

5.5

%

Un

exp

ecte

d r

ate

-hik

ing

cycle

as e

co

no

mic

g

row

th

imp

roved

fo

llo

win

g

'91

recessio

n1994

7.9

%

Lo

win

po

licy-r

ate

cycle

fo

llo

win

g

tech

b

ub

ble

bu

rsti

ng

2003:

3.4

%

Sta

rto

f a r

ate

-

hik

ing

cycle

as

inflati

on

cre

pt

up

wit

h r

eco

very

fr

om

'01

recessio

n

2004

4.7

%

QE

3

2012:

1.6

%QE

2

2010:

2.5

%

GF

C

QE

1

2008:

2.3

%

Pan

ic o

f 1796-

1797;

US

real

esta

te c

ollap

se

an

d e

nsu

ing

d

ep

ressio

n1790:

8.7

%

US

dep

ressio

n

(late

1780s)

Pan

ic o

f 1819

follo

win

g th

e e

nd

o

f th

e W

ar

of

1812

an

d m

is-

man

ag

em

en

to

f th

e

Seco

nd

Ban

k o

f th

e U

nit

ed

Sta

tes

US

eco

no

mic

b

oo

m

Recessio

n fo

llo

win

g

oil s

ho

ck

1900:

2.9

%

1920:

5.6

%

Dep

ressio

n

of

1920-2

1;

Fed

hik

ed

rate

s t

o

co

ntr

ol

po

st-

war

inflati

on

; re

turn

ing

so

ldie

rs

weig

hed

o

n

wag

es

1969:

7.9

%

Fed

hik

ed

as

eco

no

my h

eate

d u

p

Vie

tnam

w

ar;

US

co

mb

at

invo

lvem

en

t

('65-'

73)

Fir

st

Ban

k o

f th

e

Un

ited

S

tate

s

(1791)

1913:

Fed

era

l

Reserv

e S

yste

m

cre

ate

d

Th

e G

reat

Railro

ad

Str

ike

1877:

4.5

%

1907:

3.3

%

Pan

ic o

f 1907;

failed

att

em

pt

to c

orn

er

the

mark

et

on

th

e

sto

ck o

f a

larg

e c

om

pan

y

gen

era

ted

ban

k l

osses,

a

cri

sis

in

co

nfid

en

ce in

b

an

ks,

an

d

ban

k r

un

s

Fed

tap

eri

ng

,

hik

ing

,ru

no

ff

2016:

1.5

%July

2019:

2.1

%

Negative territory Negative yielding sovereign debt, $ tn

Germany: Yielding below Japan German and Japanese yield curves, %

0

1

2

3

4

5

6

7

2014 2015 2016 2017 2018 2019

EUR

JPY

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

1 4 7 10 13 16 19 22 25 28

DEM

JPY

Stock prices have risen alongside falling interest rates… …and the yield gap currently equals 380bp

Cyclicals vs. defensives are pricing US growth of ~1.5%... …and policy uncertainty has weighed on equity valuations

The S&P 500 appears to be trading near fair value... …and we see the index moving largely sideways through year-end

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

1800

2000

2200

2400

2600

2800

3000

2016 2017 2018 2019 2020

10-yearUS Treasury yield

(rhs)

S&P 500(lhs)

0 %

2 %

4 %

6 %

8 %

10 %

12 %

14 %

16 %

18 %

20 %

1976 1982 1988 1994 2000 2006 2012 2018

S&P 500 earnings yield

US 10-year Treasury yield

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

80

85

90

95

100

105

110

2015 2016 2017 2018 2019 2020

US Current Activity Indicator

(rhs)

Cyclical vs. defensive US equity industry groups

(lhs)

0

50

100

150

200

250

(100)bp

0 bp

100 bp

200 bp

300 bp

400 bp

500 bp

600 bp

700 bp

800 bp

900 bp

1000 bp

2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

S&P 500 yield gapvs. 10-year US

Treasury

Economic policyuncertainty index

(3m avg, rhs)

(100)bp

0 bp

100 bp

200 bp

300 bp

400 bp

500 bp

600 bp

700 bp

800 bp

2002 2005 2008 2011 2014 2017 2020

ModeledActual

R2 = .69

The current yield gap is in line with

model-implied levels, and we see

it widening slightly by year-end

2020 adjusted EPS

$175 $178 $181 $184 $187

525 bp 2500 2525 2575 2625 2675

475 bp 2675 2725 2775 2825 2875

425 bp 2900 2950 3000 3050 3100

375 bp 3175 3225 3275 3350 3400Current

yield

gap

325 bp 3500 3550 3600 3675 3725

GS EPS

est.

Yie

ld g

ap

(S&

P 5

00 E

PS

yie

ld -

10Y

US

T y

ield

)

Cons. EPS

est.

GS forecast:

Risk up, bonds down Global beta index*; US 10-year Treasury yield, % (rhs)

Looking stretched Historical percentile ranks*

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

90

95

100

105

110

115

120

125

130

135

140

145

150

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Global beta index (Cross-asset long onlyperformance)US 10-year yield (RHS)

0% 25% 50% 75% 100%

EMBI OAS

HY OAS

S&P 500 PE

IG OAS

MSCI EM PE

Post-crisis history

Full history: 1997-present

ExpensiveCheap

Defensive flavor Cum. excess returns on a monthly rebalanced long-short strategy of

broad HY vs. CCC-rated bonds, %; HY cum. excess returns, % (rhs)

Performing at full-employment Performance of long strong vs. weak balance sheet stocks before and

after US unemployment dips below 4.5%

-2%

8%

18%

28%

38%

48%

58%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Long-short HY vs. CCC cumulative

excess returns, vol-neutral

HY Cumulative excess returns (RHS)

Quality outperforms

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

-12-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24

1998 2006 2017

Quality outperforms

60/40 equity/bond portfolios had their best 1H in decades… … but investors have also increased allocations to “safe”

assets

Equity fund flows have been as negative as during the GFC… …while low-vol stocks have performed particularly strongly

Monetary policy has been the main driver of risk appetite… …but better growth is likely needed to sustain the current rally

-1.2

-0.6

0.0

0.6

1.2

1.8

2.4

3.0

3.6

-8%

-4%

0%

4%

8%

12%

16%

20%

24%

63 71 79 87 95 03 11 19

60/40 portfolio YTD Return

Sharpe Ratio (RHS)

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

16 17 18 19

Risky assets

Safe assets

Risk appetite indicator

-200

-150

-100

-50

0

50

100

150

200

250

07 08 09 10 11 12 13 14 15 16 17 18 19 20

Money Market

Govt

Credit

Equity

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

91 95 99 03 07 11 15 19

S&P 500 low vol index

S&P 500 low vol index vs. S&P 500

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

14 15 16 17 18 19

PC1: Global growth

PC2: Monetarypolicy

TINA Reflation Goldilocks Growthslowdown

Feddovishpivot

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

14

07 09 11 13 15 17 19

PC1: Global growthGlobal CAI (RHS)

The C

AP

E u

ses a

10

-year

ave

rage o

f re

al S

&P

500 r

eport

ed e

arn

ings p

er

share

.

We d

efine t

he s

tart

of

a r

ate

-hik

e c

ycle

as t

he f

irst hik

e a

fter th

e p

olic

y r

ate

has p

late

aued o

r been c

ut,

usin

g t

he d

iscount

rate

fro

m 1

955-1

971 a

nd t

he f

edera

l funds r

ate

th

ere

aft

er.

A r

ate

-hik

e c

ycle

ends e

ither

when t

he s

ubsequent

Fed m

ove

is a

cut

or

when t

he p

olic

y r

ate

is s

table

for

the s

ubseq

uent

12 m

onth

s.

We d

efine a

rate

-hik

e c

ycle

as lasting m

ore

than o

ne m

onth

and inclu

din

g m

ore

than o

ne h

ike.

GS

GIR

: M

ac

ro a

t a g

lan

ce

Watc

hin

g

•D

es

pit

e r

isin

g r

isk

s,w

e s

till

exp

ect s

olid

glo

bal g

row

th o

f 3

.3%

in 2

019,i

n li

ne w

ith

co

nsensus.

•In

th

e U

S, w

e e

xpe

ct s

lightly

ab

ove-t

rend g

row

th o

f a

bo

ut 2.0

% in

2H

, w

ith

th

e im

pa

ct o

f tig

hte

r finan

cia

l con

ditio

ns fad

ing o

ver

tim

e. T

he

co

ntinu

ed p

oss

ibili

ty o

f tr

ade e

scala

tion

skew

s r

isks

to

gro

wth

to

th

e d

ow

nsid

e.

•W

e t

hin

k t

he

Fe

d w

ill c

ut ra

tes

tw

ice t

his

ye

ar,

likely

in J

uly

and

Se

pte

mb

er.

We

exp

ect m

oves in

25b

p in

crem

ents

an

dth

att

he fu

nds r

ate

will

re

ma

in b

elo

w 2

% a

t le

ast u

ntil t

he 2

020 e

lect

ion.

•In

th

e E

uro

are

a, w

e s

ee G

DP

exp

an

din

g a

t o

nly

a s

ligh

tly a

bo

ve-p

ote

ntial p

ace o

f 1

.25

% in

2H

, w

ith

ge

op

olit

ica

l te

nsio

ns

an

d a

we

ake

r e

xte

rna

l en

viron

men

t, a

mon

g o

ther

facto

rs, w

eig

hin

g o

n

gro

wth

; tr

ade

ten

sio

ns a

nd It

alia

n b

udg

et fr

ictions p

ose a

dd

itio

nal d

ow

nsid

e r

isks. D

espite the

com

ing c

han

ge in

th

e U

K P

M, w

e e

xpe

ct a

n o

rderly B

rexi

t, m

ost lik

ely

in la

te 2

019

/ea

rly 2

020

.

•W

e e

xp

ect

the E

CB

to

cu

t ra

tes

by 2

0b

p, re

-sta

rt n

et

asse

t p

urc

hase

s, a

nd

de

liv

er

str

on

ge

r fo

rward

gu

ida

nce a

t it

s S

ep

tem

be

r m

eet

ing

giv

en s

till-

slu

gg

ish

gro

wth

/infla

tion in

the

Eu

ro a

rea

an

d r

ecen

t do

vish c

om

mu

nic

ation fro

m E

CB

Pre

sid

en

t Ma

rio D

rag

hi.

The

appo

intm

en

t of IM

F c

hie

f C

hri

stin

e L

aga

rde

to s

ucc

ee

d D

ragh

ipoin

ts to c

ontinuity

in E

CB

po

licy.

•In

Ch

ina, w

e e

xpe

ct full-

year

GD

P g

row

th o

f 6

.3%

in 2

019, th

oug

h tra

de te

nsio

ns

an

d w

ea

ker g

lob

al g

row

th p

ose

do

wn

sid

e r

isks

.

•W

AT

CH

TR

AD

E.

De

sp

ite th

e c

urr

ent U

S-C

hin

a tra

de

tru

ce, w

e s

till

thin

k it

is m

ore

like

ly than

not th

at th

e U

S im

po

se

s ta

riffs in

the

com

ing m

on

ths b

efo

re a

lim

ite

d a

gre

em

en

t is r

eache

d la

te this

ye

ar

or

earl

y in

20

20. W

e d

o n

ot exp

ect t

he T

rum

p A

dm

inis

tra

tion

to im

po

se b

road a

uto

ta

riffs, a

nd b

elie

ve p

assa

ge o

f th

e r

ev

ised N

AF

TA

(U

SM

CA

) is

mo

re li

kely

th

an n

ot b

y y

ea

r-end

.

So

urc

e: G

old

ma

n S

achs G

loba

l In

ve

stm

en

t R

esea

rch

Gro

wth

So

urc

e: H

ave

rA

na

lyti

cs a

nd

Go

ldm

an

Sa

ch

s G

lob

al In

ve

stm

en

t R

ese

arc

h.

No

te: G

S C

AI is

a m

ea

su

re o

f cu

rre

nt g

row

th. F

or m

ore

in

form

ati

on

on

th

e m

eth

od

olo

gy o

f th

e C

AI p

lea

se s

ee

“T

rackin

' All O

ve

r th

e W

orl

d -

Ou

r N

ew

Glo

ba

l CA

I ,” G

lob

al E

co

no

mic

s A

na

lyst,

Fe

bru

ary

25

, 2

01

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4.7

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20192020

2021

Cu

rrent

Activity Ind

icato

rH

isto

rical G

DP

GS

Q2 G

DP

Estim

ate

Disclosure Appendix

’

’

’