Markets have been in an unsustainable "Goldilocks" mode, according to Goldman Sachs Group Inc., in which expectations of rising economic growth combined with sinking bond yields have laid the foundation for a rally in stocks.
But this environment can't hold much longer as acceleration in growth will fail to materialize or come at a cost, accompanied by a rise in government bond yields.
"Like Goldilocks herself, the market might get away with it for a while but it will eventually get caught by a bear," said Chief Global Equity Strategist Peter Oppenheimer. "Either bond yields and interest rates stay at record lows and economic and profit growth disappoints once again (capping valuations), or growth and inflation surprise to the upside (perhaps on the back of more fiscal easing) but bond yields adjust higher (also capping valuations)."
Oppenheimer sees three ways forward for markets:
- Reflation — growth picks up, but bond yields do too;
- Stagflation — inflation propels bond yields higher, but without a commensurate acceleration in growth; and
- Fat and Flat — the most likely scenario, a continuation of the current trend of sluggish growth and low bond yields.
Notably, the potential for multiple expansion in light of ultra-low bond yields – a key component of the Fed Model that's pointed to attractiveness of equities over sovereign debt – isn't likely to come to fruition even under the "fat and flat" scenario, the strategist argues.
"There are limits to how much yields alone can drive equity valuations, in our view," he writes. "Eventually, they have to reflect a realistic assumption about long-term nominal growth."
Measures of the equity risk premium — the excess return derived from investing in stocks is expected to provide relative to the risk-free rate — are assuming profit growth that's likely unattainable should the current slow-growth environment that's gripped the world (and is reflected in ultra-low to negative bond yields) endures.
As a caveat, there are a myriad of ways to calculate the equity risk premium depending on the assumptions made when estimating the expected return.
Globally, Oppenheimer estimates that measures of the equity risk premium are near levels reached during the European sovereign debt crisis and amid the market turmoil following the Chinese devaluation.
But if one assumes that slow-growth environment that's prevailed since the financial crisis is a "new normal," rather than a series of stiff headwinds that will fade over time, equities don't look like as much of a screaming buy:
The upshot of Oppenheimer's analysis is that equities are likely to do better than bonds over the medium term, but that investors should temper their expectations on the extent of this outperformance.
"Here lies the great dilemma for investors: on the one hand, current bond yields imply that valuations can continue to rise for financial assets (as they have already done over recent years), but, on the other hand, to justify current risk free rates into the future, we should assume lower long-term growth (consistent with ‘secular stagnation’)," concludes Oppenheimer.