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Goldman Sachs AM's five key themes for H2

GSAM highlights five key themes for the second half of the year.

Goldman Sachs Asset Management believes that risks to global growth are now balanced following a reset to lower growth momentum. 

In its 2018 mid-year outlook, the firm highlights five key themes that it is watching in the second half of the year, from volatility trends to the importance of big data. 

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Goldman Sachs Asset Management believes that risks to global growth are now balanced following a reset to lower growth momentum. 

In its 2018 mid-year outlook, the firm highlights five key themes that it is watching in the second half of the year, from volatility trends to the importance of big data. 

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1. Continued expansion

We think that risks to global growth are roughly balanced following the reset to somewhat lower growth momentum. We see risks to the upside for the US and Japan, but risks as being somewhat to the downside for the Euro area and China.

In the US a stronger fiscal impulse is near

The February US budget agreement has significantly increased the expected fiscal impulse to growth, while the potential headwind from a tightening of financial conditions has yet to show up. This, together with the moderation we have seen in data means that risks are tilted to the upside from current growth rates.

We see downside risks for the euro area

The euro area has enjoyed very strong growth over the last year and a half, though very recently there have been clear signs of moderation in the high frequency data. From here, support is fading given the strengthening of the euro, rising interest rates and a likely moderation in global industrial activity

And in China

We continue to see a hard landing in China as unlikely in the next few years, but incoming information continues to suggest some degree of shift in priorities toward reform after the leadership consolidation. This is likely to weigh on growth this year, and we expect a gentle downward pressure on Chinese growth.

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2. A reset of rates risk

The rise in US rates this year has not translated into the tightening of broader financial conditions that we think is needed to bring US growth rates to a more sustainable level. 

We see a need for tighter financial conditions

Rates have risen, however, broader financial conditions have not tightened substantially and the shift in rates has now lost some momentum.

But a lack of catalysts

We see fewer near-term catalysts for a further shift in rates. We expect four rate hikes in total this year and still think the market is underpricing the pace of hikes, but the gap is much smaller than it used to be. Also, with the market already pricing a roughly 100% chance of a rate hike in June, it is very possible that we need to wait until later this year before the path indicated by the market comes under clearer pressure from central bank communication. We are still bearish on US duration, but we think a period of consolidation is likely before yields continue their rise.

Makes us less worried about the risks to other assets

The recent sell-off in rates helped close the gap between market expectations and Fed guidance for tightening, while reducing potential catalysts for a rapid rise in rates ahead. We believe the risk to equities from higher rates has moderated and see opportunities in EM and US small caps.

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3. Higher volatility, but not a high volatility regime

We have seen a spike in equity volatility after an extraordinarily calm 2017. We expect more frequent drawdowns from here, requiring a dynamic approach to investing. However, we believe volatility will be episodic, related to temporary drawdowns, rather than shifting to a persistently high volatility regime at this point in the cycle.

Volatility in 2017 was abnormally subdued

The S&P 500 experienced a record stretch without at least a 5% drawdown until the equity sell-off hit in late January.

The sell-off was in line with our view that we were likely to see more volatility in 2018, as markets would have to digest a moderation of growth momentum and higher interest rates. For the near term, the sell-off has brought us to a better balance of risks and hence a more positive outlook. Over the medium term, we do expect to see more frequent sell-offs giving rise to opportunities for active investment strategies, but not an outright shift to a high volatility regime.

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We are at a point in the cycle where volatility normally picks up

We divide the economic cycle into four phases, and the data generally suggests that we currently are a bit past the middle of the expansion phase.

We expect episodic bouts of volatility, related to temporary drawdowns, rather than a persistently high volatility regime, which normally occurs much later in the cycle.

The balance of risks is now better, but that is likely temporary

We expect it to be increasingly evident later this year that a firmer offset from monetary policy is needed to avoid more substantial overheating in the US economy given the size of the positive fiscal impulse. The balancing act between fiscal and monetary policy is a highly likely source of volatility.

We also worry about a number of risks that are not part of the core scenario. Geopolitical risks remain high, a more significant upside surprise to inflation could be disruptive, and we think the market is at risk of end of cycle scares if we were to see an unexpected bout of data weakness.

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4. Lowflation in the euro area

The euro area recovery is moderating but ongoing, and the output gap is expected to close this year. Despite expansionary activity, upward inflationary pressures remain scarce. In turn, our inflation and monetary policy outlook is more dovish than consensus and the ECB.

Firm activity has not boosted inflation, which remains sluggish. Annual headline and core inflation have averaged just 1.4% and 1.2%, respectively, over the past decade. We think this 'lowflation' trend is likely to persist due to three main cyclical and structural factors, leading the ECB to move only gradually toward policy normalization.

Excess slack in the labour market

Several indicators point to slack in the labour market. Unemployment and hours worked are above and below pre-crisis levels, respectively. Youth unemployment exceeds 30% in several peripheral countries and the proportion of part-time workers is in excess of 22% in the euro area. Taken together, these factors build a weak case for employers to raise wages.

 

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Increased labour migration

Even if unemployment declines, wage growth—which in turn spurs broader price pressures through higher domestic demand—is not guaranteed. Other than a brief five-month period during the global financial crisis, the German unemployment rate has been on a sustained downward trend since 2005, but wage growth remains lacklustre. This is due to migrant labour from surrounding countries where wages are lower than in Germany.

Technological disruption

The disinflationary impacts of technological advances are not unique to the euro area, but given the uptake of technology lags other markets, the inflation impact may still be in the pipeline. For example, e-commerce activity as a proportion of total retail sales is just 3.2% in Italy, compared to 9% in the US and 19% in the UK. Increased internet penetration and rising e-commerce activity will alter underlying inflation dynamics across sectors, while increased automation may pressure wages in certain sectors.

We are below consensus on euro area inflation as we believe there is still pent-up capacity in the labour market, despite low unemployment and above-trend growth.

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5. What Big Data is telling us about market themes

Companies are connected in ways that may impact their performance, but are often subtle and unnoticed. In our experience, analysing unstructured 'Big Data' can help bring these connections to light.

We believe the importance of thinking broadly about unexpected connections between companies will continue to grow as technological change morphs the definitions of economic sectors.

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The internet of food

People are moving online for more of their entertainment. Big data suggests the same is true of how they get their food. We have seen restaurants and internet software and services (ISS) companies connected through themes such as 'website,' 'strategy' and 'social,' indicating a trend towards an integration of food preparation and delivery with internet platforms.

Studies have shown that restaurants that employ a form of online delivery services have benefited from significantly stronger revenue growth relative to their non-internet connected peers. On the other hand, many ISS companies have incorporated online food delivery into their business models, utilising their comparative advantage in logistics to supplement restaurant supply.

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Greener, cleaner and cheaper

We see multiple seemingly unrelated industries benefiting as the cost of manufacturing semiconductors continues to fall. We identified linkages between semiconductor manufacturers, generators of renewable electricity and engineering firms through themes such as 'solar', 'electricity' and 'installation'.

The same cost-saving techniques used in semiconductor manufacturing are now used in solar cell manufacturing, resulting in an overall cost reduction when manufacturing and installing solar power plants. This coincides with growing demand for solar energy, which grew by 26% in 2017 as more nations look toward clean, renewable energy.

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Legally bound

Another theme we see is the acceleration of companies facing future liabilities based on their past actions. For example, tobacco companies and oil producers are linked through litigation-based themes such as 'appeals', 'judgments', 'trials' and 'damages'.

More governments and tobacco users have been suing tobacco companies for damages, and governments and activists have filed lawsuits against oil companies for damages from climate change.

For example, the states of Minnesota and Iowa sued multiple tobacco companies for hiding or downplaying risks of smoking, while New York City is suing the world’s five largest publicly-traded oil companies, seeking to hold them responsible for damage to the city from climate change.

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