Just like other risk assets, the benchmark US stock index, the S&P 500, has endured a wild start to the year.
Having closed 2015 at 2043.6 points, the index subsequently tanked more than 11% by early February, dragged down by heightened concern at the time to the outlook for the Chinese economy.
Then, as quickly as it arrived, the index subsequently rebounded, rallying by more than 16% from its February nadir to a high of 2,111 points by April 20.
Volatility dropped, risk assets went bid and the world, at least in a financial markets sense, was suddenly good again.
Along with a perceived reduction in concern surrounding the outlook for the Chinese economy, largely as a result of diminished fluctuations in the Chinese yuan at the time, the sharp drop in volatility coincided with new monetary policy easing from the European Central Bank and Bank of Japan, along with a dovish shift in the rhetoric from the US Federal Reserve.
The chart below, supplied by Goldman Sachs, reveals the recent reduction in Wall Street’s so-called “fear gauge”, the VIX, or volatility index. It uses options pricing to gauge expected market volatility looking 30-days ahead.
Since the high of April 20 the S&P 500 has been trading between 2,040 and 2,100 points, leaving many investors wondering which way it will move next.
Is there going to be a sharp break to the upside or downside, or merely a consolidation around current levels?
While nothing in markets is ever certain, Krag Gregory and Aleksandar Timcenko of Goldman Sachs believe that the risks are skewed to the downside rather than upside moving forward.
Here’s a snippet from a research note released by the pair overnight explaining why.
The Fed remains supportive and the economic data, despite some recent hiccups, continues to be generally supportive of our house view for slow, but steady, US growth. However, the trinity of supportive policy, improving data and a dearth of event catalysts has, by and large, dissolved. In their latest Kickstart, our U.S. Portfolio Strategy team argued that the S&P 500 index is likely to experience at least one 5%-10% drawdown between now and the end of the year. Identifiable headwinds include: higher valuation, positioning, waning buyback demand, potentially hawkish Fed surprises, negative growth surprises and event risks including “Brexit” and the U.S. election. This long list of potential risks skews the distribution of risks to the downside, and after a hefty rally, it seems easier to see the index 5% or perhaps 10% lower rather than higher.
While Goldman’s believe that risks for the S&P 500 are currently skewed to the downside, it doesn’t foresee any substantial move lower should the bank’s US economic growth forecasts come to fruition.
“If our house view of US growth materialises, the minefield of risks cited above could once again prove transient, leading the market back to a course of mostly sideways equity market returns and a resumption of below-average volatility,” they note.
Although that outcome would likely disappoint some investors, it must be remembered that Goldman is talking about a potential decline of 5-10% for an index that’s risen 210% since the depths of the financial crisis.
While some may disagree, others may see that as good outcome, particularly given the level of uncertainty that continues to exist, none more so than in the path for US interest rates.