What a turnaround that it’s been for markets since the Brexit vote. From fear to frenzy, the recovery in risk assets from the lows struck just eight days ago has been amazing to watch.
How, given Brexit was going to lead to the unraveling of the European Union and throw the global economy into disarray, have financial markets managed to brush it off in a Teflon-like manner?
According to Goldman Sachs’ portfolio strategy research team, there’s a simple explanation: while Brexit will likely drag on economic growth, that threat will be mitigated, and overrun, by the prospect of additional monetary policy stimulus.
Like Pavlov and his dog, having been given a taste of stimulus, and seen it push asset prices to extreme levels in the years following the financial crisis, markets want more.
Champing at the bit, they are. Salivating in anticipation.
“The resumption of the search for yield has been fueled by the market treating Brexit as a negative local growth shock, which would mainly affect the UK and Europe, and a positive global rate shock, as it will likely drive easier monetary policy by the G7 central banks,” says Goldman Sachs.
As the excellent chart below reveals, with the exception of the British pound and Brent crude, assets — whether risky or defensive — have enjoyed a stellar run over the past week.
While the markets have re-embraced risk assets with vigour, Goldman Sachs remain cautious, suggesting that there are a plenty of risks associated with stocks and bond rallying in unison.
“This drives expensive valuations for both asset classes and makes them vulnerable to shocks,” says Goldman.
“Bonds could sell off sharply as a result of central bank disappointment, positive inflation and data surprises and/or illiquidity, which would likely drive weakness in equities and other risky assets, at least initially. Equities could sell off owing to negative growth surprises and with yields at all-time lows, bonds are unlikely to be good hedges.
“This leads to a lack of diversification and higher portfolio risk at a time when return potential is already limited,” it adds.
Given these perceived risks, Goldman have retained a defensive portfolio allocation, remaining overweight cash given elevated asset valuations and expectations that the position-driven risk rally over the past week will fade.
“With valuations across assets elevated, we remain overweight cash and would suggest a broadly diversified portfolio of currencies, including risk-on and risk-off currencies. Gold can also help diversify and reduce portfolio risk,” it says.
Here’s Goldman’s view on the outlook for stocks.
We still believe equities are fragile and stuck in their ‘fat and flat’ range with little return potential but potential for drawdowns. Elevated valuations and lack of growth drive negative asymmetry and while risk appetite has picked up, high political uncertainty and risks from financials weigh on equities. We remain neutral over 3 and 12-month horizons but would reduce risk on continued strength and with further normalisation of risk appetite.
And again for bonds.
Given the strong search for yield, we also upgrade bonds to neutral for 3 months – we remain underweight bonds over 12 months. We remain bearish on duration in the medium term but find a lack of near-term catalysts to drive a sustained shift higher in bond yields. Despite the strong US non-farm payrolls report on July 8, bond yields have been anchored. Our economists still see a two thirds chance that the Fed will raise rates this year, most likely in December. Until then there might be further easing by the BOE on July 14, BOJ on July 28 and the ECB in the autumn.
Outside of stocks and bonds, Goldman remain overweight on credit over a 3- and 12-month time horizon, suggesting that “relative valuations appear cheaper than in equity considering the growth backdrop and attractive carry”.
On commodities, the bank is neutral over both a short and longer-term time frame.
“We continue to expect industrial metals price weakness owing to a combination of excess supply and weak demand, and have the view that the support from China will be temporary,” it says. “We expect WTI oil to remain in a range of US$45-50/bl over the next 12 months as supply rebalancing continues to take place.”
It’s certainly a cautious approach, but an understandable one. Many others suggest that asset price valuations were looking stretched, even before the recent rally.
Only last week Ajay Rajadhyaksha, head of macro research at Barclays, suggested that investors should fade “the post-Brexit relief rally in equities given stretched valuations and a cloudy earnings outlook.”
“It would be much easier if financial assets were priced accordingly, but that is not the case in most major asset classes,” he said. “Asset allocation is now about choosing the least attractive alternative, and equities do not fit the bill in our view.”
Despite those concerns, markets, yet again, are putting a lot of faith in the hands of central banks. Buying raucously at or near all time highs underlines this point.
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