By FS Staff
Financial Sense Newshour recently interviewed John Tousley, Head of US Market Strategy at Goldman Sachs Asset Management, on their Q3 2017 Market Know-How report regarding the global economic expansion underway, how this could turn out to be the longest on record for the US, and why international small caps are a potential area for outperformance at this stage in the cycle.
Healthy Global Expansion Underway
"Our expansion is now 100 months old and there is this incorrect thought process out there, even in the economic community, that at 100 months we are an old expansion and having exceeded the average of 72 months substantially, using a baseball analogy, we are in extra innings and the end is near. And I would suggest that...while we are old chronologically, age is not a predictive indicator and at the end of the day, just like with an individual, the older you get, the less age becomes relevant and the more your health becomes relevant. And so when we look at the health and give the global economy a physical, we come away with this theme of synchronicity and that we are in this synchronized global expansion, we have broad participation with 98% of global economies on a GDP-weighted basis with positive GDP. Every single country of the 35 countries in the OECD has positive GDP. Of those, 65% of them are expanding and so while, yes, we are 100 months old, we are as healthy in terms of broad, global participation that we've been at any point in the 100 months."
Possibility for Longest on Record
"As investors and portfolio managers, we always have to look at the world and say, "What are the risks to our view?" So we just talked about global economies, and one of the models we use is we assess what's the probability of a recession given the composition of current data and things that would be included in current data include things like lagged GDP growth, the slope of the yield curve, equity levels, housing price data, broader housing data for the economy, the output gap, private debt-to-GDP, savings rates, policy uncertainty, availability of lending - so all of these inputs, economically, we've put into a model that does a decent job of giving us a predictive sense of where recession risk is. So, in this 2-year model, the current recession risk is about 31-33%, so there's about a one-third chance that we have a recession within two years. Conversely, there's a two-thirds chance that we don't have a recession in the next two years and, as a result, that would make this expansion the longest expansion on record."
Easy Money Has Been Made
"When we think about equities, I think it's safe to say that the easy money has been made in the market. The rising tide of higher valuations and higher PE multiples has floated everybody's boat and that's been a very important period of time. Since the lows of the market, the PE multiples have expanded about 65% - the market is up 250% even though earnings are only up about 125%, so stocks have outperformed the earnings of companies and, as a result, the market has found itself at the upper end of valuations. Now that doesn't cause us concern necessarily about sustainability or corrections. Expensive markets historically stay expensive for multiple months and, frankly, for multiple years so as long as the macro backdrop supports earnings growth, these markets will probably stay expensive, but you'll probably see the majority of your equity returns, not only in the US but also around the globe, really dominated by earnings growth. And, you know, that's what you want - you want your returns to be commensurate with the profits your companies are able to make. Now, if we look at the first two quarters, we've had excellent quarterly data. We've had earnings growth in the low teens. We've had the average company outperforming by one standard deviation in earnings expectations, and these have been the best two quarters we've had since 2010 and...so what we would tell investors is be realistic about your forward expectations. We still like equities more than other risk asset classes but really set those expectations and align them with earnings growth."
Key Risk Late-Cycle
"The key risk is really monetary policy and there's a great line out there that economic expansions have never died of old age, they've been murdered by the Fed. And there is this recognition that there's tremendous sensitivity to the evolution of monetary policy and I think that is absolutely the case right now and, in fact, that markets are underpricing central bank policy. Right now, in the forward market in the US, they are pricing in only two more tightenings from the Fed total and then they are done with their policy normalization. We think that is way too shallow and expect the Fed to normalize with a tightening in December, clarity on balance sheet strategy this September with the execution starting in October and we think that you'll probably get four tightenings in 2018."
International Small Caps
"One of the areas where people are chronically underweight is international small cap. They tend to have plenty of their local small cap like the Russell 2000 as an index but they tend to be underweight all the time international small cap, and we think that is potentially an interesting opportunity right now. Number one, when you see international markets outperform the US like we see this year...international small cap meaningfully outperforms international markets. And so it's this great little booster in a portfolio that with a little bit you get a nice little return. However...when international markets underperform, the drag on your portfolio by owning international small cap is not that great. So this is an asymmetry - the reward when things are working is much better than the penalty if they're not."