There are signs investors are increasingly bullish, as the U.S. economy appears headed for a soft landing and inflation cools. However markets are already priced for an improving outlook for growth, suggesting some investors could be in for disappointment in the coming months, says Christian Mueller-Glissmann, head of asset allocation research within portfolio strategy at Goldman Sachs Research.
The Goldman Sachs Risk Appetite Indicator rose this summer to the highest levels in about two years, as inflation moderated and economic growth was resilient—which doesn’t usually happen. “If you look historically, inflation and growth usually go down together,” Mueller-Glissmann says. “Yet you've had a huge amount of inflation normalization without the growth damage. Especially the services sector has been remarkably resilient.”
The second half of the year could be more challenging. Purchasing manager index (PMI) surveys suggest confidence in the global economy is weakening, not just in manufacturing but increasingly in services. While economists at Goldman Sachs Research expect the U.S. to avoid recession, that doesn’t mean GDP growth will be robust. “The growth picture in the second half is not that exciting,” says Mueller-Glissmann. “I think you're dealing generally with growth being below trend in a lot of places.”
On balance, he says the traditional 60-40 portfolio — split between stocks (60%) and bonds (40%) — could make more sense again in the near term, even as that setup has challenges over the longer-term as inflation could re-emerge, economic growth could sputter, and there are signs investors may drive longer-maturity bond yields higher. Innovation in artificial intelligence, meanwhile, may ripple through to everything from stock prices to economic productivity and interest rates.
The Goldman Sachs Risk Appetite Indicator is near its highest level of the year. What is that telling you?
Going into the year, a lot of investors had been quite a bearish, and there were several reasons to be bearish. You still had a lot of uncertainty with regards to U.S. recession risk, with lots of forecasts being quite a bit more bearish than ours.
You had the European energy crisis still going on, and there was a lot of uncertainty on China. Many of these concerns have moderated, and that has meant that this bearish sentiment and positioning has been squeezed into a more bullish setup. The U.S. has turned out to be very resilient, especially on the consumer side. China, at least in the first half of the year, had a strong reopening impulse.
That has meant positioning and sentiment shifted from pretty bearish levels to pretty bullish levels. But in the first half of the year, the most important shift has not been in growth, but it has been in inflation where I call it a bit like an inverse Goldilocks scenario.
When we speak about the Goldilocks scenario for markets in the last cycle, it usually meant that growth picked up without inflation. And that's a very friendly backdrop for equity investors, and generally for risky assets. What happened in the first half of the year is that growth remained relatively resilient, but inflation started normalizing. So the result is the same. The growth/inflation mix has been getting better.
You have the largest decline in inflation since the global financial crisis. That's what's been so unusual about the first half of the year. If you look historically, inflation and growth usually go down together. Yet you've had a huge amount of inflation normalization without as much growth damage.
What does that suggest about the second half of 2023?
I think, going into the second half of the year, the market is already extrapolating a bit of improvement in the growth-inflation mix: inflation continues to normalize and possibly growth not only is resilient but actually starts picking up. If we benchmark the risk appetite indicator to economic sentiment, and this is the PMIs, you actually find that risk appetite is quite a bit ahead of the data.
So it indicates that some pickup in growth in the second half is already discounted — at least that was the case up until the last week or so. It feels like the market is expecting the second half to have some type of improvement in the macro picture, which is not easy to see, considering that you're still in a soft landing. You’re unlikely to see activity re-accelerate — you're still landing, and I think that's where a disappointment could come from.
And how does that feed through to your views on asset allocation?
The growth picture in the second half is not that exciting. I think you're dealing generally with growth being below trend in a lot of places, there will potentially be selective opportunities for a pick up in global manufacturing and China-related assets.
But as I mentioned, the challenge is that some of that's already discounted. Markets have already priced some of that recovery. So from an asset allocation point of view, the more important trend for us has been the disinflation.
We've been neutral equities and neutral credit for most of this year, but we've done a shift in our recent asset allocation update and for the second half of 2023. We also shift to neutral on bonds.
We've been underweight bonds in our asset allocation since June 2020. And now we think the level of yields available in the bond market, coupled with the disinflation trend which we currently have and we're likely to see into year-end, that bonds are becoming more interesting in a portfolio context.
We've done a lot of research on 60-40 portfolios. We were very worried about 60-40 portfolios at the end of 2021 because of elevated valuations for both bonds and equities and rising inflation and that materialized in a large drawdown in 2022. But now we are on the other side of that, and we see some real improvement on the inflation picture towards more normalized levels. That means the growth/inflation mix, or in particular the inflation picture, is starting to be more in favor of bonds in the portfolio.
So that's been the major shift, but we are relatively neutral in the allocation equities, credit, and bonds. Currently it's again a lot more about balance in portfolios.
And so what is your outlook for the 60-40 portfolio in the long run?
It's really important to discriminate between the longer term and the short term. What we wrote at the end of 2021 is that we think there's an elevated risk of a lost decade for the 60-40 portfolio, and we had one of the largest drawdowns in 60-40 portfolios in 2022. Since the beginning of the year we recovered a large amount of that especially on the equity side, but not necessarily on the bond side. Inflation has been elevated throughout that period, so in real terms you are still working hard, and you have to work hard in the coming years, to avoid a lost decade, in order to recoup what you lost in real terms last year.
The risk of a lost decade for investors remains if you were invested since 2021 and you are still recovering from that drawdown in real terms.
In the long run, what are the two main blind spots of a 60-40 portfolio? It's either stagnation or inflation. We just had a major inflationary surge in the Covid-crisis-recovery. I think we might see inflationary spikes again in the next few years, which will keep that risk of a lost decade elevated. But the other thing you have to consider is still stagnation risk.
Coming out of Covid growth has been boosted by excess savings, fiscal policy, and liquidity that has been pumped into the system, and we know some of those tailwinds will disappear again. So what's trend growth going to be like in the next few years? With population growth and with the kind of productivity growth we have right now there is still risk of stagnation in a lot of economies and possibly globally.
Are there any factors that could boost growth and the outlook for asset prices?
The big wildcard is AI. If AI generates a major increase in productivity, the outlook for the next decade for 60-40 portfolios might be a bit more friendly, especially if the companies that are benefiting from AI are part of the public equity market. Historically, that's been the case, that in technology revolutions you did have beneficiaries in the public equity market. In the long run, I think there is still risk that you do get a lost decade in certain markets that have less structural tailwinds.
But in the near term, we do think 60-40 is not a bad starting point for a multi-asset portfolio again. Going into the second half of 2023, being balanced with disinflationary momentum supporting the bond market, and you still have uncertainty on growth with regards to equities, means 60-40 is not a bad idea. The longer-term challenge for 60-40 remains.
Are you worried about any near-term risks to the 60-40 portfolio?
Recently there's been an increasing focus on longer-dated bond deals being possibly too low. You had the yield curve control policy from the Bank of Japan being tweaked. In addition, the downgrade from Fitch for the U.S. coupled with expected fiscal policy and Treasury issuance has meant that the market is revisiting the level of longer-dated bond yields and the risk premium you should demand for holding Treasuries vs. cash.
Despite the disinflation trend, you've seen longer-dated bond yields shift up a bit. I would still say that the more important driver is actually the disinflation, and that will eventually stabilize bonds both in the back- and the front-end, and eventually that means 60-40 will be a better place to be, but it's certainly an unusual situation. You've never in the past had as deeply inverted a yield curve outside of the 70s. In the 70s front-end rates were much higher, so that means that there's a risk that you get a bit of increase in longer-dated bond yields even though you have disinflation.
We've had a tailwind from disinflation for 60-40 portfolio and that will continue in our view in the second half and into next year. But there's now this new factor where the market is worried that maybe longer-dated bond yields are just too low. Ultimately, we do know bond yields compared to the front-end are a bit low. The yield curve is very inverted. So just stepping back from it all, it's not completely crazy to expect less yield curve inversion if you do get a soft landing. If you do get maybe even AI supporting trend growth in the long run, that potentially boosts long-term equilibrium rates as well.
Going back to 60-40, that might provide a drag from here. Inflation seems to be fading as a risk, but the yield curve remains deeply inverted, which means that longer duration bonds could go through some periods of repricing that are unrelated to inflation.
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