Goldman Sachs Asset Management: Continued Emerging Market Outperformance, Rising Inflation in Second Half

The firm sees widening economic expansion, higher volatility in 2H2017 in its Q3 investment outlook.

Goldman Sachs Asset Management (GSAM) sees widening global economic expansion as a cornerstone of the investment environment for the rest of the year, according to its Q3 Investment Outlook.

“Global growth is in the midst of a synchronized upswing, led by developed markets, and with support from recovery in emerging economies,” GSAM analysts wrote. “The US is benefiting from loose financial conditions and a strong labor market, and growth surprises have driven our Europe outlook significantly higher.”

The firm sees the widening economic expansion it identified as a central theme at the beginning of the year to continue. “One of our key themes for the year has been that the expansion would continue and widen out to a broader set of countries than at any point since 2010,” GSAM analysts wrote. “This is now well underway and we expect it to continue.”

However, higher expectations for global growth and elevated asset prices could set the stage for higher volatility in the second half.

The firm identified emerging market equities followed by Europe and Japan – so called high beta developed markets—as having the highest potential for outperformance.

“We remain constructive on the strong fundamentals for EM equities. EM economic growth premium to DM continues to widen and inflationary pressures are moderating, supporting the earnings rebound,” GSAM analysts wrote. “We are constructive on the EM consumer, due to improving macro conditions, particularly in Asia. Following five years of underperformance versus DM, EM trades at an attractive discount.”

A shift in fundamentals, investor sentiment, and a decline in political risk are meanwhile creating upside potential in Europe. “We are finally seeing a much-awaited earnings rebound, led by cyclicals. Q1 earnings results were the best in three years and consensus estimates have seen year-to-date upgrades, a departure from the persistent downgrades of previous years,” GSAM analysts wrote. “Fading political risk in Europe should be supportive for corporate confidence, in turn boosting investment, M&A, and earnings growth. Rising valuations and increasing investor positioning suggest growing recognition of these tailwinds, but significant potential remains for an earnings-driven recovery.”

Continued corporate reform combined with cheap valuations leave Japanese equities well positioned, the firm said. “We are encouraged by continued progress on economic and corporate reform in Japan. Japanese companies have lagged companies in other DM countries with respect to returns on capital, but are catching up,” GSAM analysts wrote. “Valuations remain attractive—while valuations have increased, Japanese equities are cheaper than many other developed markets.”

While the Trump administration’s stated agenda of fiscal expansion and deregulation had been embraced by investors and powered market dynamics earlier in the year, GSAM said that it has now almost wholly been abandoned. This leaves the potential for upside surprises on even incremental advances.

“Market sentiment on Trumponomics has swung too far in the other direction, resulting in an almost full unwinding of the ‘Trump trade,’“ GSAM analysts wrote. “With expectations so low, we think US equities now have upside potential on reform as any incremental progress on reform could be a positive surprise. We see attractive opportunities in specific sectors such as Financials, which can reap significant benefits from a clearer and more effective implementation of existing regulatory legislation.”

While the firm’s predictions of higher inflation have so far proved elusive, it sees inflation as eventually picking up with increasingly tight labor markets. “We see the weakness in US inflation as temporary, and expect inflation to rise as labor markets tighten,” GSAM analysts wrote. “However, we acknowledge that the timing of the turn is uncertain.”

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