(April 6, 2014) — US economic and market cycles are out of sync with monetary policy, according to Goldman Sachs Asset Management (GSAM).
GSAM’s research concluded that economic growth in the developed world—largely led by the US and the UK—was shifting from recovery to expansion, benefiting from improved job growth, strong corporate balance sheets, and confident consumer spending.
Monetary policy, however, has lagged behind.
“Policy rates in the US and UK remain at levels that are more consistent with recession or the early stages of recovery rather than economics transitioning from recovery to expansion,” the report said. “If growth is transitioning into the expansion phase, both history and intuition suggest that rates should be moving higher as the central bank tightens policy and investors shift from safe-haven assets to risk assets.”
This phenomenon was particularly evident in the US, GSAM argued, as the Federal Reserve continues to taper quantitative easing while suggesting interest rate policy will remain static.
Risk asset valuations in the developed economies are also asymmetrical to the monetary and economic cycle, the firm contended, being more aligned with maturing economic expansion.
“Volatility and excess returns have declined in recent years from very high levels and are now at more moderate levels consistent with what we generally expect to see in the expansion phase of the cycle,” the report said.
GSAM predicted the expansion phase to continue for at least one to two years before moving into the late cycle of investing, characterized by overreaching for return, increased policy tightening, and a “downward correction in asset prices.”
Emerging economies, in contrast, are already moving from expansion to the late cycle phase, GSAM argued. China’s economy has recently grown at a slower rate than in the recovery period following the financial crisis. This combined with excessive leverage and monetary policy tightening could lead to a rise in defaults, the report said, and ultimately push China into a recession.
“Something has to give in the US and UK,” GSAM’s analysts wrote. “Based on our outlook for growth, we think it is policy that will need to catch up.”
Catching up would require the Fed to increase rates sooner than the market anticipates. Investors should also still see “modest but positive” excess returns from fixed income risk assets s in the rising rate environment, the firm predicted.
“Assets tied to late-cycle emerging economies or Fed liquidity are likely to be more volatile,” the report said. “Returns could decline relative to the expansion phase, or even turn negative.” These trends have already started to play out through volatility in emerging markets, according to GSAM.
However, the asset manager argued there is no immediate risk of “overheating growth, inflation, or bubbles in developed market fixed income risk assets” due to a lagging Fed policy.
“With low default rates, strong corporate balance sheets, and an improving housing market, fixed income risk asset valuations appear to be well-supported by fundamentals,” the report said.
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