Goldman Sachs warned of an impending end to the current bull run after years of stretched valuations in a note Wednesday.
“We are nearing the longest bull market for balanced equity/bond portfolios in over a century, boosted by a ‘Goldilocks’ backdrop of strong growth without inflation. A 60/40 portfolio has not had a drawdown of more than 10% since the great financial crisis,” wrote Christian Mueller-Glissmann, a Goldman Sachs equity strategist based in London.
The question now is whether the day of reckoning will come quickly or not.
It’s true the stars have aligned for global markets in recent years. But the ‘Goldilocks’ environment of strong growth without inflation Goldman Sachs identifies in its note has resulted in valuations across equities, bonds, and credit getting the most stretched since 1900, a development Goldman believes will lead to tough times ahead for investors.
“It has seldom been the case that equities, bonds and credit have been similarly expensive at the same time, only in the Roaring ‘20s and the Golden ‘50s,” Mueller-Glissman wrote in the report. “All good things must come to an end” and “there will be a bear market eventually.”
According to the note, as central banks reduce their quantitative easing, the premiums investors demand to hold longer-dated bonds will be pushed up, and returns are “likely to be lower across assets” in the medium term.
Mueller-Glissmann and his team lay out two scenarios they see as being the most likely:
- Scenario #1: “Slow Pain” – “Low yields and high valuations persist as macro is stable, but there are less windfall gains from rising valuations and less carry – as a result, returns are likely to be lower across assets. There might be some gradual mean reversion in valuations as a result of the withdrawal of QE, higher term premia and bond yields.”
- Scenario #2: “Fast Pain” – “There is either a material negative growth or inflation/rate shock, or a combination of both, which drives a drawdown in 60/40 portfolios… A sharp rise in inflation could weigh on valuations across assets… This leads to some mean reversion in valuations.”
Goldman says scenario one is a more likely outcome than scenario two, but the fact that they are entertaining the idea of a major market downturn should be cause for alarm for investors.
“There will likely be a balancing act with slowing growth and rising inflation,” Mueller-Glissmann wrote in the note. “And at current low yield levels and with the ‘beginning of the end of QE,’ bonds might be less effective hedges for equities and are likely a larger drag on balanced portfolios.”
The pain ahead will be amplified by high valuations because there is “less buffer to absorb shocks” according to Goldman’s note.
In the event of a market crash or recession, central banks will be faced with fewer options to ease monetary policy given the already low rates and ballooning balance sheets, which means that when the day of reckoning arrives, it will certainly be painful as investors won’t be able to count on central banks to come to the rescue as they did in 2008.
Goldman isn’t the only one ringing the alarm. The European Central Bank is urging caution as well.
In its biannual financial stability review, the ECB said Wednesday that despite few signs of stress currently, “the risk of a rapid repricing in global markets nevertheless remains.”