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Global equities are at the upper end of their "fat and flat range," according to Goldman Sachs, who downgraded stocks to "underweight" on Monday as part of its 3-month asset allocation.
The bank remains "neutral" on equities over a 12-month period and continues its "overweight" position in cash. The downgrade comes after a rally in risk assets over the past few weeks driven by the U.K.'s vote to leave the European Union on June 23 and the search for yield amid expectations of easing. But Goldman suggests equities are now expensive and with weaker-than-expected earnings growth it views this as the right time to downgrade.
"Until the growth situation improves, we are not that constructive on equities, particularly after this type of rally and amid continuing concerns about the sustainability of stimulus-led growth in China, global policy uncertainty and in Europe in particular, dovish central bank expectations, and heightened prospects of unknown shocks e.g. Turkey recently," a team of analysts at the bank, led by Christian Mueller-Glissmann, said in a note Monday.
The bank however remains "overweight" credit, which it considers has less negative asymmetry than equities.
In the note, Goldman Sachs warns that an equity drawdown at this point could be painful for multi-asset investors since the potential to diversify in "risk-off" periods might be more limited with bonds at very low yields.
"When bonds and equities rally together due to a search for yield, this can drive inflated valuations for both and increase the vulnerability to shocks, which we think has occurred," Goldman said.
The note further explains that the rally in equity markets recently could be due to a combination of expectations of more easing from central banks and support from better macro fundamentals in the economy. "Our global macro surprise index (MAP) had an increase in July, driven by developed markets," the note said, adding that there is a "good news is good news" environment as dovish Federal Reserve expectations have been anchored.
However, this could be due to lower expectations from markets into and after Brexit, Goldman warned.
On the Fed's chances of increasing its interest rate, Goldman economists see a 65 percent probability of a rate hike this year – 45 percent for December and 20 percent for September – following the Fed's recent meeting where the FOMC (Federal Open Market Committee) indicated that near-term risks to the economic outlook have diminished.
But with Brexit, investors' expectations for incremental easing from other central banks have increased, the note said. Goldman expects the Bank of England to announce a 25-basis point cut in its bank rate, gilts and corporate purchases and an extension of the Funding for Lending scheme – which was designed to boost bank lending.
Meanwhile, on the European Central Bank, economists at Goldman Sachs expect it to announce an extension of its asset purchase program to the end of 2017 at its September meeting.
"New fiscal easing in Japan is also broadly expected in the near term but we have concerns that this fails to sustainably boost the market, as has often been the case in the past," the note said.