Goldman Sachs remains pro-risk in equities, but the investment bank's top strategists say "time is running out for Goldilocks."
An economy growing at just the right speed to support stock prices but not trigger inflation will soon end as consumer prices and rates start creeping higher next year, according to the report from the global Goldman equity strategist team, led by Christian Mueller-Glissmann.
"2017 has been a strong year for risky assets, boosted by a 'Goldilocks' scenario of anchored inflation and accelerating growth," Mueller-Glissmann assured clients. "However, with continued central bank tightening and a gradual pick-up in inflation, we expect more of an increase in bond yields; as a result, bond returns are likely to become a larger drag on returns compared to 2017."
The past year has proven lucrative for many investors.
With the aforementioned "Goldilocks" conditions, the has appreciated more than 18 percent while the Dow Jones industrial average continues to shatter all-time record this year, closing above 24,000 for the first time last Thursday. Even as equities grind higher, the Cboe Volatility Index (VIX) has remained near its lowest levels in recent memory.
"We are late-cycle optimists and think 2018 is set to be another year of good, albeit flatter returns," added Mueller-Glissmann. "The key question is if, how and when the 'Goldilocks' backdrop will fade."
As monetary leaders around the world start to rein in the accommodative quantitative easing policies enacted during the financial crisis, strategists such as Mueller-Glissmann may start to temper their equity outlook.
"We expect the Fed to hike 25 basis points quarterly until end-2019, slow by historical standards but much more hawkish than current market pricing," he explained. "While U.S. inflation prints have fallen short of expectations year to date, this was mostly due to temporary factors and the U.S. remains close to full employment."
Goldman said equities should be able to "digest" higher rates given a gradual and predictable rollout. However, sharply higher rates accompanied by a flatter yield curve could spell something more malignant. Goldman economists argue that the market is underpricing Fed action, which they believe will amount to four rate hikes in 2018.
As far as Goldman's key themes in 2018, the strategist team likes liquid stocks with 10 percent recent sales growth and 10 percent long-term earnings growth minus excessive valuation. They also like stocks with high M&A potential and those that could benefit from increased defense spending.
Their "top trade #1" is to short (bet against) the benchmark U.S. 10-year Treasury note with the expectation of rate hikes looming.