Why ‘everything aligns' for Japanese stocks

- Why investors still expect a U.S. recession # # --------------------------------------------------------------- The key takeaways today: - Are high-yield bond defaults going to rise? - Investors are still bearish on the economy - Why U.S. stocks may rally - U.K. mortgages are particularly exposed to rising rates Was this newsletter forwarded to you? ([Sign up now.]( --------------------------------------------------------------- Why ‘everything aligns' for Japanese stocks One of the surprise performances of the year has been Japanese stocks which have recently hit their highest levels in more than 30 years. The country's stock exchange is pushing companies to improve their valuations as foreign investors become net buyers of Japanese stocks. Meanwhile, the economy is expanding as inflation and wage growth return and higher-spending tourists come back, explains Goldman Sachs Research's Bruce Kirk, chief Japan equity strategist, on the latest episode of [Goldman Sachs Exchanges](. “Every decade or so we will have a period in Japan where everything aligns the right way and suddenly it becomes a lot easier to make money on the long side,” he says. While Kirk expects a seasonal moderation in the markets in the near term, whether stocks can continue to move higher depends, in part, on the Tokyo Stock Exchange's progress on its proposed reforms, he says. --------------------------------------------------------------- Will there be a spike in US high-yield bond defaults? The macro picture provides plenty of reasons for concern. Rates have surged, and both economic growth and earnings growth are slowing. But Gurpreet Gill, macro strategist in the fixed income team at Goldman Sachs Asset Management, says there's more to the story. She notes that the high-yield bond market is of higher quality today than in previous cycles. Partly because the pandemic shock knocked out many of the shakiest companies, fewer high-yield corporate bonds are now rated CCC (the lowest tier) and more are rated BB (the highest rating for non-investment-grade debt) than in recent years. She also points out that time may be on issuers' side. Since many companies raised money back when rates were low, relatively few bonds are maturing in the next few years. Most don't come due until 2025 or later. By the time this debt must be refinanced, rates may well have come back down — allowing some companies to sidestep today's high rates. For these reasons, Gill expects to see fewer high-yield defaults than some currently fear. But she acknowledges that challenges abound. “An uncertain and complex investing environment does not make for smooth sailing,” Gill says. “This means an active approach to bond selection is essential.” Watch [our video]( to learn more. --------------------------------------------------------------- July QuickPoll: Investors still expect a US recession Investor sentiment is stubbornly bearish, according to the July Marquee QuickPoll, which surveyed close to 900 institutional investors. Market sentiment is still stuck in “deeply bearish” levels with the latest survey indicating that 59% of respondents view themselves as bearish compared with 25% who say they are bullish. “The biggest surprise is that investors have actually not bought into the soft-landing narrative but have merely pushed back their recession expectations by a few quarters,” says Goldman Sachs' Oscar Ostlund, global head of Content Strategy, Market Analytics and Data Science for Marquee in Global Banking & Markets. According to the survey, about two-thirds of participants expect the U.S. to fall into a recession in the next 12 months and, as a result, favor holding developed market bonds for returns and betting against developed market equities. Overall, investors view U.S. equity market valuations as expensive, with 57% expecting the S&P 500 to fall below 4,400 by year end. Only 21% expect the S&P 500 to end the year above 4,600. --------------------------------------------------------------- Why US stocks may rally more than expected this year At the start of the year, Asset & Wealth Management Investment Strategy Group (ISG) at Goldman Sachs [laid out a base case]( for the S&P 500 to finish 2023 with a low double-digit total return at the midpoint of its 4,200 to 4,300 target range. Having reached that mark with more than half the year left to go, [ISG believes the rally may have more room to run](. ISG isn't changing its base-case target range for now, given that it was already above the consensus of around 4,000 coming into 2023, Brett Nelson, head of tactical asset allocation for ISG, writes in a [mid-year update](. But ISG did raise the odds of the S&P 500 reaching 4,800 — their original best-case scenario — by year end to 25% from 20%. ISG's forecasts may differ from those of other groups at Goldman Sachs. First-quarter results were strong. Aggregate S&P 500 earnings exceeded consensus estimates by about 6.5%, reflecting not only stronger-than-expected sales but also profit margins that rose for nine of the 11 S&P sectors. As a result, about 60% of S&P 500 companies saw their full-year 2023 estimates revised higher over the past month. History suggests prices and valuations may not be an obstacle. In the post-WWII period, the beginning price-to-earnings ratio has revealed little about potential returns over any given year. Current prices are also “unexceptional” when compared to past periods with similar interest rates, ISG notes. In addition, they highlight that during prior periods in which the stock market recovered half of its bear market losses, as it did on May 18 of this year, the skew of subsequent returns has been favorable. It all adds up to an argument for staying invested, Nelson writes, even allowing for occasional market pullbacks of 5% to 10%. --------------------------------------------------------------- Why UK mortgages are more exposed to rising rates U.K. mortgage holders are more exposed to rising interest rates than those in the U.S. and euro area because the loans tend to be fixed for a shorter period of time, Goldman Sachs Research economist James Moberly [writes in the team's report](. Higher mortgage rates are also expected to have a meaningful impact on GDP growth. The effective rate on outstanding mortgages will rise to 4.6% in the fourth quarter of 2024 from 2.9% in first quarter of 2023, according to our economists' model. That's projected to translate into a drag on GDP of 0.6% by the end of 2024. More than 50% of that drag is still forecast to come. Fortunately for mortgage holders, it will take longer than in the past for higher rates to flow through because more of the loans are fixed-rate instead of floating. (Floating-rate mortgages accounted for roughly 70% of the outstanding stock a decade ago, but just 12.5% as of March.) If the share of floating-rate mortgages were as high as a decade ago, the effective rate would have already risen to almost 5% by the first quarter of 2023. “The mortgage affordability channel, which has historically been highly important for U.K. policy transmission, is operating far more gradually than in previous hiking cycle,” Moberly writes. That may make Bank of England policy even more hawkish. U.K. inflation has shown signs of persistence, making it important to reduce output in the immediate term to prevent inflation becoming entrenched. And slower transmission through mortgage rates means a larger adjustment in rates is needed. Our economists raised their terminal rate forecast to 6% (from 5.75% previously). They don't expect a rate cut until the third quarter of next year. --------------------------------------------------------------- Briefings Brainteaser: Running out of breadth? Returns for the S&P 500 are up through midyear, but those gains have been led by a handful of stocks. For this week's Brainteaser, can you guess how many companies in the index contributed to roughly 80% of the index's change in market capitalization this year? A) 5 B) 7 C) 10 D) 15 [Check the answer here.]( --------------------------------------------------------------- Goldman Sachs in the news [CNBC]( July 10 [Goldman Sachs says India will overtake the U.S. to become the world's second-largest economy by 2075]( [CNBC]( July 7 [Jobs report seems consistent with soft landing in labor market, says Goldman's Jan Hatzius (3:58)]( --------------------------------------------------------------- --------------------------------------------------------------- Some of the images used in this newsletter are sourced via Getty Images. The data provided in this newsletter is for information purposes only and should not be construed as investment or tax advice nor as a recommendation to buy, sell, or hold any particular security. Goldman Sachs believes the data in this newsletter is accurate, but does not verify its accuracy independently and does not warrant or guarantee that it is accurate or complete. Goldman Sachs has no obligation to provide any updates or changes to the data. No investment decisions should be made using this data. Past performance is not indicative of future performance. To the extent this newsletter includes material from Goldman Sachs Global Banking & Markets, please [click here]( for information relating to Goldman Sachs Global Banking & Markets material and your reliance on it. The Investment Strategy Group, part of the Asset & Wealth Management business (“AWM”) of GS, focuses on asset allocation strategy formation and market analysis for GS Wealth Management. Any information that references ISG, including their model portfolios, represents the views of ISG, is not financial research and is not a product of GS Global Investment Research and may vary significantly from views expressed by individual portfolio management teams within AWM, or other groups at GS. 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