Since Q4 2014, valuations have again been a significant driver of equity returns, reflecting little earnings growth. The US likely entered the ‘Optimism’ phase at that point, where valuations and long term expectations drive equities more. However, up until the second half of 2016, there was little growth optimism owing to concerns about structural headwinds for growth and inflation coming from demographics, debt, low productivity growth, China and EU limitations. The market had embraced the narrative of lower equilibrium real rates owing to lower trend GDP growth. That kept rates low and supported equity valuations.

However, the reflation trend evident since July 2016, further boosted by the US election outcome, has fueled increased optimism on fiscal easing as a new driver of growth. Also, after earlier sharp earnings downgrades, earnings sentiment in the US and globally has turned positive. As a result, US equities have digested higher bond yields well so far, with the equity risk premium falling and US indices at all-time highs. But the potential for disappointment remains and US late-cycle concerns are likely to linger in 2017. Without another ‘Growth’ phase, the risk is that the cycle ends in ‘Despair’. GS’s economists estimate the risk of a US recession next year is below average but there is increased policy uncertainty.

The single biggest policy risk probably arises from President-elect Trump’s anti-globalization rhetoric. Threats to repeal international trade agreements and enact protectionist measures are clearly not helpful to global growth. Global trade volumes were already very weak before the US election. The replacement of low-cost imports by higher-cost domestically made products would lift US inflation and increase the cost of living for those Americans who could least afford it. For now, the market is assuming that the more extreme elements of Mr Trump’s policy platform will be moderated by either himself, his advisers or the Republican Party.

The base-case view is that US GDP and earnings are entering a new or extended ‘Growth’ phase, supported by the coming US fiscal stimulus. But, with the US economy already more late-cycle with respect to output and employment almost at full capacity, the question is how much can the growth/inflation mix improve?

In GS’s view July probably marked the “end of the affair” that investors have had with bonds for 35 years. While we are unlikely to see a rapid rise in bond yields from current levels, the turning point itself, and the moderating deflation risk premium, has been the key driver of the rotation we have seen since July.

GS have upgraded equities to Overweight (and remain Underweight bonds), so they have followed the risky rotation path. In the near term, the mix of growth optimism and rates is likely to be more important for risky assets than the actual growth/inflation mix itself. Higher rates have not been digested equally well by different assets as the growth optimism outside the US has been more muted. While US equities have made all-time highs, other assets have struggled to buffer higher yields as optimism has been more muted, with equity/bond return correlations in Europe and Emerging Markets staying positive. The reflation optimism has not been enough to outweigh higher bond yields in a number of those markets.

How far can bond yields rise before hurting equities? There are three drivers GS considers: 1) the relative movements between bond yields and earnings growth expectations, 2) the level of bond yields, and 3) the valuation of bonds (how far away from ‘fair value’). The rise in yields has already started to push the market PE ratio lower via a de-rating of defensives. GS’s assessment is that US 10-year bond yields above 2.75% (currently circa 2.35%) and/or German yields of between 0.75% and 1% (currently circa 0.35%) would be more problematic for equity levels.

How long can the leadership rotation last? In recent years the persistent decline in growth and inflation expectations has resulted in: (1) defensives outperforming cyclicals, (2) growth outperforming value, and (3) low-volatility stocks outperforming higher-beta stocks. These styles have all reversed since July. A particularly extreme divergence has been the outperformance of financials versus consumer staples. GS thinks this rotation has some way further to go, so they remain overweight banks and underweight consumer staples.

Outside of these two groups the valuation spreads between cyclicals and defensives has closed. The speed of the rebound suggests to GS that there is little room left for general cyclical outperformance, and that the main valuation dislocations are for defensive sectors such as pharmaceuticals, telecoms and utilities. GS are overweight these sectors.

Given GS sees much slower rises in bond yields from here, the extreme binary sector moves in the markets are unlikely to continue. Stock dispersion should rise versus sector dispersion, and themes should gain prominence. GS continues to like stocks with US and dollar exposure and companies that are beneficiaries of increased infrastructure spending. GS also emphasizes that, with narrower valuation spreads in the market, investors should look for alpha from stocks with a reasonable yield and healthy dividend growth, i.e. GARY stocks (Growth And Reasonable Yield).

For now the market is living on a prayer until the ‘Optimism’ phase is replaced by either ‘Despair’ or (more likely) ‘Growth’.