One week ago, we reported that according to Goldman’s chief equity strategist David Kostin, the biggest worry consuming the bank’s clients was the increasingly adverse impact of rising oil prices on the broader economy, and with good reason: “higher energy input costs weigh on the profit margins of firms in other sectors” Kostin said, adding that “higher gasoline prices also reduce the disposable income of consumers and weigh on spending.”
As a result, it is hardly surprising that as oil prices continued to rise in the past week, nearing $70 on fears Trump is about to end the Iranian nuclear deal, eliminating 1 million barrels in Iranian oil exports from the global market, and sending the price of oil even higher, Goldman’s clients are expanding their worries and as Kostin writes in his latest Weekly Kickstart, “Many investors fear the current economic expansion will soon end.”
Here, as Matt King did yesterday, Kostin also highlighted the “paradox” plaguing the market: why despite a blockbuster earnings season is the S&P still down for the year, and why are investors becoming increasingly fearful of the future. Here is Kostin: “Despite the strong 1Q earnings growth reported by so many companies, the top question from portfolio managers is actually macro-related: “What is the timing of the next economic downturn?”
Here, Goldman’s own economic team has not been helping boost optimism: as we reported last week, the bank found that its proprietary Global Economic Momentum indicator, a coincident proxy for GDP, had just declined to the lowest level since 2011.
Kostin confirms as much, noting that “although the US Current Activity Indicator (CAI) suggests an economy growing at an above-trend pace of 3.1%, the second-derivative shows growth deceleration, raising investor concerns.” Worse, looking at just the US, Kostin notes that “the Goldman Sachs US MAP index – a measure of economic data surprises – turned negative in April. Today’s non-farm payroll gain of 164K jobs was below the 192K consensus forecast although the unemployment rate fell to 3.9% vs. 4.0% expectation. The ISM manufacturing index registered a nine-month low and disappointed relative to the consensus forecast (57.3 vs. 58.5). Similarly, the ISM non-manufacturing index was also below expectations (56.8 vs. 58.0).”
In short, Goldman’s clients have reason to be worried.
Or maybe not, because unlike Matt King who far more credibly warns Citi clients that the real yield cycle is now transitioning from Stage 3 to Stage 4 when equities get painfully whacked…
Kostin remains resolute, and despite admitting that global economic momentum has hit a brick wall, he contends the economy is still not in contraction as Goldman’s famous swirlogram shows:
And here things get amusing, because despite its growing economic skepticism, Kostin underscores that the bank forecasts the current nine-year-and-counting expansion – now the second longest on record – will continue for several more years, and forecasts the following GDP for the near-future:
- 2018: 2.8%
- 2019: 2.2%
- 2020: 1.5%
- 2021: 1.3%
The trend may be clear, but don’t let that fool you, as Kostin will quickly counter that Goldman’s recession probability model assigns a 5% likelihood of a recession during the next four quarters, 19% during the next eight quarters, and 34% during the next 12 quarters. Then again, the Goldman only assigned a maximum 30% probability of a recession taking place in the next 4 quarters the last three times a recession actually hit.
And while one can exhibit a healthy dose of skepticism when it comes to the latest dose of Goldman doublespeak, it will not stop Kostin from pushing the party line that a recession is not imminent, as:
“the consumer accounts for 69% of US GDP and confidence stands near its 20-year high. Business spending is also robust. S&P 500 capex is tracking at +24% in 1Q year/year. We forecast 2018 capex growth of 10% to $690 billion (27% of cash spending).”
Ironically, both confidence, profit growth and capex spending were all at their peaks just prior to the last 3 recessions too.
In short, one almost gets the impression that Goldman is pushing a specific angle here, and sure enough, from warning about the future, to easing fears of a recession, Kostin then promptly pivots to the bank’s next recommendation for this confused period, and tells Goldman’s investors to be overweight Financials, and banks in particular. Why? Goldman lays out 7 specific reasons why investors should drop everything and buy bank stocks (such as Goldman Sachs):
(1) Rising interest rates. Financials typically outperform when 10-year Treasury yields rise, but lag when the yield curve flattens. However, a sharp divergence has occurred as the recent back-up in Treasury yield has corresponded with sector underperformance.
(2) Increased capital return. In early April, banks submitted to the Fed their proposed plans under the Comprehensive Capital Analysis and Review (CCAR) program. By late June, the Fed will render its opinion. Last year, the government approved a 43% jump in capital returned to shareholders via buybacks and dividends.
(3) Further deregulation. Proposed amendments to the CCAR rules that would take effect next year would increase balance sheet capacity and give boards more control over the use of their capital. See CCAR stress capital buffer proposal…, April 11, 2018 and SLR/TLAC proposal, April 12, 2018.
(4) Strong M&A advisory fees. ”Merger Monday” kicked off one of the busiest weeks of the year for corporate actions. In the past two weeks, deals totaling $150 billion were announced, lifting YTD growth to +100% vs. the same period in 2017.
(5) Net Interest Margin (NIM) expansion. As the long end of the yield curve rises, benefits accrue to banks through higher investment and loan yields. Since the Fed began the current hiking cycle in December 2015, NIMs for the US banking system have expanded by 22 bp (to 317 bp from 295 bp).
(6) Loan growth. The major investor pushback we receive on our overweight recommendation for banks relates to the perceived anemic loan growth. Fund managers focus on the 2.6% year/year loan growth for the Top 25 domestic banks, the lowest since 2014 and dragged down by the -1% growth at Wells Fargo (WFC). However, small banks have registered a 7.7% jump in loan growth boosting the overall bank loan growth to 4.6% Furthermore, the drivers of loan growth are trending in a positive direction (increased capex plans, increased M&A, and low cash balances).
(7) Attractive valuation and growth. The Financials sector trades at an above-average relative valuation discount vs. the S&P 500 across several metrics. However, Financials operate with much lower leverage than in the past. Consequently, the median return on tangible equity (ROTE) for the sector equals just 13%. Loan growth, NIM expansion, and advisory fees should drive EPS growth of 30% (2018) and 10% (2019). Buybacks will lower the equity base, and support a higher P/TB valuation than the current 2.0x. Dividends will grow by 16% in 2018 and 12% in 2019.
So to summarize all of the above, while using the traditional Goldman filter of what the bank really means, a recession is coming and Goldman has a lot of bank stocks to sell ahead of it. For definitive confirmation of what to do next, however, we would wait until Gartman turns bullish “of” banks.
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