On Sunday night, Goldman Sachs (GS)’ weekly Investment Strategy Group memo went out as it does every Sunday; as one could imagine, this week’s was a fairly fun read. Consider the title: “A ‘Lehman Moment’ Under Every Rock.” Highlights:
Where can you find a Lehman Moment? Emphasis always ours:
Over the last several months, as the US debt ceiling negotiations dragged on and the sovereign debt crisis in Europe deteriorated, it seemed that a day did not go by without an article or market commentator asking if another Lehman Moment was imminent. Today, the question is whether the Lehman Moment has arrived…Against this backdrop, clients are wondering whether the US will experience a double-dip recession and much greater downside in equities—of the magnitude seen in 2008 and early 2009.
So, did it? Mind you, this was on Sunday night:
In the US, the path to the debt ceiling agreement and the absence of clear spending cuts has undermined confidence in the long-term effectiveness of US policy makers. In China, the high-speed railway accident has brought to fore many questions about the sustainability and quality of Chinese growth. And yes, the odds of a recession in the US and Europe have clearly increased as global growth projections are revised downward.
However, that is not to say that we are close to a repeat of the 2008/09 economic and financial crisis: in the US, the economic backdrop, the earnings environment, private sector leverage, and market valuations do not point in that direction.
Why not? Essentially, history would have it that we just need to decompress after all the good times that lead up to the trouble we’re in:
….We should expect slower growth rates for the next several years and with them, episodic concerns over renewed recessions. Our base case is for GDP growth of about 2% over the next 18 months. One of the key drivers of slower growth in the periods after financial crises is the deleveraging that is required to unwind the excesses of the prior cycle.
Odds of a recession?
We agree with our colleagues in Global Investment Research that the odds of a recession are 30% – 35%, particularly given that the low trajectory of US growth makes the economy more vulnerable to any external shocks. These shocks include ones we cannot anticipate…such as…a negative reaction by the markets to the S&P downgrade (to which we assign a lesser likelihood).
And about that S & P downgrade:
As much as Standard and Poor’s had telegraphed their intention to downgrade US’s sovereign credit rating from AAA baring a $4 trillion fiscal consolidation plan, their announcement of a downgrade on Friday evening was still a surprise. After all, the Budget Control Act of 2011 was passed before the August 2 ―deadline, and while not $4 trillion package, the $2.1 – 2.4 trillion budget cut target seemed to be a step in the right direction and certainly ahead of expectations even last year. It is even more surprising that they proceeded after the Treasury, according to multiple sources, pointed out a $2 trillion error in S&P’s analysis….We highlight the $2 trillion error and S&P’s assessment of the US political process because it may well temper how the markets react to the downgrade. That said, we have no direct US experience against which to assess what a downgrade might imply, since the US has had the highest rating from both S&P and Moody’s since they initiated coverage in 1941 and 1917, respectively.
Conclusion? Things might get rocky. Or might not. Keep a diverse portfolio. And keep managing your money with Goldman Sachs.
So what should our clients do against a backdrop of slowing US growth and now a US rating downgrade? As we have written for the last several months, we think clients should brace themselves for more turbulence. With the right strategic asset allocation tailored for each client, a well-diversified portfolio has enough fixed income securities and hedge funds to withstand the current volatility. For example, while equities dropped 12.5% from their recent highs, a diversified portfolio would probably have declined 4-5%, which seems tolerable for a client with moderate risk appetite. Since a recession is not our base case, we would not recommend underweighting equities at current levels. However, because the risk of adverse outcomes remains elevated, we have recommended clients hedge tail risks, where equities could drop well below 15%, with out of the money puts. Again, while a recession is not our central case, we believe some cheap protection against that scenario is appropriate.
Like, for example, some insurance.
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