Goldman Sachs: What is the logic behind the "breakthrough at high levels" in the European and American stock markets next year?

As major central banks around the world end their interest rate hike cycles, what is the outlook for the European and American stock markets?

According to analysts at Goldman Sachs, including Peter Oppenheimer, global inflation is slowing down and interest rate cuts may come soon. The European and American stock markets are expected to break through the wide range of sideways fluctuations next year and continue to rise. It is projected that by the end of 2024, the S&P 500 could reach 5,100 points, with the increase extending beyond cyclical sectors.

Inflation at a high level, the US stock market enters the most rewarding period

Goldman Sachs points out that most global stock indices have had limited gains since the start of the interest rate hike cycle and are still below the levels seen at the beginning of 2022.

European stocks suffered the most severe decline at the beginning of the interest rate hike cycle due to the impact of rising energy prices caused by the Russia-Ukraine conflict. However, they rebounded significantly from October 2022 to March 2023, as natural gas prices fell and China relaxed its pandemic control measures.

As for the US stock market, from the low point in the spring to the end of summer 2023, the market experienced relatively small fluctuations. After the summer, the market underwent an adjustment due to the expectation of the Federal Reserve maintaining "higher for longer" interest rates. However, this expectation was shattered in November, and the US stock market experienced one of the strongest rebounds since the financial crisis.

The recent optimism in the stock market rebound indicates that investors' confidence in a soft landing is growing. Goldman Sachs also believes that there is already clear evidence that global inflation is slowing down and interest rate cuts may come soon.

Goldman Sachs economists estimate that the annualized growth rate of core inflation over the past three months is 2.2%. In November, the core inflation rate was only 1.3% among the G10 countries and early rate-hiking countries in emerging markets, excluding Japan.

The bank predicts that the Federal Reserve will cut interest rates at least once between March and June, with a pace similar to that of 1995, 1998, and 2019.

Meanwhile, the slowdown in inflation in Europe is more significant, so the magnitude of interest rate cuts will also be greater. Goldman Sachs predicts that the European Central Bank will cut interest rates by 175 basis points from the current 4% to 2.25% by early 2025. The UK will start cutting interest rates in June next year, with a total reduction of 225 basis points from the current 5.25% to 3% by mid-2025.

Goldman Sachs' GDP forecasts for all major economies are still higher than the consensus, and economists have an optimistic view of economic growth and the labor market. For the United States, economists expect real GDP to grow by 2.0% by the fourth quarter of 2024, and the unemployment rate to drop to 3.6% by then.

Therefore, Goldman Sachs expects that the magnitude of interest rate cuts by major central banks after mid-2024 may not be as aggressive as the market expects.

Based on historical analysis of the S&P 500, Goldman Sachs divides the stock market into four cycles: despair, hope, growth, and optimism, with average durations of 14 months, 9 months, 45 months, and 22 months, respectively.

The current stock market is in the "optimism" phase of the cycle. Although this phase is usually not as impressive as the "hope" phase, the stock market's gains during the "optimism" phase will be stronger than during the "growth" phase, driven by continuously growing profits and rising valuations. Currently, the progress of the cycle is quite close to the typical pattern. The "hope" phase is basically consistent with the mean in terms of length and intensity, while the "growth" phase has performed poorly due to the significant rise in interest rates.

Analysts say:

As long as economic growth continues, the slowdown in inflation will bring benefits to the stock market. From historical experience, if economic recession can be avoided, the US stock market usually shows positive returns after the peak of interest rates. This evidence is also consistent with other regions, where the stock market usually experiences the best returns during the period of inflation falling from high levels.

S&P 500 expected to reach 5,100 points by the end of 2024, oversold sectors expected to rebound strongly

Goldman Sachs strategists have raised their year-end target for the S&P 500 index to 5,100 points, an increase of 8% from the current level, with a price-to-earnings ratio of 20 times.

The bank's previous target was 4,700 points with a price-to-earnings ratio of 18 times.

However, considering the risks of rising inflation and economic recession, Goldman Sachs also believes that although the stock market may break out of the wide and flat range during the upward trend, the subsequent pace and scale of the rise may slow down. And although lower interest rates may support higher valuations, the starting point for risk premiums is still very low.

In particular, the stock market may already be too expensive, with price-to-earnings ratios (especially for US stocks) approaching the highest levels in the past 20 years, leaving little room for valuation expansion.

The rally will further expand beyond the technology sector

Analysts also emphasized that economic growth and the slowdown in inflation are also expected to drive more sectors to rise:

Since the Federal Reserve began raising interest rates, the stock prices of the world's largest companies (mainly large US technology stocks) have risen by about 25%, with the stock prices of the top 15 companies rising by 21%.

In addition to technology stocks, the overall market has risen by 4%, while the median stock price increase is only 2% (actually negative). European and Japanese stocks have lower valuations compared to US stocks, and sectors outside of technology have also performed better, mainly focusing on defensive growth stocks.

For sectors other than technology and consumer services, oversold sectors in the fourth quarter of this year may perform strongly next year. As the industries that are most affected by high interest rates rebound first, the upward trend will rotate to more sectors. After the market achieves a breakthrough at a high level, we believe that the expansion of market returns may continue.