Goldman Sachs Sees 4% EPS Growth, Cautions on Labor Data

Goldman Sachs has identified a favorable macroeconomic environment for risk assets, describing it as a "Goldilocks" scenario. This environment is characterized by an economy that is neither overheating nor experiencing excessive inflation, creating an ideal backdrop for central banks to maintain accommodative policies. The investment bank attributes this scenario to three key factors: enhanced dovish expectations from the Federal Reserve, reduced geopolitical risks, and progress in trade negotiations. These factors have collectively contributed to a more optimistic market sentiment, driving an increase in risk appetite.

Despite recent macroeconomic data from the United States, such as personal spending, new home sales, and consumer confidence indices, falling short of market expectations, the overall global growth outlook has improved. This indicates that market participants are more focused on the benefits of easing monetary policies, which have pushed risk appetite indicators to 0.3 and driven U.S. stock markets to new historical highs. Goldman Sachs has advanced its rate cut expectations to September and lowered its terminal rate forecast to 3-3.25%. However, the upcoming labor market data on Thursday will be crucial in sustaining this positive momentum.

With the reduction in macroeconomic risks, investors are shifting their focus towards corporate fundamentals. A positive signal is the improvement in earnings expectations. Over the past month, consensus estimates for earnings per share (EPS) have become less pessimistic across most regions, with U.S. markets even showing positive growth. The upcoming second-quarter earnings season will be pivotal in validating this market optimism. Goldman Sachs' U.S. strategists note that market expectations for this quarter's EPS growth are relatively low, at 4%, compared to 12% in the first quarter. This sets a lower bar for companies to exceed expectations.

Additionally, the implied correlation of stocks has been declining since April, suggesting that investors anticipate varied individual stock performances during the earnings season, while macroeconomic risks recede. Specifically, the implied correlation for the S&P 500 and Nasdaq-100 indices has fallen to the 17th and 10th percentiles since 2020, respectively. This contrasts with the European STOXX 50 index, which shows a different trend.

While market sentiment is optimistic, it is not without risks. The labor market data to be released on Thursday is critical for maintaining the current positive trend. Goldman Sachs economists predict non-farm payrolls to be 85,000, below the market consensus of 113,000. If the data falls short of expectations, it could further reinforce market expectations for rate cuts. Given the market's pricing of an ideal "Goldilocks" environment, Goldman Sachs advises investors to use options hedging strategies. This includes purchasing put options on U.S. high-yield debt or credit default swaps to hedge against stagflation risks, and buying payer positions in interest rate swaps to hedge against reflation risks. Other recommendations include using call options on European bank stocks and emerging market put options to hedge against portfolio reversal risks.