July 26 (Bloomberg) -- Global equities and bonds may retreat in the next three months, with stocks at risk of a brief selloff, as rising inflation boosts yields, according to a quarterly strategy report by Goldman Sachs Group Inc.
The bank cut its rating on stocks to neutral, the equivalent of hold, for the next three months, a note to clients from its portfolio strategy group showed. Goldman Sachs also lowered corporate credit to underweight and predicted that government bond yields will increase.
“We are concerned that a selloff in government bonds will lead to a temporary selloff in equities in line with what we saw last summer, though the magnitude is likely to be smaller as the need for bond yields to correct is lower,” a group of 11 strategists, including David Kostin, Kathy Matsui and Peter Oppenheimer, said in the report, known as the global opportunity asset locator.
The MSCI All-Country World Index lost 8.8 percent from May 21 to June 24 in 2013, a period in which yields on 10-year Treasuries rose to about 2.54 percent from 1.93 percent, data compiled by Bloomberg show. The 10-year yield is about 2.46 percent now. Goldman forecasts it will rise to 3 percent by the end of 2014 and to 4 percent by the end of 2017.
Bond yields will rise because of “strong growth and an acceleration of inflation in the U.S.; our expectation that, as the Fed concludes bond purchases in October 2014 and the macro outlook strengthens, the market will become more hawkish relative to the timing, speed and size of the Fed tightening cycle,” the strategists wrote.
U.S. gross domestic product is forecast to have expanded 3.3 percent in the second quarter, up from a weather-influenced 2.9 percent contraction in the first quarter. GDP is expected to show growth of 1.7 percent for the full-year 2014, then improve to 3 percent in 2015 and 2016.
The U.S. consumer price index increased 0.3 percent in June after a 0.4 percent gain the prior month, according to figures from the Labor Department, showing the economy is generating little price pressure as growth accelerates.
Goldman Sachs downgraded its three- and 12-month corporate credit forecasts to underweight. There is less possibility of further spread tightening to offset rising government bond yields, according to the report. That’s especially true for investment-grade bonds, which already have the smallest spreads, it said.
The firm advised investors to hold fewer government bonds because yields will probably rise as U.S. inflation accelerates and the Fed stops its bond purchases in October. Treasuries have returned 3.3 percent this year through July 24, according to Bloomberg World Bond Indexes, the most over the equivalent period in four years.
“As time has passed while yields have stayed low, the time window over which we would expect this selloff in bonds has shortened from one side,” the strategists wrote. “At the same time, the data has shortened it from the other by moving forward our expectation for the first rate hike. We now see the likelihood of a selloff in bonds as large enough that we adjust our allocation to both equities and credit as a preparation for a rise in yields.”
U.S. and European stocks fell yesterday as companies from Amazon.com Inc. to LVMH Moet Hennessy Louis Vuitton SA missed earnings estimates. A Commerce Department report showed orders for U.S. business equipment rose in June following a revised drop the prior month, indicating corporate investment remains stop-and-go and could hold back growth.
While cutting its quarterly outlook, Goldman Sachs is bullish on equities over the longer term. The firm is overweight global stocks on a 12-month basis, citing the potential for earnings appreciation driven by sustained economic growth.
Goldman’s quarterly downgrade came less than two weeks after the firm raised its year-end Standard & Poor’s 500 Index forecast. The benchmark gauge will climb 3.6 percent to 2,050 by the end of 2014 as economic growth picks up, strategists led by Kostin forecast, boosting an earlier projection of 1,900.
Stocks with lower valuations will outperform the market before the Fed begins tightening interest rates, the strategists wrote. Goldman Sachs’s year-end projections for the S&P 500 in 2015 and 2016 remained unchanged at 2,100 and 2,200, respectively.
The firm’s adjusted equity outlook comes at a time when investors are showing concern that stock valuations have become overextended. Forty-seven percent of financial professionals view the equity market as close to unsustainable levels, while 14 percent already see a bubble, according to a quarterly poll of 562 investors, analysts and traders who are Bloomberg subscribers.
The S&P 500 trades at 18 times earnings, close to the highest level since March 2010. The valuation measure has increased more than 4 percent in 2014 and sits 14 percent above its five-year average.
--With assistance from Arie Shapira in New York.