Goldman Sachs: Don't wait for the midterm elections, the "Goldilocks" market may ignite the U.S. stock market's year-end rally early

Author: Ye Zhen, Wall Street Journal

Goldman Sachs partner Mark Wilson recently pointed out that global stock markets are facing increasingly clear upward opportunities before the end of the year. The market has fully priced in the risk of stagflation, and as a more moderate "Goldilocks" economic scenario gradually emerges, investors do not need to wait for the U.S. midterm elections to end before returning to invest in risk assets.

Recent market price movements confirm this optimistic expectation, as the "fear of missing out" (FOMO) driven by AI has returned to the market. After Meta launched its Muse product, the market's expectations for the timeline of AI's widespread adoption among consumers have significantly accelerated, driving a strong upward breakout on Monday for AI-themed assets like the Nasdaq index, following three months of consolidation and a historic surge in the second quarter.

Meanwhile, U.S. bond yields have risen again. Unlike the previous competition for funds driven by government and AI capital expenditures, or inflationary pressures caused by energy prices, this round of yield increases is primarily supported by stronger-than-expected Purchasing Managers' Index (PMI) data, reflecting that U.S. nominal economic growth remains robust, and the stock market has maintained its upward trend despite significant fluctuations in yields.

The current market is generally concerned that the seven-month consecutive rise in the U.S. ten-year Treasury yield (the longest streak in fifty years) will ultimately drag down the stock market, and investors are inclined to wait until the Gulf situation cools down and the midterm elections are safely passed before willing to increase their risk exposure. However, Goldman Sachs' analysis breaks this consensus, pointing out that substantial improvements in the three fundamentals of inflation, economic growth, and corporate earnings are providing a solid foundation for a stock market rebound by the end of the year.

Easing Inflation Pressures and Deflationary Effects from AI

Recently, due to the impact of the Iran conflict, rising energy prices have overshadowed the downward trend in core inflation.

However, Goldman Sachs noted that the tariff transmission effect is currently weakening, and the effects of interest rate hikes and the resulting tightening financial conditions are becoming evident. If logistics in the Strait of Hormuz return to normal, energy prices will face significant downside risks, especially considering that Iran's maximum negotiation leverage window is expected to end around November 2, and a new deflationary energy narrative may emerge at any time.

More importantly, Meta's Muse product has fired the "first shot" of deflation in the consumer goods and services sector.

Goldman Sachs' research on the "business agent-style AI era" indicates that technological advancements are substantially lowering costs at the consumer end, which will become a more important deflationary driver than falling energy prices.

Economic Growth Expectations Cooling Limits Central Bank Hawkishness

Despite facing geopolitical and energy price uncertainties over the past six months, U.S. economic activity continues to show unexpected resilience. However, Goldman Sachs economist Jan Hatzius' research shows that this upside risk is diminishing, and the second derivative of economic growth will begin to slow.

As fiscal benefits such as tax cuts fade, rising gasoline prices and mortgage rates will impact certain economic sectors and consumers.

Additionally, while the capital expenditure cycle in the AI sector will continue, its growth rate will also slow. Given the expectations of falling inflation, central banks are likely to raise interest rates less than current market pricing suggests.

Mark Wilson emphasized that now is not the time to worry about rising yields; such concerns were only reasonable seven months ago.

Core Earnings Remain Strong, Fundamentals Support Stock Market Valuation

In response to the current intense debate in the market regarding the sustainability of corporate earnings and "earnings bubbles," Goldman Sachs' U.S. strategy team leader Ben Snider believes that while some companies are experiencing "excess profits," an overall earnings bubble has not formed.

Goldman Sachs advises investors to pay attention to three facts:

First, one should not pay a high premium for record "other income"; second, storage chips and certain semiconductor stocks are indeed currently in a state of excess profits; third, at least until the end of 2027, corporate core earnings are likely to remain particularly strong even if growth slows, providing fundamental support for stock market valuations.

Stagflation Narrative Fails, "Goldilocks" Reshapes Market Landscape

The market had previously attempted to price in a significant slowdown in economic growth and earnings along with higher interest rates, but macro data does not support this perfect "stagflation" narrative. On the contrary, slowing growth, declining inflation threats, a softening central bank stance, and a year of valuation adjustments together constitute a favorable market combination.

Goldman Sachs believes that the current situation is very similar to the market's bull-bear struggle during the major technological transformation period in the mid-to-late 1990s.

If the market ultimately experiences a "Goldilocks" scenario (where economic growth is just right, neither overheating causing inflation nor cooling leading to recession), then the historical pattern of stock market rebounds after midterm elections remains applicable.

Mark Wilson concluded that investors should not wait for the midterm elections to end before taking action, and as the threat of rising energy prices diminishes, European and UK stock markets are also well-positioned to participate in this round of increases.