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Goldman turns cautious on stocks as Fed threatens to upset calm

A view of the Goldman Sachs stall on the floor of the New York Stock Exchange July 16, 2013.

© Brendan McDermid / Reuters

The longer the seemingly unstoppable reflation rally continues, the more warning signs start to flash for Goldman Sachs Group Inc. -- especially in stocks.

The bank's strategists have lowered their three-month outlook for global stocks to neutral, while staying overweight cash and underweight bonds given the recent shift by central banks to a "slightly more hawkish" stance. The Federal Reserve is forecast to raise its benchmark interest rate Wednesday in an environment where markets are demonstrating historic calm.

"With growth momentum nearing its peak and rates increasing further with a hawkish Fed, the asymmetry for equities is turning increasingly negative," Goldman analysts including Christian Mueller-Glissmann wrote in a note for institutional clients. "A slowing cycle makes equities more vulnerable to higher rates and also shocks, e.g. from European politics, U.S. policy, commodities or China."

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Goldman cites high equity valuations -- see here what worries Robert Shiller on that score.

After a blip to start the year, strong macroeconomic data including U.S. jobless claims at a 44-year low have given investors renewed confidence to buy stocks, the analysts said. Valuations have been supported by "very low" bond yields, but a negative rate shock "looms large" as inflation accelerates, they wrote.

"At some point, rising bond yields will become a constraint on equities," Peter Oppenheimer, a contributor to the report, said in a separate interview. Bond yields are still some way away from normal levels in Europe and Japan, "but in the U.S. we're getting much closer to that," he said.

The Goldman analysts also warned about trading dynamics in equities. Historically low volatility has pulled in "risk parity funds" that take their cue from risk levels, according to the team. "Commodity trading advisors" who gauge trends or momentum and use futures also tend to pile in to markets with low volatility and established trends, they wrote.

"In the event of a reversal of the trend, these systematic investors are likely to reduce equity exposure quickly, which could exacerbate an equity drawdown and result in a faster and larger volatility spike," the Goldman analysts wrote.

Investors should bear these points in mind:

The analysts suggest investors replace their equity positions with calls, including shorter-dated calls on the S&P 500 and longer-dated Euro Stoxx 50 and Nikkei 225 calls

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They are still positive on equity returns longer term, with a 12-month overweight rating for all regions except the S&P 500, which stays underweight

Rising U.S. rates should benefit Europe and Japan even as they become a headwind to the U.S., and there is also potential for a relief rally in the event of a "market-friendly outcome" to the French elections

Goldman is also positive on the Asia-Pacific region, especially China, with the firm returning to an overweight on Chinese stocks earlier this week on mounting evidence of strength in the economy.

"Trump protectionism, rising rates and slowing China data are risks but strong growth in the region should be able to digest these," the analysts said.

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