Goldman Sachs: Don't wait for the midterm elections, the "Goldilocks" rally may ignite the year-end rally in US stocks ahead of schedule.

Goldman Sachs partner Mark Wilson recently pointed out that global stock markets are facing increasingly clear upside opportunities before the end of the year. The market has already fully priced in the risks of stagflation, and as a more moderate "Goldilocks" economic scenario gradually emerges, investors can return to the market to participate in risk asset investments without waiting for the US midterm elections to conclude.

Recent market price movements are confirming this optimistic expectation, with the "fear of missing out" (FOMO) brought about by AI returning to the market. Following Meta's release of the Muse product, market expectations for the timeline of large-scale AI adoption by consumers have accelerated significantly, driving AI-themed assets such as the Nasdaq index to achieve a strong upward breakout this Monday after three months of consolidation and position reduction following the historic surge in the second quarter.

Meanwhile, U.S. bond yields rose again. Unlike previous increases driven by competition for funds from government and AI capital spending, or inflationary pressures from energy prices, this round of yield increases was mainly supported by stronger-than-expected Purchasing Managers' Index (PMI) data, reflecting continued strong nominal economic growth in the U.S. and the stock market's resilience in the face of significant yield volatility.

There is widespread concern in the market that the seven-month-long rise in the US 10-year Treasury yield (the longest such streak in 50 years) will ultimately drag down the stock market, and that investors are inclined to wait until tensions in the Gulf region ease and the midterm elections are safely over before increasing their risk exposure again. However, Goldman Sachs' analysis breaks this consensus, pointing out that substantial improvements in three key fundamentals—inflation, economic growth, and corporate earnings—are providing a solid foundation for a stock market rebound at the end of the year.

Easing inflationary pressures and the deflationary effect brought about by AI

In the past period, rising energy prices have masked the downward trend in core inflation due to the impact of the conflict in Iran.

However, Goldman Sachs points out that the transmission effect of tariffs is weakening, and the interest rate hikes and the resulting tightening of financial conditions have already taken effect. If logistics flows through the Strait of Hormuz return to normal, energy prices will face significant downside risks, especially given that Iran's largest negotiating window is expected to close around November 2nd, and a new deflationary energy narrative could emerge at any time.

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

Goldman Sachs' research on the "era of commercial agent-based AI" suggests that technological advancements are substantially reducing costs for consumers, which will become a more significant deflationary driver than the decline in energy prices.

Cooling economic growth expectations limit the central bank's hawkish stance.

Despite geopolitical and energy price uncertainties over the past six months, U.S. economic activity has shown greater resilience than expected. However, research by Goldman Sachs economist Jan Hatzius suggests that these upside risks are diminishing, and the second derivative of economic growth is beginning to slow.

As the fiscal benefits of tax cuts and other incentives fade, rising gasoline prices and mortgage rates will impact certain sectors of the economy and consumers.

Furthermore, while the capital expenditure cycle in the AI sector will continue, the growth rate will slow. Considering the expectation of declining inflation, future interest rate hikes by central banks worldwide are highly likely to be lower than currently priced into the market.

Mark Wilson emphasized that now is no longer the time to worry about rising yields; such concerns were only justified seven months ago.

Strong core earnings support stock valuations.

In response to the heated debate in the market regarding the sustainability of corporate profits and the "profit bubble," Ben Snider, head of Goldman Sachs' US strategy team, believes that while some companies are currently experiencing "excess profits," there is no overall profit bubble.

Goldman Sachs reminds investors of three facts:

First, a high premium should not be paid for record "other income"; second, memory chip and some semiconductor stocks are indeed currently in a state of excess profitability; third, at least until the end of 2027, even if the growth rate of core earnings slows down, companies are very likely to remain particularly strong, which provides fundamental support for stock market valuations.

The stagflation narrative fails; "Goldilocks" reshapes the market landscape.

The market had been trying to price in a significant slowdown in economic growth and earnings, as well as higher interest rates, but macroeconomic data did not support this perfect "stagflation" narrative. Instead, slower growth, a diminished threat of inflation, a softening central bank stance, and a year of valuation downgrades combined to create a favorable market mix.

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

If the market ultimately experiences a "Goldilocks" scenario (i.e., economic growth is just right, neither overheating and causing inflation nor cooling and causing recession), then the historical pattern of a stock market rebound at the end of the year following the midterm elections will still apply.

Mark Wilson concluded that investors should not wait until after the midterm elections to take action, and that with the energy price threat fading, European and UK stock markets are well-positioned to participate in this rally.

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