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

Mark Wilson, a partner at Goldman Sachs, recently pointed out that global equity 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 do not need to wait until the U.S. midterm elections are over to return to the market and participate in risk asset investments.

Recent market price movements have confirmed this optimistic expectation, as the AI-driven “Fear of Missing Out” (FOMO) has returned to the market. After Meta released its Muse product, market expectations for the timeline of mass AI adoption by consumers have accelerated rapidly, pushing AI-themed assets such as the Nasdaq index to break out strongly on Monday after three months of consolidation and reduced positioning following a historic surge in the second quarter.

Meanwhile, U.S. bond yields have risen again. Unlike previous cycles driven by competition for funds due to government and AI capital expenditures, or inflationary pressures brought on by energy prices, the current uptick in yields is mainly supported by stronger-than-expected data, such as the Purchasing Managers' Index (PMI), reflecting the continued strength of nominal U.S. economic growth. Furthermore, the equity market has managed to hold its gains despite substantial yield volatility.

At present, there is widespread market concern that the longest seven-month consecutive climb in the ten-year U.S. Treasury yield (a fifty-year record) will eventually drag down equities. Investors are also more inclined to increase risk exposure only after tensions in the Gulf subside and the midterm elections safely pass.However, Goldman Sachs’ analysis challenges this consensus, pointing out that the substantial improvement in the three key fundamentals—inflation, economic growth, and corporate earnings—offers a solid foundation for a year-end equity market rally.

Relief of Inflationary Pressure and the Deflationary Effects of AI

In the recent period, rising energy prices due to the Iran conflict have obscured a downward trend in core inflation.

However, Goldman Sachs notes that tariff pass-through effects are diminishing, and rate hikes combined with tighter financial conditions are achieving results. Should logistics through the Strait of Hormuz return to normal, energy prices face significant downside risk, particularly as Iran's main negotiation window is expected to close around November 2, creating the possibility for a new deflationary energy narrative at any time.

More importantly, Meta’s Muse product has fired the “first shot” of deflation in the consumer goods and services space.

Goldman Sachs’ research on the “era of business agent AI” shows that technological advancements are substantially lowering costs on the consumer side, which will become a more vital driver of deflation than a pullback in energy prices.

Cooler Economic Growth Expectations Limit Central Banks' Hawkishness

Despite facing geopolitical and energy price uncertainties over the past six months, U.S. economic activity has shown greater-than-expected resilience. Yet, research by Goldman Sachs economist Jan Hatzius shows that such upside risk is moderating, and the second derivative of economic growth will begin to slow.

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

In addition, although the capital expenditure cycle in the AI sector will continue, its growth rate will also slow down. In light of easing inflation expectations, the magnitude of future rate hikes by central banks is very likely to fall short of current market pricing.

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

Core Earnings Remain Robust, Fundamentals Support Equity Valuations

Regarding the heated debate in the market about the sustainability of corporate earnings and a possible “earnings bubble,” Ben Snider, head of Goldman Sachs US strategy team, believes that while some companies do have “excess profits,” there is as yet no overall earnings bubble.

Goldman Sachs urges investors to focus on three facts:

First, one should not pay a high premium for record-level “other income”; second, memory chip and some semiconductor stocks are indeed in a phase of excess profitability; third, at least until the end of 2027, even if growth slows, core corporate earnings are highly likely to remain very robust, providing fundamental support for equity valuations.

Stagflation Narrative Fails, “Goldilocks” Reshapes Market Landscape

The market has previously tried to price in a significant slowdown in economic growth and earnings alongside higher rates, but macro data does not support this perfect “stagflation” narrative. On the contrary, a combination of slowing growth, declining inflation risks, more dovish central bank stances, and a year of valuation corrections has created a favorable market environment.

Goldman Sachs believes the current environment closely resembles the market tug-of-war during the major technological transformation in the mid-to-late 1990s.

If the market ultimately enters a “Goldilocks” scenario (where economic growth is just right—neither too hot to spark inflation nor too cold to spur recession), historical data shows that the year-end equity rally after the midterm elections still applies.

Mark Wilson concludes that investors should not wait until the end of the midterm elections to take action; with energy price risks fading, European and UK equities are also well-positioned to participate in this rally.