Finding the winners from populism and reflation.

Wondering how to invest in a year marked by President-elect Donald Trump's inauguration, China's attempts to keep growth both high and sustainable, and the continued rise of populism in Europe?

Goldman Sachs Group Inc. has got you covered, with a team led by Co-Head of Global Macro and Markets Francesco Garzarelli releasing its first set of top trade recommendations for 2017 in a note to clients.

Some of these six trades are a continuation of existing high conviction calls from the bank; others are fresh ideas.

A warning: the recent track record for Goldman's year-ahead trade ideas has been less than stellar.

Amid the market turmoil that characterized the start of 2016, the bank was stopped out of five of its six recommended top trades before Valentine's Day.

1. U.S. dollar the winner from developed market populism

Remember the much-ballyhooed divergence trade that was among the most consensus calls of 2016? It's back — but with a twist.

The rationale for this trade is now grounded in political considerations; chiefly, the populist tide sweeping the globe.

"In the U.S., events have moved in a U.S. dollar-positive direction, between the rising likelihood of fiscal stimulus, more protectionism and immigration controls, all of which add up to a more inflationary mix and tighter-than-otherwise monetary policy setting," the team writes. "In Europe, ongoing uncertainty over the Brexit process will likely weigh on the pound, while the slew of elections, including the Italian political fallout after the constitutional referendum on Dec. 4 and general elections in France, Germany and the Netherlands, will weigh on the euro."

The strategists are targeting 10 percent upside in the U.S. dollar relative to an equal-weighted basket of the euro and pound, and would exit the position if the trade went against them by 5 percent. This would entail the euro falling to parity against the greenback, and the pound sinking to 1.14 on a 12-month horizon.

The primary risks to the trade would be tapering from the European Central Bank and a delay in triggering Article 50 to begin the Brexit process.

2. Bet on Trump getting more upset about China's currency

Goldman sees Beijing's policy of managed depreciation versus the U.S. dollar continuing in 2017.

The strategists advise going long the 12-month non-deliverable forward contract, which calls for the U.S. dollar to hit 7.07 Chinese yuan, looking for it to move to 7.30. The team would cut the position if the contract fell to 6.75.

"The fundamental dilemma of China’s currency regime is that, in an environment of a rising dollar, keeping the CFETS basket stable requires $/CNY to move higher meaningfully, which carries the risk that capital outflows re-escalate," the team writes. "Our base case is one where the $/CNY fix continues to grind higher, driven by domestic pressures and in the context of a stronger dollar."

The dollar has gained 7.5 percent against the yuan over the past year; the rate of appreciation required to hit 7.30 would actually imply a smaller move for the greenback over the next twelve months.

3. Keep calm and carry the right EM currencies

The strategists recommend going long an equal-weighted basket of the Brazilian real, Russian ruble, Indian rupee, and South African rand against the South Korean won and Singapore dollar, two currencies often used as proxies by investors looking for another way to get short exposure to China.

"The expected return, including approximately 7 percent carry (on an annual basis) and 7 percent price return, is around 14 percent," writes Garzarelli.

In the aftermath of the U.S. election, some of these relatively higher-yielding currencies have been indiscriminately battered amid the selloff of emerging market assets, making it a good time to initiate long positions.

"The countries represented on the long side of our FX basket also have more limited exposure to U.S. trade/demand risks if the protectionist rhetoric from President-elect Trump is transformed into action," the strategists add.

4. Long EM stocks with "insulated exposure to growth"

"Looking across the EM equity spectrum, we find that Brazil, Poland and India offer an ‘insulated exposure' to the EM growth recovery story, without being particularly exposed to China growth or U.S. trade policy," the team writes.

Goldman recommends buying an equal-weighted, currency unhedged basket composed of the Warsaw Stock Exchange Total Return Index, the Ibovespa Brasil Sao Paulo Stock Exchange Index, and the NSE Nifty 50 Index, looking for a gain of 20 percent and bowing out if the position falls 10 percent from current levels.

5. The reflation trade has legs

Whoops! This is the same position Goldman recommended at this time last year, which quickly fizzled out.

Strategists are once again advising investors to go long 10-year U.S. break-even inflation (derived from the gap between nominal and inflation-protected Treasury yields).

The team expects the spread between nominal and inflation-protected Treasury yields to rise to 230 basis points, and would exit the position if it fell to 160 basis points.

This time, they're also recommending a version of the same trade for inflation in Europe, using swaps.

"We think there is scope for the 'reflation' trade to perform better in 2017 for a combination of factors," the team writes, citing firming energy prices, the end of austerity, and central banks' likely tolerance of above-target inflation.

6. Long European dividend growth

Goldman's final top trade recommendation for the year ahead: go long European dividend growth by way of the Euro Stoxx 50 2018 dividend futures in a currency-hedged position.

"Dividend swaps, as a hybrid between credit and equities, currently appear attractive in a cross-asset context," writes Garzarelli. "We forecast a high 'carry' compared with other assets, which reflect both fundamental risks and supply/demand imbalances from structured products issuance."

Since 2018 isn't too far away, the trade doesn't have a ton of duration risk, and visibility into dividend growth should come quickly — according to the team, 70 to 80 percent of payouts in Europe are usually announced at the end of the first quarter.

"Shorter-dated dividends are less driven by changes in equity valuations and more closely linked to underlying earnings and cash flows," the strategists explain. "Despite little earnings growth in 2016, EURO STOXX 50 2017 dividends delivered a return of 6 percent with a volatility of 7 percent year-to-date."

This index is currently trading at 112. Goldman is targeting a rise to 125, and would close the position if it fell to 105.

Source:
courtesy of BLOOMBERG

by Luke Kawa

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