GOLDMAN: A 'Dramatic Divergence' Is Coming To Stocks And Bonds

David Kostin and the U.S. equities team at Goldman Sachs are out with a big call on stocks and bonds in the coming years: "dramatic divergence."

Factoring in the impact of the Fed raising interest rates - which Goldman's economics team expects to happen in the third quarter of 2015 - Kostin and his team expect the real return for stocks to be 4% annualized while bonds will return -1% annualized over the "next several years."

Kostin writes:

"We forecast a dramatic divergence between potential stock and bond returns during the next several years. We assume a neutral fed funds rate will be reached in 2018 and 10-year Treasuries will yield 4.5%. Our baseline scenario implies an annualized total return of 1% on a constant maturity 10-year Treasury note through year-end 2018 (roughly corresponding to a return on an intermediate-term bond fund). Buying a 10-year Treasury note and holding it through 2018 would also generate a nominal annualized return of 1%. In contrast, our scenario anticipates the S&P 500 will generate an annualized total return of 6%. Taking inflation into account, the annualized real total return forecast equals -1% for a constant maturity bond strategy (-2% for a buy-and-hold) compared with +4% for S&P 500."

Now, a major factor in Kostin's call is a Fed funds rate of 4% in 2018, a view roughly in-line with the Fed's long-run projection for a 3.75% rate.

The current Fed funds rate is 0%-0.25%.

Kostin notes that some argue current yields reflect a change in the future prospects of the U.S. economy, or what Larry Summers famously called "secular stagnation."

This view holds that long-term interest rates are likely to hold near 2% rather than the 4% Goldman is forecasting.

This chart shows Goldman's interest rate projections against this outlook.