Rising dollar tops Goldman Sachs' 2016 trade tips

By Marc Jones and Jamie McGeever

LONDON (Reuters) - U.S. investment bank Goldman Sachs tipped a higher dollar as its top trade for 2016 on Thursday, heading a list that also bet on rising U.S. inflation and long-dated Italian bonds outperforming German bonds.

Goldman said big U.S. banks will outperform the S&P 500 index and recommended that investors take advantage of emerging market divergence by buying the Mexican peso and Russian rouble against the South African rand and Chilean peso.

The backdrop to its top trade tips is "unusually uncertain", but one broadly characterized by higher global growth and U.S. inflation than markets currently expect, diverging monetary policy paths, less market liquidity and a slowdown in emerging markets rather than a meltdown.

The long-term dollar bull reiterated its buy recommendation versus the euro and yen, saying strength in the U.S. labor market and domestic demand would see the Federal Reserve drive up interest rates faster than currently expected by the markets.

Meanwhile, the European Central Bank and Bank of Japan will be easing policy further.

"The divergence between the Fed and both the ECB and BoJ will continue to be one of the more durable themes of 2016," Goldman said in a note on Thursday.

Related to this, Goldman also said it expected U.S. inflation to accelerate through next year and recommended buying 10-year Treasury inflation-protected notes (TIPS) and selling conventional Treasuries.

"The option market assigns a 40 percent probability to CPI (inflation) averaging less than 1 percent over the next 5 years. We think this represents an opportunity to take the other side of too pessimistic expectations," Goldman said.

In U.S. equities, Goldman favors going long large-cap U.S. banks relative to the S&P 500.

"U.S. banks are still relatively well-priced ... with a P/E (price/earnings ratio) below that of the overall market, and at about median levels compared with its own past history," Goldman said.

In Europe, increased bond buying from the ECB would be more of a boost for longer-term Italian bonds than their German peers, which should narrow the gap between the two countries' 10-year yields by around 30 basis points to 75 basis points.

Of the more exotic trades it recommended buying Mexico's peso and Russia's rouble versus South Africa's rand and Chile's peso. Whereas Goldman said it saw limited further falls in oil prices, industrial metals which are particularly important to South Africa and Chile could continued to slide.

The three main risks to its 2016 outlook are bond yields rising faster than it anticipates, a devaluation of the Chinese yuan and another slump in commodity prices, particularly oil.

(Reporting by Marc Jones and Jamie McGeever)

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