Goldman - July 25

July 25, 2014
GOAL: Global Opportunity

Asset Locator

Portfolio Strategy Research
Preparing for higher yields: Downgrading equities and credit
Macro outlook: Sustained growth and higher bond yields
Growth has improved substantially. Most of the acceleration we had
expected is now behind us, but we expect growth to be sustained at
current or slightly higher levels, with the US growing at around 3% through
2017. We think the likelihood of a rise in government bond yields has
increased and see this as a key aspect of the near-term macro outlook.
Our recommend allocation and investment themes
Equities: We downgrade to neutral over 3 months as a sell-off in bonds
could lead to a temporary sell-off in equities. This makes the near-term risk/
reward less attractive despite our strong conviction that equities are the
best positioned asset class over 12 months, where we remain overweight.
Commodities: We expect dispersion within commodities due to different
supply situations together with backwardation to drive returns and see
opportunities in nickel, zinc palladium and aluminum. However our return
forecast for the asset class as a whole is low and we remain neutral.
Corporate credit: We downgrade to underweight over both 3 and 12
months. We think spreads will narrow slightly, but given already tight
levels, rising government bond yields are likely to dominate the returns,
especially for US IG credit where spreads are the lowest.
Government bonds: We stay underweight. We expect yields to rise due
to sustained high US growth and accelerating inflation, a decline of
deflation concerns in Europe and an improving inflation outlook in Japan.
Investment themes: We seek to benefit from sustained growth at current
higher levels and the return of cash to shareholders. See page 4.
Expected returns and recommended asset allocation
Source: Goldman Sachs Global Investment Research.

Anders Nielsen
+44(20)7552-3000 anders.e.nielsen@gs.com
Goldman Sachs International

Peter Oppenheimer
+44(20)7552-5782 peter.oppenheimer@gs.com

Jeffrey Currie
(212) 357-6801 jeffrey.currie@gs.com
Goldman, Sachs & Co.

Francesco Garzarelli
+44(20)7774-5078 francesco.garzarelli@gs.com

Charles P. Himmelberg
(917) 343-3218 charles.himmelberg@gs.com

David J. Kostin
(212) 902-6781 david.kostin@gs.com

Fiona Lake
+852-2978-6088 fiona.lake@gs.com
Goldman Sachs (Asia) L.L.C.

Kathy Matsui
+81(3)6437-9950 kathy.matsui@gs.com
Goldman Sachs Japan Co., Ltd.

Timothy Moe, CFA
+852-2978-1328 timothy.moe@gs.com

Aleksandar Timcenko
(212) 357-7628 aleksandar.timcenko@gs.com

Dominic Wilson
(212) 902-5924 dominic.wilson@gs.com

Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors
should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors
should consider this report as only a single factor in making their investment decision. For Reg AC certification and other
important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by
non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.
The Goldman Sachs Group, Inc. Global Investment Research
AssetClass Return* Weight AssetClass Return* Weight
Cash 0.1 % OW Equities 10.5 % OW
Equities 1.8 N Cash 0.5 N
Commodities 0.5 N 5yr.CorporateBonds 0.6 N
5yr.CorporateBonds 0.3 UW Commodities 0.1 N
10yr.Gov.Bonds 1.6 UW 10yr.Gov.Bonds 4.7 UW
*Returnforecastsassumefullcurrencyhedging
12MonthHorizon 3MonthHorizon
NewRecommendation
July 25, 2014 Global

Goldman Sachs Global Investment Research 2
Whats new?

Since our last GOAL report the likelihood of a rise in bond yields with knock-on
implications for other assets has increased. To prepare, we downgrade corporate
credit to underweight over both 3 and 12 months and downgrade equities to
neutral over 3 months. For a 12-month horizon and beyond we still see the best
strategy as being overweight equities and underweight government bonds to
capture the equity risk premium which remains very high.

The biggest news on growth since our last GOAL report has been the continued
improvements in China with support from easy policy on both the fiscal, monetary and
administrative side. We now expect to see some moderations in policy support, but the
overall stance is likely to remain loose. We expect qoq growth to accelerate further in 3Q14
to 8.4% reflecting the strong momentum coming into the quarter before falling back a bit in
4Q14 to 8.0%. In Europe on the other hand our current activity indicator (CAI) has
weakened marginally in June to 1.2%. German and French data have disappointed while
we have revised our forecasts for Spain higher. Our annual growth forecast for the Euro
area is unchanged and we expect growth of 1.6%-1.7% in the second half in line with the
level of our CAI in April. The 1.2pt improvement in the July Euro area flash PMI is
encouraging in this respect.

In the US, growth has been steady over the last month as we expected, with the most
interesting data point being the continued decline in unemployment. Given the improved
labor market, upside surprises to inflation and very easy financial conditions our US
economists have shifted their forecast for the first rate hike to 3Q15 instead of 1Q16. This
forecast of near-zero rates for another year reflects that broader measures of the labor
market remains weaker than unemployment alone would suggest, our expectation of a
slow normalization of inflation as wage growth remains low and the risk/reward favoring
policy makers erring on the side of being a bit late rather than a bit early.

At the same time 10-year yields have declined further and are now around their lowest
levels post the sell-off over the summer last year (Exhibit 1). In the case of Germany we
have even surpassed the lows from before the sell-off. We expect bond yields to be pushed
higher by sustained high US growth and accelerating inflation, a decline of deflationary
concerns in Europe and an improving inflation outlook in Japan. The conclusion of Fed
bond purchases in October could also be a catalyst for a reassessment of the speed and
size of the hiking cycle as well as the neutral rate. As time has passed while yields have
stayed low, the time window over which we would expect this sell-off in bonds has
shortened from one side. At the same time, the data has shortened it from the other by
moving forward our expectation for the first rate hike. We now see the likelihood of a sell-
off in bonds as large enough that we adjust our allocation to both equities and credit as a
preparation for a rise in yields. We balance these changes with an upgrade of cash to
overweight over 3 months.

We downgrade corporate credit to underweight over both 3 and 12 months. We continue to
have a benign outlook for spreads and expect a slight further tightening over the coming
year as monetary policy remains very accommodative and inflation and macro risks remain
relatively low leading to a strong search for yield. However, spreads are now so tight that
carry and further spread compression offer a relatively low offset against the rise we
expect in the underlying government bond yield, especially for US investment grade
credits. This tension between total return and spread return expectations have existed for a
while, but the latest developments have shifted the balance between these two forces far
enough for us to prefer a credit underweight, given that our credit portfolio puts 60%
weight on US investment grade.

In summary
On growth
An earlier hike
Yields to rise
Downgrading credit

Exhibit 1: Government Bond yields back at very low
levels

Exhibit 2: US data surprises close to high
3-month linearly weighted data surprises vs. consensus for
the US and Euro area, as measured by our MAP indexes

Source: Datastream, Goldman Sachs Global Investment Research.

Source: Haver Analytics, Goldman Sachs Global Investment Research.

We also downgrade equities to neutral over 3 months. We are concerned that a sell-off in
government bonds will lead to a temporary sell-off in equities in line with what we saw last
summer, though the magnitude is likely to be smaller as the need for bond yields to correct
is lower than it was back then. At the same time, on our forecasts the acceleration of
economic growth is now largely behind us, with any further expansion being very small
compared to what we have seen. We see an environment where growth is sustained
around current levels as being positive for equities over the longer term, but would expect
the pace of returns to slow down relative to the strong performance we have seen over the
last couple of years. This suggests that the forgone return by lowering the equity exposure
temporarily if equities continue their grind higher is likely to be lower than it has been. This
is particularly true in the US where earnings and valuations are at high levels, and where
data surprises are already very positive. Our MAP index of data surprises here is close to
its highest levels over the last couple of years (Exhibit 2). Over the longer term we still see
equities as the best positioned asset class, and remain overweight over 12 months. We
would see any sell-off over the next few months as an opportunity to increase exposure
again also on a short-term basis.

Geopolitical risks remain high, but in the case of both Iraq and Ukraine our expectation is
that the likelihood of a broader market impact is low. Still, both conflicts remain very
volatile and have the potential to have broad impact if they escalate beyond our
expectations and this risk provides additional support for our equity downgrade. The risks
to our growth outlook on the other hand have diminished as we now see the risks to our
Chinese growth forecast as being broadly balanced rather than skewed to the downside.
We see a move in bond yields as the most likely cause of market volatility in coming
months and think our new allocation lowers the risks to the portfolio from this.

In our last GOAL report, we maintained our equity overweight and government bond
underweight over both 3 and 12 months. Since then equities have returned 1.4%
outperforming the 1.0% return on government bonds.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Jul-12 Mar-13 Nov-13 Jul-14 Mar-15
%
US 10-Year UK 10-Year
Germany 10-Year Japan 10-Year
'Taper tantrum' sell-off
-2
-1
0
1
2
Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14
Euro Area
US
Downgrading equities
An update on risks
Performance

Investing in our themes
To benefit from the stronger growth environment, we would position in stocks with high
operational gearing, exposure to developed markets or both. We have active
recommendations to leverage this view across the four regions that we look at. We see the
reflation story in Japan as another angle on this theme. In government bond markets we
are long Euro area inflation and short 3 year US Treasuries.
Exhibit 3: Our recommendations position for a cyclical recovery

As risk aversion moderates we expect companies to put cash to work. Given regional
differences in return policies, we have developed different strategies for the different
regions to capture this, but we like the theme in both the US, Europe and Japan.
Exhibit 4: ...and companies using cash for shareholder returns

We are long the US dollar vs. the Canadian dollar.
Exhibit 5: Other trade recommendations

Cyclicalrecovery
UScompanieswithhighoperationalleverage(GSTHOPHI)vs.UScompanieswithlowoperationalleverage(GSTHO
USstocksweexpecttobenefitfromhigherrates(GSTHUSTY)vs.S&P500
UScompanieswithhighweakbalancesheets(GSTHWBAL)vs.UScompanieswithstrongbalancesheets(GSTHSBAL
DAXvs.Stoxx600
OperationallygearedDMexposedEuropeancompanies(GSSTDMGR)vs.Stoxx600
Europeanfinanciallyleveredcompanies(GSSTFNLV)vs.Stoxx600
FTSE250vs.FTSE100
Asianglobalcyclicals(GSSZMSGC)vs.defensives(GSSZMSDF)
AsiaexJapanmarginexpandersvs.margincontractors(seeJune303Qviews:Harderearnedreturns)
Japanesecapexgrowthbeneficiaries(GSJPCPEX)
WavefrontUSConsumerGrowthbasket(GSWBCOGA)
LargecapbanksintheUS,EuropeandJapan,withEqualweightsinBKX,SX7EandTPNBNK
LongEuroarea3yearinflationswaprates2yearforward
Short3yearUSTreasuries
E
q
u
i
t
y
G
o
v
B
o
n
d
s
Shareholderreturn
UScompanieswithhightrailingbuybackyieldrelativetotheirsector(GSTHREPO)vs.S&P500.
Europeancompanieswithhighdividendyieldsandgrowth(GSSTHIDY)vs.StoxxEurope600
Japanesetotalshareholderyieldstocks
E
q
u
i
t
y
Othertrades
S&P500Dec14FuturefundedoutofshortAUD/USDDec14future
Japanesewomenomicswinnerbasket(GSJPWMN2)
ShanghaiHongKongstockconnectbeneficiaries(seeJune303Qviews:Harderearnedreturns)
F
X
LongUSDCAD
E
q
u
i
t
y
X
a
s
s
e
t
Cyclical recovery
Shareholder return
Other strategies

Our forecasts
Exhibit 6: Our forecasts across asset classes

Exhibit 7: US GDP growth vs. our CAI

Exhibit 8: Euro area GDP growth vs. our CAI


Exhibit 9: Our forecasts for global economic growth vs. consensus

Source: Consensus Economics, Goldman Sachs Global Investment Research.
Returnin%overlast Current Forecasts
12m 3m 1m Level 3m 6m 12m Unit
Equities
S&P500($) 20.4 6.4 2.1 1988 2000 2050 2075 Index
StoxxEurope600() 18.2 3.8 0.2 344 360 370 385 Index
MSCIAsiaPacificExJapan($) 17.1 7.1 4.5 509 500 520 535 Index
Topix() 6.2 9.2 0.2 1270 1250 1300 1450 Index
10YearGovernmentBondYields
US 3.6 2.1 0.6 2.50 2.75 3.00 3.25 %
Germany 6.3 3.3 1.0 1.18 1.40 1.60 1.92 %
UK 1.5 0.9 1.0 2.71 2.81 3.00 3.13 %
Japan 3.5 1.1 0.5 0.56 0.73 0.75 0.88 %
5yearcreditspreads*
iBoxxUSD 6.8 1.8 0.4 78 75 73 70 Bp
BAMLHYMasterIndexII 8.7 1.6 0.5 348 339 332 320 Bp
iBoxxEUR 6.7 2.2 0.4 109 102 99 95 Bp
Commodities
WTI 1.7 2.1 3.2 102 96.00 95.00 90.00 $/bbl
Brent 7.0 0.9 5.6 107 105.00 105.00 100.00 $/bbl
NymexNat.Gas 5.5 18.0 13.5 3.85 4.50 4.25 4.25 $/mmBtu
Copper 2.1 6.3 4.0 7170 6600 6600 6200 $/mt
Aluminium 0.6 7.0 6.6 2026 2000 2050 2100 $/mt
Gold 2.3 0.1 2.2 1291 1195 1135 1050 $/troyoz
Wheat 23.4 25.0 9.0 529 610 560 575 Cent/bu
Soybeans 8.4 10.7 11.4 1085 1400 1050 1050 Cent/bu
Corn 23.5 23.6 14.7 362 450 400 400 Cent/bu
FX
EUR/USD 1.8 2.6 0.9 1.35 1.35 1.34 1.30
USD/JPY 1.6 0.5 0.3 102 103 107 110
*Weshowperformanceforcreditintotalreturnterms,butcurrentlevelandforecastsareforspreads
-3
-2
-1
0
1
2
3
4
5
6
Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
%
Annualised QoQ GDP Growth
GS Forecast
CAI
Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116
3.2 3.3 3.3 3.0 3.0 3.0 3.0 3.0
QoQGDPGrowthForecasts(%Annualised)
-3
-2
-1
0
1
2
3
4
5
6
Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
%
Annualised QoQ GDP Growth
GS Forecast
CAI
Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116
0.8 1.7 1.6 1.4 1.6 1.5 1.6 1.8
QoQGDPGrowthForecasts(%Annualised)
2014E 2015E 2016E 2017E
GS Consensus* GS GS GS
USA 2.8 1.9 1.6 1.6 3.1 3.0 3.0
Japan 1.4 1.5 1.5 1.5 1.2 1.6 1.5
Euro Area -0.6 -0.4 1.0 1.1 1.5 1.7 1.6
China 7.7 7.7 7.3 7.3 7.6 7.6 7.4
BRICs 5.9 5.9 5.5 5.6 6.3 6.6 6.7
Advanced
Economies
1.4 1.3 1.8 1.8 2.5 2.5 2.5
World 3.1 2.9 3.1 3.0 3.8 4.1 4.1
* Consensus Economics July 2014
2013 % yoy 2012

Equities: Downgrade to neutral over 3 months
We downgrade equities to neutral over 3 months but remain overweight over 12. The longer-term case for equities
is still strong: we expect sustained economic growth around current levels to drive earnings growth and
performance, while the potential for equity risk premia to compress from still very high levels leaves room for
equities to perform over the longer term despite a rise in bond yields. However in the short term we worry that a
rise in bond yields will drive equities lower, and we also expect the general pace of returns to slow compared to
what we have seen in the last couple of years. We maintain our regional allocation with an underweight in the US
over both 3 and 12 months balanced by an overweight in Europe over 3 months and Europe and Japan over 12
months.
We downgrade equities to neutral over 3 months as we are
concerned about the potential impact of rising rates. We
also think the acceleration in economic growth is largely
behind us and geopolitical risks are elevated. While these
issues weaken the risk/reward from equities in the near
term, they do not change our view that equities are the
most attractive asset class on a 12-month horizon by a wide
margin and we remain overweight.
Many investors are concerned about current valuation
levels, but in our central economic scenario we expect
these levels to be sustained. For us the main concern
related to valuation is that current levels create downside
risks if the economic environment was to disappoint.
Whereas absolute valuations are on the high side, relative
valuations remain attractive. The gap between dividend
yields and bond yields shown on Exhibit 10 is still high and
our estimates of equity risk premia ranges from 5.2% in the
US to 8.5% in Asia ex-Japan. We expect continued
compression of these high premia to offset the rise in bond
yields over the longer term and therefore think valuations
should be relatively steady even as bond yields rise.
This leaves earnings as the key driver of returns in our view.
Whereas earnings were revised down across all markets
except Japan at the beginning of the year, they have now
stabilised in all regions except Europe, where the
downward revisions have continued. This stabilization is
supportive of our forecasts for earnings growth which are
roughly in line with consensus in all regions except for
Japan where we are more optimistic. We are concerned
about the continued downward revisions in Europe and see
this as a key risk to our overweight here. But, we expect
both a slight improvement in European economic growth
for the rest of the year as well as the currency depreciation
to lead to a stabilisation of earnings. Though it is early, the
2Q14 earnings season in Europe has so far been positive,
which is encouraging.
We continue to see the return of cash to
shareholders as a key theme across the US, Europe
and Japan and recommend strategies to capture
this in all these regions. We also recommend a
number of strategies geared towards capturing the
stronger environment for economic growth that we
have now shifted into (see page 4 for a list of these
trades).

Exhibit 10: Dividend yields are high vs. real bond yields
Dividend yields minus 10-year real government bond yields.
We use five-year average inflation as a proxy for inflation
expectations. The distribution uses data from 1990 except for
Asia ex-Japan where it is from 1995

Exhibit 11: Earnings revisions have stabilized except in
Europe
Percent change in consensus expectations for the level of
2014 EPS vs. expectations at the beginning of the year.

Source: Datastream, Haver Analytics, Goldman Sachs Global Investment
Research.

Source: Datastream, Goldman Sachs Global Investment Research.

-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
Europe US Asia Ex-Japan Japan
+/- stdev
current
Average
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
Dec-13 Jan-14 Mar-14 Mar-14 Apr-14 May-14 Jun-14
Europe (STOXX 600)
US (S&P 500)
Japan (TOPIX)
Asia ex Japan (MSCI Asia ex Japan)


Our sector weightings also reflect the stronger economic
environment, with overweights in many of the financial
sectors, technology and parts of the industrial space,
whereas we underweight more defensive sectors including
the more defensive parts of the consumer space. (See
Exhibit 17 for sector details).
Our pro-cyclical thematic trades and sector
recommendations could suffer under a temporary
drawdown. But we have kept these recommendations, due
to our constructive longer-term outlook.
We keep our regional allocation unchanged, with an
underweight in the US over both 3 and 12 months balanced
by an overweight in Europe over 3 months and Europe and
Japan over 12 months.
Exhibit 12: Global indices price targets and earnings growth
All data is in local currency except data for the MSCI Asia Pacific ex-Japan index which is in US$

Source: Bloomberg, I/B/E/S, Goldman Sachs Global Investment Research.
Exhibit 13: Earnings sentiment by region
Upgrades less downgrades, as percentage of changes in estimates (last four weeks)

Source: FactSet, I/B/E/S, Goldman Sachs Global Investment Research.
Exhibit 14: Global valuation metrics
P/E is NTM on consensus earnings, net income margins is consensus 2013, all other data is 2013 or last twelve months

Source: Worldscope, I/B/E/S, Datastream, FactSet, Goldman Sachs Global Investment Research.
Current Earnings Growth
Price GS Target Upside to target (%) GS top-down Consensus bottom-up
Index 24-Jul-2014 3-m 6-m 12-m 3-m 6-m 12-m 2014E 2015E 2014E 2015E
Stoxx Europe 600 344 360 370 385 4.6 7 12 6 12 5 13
MXAPJ 509 500 520 535 -1.7 2 5 9 13 10 10
S&P 500 1,988 2,000 2,050 2,075 0.6 3 4 8 8 10 12
TOPIX 1,270 1,250 1,300 1,450 -1.6 2 14 16 14 7 11
Note : TOPIX EPS is based on fiscal, not calendar, years (i.e 2014 represents the fiscal year ending in March 2015).
-80%
-60%
-40%
-20%
0%
20%
40%
60%
Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14
Pan-Europe US
-80%
-60%
-40%
-20%
0%
20%
40%
60%
Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14
Asia ex-Japan Japan
P/E EV / EBITDA FCF Yield Div Yield P/B Net Income ROE Implied
(X) (X) (%) (%) (X) Margin (%) (%) ERP (%)
S&P 500 15.9 9.8 4.6 2.0 2.8 8.9 14.7 5.2
Stoxx Europe 600 14.3 8.3 3.9 3.1 1.8 6.4 9.3 7.2
MSCI Asia Pacific ex-Japan 12.4 8.7 2.3 2.9 1.7 8.8 12.1 8.5
Topix 13.7 7.6 5.2 1.9 1.3 7.1 8.7 6.4
Note : TOPIX EPS is based on fiscal, not calendar, years (i.e 2013 represents the fiscal year ending in March 2014)


Exhibit 15: Regional valuation relative to historical distribution (using data from 2001)

Source: Worldscope, I/B/E/S, Goldman Sachs Global Investment Research.
We remain constructive on Japan over the longer term,
where we expect performance to be supported by further
profit expansion and implementation of additional reforms.
We see the governments new growth strategy released in
June as supportive of this view with its focus on an
eventual reduction in the corporate tax rate to below 30%,
a new corporate governance code in 2015, neutralization of
the tax code to encourage more married women to work,
and an aim to boost foreign workers. Despite this we stay
neutral over 3 months, as we think it is a little late to
upgrade tactically after the strong performance over the
last couple of months.
We believe that Europe has solid return potential going
forward. This year earnings have been disappointing, but
earnings growth has turned positive on a trailing basis and
we expect it to accelerate as margins recover from
cyclically depressed levels. We also see room for strong
earnings growth for the financial sector where earnings
are depressed.
We expect reasonable returns for the US on an absolute
basis over the coming year, but relative to other markets,
the longer-term recovery potential is smaller given already
high margins and strong performance so far.
Asia ex-Japan has been supported by the improvement in
Chinese and US economic growth, but most of the
acceleration is now behind us. Longer term, there is still
significant uncertainty about the Chinese growth outlook
and we also worry that pressure on EM assets as a
consequence of higher DM yields could have a knock-on
impact for Asia ex-Japan even though we see it as much
less vulnerable than the rest of EM. We therefore stay
neutral despite the current economic improvements.
Exhibit 16: Our recommended weighting within equities
Total return forecasts for each region (in local currency and in USD) and the allocation we would currently make relative to
benchmark on both a 3- and 12-month horizon

0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
0
5
10
15
20
25
30
35
40
Europe US Asia
ex-Japan
Japan Europe US Asia
ex-Japan
Japan
(x)
"+/- 1 Stdev"
Average
Current
High/low
12monthforwardPE(LHS) TrailingP/B(RHS)
Recommended Recommended
Local Cur. In USD Allocation Local Cur. In USD Allocation
StoxxEurope600 5 6 Overweight Topix 16 8 Overweight
Topix 1 2 Neutral StoxxEurope600 15 11 Overweight
MXAPJ 1 1 Neutral MXAPJ 8 8 Neutral
S&P500 1 1 Underweight S&P500 6 6 Underweight
3-Months 12-Months
Index
Return Forecasts Return Forecasts
Index


Exhibit 17: Recommended sector weightings by region

Analyst Contributors
Peter Oppenheimer
+44(20)7552-5782
peter.oppenheimer@gs.com
David J. Kostin
(212) 902-6781
david.kostin@gs.com
Goldman, Sachs & Co..
Kathy Matsui
+81(3)6437-9950
kathy.matsui@gs.com
Goldman Sachs Japan Co., Ltd.
Timothy Moe, CFA
+852-2978-1328
timothy.moe@gs.com
Anders Nielsen
+44(20)7552-3000
anders.e.nielsen@gs.com
Matthieu Walterspiler
+44(20)7552-3403
matthieu.walterspiler@gs.com
Overweight Neutral Underweight
US
Information Technology Financials Consumer Staples
Consumer Discretionary Health Care Utilities
Industrials Energy Telecom Services
Materials
Europe
Banks Oil & Gas Chemicals
Autos & Parts Media Basic Resources
Insurance Telecoms Retail
Technology Real Estate Food & Beverage
Healthcare Constructruction & Materials
Financial Services
Utilities
Travel & Leisure
Personal & Household Goods
Industrial Goods & Services
Europe Subsectors
Integrated Oil & Gas* Oil Services*
Luxury Goods* Food Products*
Staffing
UK Homebuilders
Civil Aerospace
Japan
Steel & Nonferrous Chemicals Retail
Industrial Electronics Elec components & Precisions Household Products
Banks Trading Securities & Other Financials
IT Services Telecom Software & Internet Services
Media Transportation Consumer Electronics
Machinery Automobiles & Parts Utilities
Construction Food & Beverage
Insurance
Real Estate & Housing
Pharmaceuticals
Energy
Building Products
Asia ex-Japan
Software & Services Banks Real Estate
Energy Metals & Mining Utilities
Capital Goods Autos & Components Consumer Staples
Tech Hardware & Semis Transportation Telecom Services
Insurance & Other Financials Health Care
Chemicals & Other Materials
Consumer Retail & Services
*denotes long/short trade.


Commodities: Muted reactions to geopolitical risks; supply
dynamics to remain key to return differentiation
As the long anticipated macroeconomic acceleration shows tentative signs, not all commodity markets are likely
to benefit due to significant supply differentiation. While we maintain our neutral recommendation with 12-
month expected GSCI S&P returns of 0.1%, we see opportunity in Nickel, Zinc, Palladium and Aluminum markets
should the acceleration continue as expected.

Despite a very modest rise and subsequent decline in oil
prices during late June, the broader commodity prices as
measured by the S&P GSCI are almost back to the same
place they started the year (and 2011/2012 for that matter).
In addition, volatility across nearly all the sectors continues
to grind lower despite extremely high geopolitical risk.
With events in Ukraine, Iraq and Israel occurring all at the
same time, the price reaction from both commodity and
financial markets has been extremely muted as the
likelihood of a supply disruption remains very low and the
ability of other regions to respond, particularly the US
energy sector, remains high (see: Top of Mind: Geopolitics
and Oil Whats Changed?, July 22, 2014). Instead, market
focus has been on the long awaited tentative signs of a
macroeconomic acceleration in both the US and China.
However, while financial markets have reacted favorably to
these signs, with equities reaching new highs, commodity
indices have remained mostly flat.
However, this relatively benign description of commodity
prices misses two important themes: 1) an extremely high
level of dispersion across commodity markets that has
come to characterize 2014, and 2) commodity returns as
measured by the enhanced S&P GSCI are up 2.2% year-to-
date as the positive carry in key markets has continued to
generate returns. While we maintain our neutral
recommendation and a flat 12-month return forecast for
the S&P GSCI, we believe that these themes will continue
to characterize commodity markets in 2014.
Commodity dispersion is driven by supply
differentiation
This lack of reaction by broader commodity indices does
not suggest that all commodity market have not reacted to
the macroeconomic recovery. Some key energy and metal
markets have reacted to the cyclical upswing, while other
commodity prices remain unchanged increasing the
already high level of dispersion since the start of 2014,
initially due to weather events. Driving this recent
dispersion is a high level of supply differentiation between
those commodity markets which are now firmly in the
Exploitation phase versus those which either remain in the
Investment phase or are suffering from negative supply
shocks.
While cyclical recovery will see rising commodity demand,
returns will largely be determined by more structural
supply factors. Accordingly, not all boats are expected to
rise with the tide created by continued improvement in
global macroeconomic data. Due to weaker supply growth
we see upside in Nickel, Zinc, Palladium and Aluminum
prices as macroeconomic acceleration gets further
underway (see: Bulks, Base, Bullion: Mining commodities
riding the exploitation phase, July 23, 2014).
Backwardation surging in WTI as it fades in Brent
The second theme that has generated returns this year,
despite relatively weak price action and low volatility, is
backwardation in key commodity markets. This
backwardation provides a positive carry in the form of a
roll yield on the S&P GSCI. As well as increasing
structurally during the Exploitation phase of the
commodity cycle (which we have been in since early 2011),
the roll yield typically increases with cyclical strength in
economic growth. As we move further into the Recovery
phase, and eventually the Expansion phase, we see further
reinforcement of both supply differentiation and positive
roll yields drivers.

Exhibit 18: S&P GSCI Enhanced Commodity Index and strategies total returns forecasts

Source: S&P, Goldman Sachs Global Investment Research.

Current 12-Month
Weight Forward
(%) 2012 2013 2014 YTD 12-mo Forecast
S&P GSCI Enhanced Commodity Index 100.0 -0.1 -0.8 2.2 0.1
Energy 72.4 -1.5 5.6 1.3 1.5
Industrial Metals 7.0 1.3 -13.0 4.6 0.0
Precious Metals 2.8 6.2 -29.7 8.5 -15.0
Agriculture 11.3 5.4 -18.0 -6.0 -2.0
Livestock 6.5 -2.8 -2.8 29.5 -5.0
YTD returns through July 22, 2014


Energy
We expect 1.5% returns on the S&P GSCI Enhanced
Energy index on a 12-month horizon.
Petroleum: Brent price risks remained skewed to the
downside amid heightened geopolitical risks
During the last quarter, Brent prices have fluctuated
between $105-$115, with pressure on the upside strongest
by mid-June due to Iraqi supply disruption fears. As those
fears subsided and news arrived about some Libyan
exports becoming available in the near term, prices came
back down, fluctuating during the last week at around $107.
Geopolitical tensions, however, are once again rising on
stronger US sanctions on Russia, and rising violence in
Israel. Amid this backdrop of elevated geopolitical risks,
crude oil volatility has remained close to record low levels,
despite global oil inventories remaining low by historical
standards. In our view, this relatively stable market
environment both in terms of Brent prices and low
volatility is a sign of a balanced underlying crude oil
market in which the US shale revolution has resulted in a
much flatter oil supply curve, increasing supply flexibility
with the effect of limiting price volatility. Importantly, we
believe three key shifts that occurred in 2H13 will continue
to shape the 2014 global crude oil market: (1) demand
rotation with stronger DM demand offsetting weaker EM
demand, (2) supply normalization with non-OPEC
production outside North America continuing to grow, and
(3) OPEC supply disruptions with Libyan supply
uncertainty remaining elevated. Taken together, our
supply and demand outlook for 2014 continues to suggest
a modest weakening of the global oil balance and as a
result points to a modest decline in prices, leading us to
leave our year-end Brent price forecast unchanged at
$105/bbl.
In the US, WTI has fluctuated as well on geopolitical
tensions, but in a tighter range ($101 - $107). The WTI-
Brent differential has continued to narrow, and it sits
currently at -$4.9/bbl, the highest level since April, up from
-$12/bbl at the beginning of the year. WTI timespreads
remain well supported, with strong backwardation. Driving
this strength in WTI prices and the level of backwardation
was the continuous outflow of crude from Cushing to the
Gulf Coast via the new MarketLink pipeline. Going forward,
we believe that there exists only very little room for light
crude import displacement and that exports to Canada will
play a role in the adjustment process during the rest of
2014. Importantly, we estimate this still happens at a WTI-
Brent spread between -$7.00/bbl and -$10.00/bbl. However,
within that range, we believe that the adjustment will be
far from a continuous sequential process, but rather
characterized by volatility as the ability for US refineries to
process the excess crude oil remains a key driver.
US natural gas
US natural gas prices have traded down 14% since the
beginning of the month, closing at $3.85/mmBtu as of July
25. Despite coming out of last winter with the lowest gas
inventories since 2003, in the last 10 weeks the market has
been rebuilding storage at record rates. While the market
was relatively comfortable with large builds in May-June
on the back of the impressive supply growth viewed as
necessary to balance the market next winter, pricing has
reacted negatively to continued strong builds in July.
Bearish pricing has been a function of significantly weaker-
than-normal power demand in July, driven in turn by 10%
milder-than-normal temperatures in the US. In our view,
the current bearish pricing environment is driven by the
need for the market to encourage price-induced coal-to-
gas switching to compensate for lower overall power
generation demand in this period of mild weather.
However, we currently maintain our view that under
normal weather conditions into August, the market will not
need to incentivize significant coal-to-gas switching until
significant supply growth comes online in November,
driven by pipeline debottlenecking out of the Marcellus
and Utica shale plays. Accordingly, we maintain our 2014
and 2015 forecasts of $4.50/mmBtu and $4.25/mmBtu,
respectively. However, emphasize that risks to our 2014
forecast are no longer skewed to the upside, and we would
view continued mild weather into August as a downside
risk to pricing through the rest of 2014.
European natural gas
Despite a brief rally in European gas prices last week on
the back of US and EU sanctions against Russia and
escalating geopolitical tensions in Ukraine, northwest
European gas prices have largely continued on their strong
downward trajectory, which started last December. Indeed,
on July 15, NBP closed at 36.7 p/th, more than 50% off its
December peak. The northwest European market has
struggled to adjust to the oversupply it was left with at the
end of the mild winter, and for the first time in more than
two years, we now estimate that prices have fallen to
levels that incentivize coal-to-gas switching in UK power
markets. In our view, coal-to-gas switching demand will
continue to be needed throughout the summer to balance
northwest European gas markets, requiring prices to trade
on average at 34.2 p/th through 3Q2014. From winter 2014,
however, we believe that European gas markets will
tighten again, on a return to demand growth and as the
effects of the Dutch production cut from the Groningen
field will require imports from Russia at levels close to
2013. As a result, we forecast that NBP will trade at a
relatively tight average annual discount of 5.8 p/th to our
estimate of the oil-linked contract price through 2015.
Accordingly, we change our 2015 average price forecast
for NBP to 57.2 p/th. We continue to view the risk of
significant disruptions to Russian imports to northwest


Europe as limited (even given the recent expansion of
sanctions), as the EU still finds the costs of gas exports
sanctions on Russia unacceptable for its own economies.
Indeed, we note that no sanctions have been placed on
Gazprom, the monopoly Russian supplier of pipeline gas
to Europe. We continue to expect that disruptions to
European imports of Russian gas would only be employed
as a last resort.
Industrial metals
We expect 0.0% returns on the S&P GSCI Enhanced
Industrial Metals index on a 12-month horizon.
Over the year to date, the LME copper price has fallen by
3%, a substantially weaker outturn than the 15% rally in
LME zinc, c.23% increase in all-in aluminium prices
(including a 15% increase in the LME price), and 35%
increase in LME nickel. Looking ahead, we expect further
base metals price differentiation over the next 12 months,
with copper set to continue to underperform relative to
nickel, aluminium and zinc, in line with the medium-term
outlook we presented in our July 2014, Base, Bulks and
Bullion report.
The copper price declines over the year to date come
despite recent bullish macroeconomic (improving China
sentiment and US demand) and copper specific
developments (such as Indonesia export disruptions and
Chinas Reserve Bureau copper purchases). In our view the
outright price declines and coppers underperformance
reflect structural factors that are unlikely to ease over the
next 12-18 months. We believe that sluggish copper
demand growth particularly from Chinas construction
sector to which copper is heavily exposed combined with
a once in 20 year supply boom will push prices down to
6600 on a 3 to 6-month horizon and to 6200 on a 12-month
horizon. We also see limited upside risks to Chinese
demand growth owing to highly leveraged Chinese
corporate balance sheets and anticipated weakness in
copper-intensive construction completions, and downside
risks to our price forecasts in the case of a rapid unwind in
Chinese Copper Financing Deals (not our base case), or a
larger-than-expected slowdown in the Chinese property
market.
By contrast, low supply growth following years of
underinvestment in new capacity outside of China, in
combination with a cyclical upswing in demand have seen
zinc and aluminium prices rise strongly in 1H14.
Meanwhile nickel is being boosted by the attempts of a
large producer (Indonesia) to encourage value-add
capacity domestically. We see these themes continuing to
support base metals prices ex-copper over the next 12
months and see 15% upside in nickel prices (to $22,000/t),
6% further upside in zinc (to $2,500/t) and 5% further
upside in aluminium (to $2,100/t) over this period.
Precious metals
We expect -15.0% returns on the S&P GSCI Enhanced
Precious Metals index on a 12-month horizon.
Higher inflation prints over recent months coupled with
disappointing US 1Q GDP growth have provided support
for gold prices around $1,300/toz. More recently, hawkish
comments by Fed Chair Yellen and signs of a pickup in US
2Q GDP growth (as evidenced by our US Current Activity
Indicator running at c.3.5% annualized and strong labor
market stats over 2Q) have seen gold lose just over $40
from July 11 to 15. However, following recent events in
Ukraine and escalation of violence in the Middle East,
geopolitical risk sentiment has deteriorated sending gold
back to just over $1,300/toz.
We expect continued sequential acceleration in US
economic data over 2014H2 and for nominal 10Y yields to
rise to 3.0% by end-year. At the same time, we believe that
US inflation has now returned to a more moderate upward
trajectory (following unexpectedly high prints in April and
May). As such we continue to see real interest rates
grinding gradually higher and gold prices gradually lower.
That said, ongoing political uncertainties in the Ukraine
and the Middle East remain, posing continued upside risks
to our forecasts.
Agriculture
We expect -2.0% returns on the S&P GSCI Enhanced
Agricultural index on a 12-month horizon, and -5.0%
returns in the Enhanced Livestock index.
Agriculture prices rallied sharply to the end of May this
year (+20%ytd), but have since reversed and are now down
8%ytd. The key drivers of this moderation have been signs
of more moderate demand for the old crop (increasing
ending stocks in 13/14), no disruptions to Black Sea
exports despite the ongoing tensions in Ukraine and
favorable weather conditions for the new crop as: 1)
drought conditions have eased in southern US states; 2)
weather has remained cool and dry in the US corn belt; 3)
rains have returned to Brazil. Global corn, soybeans, wheat
and cotton inventories also remain elevated. Soft
commodities have seen prices trade sideways, but remain
volatile, as the full effect of the previous drought in Brazil
and the potential for an El Nino later this year (which
would shift most soft commodity markets into deficit in
2014) remains uncertain. That said, with lower seas surface
temperatures in the Pacific (and better progress of the
Indian monsoon), there are tentative signs that an El Nino
may now be less likely. In livestock, with the continued


outbreak of the PED virus reducing hog numbers, and little
sign of increased breeding, we see hog prices remain
elevated for the next couple of months before moderating
on seasonal effects later in the year.

Jeffrey Currie
(212) 357-6801
jeffrey.currie@gs.com
Damien Courvalin
(212)902-3307
damien.courvalin@gs.com
Samantha Dart
+44(20)7552-9350
samantha.dart@gs.com
Max Layton
+44(20)7774-1105
max.layton@gs.com
Christian Lelong
+61(2)93218635
christian.lelong@gs.com
Roger Yuan
+852-2978-6128
roger.yuan@gs.com
Michael Hinds
(212) 357-7528
michael.hinds@gs.com
Anamaria Pieschacon
(917) 343-9076
anamaria.pieschacon@gs.com
Daniel Quigley
+44(20)7774-3470
daniel.quigley@gs.com
Amber Cai
+65 6654-5264
amber.cai@gs.com
Goldman Sachs (Singapore) Pte



Credit: Downgrade to UW on lower spread cushion vs. higher rates
Corporate bond spreads continued to tighten in 2Q14. Investment grade bond spreads are now at their 42nd
percentile since 1985, while HY bonds are even tighter - near their 23rd percentile. Although risks are obviously
becoming increasingly one-sided, we expect volatility to remain low, and for spreads to trade flat-to-tighter from
here, driven by a pick-up in economic growth and continued monetary accommodation.
We continue to think that spreads will grind incrementally tighter as bond yields rise. Despite of this, we
downgrade to underweight over both 3 and 12 months, because there is now less carry and scope for additional
spread tightening to offset the expected rise in government bond yields. Within corporate credit, we continue to
suggest that investors find relative value in IG financials, shorter-duration bonds in HY, levered loans, cyclical
sectors, and illiquids. Tactically we expect EUR bonds to outperform USD, despite our continued concern over
the lingering tail risk of systemic shocks in European financials.
We continue to think that credit markets remain carry
friendly. We remain directionally constructive on the top-
down demand for credit spread, with stable growth (good
but not great) amid low yields and low expected returns
across most asset classes being the primary drivers.
Mainly for this reason, we expect spreads to continue their
slow grind tighter over the next year, in both IG and HY, in
both the United States and Europe.
Better growth, weak inflation, and thus accommodative
monetary policy should continue to support credit risk
appetite. Our constructive credit view is underpinned by
our macro outlooks for the United States and Europe,
where we expect modestly improving economic growth
against a backdrop of persistent slack and hence,
continued low to moderate inflation.
We think the sea change in financial regulation (including a
new macroprudential regulatory philosophy) has
materially curtailed the growth in leverage that has
historically accompanied economic expansions. In turn, we
think this muzzling of the financial accelerator (i.e., the
feedback loop between economic growth and credit
growth) has likely reduced the magnitude of both growth
and financial market volatility. A sustained period of low
volatility is a carry friendly environment for credit.
We also think this low-volatility environment implies that
the risks to growth and inflation remain skewed to the
downside (more so in Europe than in the US, despite the
determined efforts of central banks in both regions to push
inflation higher). We therefore believe that as growth data
continue to improve, as we expect, monetary policy will
continue to follow a relatively dovish reaction function.
We expect overnight policy rates in the United States to
remain at zero until the second half of 2015, and well
beyond that date for Europe.
We maintain our forecast for a continued grind
tighter.
We think IG 5-year spreads will continue their grind tighter,
with USD spreads reaching 73 bp by year-end, and EUR
spreads reaching 99 bp. In HY we project that OAS on the
BAML USD HY index will reach 332 bp by year-end and
320 bp by the end of 2Q15.

Exhibit 19: We forecast a slow grind tighter in both IG,
HY
IG 5y spreads to Treasury, and HY OAS by rating.

Exhibit 20: IG spreads are at their 42
nd
percentile
Current vs historical distribution of OAS since 1985

Source: Yieldbook, iBoxx, Goldman Sachs Global Investment Research.

Source: BAML, Goldman Sachs Global Investment Research.


Exhibit 21: HY spreads are forecast to grind tighter
OAS spreads on broad index and by broad rating index.

Source: Yieldbook, Goldman Sachs Global Investment Research.
A US inflation surprise is our top risk to credit
We now rank a US inflation surprise as our top risk to
credit. To be clear, our baseline view remains relatively
sanguine about the probability of meaningful upside
surprises in US inflation data (and the unexpectedly early
withdrawal of monetary accommodation this could imply).
But this risk scenario is one of the more painful we can
envision for credit spreads, so it warrants close scrutiny,
despite its low probability.
Surprisingly high inflation and the resulting removal of
monetary accommodation would obviously provoke a
painful risk-off event for rates and equities, but we think it
could be even more painful for credit, for the following
reasons:
First, we do not think markets for risk or rates are
priced or well-positioned for such a surprise.
Second, a monetary shock driven by inflation rather
than growth would reverse the usual negative
correlation between rates and credit spreads, causing a
double whammy of rising rates and wider spreads
for corporate bond yields (our baseline scenario, driven
mainly by better growth, envisions tight spreads amid
a benign normalization of rates).
Third, such a sharp rise in bond yields might spark
further selling by mutual fund investors, thus
generating additional spread widening on temporary
market imbalances.
We recently noted the many reasons why inflation will
most likely remain well-contained: core PCE is tracking at
just 1.5%; unemployment still remains high by historical
standards; global growth and inflation are low, while the
dollar should strengthen, keeping downward pressure on
inflation (growing domestic energy production in the US
should help too); wage inflation is still dormant; and the
logic of the Greater Moderation implies upside for demand
growth, and hence inflation pressure, is limited (see A US
inflation surprise: An unlikely but painful risk scenario
(especially for credit), Global Markets Daily, July 22, 2014).
Our US economic forecast.
We expect 4Q/4Q headline and core inflation to end the
year at 2.3% and 2.1%, respectively, and core PCE (the Feds
preferred inflation measure) to register just 1.7% 4Q/4Q for
2014 (from its current level of 1.7%), still well below the
Fed's target level of 2%. So under our forecasts, the
concerns raised here are simply risk scenarios.
That said, we cannot completely discount the risk from
inflation due to the potential magnitude of the impact. Nor
is it easy to discount that a wide range of inflation
indicators appeared to move higher in March, reversing the
prior-year trend during which year-on-year core PCE
inflation averaged less than 1.2%, and appeared to be
headed even lower in January and February.
Balance sheet re-leveraging also warrants a wary eye
Re-leveraging risk also remains high on our risks to credit.
To be clear, we remain skeptical of the popular view that
corporate leverage will inevitably rise due to low corporate
bond yields. We think the 2005-07 period provides a
counter example because corporate leverage actually fell
during the midst of what was clearly a period of easy
access to credit.
And to further avoid being misunderstood, when we worry
about re-leveraging, we are more concerned about weak
earnings than about financial engineering. Our bottom-up
analysis suggests that a sizeable portion of the increased
leverage since 2011 reflects weakness in the growth of
revenues and earnings. As US GDP growth is expected to
firm in the second-half, the resulting strength of earnings
growth should help stabilize aggregate debt-to-EBITDA
metrics.
That said, we continue to worry that low yields, tight
spreads, and the lack of financial leverage available to
investors all create clear incentives to seek leverage instead
through company capital structures. While company
managements have for the most part resisted the
temptation to abandon their still-conservative capital
structures, we are concerned that high stock market
valuations and future slowing of the M&A boom will
increase pressure for higher payouts via higher leverage if
future growth is not forthcoming.
For now, we view re-leveraging risk as less systematic than
idiosyncratic, especially for companies that have
underperformed their peers.



And of course, rising rates are not a risk but our
baseline
Following the first six months of the year during which
most credit investors benefitted quite unexpectedly from
the rally in rates, we have argued that it now makes sense
to seek refuge in shorter durations (see Searching for carry
in a duration-risky world, The Credit Line, March 26, 2014).
In IG, the modest spread tightening that we envision at the
five-year point, for example, would be overwhelmed by the
60 bp increase in 5-year Treasury rates that we foresee by
year-end. Thus, we expect negative total returns over the
rest of the year. In HY, higher carry provides enough return
to offset the rate increase, but we still see room for only
modest incremental returns from here.
We do not worry that a rate rise will cause retail investors
to flee fixed income and push up spreads. And to the extent
we are wrong on flows, we expect such spread widening to
be met by yield-seekers, as long as higher rates are driven
by growth and not inflation (see Why our fund flow view
passed the taper tantrum test, The Credit Line, March 6,
2014).
Relative value: We still like IG financials, shorter-
duration bonds in HY, cyclicals, and illiquids
Although much progress has been made since the financial
crisis, US IG financial credits still trade wide compared to
non-financials. We think these financial credits look
attractive for three reasons. First, higher carry will boost
returns, consistent with our top themes for 2014 (see A
carry-friendly world, Global Credit Outlook, November 22,
2013). Second, financial yields tend to move less than non-
financials in response to Treasury rate moves, insulating
financials from the risks around a rate increase. And third,
we expect the spread between financials and non-financials
will invert by year-end.
Within high-yield, investors who are concerned about the
rate increase in our forecast should either shorten duration
or move down in the rating spectrum. The former makes
more sense to us, but we also think B-rated bonds are now
in the sweet spot of the tradeoff between carry and
duration, as they feature a relatively high loss-adjusted
carry with lower duration than longer-dated credits.
We also recently reconfirmed our view that cyclical sectors
should outperform in the second half as the economy
accelerates (see Growth is back in favor in IG, still ignored
in HY, The Credit Line, July 11, 2014), and we also continue
to think liquidity premia offer opportunities for spread
enhancement.
Finally, we have a tactical preference for EUR over USD
bonds given their wider spreads and hence great appeal to
yield searchers. However, we still see elevated tail risks in
the Euro area, hence we continue to prefer US credit over
Europes on a fundamental basis.

Exhibit 22: For spreads, a slow grind tighter in USD
Historical vs forecast 5-year spreads to US Treasuries.

Exhibit 23: and in EUR
Historical vs forecast 5-year spreads to German Bunds.

Source: Compustat, Goldman Sachs Global Investment Research.

Source: Compustat, Goldman Sachs Global Investment Research.

Charles Himmelberg
(917) 343-3218
charles.himmelberg@gs.com
Lotfi Karoui
(917) 343-1548
lotfi.karoui@gs.com
Kenneth Ho
852-2978-7468
kenneth.ho@gs.com


Government Bonds: The bond bearish case
We continue to recommend an underweight on government bonds over both a 3- and 12-month horizon.
Forward bond yields are below our forecasts and we expect them to increase on the back of: (i) strong growth
and an acceleration of inflation in the US; (ii) our expectation that, as the Fed concludes bond purchases in
October 2014 and the macro outlook strengthens, the market will become more hawkish relative to the timing,
speed and size of the Fed tightening cycle, also revising upward its assessment of the neutral rate; and (iii) a
rebuild of the global term premium as Euro area inflation stabilizes and the tail risk of deflation in the currency
union fades.
Over most of the first quarter we held a neutral duration
stance and focused mostly on cross-country opportunities.
Our views of a divergence in economic outlook and the
direction of monetary policy stance between the US and
the Euro area, crystallized with our Top Trade
recommendation to receive 5-year EONIA against going
short 5-year US Treasuries, played out. Entering the
second quarter, we advocated outright bearish exposures
to longer-dated bonds both at the 3-and 12-month horizon.
But, since then, bond markets across the developed world
have continued to rally with 10-year yields in the US and,
most notably, in Japan and Germany now at their
minimum levels since the beginning of the year (and in the
case of German Bunds, the lowest in their history). Year-to
date total returns at the 7-10 year sector (using EFFAS
indices) are 2.3% in the JGB market (with low volatility),
4.2% in Gilts, 5.5% in US Treasuries, and 7.8% in German
Bunds. The reasons behind this global fixed income rally
are manifold, but we have argued that the following ones
stand out:
Policy easing from the ECB: Expectations of policy
easing have been building during the year on the back
of continued downward surprises in Euro area CPI
inflation. Since October 2013 and today, our own
forecasts for 2014 and 2015 inflation have come down
by 50bp, from 1.1% to 0.6% and from 1.6% to 1.1%,
respectively. Facing this challenging macroeconomic
outlook, at the June 5 policy meeting, the ECB brought
the rate at which excess liquidity deposited with the
central bank is remunerated to minus 10bp.
Additionally, the Governing Council announced further
injections of liquidity and the scheme for banks to lock
in funding at a fixed rate of 25bp for a minimum of 2
years, with the possibility of extending the funding for
two more years provided certain net credit creation
targets are met. As a result, the whole money market
curve out to three years has flattened, with the
forwards discounting no reversal of this policy until
the end of 2016. In our assessment, we find similarities
between the potential effects that the set of policies
announced by the ECB could have on euro are longer-
dated yields with the impact of the Feds calendar
guidance (in place from mid-2011 to end 2012) on US
Treasuries.
Duration risk absorption by the BoJ: Long-dated
JGBs are expensive relative to their macro
underpinnings as the BoJ continues to absorb around
two thirds of their gross monthly issuance and has in
its portfolio around 15% of the total stock of
government bonds outstanding. On top of the
depressing effect that the removal of duration by the
central bank has on yields, expectations of further
easing are on the rise. Our Japanese economics team
expects that the BoJ will expand its Quantitative and
Qualitative programme (QQE) sometime in 2H14 in
order to boost inflation further.
Cyclical weakness in 1Q14 in the US economy
and a dovish Fed: The remarkable, and completely
unexpected, contraction in real GDP in the US during
the first quarter of this year (minus 2.9%), has lent
support to the view that the economic recovery will be
tepid. Adding to this, Chair Yellens tone has been
mainly tilted to the dovish side, in particular given her
considerations about the amount of slack in the labour
market and the importance she assigns to closing this
gap before contemplating a lift to policy rates.
Exhibit 24: ECB policy rates floored until end 2016 as
excess liquidity increases
Euro area excess liquidity and EONIA forwards

Source: Haver Analytics, Bloomberg, Goldman Sachs Global Investment
Research.

-0.25
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
0
100
200
300
400
500
600
700
800
900
09 10 11 12 13 14 15 16 17
%
EURbn
Range exc. reserves
(lhs)
Excess reserves (lhs)
1m EONIA (rhs)
MRO rate
Deposit rate
forecasts


Exhibit 25: Lower Euro area yields have pulled the global
term premium down
Cumulative rate bullish 'shocks' in German Bunds outweigh
rate bearish 'shocks' in USTs

* Footnote: Shocks here are cumulated errors from a structural
VAR, See Whos in the Driving Seat? Fixed Income Monthly, Feb
12, 2013
Source: Bloomberg, Goldman Sachs Global Investment Research.
Marking to market our forecasts
Against this background, and recognizing the possibility
that the ECB engages in purchases of credit assets, thus
lifting inflation expectations, may come later than we had
expected (the timeframe we now have in mind is between
the fall and next spring), earlier this month we lowered our
bond forecasts a touch for the US and Japan, while we
lowered our forecasts for German Bunds more
substantially. In the case of the former two bond markets,
we simply shaved 25bp off from our 10-year yield
forecasts until 2017 recognizing that the global bond
premium has fallen year to date. Instead, we now see
German Bunds yields ending the year at 1.6% (2.25%
previously) and increasing to 2.25% (3% previously) by
end-2015. This forecast, however, stills reflect our more
bearish stance relative to the market, as we are still above
the current forwards by about 40bp and 75bp, respectively.
The case for a bearish stance on intermediate
maturities
Even accounting for our lower bond yield forecasts, we
still expect negative returns on holdings of intermediate-
maturity government bonds. We envisage that the
following forces will drive yields higher:
1. We expect a material pick-up in US economic activity
relative to 1Q14, with real growth rates slightly above
3% until end-2017, supported by easing financial
conditions and an acceleration of inflation towards the
2% PCE inflation objective of the Fed.
2. As the Fed concludes bond purchases in October 2014
and the macro outlook strengthens, the market will
become more hawkish relative to the timing, speed
and size of the tightening cycle, also revising upward
its assessment of the neutral rate.
3. A rebuild of the global term premium as the tail risk
of deflation in the Euro area declines. Moreover, we
think that the implementation of the Banking Union
will contribute to the reduction in the fragmentation of
European financial markets. This, together with the
targeted LTROs and purchases of ABS by the ECB
should support the expansion of corporate credit and,
consequently, aggregate demand. We forecast a
sequential slow improvement in Euro area growth and
a stabilization of Euro area inflation in the coming
months, with a slow increase in 4Q14 and further rises
during 2015 until approaching 2% by the end of 2017.

Exhibit 26: US services inflation accelerates
Estimates of trend inflation of services component following
Stock-Watson (2007) methodology

Exhibit 27: The decrease in bond premium in 1H14 should
reverse in coming months
Latent common factor in regression of G-4 10-year
government bond yields against macro variables

Source: Haver Analytics, Goldman Sachs Global Investment Research

Source: Goldman Sachs Global Investment Research

-8
-6
-4
-2
0
2
4
Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14
US Germany
UK Japan
Cumulative
standard errors
0
1
2
3
4
5
92 94 96 98 00 02 04 06 08 10 12 14
Service Inflation (yoy)
Trend
16%-tile
84%-tile
%
-16
-12
-8
-4
0
00 02 04 06 08 10 12 14
Global Bond Premium
(US,UK, Germany and Japan)
Jan-14
level


In terms of strategy, in this macro scenario we see scope
for:
1. The term structure of US yields to move upward and
flatten by more than what is discounted by the
forwards, as the risk of an earlier and faster tightening
cycle increases. We point out the inconsistency of
having a negative term premium at the front end in an
environment in which the uncertainty about the
amount of slack left in the jobs market is very elevated;
2. The intermediate part of the Euro area nominal rate
curve should bear-steepen, led by a combination of
healthier credit dynamics in the second half of the year,
a reduction in the negative inflation risk premium
priced in the Euro curve as tail deflationary risks
dissipate, and in sympathy with the sell-off in US
rates; and,
3. A further pick-up in Japanese underlying inflation, led
by demand-pull factors and underpinned by further
BoJ easing, that ultimately should translate into higher
nominal longer-term yields, and the possibility that
Japanese pension funds and insurance companies
portfolios should be rebalanced in favour of equities at
the expense of bond holdings.
Reflecting these views, we are currently recommending to:
(i) be short 3-year US Treasuries, opened at 93 bp on June
16, 2014, with a target of 150 bp (35 bp above 3-month
forwards) and a stop on a close below 70 bp, currently at
98 bp, and (ii) be long Euro area 3-year inflation swap rates
2-years forward, opened at 1.46% on May 30, 2014, with a
target of 1.70% and a stop on a close below 1.35%,
currently at 1.54%.

Exhibit 28: Goldman Sachs forecasts for 10-year government bond yields
End of year forecasts (%)


Year USA Germany Japan UK
2014 3.00 1.60 0.75 3.00
2015 3.50 2.25 1.00 3.25
2016 3.75 2.50 1.25 3.50
2017 4.00 3.00 1.50 3.75
Francesco U. Garzarelli
+44(20)7774-5078
francesco.garzarellli@gs.com
Goldman Sachs
International
Silvia Ardagna
+44(20)7051-0584
silvia.ardagna@gs.com
Mariano Cena
+44(20)7774-1173
mariano.cena@gs.com


Major FX views: Still Dollar Bullish
We provide up-to-date views on the major FX rates. We continue to expect the USD to strengthen against the
major crosses. We refreshed our Euro view after the ECB easing in June and expect the currency to trade at 1.34 by
year end and 1.30 in 12 months. We continue to expect USD/JPY higher in the near- and mid-term in anticipation
of further BoJ easing including clarification on what the BoJ intends to do with its QQE program in 2015 and
beyond. We have refreshed our GBP views and expect Sterling to continue to appreciate against the Euro.

We argued in the spring edition of the FX Quarterly that
there were three major drivers of USD strength against the
major currencies interest rate differentials, shifts in the
oil balance in the US and safe-haven demand. We still
believe in those arguments even though it has been a
frustrating time for dollar bulls. The USD on a TWI basis
has been broadly flat against the G10. However, this TWI
performance goes against interest rate differentials which
are becoming more supportive of Dollar strength. Indeed,
the 2-year rate differential of the US versus the trade-
weighted G10 has risen to its most Dollar supportive level
since 2009 (Exhibit 29), as underscored by our US
economics team bringing forward their assumed date for
the first rate hike to 3Q15.
The ECB has eased, pushing the Euro weaker. The Euro
has weakened from 1.40 to 1.34 in expectation of and
subsequent delivery of ECB easing at its June meeting. As
a result, we have changed our 3-month EUR/USD forecast
to 1.35 from 1.38. Our 6- and 12-month forecasts are
unchanged at 1.34 and 1.30. Our continued expectation of
Euro weakness rests on relative growth and monetary
policy dynamics vs. the US. A regular client push back to
this view is the Euro areas solid current account surplus
and strong portfolio inflows. However, foreign buying of
European equity and fixed income is already very strong
and in line with historical trends (Exhibit 30). Therefore we
expect ECB easing to trump the solid Euro area external
surplus and cause the Euro to weaken over the next 12
months.
The USD/JPY has been stuck between 101.5 and 102.5
since early April. However, relative monetary policy
dynamics are likely to change in October, when the Fed
ends its tapering process and the BoJ eases policy further
as inflation softens into year end, thus providing a kicker
for USD/JPY higher we expect Japanese CPI to soften to
0.8% yoy (ex VAT) by year end, below the BoJs forecast.
BoJ easing is likely to take the form of doubling the
purchase amount of ETFs to JPY2 tn, and the BoJ needs to
clarify what it intends to do with QQE into 2015. Our
forecast is 110 in 12 months' time.
BoE has been more hawkish pointing to a lower EUR/GBP.
EUR/GBP has lagged the sharp move in rate differentials,
so that even though front-end rates in the UK have
moved quickly to reflect the change in rhetoric from the
BoE there is plenty of room for the move lower in
EUR/GBP to extend further (Exhibit 31). This is the reason
that we recently upgraded our GBP forecasts, where we
now foresee 5.8% appreciation on a trade-weighted basis
over the next 12 months, the bulk of which against the
Euro. Our new EUR/GBP path is 0.78, 0.77 and 0.75 in 3, 6
and 12 months.

Exhibit 29: Two-year interest differentials supportive of
USD TWI appreciation

Exhibit 30: Foreign buying of Euro area assets has
already been very strong

Source: Bloomberg, Goldman Sachs Global Investment Research.

Source: Haver Analytics, Goldman Sachs Global Investment Research.

-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
60
70
80
90
100
110
120
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
US Dollar TWI
against majors
2-year swap rate
differential, in %
5-year swap rate
differential, in %
10-year swap rate
differential, in %
Index
-800
-600
-400
-200
0
200
400
600
800
1000
01 03 05 07 09 11 13
EURbn
Portfolio Investment:
Assets
Portfolio Investment:
Liabilities
Draghi "Do what it takes"
Rolling 12-mth cummulative total


Exhibit 31: EUR/GBP has plenty of room to catch up with
rate differentials, which put this cross much lower.

To be short the AUD in anticipation that the currency will
weaken and therefore reflect its underlying fundamentals
has been a frustrating trade so far this year. One argument
for the AUDs resilience is strong foreign buying of
Australian assets and reserve diversification into the AUD.
Certainly Japanese buying of Australian assets has picked
up since March and with total Japanese bond outflows
remaining firm, it is likely that Japanese buying of
Australian assets has remained strong. The 1Q14 IMF data
on FX reserves did reveal an increase in central bank
allocation to AUD. While these flows are supportive of the
AUD, they need to be put into context of a deteriorating
trade and current account balance and therefore Australias
external balance is likely less healthy than generally
perceived. A further hamper to a weaker AUD is the fact
that a short AUD trade has negative carry. This is likely
unpalatable given tough market conditions and that a low
volatility environment favours carry trades. Consequently
the RBA easing we expect in September may well be the
kicker to cause the AUD to catch-down to its deteriorating
fundamentals.
In the past month or so, the CNY fix has become more
volatile, in particular showing notable strength around the
release of the bumper May trade surplus and more recently
ahead of the US-China strategic economic dialogue.
Interestingly the volatility has tended to follow the volatility
of the DXY since the band widening in mid-March. Given
the Chinese authorities desire to curb speculative inflows
into the CNY, a more volatile fix is an ideal policy tool,
particularly given that the ongoing solid trade surplus limits
the scope of further CNY weakness. However, implied
volatility at the 3-month tenor is currently at the bottom of
its range since early February, suggesting that the market is
not yet pricing a more volatile fix.
Exhibit 32: Our FX forecasts

0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
1.00
06 07 08 09 10 11 12 13 14
EUR/GBP
Fitted using 2-year differential
Fitted using 5-year differential
Forecasts Forecasts
Current 3months 6months 12months Current 3months 6months 12months
EUR/$ 1.35 1.35 1.34 1.30 A$/$ 0.94 0.90 0.88 0.86
$/JPY 101.84 103.00 107.00 110.00 $/C$ 1.07 1.10 1.12 1.14
/$ 1.70 1.73 1.74 1.73 $/KRW 1030 1030 1050 1070
EUR/ 0.79 0.78 0.77 0.75 $/BRL 2.22 2.30 2.40 2.55
EUR/CHF 1.22 1.25 1.28 1.28 $/MXN 12.96 13.00 13.00 13.00


Exhibit 33: US BBoP vs. Current Account

Exhibit 34: Euro area BBoP vs. Current Account

Source: National sources, Goldman Sachs Global Investment Research.

Source: National sources, Goldman Sachs Global Investment Research.
Exhibit 35: /$ spot vs. GSDEER

Exhibit 36: US real trade weighted index



-8
-6
-4
-2
0
2
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
% of GDP
4qtr avg
Current Account BBoP
-5
-4
-3
-2
-1
0
1
2
3
4
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
% GDP
12-mth ma
BBoP Current Account
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
90 92 94 96 98 00 02 04 06 08 10 12 14
GSDEER EUR/USD Spot
70
80
90
100
110
120
130
140
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
real USD TWI
TWI Appreciation
Fiona Lake
+852 2978-6088
fiona.lake@gs.com
Robin Brooks
(212) 902-8763
robin.brooks@gs.com
Goldman Sachs & Co


How we construct our asset classes
Exhibit 37: Goldman Sachs 3- and 12-month return forecasts by asset class

Exhibit 38: Performance of our asset classes since the last GOAL report

Source: Datastream, Bloomberg, Goldman Sachs Global Investment Research.
Localcurrency InUSD Localcurrency InUSD
Equities 1.8 1.8 10.5 8.4
S&P500 40 1.1 1.1 6.4 6.4
Stoxx 30 5.4 5.7 15.3 11.3
MXAPJ(inUSD) 20 0.9 0.9 8.4 8.4
Topix 10 1.1 2.2 16.2 7.6
10yr.GovernmentBonds 1.6 1.5 4.7 6.3
US 50 1.5 1.5 4.0 4.0
Germany 50 1.7 1.5 5.4 8.7
5yr.CorporateBonds 0.3 0.3 0.6 1.2
US:iBoxxUSDDom.Corporates 60 0.5 0.5 1.0 1.0
BAMLHYMasterIndexII 20 0.0 0.0 0.7 0.7
Europe:iBoxxEURCorporates 20 0.1 0.2 0.4 3.8
Commodities(GSCIEnhanced) 0.5 0.5 0.1 0.1
Cash 0.1 0.2 0.5 1.2
US 50 0.1 0.1 0.6 0.6
Germany 50 0.1 0.3 0.5 3.0
FX
3month
target
Returnvs
USD
12month
target
Returnvs
USD
EUR/$ 1.35 0.3 1.30 3.4
$/YEN 103 1.1 110 7.4
12monthTotalReturn
AssetClass
Benchmark
Weight
3monthTotalReturn
97
98
99
100
101
102
103
104
105
23-Jun 30-Jun 07-Jul 14-Jul 21-Jul
Equities S&P 500
Topix MXAPJ
Stoxx Europe 600
94
95
96
97
98
99
100
101
Commodities
99
99.5
100
100.5
101
101.5
102
Government bonds
US 10 year Gov. bonds
German 10 year Gov. bonds
99
99.5
100
100.5
101
101.5
102
Credit
US IG Credit
European IG Credit
US HY Credit

Equity basket disclosure
The Securities Division of the firm may have been consulted as to the various components of the baskets of securities discussed in this report prior to
their launch; however, none of this research, the conclusions expressed herein, nor the timing of this report was shared with the Securities Division.
Note: The ability to trade these baskets will depend upon market conditions, including liquidity and borrow constraints at the time of trade.


Disclosure Appendix
Reg AC
We, Anders Nielsen, Peter Oppenheimer, Charles P. Himmelberg, David J. Kostin, Kathy Matsui and Timothy Moe, CFA, hereby certify that all of the
views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also
certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this
report.

We, Jeffrey Currie, Francesco Garzarelli, Fiona Lake, Aleksandar Timcenko and Dominic Wilson, hereby certify that all of the views expressed in this
report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships.
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Goldman - July 25

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July 25, 2014

GOAL: Global Opportunity

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