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2011_Outlook - GS

2011_Outlook - GS

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Investment Strategy Group January 2011

Stay the Course

The American Evolution: Much like George Washington crossing the Delaware River in the winter of 1776-77, America’s structural resilience, fortitude and ingenuity will carry the economy and financial markets in 2011 – and beyond.

For Private Wealth Management Clients

Stay the Course
3 We have been optimistic about the US as an investment story since the depths of the financial crisis. We remain so for the year ahead. The US Will Not Face a “Lost Decade” The current economic environment has led some to question whether the US will face a “lost decade” akin to Japan’s in the 1990s. We believe that is highly unlikely. Faster Growth Does Not Result in Higher Returns Some emerging markets are likely to continue seeing higher GDP growth rates than the US. But that does not necessarily make their equity markets more attractive. Structural Benefits of the US The US’s inherent resilience, flexibility and dynamism continue to make it uniquely attractive from an investment perspective.





2011 Global Economic Outlook


2011 Financial Markets Outlook

17 United States 21 Eurozone 22 United Kingdom 22 Japan 22 Emerging Markets

29 United States 32 Eurozone 34 United Kingdom 35 Japan 37 Emerging Markets 38 Currencies 42 Fixed Income 47 Commodities 51 Key Global Risks

This material represents the views of the Investment Strategy Group in the Investment Management Division of Goldman Sachs. It is not a product of the Goldman Sachs Global Investment Research department. The views and opinions expressed herein may differ from those expressed by other groups of Goldman Sachs.
Cover photo © Art Resource, NY.

Stay the Course
Sharmin Mossavar-Rahmani Chief Investment Officer Goldman Sachs Private Wealth Management

Brett Nelson Managing Director Goldman Sachs Private Wealth Management

Additional Contributors from Goldman Sachs Private Wealth Management: Neeti Bhalla Managing Director Leon Goldfeld Managing Director Maziar Minovi Managing Director Thomas Devos Vice President Benoit Mercereau Vice President Matthew Weir Vice President Harm Zebregs Vice President

“America boosters!” That is how one of our most sophisticated and well-informed clients sarcastically concluded what was to be our last client meeting of 2010. His exclamation was all in good fun, but also based in truth: Since the depths of the financial and economic crisis, we have stood against the crowd in our optimistic view of a US recovery, US investment opportunities and the US dollar as the reserve currency of the world for the foreseeable future. That outlook, unpopular as it was, led us to two key investment recommendations: overweight US high yield bonds and US equities in our clients’ portfolios. Market returns and the US economic recovery have proven us correct. At a total return of 83% since March 2009 (as measured by the Barclays Capital US Corporate High Yield Index), US high yield bonds have offered not only extremely attractive absolute returns (over 100% from their trough), but also the most attractive investment return per unit of risk as measured by volatility, far surpassing any other asset class. If one were to include other measures of risk such as safety of assets and capital controls, the risk/reward is even more attractive. Similarly, US equities have returned 93% (as measured by the S&P 500 Index) with annualized volatility of 17% in spite of annualized economic growth of only 2%. Over the same period, emerging markets returned 100% (as measured by the MSCI Emerging Markets Index) with annualized volatility of 18% and annualized economic growth of 7%. And the US dollar is actually about 7% higher than its pre-crisis levels. Our favorable inclination toward the US is longstanding. In our 2009 Outlook, Uncertain but not Uncharted, we argued that while the financial crisis was more severe than anything in recent memory, one only had to go back a little

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january 2011

further in time to the deep recessions of 197374 and 1980-82 to find a road map for the US recovery. In our May 31, 2009 report, The US Dollar: As Good as Gold?, we argued that no other currency or basket of currencies, including the euro (this was well before the Eurozone sovereign debt crisis) or the International Monetary Fund’s Special Drawing Rights, would unseat the US dollar as the reserve currency of choice (notwithstanding clamors by Russian and Chinese authorities for alternatives). In our 2010 Outlook, Take Stock of America, we argued that the US economy would recover along the paths of previous US recoveries and that the crisis had not dealt a fatal blow to the US as the preeminent economic and geopolitical power; one only had to go back to similar rhetoric about Japan and the Asian Tigers in the late 1980s and early 1990s and about Soviet scientists and engineers in the late 1950s to find a road map for the US proving the “declinists” wrong yet again. Our view for 2011 is still constructive US high yield bonds and US equities for our clients’ core assets. We remain optimistic about the US on a longer term structural basis, as well. As we discuss below, we believe the strength of government and private sector institutions, the resilience of the economy, the rule of law and the respect for property rights will carry the day for the foreseeable future. The 100% increase in corporate earnings since their trough, the 6% increase in productivity levels relative to precrisis levels, and the historic November 2010 mid-term elections are but three examples of this exceptional and unparalleled resilience. As we have said before, Alexis de Tocqueville was particularly astute some 200 years ago when he wrote: “the greatness of America lies not in being more enlightened than any other nation, but rather in her ability to repair her faults”1 – to which we would add: “quickly.” In this year’s issue of Outlook, we carefully examine our optimism about the US economy, US investments and the role of US assets as a core holding in any well-structured portfolio. We will begin with some of the key themes supporting our view: why the US will not face a so-called “lost decade” similar to what Japan suffered in the 1990s; why faster economic

growth does not translate into higher equity returns; and why the long-term structural advantages of the US relative to other economies – developed and emerging – lead us to conclude that US assets should remain as the core holding of our clients’ portfolios. Following this thematic discussion, we present our 2011 outlook for US and global economies, our investment outlook for the capital markets globally, and the multiple risks to our outlook. As usual, we put forth our views with a strong dose of humility, knowing full well that there is no proverbial crystal ball. Before we proceed, it is very important that we highlight two key pillars of our investment philosophy: 1) history repeats itself in many ways and helps to provide a useful forwardlooking guide; and 2) fear and greed drive markets to extremes, and it is those extremes that provide the most attractive – and most unattractive – investment opportunities. It is also at those extremes – positive and negative – that we often hear the expression: “This Time is Different.” We urge our clients to be particularly cautious when they hear those words. They were spoken to justify lofty Japanese equity valuations in the late 1980s and internet stocks in the late 1990s. Today, they are used to posit a lost decade – or more – for the US, to justify gold at $1400 per ounce and to allocate substantially more assets away from US equities to emerging market equities. Our response to this was first said by Ecclesiastes: “There is nothing new under the sun.”

Our view for 2011 is still constructive US high yield bonds and US equities for our clients’ core assets.

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Real estate values in Japan peaked at 17 times disposable income in 1990, having appreciated by 182% over the prior five years. You may Over the last year or so, many credible – and remember the oft-repeated comment that at its some not-so-credible – researchers, economists, peak in value, the land in the Imperial Palace journalists and television commentators have warned about the US repeating the “lost decade” in Tokyo was worth more than all the land in California. In the US, real estate values peaked of Japan. Articles with titles such as “Lost Decade Looming?”2 and “Will the US be Jealous at 8.5 times disposable income in 2005, and had appreciated by 77% over the prior five years. of Japan’s Lost Decade?”3 have cascaded upon Therefore, one can say that Japanese real estate us, prompting some clients to express concern was 100% more overvalued than US real estate, about their US-based investments. During Japan’s lost decade (which, in fact, has and a greater correction was warranted. Similarly, Japanese stocks were more been two decades and counting) GDP has grown overvalued than US stocks at the beginning of at an annualized rate of 1%, equity markets the crisis. At the peak in Japanese equity markets declined by 76% peak to trough, inflation has in December 1989, the Topix’s price to trailing measured 0.4%, overnight rates have been 12-month earnings stood at 52 times; while less than 0.25% for half the time and 10-year at its peak in October 2007, US equities’ (as bonds have been below 2% for more than half represented by the S&P 500) price to trailing of the time. In our view, the likelihood of the 12-month earnings stood at 21 times. One can US experiencing one or two such decades is assert that Japanese equities were as much as negligible, if not zero. 250% overvalued if we compare price to trailing While on the surface there may be some 12-month earnings; alternatively, one can deduce similarities between the US and Japan, there a 60% overvaluation if we compare price to are far greater and more significant differences. book measures. Just like real estate, Japanese The similarities are that both countries faced equities had a lot further to fall. a big drop in commercial and residential real estate markets, a big decline in equity markets, and high private sector leverage (corporate Difference Two: Monetary and Fiscal and financial sectors in Japan, and household Policy Responses and financial sectors in the US) that required The US monetary and fiscal policy responses deleveraging. It is the specific prospect of have been faster, larger and more extensive than further deleveraging in the US, especially in the Japan’s were during the early stages of its crisis. household sector, that weighs on the minds of While both central banks reduced interest rates, the lost decade proponents. the Federal Reserve cut the Federal Funds rate to The differences are the starting valuation 1% in 14 months from peak interest rates and levels in the equity and real estate markets, to 0% within 2 months after that. The Bank of the monetary and fiscal policy responses, Japan took 46 months to cut to 1% and then government policies to address the financial another 77 months after that to cut rates to 0%. sector difficulties, productivity and demoWith respect to quantitative easing, it took the graphics. These bear further discussion. US one year from its peak in interest rates to raise its money supply to 14% of GDP; it took Japan nine years. Difference One: Starting Valuation Levels Similarly, the US announced a fiscal One of the most important factors to consider is the starting level of valuations in both the real stimulus package of $787 billion, equivalent to 5.6% of GDP, within a year and a half of estate and equity markets when the downturns the equity market peak. In Japan, the actual began. While no one valuation measure tells the fiscal stimulus in the first three years was $100 whole story, all metrics point to substantially billion, equivalent to 2.3% of GDP. While some greater starting valuation levels in Japan than in might say that the policy response in Japan the US. was appropriate given the growth rates and the

The US Will Not Face a “Lost Decade”

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Exhibit 1: US Demographics Are More Favorable Than Japan’s Since their respective market peaks, the workforce continues to grow in the US and shrink in Japan.
115 Population of Working Age (15-64) Indexed to Equity Market Peak** 110 105 100 95 90 85 80 0 5 10 15 20 25 Years from Equity Market Peak
Data as of December 2010 *Japan forecast for 2015 **Japan equity market (Topix) peaked in December 1989; US equity market (S&P 500) peaked in October 2007 Source: Investment Strategy Group, UN World Population Prospects 2008

Japan* US (forecast)

limited changes in unemployment at the time, Japan’s equity and real estate markets had both fallen further in the first downdraft than US markets. With the benefit of hindsight, we now know that officials misread the price signals from the market. In addition, a key economic indicator – the unemployment rate – was unreliable, since Japanese companies were reluctant to lay off workers as a matter of corporate policy. We also believe that the Federal Reserve has been more responsive than the Bank of Japan because 1) it has a dual mandate of price stability and stable growth, and 2) its chairman has been steeped in lessons learned from both the Great Depression and the lost two decades of Japan. Chairman Ben Bernanke certainly heeds the 1905 warning of Spanish American philosopher George Santayana: “Those who cannot remember the past are condemned to repeat it.”4
Difference Three: Government Response to Financial Sector

Exhibit 2: Correlation Between Equity Returns and GDP Growth There is no stable relationship between growth and equity returns regardless of timeframe.
0 .5 0 .4 0 .3 0 .2 0 .1 - 0 .0 - 0 .1 - 0 .2 -0.25 105 Yrs 43 Yrs 42 Yrs 26 Yrs 20 Yrs 15 Yrs 10 Yrs -0.12 0.07 0.43 0.33

Number of Years for Which Data is Available
Data as of 2005 Source: Investment Strategy Group, ABN-AMRO Global Investment Returns Yearbook 2005

Again, US policy makers were much more aggressive in responding to the crisis in the financial sector than their Japanese counterparts. In the US, within a year of the equity market peak, the first financial institution failed, five major financial institutions including Merrill Lynch, Wachovia and Washington Mutual were sold, and the government authorized $700 billion dollars or 5% of GDP through the Troubled Asset Relief Program (TARP) to stabilize financial institutions. In Japan, with government forbearance, no major banks failed until eight years into the downdraft and the government only authorized 2.3% of GDP for funds to recapitalize the banks. Not only were Japanese policy makers slower to respond, they had a bigger problem to contend with: financial sector leverage in Japan stood at 157% of GDP at its peak compared with 121% in the US. Soon, Japanese banks became known as zombie banks. While the term was bandied about with regard to US banks when TARP U S was 115 launched, it is worthy to note that within two Japan* 10 years of TARP, all major US1 banks have repaid these funds – and all have done so with a profit 105 to the US government. Leverage levels have also 100 been reduced to 98% of GDP since the onset of 95 the US crisis, while leverage in Japanese banks
90 85 80

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declined only marginally to 152% over the same three-year window.
Difference Four: Productivity

Another key difference is changes in labor productivity following the real estate and equity market drops. Productivity growth decelerated significantly in Japan in the first three years after its real estate and equity markets collapsed. In the US, productivity growth has actually accelerated. This divergence can be attributed to the faster pace of restructuring in American companies versus the slower pace in Japan. US companies reduced their labor force rapidly, driving up the unemployment rates from 4.7% to over 10% in two years. In Japan, the unemployment rate remained unchanged at 2.1% in the first two years and reached 5.5% over the next ten years. US productivity was also boosted by a drop in unit labor costs of about 3% through the crisis while in Japan, unit labor costs were actually 15% higher four years into their crisis. Aggregate non-financial corporate leverage levels, which peaked at 152% compared to US companies at 80%, also hampered the pace of restructuring in Japan. In the US, trailing 12-month corporate default rates reached 14.7%. In Japan, default rates as reported by Moody’s in 2010 for rated corporate bonds stood at zero for nearly ten years into the crisis. The key message here is that US companies, just like US policy makers, restructured faster and more extensively and were able to increase earnings by 100% – US resilience and responsiveness at work.
Difference Five: Demographics

US fertility rates and immigration. In November 2010, the governor of the Bank of Japan “crucially attributed” Japan’s lost decade to declining productivity and declining working population.5 Given the global significance of both economies and the severity of their respective crises, it is easy to see how comparisons between the Japanese and US downturns get drawn. But the multitude of differences between the two far outweigh the similarities, and thus the chances of the US experiencing a “lost” decade – or any other significant period of time – similar to Japan’s are very remote, indeed.

Faster Economic Growth Does Not Result in Higher Equity Market Returns
One of the questions we are asked most frequently is whether our clients should allocate an increasing share of their assets to the faster growing emerging markets. Over the last 20 years, emerging market countries have grown at double the rate of the US: 4.9% versus 2.5%. Will this faster economic growth result in higher equity returns? All the data we have examined point to the absence of any such relationship, and in many cases, the data actually point to a negative correlation. In our view, maintaining market capitalization weighting on a strategic basis, tactically adjusting based on valuations and taking advantage of opportunities in the private equity market is a more effective emerging market investment strategy. The most extensive authoritative studies we have seen are those of Elroy Dimson, Paul Marsh, and Mike Staunton from the London Business School and of Jay Ritter from the University of Florida. Jay Ritter, in fact, not only provides compelling empirical evidence but also provides rigorous theoretical analysis as to why economic growth does not necessarily benefit stockholders.6 The studies have examined data across developed and emerging markets since 1900.

The last factor is perhaps one of the simplest to identify, but virtually impossible to rectify quickly: the unfavorable demographics in Japan and the much more favorable demographics in the US. As shown in Exhibit 1, Japan’s working population has declined by more than 5% over the last 20 years, and is expected to decline an additional 5% over the next five years. The working population in the US, on the other hand, is expected to grow by more than 10% over the next 25 years through a combination of

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Dimson et al have concluded that there is no stable relationship between growth and equity returns, as shown in Exhibit 2. The correlations vacillate between virtually zero and -0.25 for the first 30 years or so and then rise to 0.43 over 42 years only to drop to virtually zero again over 43 years. The point of highlighting such odd years is to demonstrate that within the investment horizon of our clients, the relationship is negative and beyond the investment horizon of our clients – let’s say 40 to 100 years – the relationship is completely unstable. Similarly, our own analysis within the US has shown no statistical significance in the relationship between equity returns and pace of economic growth. A recent report published by our colleagues in Goldman Sachs Global Economics, Commodities, and Strategy Research also showed that there was no statistically significant relationship between growth conditions, as identified by a country’s growth environment score, and subsequent equity returns (equity valuations, on the other hand, were more significant).7 The divergence between equity returns and economic growth is even more stark when we look at actual returns of slower growth versus faster growth countries. Dimson et al have shown that if one invested in the slowest growing quintile of countries during this hundred-yearplus period, the equity returns would have outperformed the fastest growing quintile by 3% a year as shown in Exhibit 3. Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly 5% a year. China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns. As shown in Exhibit 4, China’s economy has outgrown that of the US by about 8% a year since the end of 1992 (the inception date of the MSCI China equity market index). Its equity market, however, has lagged that of the US by about 8% a year. Over the last 15 years, earnings per share growth in China has been negative 0.9% while that of the S&P 500 companies has been 5.4% a year. Most recently, in 2010, China

Exhibit 3: Total Annualized Equity Returns by GDP Growth Cohort Stocks in slower growing economies have actually outperformed historically.
9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Lowest 20% Middle 60% Highest 20% 5.9% 5.0% 8.0%

Data as of 2005 Note: Based on 105 years of data from 17 countries as of 2005 Source: Investment Strategy Group, ABN-AMRO Global Investment Returns Yearbook 2005

Exhibit 4: GDP Growth and Equity Performance: China vs. US Chinese equity returns have been lower and more volatile than those of the US despite better growth.
40% 35% 30% 25% 20% 15% 10% 5% 0% -5% GDP Growth* -2.3% Equity Market Return -0.9% EPS Growth** Volatility 10.4% 6.1% 2.6% 5.4% 15.3%

US China


Data as of December 31, 2010 The MSCI China Index is an index of H, B, Red and P Chip share classes available to foreign investors. All figures are annualized. * GDP growth through 2009 ** EPS growth October 1995-December 2010 Source: Investment Strategy Group, IMF WEO October 2010, Datastream, MSCI

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has outgrown the US by an estimated 7% but the MSCI China Index has returned just 4.8% (the local Shanghai Composite Index is actually down 12.8%). On the other hand, US equities have returned 15.1%. Since the peak of US and Chinese equities in October 2007, China has outgrown the US by an estimated 10% a year, but Chinese equities have lagged the US by 2.7% a year. Whether it is 1 year, 3 years or 18 years, economic growth has not translated into better investment returns in China. That is not to say that Chinese equities have not outperformed US equities significantly over specific periods of time; Chinese equities provided an annualized return of 46.0% a year compared with US returns of 15.0% a year between October 2002 and October 2007, during which China grew at 11.1% a year compared with US growth of 2.6%. In general, however, the timing of entering and exiting a market, as well as its valuations, are much more important than faster economic growth. The evidence shows that faster economic growth rates do not result in higher equity returns. In fact, if faster growth is priced into the equity markets, the equity markets are most likely going to lag those of slower growth economies. Rather, it is the unexpected changes in economic growth rates (and earnings growth rates) that affect stock prices. As such, we think allocating more assets to the faster growing emerging markets beyond market capitalization levels is not prudent given current market expectations and the higher valuations.

The Major Structural Advantages of the US from an Investment Perspective
Faster growth is but one of the arguments made to sway investors to reduce exposure to US assets in favor of emerging market countries. A second and more nebulous argument is that the US is undergoing a structural decline in the face of the emerging BRIC countries (Brazil, Russia, India, China) – and, more specifically, China as the dominant economy and power of the 21st century. There is no doubt that the annual economic growth rates of China and India at 10.3% and 6.8% over the last 10 years are phenomenal absolute rates. Over the same time period, the US has grown by 1.8% per year and the Eurozone by 1.6% per year. However, we believe the argument that this makes the US less attractive from an investment perspective is misplaced. First, we have to look at these growth rates and see if these rates are as unprecedented as they seem, or are they following in the footsteps of other “Asian Tigers” who grew rapidly as they moved from developing to advanced economies? It is important to review the historical track record to see whether China and, to a much lesser extent, other emerging market countries, are experiencing the kind of seismic shift that would justify a significant shift in strategic asset allocation away from the US towards emerging market countries. In the absence of such a fundamental turn, we believe clients should stay the course with their US assets. Economics Nobel Laureate Gary Becker8 and Professor Alwyn Young of the London School of Economics have shown that these higher growth rates are, in fact, similar to those experienced by other countries in a similar stage of development and by “no means extraordinary.”9 As shown in Exhibit 5, China has followed the export-led growth model of other Asian economies – namely Japan and Taiwan starting in the 1950s, Hong Kong and Singapore in the 1960s, and Korea starting in 1960 – while relying on cheap labor. And like the other Asian economies, it has also accumulated huge reserves. These countries maintained 8+% growth rates for about two decades after which growth tapered off to the 6-8% levels. It is important to note that the growth of these other

Faster growth is but one of the arguments made to sway investors to reduce exposure to US assets in favor of emerging market countries. We believe that argument is misplaced.

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countries co-existed with growth, productivity and prosperity in the US. What is different about China is that it has maintained higher growth rates for three decades on a substantially larger scale, and expectations are for 8+% annual growth for at least another 5-10 years. But as you can note from Exhibit 6, China started from a lower level of GDP per capita than any other country; the poorer the country as measured by GDP per capita, the higher the growth rates that can be maintained. According to the Conference Board, China’s GDP per capita started at $973 in 1978 while that of the other Asian Tigers started at anywhere from $1,568 for Taiwan to $4,907 for Hong Kong (all in 2009 US dollars). At its current level of $4,283 in current nominal dollars, China’s GDP per capita is still substantially below that of other Asian Tigers. The second reason we believe the argument to re-allocate assets away from the US is misplaced is that it presumes the cyclical decline of the US due to the financial and economic crisis will lead to a structural decline of the US itself. Such misplaced extrapolation has occurred repeatedly in the US in past cyclical downturns (1973-74, 1980-82, 1990-92 are just a few recent examples and one can find similar commentary even as far back as 1907 after that year’s stock market crash). The 2008-09 crisis is no different. The argument, moreover, completely ignores the inherent structural resiliency of the US and its institutions – which provides a direct and positive impact on the viability, profitability, and safety of our clients’ investments in the long run. The system’s fundamental structure is unique among global markets – developed or emerging – and offers distinct advantages. Below we review each of these in detail.
Advantage One: Political Structure and its Resilience

Exhibit 5: 10-Year Average Annual GDP Growth Rate Chinese growth today is similar to other countries at a comparable stage of development.
12% 10% 8% 6% 4% 2% 0% +10 +15 +20 +25 +30 +35 +40 +45 +50 +55 +60 +65 +70 Years Into Development

Japan (1950-Present) Taiwan (1951-Present) Korea (1960-Present) Singapore (1960-Present) China (1978 -2010) Hong Kong (1960-Present) China (GIR Forecast)

Data as of December 30, 2010 Note: GDP based on purchasing power parity Source: Investment Strategy Group, The Conference Board Total Economy Database, September 2010, Goldman Sachs Global Investment Research

Exhibit 6: Lower GDP Per Capita Generally Yields Higher Growth Poorer countries can maintain higher growth rates given their low starting point.
12% 10-Year Average Annual Growth Rate 10% 8% 6% 4% 2% 0% 10,000 20,000 30,000 40,000 50,000 60,000 GDP Per Capita (2009 Dollars)
Data as of December 30, 2010 Note: GDP per capita based on Purchasing Power Parity Source: Investment Strategy Group, The Conference Board Total Economy Database, September 2010

Japan Taiwan Korea Singapore China Hong Kong Linear (All)

We think the most important structural advantage of the US – from which all other advantages emanate – is its strong, robust and resilient system of government and governance. Over the course of the last 3 years, we have seen several examples of how this structural advantage has benefitted the US and how its absence has negatively impacted other countries or regions.

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We can start with the easy example of fiscal and monetary union. As those who have been following the European sovereign debt crisis know, one of the biggest problems in dealing with this crisis is the absence of fiscal union in the presence of monetary union. Germany on its own cannot impose its austerity standards on Greece, Ireland or any of the other peripheral Eurozone countries, and yet the German electorate will have to bear the brunt of the financing requirements of these countries. We have to tip our hat to Alexander Hamilton, who in 1790 realized the newly formed US political union would only survive if it had fiscal union. He proposed that the new federal government assume the debts that the individual states had incurred during the Revolutionary War so that individual states would not abandon the union if financial self-interest dictated it. To enlist the support of Thomas Jefferson to vote for the proposal (which had already been voted down five times), he agreed to move the new capital to the banks of the Potomac; to ensure Pennsylvania’s support, the capital would be moved to Philadelphia for ten years.10 Europe is just now debating fiscal union 220 years after the United States, with no resolution in sight! The historic 2010 mid-term elections are another example of de Tocqueville’s observation that the US has a unique ability to self-correct – that’s just what happened when the political pendulum swung too far for a centrist nation following the 2008 Presidential election. A wealthy, educated and free electorate formed advocacy groups like American Crossroads and American Action Network to supplement the work of the U.S. Chamber of Commerce, the Tea Party and other Republican political groups to change the political landscape. In November, the Republicans gained 63 seats in the House of Representatives; such a win was last seen in 1938. They also gained six seats in the Senate. Similar organizations such as MoveOn.org and Center for American Progress have been set up in the past by Democrats to offset Republican influence. While many observers are concerned that a divided government cannot deal with the deteriorating fiscal profile in the US, we should

point out that five of the last six major fiscal reforms occurred under a split government, where each party controlled at least one house of Congress or the White House. The December 2010 report from the National Commission on Fiscal Responsibility and Reform, as well as the tax compromise in the same month, both provide some optimism that history might very well repeat itself with both parties working together on much needed fiscal reform. Another very recent example of the resilience and ingenuity of US government institutions is the responsiveness of the Federal Reserve and other financial regulators during the financial crisis. It may well be too early to tell whether all their measures were successful, but from the rapid lowering of interest rates, to a dozen or so other programs instituted within a month of Lehman’s bankruptcy in 2008, to additional liquidity facilities, temporary guarantee programs and swap agreements with other central banks, to the latest round of quantitative easing, the US has acted rapidly, extensively and decisively. We have already contrasted US responsiveness to that of the Bank of Japan above. The US also stands in sharp contrast to Europe. As the US was lowering rates rapidly in 2008, the European Central Bank actually raised rates in August 2008. Only when the financial system was in disarray did the ECB begin to ease. Similarly, since the beginning of the sovereign debt crisis, the response by the ECB and the European Union has been somewhat “piecemeal” (as described by IMF Managing Director Dominique Strauss-Kahn),11 whether it is in setting up liquidity facilities or providing emergency aid. There are many other examples of how the strength, stability and resilience of US government institutions and the US system of checks and balances have served the country in good stead for 230 years. What major emerging market country’s system of governance has stood this test of time? Again, while allocating some assets to these emerging market countries is appropriate, one should be realistic about the structural stability and risks inherent in all these countries.

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Advantage Two: Shareholders Are the Primary Stakeholders

We have already discussed corporate resilience in our discussion above comparing the US to Japan. However, it is also important to emphasize the freedom of corporate boards and company management to act in the best interest of shareholders. US companies’ primary stakeholders are their shareholders; companies are not owned by the government and when the government has become involved, as we have seen in this crisis, both the companies and the government have sought to disengage from each other as quickly as possible. Witness the speed with which financial institutions repaid US Treasury capital, the intensity with which AIG is seeking to return such capital, and GM’s efforts to revive itself as a publicly traded company with its $23.2 billion IPO this November. With the divestments to date, we estimate that the US government currently owns only 2.2% of the market capitalization of US equities. At the height of the financial crisis, government ownership was about 3.7%. In key emerging market countries, we estimate that in various forms (directly and indirectly), government ownership as a share of total market capitalization ranges from a high of 67% in China to 35% in Russia, 29% in India and 14% in Brazil. A brief review of the oil industry will best illustrate the impact of government ownership on shareholders in emerging market countries. According to Ian Bremmer, President of the Eurasia Group, three quarters of the world’s oil reserves are now owned by state owned enterprises, e.g. Petrobras (Brazil), CNPC (China), and Gazprom (Russia).12 Just a brief examination of two of these companies demonstrates that the economic and political interests of governments can be served ahead of the interest of private sector shareholders. Let’s begin with Petrobras. With its latest rights offering in September 2010, the Brazilian government and its affiliates own about 64% of common voting shares and 48% of total shares outstanding. The offering documents state that “the Brazilian federal government, as our principal shareholder, has pursued, and may pursue in the future, certain of its

macroeconomic and social objectives through us.” Some have seen Petrobras’s decision to invest in refineries in the Northeast of the country an indication of the company being used to serve the government’s broader interests. According to The Economist, the government is also drawing up requirements that Petrobras will have to procure its oil servicing equipment locally in an effort to create a national oil servicing industry.13 Similarly, in China, our equity analysts in Goldman Sachs Global Investment Research have pointed out that due to PetroChina’s state-owned enterprise background, “it has the responsibility to ensure the sufficiency of supply to the market … As such, PetroChina will likely experience a gradual structural shift toward relatively heavier refining exposure that has lower returns.”14 About 86% of PetroChina is owned by the Chinese government. And in the context of the oil industry, we can also highlight the risk of confiscation, nationalization or changing production sharing agreements in some emerging market countries. We cannot imagine the US government interfering in Exxon’s operations other than in a state of national emergency. In our view, investing in such government-dominated equity markets requires a significant risk premium and extremely attractive valuations – neither of which exists at this time.
Advantage Three: Demographics, Immigration, Education and Innovation

In a comprehensive discussion of world demographics, Nicholas Eberstadt of the American Enterprise Institute describes how most OECD countries and many emerging market economies are set to experience shrinking working age populations. The problem is most acute in Japan and some Western European countries, but China, Russia, Eastern European countries and former Soviet Republics will all have the same problem. According to Eberstadt, the biggest drop in young working age population is “set to take place in China,” a result of its one-child policy. Interestingly enough, he mentions the US as the demographic exception due to the “country’s relatively high fertility rates and its continuing influx of immigrants.”15 Here again, the US has a

12 Goldman Sachs

major structural advantage. Immigration has not only enhanced US demographics, but it has also been a source of innovation and increased output per worker.16 According to the newly formed Partnership for a New American Economy, immigrants were responsible for 25% of America’s high tech startup companies between 1995 and 2005 and 25% of America’s international patents were based on the work of immigrants. With the US having the largest influx of immigration both on an absolute basis and relative to any other country, we expect this major structural advantage will continue for the foreseeable future. As Lee Kuan Yew, Singapore’s founding father who served as Prime Minister for 30 years, recently said to a US television interviewer: “You are attracting all the adventurous minds from all over the world and embracing them and they become part of your team.” He goes on to mention the fact that other cultures are not as embracing of immigrants as the US.17 A major source of highly educated immigrants has been US universities. 33% of all Ph.Ds and 57% of all post-doctorates in science and engineering from US universities were awarded to foreign students. What is most astonishing is that 60% of these foreign students stay in the US for at least 10 years.18 What we found most surprising in this educational data was that the highest stay rate is among Chinese students: 92% of those who received science and engineering degrees in 2002 were still in the US in 2007. We expect this trend to continue given that most of the world’s top universities are in the United States. According to the highlyrespected Times Higher Education latest rankings, 15 of the top 20 universities in the world are American. In the top 50, only three are based in emerging market countries: a Korean university ranked 28th, and two Chinese universities ranked 37th and 49th respectively. With the highest ranked university system, the US has the ability to not only attract some of the world’s greatest talent, but as the high stay rate indicates, it also has the ability to retain most of this talent. Of course, some emerging countries have made significant attempts to improve their universities: Project 985, named after the date it

Exhibit 7: Gross Expenditure on Research and Development Across Regions The US is the global leader in R&D spending.

2010 GERD (PPP*, $bn) Americas US Asia Japan China India Europe Rest of World Total 446.7 395.8 400.4 142.0 141.4 33.3 268.6 34.8 1150.6

2010 GERD (% of GDP) 2.2% 2.7% 1.9% 3.3% 1.4% 0.9% 1.6% 1.2% 1.90%

2010 % of Total R&D Spending 38.8% 34.4% 34.8% 12.3% 12.3% 2.9% 23.3% 3.0% 100%

Data as of December 2010 *PPP = purchasing power parity Source: Investment Strategy Group, Battelle

was announced (May 1998), was an effort to raise Chinese universities to the level of US Ivy League schools.19 The US continues to dominate R&D spending, as well. As shown in Exhibit 7, at an estimated $396 billion, the US accounts for 34.4% of global R&D spending; all of Asia including Japan, China and India account for 34.8%. But it is important to note that in an increasingly global world, R&D will be shared more globally. Many US companies have multiple R&D centers throughout Asia. China has increased its R&D spending by about 10% a year over the last decade and has made technology a cornerstone of the next phase of the country’s growth, to the point of requiring foreign companies who want to do business in China to share their technology. Nevertheless, the US still maintains a substantial R&D lead over other countries. The number of Nobel laureates is but one measure: with 326 Nobel Laureates, the US accounts for over 40% of all Nobel laureates in the world and over 58% in the last decade. Russia stands at 25, China at 12 (two were Peace laureates; nine received their awards while living outside of China), India at nine, and Brazil at one.20

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Outlook 13

january 2011

Advantage Four: Wealth, Natural Resources, and Great Location

The US is an “empire of wealth.”21 At $14.6 trillion, its GDP is the highest of any country in the world; at $47 thousand, its GDP per capita is the highest of any country with a population over 25 million people. It has a wealth of natural resources and arable land as shown in Exhibit 8, so its growth will not be hampered by a lack of resources. No major emerging market country, with the exception of Russia, has the same depth and breadth of resources on a per capita basis. The US also has the good fortune of having an ocean on each side and a friendly and stable Canada to the north. To the south, Mexico is friendly, but the drug-torn border may become a bigger problem in the future. The same cannot be said about Asia as has been brought to the fore most recently with North Korea’s attack on South Korea, with Japan’s increased concern about disputed islands in the East China Sea and with India’s border disputes with China. And, of course, the political and regulatory climate in the US provides a wealth of freedom for entrepreneurs and venture capitalists to take advantage of the wealth of opportunities.
Some Risks

There is no doubt that the US faces its own list of risks, with the fiscal deficit being one of the most important, followed by concerns about political partisanship, immigration restrictions, geopolitics and housing. Gross government debt in the US currently stands at 84% of GDP and is forecasted to rise to over 100% in five years. While this is a legitimate concern, the US has a demonstrated ability to reduce its debt burden. After World War II, the US reduced its debt burden from 120% of GDP to 32% by 1981. Over the last several decades, the government has enacted fiscal reform multiple times – and at each one, the process was exceedingly difficult, as it no doubt will be now. But the recent mid-term elections have provided some further impetus to needed fiscal reform, and most importantly, the US has what the International

Monetary Fund has called “fiscal space.” Given its reserve currency status and deep and liquid financial markets, the US has the fiscal space to have at least some time to tackle its debt problems. With respect to the great concerns about too much partisanship in Washington, Joseph Nye of Harvard University notes that the “sourness of current US politics” needs to be considered in the context of history, and is arguably less serious than that of the past during McCarthyism, the civil right movements and abolition of slavery.22 More recent examples include the Vietnam era and Nixon era. In other words, the US has experienced much more extreme partisanship in the past and that did not sideline the growth and prosperity of the country. Nye warns, however, that if the country were to turn inward and curtail immigration, it would be of “grave concern.” Immigration has generally been a bi-partisan issue; while current high unemployment rates have increased anti-immigration sentiment, the majority of Americans still favor immigration. To that effect, the likes of Rupert Murdoch and Mayor Bloomberg have gathered forces to form a new private sector advocacy group – Partnership for a New American Economy – to influence the political process in favor of immigration. Geopolitical risks are another important worry. In addition to armed conflicts – ongoing or potential – around the world, there is a real threat from non-nation-state factors described by Nye as “terrorists who traffic weapons, hackers who threaten cybersecurity and challenges such as pandemics.” We also recognize that there is still uncertainty with respect to the housing market (touched upon later in this report). The overhang of inventory and the volume of foreclosures could contribute to weaker growth; however, we believe the housing sector is at or close to the bottom of its cycle. To our readers who are responding to our clear US optimism in this year’s Outlook by wondering – like our client mentioned above – if we are a group of Pollyanna-ish “America boosters,” let us provide a demographic snapshot of the Investment Strategy Group. Our team is comprised primarily of investment professionals born outside the United States.

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Exhibit 8: The US Has a Wealth of Natural Resources and Arable Land The United States’ proven reserves per capita are among the highest in the world.

Energy Oil Natural Gas Coal Uranium Metals and Minerals Copper Zinc Nickel Gold Potash Rare Earths Agriculture Total renewable water resources Irrigated land Arable land

Unit Barrels Thousand cubic meters Tonnes Kilograms Kilograms Kilograms Kilograms Grams Kilograms Kilograms Cubic meters Square meters Square meters

United States 92 22 768 1.5 113 45 – 9.7 290 42 9,893 722 5,705

China 11 1.8 86 0.1 23 25 0.8 1.4 150 27 2,127 410 1,098

Brazil 64 2 35 – – – 22 10 1,492 0 40,939 145 2,934

India 5 1 50 – – 9 – – – – 1,626 476 1,368

Russia 532 318 1,126 – 143 – 47 36 12,913 – 32,269 330 8,795

World 197 28 122 0.6 80 30 10.5 6.9 1,256 15 n/a* n/a* n/a*

Data as of December 31, 2010 *CIA data not provided Resources per capita are immaterial where fields are left blank. Source: BP Statistical Review of the World, World Energy Council Survey of Energy Resources 2010, USGS Annual Mineral Commodity Summaries, CIA

In fact, many harken back to emerging market countries: Brazil, Bulgaria, China, Colombia, Czech Republic, India/Kenya, Iran, Lebanon, Lithuania and Morocco to name a few. We have lived in these countries and compare and contrast the strength, stability and sustainability of their private sector and government institutions to those of the US. We conclude that the unique combination of factors discussed above – the very same ones that underlie “American exceptionalism” – is alive and well; hence our recommendation to maintain core assets in the US while having a measured strategic allocation to emerging market equities and opportunistically looking for tactical exposures to emerging market equities and debt, much like our current emerging market local debt tilt. n

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Outlook 15

january 2011

2011 Global Economic Outlook

This year’s global economic landscape contains a simple paradox: while the direction of the world’s economies has rarely been more synchronized, the level of their growth has seldom been more divergent. Indeed, in the spirit of Dickens’ A Tale of Two Cities, the growth differential between emerging and developed economies, or Europe’s core and peripheral economies, is striking (Exhibit 10). As a result, nominal GDP has already exceeded its 2008 peak in much of the emerging world, while it remains below that level in most of Eurozone, as well as Japan. These different axes of growth have important implications for each region’s economic outlook. As shown in Exhibit 11, above-trend growth in emerging markets has already reduced much of their excess capacity, fueling inflationary pressures, tighter monetary

policy and currency appreciation. In contrast, the large output gaps and tepid growth in most of the developed world have made deflation the more prevalent fear, providing ample cover for accommodative monetary policy and fostering a desire for weaker currencies. Within the Eurozone, the challenge is even more daunting, given the disparate health of the core and periphery. The one-size-fits-all position of the European Central Bank (ECB) is likely to remain problematic, especially while the unemployment rate in Spain is 20% versus only 7% in Germany. In a rare sliver of commonality, we expect interest rates to trend higher this year in most markets around the world, a function of both better growth and historically low policy rates. Against this backdrop, we believe the interplay between growth, inflation and policy will not only drive economic developments

Exhibit 9: ISG Economic Outlook for Developed Markets Our forecast features relatively tame inflation, still-accommodative monetary policy, and continued normalization of interest rates.

United States Current Real GDP* Headline CPI** 10-Year Rate Policy Rate 2.8% 1.1% 3.29% 0.0 – 0.25% 2011 Forecast 3.0 – 3.5% 1.25 – 2.0% 3.5 – 4.25% 0.0 – 0.25%

Eurozone Current 1.7% 1.9% 2.96% 1.0% 2011 Forecast 1.0 – 2.0% 1.25 – 2.0% 3.00 – 3.75% 1.0%

Japan Current 3.2% 0.1% 1.12% 0.1% 2011 Forecast 1.5 – 2.0% (0.5) – 0.25% 1.25 – 2.0% 0.1%

United Kingdom Current 1.7% 3.3% 3.40% 0.5% 2011 Forecast 1.25 – 2.25% 3.0 – 3.75% 3.75 – 4.5% 0.5 – 1.0%

Data as of December 31, 2010 Current real GDP are Economist consensus estimates for 2010 real GDP growth. * For current headline CPI readings we show the year-over-year inflation rate for the most recent month available. ** Source: Investment Strategy Group, The Economist

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Exhibit 10: “A Tale of Two Cities” The expected GDP growth differential between emerging and developed economies or Europe’s core and periphery is striking.
7% 6% 5% 4% 3% 2% 1% 0% Emerging Markets Global Developed Markets Core* Eurozone Periphery** 2.0% 1.8% 0.6%


within regions, but across them as well. Even now, better US growth visibility is providing a catalyst for additional emerging market tightening, as fear of a US double-dip recession likely kept emerging market policy easier than domestic growth warranted. A summary of our GDP, inflation and interest rate forecasts for the developed economies is presented in Exhibit 9, while our emerging market views are presented later in Exhibit 17.

US Economic Outlook
In thinking about the resilience of the US economy, and the US consumer in particular, we were reminded of Mark Twain’s famous quip, “The reports of my death are greatly exaggerated.” For despite numerous macroeconomic assaults last year, US consumers nonetheless managed to push adjusted retail and food service sales to within 1% of their 2007 high. Given that consumption constitutes 70% of US GDP, its trajectory is naturally vital to any US economic forecast. But this recent pickup in spending is important for another reason: it marks a critical shift in the mix of growth away from purely transient drivers. Indeed, the lion’s share of growth since mid-2009 has come from inventory re-stocking and fiscal stimulus, not core consumption. Encouragingly, growth excluding these temporary factors rose dramatically in late 2010, laying the foundation for more enduring gains this year. As shown in Exhibit 12, our forecast builds on this theme. Whereas consumption represented less than half of 2010 GDP growth, we expect it to contribute about two-thirds this year, with the balance of growth arising from capital investment. Moving in the opposite direction, inventories are forecast to have no growth impact in 2011. This marks a noteworthy change from last year, when they represented over half of total growth. Our optimism is rooted in the prospect for higher business investment and improvements in the key drivers of consumption. Namely, we think strengthening employment and

Data as of December 28, 2010 Note: Growth expectations are IMF forecasts (purchasing power parity weighted) Source: Investment Strategy Group, Datastream, IMF WEO October 2010 * Eurozone core = Germany, France, Austria, Belgium, and the Netherlands ** Eurozone periphery = Portugal, Ireland, Italy, Greece, and Spain

Exhibit 11: Economic Slack Is Being Reduced Much Faster in Emerging vs. Developed Economies Rapidly narrowing output gaps in emerging markets are leading to inflationary pressures, monetary tightening, and currency appreciation.
4% Actual GDP Less Potential GDP as a Percent of Potential GDP 2% 0% -2% -4% -6% -8% Developed Markets Emerging Markets Jan-07 Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10 Feb-11 Sep-11 Apr-12


Data as of Q3 2010 Source: Investment Strategy Group, Goldman Sachs Global Investment Research

Investment Strategy Group

Outlook 17

january 2011

accommodative fiscal/monetary policy will benefit consumer spending, while the upward trend in the savings rate, a significant drag on consumption since the financial crisis began, will stabilize. For their part, businesses are expected to unlock their cash coffers, supporting higher investment levels and better employment growth. Below we discuss our expectations for each of these key components of 2011 growth.
Business Investment

Exhibit 12: US Real GDP by Component Our forecast features a notable shift away from transient inventory gains toward consumption and investment.
Share of GDP* 70% 2% 10% 1% 20% -4% 100% ISG Central Case 2010 1.2% -0.1% 0.6% 1.5% 0.2% -0.6% 2.5 – 3.0% ISG Central Case 2011 2.0% 0.1% 0.9% 0.0% 0.1% 0.0% 3.0 – 3.5%

Component Consumption Residential Investment Non-Residential Investment Change in Inventories Government Net Trade Total

After massive retrenchment in response to the financial crisis, business investment turned decisively higher in the second quarter of 2010 and accelerated in the third. We believe this trend is likely to continue for several reasons. First, corporations are under-investing now, as capital expenditures are less than depreciation expenses for 70% of the S&P 500. Partly as a result, firms have ample funds to deploy, with cash representing 11% of total assets, the highest level in decades. Second, recent fiscal stimulus, including R&D and depreciation credits, provides an additional investment incentive. Third, the economic and political uncertainty that has hindered business investment continues to dissipate, especially with perceptions of a more business-friendly tone emanating from Washington now. Finally, and perhaps most importantly, profit growth has historically been a leading indicator for investment, as seen in Exhibit 13. Given the strong profit gains of this cycle, there is ample scope for investment growth to follow. In fact, this robust profit growth is one of the key differences between this financial crisis and its predecessors, as it has led to a tremendous pool of investable capital (Exhibit 14). Of course, profits tend to lead not only to capital investment, but also to employment gains. No wonder, then, that the historical correlation between the two has been over 80%. Perhaps former German chancellor Helmut Schmidt said it best, “Today’s profits are tomorrow’s investments and the jobs of the day after.”

Data as of December 21, 2010 * Shares may not add up to 100% due to rounding Source: Investment Strategy Group


While there is little question that employment gains have been paltry thus far, we see ample scope for improvement in 2011. For example, temporary help jobs, aggregate hours worked, and corporate profits – all leading indicators of employment – continue on a strong upward trajectory. In addition, the 4-week moving average of initial unemployment claims, another leading indicator, has fallen to its lowest level since July of 2008. Coupled with ongoing improvement in continuing claims, the upshot is that overall claimants are now falling, an important shift in trend. This message was echoed by November 2010’s ISM non-manufacturing employment index, which recaptured a pre-crisis level last seen in October 2007. Not to be left out, small businesses, often considered the engine of job growth in the US, have also recently increased their hiring plans, according to the NFIB Small Business Hiring Plans Index. Of equal importance, the number of available jobs is increasing, with 3 million job vacancies reported in the latest Bureau of Labor Statistics Job Openings and Labor Turnover Survey (JOLTs), the highest level since late 2008. Even so, many have questioned this improvement, arguing that the available unemployed cannot be “matched” with these open positions. While

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Exhibit 13: Profit Growth Tends to Lead Business Investment Today’s strong profit gains bode well for further non-residential investment growth.
60% 50% Year over Year Percent Change 40% 30% 20% 10% 0% -10% -20% -30% -40%
54 58 62 66 70 74 78 82 86 90 94 98 02 06 10

Perhaps former German chancellor Helmut Schmidt said it best: “Today’s profits are tomorrow’s investments and the jobs of the day after.”

Corporate Profits* Non-Residential Investment

26.4% 8.2%

Data as of Q3 2010 * Profits include inventory valuation and capital consumption adjustments Source: Investment Strategy Group, Datastream

Exhibit 14: Profits are Higher Today Than During Previous Financial Crises Corporate profits as a percent of GDP now stand well above the levels seen in Japan during the 1990’s or the US Great Depression.
12% 10% 8% 6% 4% 2% 0% US: 1930s Japan: 1990s US: Q3 2010 4.8% 3.3%


Data as of Q3 2010 Note: US profits include inventory valuation and capital consumption adjustments. Source: Investment Strategy Group, Datastream, Empirical Research Partners, US Department of Commerce

Investment Strategy Group

Outlook 19

january 2011

Exhibit 15: Share of Unemployment Rate Attributable to “Matching Inefficiencies” The ability of today’s labor market to match the unemployed with open jobs is no worse than in 1982, a year followed by impressive employment gains.
12% 10% 8% 6.5% 6% 4% 2% 0% 1982 2009 Average 1976 – 2009

it’s clear from Exhibit 15 that such matching inefficiencies are higher than normal in this cycle, we note that they are less than 1982, a period when unemployment nonetheless fell from 10.6% to 7.3% over two years. As such, it is still too soon to call this a “jobless” recovery, in our view.

11.0% 10.0%

Source: Investment Strategy Group, Empirical Research Partners

Despite the incessantly negative headlines about deleveraging, US consumers may be further along in repairing their balance sheets than many think. Over the last three years, the savings rate in the US has more than tripled, from 1.7% to its current 5.7%. This fits neatly with the conclusions of two recent International Monetary Fund (IMF) reports that found that an appropriate savings level, incorporating consumers’ need to further reduce debt, was between 4.75-7%.23 In other words, the current level is already close to the median of the IMF range. Meanwhile, other measures suggest the savings rate may already be too high. For example, household assets to GDP have had a 90% negative correlation with the savings rate in the post-World War II period (as asset values rise, the need to save falls). Currently, this relationship suggests that lower end of the IMF range is more appropriate.

Despite the incessantly negative headlines about deleveraging, US consumers may be further along in repairing their balance sheets than many think.

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In addition to improved savings, several other indicators suggest that consumer deleveraging is well advanced, including the ongoing decline in banks’ non-performing consumer loans, the marked decline in early stage delinquencies and the resulting relaxation of lending standards. Taken together, these improvements support our view that the savings rate will stabilize around current levels. Bear in mind that it’s the change in the saving rate, not the level, that matters for GDP growth. In other words, it is only when the savings rate is rising that it acts as a drag on growth. Once it stabilizes, the pace of income growth is what matters. On this last point, we are comforted by the fact that 51% of income is comprised of wages, which should benefit from our more optimistic view on employment. In addition, capital income, which represents another 26%, should increase given strong market gains and increasing dividend payments by corporations. Thus, roughly 80% of the individual income components should benefit from the positive tailwinds we expect. Of equal importance, we think the extension of the Bush tax cuts and unemployment benefits removes the biggest downside risk to income growth and, in fact, adds about $175 billion or 1.5% to disposable income growth this year. Indeed, we have said since 2008 that our greatest concern was a policy error, but the US appears to be effectively avoiding the Depression era blunders of premature fiscal and monetary tightening by implementing more fiscal stimulus and a second round of quantitative easing. In turn, these easier financial conditions should manifest themselves in stronger economic growth this year, given their historically strong leading relationship. Against this backdrop, consumer and business confidence should improve, as fears of a double-dip recession fade. On the back of these views, we expect above consensus real GDP growth of 3.0-3.5% this year, as shown in Exhibit 9. Despite stronger growth, our inflation views remain tame, given the still-excessive slack in the US economy. As just two examples, capacity utilization stood at around 75.2% as of November 2010, well below its long-term average of 80.9%, while the unemployment rate has only been higher

2% of the time since 1950. With inflation below the Federal Reserve’s comfort level, and unemployment above, we expect the Fed to remain on hold this year, despite better growth. In our view, it will likely take many years of sustained real GDP growth of 3-4% to return unemployment to its long-term average of around 6%. Even so, interest rates should move higher this year, as stronger growth raises expectations of eventual monetary policy tightening, and inflation expectations advance toward their longer-term averages.

Our economic growth outlook for Eurozone is best summarized as a strong core, combined with a weak periphery, yielding a mediocre average. Regardless of the measure, the differences between these two cohorts are stark. Spain’s unemployment rate, for example, is around 20%, while Germany’s is just 7%. And whereas Germany need only reduce its deficit by three percentage points to achieve fiscal sustainability by 2030, the comparable threshold for Ireland is 12 percentage points, according to IMF estimates. Not surprisingly, the resulting growth profile of the region is mixed, with Germany growing 3.6% in the first three quarters of 2010, while Italy and Spain grew just 1.1% and 0.4%, respectively. As a result, Germany accounted for 60% of Eurozone growth since the second quarter of 2009, despite representing only 30% of the area’s GDP. We expect these divergences to persist in 2011, with Germany outperforming the region and peripheral Europe struggling with anemic growth. Overall, our forecast calls for 1-2% GDP growth this year. As in the US, we expect inflation to be subdued, as likely hikes in the VAT and rising oil prices counterbalance the deflationary impulse from the implementation of various austerity measures. Despite this, German long-term rates should rise, given the better growth profile we expect. A summary of our views for Eurozone is presented in Exhibit 9.

Investment Strategy Group

Outlook 21

january 2011

United Kingdom
Given that net exports constitute 20% of the UK’s GDP, improving global growth should disproportionately benefit the UK, especially with the sterling arguably cheap. But while we expect positive contributions from net trade this year, the relatively tepid growth we envision for Eurozone (the UK’s main trading partner, representing 50% of exports) serves as a headwind. In addition, the newly formed coalition government has made cutting the budget deficit a key priority. As a result, government spending, which grew at an 11.5% annual rate last year, is set to be flat to slightly down this year and contract about £81bn (~6% of GDP) over the next five years. Against this backdrop, we expect moderate GDP growth of 1.25-2.25% this year (Exhibit 9). Unlike many of its developed market counterparts, however, inflation is likely to remain a problem in the UK. The main culprits have been higher value-added taxes (VAT) and energy prices, which together have kept inflation above the Bank of England’s (BOE) 2% target for the last 11 months. Unfortunately, this upward pressure is unlikely to abate soon, as a further VAT increase and higher gas prices from UK utilities are on the docket for this year. As a result, we expect the BOE to start hiking rates in late 2011, although at 0.5-1.0%, the absolute level will remain low by historical standards. In turn, we think long-term interest rates should rise over the course of the year.

net trade is only 5% of Japanese GDP, it represented over half of last year’s total growth. Another third of Japanese growth arose from fiscal stimulus, which boosted consumption directly by subsidizing durable goods purchases. With exports approaching pre-crisis levels where they will likely level off, we believe net trade will contribute significantly less to GDP growth this year. Moreover, while the government is considering new stimulus measures, they are likely to be limited by the magnitude of Japan’s budget deficits and public debt. Acting as an offset, fixed investment should strengthen on the back of strong corporate earnings and the recovery in exports. Weighing these factors against each other, we expect GDP to grow 1.52.0% this year, as shown in Exhibit 9. Against this backdrop of low growth and persistent deflation, we expect monetary policy to remain accommodative. As a result, we think long bond rates should remain anchored, particularly with the Bank of Japan likely to resume Japanese Government Bond (JGB) purchases.

Emerging Markets

On the back of a pronounced global inventory restocking cycle, emerging market growth has recovered more rapidly, and to higher levels, than that of developed economies. Indeed, emerging markets real GDP expanded nearly 5 percentage points faster than developed markets in 2010. Confirming our intuition from last year, the highly synchronized nature of the downturn has also worked in reverse, with exports to the Japan developed world serving as a key transmission mechanism for emerging market recovery As we highlighted last year, the Japanese economy was one of the primary casualties of the (Exhibit 16). But with growth come challenges. Many global crisis, as exports collapsed a remarkable emerging markets have now recaptured, and 36.5%, contributing to an 8.6% peak to trough in many cases exceeded, their trend growth decline in GDP. But as global growth has levels. In turn, these positive “output gaps” improved, this same dynamic has worked in the have stoked inflationary pressures. To date, opposite direction: exports have risen close to much of the rise in prices is attributable to food, 50% from their first quarter 2009 trough, with exports to Asian countries now close to pre-crisis a problem magnified by food’s 28% share of emerging market consumer price index (CPI) levels last seen in 2007. Furthermore, although

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baskets, a weighting close to double that in the G-10 CPI. While overall inflation has only returned to average pre-crisis levels, the concern is that stronger global growth coupled with monetary policy that is arguably too loose in many emerging markets could push inflation still higher. Not surprisingly, a variety of emerging market countries have already begun to tighten monetary policy, and have allowed their currencies to appreciate. This interaction between above-trend growth, price pressures, and monetary policy emerges as a clear theme in the individual country and regional discussions that follow. A summary of our emerging market growth views is presented in Exhibit 17.
Emerging Asia

As home to both China and India, it’s not surprising that Emerging Asia is both the largest and fastest growing region in the emerging markets. While growth should moderate somewhat as the global restocking cycle wanes this year, strong domestic demand provides an offset. With continuing growth, inflation pressures will persist. In response, we expect further policy tightening, most likely in the form of rate hikes and currency appreciation, but with the potential for additional capital controls. Policy will also be shaped by capital inflows, which are likely to remain substantial given the region’s strong GDP growth and undervalued exchange rates. Even so, as long as inflation does not accelerate or become more broad-based, policymakers are likely to move cautiously, at least until they see clearer evidence of an entrenched recovery in the United States and Europe.

Exhibit 16: Emerging Market Growth Remains Synchronized to the Developed World Despite different levels of real GDP growth, emerging and developed economies have not decoupled.
12% 10% 8% 6% 4% 2% 0% -2% -4% -6% 1995 G-3 EM All BRICs 1997 1999 EM ex. BRICs World 2001 2003 2005 2007 2009 2011


Data as of December 30, 2010 Note: G-3 is comprised of the US, Eurozone, and Japan. *Average of IMF and Goldman Sachs Global Investment Research forecasts Source: Investment Strategy Group, IMF WEO October 2010, Goldman Sachs Global Investment Research

Exhibit 17: ISG Economic Outlook for Emerging Markets We expect high growth to lead to increased inflationary pressures.

China Current Real GDP* Headline CPI** 10.2% 5.1% 2011 Forecast 8.75% – 9.75% 4.0% – 5.0%

Brazil Current 7.5% 5.6% 2011 Forecast 4.0% – 5.0% 5.0% – 6.5%

India Current 8.8% 7.5% 2011 Forecast 8.0% – 9.0% 5.5% – 7.5%

Russia Current 4.0% 8.1% 2011 Forecast 3.5% – 5.0% 7.0% – 9.0%

Data as of December 31, 2010 * Current real GDP are Economist consensus estimates for 2010 real GDP growth. ** For current headline CPI readings we show the year-over-year inflation rate for the most recent month available. WPI is shown for India. IPCA Inflation is shown for Brazil. Source: Investment Strategy Group, The Economist, CEIC Database

Investment Strategy Group

Outlook 23

january 2011

China We expect Chinese GDP growth of around 8.75-9.75% in 2011, reflecting a mix of still-strong domestic demand and government investment tempered by fading government stimulus. While a hard landing remains unlikely despite China’s numerous structural challenges, we do worry about the recent trajectory of inflation. Indeed, inflation rose to 5.1% year-overyear in late 2010, above the government’s – and markets’ – comfort zone. While the authorities have already begun to tighten monetary policy in response to the rise in inflation, we expect further action, including reserve requirement increases, interest rate hikes, loan guidance, and possibly measures directed at the property sector. More unconventional measures, such as direct price controls, are also possible and have been alluded to by policymakers. Against this backdrop, we expect inflation to be 4.0-5.0% in 2011. While we remain concerned about the medium-term risks to China’s development, near-term risks are more balanced. While stronger than expected US growth could boost China’s GDP, it could also intensify pricing pressures. In response, the authorities might inadvertently tighten too much as they implement progressively more blunt monetary tools. While this is not our base case, it’s a risk we are carefully monitoring given the negative implications for growth, commodity prices and market sentiment.

Latin America

Latin America made an impressive recovery in 2010, helped by rising commodity prices, the global restocking cycle and surging credit. Although we expect the global restocking cycle to wane, continued domestic demand and loan growth should still support healthy GDP growth. As a result, central banks are likely to further tighten monetary policy to keep inflation expectations in check. However, as in Asia, policymakers will move cautiously to avoid attracting additional speculative capital inflows, especially as this could fuel currency appreciation pressures. As such, additional capital controls are possible, but given the region’s need for external financing, they are less likely to be stringent, in our view.

Brazil After an exceptionally strong recovery last year, we expect GDP growth to decelerate to a more normal 4%-5% in 2011. This is helpful, as the current heady pace of domestic demand growth is fueling inflationary pressures (which have started to creep into core CPI) and a widening current account deficit. The latter is troubling, as it is placing upward pressure on Brazil’s already over-valued currency. As is typical in Brazil, the burden of curbing inflation will reside with the central bank, as fiscal policy has remained somewhat loose and is unlikely to be meaningfully tightened under the new administration. The central bank will probably move cautiously, not wanting to invite India The Indian economy staged a strong remore capital inflows. Against this backdrop, we covery in 2010, supported by investment, ample see inflation in the 5.0-6.5% range in 2011, close credit, rising consumption and, to a lesser extent, to the upper band of Brazil’s inflation target. a recovery in exports. As liquidity conditions tighten and investment moderates, we expect Europe, Middle East, Africa (EMEA) GDP growth to ease to 8-9% this year. Even so, EMEA has lagged the strong recovery seen with demand outpacing output, we think inflain other emerging markets – especially the tion is likely to remain elevated at 5.5-7.5%. countries in Central and Eastern Europe – given In addition to inflation, India’s widening its dependence on external financing during current account deficit is worrisome, as the the 2009 crisis and close links to the European capital flows financing it are increasingly Union (EU) business cycle. While ongoing fiscal investment related. As a result, India is now consolidation and the region’s large exposure more susceptible to sudden stops in external to the troubled EU will act as a headwind, financing, should investors lose their appetite we expect the recovery that began in 2010 to for India. continue, supported by improving labor markets and low real interest rates. Even so, with growth still well below trend, EMEA should avoid the

24 Goldman Sachs

inflationary pressures facing most of its emerging market brethren, in our view. Within the region, we believe Turkey stands out as best-positioned to outgrow expectations. Domestic demand is accelerating, fueled by high wage growth. Meanwhile, currency appreciation, which has helped to contain inflation, is likely to decelerate, as the Turkish lira has become overvalued. On the other hand, Hungary is most likely to disappoint, as the country is most vulnerable to further escalation of the sovereign debt crisis in peripheral Europe.

Among the BRICs, Russia has underperformed in both directions, suffering the sharpest slowdown in 2009 and recording only a modest recovery last year. While the economy did benefit from the rebound in global energy prices and expansionary fiscal policy last year, overall growth lagged as the summer draught undermined domestic consumption. Looking forward, we believe consumption is unlikely to recapture pre-crisis levels this year, as banks have recently tightened lending standards, thereby limiting consumer credit. On a more positive note, fixed investment in Russia has begun to recover and is expected to be an important driver of GDP growth in 2011, which we forecast to be 3.5%-5%. While the level of inflation is high at around 8% as of late 2010, it has remained well below pre-crisis levels, a reflection of moderate demand pressures and more proactive monetary policy that is steadily moving toward an inflation-targeting framework. As such, our expected inflation range is 7-9% this year. n

Investment Strategy Group

Outlook 25

january 2011

2011 Financial Markets Outlook

The equity market has an uncanny ability of changing the locks right when investors think they have found the keys. Consider the March 2009 low, when portfolios positioned for the next Great Depression were caught wrongfooted by forceful policy action. More recently, at the April 2010 high, renewed concerns about fiscal sustainability in Europe punished investors who had just begun to wade begrudgingly back into stocks. Both instances emphasize the interplay between policy and positioning in response to systemic fears, a central feature of the market backdrop of the last few years. As a result, investment success has had more to do with anticipating the various “risk on, risk off” phases than with traditional fundamental analysis, despite the resilience of global growth and corporate profitability over this period. We believe the uncertainty, defensive positioning and high correlations across assets that this “risk-on, risk-off” mentality engendered have important implications for this year’s investment landscape. In particular, we think the transition to a self-sustaining economic recovery will ease some of this uncertainty and support the following key themes:
Stocks over Bonds and Cash

short-rates low. The low opportunity cost hurdle of cash and bonds, paired against the improving backdrop for equities, suggests stocks can continue to outperform, just as they have for the last two years (Exhibit 19).
Falling Correlations

When macroeconomic risks dominate the investment landscape, as they did last year, correlations across all assets increase, as idiosyncratic fundamentals are trumped by systemic fears. For example, the percentage of S&P 500 stocks moving in the same direction over the last six months of 2010 was close to 80%, a level exceeded only 2% of the time since 1972. This dynamic was not limited to equities, however, as correlations among the majority of ISG’s strategic asset classes remain near all time highs (Exhibit 18). Despite their elevated current levels, we expect the mean-reverting nature of correlations, in addition to their tendency to fall as economic stress abates, to reward fundamental analysis and active management going forward.
Active over Passive Management

Accelerating growth coupled with accommodative policy is a powerful elixir for stocks, especially given current undemanding valuations. At the same time, this backdrop is negative for bonds, as normalizing interest rates penalize duration. Cash returns are even worse, given the Federal Reserve’s commitment to keeping

The investment landscape described above has been particularly toxic for active managers, as stock picking became secondary to market timing. To make matters worse, the performance differential between individual stocks, a crucial driver of active manager alpha, was historically low last quarter, as the best 50 S&P 500 stocks outperformed the worst 50 by around 40 percentage points, well below the 50% long-term average. This combination contributed to the

26 Goldman Sachs

Exhibit 18: Correlations Across Assets Remain Elevated

1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

Last 12-Months Cross-Correlation* Average 0.78 0.58

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Data as of November 30, 2010 * Average 1 year correlation between the following asset classes: High Yield, US Large Cap Value, US Large Cap Growth, US Small Cap, Non-US Equity, EM Equity, Relative Value Hedge Funds, Event Driven Hedge Funds, Equity Long/Short Hedge Funds, Macro/Tactical Trading Hedge Funds, Buyout Private Equity (Proxy), Mezzanine Private Equity (Proxy), Distressed Private Equity (Proxy), Venture Private Equity (Proxy), Energy Private Equity (Proxy), Private Real Estate (Proxy) Source: Investment Strategy Group, Datastream, MSCI

Exhibit 19: 2010 Asset Class Performance Risk assets outperformed again in 2010.
20% 19.2% 15.7% 15% 15.1% 15.1%





6.5% 3.1%


0% -0.9% -5% Emerging Markets Equity Emerging Markets Debt (Local) Barclays High Yield US Equity Goldman Sachs Commodities Index Non-US Equity MultiStrategy Hedge Funds* Barclays Aggregate Barclays Muni 1-10 US Trade Weighted Dollar

Note: Returns are total returns in USD. * Performance through November 30, 2010 Source: Investment Strategy Group, Datastream, Barclays Capital, Credit Suisse Indices used: Emerging Markets (MSCI Emerging Markets Index); Emerging Markets Debt (JP Morgan GBI EM Global Diversified Index); US Equity (S&P 500 Index); Goldman Sachs Commodities Index (S&P GSCI Total Return Index); Non-US Equity (MSCI EAFE Index); Multi-Strategy Hedge Funds (modeled using the following mix of styles: 10% Relative Value (Blend of CSFB/Tremont Indices: 20% Convertible Arbitrage, 40% Equity Market Neutral, 40% Fixed Income Arbitrage Indices), 35% Event Driven (CSFB/Tremont Event Driven Index), 35% Equity Long/Short (CSFB/Tremont Equity Long/Short Index), and 20% Macro/Tactical Trading (Blend of CSFB/Tremont Indices: 50% Global Macro, 50% Managed Futures Indices)

Investment Strategy Group

Outlook 27

january 2011

worst year on record for active managers, with just a quarter of them topping their benchmark. As a result, retail and institutional investors have pulled almost $750 billion from active managers since the beginning of 2008, representing nearly 10% of assets under management, according to Empirical Research Partners. Against this backdrop, we see two catalysts that should favor active management going forward. The first is the historical tendency for active stock selection to outperform for several years after periods of high correlations and low performance spreads.24 Secondly, we note that correlations typically fall rapidly in the third year of equity market recoveries, as classic business cycle dynamics replace systemic fears. Taken together, we think these tendencies will provide a positive tailwind to active management going forward.
Shareholder-Friendly Capital Deployment

Exhibit 20: Abundant Free Cash Flow Provides Ample Fodder for Increased Spending The combined free cash flow of US consumers and businesses as a percent of GDP stands at a 50-year high.
12% 10% 8% 6% 4% 2% 0%
54 58 62 66 70 74 78 82 86 90 94 98 02 06 10


1952 Through Q3 2010 Note: Based on 1500 largest US stocks, excluding financials and utilities Source: Investment Strategy Group, Empirical Research Partners, US Department of Commerce, Corporate Reports

There is little question that global corporations are cash-rich. In the US, non-financial companies had nearly $2 trillion in cash and equivalents at the end of September 2010, according to the Federal Reserve. Among the S&P 500 nonfinancials, cash levels have grown almost 40% since 2008 and now represent around 11% of total corporate assets, the highest level in decades. In fact, based on projected free cash flow this year, corporations must spend an additional $300 billion just to keep their cash coffers from growing. Including the positive contribution from consumer deleveraging we discussed earlier, Exhibit 20 shows that total business and consumer cash flow has reached a staggering 10.2% of GDP, by far the highest level in over 50 years. As the uncertainty that has thus far served as an impediment to capital deployment recedes this year, we expect firms to increase their pace of capital deployment. On this point, we note that the current 28% dividend payout ratio stands well below its long term average of 43%. Moreover, almost 80% of S&P 500 companies reduced their share count through buybacks in 2010, a trend we expect to intensify this year. Indeed, given still-low borrowing costs and high earnings yields, it is actually accretive to earnings for about one-fifth of S&P 500 firms to issue

Exhibit 21: Percent of Time US Valuations Have Been Less than Current Levels Since 1974 Regardless of measure, today’s US valuations stand around the mid-point of their historical ranges.
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Price to Trend Earnings Price to Peak Earnings Price to Book 54.1% 49.4% 53.4%

Data as of December 30, 2010 Source: Investment Strategy Group, Datastream, Robert Shiller

28 Goldman Sachs

debt to repurchase shares (a so-called “leveraged recap” strategy). Lastly, as corporations search for ways to bolster organic growth, we think increased merger and acquisition activity is likely, particularly with many companies still trading at attractive valuations.

US Equities: The Ascendancy of Earnings
Perhaps one of the biggest surprises of 2010 was the endurance of corporate profitability. Despite anemic developed market growth, a European sovereign debt crisis and global political uncertainty, US companies managed to top consensus earnings expectations by some 8-10% each quarter. The result has been remarkable earnings growth, with trailing twelve-month S&P 500 operating earnings doubling since the third quarter of 2009. In fact, economy-wide profits, including both public and private companies, stood at an all-time high as of the third quarter of 2010. The big question, of course, is where do we go from here? To develop our equity market outlook, we consider four major factors:

Fed traditionally has not raised short rates until loan growth resumes, just as it did in both 1994 and 2004. With leading indicators suggesting that loan growth will resume in mid-2011, market participants’ memory of the Fed’s actions may keep multiples in check, even if the Fed ultimately breaks precedence by keeping rates low. Finally, several provisions in the broader tax reform bill will expire at the end of 2011, which could rekindle fears of a fiscal drag on growth in early 2012, thereby reducing the multiple investors are willing to pay at the end of this year.

Naturally, the pace of the earnings recovery described above has led to concerns about its sustainability, with investors troubled by a potential peak in profit margins and/or earnings growth. On the latter concern, the level of earnings is more important than the growth rate, since the market ultimately follows the path of profits, as seen in Exhibit 22. As a result, even if profit growth did peak in 2010, it has historically taken another two to three years before the level of earnings fell. This dynamic was clear in the last cycle, as earnings growth peaked in July of 2004, more than three years before market prices did.
Exhibit 22: The Market Ultimately Follows the Path of Earnings
1800 1600 1400 1200 1000 800 600 400 200 0 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Data as of December 31, 2010 Source: Investment Strategy Group, Intrinsic Research

As shown in Exhibit 21, today’s S&P 500 valuations are not demanding, residing around the mid-point of their historical ranges, on average. Thus, while the valuation dislocation that characterized the March 2009 low has passed, we are far from reaching lofty multiples. In fact, multiples could potentially expand further from current levels, given the prevailing low interest rate environment. Based on our analysis, during similar historical periods of low interest rates, the price-to-trend earnings multiple (our preferred valuation measure) generally resided several points above its current level. That said, our willingness to assume that multiples expand in our central case is tempered by several factors. One, rising interest rates are often a headwind to expanding multiples, as was the case in 2003-2006. Our central case assumes that rates continue to normalize this year, as economic growth strengthens. Two, the

S&P 500 Price (LHS) Operating Earnings Level (RHS)

100 90 80 70 60 50 40 30 20 10 0

Investment Strategy Group

Outlook 29

january 2011

Exhibit 23: Today’s High Incremental Margins Enable S&P 500 Firms to Spend More Without Destroying Profitability Every dollar of new sales generated around 25 cents of net profit in the third quarter of 2010.
40% 35% 30% 25% 20% 15% 10% 5% 0% Q2 2010
Data as of Q3 2010 * Net income/sales ** Change in net income/change in sales Source: Investment Strategy Group, Bloomberg, Empirical Research Partners

costs currently, supporting margin durability. Lastly, the yield curve tends to lead corporate profitability by two to three quarters. As such, we believe the steep slope of today’s yield curve relative to history suggests a meaningful profit contraction is not yet in sight.


Base Margin* Incremental Margin** 25.3%




Q3 2010

Moreover, with global economic growth set to accelerate in 2011, it is hard to imagine the level of earnings declining, in our view. Of course, earnings could still falter if margins collapse, but significant margin erosion is unlikely for several reasons. First, S&P 500 40 companies are still benefitting from a high 35 degree of operating leverage. As can be seen in 30 Exhibit 23, every dollar of new sales generated 25 25 cents of net profit in the third quarter. This 20 large “incremental” margin provides firms with 15 a healthy buffer from which to hire and increase 10 capital expenditures without significantly 5 compromising their profitability. Second, 0 margins tend to follow the business cycle, falling just as new recessions begin, generally at a time when unemployment is at low levels and unit labor costs are high. The absence of these conditions today makes a significant decline in margins unlikely. In fact, corporate pricing power appears to be rising faster than unit labor

The S&P 500’s technical configuration is consistent with a strong uptrend in underlying prices, as the 50-day moving average is comfortably above the 200-day moving average, and both are rising. Importantly, the market’s late-2010 push to new highs was broad-based, as evidenced by the cumulative advancing-less-declining issues index simultaneously making fresh highs. In contrast, market peaks, such as those in 2000 and 2007, are characterized by a notable contraction in the number of advancing shares. There are also two historically reliable technical patterns that may prove consequential this year. First, 2011 is the third year of the presidential cycle. Looking at data since 1900, this period has generated positive returns 95% of the time when the economy was expanding, with price gains of around 21%, almost double the full period average. Second, it is often noted that the best gains of the year occur from November to April. Less discussed is whether the returns preceding this period shape the subsequent outcome. Based on an interesting study by SentimenTrader,25 it appears they do. If the market navigates the traditionally volatile September-October period without a hiccup, as it did in 2010, then 80% of the following November-April periods experienced a positive return, with a median gain at the best point of nearly +13% and not one instance of a correction greater than -10%.

30 Goldman Sachs

Exhibit 24: Cumulative US Mutual Fund Flows Since Market Bottom in March 2009 Despite the S&P 500’s almost 90% rally since the trough, investors have pulled over $100 billion out of US equity mutual funds.
700 Net Inflows to Mutual Funds ($ Billion) 600 500 400 300 200 100 0 -100 -200 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 -113 Dec-10 US Equity Flows US Fixed Income Flows

Sentiment / Positioning


Data as of December 21, 2010 Source: Investment Strategy Group, Datastream, ICI

Exhibit 25: There Is Still Plenty of Sidelined Cash That Could Flow Into Equities The ratio of cash to S&P 500 market cap remains above its long-term average, providing scope for further equity flows.
70% 60% 50% 40% 30% 20% 10% 0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
1990 Through November 2010 Source: Investment Strategy Group, Datastream, ICI

Money Market Mutual Funds Net Assets as % of S&P 500 Market Cap Average

26% 21%

While much has been made of the upturn in equity sentiment late in 2010, it is hard to argue that investors are bullish on US equities when considering Exhibit 24. Remarkably, despite the S&P 500’s 80%+ rally since the March 2009 trough, there have been over $100 billion of outflows from US equity mutual funds over that time. In fact, US household bond holdings now represent around 21% of total discretionary financial assets, a level that has been higher only 10% of the time since 1952. In addition, the ratio of money market funds to equities remains above its long-term average, suggesting scope for further flows out of cash and into the stock market (Exhibit 25). For their part, institutions have been no warmer toward stocks, with large endowments now having just 15% of their assets allocated to long equities, down from 25% in 2006, according to Cambridge Associates. Not to be left out, sell side analysts have also joined the retreat. Of the roughly 160,000 analyst recommendations compiled by Bloomberg on US stocks, only 29% represent buy ratings, a far cry from the 75% that prevailed at the height of the internet bubble in June of 2000. Historically, the catalysts for a shift in flows back into equities have been threefold: confidence in the durability of the economic recovery, negative returns in bonds as rates normalize higher and, paradoxically, higher equity prices. Our central case scenario features all three, suggesting the incipient uptick in equity fund flows late in 2010 may persist, especially with ostensibly “risk-free” Treasuries delivering a notable loss in the fourth quarter. In fact, fixed income mutual funds saw their fourthlargest redemption on record in late 2010, while broader fixed income was on course for its worst quarterly performance in a decade.26 Our conclusion at the end of 2009 is as relevant today: even moderate rebalancing toward stocks by retail investors, who represent 85% of mutual fund owners, would represent a sizable tailwind to equities this year. Indeed, given the data just presented, capitulation from bond funds may have already begun.

Investment Strategy Group

Outlook 31

january 2011

Our View on the US Market

Taking these four factors together, our work suggests the market is poised to deliver around 8% total returns to the mid-point of our forecast range this year, as shown in Exhibit 28. This return is underpinned by mid-to-high single digit earnings growth, a level roughly in line with the trend over the last 30 years. The upside to our central case could come about through higher valuation multiples, to which we assign a 25% probability in our good case. Turning to sectors, we continue to like large capitalization US banks, where attractive valuations, falling credit costs, negative sentiment and resumed capital deployment via dividends/buybacks should support higher share prices, in our view. Moreover, the stronger employment trajectory we expect this year should boost bank profits, especially since credit costs are already falling despite extremely elevated unemployment. The pharmaceutical sector is another area we are investigating, as valuations appear reasonable and dividend yields are attractive. We think clarity on what the growth profile of the industry will be after patent expirations could provide a catalyst for outperformance around mid-year. Until then, we continue to prefer more cyclical sectors. Beyond 2011, we think the market is priced to deliver average total returns of about 7% per year, assuming earnings and multiples normalize over the next three to five years. While below the historical average for US equities, this return remains attractive relative to investment grade fixed income and cash. As such, we continue to recommend clients build toward (or maintain) their strategic allocation to equities.

As seen in Exhibit 26, the core of Europe dramatically outperformed the periphery last year. At issue stands the uneven fiscal health of the various sovereigns within the EU, and for the weaker among them, their ability to honor austerity measures. Related to this, we believe the condition of each country’s banking system remains a key equity performance driver. More fundamentally, investors’ question whether having monetary union without fiscal union is inherently flawed. Given the structural nature of these concerns, European equities do appear somewhat undervalued on a few measures. Even so, when we take the average of our preferred valuation metrics, Europe is priced around the midpoint of its historical range over the last 35 years, having been cheaper about 50% of the time. The signal is more favorable relative to US valuations, however, as Europe currently trades at about a 40% discount, compared to its long-term average of 34%.
Exhibit 26: Equity Markets in the Core of Europe Dramatically Outperformed the Periphery in 2010

50% 40% 30% 20% 10% 0% -10% -20% -30% -40% Portugal Belgium Ireland U.K. Switzerland Netherlands Stoxx 600 Germany Sweden Norway Austria Finland Greece Spain Italy France Denmark -50% -42.6 -14.1-11.9 -20.2 -1.0 -0.3 -8.7 8.1 8.5 8.6 4.6 6.3 13.4 14.514.8 23.6 39.0

Data as of December 31, 2010 Source: Investment Strategy Group, Datastream

32 Goldman Sachs

Exhibit 27: ISG US Equity Scenarios – Year-End 2011
Good Case (25%) End 2011 S&P 500 Earnings S&P 500 Price-to-Trend Reported Earnings End 2011 S&P 500 Fundamental Valuation Range End 2011 S&P 500 Price Target (based on a combination of trend and forward earnings estimates)
Data as of December 31, 2010 Source: Investment Strategy Group

Central Case (60%) Op. Earnings $88 – 93 Rep. Earnings $75 – 79 Trend Rep. Earnings $74 15.5 – 18.5x 1153 – 1376

Bad Case (15%) Op. Earnings ≤ $70 Rep. Earnings ≤ $53 Trend Rep. Earnings ≤ $74 12 – 14x 892 – 1041

Op. Earnings $96 Rep. Earnings $85 Trend Rep. Earnings $74 18.5 – 20.0x 1376 – 1487


1300 – 1375


It is important to note, however, that the region’s relative undervaluation is concentrated in the financial sector. In total, financials account for almost a quarter of total market capitalization in Europe, the largest sector by far. In addition, the least expensive countries in the Eurozone, Spain and Italy, have the largest financial sector market cap concentration, at 42% and 34%, respectively. Notably, our analysis suggests Eurozone financials may not be as undervalued as they appear. Although European financials trade at an attractive 0.9 times book value, adjusting this for likely losses suggests a multiple closer to 1.2 times, not far from fair value given a normalized ROE expectation of 8-10%. Moreover, we think bank multiples should be lower now, given the inability of many ailing European sovereigns to continue to financially support their banks. Finally, European banks are by far the largest holders of troubled peripheral debt, increasing their risk profile. According to the Bank of International Settlements, European banks have some $2.2 trillion of exposure to Greece, Ireland, Italy, Portugal and Spain.

We continue to recommend clients build toward (or maintain) their strategic allocation to equities.

Investment Strategy Group

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january 2011

Exhibit 28: ISG Global Equity Targets – Year-End 2011 While we expect global equity markets to be higher this year, risk-adjusted returns favor the developed markets.
Implied Upside from Current Levels 3 – 9% 9 – 16% 5 – 12% 20 – 31% 1 – 11% Current Dividend Yield 1.8% 3.1% 3.1% 2.0% 3.0% Implied Total Return 5 – 11% 12 – 19% 8 – 15% 22 – 33% 4 – 14% Volatility Since 1988 15.1% 16.2% 15.1% 19.8% 23.4%

Country US Europe UK Japan Emerging Markets

Reference Index S&P 500 Stoxx 600 FTSE 100 Topix MSCI Emerging Markets

Current Level 1258 276 5900 899 48171

2011 Target Range 1300 – 1375 300 – 320 6200 – 6600 1080 – 1180 48700 – 53500

Data as of December 31, 2010 Source: Investment Strategy Group, Datastream

United Kingdom
Given the disparate health of various EU members, we think the wide dispersion in individual country returns will likely persist. While we are mindful that significant fiscal adjustments do not necessarily entail equity underperformance – as is clearly shown in Exhibit 29 – we think ongoing financial concerns could remain a headwind for valuation multiples. As a result, we are tactically neutral on European equities, but think investors should maintain their strategic weight. Tactically, our preference is to gain exposure to Europe through our Eurostoxx 50 dividend swap tilt. While we are still exposed to dividend risk in this tilt, its returns are driven by dividend levels, not stock price levels; as a result, it allows us to participate in earnings-driven upside without having to bear the risk of multiples contracting. With middling valuation levels compared to both its own history and the US’s, the case for UK equity investment does not rest with cheapness, especially since valuation multiples are likely to be kept in check by persistent inflation that has remained above the government’s 2% inflation target for 11 months. Instead, UK equities largely reflect a view on both the financial and commodity sectors, as these together represent over half the FTSE 100 market cap. On this score, the message is mixed. While energy and financials appear attractively valued, and UK banks seem to have manageable exposure to peripheral Europe, the materials sector, which comprises about 15% of the country’s market capitalization, is now the most expensive. Thus, while the valuation backdrop is not clear-cut, the country’s exposure to global growth is attractive given our constructive cyclical outlook. Indeed, over 80% of FTSE 100 sales come from outside the UK, with two-thirds of that emanating from the faster growing economies of the US, Asia and emerging markets. Given this global orientation, the 10% undervaluation of the sterling relative to the euro is a strong export tailwind, as 32% of FTSE 100 sales originate in Europe. Our equity return expectations for the UK are presented in Exhibit 28.

In our view, Japan offers the most compelling risk/reward trade-off of the global equity markets.

34 Goldman Sachs

Exhibit 29: Fiscal Austerity Plans Do Not Necessarily Lead to Poor Equity Performance Countries undertaking fiscal adjustment actually saw their equity markets outperform on a relative and absolute basis historically.
Annualized Performance Fiscal Adjustment Starting Denmark Belgium Greece Ireland Sweden Finland Italy UK France Austria Netherlands Average Median 1982 1984 1989 1988 1983 1993 1989 1993 1993 1995 1990 Ending 1986 1998 2001 1996 1988 2000 1997 1999 1997 2001 2000 Absolute Local 10% 16% 18% 12% 23% 49% 7% 13% 12% 0% 14% 16% 13% USD 10% 19% 10% 12% 27% 46% 4% 14% 10% -5% 12% 14% 12% vs. MSCI World Local -8% 4% 12% 4% 6% 37% 0% -3% -1% -9% 7% 4% 4% USD -9% 6% 4% 4% 5% 34% -4% -2% -3% -12% 5% 3% 4%

Data as of December 31, 2010 Source: Investment Strategy Group, Datastream, BCA

In our view, Japan offers the most compelling risk/reward trade-off of the global equity markets, as all four of our investment pillars are supportive. As shown in Exhibit 30, we find that absolute valuations provide an attractive margin of safety, having been lower than current levels only 6.5% of the time since 1992. Furthermore, on a relative basis, Japan is trading at a bigger discount to the US and Australasia, Europe and Far East (EAFE) than it has historically. Importantly, if multiples returned just to their 12-month highs, which themselves stand 30% below long-term averages, the Topix would generate a double-digit return. We think such a scenario is likely, given the better than expected progression of fundamentals. Japanese earnings have exceeded expectations in each quarter of the recovery so far, despite Japanese yen (JPY) appreciation.

Exhibit 30: Japanese Valuations Have Rarely Been Cheaper Since 1992, MSCI Japan valuations have only been lower than current levels 6.5% of the time.

Percent of Time MSCI Japan Valuations Have Been Less than Current

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
1992 through December 30, 2010 Note: Based on price to long-term cash flow, price to trailing 12 month cash flow, price to book, and price to peak earnings. The percent of time less than current is calculated on a cumulative basis, i.e. at each point in time, the current valuation level is compared to valuations during all periods prior to that point in time. Source: Investment Strategy Group, Datastream, MSCI

23.7% 8.9% 6.5%

Investment Strategy Group

Outlook 35

january 2011

In fact, investors may systematically overreact to JPY strength, as our work suggests global demand is a far more important driver of Japanese profits (Exhibit 31). On this point, accelerating global growth this year should directly benefit Japan’s export-driven earnings, which constitute more than half of corporate profit growth. In addition, we believe the high operating leverage resulting from cost cutting, coupled with margins that stand well below historical peaks, provide ample scope for continued positive earnings surprises. In addition to supportive fundamentals, we see several other reasons for optimism. Global active managers are broadly underweight Japanese stocks, a potential tailwind as these positions are reversed. In addition, foreign buyers, historically the marginal purchasers of Japanese equities, have recently showed renewed interest. Lastly, we think the technical profile of the market is improving, with short- and

medium-term indicators suggesting that the underlying price trend is rotating higher. Against this backdrop, we see three potential catalysts on the horizon. One, the divergence between Japan’s consistently positive earnings revisions and market performance should resolve in favor of fundamentals, with the market ultimately following the path of higher earnings. Two, policy in Japan, both monetary and fiscal, is likely to remain accommodative, a comparative benefit as other Asian exporters facing inflationary pressures are likely to tighten. Moreover, the anticipated cut in corporate tax rates should help corporate Japan’s relative competitiveness. And three, our more constructive view on the US should strengthen the US dollar relative to JPY, a positive tailwind to Japanese equities given the recent strong negative correlation. This year’s expectations for the Topix are set forth in Exhibit 28.

Exhibit 31: Global Demand Is Far More Important to Japanese Corporate Profits Than Yen Fluctuations

Exhibit 32: Despite Higher Growth Last Year, BRIC Equities Underperformed the US

25% Percent Explained by Each Factor 20% 15% 10% 5% 0%

23.7% 21.7%


14% 12% 10% 8% 7.4% 8.3%



6% 4% 0.6% 2% 0% 2010 Equity Performance 2010 GDP Growth (Consensus Forecast) 2.8%

Goldman Sachs China Activity Index

US Retail Sales


1992 Through Q3 2010 Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Datastream

Data as of December 31, 2010 Source: Investment Strategy Group, Datastream, IMF WEO October 2010, The Economist

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Emerging Markets: Growth, But At What Price?
It may come as a surprise that despite significantly higher emerging market (EM) economic growth last year, emerging market equities did little better than their counterparts in the slower-growing US. In fact, this unexceptional performance came despite emerging markets’ impressive 30% earnings growth. As can be seen in Exhibit 32, the BRIC markets, in particular, lagged. As a group, they returned around 7.4% in local currency terms, less than a half of the S&P 500’s total return, despite growth that was, on average, over five percentage points higher. While there is little question that the structural growth profile of emerging markets is attractive, the more pertinent investment consideration is what one is paying for that growth. A large part of the performance drag this year resulted from valuation compression, as emerging markets started the year with lofty valuations. Unfortunately, valuations remain unattractive today, in our view. On an absolute basis, EM valuations are roughly 8% overvalued and have been lower about 70% of the time historically. Compared to developed markets, valuations are even more stretched, sitting some 20% above traditional levels. As shown in Exhibit 33, these relative valuations, regardless of measure, have been cheaper about 77% of the time. At least part of this valuation premium has rested on the scarcity value of growth, especially in a “new normal” environment, where developed markets offered limited growth prospects. But the recent upward revision to mature economies’ outlooks, especially the US’s, has narrowed this differential and may well pressure EM valuations further. After all, equity returns are far more sensitive to surprises in growth than absolute growth levels. It stands to reason, then, that better US growth expectations in late 2010 drove its relative outperformance, even though EM economic expansion remained considerably faster.

Exhibit 33: Emerging Markets Look Expensive on a Relative Basis On average, emerging markets have been cheaper than current relative to developed markets about 77% of the time historically.

Percent of Time EM Multiple/DM Multiple Has Been Less than Current

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Price to Book 77.8%





Price to Long-Term Cash Flow

Dividend Yield*

Price to Forward Earnings


Data as of December 30, 2010 * Percent of time EM dividend yield – DM dividend yield has been greater than current. Source: Investment Strategy Group, Datastream, MSCI

Exhibit 34: Inflationary Pressures Have Not Been Good for Emerging Market Valuations Historically
15 10 5 0 -5 -10 -15 02 03 04 05 06 07 08 09 10 Median 12M Change in P/E* (LHS) Median 12M Change in Inflation Led 5 Months** (RHS inverted) 8% 12 Month Change in Inflation (pp.) 6% 4% 2% 0% -2% -4% -6%

Data as of December 2010 *Median 12M Change in P/E among MSCI EM Index constituents **Median 12M Change in CPI among MSCI EM Index constituents Source: Investment Strategy Group, Datastream

Investment Strategy Group

Outlook 37

january 2011

This growth sensitivity is particularly acute in emerging markets, given already elevated expectations. For example, consensus longterm earnings growth forecasts stand at 18%, leaving little margin for error. Moreover, as we highlighted in last year’s Outlook, longterm structural growth trends are frequently eclipsed by cyclical factors over a shorter time horizon. As such, stronger growth in emerging markets today is fueling inflationary concerns, with the upward pressure on policy rates a clear headwind to valuation multiples, as shown in Exhibit 34. Against this backdrop, we think the exuberant sentiment toward EM equities provides a cautionary signal to contrarians. Investors’ thirst for growth exposure has fueled significant inflows into EM mutual funds. In fact, EPFR Global estimates that 70% of all global equity fund flows (both mutual and institutional funds) have accrued to emerging markets, a remarkable statistic. In addition, the combined net assets of the two largest emerging market ETFs now exceed the size of the S&P 500 SPDR (SPY), despite the fact that the US equity market is some 4 times the size of the investable EM universe. For their part, institutional investors have followed suit, with a recent survey showing a record percentage of portfolio managers overweight. This bullish positioning is very similar to the start of 2008 and 2010 – both periods preceding bouts of risk-adjusted emerging market underperformance. This is not to suggest that there aren’t pockets of opportunity in the emerging markets. Russia continues to screen well in our work, benefitting from an undervalued currency and equity market, as well as earnings that remain below trend. Moreover, Russia can be seen as a natural vehicle to express a bullish oil view, given that the energy sector constitutes nearly 60% of the MSCI Russia Index. Across EM more broadly, the energy, technology and telecom sectors also appear attractive. While the structural story behind growing EM domestic demand is alluring, the investment vehicles to capture it are hard to access and/or very expensive. Consumer staple stocks in India, for example, currently trade at around 8 times book value! Furthermore, we find purchasing the

EM index outright is too general an approach, as just 14% of market cap is represented by domestic-facing sectors. For these reasons, we continue to believe an investor can get cheaper, more transparent and less volatile access to underlying emerging market growth by owning fairly valued multinationals. These firms actually sell into emerging market regions, as opposed to the local indices which largely capture the profits of emerging market exporters. In summary, although our expected EM returns are in line with our US forecasts, riskadjusted returns are less attractive, given the higher volatility of emerging markets. As a result, we retain our neutral weighting as our generally constructive growth view makes meaningful emerging market underperformance less likely. As was the case last year, we prefer to express our positive stance on long-term emerging market growth through our currency and EM local debt tilts, as well as selective exposure through EM private equity funds, rather than EM equities outright.

2011 Global Currency Outlook
Although exchange rates have always been an instrument of monetary policy, fears that they are becoming a weapon of trade have intensified recently. To be sure, provocative headlines such as “G20 Currency Fist Fight Rolls into Town”27 or “Currency Wars: A Fight to be Weaker”28 haven’t helped. At the core of the issue is whether large global trade imbalances and the uneven growth trajectories of the world’s economies will result in the type of full-scale competitive currency devaluations prevalent during the Great Depression. Indeed, recent quantitative easing in the developed world, as well as greater capital controls in emerging markets, are seen by many as the opening salvo of a brewing currency war. Notwithstanding further sensationalist headlines, we think it’s unlikely that currency wars or widespread trade protectionism will erupt this year. Such events typically result during periods of very weak global demand –

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such as that seen during the Great Depression – when countries desperately tried to resuscitate domestic demand through competitive devaluation. In contrast to the 1930’s, today’s global growth remains relatively resilient, despite expansion that is still below potential in much of the developed world. Moreover, stronger US growth recently has lifted the dollar, at least partially easing global exchange rate tensions that followed the greenback’s weakness (from “flight to quality” flows) into early November 2010. We note that exchange rates also benefit from a natural self-correcting tendency. Thus, even if many emerging countries wished to devalue, their faster growth, rising inflation and faster policy normalization necessitates currency appreciation instead. While some have fretted about various emerging markets’ use of capital controls to prevent overheating, such controls are nothing new, as nearly every emerging country has some form of them in place. Importantly, most of these controls have represented more market-friendly restrictions by taxing, rather than banning, inflows. As long as large net inflows to emerging markets continue, we expect both incremental capital controls and further currency intervention in 2011. While these may slow down appreciation and reduce short-term speculative inflows, we do not expect such measures to reverse the moderate currency appreciation trend in emerging markets, especially in Asia. It is also important to recall that globalization itself has reduced the potential for currency wars. By significantly increasing the interdependency of countries, the cost of a serious escalation is much higher for everyone, particularly the US and China. Furthermore, countries today have more constructive ways of addressing trade disputes than resorting to competitive devaluation. To wit, the World Trade Organization (WTO) now represents most of the global economy, enabling members to voice protectionist concerns on the debate floor without causing a major impact on the underlying currency flows. Thus, while the “Currency War” proclamations are likely to continue, we do not expect them to materially disrupt the currency views we present next.

US Dollar

Despite alarming newspaper headlines calling for the imminent collapse of the US dollar (USD), we see several factors supporting its appreciation over the medium term, primarily relative to developed currencies. Chief among these is valuation. With the dollar having already depreciated close to 40% since 2002, it now stands about one standard deviation below its long-term average on a real trade-weighted basis. Historically, such valuation levels have preceded nominal appreciation over the subsequent 3-5 years. Of equal importance, all currencies reflect relative and not absolute fundamentals. Thus, while it is true the US has high budget deficits, so do most developed economies. In fact, the reserve currency status of the USD affords the government more time to address its fiscal issues before the market challenges them, particularly with roughly two-thirds of the world’s total allocated foreign exchange reserves held in dollars. Most developed economies also have historically low interest rates, have employed some form of quantitative easing and face substantial slack in their economies. Indeed, because of this excess slack, we put very low odds on hyperinflation, since the Federal Reserve has both the time and the tools available to extract the liquidity it has provided. As such, we view these frequently cited dollar concerns as necessary, but not sufficient, conditions for USD weakness. If anything, recent upward revisions to US growth and the widening growth differential to the bulk of the developed world supports further dollar strength, particularly against the euro. In contrast, many emerging markets’ tighter monetary policies in response to overheating

Although exchange rates have always been an instrument of monetary policy, fears that they are becoming a weapon of trade have intensified recently.

Investment Strategy Group

Outlook 39

january 2011

risks provide scope for some relative dollar weakness, especially to Asia. We are tactically positioned for both euro weakness and Asian currency strength. Of course, while the dollar might be the “best house in a bad neighborhood” among major developed currencies, many have begun to question the legitimacy of all fiat money. To them, the solution lies in returning to the “gold standard” under which each country’s currency is backed by a fixed amount of gold. In theory, this would assure long-term price stability and curtail central bankers’ self-directed money printing, thereby minimizing excess leverage and credit bubbles – the root causes of financial crises. But whatever accolades the gold standard wins for its simplicity, it loses for its impracticality. First, implementation would be highly deflationary, since world GDP growth would be limited by annual gold production growth, which is currently just 1.5%. Second, short-term prices would be extremely unstable, as each major gold discovery would translate into a global price shock. Third, macroeconomic volatility would increase and unemployment would rise, given the limits on central bankers to offset shocks through policy adjustments. Notably, as seen in Exhibit 35, GDP volatility was higher when the gold standard was in place, averaging about 5.8% in 1900-1944, vs. only 1.2% in 1984-2010. On this point, Barry Eichengreen, a leading expert on the gold standard, argues that far from being the stabilizing influence it was perceived to be, the gold standard was itself the main threat to financial stability and prosperity between World Wars I and II. Indeed, the gold standard contributed to the Great Depression by forcing central banks to raise interest rates to maintain parity between their currency and gold, even though their economies were already in recession. Finally, like a cartel, the gold standard only works if all members adhere to it. But as history has repeatedly shown, members are likely to abandon the standard during times of crisis, defeating its very purpose. As such, we think restoring the gold standard is as ill-advised as it is unlikely.


As mentioned above, we are tactically short the euro relative to the USD, a reflection of several underlying factors. For one, the euro is some 1015% overvalued compared to the dollar, making valuations unattractive, in our view. Second, relative fundamentals in the US are improving, particularly with the US expected to outgrow Europe in the medium-term. Moreover, risks to Eurozone growth are skewed to the downside, as political uncertainty in four of the most fragile European economies (Ireland, Portugal, Italy and Belgium) could undermine necessary fiscal reform there. Meanwhile, financial contagion remains a concern, as Portugal will likely need to be bailed out, while existing mechanisms such as the European Financial Stability Facility (EFSF) and the related European Financial Stability Mechanism (EFSM) are insufficient to save Spain if it were to follow suit. In short, continued uncertainties around Eurozone’s fiscal challenges, in addition to better relative fundamentals in the US, do not justify the euro’s valuation premium, in our view.
Pound Sterling

The pound remains fairly valued against the US dollar, while about 10% undervalued relative to the euro. As such, we expect the pound to remain relatively range-bound compared to the USD, despite the small positive carry likely to result from the Bank of England tightening before the Fed. In contrast, we think the pound should slowly appreciate against the euro, given supportive valuations and ongoing political and economic uncertainty in the Eurozone. Higher interest rates and our expectation that the Bank of England tightens ahead of the ECB are also positive catalysts. Of course, renewed concerns around UK fiscal sustainability could hurt the pound, as they did during the 2010 election campaign, but this is not our central case.

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Exhibit 35: GDP Volatility Was Higher Under the

The valuation signal for the JPY is mixed. While Gold Standard the currency appears somewhat overvalued rela- The 20-quarter rolling annualized volatility of US GDP growth has tive to the dollar on some measures, the extent of fallen significantly over time. this overvaluation differs significantly. Moreover, on a trade-weighted basis, valuation is neutral. 12% Turning to fundamentals, the yen is highly correlated with the yield differential between Japanese 10% 1900-1944 government bonds and US Treasuries: as TreaAverage = 5.8% 8% sury yields declined from their April 2010 highs, 6% the JPY appreciated. Given our expectation for 1945-1983 better growth and rising rates in the US, we think 4% Average = 2.9% 1984-Current the resulting yield differential will likely weigh 2% Average = 1.2% on the yen, as will further BOJ intervention in 0% the currency market. That said, intervention did 00 10 20 30 40 50 60 70 80 90 00 10 not prevent the yen from appreciating further in the 1990’s and again in 2003-04. Taking these Data as of Q3 2010 various cross currents together, we expect the yen Source: Investment Strategy Group, NBER to depreciate against the dollar, but not enough to warrant a tactical view at this time.
Asian Area Currencies

While emerging market currencies in aggregate have appreciated to around fair value, Asia remains the most undervalued region, in our view. China is a case in point, with the yuan some 15-25% undervalued relative to the USD. As we speculated in last year’s Outlook, the Chinese decided to resume appreciation of the renminbi (CNY) roughly 6 months ago, with the currency rising almost 3% since. Although relative fundamentals and valuation could certainly justify it, we think rapid appreciation is unlikely, given pressure from China’s exporters, political concerns about appearing to have bowed to US trade pressures, and fears that brisk appreciation could duplicate the mistakes of Japan in 1985-1987. Instead, we expect the CNY to strengthen gradually by 4-6% this year, with the Chinese authorities searching for a rate that is fast enough to ward off protectionist pressures, but slow enough to facilitate a gradual rebalancing of their economy from exports to domestic consumption. Despite expecting currency appreciation in Asia, we do not think the renminbi is the best vehicle to capture it, as China’s strict capital controls ultimately erode much of the potential gains. Instead, we recommend a basket of Asian currencies that we believe are most likely

While emerging market currencies in aggregate have appreciated to around fair value, Asia remains the most undervalued region, in our view.

Investment Strategy Group

Outlook 41

january 2011

Even with the dramatic backup in US yields in late 2010, interest rates remain extremely low by historical standards, a reflection of the depth of the recession, the resulting aggressiveness of monetary policy and the relatively tepid pace of recovery in much of the developed world thus far. Ten-year Treasury yields, for instance, have been lower only 2.5% of the time since 1962, Other Emerging Market Currencies with the bulk of those occurrences in the last Outside of Asia, we think the risk-adjusted decade. From such low starting levels, it is not returns of emerging market currencies are difficult to imagine rates normalizing higher, more balanced. For example, Latin American particularly as economic growth resumes and currencies, like the Brazilian real, offer very policy accommodation is withdrawn. Against attractive yields and large foreign exchange this backdrop, we expect fixed income to have reserves to buffer against shocks. However, paltry returns over the next three years, as seen these positives are offset by a host of negatives, in Exhibit 36. including overvaluation, more prevalent use Our tactical positioning reflects this view, of currency intervention, higher volatility and as all of our current tilts are funded out of exuberant investor sentiment. Similarly, the investment grade fixed income. Even so, we potential offered by the impressive recovery find some fixed income alluring, as we continue in countries like Poland, Israel and perhaps to maintain overweight positions in corporate Turkey is balanced against the greater volatility high yield and emerging market local debt. On associated with ongoing sovereign debt issues in the former, we think spreads are still wider than Europe. the likely path of defaults warrants, while on Perhaps not surprisingly, these offsetting the latter, attractive coupon payments coupled characteristics leave us broadly neutral on emerging market currencies outside of Asia. Even with modest local currency appreciation yield high single-digit returns. These tilts also have so, we are watching Hungary as a potential risk shorter duration than their funding source – a to ex-Asia emerging market currencies, as the comparative benefit in the rising interest rate new government’s pursuit of populist policies environment we expect. could not only be jeopardizing the country’s But for our US portfolios, our tactical existing IMF/EU aid package, but also increasing underweight to investment grade municipal its vulnerabilities to further debt concerns in bonds should not be construed as an indictment peripheral Europe. of their safety. Indeed, we continue to see this asset class as the bedrock of the “sleep well” portion of a client’s portfolio and think concerns about an imminent municipal crisis are likely overblown.
US Municipal Bond Market

to appreciate in tandem with the CNY, are undervalued and face large capital inflows that should necessitate further currency appreciation. In this regard, our favorite Asian currencies include the Singapore dollar, Malaysian ringgit, Indonesian rupiah, Indian rupee, and the Korean won, all of which are part of our Chinese Appreciation Proxy Currency Basket.

2011 Fixed Income Outlook

There has been no shortage of negative headlines concerning the municipal bond market in recent years. Put simply, they reflect the fear that states’ budgetary shortfalls, high debt burdens, waning Federal assistance and massive unfunded pension liabilities will soon conspire to produce widespread municipal defaults. While we acknowledge the intuitive appeal of

42 Goldman Sachs

this reasoning, we disagree with the conclusion. In our view, it is the failure to address these concerns that precipitates defaults, not their mere existence – and we think the states still have many options available to remedy these shortcomings. Below, we examine the key reasons for our less pessimistic view.

Exhibit 36: Expected 3-Year Returns on Fixed Income and Cash Are Paltry
1.4% 1.2% 1.0% 0.8% 0.6%


Budgetary shortfalls are cyclical and improving 0.4% 0.33% The good news for deficits is that tax revenues 0.18% 0.2% are highly cyclical. In New York, for example, 0.0% economically-sensitive personal income, sales Cash Short Intermediate and corporate income taxes account for 89% of Return* Duration** Duration*** revenues; in California, it’s 95%. Consequently, tax revenues continue to benefit from improveData as of December 30, 2010 ments in the US labor markets, as shown in Note: Returns are ISG forecasts based on current and forward yield curves, assuming portfolio duration is constantly rebalanced. Exhibit 37. As a result, each of the first three * Portfolio of 3-month Treasury bills quarters of 2010 showed sequential improve** Portfolio of 2-year Treasury notes ment in state tax receipts – a trend likely to *** Treasury portfolio with 4.6 year duration Source: Investment Strategy Group, Bloomberg continue, given the improving US growth and employment levels we expect. Against this improving cyclical backdrop, states have already taken aggressive steps to close budgetary gaps. Since fiscal year 2008, spending Exhibit 37: State Deficits Tend to Be Highly Cyclical has been reduced by about $42 billion. Even so, states continue to implement further measures, including additional spending cuts, wage freezes, 0 State Tax Revenue Growth (LHS) 15% Initial Jobless Claims (RHS Inverted) deficit financing, new taxes and asset sales. 100 10% Arizona, for instance, raised $1 billion by selling 200 5% state buildings and leasing them back. Indeed, 300 projected budgetary shortfalls do not take into 0% consideration the numerous assets that states 400 -5% own, including roads, sewers, buildings and 500 water reservoirs, which could be privatized, if -10% 600 necessary. 700 -15% In addition, we note that the alarming $160$200 billion state deficit numbers that are frequently cited in the press include projected spending increases. Excluding these increases, Data as of Q3 2010 Source: Investment Strategy Group, US Census Bureau, Datastream the shortfall is closer to $50 billion, a nontrivial but more manageable sum. New Jersey Governor Christie, for instance, was able to close an $11 billion budget gap by simply preventing automatic spending increases. While doing so is no easy political task, it is much easier, and significantly less disruptive to the economy, than cutting $11 billion worth of jobs.
State Tax Revenue Growth (YoY%) Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10

Investment Strategy Group

Outlook 43

Initial Jobless Claims (Thousands)

january 2011

States are not like troubled European Sovereigns Despite frequently made comparisons between the two, we think there are material differences. Unlike sovereigns, US states are required to operate under balanced budgets, thus preventing them from routinely issuing debt to fund deficits. Moreover, because municipal debt tends to be project specific, it has little rollover risk, is generally long-term, has a fixed rate and is paid down over the life of the bond. As a result of these differences, the average state debt/GDP ratio is just 2.4%, compared to triple-digit levels in many troubled sovereigns. In fact, state and local governments constitute just 10% of total bonded debt in the US, while the average state spends a mere 3.7% of its revenues annually servicing its debt. Deficits even without fiscal stimulus are improving Although states are set to lose about $16 billion of federal aid in the second half of 2011, this is equivalent to roughly 2.5% revenue growth, a number that could be achieved through stronger US growth and some tax increases. In fact, state budgets were set during last year’s mid-cycle slowdown, making it probable that this year’s revenues exceed expectations. As seen in Exhibit 38, even when we remove fiscal stimulus, state and local deficits have already improved some $50 billion since Q2 2009 and seem to be following a trajectory similar to the last recovery. Unfunded pensions are not a source of nearterm default risk While pension costs are a significant long-term credit issue, they are not a source of near-term default risk, in our view. States have many years to address these costs, and nearly three-quarters of states have already implemented some form of pension reform since 2007, according to PEW Center on the States report. Perhaps most importantly, growing public concern over this issue is providing governments with political cover to bring stakeholders to the table and implement difficult but necessary structural changes, such as increasing the retirement age, reducing program benefits, raising contribution rates and even converting to defined contribution plans.

Exhibit 38: State Deficits Even Without Federal Aid Are Improving State and local governments’ budget deficits without Federal aid as a percentage of GDP have improved in each of the last 3 quarters.
0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% -4.5% 99 00 01 02 03 04 05 06 07 08 09 10 -3.3%

Data as of Q3 2010 Source: Investment Strategy Group, Bureau of Economic Analysis

Defaults have historically been low…for good reason By any measure, municipal defaults have been extremely rare historically. According to a recent Fitch report, the cumulative default rate over the past ten years for all rated municipal bonds – including non-investment grade – ranges from 0.04%-0.29%, based on estimates from all three major rating agencies. By comparison, Moody’s found 2.5% of investment grade and 0.5% of AAA-rated corporate bonds default over a similar time frame. Even during the Great Depression, the worst single-year default rate was only 1.8% in 1935. Within 2 years, nearly all the defaults by larger municipalities had been cured, with an average recovery rate close to 97%!29 High recovery rates persist today, with an average of nearly 70%. This low default rate is not historical happenstance. States are constitutionally bound to balance their budgets and meet their municipal debt obligations, as creditors can sue for failure to pay. Moreover, states cannot legally file for bankruptcy and would be reluctant to do so anyway, given their ongoing need for public financing. Although other public entities can file under Chapter 9, city managers are averse to doing so given the financial and political costs, as well as the uncertainty of the outcome. Lastly,

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municipalities have several options available to address short-term cash deficits, such as issuing cash-flow notes, delaying vendor and state-aid payments, arranging lines of credit and allowing inter-fund borrowing.
Our View

With muni-treasury valuation ratios now close to their historical averages and Treasury yields expected to move higher, we expect intermediate muni total returns of around 1% this year. While headline risk will surely persist, particularly around the potential expiration of the Build America Bond program (BAB) which diverted supply to the taxable market last year, we think states still have many options to eventually bring about the required fiscal consolidation. Moreover, the recent uptick in US growth provides a positive tailwind to state and local finances. As a result, we think defaults are likely to remain uncommon, situation-specific events. Against this backdrop, we recommend that clients maintain their muni exposure. For those who remain very concerned about municipal risk, however, we suggest a move into Treasuries and/or a national muni portfolio. We do not recommend, however, diversifying into nonUS government bonds (on either a hedged or unhedged basis), as the tax considerations and transaction costs make this unattractive.
TIPS (Treasury Inflation-Protected Securities)

if inflation increases, TIPS could still generate negative returns over shorter periods if the Fed raised policy rates sooner or more than expected. Second, TIPS are better suited for tax-deferred accounts and those who are not dependent on bond income for current spending. This is because as inflation rises, the increase in the TIPS principal is considered taxable federal income, even though this increased principal is not received until the bond is sold or matures. As a result, the after-tax coupon payment for TIPS will usually be less than a nominal Treasury, a disadvantage for income-dependent investors. Thus, a client must consider both the tax and income ramifications of TIPS, in addition to the inflation view, before proceeding. For clients who remain particularly concerned about higher inflation, we recommend purchasing a mix of T-bills and TIPS. For their part, T-bills reduce the portfolio’s duration risk, while enabling clients to more frequently roll their maturing principal into new bonds at progressively higher interest rates. In fact, during the unexpected bout of UK inflation between 1988-90, a strategy of buying the UK 3-month T-Bill actually outperformed UK inflation-linked securities, although both outperformed nominal bonds. While only a single example, it’s something clients should consider in choosing the mix of securities for their inflation-hedged portfolio.

0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 -4.0 -4.5

By design, TIPS benefit from higher-thanexpected inflation. Thus, if inflation over the next decade turns out to be greater than the 2.2% currently expected by the bond market, 10-year TIPS will outperform 10-year Treasuries. While our forecast calls for tame inflation given still-excessive slack in the US economy, there is some risk that the Fed’s actions ultimately prove inflationary. In this context, longer maturity TIPS, such as the 10-year, do offer clients a valid inflation hedge, particularly given the low breakeven inflation point (2.2%). Of course, this relatively simplistic analysis comes with two significant caveats. First, breakeven rates only apply if the bonds are held to maturity; but in the meantime, investors face mark-to-market risk. In particular, TIPS decline in value when real yields rise. Thus, even

A client must consider both the tax and income ramifications of TIPS, in addition to the inflation view, before proceeding.

Investment Strategy Group

Outlook 45

january 2011

Corporate High Yield Outlook

With high yield spreads now around their long term average since 1994, this year is unlikely to register the same double-digit gains to which investors have become accustomed over the last two years. Even so, we retain a 2% overweight to corporate high yield bonds based on several investment positives. For one, recoveries on defaulted bonds are running higher than their historical average: the recent 3-month recovery rate is around 51%, compared to a long-term average of 45%. Moreover, as shown in Exhibit 39, the compression in spreads continues to track the improvement in defaults. Indeed, even assuming 30% recoveries, (a conservative assumption given the current run rate), today’s spread level implies defaults of around 7.5%. This is over two times higher than the recent three-month annualized default rate of 3.1% and comfortably above the year-ahead forecasts of either Moody’s, at 2.1%, or S&P, at 2.4%. Furthermore, we think the likelihood of future defaults has been reduced, as companies have aggressively refinanced and extended their debt maturities. As a result, the amount of debt scheduled to mature in the next three years has dropped by nearly $250 billion. Thus, although the well publicized “wall of maturities” still peaks in 2014, the intervening years now represent a more manageable refinancing hurdle. Of equal importance, strong bottom-up fundamentals continue to underpin spread compression. Among high yield companies reporting in Q3 2010, revenues were 15% higher than last year, the fastest pace in four years and the third consecutive quarterly gain. In addition, gross margins improved to 32%, also the highest level in four years. Remarkably, high yield issuers have now fully recovered the entire EBITDA shortfall they experienced during the recession. We believe that stronger US growth should further bolster high yield credit metrics. Taking these factors together, we expect corporate high yield to deliver around 6% returns this year, with risks to the upside if stronger fundamentals push spreads tighter from current levels.

Exhibit 39: High Yield Spreads Have Scope to Follow Defaults Lower

2000 1800 1600 High Yield Spread (bps) 1400 1200 1000 800 600 400 200 0

High Yield Spread (LHS) Forecast Actual High Yield Default Rate* (RHS) Moody’s Forecast High Yield Default Rate (RHS)

16% 14% 12% 10% 8% 6% 4% 2% 0% High Yield Default Rate (%)

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Data as of December 31, 2010 *Default Rate Data as of November 30, 2010. Source: Investment Strategy Group, Barclays Capital, Moody’s

Emerging Market Local Currency Debt Outlook

We continue to recommend clients overweight EM local currency debt,30 based on several supporting factors. First, EM local debt boasts a yield of almost 7%, while its spread to US debt remains close to its widest levels since 2002. Second, the relative fiscal health of emerging economies compared to developed ones favors EM bonds. While the debt burden of emerging markets is projected to remain flat at around 33% of GDP by 2015, it is expected to rise to 106% for developed countries, according to the IMF. Third, according to JP Morgan, global institutional investors account for only 7% of the EM local bond universe compared to 80% of the more traditional EM dollar-denominated bond market, providing scope for reallocation flows. Finally, EM bonds offer diversification benefits to a global portfolio, as they have about half the volatility of EM equities and a favorable correlation profile: the combination of US and EM equities only explains about 40-50% of the returns of EM local bonds. Although we expect inflationary forces in many EM markets to pressure local interest rates higher, currency appreciation in these same markets will provide an offset. Netting the two, we expect a small to moderate boost to our

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expected returns from currency appreciation, resulting in a full-year total return target in the mid-to-high single-digit range. Despite our positive disposition, we caution that EM local bonds are risky, with annual volatility of 11% and a peak-to-trough decline of 28% during the recent crisis. As such, we believe they should not be considered a substitute for the “sleep well” portion of clients’ portfolios.

Exhibit 40: Total Returns on Commodities Although it was a bumpy ride, commodity returns were mostly positive last year.

140 130 120 110 100 90 80

GSCI GSCI Gold GSCI Oil GSCI Agriculture GSCI Industrial Metals

134.2 128.7 116.7 109.0 99.9

There is little question that a combination of improving global demand, force majeure, the US Fed’s second round of quantitative easing (QE2), low rates, and fears of higher inflation provided a potent mix for commodities in 2010 (Exhibit 40). Indeed, out of a basket of 73 different commodities, including everything from metals to fibers, a remarkable 90% were up last year, well above the typical 50-70% range that has prevailed since 1974. Price gains were equally impressive, with commodities as diverse as cotton, silver and coffee all rallying more than 50%. Perhaps not surprisingly, the consensus expects a continuation of these themes this year. While our own forecast features better global growth, a positive for commodity demand, our view on the dollar and inflation is less supportive. As discussed earlier, we think excessive slack in much of the developed world will temper inflationary pressures, while better US growth is more likely to support dollar appreciation, particularly given today’s valuation levels. Moreover, better US growth makes another round of quantitative easing unlikely, removing a key source of downward pressure on the dollar. More fundamentally, we note that the connections between commodities and either the dollar or inflation have historically been very tenuous. To wit, while commodities have had a 38% correlation with inflation since 1974, the range is wide at +82% to -44%. In our view, an effective hedge should have a higher and more stable correlation. Furthermore,

70 Dec-09 Mar-10 May-10 Jul-10 Sep-10 Nov-10

Data as of December 31, 2010 Source: Investment Strategy Group, Datastream

since 60% of the US CPI basket is composed of services, commodities offer less protection from generalized inflation – precisely what investors are trying to hedge against. For its part, the dollar has been little better in driving commodity returns, as movements in the greenback explain only 16% of the changes in the price of oil and gold, on average. This is not to suggest that financial factors (e.g., the dollar) don’t sway near-term commodity price movements, but rather that they are an unstable foundation on which to build an investment case. Instead, we have found idiosyncratic factors to be the more important drivers of commodity prices over time. We expect commodity markets to remain volatile for the foreseeable future, but are not expecting prices to shift enough to warrant a tactical tilt at this point. In our view, better risk-adjusted returns can be found in other asset classes such as US equities, high yield and emerging market local debt. In the following pages, we examine the fundamentals for oil, gold and agriculture.

Investment Strategy Group

Outlook 47

january 2011


Despite the fairly anemic economic recovery in much of the developed world thus far, global oil consumption nevertheless overtook its 2007 peak last year. While non-OECD countries, China in particular, represented the bulk of the stronger demand, the resilience of US oil consumption was more surprising, contributing nearly all of the OECD growth for the year. The combined demand actually exceeded supply growth, resulting in a reduction of “floating storage” inventory – oil that had been temporarily stockpiled on ocean tankers during the recession. While inventories in total remain above their 5-year average, floating storage inventory, which served as an effective buffer to absorb improving demand, has now fallen to 60 million barrels or less, one-third of its peak level during the recent crisis, according to International Energy Agency. As such, a key question for the oil price outlook is how quickly still-elevated inventory and OPEC spare capacity will be drawn down. In our view, oil demand growth of about 1.7%2.3% seems reasonable and would be consistent with global GDP growth of around 4.0-4.5%. Supply growth from non-OPEC and natural gas liquids (NGL) production will likely fall short of

this demand growth, however, necessitating some further reduction of inventories and/or spare capacity via a higher call on OPEC production, in our view. Because both inventories and spare capacity remain high by historical standards, we do not expect a major supply shortage (Exhibit 41). Even so, near-term uncertainties remain. For instance, it is unclear at what price level OPEC will increase its production quotas, and if it does so, whether this will further stoke bullish sentiment if it is perceived as a sign of tighter supply and lower spare capacity. Ultimately, we think a combination of some further inventory draw-down, some non-OPEC production growth and some increase in OPEC production should be sufficient to meet demand. But higher oil price volatility is likely, as this dynamic unfolds. As a result, we think a slightly higher oil price range of $75-100/bbl makes sense this year, compared to last year’s expectation of $60-85/ bbl and the current NYMEX future price of about $94/bbl. Our forecast range implies 21% downside to 6% upside relative to the forward curve. As we have highlighted before, however, because the curve remains upward sloping (i.e., in contango), actual investor returns to our

Exhibit 41: Historically High OPEC Spare Capacity Should Limit Any Potential Supply Shortages

Exhibit 42: Real Rates, Inflation and the Dollar Explain Less Than Half of Gold Returns Historically

7 6 Millions of Barrels per Day 5 4 3 2 1 0 98 99 00 01 02 03 04 05 06 07 08 09 10 1.9 4.2 2.7 1.8 1.8 3.2 2.6 6.1 5.3 4.7 6.0 5.5 5.5 Trade-Weighted US Dollar 16% Real Rates (%MoM) 12% CPI Inflation (%MoM) 18%

Idiosyncratic 54%

Data as of December 20, 2010 Note: Excluding Iraq. Source: Investment Strategy Group, IEA, Bloomberg

Data from February 1973 through November 30, 2010 Source: Investment Strategy Group, Bureau of Labor Statistics, Datastream

48 Goldman Sachs

materialize, as we expect, could lead to downside risk. In addition, gold has volatility similar to equities, and has, in fact, experienced a larger peak-to-trough decline in price when compared to equities over rolling three-year windows since 1969 (-64.5% for gold vs. -56.8% for equities). In short, gold is not an appropriate substitute for the “sleep well” portion of a client’s portfolio, in Gold our view. We realize that, for many, discussing gold is The shifting composition of gold demand tantamount to debating religion: each side is is another important consideration. In just likely to have deeply held views, neither side is the last 3 years, investment demand increased likely to concede despite persuasive arguments, from 17% to an estimated 34% in 2010, while and one’s ultimate viewpoint is largely a matter jewelry demand (gold’s natural buyer) now of faith. Part of this mystique reflects the represents less than half of the total, according difficulty in determining what gold is actually to the World Gold Council. As a result, the worth, since it is a non-productive asset that investment demand for gold is reaching generates no cash flows to value. It also reflects euphoric proportions, with a recent press report the unstable nature of gold’s price drivers: announcing the availability of gold-dispensing sometimes it responds intuitively to supply/ ATMs in select markets this year! Already, the demand dynamics like most commodities, while SPDR Gold Trust has become the second largest other times it reacts more like a financial asset, ETF in the world and now represents the 5th taking its direction from the dollar or inflation largest stockpile of gold globally, exceeding the expectations. gold reserves of China and Switzerland. However, while investors may trade gold The demand characteristics of gold producers as a dollar or inflation hedge, its performance have changed as well. Indeed, the major in that capacity has been spotty historically. gold miners have spent the last several years More specifically, changes in the dollar explain repurchasing their gold hedges. With that process only 16% of the changes in gold, while shifts now near completion, another source of natural in real rates explain another 12% and CPI demand will be absent from the market this year. accounts for a mere 18% (Exhibit 42). Thus, The obvious risk in all this is that investors these typically cited justifications for owning tend to be fickle, suggesting that gold demand gold account for less than half its historical could quickly evaporate, leaving few natural price movements! Furthermore, in 60% of the episodes when inflation surprised to the upside in buyers at today’s elevated prices. In fact, jewelry demand tends to be negatively correlated with the post-World War II period, gold has actually gold prices, which leaves fewer buyers should underperformed inflation. As a result, gold has not been a consistent inflation hedge, although it investment demand falter. For their part, gold is purchased as one en masse. Of equal importance, investors purchasing gold as a form of tail risk insurance against monetary debasement should appreciate the potential effectiveness and costs of that While investors may trade gold as insurance. For instance, during the recent a dollar or inflation hedge, its financial crisis, gold actually declined over performance in that capacity has 30% from its peak in March 2008 through its been spotty historically. trough in November 2008, while the dollar served as the better safe haven, rallying 24.3%. Furthermore, gold prices have already advanced on expectations of high inflation and dollar weakness, suggesting that the failure of either to upside target would be less than implied. For example, while spot oil prices rose about 13% last year, total returns were negative 0.1%. With oil price volatility around 30%, we do not find the risk/reward compelling enough to justify a tactical tilt at present.

Investment Strategy Group

Outlook 49

january 2011

producers could start re-hedging their books if prices fell, pressuring gold further. Notably, investment demand levels similar to today have tended to correspond with peaking gold prices, as seen in Exhibit 43. While some have suggested central banks could fill any void in demand, we do not expect them to be a swing factor for several reasons. First, developed market central banks hold the vast majority of gold reserves. Thus, unless there is a significant global move away from the dollar into gold, which we don’t expect, the marginal shifts among emerging market central banks will not prove decisive. Second, central bank activity has been a poor predictor of gold prices historically. For instance, central banks were net buyers in the early 1980s as gold prices collapsed. Lastly, it’s not clear whether central banks will continue to be net buyers, as they were last year. For example, the average Eurozone member has gold reserves in excess of 30% (with some countries’ reserves well in excess of 50%), despite an ECB target ratio of 15%. For our part, we expect a combination of stronger US growth, a strengthening dollar, temperate inflation and generally higher riskasset prices to raise the opportunity cost of holding gold, particularly as real rates normalize higher. Even so, momentum is a powerful market force, and it’s unclear how long strong investor demand will persist. Given these competing tensions, gold does not screen as a compelling tactical opportunity in our framework.

Exhibit 43: High Investment Demand Has Corresponded With Gold Price Peaks Historically
Investment Share of Physical Gold Demand (%) 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010e
Data as of December 31, 2010 Source: Investment Strategy Group, Bloomberg, World Gold Council, CPM Group

45% 39%

Investment Share of Gold Demand (LHS) Real Gold Price (RHS) 34% 34%

1800 1600 1400 1200 1000 800 600 400 200 0 Real Gold Price ($/Troy Ounce)

While it has been a banner year for most commodities, agriculture in particular stands out. The S&P GSCI agriculture spot index rose 41% last year, the strongest sector within the commodity complex. What has made the space so alluring to investors is an intuitive structural story coupled with weather-induced supply shortages in 2010. Structurally, industrialization and growing per-capita income in emerging markets is providing a tailwind to agricultural demand, particularly grains. Last year, weather provided a further stimulant, given the combination of a Russian drought, downward revisions to the US corn crop yield and concerns surrounding the La

Niña meteorological phenomenon. The result has been a notable reduction in inventories, which makes prices vulnerable to further increases this year. Corn is especially susceptible, with the global corn stock-to-use ratio at 16%, well below its long-term average of 24% (Exhibit 44). Because the correlation between grain price movements is high, a function of a producer’s ability to substitute acreage, we believe the bullish backdrop for corn is in many ways the outlook for grains in general. While the foregoing narrative would point toward a long opportunity, several factors leave us tactically neutral on agriculture. First, these developments are arguably already reflected in current corn prices, which have been above current levels only 1.7% of the time in nominal terms in the past 20 years. Second, prices would have to rise more than 5% per year for investors to just break even, given the contango currently present in the forward curve. Third, while weather is difficult to predict, the exceptional events of last year are unlikely to repeat this year. Finally, despite the below average stock-to-use ratio today, corn yields could surprise to the upside, particularly given their history of doing so.

50 Goldman Sachs

Key Global Risks
Throughout this year’s Outlook, we have discussed our reasons for relative optimism: accelerating US growth, continued global economic expansion, stronger equity markets, and reduced likelihood of extreme near-term “tail-risks,” to name a few. This last item, in particular, is important, as we have said since 2008 that the greatest risk to the recovery was a major policy error. While this remains the case, the collective actions of global governments in recent years have decreased the probability of extremely negative outcomes in the near future (e.g. the US’s deliberate attempts to avoid the Depressionera blunders of premature fiscal and monetary tightening through quantitative easing and extension of Bush tax cuts, or the European Union’s creation of lending mechanisms, such as the EFSF, to its troubled periphery). Even so, significant risks remain. While the policy actions taken to date have positive nearterm benefits, their potential risks are back-end loaded. While by no means an exhaustive list, the risks below represent those that would be most 50 45 detrimental to our view:
40 35 Mismanaged Policy Exit The unsustainably 30 loose monetary and fiscal policies of much of 25 the developed world will eventually need to be 20 reversed, in our view. If the exit occurs too soon, 15 10 it could derail the recovery; if too late, it could 5 lead to an inflationary outcome and/or a loss of 0

confidence in the government’s willpower. Either scenario could increase the risk premium of government debt, thereby raising interest rates and borrowing costs. Sovereign Debt/Currency Crisis Many governments in the developed economies run large deficits and have historically high debt/GDP ratios. Moreover, structural factors, such as demographics, are projected to raise healthcare costs and pension benefits in many of them, further exacerbating debt levels. This dynamic creates two potential risks. First, these countries now have little ammunition left to react to adverse economic shocks. Second, failure to implement credible fiscal consolidation plans could lead to a loss of market confidence. As we saw in much of the European periphery last year, the result is dramatically higher interest rates, a depreciating currency and difficulty rolling maturing debt. Moreover, given global financial linkages, loss of confidence in one area of the world can be quickly transmitted to another, as we saw in April of 2010. Federal Reserve’s Loss of Independence US Federal Reserve credibility is a key component of controlled inflation expectations. Were the Fed to lose its independence through political intervention, concerns about persistently loose monetary policy and debt monetization could proliferate, resulting in unanchored inflation expectations and higher interest rates.

Exhibit 44: Low Stock-to-Use Ratios Make Prices Vulnerable to Upside Pressure 1800 Low inventories, especially in the US, could lead to higher prices this year. 1600
United States 2010-11 Marketing Year Corn Soybeans Wheat 6.2% 5.5% 37%

1400 1200 1000 Long-Term Average 80021% 600 12% 400 41% 200 0

World 2010-11 Marketing Year 16% 24% 27% Long-Term Average 24% 16% 29%

Data as of December 2010 Source: Investment Strategy Group, US Department of Agriculture, World Agricultural Supply and Demand Estimates

Investment Strategy Group

Outlook 51

january 2011

Even outside the US, inflation expectations becoming unanchored, either from central bank misdeeds or more generally from spiraling costs, could prove disruptive to the markets. US Housing While low-single-digit home price movements up or down are unlikely to have a material impact on our view, a renewed and meaningful fall in housing prices would. First, this would decrease household wealth and consumer confidence, undermining consumption. Second, this would negatively impact the banking system and curtail credit availability, as the majority of bank assets remain backed by real estate. Major Geopolitical Event An outbreak of war or a major terrorist act could undermine confidence and disrupt trade with negative repercussions for financial markets. Hard Landing in China With China being a key source of marginal global demand and growth, we believe a hard landing there would have negative repercussions across the full spectrum of asset markets, particularly in the emerging markets. Trade War Although a variation of a policy error, a trade war resulting from the implementation of protectionist policies could hobble global trade and thereby hurt growth, as it did during the Great Depression.

in closing, we’ll reiterate what we said earlier:

we have no crystal ball. We offer our views with a measure of humility, knowing full well that 2011 will likely bring issues and circumstances we didn’t expect. But it is a year we look forward to with confidence that the US will continue on as the world’s financial and economic leader. This is what we hope to convey to our clients in this issue of Outlook: America, in our view, is well on the road to recovery and should continue to improve steadily from here. Stay the course. n

52 Goldman Sachs

Footnotes 1. Alexis de Tocqueville, Democracy in America, Volume I, 1835 2. Paul Krugman, The New York Times, May 20, 2010 3. Megan McArdle, The Atlantic, October 5, 2010 4. George Santayana, Reasons in Common Sense, Volume I of The Life of Reason, 1905 5. “Japan’s Tale of Caution on Fed Monetary Policy,” The Wall Street Journal, 11/22/2010 6. Jay Ritter, “Economic Growth and Equity Returns,” Pacific-Basic Finance Journal, October 2004 7. Dominic Wilson and Stacy Carlson, “Our 2010 GES: The Links Between Growth Conditions, Growth and Markets,” Goldman Sachs Global Economics, Commodities and Strategy Research, December 15, 2010 8. “China’s Next Leap Forward,” The Wall Street Journal, Sept. 29, 2010 9. Alwyn Young, “Gold into Base Metals: Productivity Growth in the People’s Republic of China during the Reform Period,” Journal of Political Economy 111, Dec 2003 10. John Steele Gordon, Hamilton’s Blessing: The Extraordinary Life and Times of Our National Debt, Walker & Company, 2010 11. Jan Strupczewski, Ingrid Melander, “IMF Critical of Eurozone Crisis Management,” Reuters, December 7, 2010) 12. Ian Bremmer, “The End of the Free Market: Who Wins the War Between States and Corporations?” Portfolio, 2010 13. “In Lula’s Footsteps,” The Economist, July 1, 2010 14. Anton Sychev, Geydar Mamedov, Arjun Murti, Nilesh Banarjee, “Rosneft vs. BRIC NOCs: Up to Neutral on cross-regional comparison,” Goldman Sachs Global Investment Research, July 12, 2010 15. Nicholas Eberstadt, “The Demographic Future,” Foreign Affairs, Nov/Dec 2010 16. Giovanni Peri, “The Effects of Immigrants on US Employment and Productivity,” Federal Reserve Bank of San Francisco, August 2010 17. Interview with Charlie Rose, October 2009 18. Michael G. Finn, “Stay Rates of Foreign Doctorate Recipients from US Universities, 2007,” Oak Ridge Institute for Science and Education, 2010 19. Battelle, “2011 Global R&D Funding Forecast,” R&D Magazine, Dec 2010 20. Laureates are counted in all countries in which they have lived or worked for a significant period of time. 21. John Steele Gordon, An Empire of Wealth: the Epic History of American Power, Harper Collins, 2004 22. Joseph S. Nye, Jr., “The Future of American Power: Dominance and Decline in Perspective,” Foreign Affairs, NovemberDecember 2010 23. Sommer Martin, “Prospects for the U.S. Household Savings Rate,” IMF Article IV Report on the United States, Selected Issues Paper, July 2010 Jaewoo Lee et al., “U.S. Consumption after the 2008 Crisis,” IMF Staff Position Note SPN/10/01, January 2010 24. Savita Subramanian “Quantitative Strategy Update: Diagnosis of a tough 2010; what’s next?” Bank of America/Merrill Lynch, November 16, 2010 25. www.SentimenTrader.com Morning Report, November 30, 2010 26. Bank of America / Merrill Lynch Global Strategy Weekly, December 10, 2010 27. Financial Times, October 11, 2010 28. Wall Street Journal, September 29, 2010 29. “Municipal Market Update,” AB Bernstein Global Wealth Management, June 2010 30. As represented by the JP Morgan Government Bond IndexEmerging Markets (GBI-EM) Global Diversified.

Investment Strategy Group

Outlook 53

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54 Goldman Sachs

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