Investment Management Division

Up Periscope

Scanning the horizon in pursuit of safe harbors and attractive investment opportunities.

Investment Strategy Group

January 2012

section 1

Up Periscope
3 Many investors battened down the hatches in 2008 and have remained below deck in an attempt to stay clear of the turbulence. But we believe that in the midst of all this volatility and uncertainty, there lie both safe harbors and attractive investment opportunities.
The US: More Than a Safe Harbor


The US is best positioned for a cyclical recovery as well as for eventually dealing with its single structural fault line: its growing debt burden at a time of political gridlock. 14 The Eurozone: Will Incremental, Reactive
and Inconsistent Policy Persist?

The most likely path for 2012 is a continuation of the recent policy approach and accompanying financial market volatility, but concerns about a more adverse outcome are justified. 17 China: Cyclical and Structural Concerns The cyclical risk of a hard landing in China is more limited than the long-term structural one of avoiding major dislocations in the transition to a more diversified economy.

section 11

section 111


2012 Global Economic Outlook


2012 Financial Markets Outlook

21 United States 25 Eurozone 27 United Kingdom 27 Japan 28 Emerging Markets

34 United States 39 Eurozone 40 United Kingdom 40 Japan 41 Emerging Markets 42 Currencies 45 Fixed Income 52 Commodities 57 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: US Department of Defense

section i

Up Periscope

Scanning the horizon in pursuit of safe harbors and attractive investment opportunities. PHOTO TBD
Sharmin Mossavar-Rahmani Chief Investment Officer Investment Strategy Group Goldman Sachs

Brett Nelson Managing Director Investment Strategy Group Goldman Sachs

Additional Contributors from the Investment Strategy Group: Neeti Bhalla Managing Director Leon Goldfeld Managing Director Jiming Ha Managing Director Maziar Minovi Managing Director Benoit Mercereau Vice President Matthew Weir Vice President

as we formulate our 2012 Outlook and finalize our investment recommendations for our clients, we are struck by the tremendous amount of uncertainty in the economic and investment outlook. Three and a half years have passed since the onset of the financial and economic crisis of 2008, yet for many investors, the storm feels as if it has barely diminished. After all, we’ve witnessed a record $2.2 trillion of fiscal stimuli, including about $930 billion in the US, $420 billion in China, $320 billion in Japan, and $270 billion in Europe. There have also been extensive and unconventional monetary policies – from zerointerest-rate policies to “quantitative easing” measures, which have increased the balance sheets of the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England by a total of $4.5 trillion. Yet global growth is still not on a certain and sustainable path. On the contrary, concerns about double-dip recessions and major policy mistakes abound. Not surprisingly, many investors battened down the hatches in 2008 and have remained below deck in an attempt to stay clear of the turbulence. But we believe that in the midst of all this volatility and uncertainty, there lie not only safe harbors, but also attractive investment opportunities.

” “Could America Turn Out Worse than Japan?” “The Eurozone’s Double Failure” and “Will China Break?” are reminiscent of those seen in the depths of the crisis.” The answer to this question. and the ability of China Fear Valuation & Greed Drive to rebalance an investment-led and exportHistory Appropriate Markets in the Orientation is a Useful Investment Short and and Margin led economy to a more diversified consumerGuide Horizon Intermediate of Safety Terms oriented economy. before we proceed. Rather. Cyclical concerns cover a broad spectrum of issues. It is with this fundamental premise in mind that we put forth our 2012 investment outlook.” “Financial Markets in Greater Danger than 2008. in other words. the very survival of the Eurozone as a monetary union in the absence of real fiscal and political union. adopt a long-term investment perspective and accept that investing involves making rational and enduring decisions at times of profound uncertainty.1 It is useful to examine and categorize these anxieties. and evaluate the most likely outcome of each one. but don’t exit the market altogether. Appropriate Level of Diversification 4 Goldman Sachs . First. They also include worries Investment Philosophy about a hard landing in China as a result of deterioration in the real estate sector and slower growth in its export-destination countries. we think it is important to reiterate two key pillars of our tactical asset allocation investment philosophy (See Exhibit 1). We then provide a more detailed analysis of our economic and investment outlook for 2012. they range from a “lost decade of growth” in the US as a result of the financial crisis of 2008. either. In the face of such cyclical and structural headwinds. When we examine these cyclical and structural issues. Investment Philosophy Structural concerns include the long-term Tactical Asset Allocation fiscal profile of the US in the face of political gridlock. However. to a deep recession in the Eurozone as a result of austerity measures. how should our clients formulate an investment strategy for 2012? Should they sit on the sidelines and avoid the storm or should they trade more actively to try to catch the big waves? Source: Investment Strategy Group Here we are reminded of a Sunday Night Insight we published in March 2009 where we quoted Seth Klarman of The Baupost Group: “The ability to remain an investor (and not become a day-trader or a bystander) confers an almost unprecedented advantage in this environment. to dimming prospects for Japan after the recent triple whammy of earthquake. In this report. tsunami and Exhibit 1: The Key Pillars of ISG’s Tactical nuclear accident. Current concerns fall into two categories: cyclical concerns that focus on nearterm economic growth prospects and structural concerns that focus on long-term sustainability of existing political or economic frameworks in various countries. is neither: don’t step up your trading activity because of the market choppiness. so they may be better understood and addressed. we examine in detail the cyclical and structural concerns for the major countries and regions of the world. history is a useful guide.january 2012 Defining the Concerns We are hearing a consistent line of questioning from our clients this year: Are we in for yet another year of ominous fiscal and financial developments in 2012? Will things finally start to improve? Or can we expect the situation to get even worse? Recent media headlines have provided little in the way of comfort: “IMF Chief Warns Over 1930s-style Threats.

US Treasuries returned about 15%. with non-negligible risks of economic or financial unraveling across some countries and/or regions of the world. respectively. given that European policymakers have approached the sovereign debt crisis incrementally over the last two years. even with our revised probabilities. Europe and Emerging Markets The US: More Than a Safe Harbor Readers of our annual Outlook reports know that we have long been optimistic about the US relative to other markets. emerging markets as measured by MSCI EM returned -18%. we believe that the US is best positioned for both a cyclical recovery and dealing with what we see to be its single structural fault line: its growing debt burden at a time of political gridlock. They barely lagged Swedish bonds and lagged Australian bonds by 3%. As we scan the horizon. Cyclical and Structural Headwinds Facing the US.” Our rationale was that while there are some similarities between the US and Japan. This makes effective diversification even more important – a portfolio must be constructed to withstand the more probable short. The differences we highlighted were: 1) real estate and equity valuations were significantly higher in Japan at the beginning of its crisis in 1990 than the US’s peak valuations in 2007. we can assume that they will continue with incremental policy responses throughout 2012. If we were to factor in the depreciation of emerging market currencies. US equities have outperformed all major equity markets: developed markets as measured by MSCI EAFE returned -12% in US dollar terms. yet still profit from the longterm upswings (which. diversification is key.P. we discussed why the US would not face a Japan-style “lost decade. that probability diminishes. With respect to emerging market debt. with Germany and Japan being two of the worst performers at -17% and -12%. while the US has favorable demographics through a combination of higher Investment Strategy Group Outlook 5 . Second. resulting in productivity growth accelerating in the US after the financial crisis while it decelerated in Japan for several years in the early 1990s. with Brazil and India being two of the worst performers at -22% and -37%. Using a basket of maturities based on the J. 2) monetary and fiscal policy responses in the US were faster. We have typically ascribed a 60–75% probability to our central case forecast scenarios. In our 2011 Outlook. Similarly. This year is no different. Such returns were achieved despite Standard and Poor’s downgrade of US government debt from AAA to AA+ on August 5. there are far greater and more notable differences. outperforming German and most other European bonds as well as Japanese bonds in their respective currencies. US bonds outperformed local debt by about 17%. this year. 4) US companies restructured more quickly and more extensively. with less than a third of the precious metal’s volatility. At times of heightened uncertainty. larger and more extensive than Japan’s were during the early stages of its crisis. US Treasuries also outperformed gold in 2011.and intermediateterm downdrafts. respectively. For example. remain more likely to occur). to 55% (the only recent year lower than that was 2008. With a total return of 2% on the S&P 500 in 2011. We should note that the US bond market is 80 times the size of the Swedish bond market and 40 times that of the Australian market. at 50%).we look at them through a historical lens and make assumptions based on how similar issues played out in the past. and 5) Japan has unfavorable demographics with a declining working population. Morgan Global Bond Index 7–10 year series. US bonds outperformed dollardenominated debt by about 8% and local currency debt by 7%. What is different now is that the financial markets seem to agree with us. 3) US policymakers were much more aggressive in responding to the crisis in the financial sector and the financial sector has been much quicker to deleverage. US Treasuries provided some of the best returns in global government bond markets. the probability of our US central case is down significantly.

As shown in Exhibit 3. Hong Kong 1997. history is just a forward-looking guide – not a perfect forecast.7% 2.0 8. “The Aftermath of Financial Crises”(NBER Working Paper Series. and if the downdraft has followed Reinhart and Rogoff’s “broadly similar patterns” across developed and emerging market countries (including two pre-World War II episodes for which data is available). real growth rates dropped by an average of 3%.5% 7. leading economic indicators point toward moderate growth in 2012 (discussed in detail in Section II of this report).5% 6. then history suggests the recovery might very well follow suit.5% per annum starting sometime in late 2012 or early 2013. Sweden 1991. Carmen Reinhart and Kenneth Rogoff. Starting with the growth-supporting factors. Average of 5 Large Financial Average of Crises* Full Sample** Real GDP per Capita Peak to Trough Duration (Years) Real House Prices Peak to Trough Duration (Years) Real Equity Prices Peak to Trough Duration (Years) Unemployment Rate Increase (pp. the increase in the unemployment rate to date is less than the averages. Japan 1992 ** Norway 1899.pdf Single column january 2012 BF Exhibit 2: The Key Characteristics of Past Financial Crises The financial crisis in the US shares striking similarities with past severe financial crises.5% 6. Korea 1997. the US would approach pre-crisis growth rates by late 2012. So we have to weigh the cyclical and structural factors that can boost growth against the cyclical and structural factors that can hinder growth. in the subsequent five years. Obviously. the peak to trough drop in home prices and equity markets in the US are in line with the averages – both that of the 15 countries overall as well as that of the five larger developed countries. As shown in Exhibit 2. It takes about four years before growth approaches the rate seen before the crisis. Norway 1987. the US will not only avoid a lost decade.) Duration (Years) Government Debt Increase (% GDP) Duration (Years) 29.0% 4. If this analogue holds. US 1929.4**** 38%*** 4. Indonesia 1997.0 US 2007 Data as of 2011 * Spain 1977. Sweden 1991.8 9.3% 1.TableBF/2_v9_123111_v2_sho. In our view.5 4. "The Aftermath of Financial Crises. In many ways.2 55. January 2009).8% 3. In the meantime. Argentina 2001 *** Currently ongoing **** Excludes Hong Kong Source: Investment Strategy Group. but – if history repeats itself – it is likely to grow at 2. International Monetary Fund. Maddison.8 32.3%**** 4. Datastream. we believe there are two key cyclical ones that point toward a greater likelihood of the US following this historical analogue: extensive private sector deleveraging over the last several years and a strong corporate If this analogue holds.1% 1. Finland 1991.9% 3. Finland 1991. Importantly.5 51. however.4 58% 1. Bloomberg. growth picked up and approached the average growth rate prior to the financial crisis – the one stark exception being Japan. the US has followed the path of a typical severe financial crisis. the US would approach pre-crisis growth rates by late 2012. Philippines 1997. in the first five years following the beginning of a financial crisis. Malaysia 1997.6 7. In several extensive studies including their recent working paper." NBER Working Paper #14656. January 2009 fertility rates and immigration. Norway 1987. Spain 1977. Colombia 1998. Japan 1992.8 5.1% 5.2% 2.9 5.5 37. Thailand 1997. The debt-to-GDP increase is greater – a cause for concern that should be watched closely.2 35.0 33%*** 5. While US unemployment is at unfamiliar and uncomfortably high levels. Carmen Reinhart and Kenneth Rogoff have analyzed the depth and duration of economic and asset market drops after severe financial crises across 15 developed and emerging market economies (including the Great Depression in the US). World Bank. 6 Goldman Sachs .

5% par with that last seen in the fourth quarter of 18.) 3 Years Following Trough Subsequent 3 Years Private Debt (% GDP) 5 Years Following Peak (Change pp. at 18.2% mortgage.0% 1993 after the deep 1990–91 recession caused by the savings and loan financial crisis. Federal Reserve will be supportive of consumption and hence GDP growth. Extensive Private Sector Deleveraging Exhibit 3: Past Financial Crises: The Shape of the Recovery The history of large financial crises suggests US growth will return to around trend in late 2012.2%. This 17. 15. Bloomberg. currently 4 years since crisis. as well as lower interest rates on the debt that remains. Carmen Reinhart and Kenneth Rogoff. We examine each of these factors in turn below. The structural factor that we believe could hinder US growth – the key fault line.pdf BG balance sheet and earnings backdrop. Average of 5 Large Financial Crises* Real GDP (Ann. With respect to factors that can hinder US growth. and a * Spain 1977. real GDP growth has been basically flat.TableBG/3_v8__jc_v2_sho. financial obligations as a percent of personal disposable 19. Since the beginning of the Source: Investment Strategy Group. Norway 1987. we do not expect it to have a materially negative impact on US growth. Source: Investment Strategy Group. immigration and rule of law. if you will – is the burgeoning debt-to-GDP ratio in the face of political gridlock.8% 1.0% through higher savings rates and lower rates 16. Our view is that the overleveraged private sectors *** Spain and Japan never returned to their pre-crisis average growth rates. and partly due to 16. in the US – households and the financial sector – have actually deleveraged quite substantially already. Crises. There are also several structural factors that support growth. World Bank.5% of new consumer borrowing. Finland 1991. in turn.9% in the third quarter of 2007. Sweden 1991.5% decrease is partly due to household retrenchment 17. innovation.) –6% One of the key issues that has been put forth since the financial crisis is that deleveraging will force US growth to be below trend for the Data as of 2011 foreseeable future. International Monetary Fund.1% 3.7% 0. Maddison.) 5 Years Following Crisis Subsequent 5 Years Years to Recover*** Nominal Equity Prices (Ann. January 2009 reflecting a peak-to-trough drop of 5. After peaking since the crisis.0% - US 2007** Investment Strategy Group Outlook 7 . everything from superior corporate management to economic diversity. the Eurozone credit crisis is certainly a cyclical factor that bears concern. Consider the household sector. The Federal Reserve of Dallas has 19% 12% 24% 3.0% 80 83 86 89 92 95 98 01 04 07 10 We believe that the current low rate of debt payments as a percent of personal disposable income is sustainable and will allow the savings Data as of November 2011 Note: Debt and other financial payments as a percent of disposable personal income rate to stay in the 4–5% range – which.4% since the trough.7 2. “The Aftermath of Financial crisis. but barring a complete meltdown in Europe.) Prior to Crisis (Prior 10y Ann. Japan 1992 cumulative growth rate of 5. Exhibit 4 Exhibit 4: Household Financial Obligations Ratio probably best shows the extent of the decrease of US households have significantly reduced their financial burden the financial burden of households. This level is on 18.0% income have dropped to 16. credit card and auto loan defaults that 16.2%.” NBER Working Paper #14656. Datastream.0% 3.) –11% –20% Subsequent 5 Years (Change pp.0% 15. ** Ongoing.5% reduce the overall household debt.

S&P operating earnings per share in the third quarter of 2011 reached their highest level ever. 8 Goldman Sachs . We conclude that the more leveraged private sectors of the US economy have already deleveraged to sustainable levels.7%. As shown in Exhibit 7. US companies are entering 2012 in a strong position. strong cash hoards and robust earnings. Cash is at a 40-year high at 11. This ratio has been lower only 5% of the time since 1970. this ratio is close to its average at 19. As shown in Exhibit 5. Between low debt levels. 14 13 12 11 10 RECESSION 13.0 9 8 9.6%. We discuss our S&P 500 views in greater detail in Section III. as shown in Exhibit 6. This two-decade low holds whether we look at equal-weighted or market capitalization-weighted data. In aggregate. corporate America has a healthy balance sheet. 2011 Source: Investment Strategy Group.0 times. compared with a 40-year-plus average of 14. Federal Reserve similarly stated that household “de-levering may be nearing an end.6%. including small and mid-size companies.0 times to 9. eclipsing the 2007 second quarter record by 5%. If we look at all non-financial companies in the US. we also observe low debt levels and close to record cash levels. This earnings achievement is even more remarkable in the face of zero growth in real GDP since the beginning of the financial crisis. In addition. if we look at financial sector leverage relative to shareholder equity for the financial institutions in the S&P 500. financial corporations’ debt-to-GDP has decreased from a peak of 120% in 2008 to 90% by the third quarter of 2011.2%. This level is on par with that last seen in 2001.”2 The financial sector has also made considerable progress in deleveraging. 140% 120% 100% 80% 60% 40% 20% 0% 75 80 85 90 95 00 05 10 90% 120% Data as of Q3. and full-year 2011 earnings appear on track to reach the highest level on record. The earnings backdrop for US companies is quite robust as well.0 91 92 93 94 91 95 96 97 98 99 00 01 02 03 04 05 06 07 09 10 11 Data as of September 30. that ratio has declined to the lowest level in over two decades – from a peak of 13.january 2012 Exhibit 5: Financial Corporations’ Debt to GDP Financial corporations have reduced their debt-to-GDP ratio by 30pp since 2008. net longterm debt (including the impact of cash) as a share of balance sheet assets for the 1500 largest US companies is at 10. Intrinsic Research Looking at the broader non-financial sector. 2011 Source: Investment Strategy Group. Strong Corporate Balance Sheet and Earnings Backdrop Exhibit 6: Financial Sector Leverage Ratio Leverage among S&P 500 financial firms has fallen to all time lows.

500 stocks excluding autos.33 US Germany Sweden Japan Canada France Australia Italy UK Poland Ireland Portugal Brazil Greece India China Data as of 2010 Note: Values are a diffusion index that returns values from 1-5 based on the average of diffusion indices (1-5) for 18 management practices Source: Investment Strategy Group. concludes that after a decade of research into global management.98 2.18 3.” We touched upon several advantages that account for US “exceptionalism. new research at leading academic institutions has confirmed and quantified the major structural advantages the US enjoys. Companies with better Exhibit 7: Cash and Net Long-Term Debt As a Share of Balance Sheet Assets Non-financial corporations in the US have low debt and close to record cash reserves. followed by Germany and Sweden.” making more money.” As shown in Exhibit 8. “American firms are on average the best managed in the world.64 3. like Brazil. India and China. natural resources and the importance of shareholders as the primary stakeholders.99 2. The first study.3 3. US companies maintain this advantage over their counterparts in other parts of the world. Investment Strategy Group Outlook 9 . 20% 18% 16% 14% 12% 10% 8% 6% 4% 70 78 86 94 02 10 Cash (LEFT SCALE) 19% Net Long-Term Debt (RIGHT SCALE) 18% 17% 16% 15% 14% 13% 12% 11% 10% 9% Data as of November 2011 Note: Based on largest 1.2 3.88 2. and emerging market countries.18 3.8 2. “Why Do Management Practices Differ Across Firms and Countries?” by Nicholas Bloom and John Van Reenen of Stanford University and the London School of Economics. profitability and safety of our clients’ assets in the long run. data smoothed on a trailing one-year basis Source: Investment Strategy Group. financials and utilities. The second study. 3. have the lowest scores. “Why do Management Practices Differ Across Firms and Countries?” Journal of Economic Perspectives.69 2.1 3.The Key Structural Advantage: A Diverse and Innovative Economy In our 2011 Outlook. immigration. Nicholas Bloom and John Van Reenen. “The Atlas of Economic Exhibit 8: Corporate Management Rankings by Country American firms are on average the best managed in the world.79 2. Empirical Research Partners management “massively outperform their disorganized competitors. respectively. Countries in southern Europe. the United States has the highest management practice scores. education.4 3.65 2. we highlighted the inherent structural resiliency of the US and its institutions.15 3.65 2.00 2. Among multinationals. Since then.0 2. such as Greece and Portugal.7 2.88 2.” including demographics. which “provide a direct and positive impact on the viability. having higher stock market values and surviving for longer.6 3.9 2. Winter 2010.13 3. growing faster. innovation. but the gap is less.99 2.

local control over manufacturing costs. captures information about the complexity of the set of capabilities in a country and closely matches its income per capita. This economic complexity. General Electric. announced plans to increase its capacity in North America – not just for American consumption but for exports around the world. the authors estimate that by 2015. a notable range of US companies announced their intentions to move some of their manufacturing from emerging market countries – primarily but not exclusively from China – to the US. General Motors. When we combine this Economic Complexity Index with the Economic Freedom Index from the Heritage Foundation and the Ease of Doing Business Index from the World Bank. The more complex an economy. we are seeing an increasing number of large companies moving at least some of their manufacturing back to the US. manufacturing in some parts of the US will be just as economical as manufacturing in China.january 2012 Complexity: Mapping Paths to Prosperity.. 10 Goldman Sachs . Japan and Germany rank as #1 and #2 and the US is the next large country at #13.” highlights the key factors making China less. compared to steady growth of this population in the US.” as are higher utility costs. a flexible work force and strong productivity growth. and is also predictive of intermediate to long-term future growth. they confirm that US economic capabilities and resources make it a great investment destination well beyond its safe haven status. “Rising wages. We should note that this study excludes the service sector. where the US is highly competitive. It specifically mentions intellectual property theft and trade dispute concerns with respect to China. “Made in America. et al of Harvard University and Massachusetts Institute of Technology. Perhaps most strikingly. It is an interesting coincidence that 2015 also marks the peak level of the working-age population in China. manufacturing in some parts of the US will be just as economical as manufacturing in China. shipping costs and land prices – combined with a strengthening renminbi – are rapidly eroding China’s cost advantages. Oil imports as a share of consumption have declined from a peak of 60% in 2005 to 45% in 2011. this compares Perhaps most strikingly. but the facts speak for themselves: at the margin. Caterpillar and NCR. Others are the Coleman Company (plastic coolers). fewer supply chain risks (as illustrated by the earthquake in Japan and floods in Thailand) and better quality control.” by Ricardo Hausmann. Again: Why Manufacturing Will Return to the US. the authors estimate that by 2015. In their Annual 2011 Country Attractiveness Score. We do not know if that prediction will materialize. provides a new approach to measuring the diversity of an economy by looking at the number of products exported by a country and the number of other countries that also export each of those products.cost country” with declining or moderately rising wages. In aggregate. Cesar Hidalgo. attractive. Examples include some of the largest US companies: Ford Motor Co. Such a reverse migration back to US shores is also occurring in the oil industry. as shown in Exhibit 9. the broader the range of its exports. Singapore is ranked #1 and the US is ranked #2. however. Manufacturing Moves Back to the US Throughout 2011. Sauder (furniture). Honda Motor Co. Wham-O (maker of such toys as Frisbee and Hula Hoop) and Sleek Audio (in-ear headphones). Of course. Alexander Groh et al ranked the US the #1 destination for venture capital and private equity investments. while the US is becoming a “lower. And what is most interesting is that these strengths are not lost on corporate America. in turn. What explains such an important shift? An August 2011 report by the Boston Consulting Group. In December. none of these various rankings alone tells the whole picture. at least. and the US more. companies are moving some of their manufacturing to the US. respectively. The US has gone from being a net importer of refined oil products for over 50 years to a net exporter of 742 thousand barrels a day. The study also cites shorter lead times.

2% China 4% 2% 0% 0. we estimate the net exposure to the GIIPS to be only about $43 billion.6% Japan Other EM TOTAL TOTAL Core Rest of Canada Mexico Eurozone Europe Data as of 2010 Source: Investment Strategy Group. including exposure to multinational corporations.9% China 0. Italy.4 However. the US working age population is projected to expand through 2050. where companies (management and labor) have the freedom to innovate.5% 1. to leverage technology. Datastream. Direct financial impact through the exposure of the financial sector (banks and investment portfolios) to losses and tighter credit availability from European banks to US businesses. would probably reduce US GDP by 5 basis points or less. of which. A sobering September 2011 report from the Congressional Research Service (CRS) estimated that US banks have about $641 billion of gross exposure to the troubled Greece.6% 0. Index (100=2010) Exhibit 10: US Exports by Trading Partner (% of GDP) US exports to Europe comprise just 3% of US GDP. Indirect financial impact through an increased risk premium.Exhibit 9: Working Age Population (2000 . United Nations Population Division Data as of 2010 Source: Investment Strategy Group.7% 150 140 130 120 110 100 90 80 70 60 00 05 10 15 20 25 30 35 Russia 40 45 50 United States Brazil India 10% 8% 6% 5. Portugal and Spain) and the rest of Europe are just 0. and US exports to peripheral Europe (defined as Greece. Gross exposure – the CRS’s figure – is substantially reduced through a range of hedges. Eurozone Sovereign Debt Crisis Unlikely to Pose Major US Threat The cyclical and structural strengths of the US notwithstanding. Ireland. according to our colleagues in Goldman Sachs Global Investment Research. which would lower the value of US equities and nongovernment bonds. just one-tenth go to the GIIPS. which is our central case. There are four channels by which this crisis can spill over to the US: 1.3 In terms of the direct financial impact.5% 1. International Monetary Fund to peak imports of 4. we believe that the impact through the first three channels will be muted. Barring a fundamental unraveling of the Eurozone. the US is not an island.2050) Unlike many emerging markets. Exhibit 10 shows that US exports account for only 13% of GDP. US economic growth is exposed to a significant deterioration in the Eurozone sovereign debt crisis.3% GIIPS 1. respectively. and 4. Such a shift is just another example of the structural advantages of the US. 14% 12% 12.1% 2. Some of these hedges are composed of credit protection Investment Strategy Group Outlook 11 . A mild recession in Europe. 3.6%.2 trillion-plus to German and French banks.1 million barrels a day in October 2005. both US banks and US investment managers have already significantly reduced or hedged their Eurozone exposure. 2.3% and 2. to move and adjust to market signals as they deem fit. Direct impact on the earnings of US companies with businesses in Europe. Ireland. based on data provided by the major globally oriented US banks in their quarterly statements.5% 4. Italy. if it were to materialize. Direct economic impact through trade. Portugal and Spain (GIIPS) bloc and another $1. With respect to the impact of diminished trade.

Our calls also included key Washington opinion makers on this issue: Norm Ornstein. The US Structural Fault Line: A Growing Debt Burden in the Face of Political Gridlock “If you would like an empirical law of government behavior. Of course. Estimates of total European exposure among these companies range from 15–20%.1% on US GDP and -0. It is important to keep in mind that while the headlines focus on notional exposure. a member of the Finance Committee. a mild recession of 1% or less in Europe would probably reduce S&P 500 earnings by 1–2%. inconsistent statements from European policymakers and front page news reports of strikes and protests in Italy all take their toll on investor confidence.3% on US equity prices. Vitek and Bayoumi estimate that a much more severe shock with Italian and Spanish 10-year rates at over 11% and 10%. it is the net exposure that could be a source of loss and a hit to bank capital – and that number is substantially less than the trillion dollar headlines. For example. as well as Senators Trent Lott. Over the course of 2011. and Nordic banks. including exposure to the UK. and Maya MacGuineas of the Committee for a Responsible Federal Budget. In a recent discussion paper. in our view. every country. “Spillovers From the Euro Area Sovereign Debt Crisis: A Macroeconometric Model Based Analysis.” —Alex J. partially offset by an increase to Dutch. While Congress did not ultimately “go . financial conditions in the US are unchanged from the beginning of the year. concerns about some European countries rolling over their debt. we do not think the indirect financial impact on the US will be material. who co-chaired President Obama’s bi-partisan deficit reduction commission.4%. The biggest reduction has been to French banks at 89%. Investment management firms have also reduced their exposure substantially. Again. Senate Majority Leader. a more serious downside scenario in Europe would have a much greater impact. our goal was to assess the probability of a so-called “grand bargain” to reduce the long-term debt burden of the US. Chairman of the Budget Committee. and John Breaux. Fears of a disorderly default in Greece. the deteriorating fiscal profile of the US and the absence of any reform is of grave concern. Swiss. With respect to S&P earnings derived from companies’ operations in Europe. every party. we hosted four client calls discussing the US fiscal outlook with distinguished former policymakers including Senator Alan Simpson. according to a Fitch Report from December 2011. however. we note that it is very difficult to have a precise number for the aggregate exposure of the S&P since many companies do not break down their earnings geographically in their financial reports.1% from US GDP and 9% from US equity prices. would detract 1. every time. US prime money market funds have reduced their Europe exposure by 45% since May. it is that in a panic or threatened financial collapse governments intervene: every government. The hardest spillover effect to gauge is the indirect financial impact. Current exposure stands at 33. the lack of fiscal reform due to political gridlock is the only structural fault line the US faces. the cumulative effect of the Eurozone crisis has been -0. While some companies have higher exposure and will be affected much more.january 2012 purchased from institutions outside the GIIPS region and others involve high quality collateral.5 Given our central case of a mild recession in Europe. Judd Gregg. the reason this impact is more muted than the headlines suggest is that many of the largest market capitalization companies in the S&P don’t have significant exposure to Europe. Throughout the year. respectively. Resident Scholar at the American Enterprise Institute. they also tighten financial conditions in the US as result of lower equity prices and higher credit spreads. Surprisingly.” Francis Vitek and Tamim Bayoumi of the International Monetary Fund estimate that through the first quarter of 2011. Pollock 12 Goldman Sachs While we are generally optimistic about the prospects for the US economy and US financial assets.

in the absence of a panic or threatened financial collapse – and in the presence of upcoming presidential elections – we think it is unlikely that we will see any further reform until after the elections. Pollock. they still represent meaningful progress relative to last year’s expectation of no cuts until 2013. “If you would like an empirical law of government behavior.9 TRILLION $4. 2010) Gang of Six (July 2011) Data as of December 2011 Data as of November 2011 Source: Investment Strategy Group. as shown in Exhibit 11.Exhibit 11: Share of US Population Identifying the Federal Budget Deficit as Their Top National Economic Worry 31% 29% 27% 25% 23% 21% 19% 17% 15% Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 23% Exhibit 12: Composition of Proposed Deficit Reduction Plans Multiple bipartisan plans to reduce the debt have been put forward. Second. no action. as the safe haven of the world. but at least to the end of 2012 – before the US has to take up the next round of debt reduction. The Committee for a Responsible Federal Budget. no action. Gallup. multiple bipartisan efforts have identified the key components of any deficit reduction plan and. This work will provide the basis of future fiscal reform. we believe that there is some time – not indefinite. we proceed with great caution. Applied to Washington in 2012. as shown in Exhibit 12. Resident Fellow at the American Enterprise Institute and former President and Chief Executive Officer of the Federal Home Loan Bank of Chicago. 2010) (Nov. Although it’s reasonable to assume these steps may result in less than $2. National Commission on Fiscal Responsibility and Reform big” in 2011. deficit reduction has taken center stage in the political arena as policymakers and the electorate acknowledge the scale of the problem. The Pew Center Source: Investment Strategy Group. one of the better core investment opportunities.”7 Applied to Washington in 2012. every country.4 1% 14% 12% 16% 8% 66% Unclassified Spending Cuts Social Security Other Mandatory Interest Savings Health Care Defense Non-Defense Discretionary Taxes/Revenues Debt Reduction Fiscal Commission Task Force (Dec. Outlook 13 Investment Strategy Group . and. And finally. said back in 2008. in our opinion.2 trillion of cuts over 10 years that will be mandated by sequestration if no other action is taken. every time. However. as unpleasant as it was. CBS/The New York Times. every party. it is that in a panic or threatened financial collapse. As Alex J. First.1 trillion in cuts as Congress tries to ameliorate their impact on the defense budget.”6 As we attempt to assess the probability of policymakers implementing further fiscal reform in 2012. We might even sum up the US government’s gridlock as Norm Ornstein does in the title of his forthcoming book: It’s Even Worse Than It Looks. we can read into this the inverse: no panic. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 37% 24% 34% 18% 16% 40% TRILLION $5. the debt ceiling debate. governments intervene: every government. To quote Maya MacGuineas: “savings of one to two trillion is clearly a significant step in the right direction.0 6% 5% TRILLION $4. we can point to three notable achievements.8 Thus. we can read into this the inverse: no panic. did result in $900 billion of debt reduction and an additional $1. there is considerable overlap.

Our base case scenario for Europe in 2012. and the probability and ESM remains €500 billion. Jeanimmune from further economic weakness in the Claude Trichet. including 17 member countries. these concerns are tions and the size of possible haircuts for Greek justified.g. half of Germany’s GDP. monetary union. it what we highlighted in last year’s Outlook: is more so when the inconsistency comes from the absence of fiscal union in the presence of the same person. We are another year into the 14 Goldman Sachs . reactive in that they have only acted in response On the cyclical side. May 2009. when we had our first client call The key concerns with Europe.january 2012 The Eurozone: Will Incremental. to which we assign a 50% probability. widening recession is deeper than we envision. alternatively.” It is striking of a policy mistake is high. Just design crisis (the flawed initial design of euro four days later. and inconsistent in that they measures – which in aggregate will be about 2% of Eurozone GDP – are enacted across the GIIPS publicly contradict each other – and sometimes and now France. stronger) country opt to leave – Greek bonds. is that this approach will In fact. when the inconsistencies are among different The biggest fault line in the Eurozone remains policymakers from the 17 different countries. and clients should be prepared for similar volatility that will emanate from Europe applicable to Europe at the present time. which in turn means higher deficits and calls for of their inconsistent approach was when the even greater austerity. the communique from the Treaty? As Jacob Kirkegaard. In less than three The greater concern. reactive and inconsistent approach created tremendous uncertainty for financial market participants and was a source of volatility throughout 2011. Since and affect all equity markets. there is a real probability that themselves. Pollock’s “empirical law of government behavior” is most continue.g.rated bonds through 2011. a competitiveness of the European Financial Stability Facility/ crisis (the economic competitiveness of the European Stability Mechanism (EFSF/ESM) of southern periphery). with more than twothirds of that destined for European markets. 2011. are on the European sovereign debt crisis. Nicolas Sarkozy – stated that EU leaders will has so aptly stated: the Eurozone crisis is an “reassess the adequacy of the overall ceiling amalgamation of a fiscal crisis. we assign a 30% probability to a more debt restructuring) have never been enough. Chancellor Merkel stated: “I area institutions). The upper limit for the EFSF issues is extremely difficult. 2010. And Germany will not be president of the European Central Bank. but on the risk characterized European policymakers as “increof significant economic deterioration and on the mental. however. however. a banking crisis and “a €500 billion ($670 billion) in March 2012. exports account for nearly that the ECB would not change its collateral framework for the sake of an individual country. stated on January 10. or will a weaker (or. we have not centered on overall volatility. One of the earliest and most notable examples a mild recession spirals into a deep recession. the ECB did an will the Eurozone exist as it stands today with about-face and changed its collateral rules to accept BBB. As austerity of credit spreads or funding pressures in the EURIBOR market). notwithstanding the rules of the Maastricht More recently.”9 Dealing with each of these have made my position clear that it should not be stepped up. is structural: months. funding for new institu17 members. it seems to us that Alex J. the risk is that the to heightened market pressures (e. reactive and inconsistent:” incremental non-negligible risk of the end of the European in that their first round of policy responses (e. on March 25. 2010. Research Fellow December 9. Monetary Union as it stands today with its the size of the bailouts. In our view. GIIPS and in France. adverse outcome in Europe. European Union (EU) at the Peterson Institute for International Summit – whose agenda was driven by German Chancellor Angela Merkel and French President Economics and a frequent guest speaker on our client calls in 2011 on the European crisis. indirectly referring to Greece. Reactive and Inconsistent Policy Persist? This incremental.

9 3. Last year. the capital would be moved to Philadelphia for ten years. we do so again. Even with the latest plan to bring forward the new European Stability Mechanism (ESM) Investment Strategy Group Outlook 15 . Every summit initiative to date has been fraught with implementation difficulties. The ECB announcement that it will increase the term of its longer-term refinancing operations to three years has addressed this critical fault line head on and has diminished the risks to the banking sector in a meaningful way.5% structural deficit ceiling in their respective constitutions and agree to face automatic sanctions if they breach a 3% deficit limit. 26 EU members. given that historical precedent.5 1.3 7. with a current estimate of a cumulative bailout of over €200 billion). starting with the first bailout package for Greece at €45 billion (subsequently revised upward several times.1 7. “who in 1790 realized the newly Another fault line in Europe is the banking sector. Here there has been an important step in the right direction. The initial funding amounts for the European Financial Stability Facility (EFSF) were also inadequate to achieve a AAA rating. Since the beginning of 2010. with the much-publicized exception of the UK. A third fault line has been the inadequacy of resources set aside to deal with the crisis.4 13. the European Banking Authority (formed in November 2010 as a result of the crisis) has estimated that European banks have a capital shortfall of €115 billion that has to be filled by June 2012. European Banking Authority.0 6. with a centralized Treasury and national Treasury securities. To enlist the support of Thomas Jefferson to vote for the proposal (which had already been voted down five times). and had to be increased by 65%. resources have been allocated incrementally. While it is certainly a step in the right direction and is necessary for further ECB support during the crisis.TableCC_Ex13_v3_010212_jc_v2_sho. 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 selfinterest dictated it.2 115 % of Total 26% 23% 13% 11% 6% 6% 6% 3% 3% 1% 0% 0% formed US political union would only survive if it had fiscal union.2 15. It is unclear whether all 26 countries will pass the necessary approvals.5 0. it is reasonable to assume that this will also be the case with the new fiscal compact. he agreed to move the new capital to the banks of the Potomac. we tipped our hat to Alexander Hamilton. announced their intention to participate in a new Euro-area fiscal compact in which countries will have to incorporate the principle of a 0.0 26. and meaningful fiscal union is nowhere in sight. Banks have to raise this capital at a time of higher funding costs and questions about their access to short-term funding. Capital Shortfall Country Greece Spain Italy Germany France Portugal Belgium Austria Cyprus Norway Slovakia Netherlands Total Level (€bn) 30. As shown in Exhibit 13. Nor is it apparent whether the presence of such a fiscal compact will calm the markets in 2012 or be perceived as a long-term solution of limited value for a near-term crisis. and hope European policymakers will take his lead! Data as of December 2011 Source: Investment Strategy Group. banks are now able to borrow from the ECB with up to three-year maturities and can post a broader range of collateral. it is still far from the fiscal union among states in the US.3 0.3 3. to ensure Pennsylvania’s support. Financial Times Banking Sector.pdf CC Exhibit 13: Bank Capital Shortfalls by Country The ECB’s three-year refinancing operations should help alleviate funding pressures for European banks. At the December 9 EU Summit.” We applauded Hamilton’s vision and his willingness to do what it took to achieve a true fiscal union. Crisis Resources Are Additional Fault Lines in Europe crisis.

the ECB’s three-year refinancing operations should provide enough liquidity to banks and indirectly to sovereign government bond purchases to avert a meltdown. has stated that “the longer this goes on. 2011 *Assuming EFSF and ESM do not overlap Source: Investment Strategy Group. and to support any financing shortfalls Spain or Italy might face (Spain and Italy alone have about €610 billion of financing needs in 2012). Datastream. International Monetary Fund. risks associated with a country or two no longer being part of the Eurozone remain. ECB to June 2012.000 800 600 400 200 0 COMMITTED Potential Resources Potential Uses 1. Chairman of Goldman Sachs International and a guest speaker on some of our client calls. and the new Spanish prime minister.400 1. such downside has not been lost on the financial markets. whose party has an absolute majority in Parliament. we have also seen some real progress at the national level. Peter Sutherland. In summary. to support bank recapitalization efforts. the greater the risk of a substantial problem in the Eurozone itself and in particular a country or countries becoming dislocated from it. the question of debt restructuring is still outstanding and the possibility of a disorderly default remains.200? 440 0 . In Greece.january 2012 Exhibit 14: European Sovereign Crisis: Potential Sources and Uses of Funds The current resources available to combat the sovereign crisis do not appear big enough to have the desired "bazooka effect. European equities. technocratic governments do not mean either Italy or Greece are out of the woods. European Banking Authority. have historically traded at a 33% discount to US equities based on price to 10-year average cash flow – a valuation metric that 16 Goldman Sachs .190 Spain & Italy bank recapitalization need 450-850? 0 .200 1. We should also note that just as we have seen some real progress at the supra-national level over the last two months. it seems that the current resources (as shown in Exhibit 14) along with support from the IMF may not have the desired “bazooka effect” (to borrow a phrase US Secretary Treasury Henry Paulson used during the US financial crisis): the total sum does not appear big enough to provide the bailout funds committed to Greece.” Jacob Kirkegaard also believes that the risk of a country or two leaving the Eurozone is greater than zero. while there has been some real progress that could lead to improvements in the financial markets. Both Italy and Greece have new reform-oriented technocratic governments. In the meantime. others take Chancellor Merkel’s statement that no new funds will be forthcoming at face value. has been introducing additional fiscal reform. Portugal and Ireland. Some expect EFSF/ESM resources to be increased in March 2012. Obviously. While ECB President Mario Draghi refers to talk of the Eurozone fragmenting in the foreseeable future as “morbid speculation”10 many experienced former European policymakers and European policy observers think otherwise." 1.200? 200 250 EFSF 250 Remaining Funds* (EFSF -----> ESM) Potential extra IMF & non-EU resources EFSF leverage and / or ESM increase New EU funds to IMF Spain & Italy financing needs 540 (2013) Ireland Portugal Greece 610 (2012) Data as of December. as measured by MSCI EMU. Of course.

such cheap valuations warrant a small tactical tilt toward European equities. a hit to the banks would make the economy quite vulnerable. as all commodity exporters get affected by lower prices. author of the recently published Understanding China’s Economic Indicators. Officials will further ease monetary policy. The most immediate impact would be lower demand for commodities. it will only take a quarter or two of GDP growth rates below 7% to prompt a very strong policy response. Sanofi.3% of European GDP. Europe and commodity prices? A hard landing in China would impact other parts of the world through several channels. Clearly. that would reduce local government revenues and affect their ability to repay loans to the major banks. There is also a direct earnings hit since some US and European companies earn a share of their profits in China. Fitch Ratings estimates that China faces a 60% chance of a banking crisis by mid-2013 as a result of the record lending for property-related investments. They raised the reserve requirement ratio. BMW. it accounts for a substantially greater proportion of world commodity consumption. Based on fourth quarter estimates from our colleagues in Goldman Sachs Global Investment Research. of course.9% of US GDP and 1. Now the same is true of China. at a deep discount to US multinationals. When we consider some of the world-class multinational companies in this universe – names like Total. went as far as to say: “It used to be that when the US sneezed the rest of the world gets a cold. Unilever. (on the flip side.13 While policymakers can lose control or make mistakes. Chinese officials started to ease financial conditions. L’Oreal. as well as lowering inflation rates (Exhibit 17 and 18). what are the implications for the US. ranging from a low of 10% of oil demand to 30% of rice demand to 40% of copper and over 50% of iron ore.75%. as global growth slowed down in 2011 and the sovereign crisis in Europe worsened.we find particularly useful as a forward-looking measure of expected returns. we think the likelihood of a sub 7% annual growth hard landing in China – in the absence of any exogenous shocks from Europe or the US – is somewhat limited.1%. of course. Now the risk is that property prices drop too steeply. However.”11 What exactly is a hard landing for China? Some define it as a full year of below 7% growth. in aggregate. lower commodity prices would be a boon to global consumers.) A lesser impact would be on exports from the US and Europe. ENI. It is important to keep in mind that Chinese policymakers had been in tightening mode since early 2010 to slow down an overheating economy and reduce rising inflation (Exhibit 15). In a country that is heavily dependent on bank financing. In our view. Exports to China account for 0. and Danone – that are trading. We think the gradual slowdown will continue and estimate 2012 growth around 7. Other measures included lending quotas. Others view a hard landing as growth rates below 7% that would prompt market concerns and elicit a strong policy response from Chinese policymakers. In our view. Telefonica. China: Cyclical and Structural Concerns The biggest question on our clients’ minds with respect to emerging markets is whether China will have a hard landing in 2012 – and if so. Today. this metric stands at a 53% discount. as shown in Exhibit 16. Daimler. the deposit rate and base lending rate. Anheuser-Busch Inbev. implement fiscal stimulus and support the development of low income housing and rural Investment Strategy Group Outlook 17 .12 China’s growth rate for the full year 2011 is expected to be 9. there will be a portfolio impact for those invested in Chinese financial assets.75–8. LVMH-Moët Hennessy Louis Vuitton. While China accounts for about 10% of world GDP. a hard landing in China would lower commodity prices and have the greatest impact on commodity exporting countries. SAP. In addition. Their tightening measures had the desired effect of reducing property prices and volume of sales. Tom Orlik. Siemens. US and European exports to those countries will also be hit. it appears that significant downside has already been priced into the market.

China’s Communist Party will convene in October 2012 to elect the new party leaders. To us. CEIC Exhibit 17: China Property Prices Policy tightening has had the desired effect of reducing property prices and sales in China's largest cities.14 its budget deficit stands at -1. the much graver concern in China is a 18 Goldman Sachs .15 In addition. among other tactics. CEIC infrastructure. and the government owns from 57% to 83% of the four major Chinese banks and 63% of the China H-share equity market (The Economist estimates state-controlled companies account for 80% of the Chinese equity market). Goldman Sachs Global Investment Research. Soufun Data as of December 2011 Source: Investment Strategy Group. deposit rates and lending rates have all been raised in recent years. to avert a hard landing. 10% 8% 25% 20% Headline Inflation (YoY%) (LEFT SCALE) Weighted Average of 13 Cities (Soufun) 6% 4% 2% 15% 10% 5% 0% 70 Cities 0% TIGHTENING PERIODS –2% –4% 01 02 03 04 Required Reserve Ratio (RIGHT SCALE) Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 05 06 07 08 09 10 11 Data as of December 2011 Source: Investment Strategy Group. we expect they will do everything in their power to maintain adequate growth during the change in party leadership. Reserve Requirement Ratio Policy tightening has started to reduce Chinese inflation. Datastream Data as of December 2011 Source: Investment Strategy Group. National Bureau of Statistics of China.january 2012 Exhibit 15: Chinese Financial Conditions Chinese policymakers have been tightening credit since early 2010. Exhibit 16: Chinese Policy Rates Chinese banking reserve requirements. its reserves total over $3 trillion. 8% 7% 6% 1 Year Deposit Rate (LEFT SCALE) 35 30 25 20 15 10 5 0 06 07 08 09 10 11 Real Domestic Credit (%YoY)* 100 102 104 China FCI (RIGHT SCALE INVERTED) FCI TIGHTENING 25% 20% 15% Base 1 Year Lending Rate (LEFT SCALE) (LEFT SCALE) 5% 4% 3% 2% 106 108 110 112 10% 5% 0% 1% 0% 01 02 03 04 Required Reserve Ratio (RIGHT SCALE) 05 06 07 08 09 10 11 Data as of November 2011 * Deflated by CPI Source: Investment Strategy Group. 50% 40% 30% 20% 10% 0% –10% –20% Jan-07 (National Bureau of Statistics) Exhibit 18: Chinese Inflation vs. They have the tools and certainly the financial means to do so: China’s sovereign debt-to-GDP stands at 27%.6% of GDP.

“during 2001–08. we can only conclude that 2012 may be just as choppy as 2011. which accounted for 13% of GDP in 2010. with the US as their most popular destination. and all these factors have already been at least partially discounted. In Europe. In the US. an increasing number of “public order disturbances. and the rest of Asia (35%). election year politics will probably impede progress on fiscal reform. the financial markets are quick to price such concerns. This is much larger than the 2001–08 average of the G7 (16%). they should be a core holding in any equity portfolio at this time. a working-age population that is estimated to peak in 2015. Others.17 Wealthy Chinese are taking note: an increasing As we identify and examine the cyclical and structural concerns in key economic centers. In China. Italy and even France – and increasingly complex and ambitious reform measures are unlikely to pass without at least a few glitches. 2012 Water Ahead Linda. we can use history as a guide. net exports and the investment which is predominantly linked to building capacity in tradable sectors have accounted for over 60% of China’s growth. policymakers have to avert a cyclical hard landing without further compounding the structural problems of an imbalanced economy. and we are concerned this one won’t be either. In the last few years. up from 40% in the 1990s. However. Bloomberg longer-term. European and Japanese equities are particularly cheap and present an attractive investment opportunity for those who can withstand the volatility. Some US financial assets such as high yield fixed income are particularly attractive. they are the only consistent and reliable hedge in a portfolio at a time of heightened uncertainty. Investment Strategy Group Outlook 19 . And as unattractive as high quality government bonds are at current interest rates.and investment-led economy to a more diversified one without major dislocations? As shown in Exhibit 19. China’s growth has been heavily dependent on exports and investments related to exports. sustainable long-term growth.18 Here again. As we present our full economic and investment outlook in the pages that follow. Euro area (30%).”16 During this period. exports have ceded some ground to real estate investment. these themes will be explored in greater detail. private sector consumption in China declined – from 47% of GDP in 2000 to 33% in 2010. According to the IMF. and it will be evident why we believe diversification – always a fundamental consideration for any investor – will be particularly important in the year ahead. That’s a tall order under ideal circumstances.Exhibit 19: Composition of Chinese GDP Growth China's recent growth has been heavily dependent on exports and investments.” and an increase in geo-political tensions with some of its neighbors. Such transitions are rarely smooth. the sovereign debt crisis has spread from a few peripheral countries to now include Spain. Share of total GDP growth 100% 80% 60% 40% 20% 0% 1990-2000 2001-2008 Net exports and investment Consumption number are looking to emigrate from China. they must accomplish it in the face of weaker global growth. are fairly valued and reflect the strong earnings and safe haven status of US companies. not consumption. In order to achieve healthy. such as US equities. structural one: How does such a lopsided economy transition from an export. China’s policymakers have to manage a transition to a balanced economy. need to figure out is “Share of total GDP” is an axis item Outlook: More Choppy or caption Data as of November 22. 2011 Source: Investment Strategy Group.

barring an exogenous shock or buildup of cyclical excesses. In short. the Bank of England announced yet another installment of quantitative easing. Second. where we expect a modest recession. is the outcome of a slew of potential leadership changes in 2012. in particular. Exhibit 20 presents a summary of our “…by land and sea. including the United States. Emerging market countries. Already. Japan approved its fourth supplemental budget.”19 So wrote Lammot du Pont. a global economy that is more vulnerable to shocks. we are quick to differentiate slowing growth from negative growth. policymakers are not without lights.january 2012 section ii Economic Outlook 2012 Global The Fog of Uncertainty That said. seven of the G20 countries. our forecast assumes below-trend. as evidenced by still large output gaps in the developed world and relatively healthy fiscal positions in the emerging markets. as a result of their expanding populations and productivity gains. our forecasts envision slower global growth in 2012. slower growth. While the potential for a hard landing in China and a disorderly breakup of the European Union are chief among them. 48 central banks have eased in the last quarter of 2011. have room to relax macroeconomic policy. France. head of the chemical conglomerate bearing his name. and in turn. given the bounty of concerns. China reduced reserve requirements. Against this uncertain future. First. and the ECB adopted a host of unconventional measures to support banks. Having emerged from a very deep economic contraction not long ago. China and Mexico. Except for Europe. the natural state of economies is to grow. will face elections or leadership changes this year. Several factors support this view. will provide cover for governments to undertake monetary and fiscal stimulus. and true to du Pont’s words. there are few cyclical excesses to correct today. in reference to the “fog of uncertainty” that was hampering Depression-era businesses. less discussed.3%). while continuing to buy bonds through its Securities Market Program (SMP). the universal practice under conditions of fog is to slacken speed. representing half of the world’s GDP. but equally unclear. 20 Goldman Sachs . Although he penned these words in 1938. they are just as applicable today. given their healthier fiscal positions and high policy rates (which average 5. Indeed. but still positive economic expansion. while the fog of uncertainty is thick. and hence moderating inflation.

2.25 . while extending unemployment benefit measures would add roughly 0. Japanese earthquake. excluding financials and utilities. That is.2.5) .5% 1.1% Investment Strategy Group Outlook 21 .7pp from GDP growth.5% 2.2. is a testament to its resilience.6% (0.4% 1.5–2.5% 2.0% 4.0% Data as of Q3 2011 JAPAN 2011 –0.0) . **For current headline CPI readings we show the year-over-year inflation rate for the most recent month available.0.5% 2012 Forecast 1.0% 1.5% 3. US Department of Commerce.0 . 19% Capital Spending % GDP (LEFT SCALE) 12% 10% 8% 6% 4% 2% United States: Slow but Steady What the US economic recovery has lacked in vigor. ***German 10-year rate shown for Eurozone.1. at least for the next few quarters.2.1% 0.5 . inflation and interest rate forecasts for the developed economies. while real GDP growth at this point in the cycle is only half that of historical recoveries.Source: Investment Strategy Group. Second. UNITED STATES 2011 Real GDP* Headline CPI** 10-Year Rate*** Policy Rate Data as of December 30. We expect this growth to continue in 2012. Meanwhile.0% Reserve.5) . such moderate 18% 17% 16% 15% 14% 13% 12% 52 57 62 67 72 77 82 87 92 97 02 07 Real Growth of Private Sector Debt YoY%. Federal Reserve. 3Y Avg. failing to extend the payroll tax cut could subtract roughly 0. consistent with stands below historical the ongoing headwinds from consumer and financial institution deleveraging.0 .25% 1.0. the collective message from a variety of leading economic indicators we follow is still one of moderate growth.25 Note: Based on corporate data for the largest 1.9% 2012 Forecast (0. Datastream EUROZONE 2011 1. Source: Investment Strategy Group. despite its resilience thus far. Empirical Research Partners. (RIGHT SCALE) 0% –2% –4% Data as of Q3 2011 Note: Based on corporate data for the largest 1.0% 2012 Forecast (1.25% –0. the US economy could still tip into recession.5% 0. Nonetheless.500 stocks. still-accommodative monetary policy.0% 0.3. Exhibit 21: Capital Spending and Private Sector Debt Growth The excesses that typically precede recessions are not present today. 2011 *2011 Real GDP is based on GIR estimates of yoy growth for the full year. including the Arab Spring.25% 1. 1. As discussed at the beginning of this Outlook.25 .75 . US Bureau of Labor Statistics. excluding financials and utilities.8% 2.5% real GDP growth is a wider range than usual. Empirical Research Partners. and some normalization of interest rates.500 stocks.5 . the 2% midpoint of our range TableA_v3_123011.0% 0. Of course.88% 0% .pdf trend.2. it has made up for in stamina.3.5 . Source: Investment Strategy Group. 2.97% 0.7% 3. our stall-speed recession models still signal an A Exhibit 20: ISG Economic Outlook for Developed Markets Our forecast features relatively tame inflation. Indeed. US Bureau of Labor Statistics growth is typical in the three to five years following a financial crisis.0% 0.0% Federal 2. particularly given its below-trend growth path. First. US GDP growth appears to have accelerated to over 3% in the fourth quarter. there are four reasons recession is not our base case for 2012. despite a notable intensification of the European crisis in the latter part of 2011. Our forecast for 1. For instance.0.75% 0. the economy’s continued upward trajectory in the face of a variety of destabilizing shocks.GDP.25 .3pp. US Department of Commerce. largely reflecting uncertainty around US policy outcomes.25% UNITED KINGDOM 2011 0. in spirit if not in magnitude.97% 1.0 . European sovereign crisis and US debt ceiling debacle.2% 2012 Forecast 1.0.

january 2012

Exhibit 22: Composition of US Employment Growth Job growth in the healthy sectors of the US economy is offsetting losses elsewhere.
Millions Millions

39 38 37 36 35 34 33 32 97 98 99

Employment in “Crisis” Sectors: Construction, Government, and Finance (LEFT SCALE)

100 99 98 97 96 95 94 93 92 91 90

Total Employment excl. Constr, Govt, and Fin.












Data as of November 2011 Source: Investment Strategy Group, Datastream, Gavekal, US Bureau of Labor Statistics

the highest level in decades. Although a more uncertain global environment may justify temporarily holding higher levels of cash, demanding shareholders will not allow these cash hoards to persist indefinitely. Two, the impressive rate of investment growth is partly a function of a low starting base, reflecting how aggressively businesses retrenched during the financial crisis. In fact, despite robust growth, business investment remains 8% below its 2007 peak. Lastly, corporations continue to under-invest, as evidenced by depreciation expense exceeding capital expenditures for more than half the S&P 500. Indeed, our colleagues at Goldman Sachs Global Investment Research found that adjusting for depreciation, growth in the real net capital stock is only about 1.5%.

elevated, but not decisive 30-35% risk of recession. Third, as shown in Exhibit 21, the typical preconditions of recession, namely excessive capital spending and private sector debt growth, are not present. Indeed, the lack of obvious exExhibit 22: The Benefits of US Economic Diversity While the "crisis" sectorswould likely temper the depth cesses to expunge in the US economy continue to shed jobs, other healthier sectors are offsetting these structural adjustments. of any economic contraction, were one to occur. Finally, although an adverse outcome in Europe 39 Millions Millions 100 and/or China could in “Crisis” a US contraction, the Employment foster Sectors: Construction, 99 probability of these and 38 Government, outcomes has not risen to a 98 Financealter our base case. As such, we (LEFT SCALE) level that would 37 place the odds of recession starting in 2012 at 97 96 36 around 30%. 95 Accordingly, barring an exogenous shock, we 35 94 Total Employment expect continued economic growth on the back ex. Constr, Gov, and Fin. 93 34 of resilient consumer andSCALE) (RIGHT business spending, as 92 well as a small upturn in residential investment. 33 91 We discuss each of these key components below.
32 97 98 99 00 01 02 03 04 05 06 07 08 09 10 90

Data as of November 2011

Business Investment

Source: Investment Strategy Group, Datastream, Gavekal, US Bureau of Labor Statistics

While business investment’s 8.4% annualized growth has already handily outpaced GDP in this recovery, we believe the trend is sustainable for several reasons. One, firms have ample funds to deploy, with robust corporate profitability underpinning record levels of cash. As of the third quarter of 2011, cash at non-financial S&P 500 firms represented 11% of total assets,

the type ush left for a scale that appears Despite numerous fits and starts throughout the on the right side of a mosaic of included ush right economic recovery, a broad chart. I’ve employment statistics havea number of these double-scaled alternates for recently firmed, a trend that should continue to benefit consumption in 2012. exhibits. For example, weekly initial jobless claims have receded to their lowest levels since early 2008 and now stand at a level consistent with ongoing employment growth. This improvement is echoed by a host of other measures, including collapsing layoff announcements in the Challenger survey, the recovery of hiring intentions to 2008 levels in the Manpower survey, an uptick in online job advertising at Monster.com and an increase in available jobs in the Labor Department’s Job Openings and Labor Turnover Survey (JOLTS). Of equal importance, small business hiring intentions in the National Federation of Independent Business survey recently matched levels last seen before the recession began. This is a critically important development, as firms with fewer than 500 employees account for about half of both private sector employment and non-farm private sector GDP. Notably, the mediocre employment gains seen thus far obscure what is actually a two-speed employment recovery. As shown in Exhibit 22, the “crisis” sectors of the economy (namely, construction, finance and government) have continued to shed jobs throughout the expansion, while employment gains outside these areas have

I’m still Employment not convinced that it’s best to align

22 Goldman Sachs

mirrored previous cyclical recoveries. As a result, these healthier sectors are offsetting, and thereby facilitating, the necessary structural employment adjustments of the weaker areas. This counterbalancing dynamic highlights a key benefit of the US economy’s diversity. The upshot is that with job losses in the crisis sectors stabilizing, overall employment growth can improve. Already, real estate–related jobs have stopped contracting in 2011, removing one headwind from the employment recovery. Moreover, whereas fiscal consolidation will likely necessitate further government job losses, the message from the financial sector is less clear. Indeed, the growing burden of regulatory compliance is necessitating headcount additions at many financial, law and consulting firms, even as the financials reduce their capital market headcount. The net, economy-wide job impact of ongoing financial sector adjustments is thus not as draconian as commonly assumed. Overall, the impact of an improving labor market is non-trivial, as each 50K increase in monthly non-farm payrolls adds about 0.15pp to our GDP growth forecast.

Exhibit 23: Private Residential Investment as a Percent of GDP Reversion to the mean in residential investment could be a tailwind for US growth.
8% 7% 6% 5% 4% 3% 2% 1% 50 55 60 65 70 75 80 85 90 95 00 05 10 2.2%

Data as of Q3 2011 Source: Investment Strategy Group, Datastream, US Bureau of Economic Analysis

Exhibit 24: S&P Case-Shiller Home Price Index National home prices have expunged the excesses of the housing bubble.
200 180 160 140 120 100 80 60 40 20 0 75 78 81 84 87 90 93 96 99 02 05 08 11 Estimated Equilibrium

Although our growth forecast assumes only a small contribution from residential investment in 2012, we believe housing accounts for a significant source of future economic upside. After all, residential investment represents just 2.2% of GDP today, its lowest level in over 60 years (Exhibit 23). In fact, 2012’s small gain will represent the first time since 2005 that housing has not detracted from US GDP. While many housing indicators remain at admittedly depressed levels, a nascent trend of improvement has emerged in recent months. For example, housing starts rose 9.3% in November 2011, to the highest levels of this recovery. Moreover, the December reading of the National Association of Home Builders (NAHB) sentiment index stood at a level last seen in the wake of the government’s homebuyer tax credit in early 2010. In addition to these recent improvements, we believe the underpinnings of a structural upturn in housing are coming into focus. As shown in Exhibit 24, national home prices have now

Case-Shiller Home Price Index*

Data as of Q2 2011 * Readjusted for seasonality by GS US Economics Research. Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Standard & Poor's

Investment Strategy Group

Outlook 23

january 2012

Exhibit 25: US Housing Affordability Index With home prices and interest rates falling, homes are now more affordable than ever.
200% 180% 160% 140% 120% 100%

Exhibit 26: Housing Starts vs. Demographic Demand for Homes Housing starts well below demographic demand works to reduce excess inventories.
2,500 2,250 2,000 1,750 1,500 1,250 1,000 750 500 250 0 70
Data as of Q3 2011 1,237


Housing Starts
(12-Month Average)

Demographic Demand for Homes*


80% 60%

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11









Data as of October 2011 Source: Investment Strategy Group, Datastream, National Association of Realtors

* 10-year average household formation plus assumed 300,000 demolitions per year. Source: Investment Strategy Group, Datastream, US Bureau of Economic Analysis

Exhibit 27: Change in Housing Inventories The large overhang of unsold homes and foreclosures is clearing.

15% 10% 5% 0% –5% –10% –15% –20%

12.4 6.6

6.1 2.3 0.2

Shadow Inventory Listed Inventory

–4.0 –8.6 –12.1 –13.2













Data as of Q4 2011 Source: Investment Strategy Group, Empirical Research Partners, National Association of Realtors, First American CoreLogic, US Census Bureau

expunged the excesses of the housing bubble and returned to levels consistent with underlying fundamentals. Falling home prices, coupled with today’s low interest rates, have pushed homebuyer affordability to its highest level on record. As a result, the October 2011 Housing Affordability Index reading of 197.8 (see Exhibit 25)

implies that a family earning the median income has 197.8% of the income necessary to qualify for a conventional mortgage covering 80% of a median-priced existing single-family home. Of course, a would-be homebuyer can always choose to rent instead. Even here, the economics favor homeownership, a reflection of today’s higher rents, attractive home prices and low financing costs. Viewed another way, housing speculation has once again become enticing, since the rental income from a purchased home is sufficient to pay the mortgage and still generate a positive return each month. Not surprisingly, investors are increasingly entering the purchaseto-rent market. To be sure, a large overhang of excess housing supply still exists. Even so, progress is being made, arguably at an accelerated pace. As shown in Exhibit 26, the supply of new homes is running significantly below demographic demand. In turn, the large overhang of unsold homes and foreclosures is clearing. This dynamic is evident in Exhibit 27, which shows inventory declines occurring at a much faster pace than at this point in 2010. Undoubtedly, any effort by the government to rent rather than liquidate its vast stock of foreclosures would be an incremental positive to this adjustment process.

24 Goldman Sachs

5% 6% 1990s.9% be. While a deep recession is intuitively appealing 14% given the magnitude of the area’s challenges. Even so. Already. Eurostat Eurozone: No Silver Bullet Against a backdrop of political turmoil.8% inflation concerns. Datastream. US Bureau of Economic Analysis. despite further economic growth. grow2% ing excess bank reserves from the ECB’s liquidity 0% measures are likely to push short rates lower. in the years ahead. GIIPS) 92 87 Eurozone 77 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2008 2009 2010 2011 Data as of Q3 2011 Source: Investment Strategy Group. standing 23% below its 2008 peak. weaker growth should temper 4. the question is no longer whether the Eurozone will experience 16% a recession in 2012. providing some scope for savings to offset falling growth.4% 5. and hence investment theme. we expect about a 10% 1% peak to trough contraction. or perhaps lack of unequivocal pessimism. with unemployment above the Fed’s comfort level. Moreover. is predicated on several Data as of Q2 2011 factors. has already contracted significantly. overall fixed investment has grown just 4% since its financial crisis trough. we expect inflation to remain well anchored. Fixed investment among the European peripherals. As shown in Exhibit 28. suggesting a moderate recession. suggesting there are fewer excesses to correct during a downturn. Finally. Ireland. Portugal and Spain) Core (Eurozone excl. but rather how deep it will 13. meanwhile. In fact. Instead. In addition.In short. we expect the Fed to honor its commitment to remain on hold into 2013. interest rates will likely end this year at higher levels. Exhibit 29 shows that Eurozone consumer balance sheets are relatively healthy. In turn. Datastream. a level consistent 8% with the recessions seen in the early 1980s and 6. as continued economic expansion raises expectations of eventual monetary policy normalization. a bank. while we have relatively modest expectations for the contribution of residential investment to GDP growth in 2012. vestment – the most cyclical element in GDP – is UK Office for National Statistics already at very depressed levels. Eurozone UK Japan US Our relative optimism. Investment Strategy Group Outlook 25 . Italy. Exhibit 28: Fixed Investment in the Eurozone There are fewer excesses to correct during a downturn. we think housing will become an increasingly important economic story. Index (1Q08=100) 105 100 95 90 85 80 75 70 GIIPS (Greece. OECD. Eurostat. that 12% is not our base case.Exhibit 29: Household Savings Rates Consumer balance sheets in the Eurozone are comparatively healthy. given the still abundant slack in the US economy. Eurozone inSource: Investment Strategy Group. ing crisis and a large fiscal drag. providing cover for the ECB 4% to reduce interest rates further. Given this moderate growth backdrop.

did not experience a large housing bust and hence does not need to rebalance its economy. a critical consideration given the importance of bank financing to the Eurozone (see Exhibit 30). As a result. These measures lessen the extent to which lending conditions would otherwise tighten. reactive and occasionally inconsistent policy responses. European firms rely heavily on bank loans for their funding. we have no delusions about the existence of a silver bullet for the region’s woes. we expect a combination of austerity measures. given the latter’s greater debt burdens and higher funding costs. As we have highlighted in various client calls and Sunday Night Insights throughout 2011. In contrast. Haver Analytics While we expect the Eurozone to remain intact. uncompetitiveness and elevated borrowing costs to result in deeper contractions in the GIIPS (Greece. Bank of America/Merrill Lynch. Bank Loans 100% 80% 60% 40% 20% 0% Bond-Market Funding France Portugal Germany Italy Greece Spain US Data as of November 2011 Source: Investment Strategy Group. forced deleveraging of the banking system is far less likely in the wake of the ECB’s extraordinary liquidity measures. unlike Spain. While our forecast calls for a relatively modest overall Eurozone recession. Germany. the bad case for Europe is more severe than the US. more severe contractions lurk beneath the surface at the country level. these “existential” challenges are likely to be exacerbated by cyclical pressures resulting from Europe’s unfolding recession and the implications of slowing growth in China and/or the US. Meanwhile. the Eurozone’s ultimate fate rests in the hands of its own politicians and the patience the market is willing to afford them. Portugal and Spain). For example. While we expect the Eurozone to remain intact. even though we accord both the US and Europe a 30% downside probability. Ireland. Italy. 26 Goldman Sachs . As was the case in the expansion. Germany’s low budget deficits (1–2% in 2012) and attractive borrowing costs may enable it to stagnate rather than contract. we expect continued incremental. In addition. an unruly. Even with Germany serving as economic ballast.january 2012 Exhibit 30: Business Funding from Bank Loans and Credit Markets Unlike US companies. particularly its willingness to accept a wide range of bank collateral in exchange for three-year loans at a 1% borrowing cost (otherwise known as LTROs. given the dangerous interplay between weakening growth and the potential for an adverse tail event (such as a disorderly default or political accident). we have no delusions about the existence of a silver bullet for the region’s woes. we expect the core of Europe to fare better than the periphery. or Long-Term Refinancing Operations).

75% by year-end. forcing the Bank of England to defend its credibility at the expense of the economy. Meanwhile. this would still be above the Bank of England’s 2% target. rebuilding efforts led to strong 5. • A mechanism to address the funding needs of weaker sovereigns that lack market access. True. and the UK in 2012. inflation could remain resilient.6% QoQ annualized growth in the third quarter of 2011. boosted by reconstruction and public investment. fixed investment will be the principal driver of this growth. earthquakerelated disruptions pushed the Japanese economy back into recession. Overall.25% in 2012. One. the imposition of technocratic governments in Greece and Italy. we expect GDP growth of 1. key EU elections. • A fiscal consolidation plan that improves structural competitiveness and growth in the periphery. reflecting a post-earthquake recovery that should endure in 2012. as opposed to just curtailing spending through austerity measures.75–2.7% of GDP). With an additional LTRO available in February. with a modest increase in long-term rates to a range of 1. Indeed. through either Eurobond issuance or direct fiscal transfers. In fact. banks were able to fund nearly twothirds of their entire 2012 funding needs during the ECB’s December LTRO. but the weakness of the economy should keep the central bank very dovish in 2012.That said. progress has been made. the election of a pro-reform party in Spain. United Kingdom: Sluggish Growth with Downside Risks We expect UK inflation to moderate gradually from current high levels. Three.5% in 2012 and to announce further asset purchases. we expect Japan to grow as fast as the US and outgrow Euroland.0–3. Even so. implementation of the fiscal consolidation could veer off track. the banks will have little difficulty rolling their maturing 2012 or 2013 debt. Although by no means a 2012 expectation. We continue to assess any proposed “comprehensive” solutions against this checklist. and elevated sovereign funding needs early in the year. it should fall back to 2. we expect the BoE to keep rates at 0. public investment will be boosted by the three post-earthquake supplementary budgets already approved. • A credible firewall to limit contagion arising from any one member’s default / exit.0–1. A mean reversion tailwind will help. As such. As mentioned above. as business investment remains 19% below its 2008 peak. Japan: Rebuilding Tailwind After enjoying a strong growth rebound in 2010 and an encouraging start to 2011. the ECB’s recent liquidity measures significantly decrease the probability of a Lehmanstyle liquidity crisis and provide politicians time to put more permanent measures in place. Meanwhile. any lasting solution to the Eurozone crisis must ultimately provide the following key items: • A fiscal integration plan that enables the socialization of losses. Despite this already tepid outlook. we think risks are tilted to the downside for three reasons. a feat that has occurred only once before in the last two decades. amounting to a combined ¥18tr (3. Not surprisingly. markets may start to challenge the UK’s bond market. Investment Strategy Group Outlook 27 . While inflation has risen on the back of commodity prices and two VAT hikes in 2010 and 2011. we expect volatility to remain elevated and headline-driven for the near future.0% in 2012 as these effects dissipate. given ongoing debate over the Greek private sector involvement. In turn. Two. and parliamentary approval of austerity measures across the Eurozone make the political commitment to reform more credible.

Japan does not need external funding.7% in 2% 2012. while we think tail risks have reducing the likelihood of a run on JGBs. we are quick to 5. in stark contrast to the developed world. On ernment debt if necessary. Finally. found that a downside scenario involving severe market dislocations in European economies and markets could shave 1. Even so. in addition to the We have long argued that emerging 1. a US recession or an it runs a current account surplus worth roughly escalation of the European debt crisis could neg3–4% of GDP. 0% 80 83 86 89 92 95 98 01 04 07 10 12 we think recent ECB actions have greatly reduced the probability of a Lehman-style growth shock. we do not expect a hard landing. a hard landing in China.6% of GDP in 2010. we think this risk is mitigated by at least three factors. less than the 6. In turn. domestic investors hold as an important counterbalance to the external more than 90% of Japanese government debt.1% in emerging markets to a below-trend 5. but still of the advanced economies. gross private savings atively impact emerging markets through hamrepresented 14. providing scope for higher government revenues. Emerging Markets: Still Coupled 28 Goldman Sachs . this market economies are not immune would reduce the rate of growth by more than from the business cycle gyrations 3 percentage points. re. a recent study by two IMF economists low in Japan relative to other OECD countries. and FX intervention were the economy to slow most EM central banks have room to cut rates materially and/or the yen to appreciate significantly. our expectation for 1% growth in Data as of September 2011 Source: Investment Strategy Group. an amount pered trade. tax levels are this point.6 percentage points (pp) from emerging market growth.5pp growth decrement they expect from the advanced economy slowdown. To be sure. although high debt levels make (given that average policy rates currently stand at the country susceptible to a sovereign crisis in the 5. particushould ease inflationary pressures. International Monetary Fund the advanced economies in 2012 is very different from the nearly 5% economic contraction that occurred in 2009. we would expect more monetary easing Indeed.20 If correct. For one. but not a hard landing. While our forecast calls for a slowdown 3% 4. diminished access to international that could be channelled toward reducing govcapital markets and lower commodity prices.7% 5% distinguish between slowing growth and negative Downside 4% Case growth. the drag on EM growth should be commensurately less. more temperate growth mains vulnerable to exogenous shocks. then. that we expect a 8% slowdown in emerging market growth.growth headwinds we expect. First. enabling larly a dramatic slowing in global growth. As a result. It should 9% Headline Growth come as little surprise. These measures serve long term. given 7% Trend Growth our relatively tepid growth expectations for 6% Base Case the developed world. 1% Several factors underpin our view. Moreover.3%). said. a significant shock. they have not been eliminated. FORECAST Exhibit 31: Emerging Markets GDP Growth Our base case envisions below-trend growth. while strong budgetary positions permit incremental fiscal stimulus. Despite this rebuilding tailwind. given that ceded.january 2012 We have long argued that emerging market economies are not immune from the business cycle 10% gyrations of the advanced economies.1pp decline following the Lehman crisis (Exhibit 31). Second. Even so. In fact. That emerging markets to relax monetary policy. Japan reOf equal importance.

In addition. China’s exports of goods and services still make up some 30% of GDP. That said. China remains on course for a soft landing. made reaching these targets the core criterion for judging local officials’ job performance.75–8. In turn. Nonetheless. Of equal importance. While it is true that Chinese growth has slowed almost 3 percentage points in less than two years.5%. much of this slowdown was intentional. Emerging Asia is particularly vulnerable to slowing global exports and tighter global trade financing. inflation has already peaked and should drop further to around 3–4% in 2012. we do not expect the resulting non-performing loans to present a major challenge to our view in 2012. as both the banking sector and the government have the resources to absorb potential losses. China Barring an extreme outcome in Europe. for the first time ever. In our view. we believe China has flexibility to employ fiscal and monetary stimulus as a counterbalance. China remains on course for a soft landing.21 Meanwhile. we expect below-trend GDP growth of 7.1% as of the third quarter of 2011. both of which are likely headwinds in 2012. while the massive stimulus employed during the 2008 financial crisis enabled China’s economy to rebound quickly. most likely in the form of rate cuts and slower currency appreciation across the region. Even so. of which the EU represents one-fifth. particularly as European banks deleverage their balance sheets. In addition. On this point. as an export-driven economy. The key challenge for China’s policymakers will be to support domestic demand growth without creating new vulnerabilities in the financial sector. China remains vulnerable to a further escalation of the European sovereign debt crisis. Of course. it also fostered real estate speculation and a surge in local government debt. Investment Strategy Group Outlook 29 . In turn. Among the larger economies in Asia.75–7. That said. trade financing remains vulnerable. supported by consumption growth and a mild pickup in investment. the absolute level of growth is still a robust 9. these hurdles should be manageable given continued current account surpluses (with the exception of India) and large foreign exchange reserve balances. the Chinese government has set a target of building 7 million affordable homes in 2012 and. For instance. Concerns about India’s twin deficits are pressuring the rupee. as the government tightened policy dramatically to forestall a burgeoning property bubble and assuage inflationary pressures. with GDP growth in 2012 slowing to a below-trend 6. although this flexibility is admittedly less than it was in 2008–09.Emerging Asia As home to many of the most open economies in the world.75% in 2012. given decelerating global economic activity. largely reflecting declining investment and tight monetary policy. primarily in public housing. India appears most exposed to jitters in global financial markets. We expect this trend to continue.75% and inflation falling to 5–6. After all. this is further tightening the financing conditions of Indian Barring an extreme outcome in Europe. slowing growth should temper food inflation and thereby provide scope for policy easing in 2012. growth momentum is likely to slow further in China. waning inflation from decelerating economic activity should provide scope for looser macroeconomic policy. India India’s economy is also slowing.

In addition. Hungary and Poland particularly at risk. The uptick will likely reflect the lagged effects of the central bank’s proactive rate cuts last summer.5%. which is likely to cut rates and improve access for foreign portfolio inflows as a means of easing liquidity conditions. and with them. Therefore. enabling them to better respond to external shocks. India appears most exposed to jitters in global financial markets. 30 Goldman Sachs . central banks are likely to loosen monetary policy further. Thus. years of experience have improved Brazil’s macroeconomic management. with the Czech Republic.5% in 2012. In practice. which rely extensively on European banks.5–6. those in EMEA have the largest external financing needs and the closest trade and financial links with the Eurozone (Exhibit 32).5–3. with considerable downside risks. As with China. the impact on commodities prices could transmit the slowdown directly. On a more positive note. Middle East. settling in a range of 5. whereas Russia and South Africa are likely to be more resilient. copper and iron ore should continue to support the terms of trade in the region. Colombia and Chile will allow some budgetary stimulus as well. Among emerging market economies. Africa (EMEA) Among the larger economies in Asia. Latin America We expect sluggish activity in Europe to keep commodity prices in check. however. Unlike other emerging markets. In turn. with just 2% of its GDP destined for the EU. as well as an expected rise in the minimum wage.january 2012 companies. the key challenge for India’s policymakers will be to revive investment without creating a bigger budget deficit or rekindling inflation. should global activity surprise on the downside. given that commodity exporters account for 43% of Brazilian market capitalization. Europe. inflation is likely to remain above its target (for the third year running). tight supply conditions in oil. large-scale investments in both oil production and infrastructure to prepare for the 2014 World Cup will provide a further tailwind. undermining consumer sentiment. Moreover. Brazil Although Brazilian growth ended 2011 at depressed levels. any easing will most likely come in the form of modest interest rate cuts. Consequently. Mexico. weak equity prices could negatively impact wage growth and wealth. Turkey is also at risk given its large current account deficit. In theory. they are far more vulnerable to an adverse outcome in Europe than their Asian and Latin American peers. That said. Brazil is relatively insulated from the unfolding Eurozone crisis. Latin American growth. Given these budding external headwinds. the healthy fiscal balance of countries such as Brazil. albeit to a still below-trend 2. We expect the burden to fall on the central bank. most EMEA countries have limited room to counteract slowing growth with policy stimulus. we expect a rebound this year. We expect growth in EMEA to slow in 2012.

0–7.Russia Although Russia’s exposure to Europe through trade and financial linkages is the largest among the BRICs. which is further constrained by the depreciation of the ruble since mid-2011 and continued capital outflows.25–4.25% in 2012. Our forecast has a similar flavor. as we expect pre-election spending and relatively stable demand for oil and gas to support GDP growth of 3. Bank Loans From Eurozone as % of Broad Money Supply 140% 120% 100% 80% 60% 40% 20% 0% 0% BRZ TRK POL HUN CZR RUS 15% 20% 25% 30% 35% 40% 45% 50% IND CHN 5% 10% Exports to Eurozone as % of GDP Data as of 2010 Source: Investment Strategy Group. its economy has thus far been resilient. International Monetary Fund Investment Strategy Group Outlook 31 .5% for the year. these high absolute levels of inflation curtail Russia’s policy flexibility. Slowing growth should allow inflation to fall in a range of 6. Russia’s main exports. This durability is largely a function of robust domestic consumption and the relative strength of oil and gas prices. Among emerging market economies. those in EMEA have the largest external financing needs and the closest trade and financial links with the Eurozone. Russia may thus find itself less able to offset a deepening of the global growth slowdown. Even so. Exhibit 32: EM Trade and Financial Linkages to Eurozone Countries in EMEA have the largest exposure to Eurozone tensions.

that should not preclude reasonable equity returns in 2012 (Exhibit 34). whether in the form of US mortgages. risk aversion was once again in vogue.22 This shift away from fundamentals proved toxic for investment managers. valuations. positive. given a combination of negative real yields. In addition. Accordingly. a notable shift from their anti-inflationary policy tightening last year.january 2012 section iii Markets Outlook 2012 Financial Aftershocks PHOTO TBD year and even hedge funds down mid-single digits for the year (as represented by the HFRI Fund Weighted Composite). despite if 2008 represented the epicenter of the financial crisis. “The fire which seems extinguished often slumbers beneath the ashes. policy announcements. correlations and contagion risks that characterized the crisis.” In the wake of these systemic concerns. few investors will lament the passing of 2011. have become much more enticing. with 75% of large cap core equity mutual funds underperforming the S&P 500 last 32 Goldman Sachs . albeit below trend. While the structural nature of today’s concerns suggests aftershocks will persist. As 17th century French tragedian Pierre Corneille wrote. that last year’s renewed focus on these macroeconomic risks engendered the same type of elevated volatility. Chinese domestic loans or European sovereign bonds. evident in the character of asset class returns seen in Exhibit 33. the financial turbulence of both periods emanates from a similar fault line: an accumulation of debt. most government bonds look unattractive in our view. Today’s low yields also make it clear that generating attractive returns will require investors to take more risk. this combination of high earnings yields and low interest rates results in lofty global equity risk premiums. bolstering the relative attractiveness of stocks. global central banks are moving more aggressively toward reflation. particularly in countries of stress like those in Europe. Moreover. Perhaps it is not surprising. today’s S&P 500 dividend yield is higher than the 10-year Treasury yield. After all. To be sure. not economic reports. China and other emerging markets are also joining the fray. In contrast. For one. In sum. As evidence. then. drove the largest equity moves in 2011. 2011 was its aftershock. duration risk and some credit risk in select sovereigns. global growth should support further earnings gains.

while easier policy in emerging markets should limit currency gains there. While our forecasts are not grim.400 2.11% 4% .89 0.0% 3.000 Implied Upside Current Level 5% . we e xpect the US dollar to remain broadly stable. In addition.000 .17% 5% .875 44.650 . 2011 except where indicated Note: Total Returns in USD.400 .1% 18.53 0. political gridlock in the US and the potential for a hard landing in China have raised the risk and severity of adverse outcomes.0% 2.325 . 10% 5% 0% –5% –10% –15% –20% Barclays Muni 1-10 Barclays Aggregate Barclays High Yield US Equity US Trade Weighted Dollar Goldman Sachs Commodities Index Multi-Strategy Hedge Funds (THROUGH 11/30/11) 7.9% Implied Total Return 7% . but non-trivial possibility of a destabilizing outcome in Europe or China.2% Emerging Markets Equity Non-US Equity Data as of December 30. Datastream Investment Strategy Group Outlook 33 .17% Current Div. In short.20% 7% . Source: Investment Strategy Group. In the presence of these low probability tail Exhibit 34: ISG Global Equity Targets – Year-End 2012 We expect positive returns across equity markets in 2012. Current Level US (S&P 500) Eurozone (Euro Stoxx 50) UK (FTSE 100) Japan (Topix) Emerging Markets (MSCI Emerging Markets) 1258 2317 5572 729 41013 2012 Target Range 1.69 0.20% Volatility Since 1988 15. Datastream.2% Sharpe Ratio* 0.0% –4.950 800 .13% 9% . Source: Investment Strategy Group. slowing global growth.6% 5. our current forecast includes a higher downside probability.69 0. A combination of a stable greenback and slowing global growth should keep oil and gold range TableF_v7_010212.0% 19. Bond sentiment is a contrarian negative as well.7% –18.6% 5.65 Data as of December 30.23 Elsewhere.1% 5. while the likelihood of a truly adverse outcome remains low.6% 2. we are by no means Pollyannaish. There is little question that the confluence of sovereign developments in Europe. Barclays Capital historically being less than half.Exhibit 33: 2011 Asset Class Performance Risk aversion drove returns in 2011. it was on this basis that we advised purchasing tail risk protection via S&P 500 puts in July of last year.23% 10% .48. the penalty for being wrong has risen.1.5.4% –1.9% 2.7% 23. around 25%.1% 0. In fact.pdf bound this year.7% 10% .2.12% 1% . as just one third of institutional investors surveyed expect rates to rise in 2012.11% 12% . Yield 2.8% 15. 2011 *Sharpe ratio equals the midpoint of the total return range divided by volatility. embedding a low.600 5.7% –11.

setting a new all-time high in the process. S&P 500 operating earnings grew roughly 17% in 2011. have historically been better buy than sell signals.25 Consequently. 2011 MARKS 0% –4% –8% –12% –16% –20% Banks All Other DebtHolders Data as of 2011 Source: Investment Strategy Group. corporate earnings are growing. In fact. why not be completely risk averse? We see at least four reasons. all conditions that exist today. Bloomberg. valuation multiples moved 34 Goldman Sachs . the 2008 financial crisis demonstrated that loss estimates are fluid and greatly influenced by prevailing sentiment. VIX Periods of elevated volatility have historically been better buy than sell signals. considering the relentless cascade of negative shocks. As shown earlier in Exhibit 33. as we have highlighted before. VIX (3M Median) US Equities: Continued Resilience 86 89 92 95 98 01 04 07 10 Data as of December 30. We discuss these positions further in the pages that follow. the additional policy steps we expect may dampen today’s draconian Eurozone loss estimates. All told. SentimenTrader The S&P 500 was clearly the best house in a bad neighborhood last year. despite a relatively flat absolute return. top-down consensus estimates for 2011 actually rose 6% over the course of the year. The US Eurozone Estimate of Debt Losses Based on: %GDP WORST MARKS ACTUAL LOSSES JUNE 2011 MARKS DEC. and sentiment on stocks has soured. we have selectively positioned our portfolio in areas where we find that the prospective returns justify the risks.”24 Second. Thus. and chances are high that it will be. both homegrown and foreign. and hence heightened uncertainty like we have today. Empirical Research Partners Exhibit 36: S&P 500 Performance vs. Exhibit 36 reminds us that periods of great volatility. that the market endured. At the root of this resilience was the persistence of strong corporate profitability.january 2012 Exhibit 35: Expected and Realized Losses in US and European Crises The US financial crisis showed loss estimates are changeable with sentiment. the US was nonetheless the lone bright spot in an otherwise dismal year for global equity markets. Third. This was a remarkable feat. . 1800 1500 1200 900 600 300 0 70 60 50 40 30 20 10 0 S&P 500 Price Index risks. In contrast. 2011 Source: Investment Strategy Group. . The first was best articulated by Oaktree’s Howard Marks in his March 2008 quarterly letter: “The things one would do to gird for the demise of the financial system will turn out to be huge mistakes if the outcome is anything else . interest rates are low. the hurdle for underweighting stocks is high when valuations are undemanding. the losses ultimately realized in the US were just half of those estimated at the worst point in the crisis (Exhibit 35). In fact. Finally.

6% 49. Robert Shiller 53.9% 2. Historically. This tug of war between resilient earnings on the one hand. when the incumbent’s approval rating was as low as it is today.88% while the S&P offers a 6% real earnings yield and a 2. valuations reside around the mid-point of their historical range. The 10-year Treasury currently yields 1. Then. historical periods of similarly low rates saw the price-to-trend earnings multiple (our preferred valuation measure) several points higher. Indeed. valuations resided around the midpoint of their historical range. averaging 13%. this environment is likely to persist. offsetting impressive earnings growth. As a result. 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Earnings Growth Dividend Yield Multiple Compression 2. is a theme we expect to endure in 2012.26 Fundamentals Data as of December 30. as now. they remain depressed relative to prevailing interest rates. a reflection of falling price to earnings (PE) ratios. it is not surprising that valuation multiples would look strikingly similar to those shown in our last Outlook (Exhibit 38). Instead. we do see scope for presidential elections to reduce uncertainty this year.1% Total Return 15. as stock prices decoupled from record high earnings. But while today’s middling valuations are unremarkable versus their own history. simply removing the uncertainty sufficed. as investors worried about the durability of earnings in the face of countless headwinds (Exhibit 37).house in a bad neighborhood last year. stocks look particularly attractive relative to Treasury bonds. While the concerns have Investment Strategy Group Outlook 35 . 100% 80% 60% 40% 20% 0% Price to Trend Earnings Data as of December 30. 2011 Source: Investment Strategy Group. This skepticism was clearly on display last year. 2011 Source: Investment Strategy Group.1% With S&P 500 price returns flat in 2011. it actually did not matter who won the election. Of course. While valuation multiple expansion does not figure prominently in our central case. inves.in the opposite direction.6% Price to Peak Earnings Price to Book The S&P 500 was clearly the best After three years of robust earnings growth. regardless of the measure. Datastream. We discuss each of the four in more detail below: Valuations Exhibit 37: Decomposition of 2011 S&P 500 Return Pervasive uncertainty pressured valuation multiples lower. as all seven historical instances showed positive returns during the election year.0% 44. tors are rightly concerned about the sustainability of further gains. earnings and valuation represent just two of the four factors that determine our outlook. Datastream Exhibit 38: Percent of Time US Equity Valuations Have Been Less than Current Since 1974 Regardless of measure.9% –15.1% dividend yield. and the multiple investors are willing to pay for them on the other. With the Fed committed to low rates into 2013. particularly given already elevated profit margins.

5% –2. that would equate to profit growth of around 6%. our assumption of stable margins is not a bet against mean reversion per se. barring an exogenous shock.5% –3. plant-level costs as a percent of revenue fell nearly 6% over this period. still-elevated US unemployment and moderating inflation should mitigate two traditional sources of margin pressure as well. Chinese labor costs are expected to be just a quarter of those in the US.0% Cost of Inputs 0. Closer to home. mean reversion is not an independent force. with the previous two lasting almost six years. Moreover. but rather a view on its speed.5% –3. If realized. Meanwhile.5% 0% –0. In fact. we expect earnings growth to continue to outpace GDP growth. Applying the historical analogue literally suggests margins will not peak until late 2014. profit margins have Changes in the Cost Structure from 1997 to 2009 historically been mean reverting.5% –1. Empirical Research Partners Exhibit 40: S&P 500 Breakdown of Operating Profit by End Market S&P 500 profits are more leveraged to areas of the economy growing faster than GDP. since recessions have historically precipitated collapsing margins. but rather a reflection of underlying fundamentals.january 2012 Exhibit 39: US Manufacturing Plants (ex-Oil Refineries): been ill begotten thus far. Already. we do not expect an imminent collapse in profit margins this year.2% –2.3% –0. last year’s strong third-quarter operating earnings run rate suggests a 73% probability that 2012 EPS will be at least $103. most of the shift in profit margins over the last decade can be traced to globalization of the manufacturing supply chain. above the level we expect for US GDP.0% –3. That said. equipment & software spending is expected to grow at over three times the pace of GDP.0% –1. After all.3% Fuels and Electricity Wages Fringe Benefits Data as of September 2011 Source: Investment Strategy Group. despite some manufacturers returning to US shores.0% –2. a function of lower labor and other input costs. 36 Goldman Sachs . Energy/Commodities Financials 16% Consumer Staples Spending 18% 14% Medical Spending 17% 21% Business Spending 14% Consumer Discretionary Spending Data as of December 2010 Source: Investment Strategy Group. the continued US growth we expect this year also bodes well. As shown in Exhibit 39. the continued industrialization of emerging markets remains a tailwind to US based energy / materials firms. commodities and exports. suggesting the % of Revenue 0. such as business spending. As Exhibit 40 makes clear. Finally. Against a backdrop of steady margins. their pace of mean reversion is likely to be very gradual. even three years from now. the S&P 500 is more leveraged to areas of the economy growing faster than domestic consumption.28 As such.27 Because these margin gains were not cyclically driven. For example. Importantly. we note that margin up cycles tend to be enduring. Bank of America Merrill Lynch skeptics will be proven right eventually.

Investment Strategy Group Outlook 37 . markets get into trouble. fourth quarter returns greater than 10% have led to continued gains in the next quarter 92% of the time since 1932. Indeed. Thankfully. this combination suggests price returns of around 8% to the midpoint of our forecast range this year. as the S&P 500 is back near its 200-day moving average. considered the dividing line between technical strength and weakness. and oblivious to the downside risks. This. although we have admittedly been early in our enthusiasm.Technicals The S&P 500’s late 2011 rally has left it at a key technical decision point. Second. In fact. the year following these episodes registered a positive return 83% of the time. improving loan growth. Our view rests on the financials’ attractive valuations. the market now faces a confluence of overhead resistance. 2011 Source: Investment Strategy Group. as the market ultimately follows the path of earnings.”30 The net message of our equity framework is that stable margins. the market’s strong fourth quarter performance (>10%) suggests further near-term strength. eager to deploy capital. a feat History teaches us that when investors are complacent. fortified balance sheets. This observation echoes the conclusion of a 2008 academic paper. On the other hand. First. as this measure moved decisively above its long-term average in October and is approaching previous highs. the median gain was 5%.4 Data as of December 26. given the 200-day moving average overlaps with a downward-sloping trendline that has ended previous rallies. AMG Data Services Our View on the US Market Sentiment / Positioning History teaches us that when investors are complacent. none of these conditions exist in the equity space today. highlighting retail investors’ limited appetite for stocks. there have been $11. financials have now underperformed the market for five years running. We continue to like US financials. With the market at a crossroads. This paints a very different picture from that of late 2007 to early 2008. eager to deploy capital. Notably. which found a “significant negative correlation between sentiment-driven fund inflows and future returns. and US banks in particular. exposure to the stabilizing / improving US real estate market. two factors argue for prices resolving to the upside. will support slower. in turn.4 billion of outflows from US equity mutual funds in 2011. Of contrarian note. where deteriorating breadth foreshadowed subsequent price weakness. and nearly universal negative sentiment. the underlying trend is improving. well above the 2% gain of any random quarter. the continued strength in the market’s breadth (the cumulative number of S&P 500 stocks advancing less those declining) is positive. but still positive earnings gains. coupled with mid-single digit revenue growth. As shown in Exhibit 41.29 Exhibit 41: 2011 Cumulative Mutual Fund Flows to US Equities Negative US equity mutual fund flows is a contrarian positive. Billions $35 $30 $25 $20 $15 $10 $5 $0 –$5 –$10 –$15 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 –$11. and oblivious to the downside risks. markets get into trouble. As shown in Exhibit 42. On the one hand. Notably. last year was one of only six such years since 1992. provides a rising fundamental floor for equity prices.

which results from prices being pulled away from fundamental value by investor emotions. neither valuation nor supportive fundamentals are a binding constraint in the short run. Earnings $78 18. which typically results when investors pay excessively high prices or purchase excessively leveraged companies.14x 858 . Moreover. as they are now. today’s US equity market is priced to deliver 7% normalized annual returns over the next 10 years. we believe there are catalysts on the horizon this year: the second round of stress tests in March. and a permanent impairment of capital.102 Rep. We acknowledge that this year’s outlook is fraught with more risks than usual. lower than historical average returns. As such.97 Trend Rep. Earnings $112 Rep. In our view. we acknowledge that this year’s outlook is fraught with more risks than usual.5 . 38 Goldman Sachs . 2011 Source: Investment Strategy Group bested only by the utility sector in the run up to the technology bubble. the US market is neither excessively leveraged nor overpriced. the next decade of US equity returns is likely to be better than the last.5 . Earnings ≤ $64 Trend Rep. In fact. Earnings ≤ $80 Rep.1443 1325 . While history reminds us that prophecies of doom have been far more plentiful than the profits that arose from positioning for them. Earnings $97 . Earnings $92 . part of our comfort in remaining invested stems from the distinction we draw between a mark-to-market loss.1560 1450 Op. the normalized PE ratio explains 80% of the variability of market returns over a decade-long period.january 2012 E Exhibit 42: ISG US Equity Scenarios – Year-End 2012 GOOD CASE (20%) CENTRAL CASE (55%) BAD CASE (25%) End 2012 S&P 500 Earnings Op.32 For the patient investor. given that 160 of the past 176 years had a higher rolling 10-year compounded annual total return than today. Earnings ≤ $78 11 . these returns would double the invested capital over this period. as what is attractively valued today can surely become more so tomorrow.0x 1443 . Although strong US corporate profitability provides a bulwark. but very attractive relative to cash and bond yields. price volatility notwithstanding. resulting in asymmetric risks that undermine fundamental analysis. Even so.1400 Op. While we don’t expect a similar magnitude of outperformance.20.5x 1209 . many of the concerns we have discussed are political in nature.18. starting valuations are a key determinant of these long-run returns. we think it makes sense to build toward or maintain one’s strategic US equity allocation when valuations are fair. One. we make two additional observations.31 Two. for those investors who have first ensured they have sufficient “sleep well money” to actually sleep well. Earnings $106 Trend Rep. That said. further clarity on regularly requirements and the expiring statute of limitations on put backs for many of the worst mortgage vintages. On this point.1092 1000 S&P 500 Price-to-Trend Reported Earnings End 2012 Fundamental Valuation Range End 2012 S&P 500 Price Target Data as of December 31. If realized. utilities managed to outperform the market by a staggering 62 percentage points in 2000 as the losing streak abruptly ended. Earnings $78 15.

the banks are no longer the only source of cheap valuation in Europe. MSCI companies. we expect sovereign developments to remain a source of uncertainty. 2011 Source: Investment Strategy Group. with a valuable array of recognizable brands (such as Total and LVMH Moet Hennessy in France. including the risk of nationalization. High Risk Given the disparate fiscal and economic health of the Eurozone’s core and periphery. was that concerns about peripheral solvency metastasized into existential doubts about the entire Eurozone. 0% –10% –20% –30% –40% –50% –60% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 –52. many of these firms derive a majority of their sales from outside Europe. Anheuser-Busch in Belgium. the market is well aware of these challenges. and high funding costs. Given these broadly attractive valuations. At the center of this uncertainty stand the Eurozone banks. Siemens. 2011’s broad-based weakness has pushed Eurozone equities into the bottom quartile of their historical valuation range. realization of private and sovereign credit losses. they now trade at a much bigger discount to US equities than they have historically. SAP. 2011 Source: Investment Strategy Group. Bloomberg Exhibit 44: Eurozone Equities Price to Long-Term Cash Flow Premium/Discount to US Equities Eurozone equities trade at a historically large discount to those in the US. derives only 11% of its sales Investment Strategy Group Outlook 39 . a fair question is why own Eurozone equities at a time when the region is not only embroiled in a sovereign crisis. Basis Points 3900 Spanish Gov't Spreads to German Bunds (RIGHT SCALE) 600 500 400 300 200 100 0 –100 3400 2900 2400 Euro Stoxx 50 (LEFT SCALE) –200 –300 Sep-10 Jan-11 May-11 Sep-11 –400 1900 Jan-10 May-10 Data as of: December 31. In addition. equity markets in the core were no longer immune to the crisis. a more extreme example. For example. Clearly. we highlight two points.4X book value multiple.6% Eurozone vs. As a result. Even adjusting book value for the prospective losses we expect. That said. and hence volatility. only one-third of LVMH’s sales emanate from Europe. however. The first is that the Eurozone is home to several of the world’s largest multinational Exhibit 43: Spanish 3-Year Government Spreads Over German Bunds vs. but also a recession? In addition to the margin of safety provided by valuations. BASF. the resulting 0. as evident in Germany’s 15% decline in 2011. In turn. Daimler.Eurozone Equities: Low Valuations. A unique feature of 2011.6X price to book multiple remains depressed. Given the structural nature of the issues and the lack of straightforward solutions. for Eurozone equities this year. Nevertheless. their large holdings of Eurozone sovereign bonds represent a key fault line in the crisis. Datastream. Euro Stoxx 50 The intensification of credit stresses is mirrored in poor equity performance. there is no shortage of headwinds facing the sector. Instead. it is not surprising that sovereign fears have been the key driver of Eurozone equities for the better part of two years.9% Data as of December 30. Of course. capital raisings. as they constitute over a fifth of the region’s market capitalization. deleveraging. evident in the sector’s distressed 0. Given their international footprint. and BMW in Germany). we recommend a small tactical overweight to European equities. as seen in Exhibit 43. as seen in Exhibit 44. US P/10yCF HISTORICAL AVERAGE –32.

80% we do not include UK equities in the Eurozone overweight mentioned above. In aggregate. Source: Investment Strategy Group. 14%. these dynamics suggest less room basis. In fact. as evidenced by their tendency to peak prior to the beginning of recessions and bottom well before GDP and earnings trough. 6. These low valuations stand at odds with the rebuilding-led growth we expect in 2012. 2011 Note: Based on price to long-term cash flow. a faster rate than we expect in term averages.700 publicly-traded companies in the Topix trade below their book value versus just 16% in the US. MSCI 40 Goldman Sachs . remain caught in the middle. 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 the UK’s increasingly intertwined relationship with the Eurozone could overshadow any mod1992 Through December 30. Notably. a remarkable 70% of the nearly 1. but not eliminate. the combination of a supportive economic backdrop with some profit margin UK Equities: Caught in the Middle expansion will yield earnings growth around While UK valuations also stand below their long. Moreover. We therefore expect high overseas exposure to mitigate. eration in inflation. price to trailing 12 month cash flow. The percent of time less than current is calculated on a cumulative Taken together. at each point in time. the Topix stands at a lower level today than it did in January 1984. approximately 45% of Eurozone companies’ sales come from overseas. 60% 5-YR. As a result. while the FTSE 100 stands 17% 100% below its 2007 peak price level. the Japanese economy is likely to grow as fast as the US and outgrow the European economies in 2012.7% 40% a gradual moderation in inflation provides scope for multiples to expand closer to their historical 20% average levels.3% 3-YR. Datastream. today’s depressed valuations already imply an earnings decline of around 9-16% for 2012. On the other hand. having moved ahead of economic fundamentals consistently in each of the five recessions since 1970. Eurozone equities may reach their trough level in early 2012.e. Turning to 2012. price to book. Japanese Equities: Abandoned and Unloved While the tragic Tohoku earthquake and unfolding global growth slowdown have penalized Japanese equities. More specifically. On the one hand. AVG. In our view.january 2012 from Europe. for upside. i. based on our expectation that the recession will likely end by mid-year. despite the fact that earnings have grown 45% over the period. whereas broad UK valuations Exhibit 45: Percent of Time that MSCI Japan have been lower 33% of the time historically. The second point is that equity markets are forward-looking. we continue to believe Japan offers a compelling risk/reward opportunity. Moreover. and price to peak earnings. For these reasons. low domestic growth and already above-trend earnings are 1. AVG. Moreover. the recessionary drag. with the balance coming predominantly from the faster-growing US and emerging markets. along with our overweight position.5–10% in 2012.7% 0% likely to limit any earnings upside. European markets have been no exception. Valuations Have Been Lower than Current Levels the comparable figure for the Eurozone is just Japanese valuations stand near all time lows. which stand near their lowest levels since 1970 on both an absolute and relative basis (Exhibit 45). they are not as attractive as Eurozone equities given their relative outperformance. In fact. This conviction is heavily rooted in Japan’s valuations. consistent with the outcome we expect due to falling sales and margin contraction. we expect UK equities to 15. the current valuation level is compared to valuations during all periods prior to that point in time. Eurozone equities stand a full 49% below. pressuring multiples lower.

With about $1 trillion in cash. That said. who have historically been the marginal purchasers of Japanese equities? We see several potential triggers. In fact. Additionally. These actions are important. Japanese firms have used low valuations to increase share buybacks in recent quarters (Exhibit 46). while Japanese growth is likely to be the fastest in the developed world in 2012. At the outset of 2011. Future earnings growth could also be supported by Tokyo’s removal of a decades-old weapons ban. according to estimates by our colleagues in Goldman Sachs Global Investment Research. the market is currently implying an earnings decline of as much as 18%. enabling Japanese firms to enter the large international market for advanced weapon systems. we think it is still too early. we believe there are structural differences that mitigate the near-term risk. valuations de-rate and EM equities fall 20% in dollar terms. as global investors perceive yen appreciation to be negative for the Japanese corporate sector. based on above-average valuations. slowing global growth has tempered inflationary pressures. it would not be immune to the financial market contagion resulting from a Eurozone meltdown. although as we discussed earlier in our Japanese economic outlook. Japan’s large government debt load and fiscal deficit leave it susceptible to the same market pressures Europe faces. relative valuations have simply returned to Investment Strategy Group Outlook 41 . Clearly. Finally. Exhibit 46: Topix Share Buybacks Japanese firms are more aggressively repurchasing their shares. again highlighting the attractive valuation of the Topix. investors will obviously discount its sustainability. Moreover. which saw margins disappoint. These buybacks. First. all against an inflationary backdrop that threatened to pressure margins and multiples alike. the emerging market (EM) outlook was a cautionary tale. many of these imbalances have been rectified. a contrary positive. given the persistent underperformance of Japanese equities. Despite these catalysts. current EM valuations are trading at around a 20% discount to their own history and have been cheaper only 12% of the time in the last 15 years. Goldman Sachs Global Investment Research Emerging Market Equities: Still Too Early What a difference a year makes. providing cover for easier policy in 2012. Finally.6%. In addition. resulted in a total shareholder yield of 3. Against this backdrop. it might be tempting to overweight EM equities. partially offsetting foreign selling.any of the other major equity regions. While absolute valuations appear attractive. After a year of marked underperformance. despite increased intervention efforts. coupled with an already attractive dividend yield of 2. the Bank of Japan has become more aggressive in stemming the rise of the yen. Billions ¥350 ¥300 ¥250 ¥200 ¥150 ¥100 ¥50 ¥0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2009 2010 2011 Data as of August 2011 Source: Investment Strategy Group. In stark contrast. lofty earnings growth expectations and exuberant sentiment. last year’s roughly $40 billion in EM mutual fund outflows suggests sentiment has cooled. the Japanese yen could always appreciate further. although Japan has very limited trade and direct financial exposure to Europe. a key question is what will stop the recent selling trend among foreign investors. the outlook for Japan is not without risks. a notion we continue to explore. Moreover. Japan is pursuing expansionary fiscal policies at a time when the rest of the developed world is fiscally consolidating.7% in 2011. having intervened on three occasions in 2011. they have ample resources to continue. Of course. Second.

In short. US corporations have produced a return on equity 2. as slowing growth has historically pressured EM margins (Exhibit 47). In addition. Moreover. Moreover. but similarly impacted. poor governance and greater exposure to European and Chinese tail risks. an event we do not expect until the middle of the year. there is scope for further negative earnings revisions. In fact. our forecast assumes growth in the 5-10% range. our favored currency bloc last year.34 As such. as the tradeweighted US dollar first depreciated to its weakest post-crisis level by mid-year but then managed to recoup these losses. Lastly. The principal driver behind these shifts was the unfolding crisis in Europe. the correlation of EM currencies to risky assets reached record highs. as does emerging markets’ broader lack of transparency. higher yield. continued trade surplus and the stability of the Chinese renminbi (up 5% vs. While we expect broader risk appetite to remain a dominant influence on currency movements this year. the US dollar). the six-month correlation between EM currencies and the S&P 500 finished last year at 80%. fund managers remain overweight EM relative to other markets based on recent survey data. we remain neutral EM equities at present. While some argue that emerging markets’ superior growth deserves a premium valuation. differentiation is emerging. as well as the 15–25% discount our work suggests is justified. We expect the renminbi to appreciate further in Exhibit 47: Leading Economic Index and Emerging Markets Earnings Growth Leading indicators suggest EM earnings growth is vulnerable to further slowing. a recent study found that while $100 of sales in the US generates $8 of free cash flow available to shareholders. standing about 20% below those of the US. we note that not all growth is created equal. held up relatively well thanks to their strong fundamentals. particularly those with the strongest trade and financial linkages to the Eurozone. Moreover. were emerging European currencies. by year-end (Exhibit 48). EM risk-adjusted expected returns are not yet over our hurdle rate. and then some. EM tends to outperform other markets only after an inflection point in economic momentum.january 2012 neutral levels. 20% 15% 10% 5% 0% –5% –10% –15% 99 00 01 02 03 04 05 06 07 08 09 10 11 EM Earnings Growth (RIGHT SCALE) YoY% Advanced 9 Months (LEFT SCALE) 100% OECD EM Leading Index 80% 60% 40% 20% 0% –20% –40% –60% Data as of October 2011 Source: Investment Strategy Group. evident in the strengthening of perceived traditional safe-haven currencies such as the US dollar (USD) and Swiss franc (CHF). Less fortunate. over the last seven years. sentiment is not yet offering a contrarian buy signal. although positive sentiment toward EM has moderated from the heady levels that prevailed in late 2010.5 percentage points higher than EM. or less volatility. 2012 Global Currency Outlook Last year was a tale of two halves. Consensus expectations for 12% earnings gains are likely optimistic in our view.33 This lower-quality growth deserves a lower valuation multiple in our view. Datastream 42 Goldman Sachs . This discount is consistent with EM’s 20% historical average discount. they come with much higher volatility. The bulk of emerging market earnings growth derives from adding additional capital. To wit. the comparable figure in EM is half that amount. Consequently. preferring to take exposure in markets with either better relative valuations. While this year’s expected EM returns are consistent with other developed markets. Asia. rather than generating a higher return on that capital. As a result. Relative valuations are not the only factor giving us pause. more consistent with the 8% average over the last 15 years.

Moreover. 2011Data as of December 31. we have few directional currency views this year. given the positive equity returns we expect this year. Second. Indeed. a contrarian positive. valuations remain attractive. several shorter-term headwinds leave us tactically neutral. a better entry point will likely present itself. the USD’s negative correlation with risky assets in recent years is a further dollar headwind. the euro has been. First. Longer-term. Datastream ience. In addition. the most resilient European asset during the sovereign crisis. this negative “carry”. we expect the ECB to cut rates further in response to the crisis. Finally. or difference in local interest rates. the euro. which in turn erodes this positive carry. short-term interest rates remain about 75 basis points higher in the Eurozone than in the US. In addition. concern about rising US indebtedness could hurt the dollar. On the other hand. especially against a backdrop of decelerating global growth. with the USD cheap against most developed currencies. 110 USD vs. some improvement in sovereign tensions in 2012. given moderating global growth and flattening reserve levels. and the Australian dollar. Euro 2012. higher short-term interest rates (“positive carry”) and healthy underlying fundamentals. Outside the renminbi. Even so. these remain lowerprobability downside risks. given its continued appreciation and resulting overvaluation. as belowtrend growth and easier policy offset the lift from investors diversifying away from the euro. the trade-weighted US dollar has been a benefactor of ongoing European stresses. while we think emerging market currencies offer an attractive mix of supportive valuations. In contrast. although other global central banks are beginning to ease. could be euro positive. In turn. a contrarian negative. they remain well behind the US Federal Reserve. despite European equities falling 17% in 2011. albeit at a slower pace. Indeed. investor sentiment is quite bullish on the dollar already. we remain bearish on the yen. as could an unruly rise in inflation. 2011 * Note: US Dollar Trade-Weighted Indecies are as of December 23. provides a further tailwind. as well as a mid-year trough in growth. by far. but undervalued against most other developed currencies. places depreciation pressure on the currency. 2011 Source: Investment Strategy Group. the euro was down only 4% on a trade-weighted basis. up almost 9% in the last four months of 2011. the Japanese yen. not our central case. particularly valuation. as we discuss later. sentiment and positioning are already very euro bearish. support our strategically bullish view on the US dollar. While the euro is somewhat undervalued on a trade-weighted basis. US D US Dollar True to its safe haven status. this statistic masks a more nuanced valuation backdrop relative to other developed currencies. Finally. As already discussed. providing a positive carry attractive to investors. including its roughly 10% undervaluation vs. Emerging Markets FX USD Trade-Weighted Index (Broad) USD Trade-Weighted Index (Major Partners) ST RE NG TH 108 106 104 102 100 98 96 94 92 Dec-10 US DW EA KN ES S Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Data as of December 31. we expect the unfolding recession and consequently more dovish ECB to neutralize the tailwind resulting from some moderation in sovereign risk this year. the euro is expensive against the USD. For the euro. On the one hand. especially the Swiss franc. aggressive ECB action. including unsterilized quantitative Investment Strategy Group Outlook 43 . While these factors.Exhibit 48: US Dollar Performance in 2011 The US dollar set a new post-crisis low in mid-2011 but more than recouped those losses by year-end. We are broadly neutral on the USD and pound sterling (GBP). US economic resil- Much to the chagrin of its numerous detractors. That said. Other relevant factors are equally mixed for the euro.

25% relative to the yen and Swiss franc and fair value relative to the US dollar. In fact. and several emerging European countries. could weaken the euro considerably. we expect better risk-adjusted entry points later this year. Our view is predicated on several factors. a contrarian negative. sentiment is positive on the yen. Emerging Market Currencies After falling about 25% during the financial crisis and recovering only marginally. In turn. Moreover. the Eurozone and the UK are also likely to maintain low interest rates for the foreseeable future. the unfolding Eurozone recession is a clear negative for the euro. this could further pressure the euro as investors diversify their holdings out of the currency. Taking full advantage of this fact. the British pound is inexpensive against a range of developed currencies. As is often highlighted in the British media. a comparative advantage in a world of yield-hungry investors facing the zero bound of policy rates in the US. the Bank of England remains committed to easy monetary policy. Namely. Even so. a stance we expect them to maintain through more quantitative easing measures this year. we think caution is warranted in the first half of 2012. a testament to its perceived safe-haven status. given the numerous sources of European political uncertainty that are likely in early 2012. In response. particularly relative to those in the developed world. the Ministry of Finance intervened repeatedly in FX markets to slow yen appreciation. In addition. the US dollar. More specifically. we retain a bearish bias on the JPY. we remain neutral on the euro for 2012. the JPY appreciated last year in response to rising global uncertainty. positioning and sentiment suggest investors already expect pound appreciation against the euro. but non-trivial probability of extinction. Perhaps most importantly. Despite a dovish BOJ. short-term government securities in India and Mexico. however. as it is now about 18% overvalued vs. their higher local interest rates compared to those in the US result in an attractive carry. their public debt burden is lower and their currencies are relatively undervalued given recent depreciation. Moreover. Monetary This year’s challenging external environment will be a serious headwind to the much-needed appreciation of Asian currencies. despite central banks’ best efforts to boost domestic demand through easier monetary policy. In addition. finishing 2011 near its all time highs. monetary flexibility is a key advantage of not being part of the European Monetary Union. we expect Asian currencies to remain beholden to broader risk 44 Goldman Sachs . slowing global growth will reduce demand for Asian exports. the UK and Japan. we remain neutral on the pound and anticipate another year of broadly range-bound trading. thereby eroding the size of the balance of payment surpluses we expect. the yen has remained defiant. Despite these tempting positives. Given these competing tensions. Despite these attractive valuations. the euro faces a small. provides a tailwind for currency appreciation. For instance. it is about 10% undervalued relative to the euro. reflected in our recommendation to hedge the FX exposure in our Japanese equities tactical tilt. offer incremental yields of 3–8% relative to US Treasury bills. in turn. and the US dollar’s tendency to act as a safe haven during bouts of risk aversion. persistently high UK inflation should erode the pound’s value over time. For example. Asian Area Currencies Like the US dollar. a contrarian negative. central banks in the US. This persistent strength has made the currency expensive. ongoing European uncertainties could threaten capital inflows. their economic growth is faster. given the ongoing sovereign debt crisis. As such. Moreover. In addition. This carry. British Pound policy is more of a neutral factor. as well as exposure to currencies that are 15–20% undervalued. Against this backdrop. Yen There is much to like about emerging market currency fundamentals.january 2012 easing on a scale equivalent to that in the US and the UK.

we expect the renminbi to trade close to its government-determined target rate against the US dollar – albeit with a bit more volatility than it experienced during either the 1997-98 or 2008-10 financial crises.3% 9.9% 12. ranging from about 5% in US corporate high yield to as high as 36% in 30-year Treasuries. were one of the few investment bright spots of 2011. Even so. depending on the specific bond sector.appetite.6% 5. the Chinese renminbi is likely to appreciate further in 2012. rates have not been this low in the US since the early 1950s. In our view. 2011 Source: Investment Strategy Group. two countervailing forces will keep high quality fixed income rates close to. Moreover. even if the European crisis escalates. On the other hand. as concerns about the downside recede. particularly those of the “safe harbor” governments.3% 35. it is inevitable that rates will rise over the next Exhibit 49: Fixed Income Returns by Asset Class 40% 35% 30% 25% 20% 15% 10% 5% 0% 30 year US Treasury 10 year US Treasury Germany 7-10 year (local) Muni 10 year High Yield Muni EM Local Debt (local) EM Dollar 17. a meaningful depreciation of the renminbi is unlikely.2% 8. the key cyclical and structural concerns discussed earlier will put downward pressure on rates as investors seek safe harbor in US Treasuries. a slower 1–4% pace of appreciation is likely this year. despite the low level of rates at the beginning of the year. interest rates will start to rise. Notably. they lowered overall portfolio volatility. export growth slowing and inflation moderating.0% High Yield Corporate 2. 2011 was a reminder of the important strategic role bonds serve in a portfolio: they provided a meaningful hedge against equity declines. 2012 Fixed Income Outlook Fixed income securities. as the ever cautious Chinese policymakers wait for the fog over Europe to clear. for taxable US investors. as they outperformed equities across the world. or slightly higher than.2% 12. As shown in Exhibit 49. JP Morgan Investment Strategy Group Outlook 45 . Barclays. As result of this strong performance. pulled higher by inflation and the expectation of monetary policy normalization.4% 7. current rates in the next year. Importantly. Despite these near-term competing tensions. Their relative returns were equally impressive. given the threat of protectionist measures from Congress. On one hand. German Bunds and. With such low starting rates. and hence closely track the path of the S&P 500 well into 2012. and they generated some income—albeit at modest levels of about 3–5%. In fact. high quality municipal bonds.5% EMU 7-10 year (local) Data as of December 30. 10-year rates are now just below 2% in both the US and Germany. they provided attractive absolute returns. as well as a desire to avoid competitive devaluations in Asia. with reserves stabilizing. That said. the critical question facing investors is what type of returns can be expected from fixed income securities in 2012.

and sell an equal amount of Treasury securities with remaining maturities of 3 years or less. As a result. 1 year Cash Intermediate Duration 10 year Treasury 0. Second.” As last year demonstrated.january 2012 location to their “sleep well money. even without further downside. Thus. 3-month Treasury bills stood mid-2013. we think changes 46 Goldman Sachs . there is some chance—albeit small--of further quantitative easing. or the more widely used ratio of municipal bonds to Treasury rates. Exhibit 50: Prospective Returns on US Fixed Income and Cash Regardless of duration. even with fixed-rate 10-year Treasuries is 2%. clients would forgo some reasonable returns as interest rates fell further. TableCT_v4_010112. paltry returns have prompted us to underweight For one. In addition. the expected Gulf or the Korean Peninsula. Japanese rates were never negative during this period due to the country’s deflationary environment. Given the unfavorable tax this year.2% and 2. Let’s review the specifics of each market. in That said. the inflation rate at which they break investment grade fixed income. given the absence of any valuation dislocation. Third. such larly compelling valuations for a few reasons. these bonds are a consistently reliable hedge in the portfolio.0% –1.8%. On this point. if the Federal Reserve were to undertake further quantitative easing.2% 3 year (Annualized) 0. if the economic growth and the unemployment rate do not improve soon. so the US and Germany could certainly follow suit. 2011 Source: Investment Strategy Group We think that US municipal rates will generally follow the path of Treasury interest rates during 2012. returns for 10-year Treasuries are negative as Turning to Treasury Inflation-Protected Secushown in Exhibit 50. real rates ranged between 1. they might consider extending the period 30-year Treasury bonds were just 2. There are four main reasons.1% –2. But that comparison is completely invalid in our view: when nominal rates in Japan dropped below 1.pdf First. If we assume the mid-point of risks such as increasing tensions in the Persian our range for the end of 2012. municipal bonds are generally in line with. Fourth and finally.7% in 1997 and reached a low of 0. 10-year TIPS have had a negative yield over the forecasts include a 30% downside probability last several months. A recent example was September 2011’s announcement of “Operation Twist. but rather when they will.5% in 2003. given that our US and European economic for 2012.5% several years: at current levels of interest rates and roughly 2% inflation. prospective returns look unattractive. US Municipal Bond Market Data as of December 30.0% –0. Whether we look at the absolute after taxyield differentials between municipal bonds and Treasuries. the question is not if rates will rise. we are not recommending a zero line with our muted 2% inflation expectations weight either. Treasury securities.88% and effect.6% –2. end of 2012 we expect the 10-year Treasury Treasury securities are one of the few sub-asset rate to rise moderately to somewhere between classes to hedge against unforeseen geopolitical 2% and 2.” whereby the Federal Reserve indicated that it would purchase $400 billion of Treasury securities with remaining maturities of 6 years to 30 years. as shown in Exhibit 51. which could also result in a further drop in long term rates. clients should maintain a sufficient altreatment of TIPS (discussed in great length in our 2011 Outlook). Indeed. the Federal Reserve has already committed to keep its policy rates on hold through US Treasury Market At the end of 2011. If this policy does not have the desired at 0. to slightly cheaper than. 10-year Treasury notes at 1. we do not recommend ownCT ing them at this time. By the to 2014. investors do not even receive a positive real yield. we do not think they offer particutive over a three-year horizon. In turn. The returns are also negarities (TIPS).89%.01%.75%. unlike the US today. we recognize that some may argue that Japan had low rates for decades. In other words.

Lastly. i. We also think that the systemic risk of deteriorating finances that hovered over the municipal market has dissipated.e. US Census Bureau in Treasury rates (as discussed above) will be the primary driver of municipal rates. we do not think it is an issue for 2012. JP Morgan.0% –0. higher taxes (revenues from both a better economic backdrop and higher tax rates. Bank of America. Citigroup. the volume of new issuance did not offset the volume of bonds that were redeemed. $600 $500 $400 $300 383 Gross Issuance Net Change in Outstanding Debt 424 386 407 431 334 287 236 168 95 $200 $100 0 –$100 155 98 –11 –62 06 07 08 09 10 11 12E Data as of December 27. state and local revenues have increased eight quarters in a row.0% Dec-11 Data as of December 30. As shown in Exhibit 53. and earlier distributions from 2009’s American Recovery and Reinvestment Act (ARRA). Most states. two states with the lowest credit ratings. compared to nine late budgets two years ago. have improved their fiscal profiles over the last 2 years. Billions .5% Dec-10 Mar-11 Jun-11 Sep-11 10-Year TIPS Yield –0. net new issuance in the US was actually a negative $62 billion in 2011. while some have raised concerns about underfunded longterm pension liabilities. Federal Reserve. 3.0% 1. Datastream Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2008 2009 2010 2011 Data as of September 30. YoY% 10-Year Breakeven Inflation 2.0% 0. managed to pass their budgets on time.1% 1.0% 20% 15% 10% 5% 0% –5% –10% –15% State and Local Total Revenues Revenues from Property Taxes 4. The supply and demand picture will be supportive of municipal bonds as well. all states with the exception of Minnesota passed their budgets on time. including sales taxes). 2011 Source: Investment Strategy Group. While they still had a $91 billion budget shortfall (mostly a result of the $53 billion drop in ARRA funds in 2012). this was the Exhibit 53: Municipal Issuance by Year Shrinking net supply is supportive of municipal bonds. Notably.1% Exhibit 52: US State and Local Government Revenue Growth State and local government revenues have increased eight quarters in a row. through a combination of primarily lower expenditures.5% 0. As shown in Exhibit 52.0% 2.Exhibit 51: 10-Year TIPS Yield and Breakeven Inflation TIPS negative yield and poor tax treatment make them unattractive.5% 1. Even Illinois and California. in our view. 2011 Source: Investment Strategy Group.5% 2. 2011 Source: Investment Strategy Group. Morgan Stanley Investment Strategy Group SHORT USD LONG USD Outlook 47 .

1 billion. Pennsylvania due to an expensive trash incinerator project. we think that clients should moderately underweight their high quality municipal bonds to fund various tactical tilts.”35 Despite these headlinegrabbing bankruptcies. high yield spreads finished last year at 699 basis points (bps). Alabama due to a sewer system overhaul. Our optimism reflects several factors. After returning 58% in 2009 and 15% in 2010. Adjusting for default rates of between 1% and 2% and conservative recovery rates of about 60%. despite recent improvement in US economic data. In summary. and in fact. based on the excess spread over actual default losses that investors have demanded historically. Hence. One of the few areas that provides an attractive relative return is the high yield sector of the municipal market.36 Viewed another way. Of course. Throughout 2010. corporate high yield’s 5% gain last year may seem paltry by comparison.” Given our view that the US expansion continues in 2012. this implied default level is more than 3 times the actual trailing default rate. Finally. Indeed. there were three Chapter 9 bankruptcy filings that garnered considerable press: Jefferson Country. That said. not far from their adverse scenario. As before. actual defaults would have to be greater than 10% to erode this spread fully. this mid-single digit return was nonetheless impressive. the most pertinent question for investors now is whether this streak of positive returns is sustainable in 2012. As shown in Exhibit 54. compared with an average annual increase of $87 billion over the last five years. Rhode Island with a population of just 19k. Notably. Given our view of generally rising rates at some point over the next few years. Harrisburg.8% over similar maturity. a mere 0. Finally. we would not recommend an overweight to such long maturity securities. A November Bloomberg story pointed out that the first two had “commonalities in the conditions that brought them to bankruptcy: risky debt structure. well above the year-ahead base case forecast of Moody’s. the rampant concerns about municipal defaults have also dissipated. we think that clients should moderately underweight their high quality municipal bonds to fund various tactical tilts. we recommend clients stay fully invested at their strategic weight in high yield municipals. we see scope for spread compression as macroeconomic fears recede. which incorporates “a double dip recession in the US. we advise clients to be fully invested in high yield municipal bonds at the customized strategic allocation. The only reason we do not recommend an overweight is the fact that high yield municipal bonds tend to have longer maturities. not the least of which is our view that today’s high yield spreads more than compensate investors for the likely path of defaults. well above the 522bps average over the last decade. But as Exhibit 33 showcased earlier. as municipal finances have improved. we don’t anticipate any meaningful defaults or bankruptcies among higher quality municipal bonds and those that do occur. US Corporate High Yield In summary. high yield municipal bonds will most likely outperform similar maturity Treasuries and high quality municipal bonds. and Central Falls. will probably be concentrated in the unrated market. 48 Goldman Sachs . In fact. overall defaults through November 2011 totaled just $2. particularly considering the dismal performance of most risky assets last year. which offers an incremental yield of 3. many commentators forecasted record defaults that never materialized in 2011. political failures and officials who spent taxpayer money with little oversight. the market seems to be discounting defaults of around 7%. clients should not go to a zero weighting for the same reasons we would not recommend a zero weighting to Treasuries.january 2012 first contraction in the size of the municipal market since 1996. high quality municipal bonds. That is not to say that the municipal market did not have some defaults and bankruptcies. We believe it is. given the pervasive macroeconomic headwinds.06% of the total outstanding market value of municipal debt.

the amount 4% of debt scheduled to mature in the next three 2. in our view. In addition.Source: Investment Strategy Group. As shown in likely path of defaults. Indeed. the “search for yield” should continue to benefit high yield bonds. only 38% in the three 6% years ending mid-2008. given the negligible returns we expect in cash and most government securities. the magnitude of defaults has been reduced in at least three ways.0% 2% years has dropped by nearly $600 billion since the end 2008. underlying credit Required to Implied Given Trailing BASE ADVERSE Fully Erode Historical Excess 12 Month Moody's Twelve Month fundamentals have been bolstered. we think Today's spreads look attractive relative to expected defaults. First. we note the high yield technical backdrop is much more favorable today. even in an adverse scenario. Moodys cial crisis.Exhibit 54: High Yield Corporate Bond Default Rates Even if a recession were to occur. reducing the default loss content of the high yield universe. Exhibit 55. Similarly. dealer inventories stand at all time lows today.4% 2.7% debt maturities. This ratio stood around 1 in Data as of December 2011 2007.” Second. making it an extremely attractive riskadjusted investment opportunity.37 As a result. high yield companies 12% have aggressively refinanced and extended their 10. Barclays. Investment Strategy Group Outlook 49 . greatly reducing the much feared 0% “wall of maturities. as high yield Current Spread Spread* Forward Forecast issuers today hold almost $2 in cash for every $1 in short term debt. the potential for orphaned bridge loans and CLO warehouse sales to pressure spreads meaningfully wider is also materially lower today. as shown in Exhibit 56.8% issuance over the past 3 years has been used to refinance existing debt. many of the weakest credits have *Implied defaults assume 30% recovery and historical excess premium of approximately 250 bps already defaulted / restructured during the finan. Taking these factors together. Finally. a very different backdrop from the bloated positions that necessitated forced selling during the financial crisis. Lastly. we expect corporate high yield to deliver around 12% returns this year. vs. suggestToday’s high yield spreads more ing a repeat of the dramatic increase in spreads than compensate investors for the that occurred during the financial crisis is less likely. which lowers their leverage and 10% future debt refinancing risk. 67% of all 8.3% 8% 6.

German Bunds benefitted from their safe harbor status relative to other European bonds. the returns in the much of the periphery were much worse. Spain performed relatively well. As a result. 2011 Source: Investment Strategy Group. with Greece and possibly Portugal providing the exception. we expect considerable interim volatility as policymakers will continue to pursue an incremental. 12% 10% 8% 6% 4% 2% 1. And like US Treasuries. fixed income securities of the peripheral Eurozone countries were the epicenter of the sovereign debt crisis in 2011. JP Morgan Just as mortgage-backed securities were the epicenter of the financial crisis in 2008. Needless to say.7% return.3% and Ireland generated a 12. Billions $350 $300 $250 $200 $150 $100 $50 0 Bridge Loan Risk $20 $45 $1.00% in 2012. there was a big divergence in returns between German Bunds and other Eurozone country bonds. the sovereign debt crisis is fraught with risk: any policy mistake at the supra-nation- 50 Goldman Sachs . dropping to their lowest levels in the post-World War II period. Bank of America Merrill Lynch.9% last year. reducing the risk of forced selling. spreads widened across all the GIIPS countries. Of course. As shown in Exhibit 59. In our central case of a mild European recession. In fact. with Italy -6. returning 9.2% behind the safe harbor returns of German Bunds was quite the surprise in 2011! Like US Treasuries. with the greatest widening in Greece. Portugal -31.82% to somewhere between 2. we expect German rates to start normalizing later in 2012 as the German economy recovers and the worst of the sovereign crisis is behind us.5 CLO Warehouses $330 2007/2008 Today Data as of November 2011 Source: Investment Strategy Group.january 2012 Exhibit 55: Primary Dealer Positions as a Share of the Corporate Bond Market Dealer inventories stand at all time lows today. reactive and inconsistent approach.8%.1% and Greece a staggering -57. Even a core eurozone country like France saw some spread widening. While this tightening will provide attractive long-term returns. As shown in Exhibits 57 and 58.25% and 3. Federal Reserve Bank of New York Exhibit 56: Bridge Loans and CLO Warehouses The HY market's technical backdrop is much better today.2% Eurozone Bonds 0% 01 02 03 04 05 06 07 08 09 10 11 Data as of December 21. along with a relatively orderly Greek debt restructuring and further progress toward fiscal integration we think the spreads of the peripheral countries are likely to tighten relative to German Bunds.9%. Datastream. Ireland providing a return that was only 0. German Bund rates are expected to rise modestly from year-end levels of 1. while Germany had a total return of 12. with yield levels implying almost 100% probability of a deep sovereign bond restructuring in 2012.

would have negative consequence for the financial markets. JP Morgan –57. it is also not a zero-probability outcome. Bloomberg Data as of December 30. Moreover. Basis Points Exhibit 58: Five-Year Government Bond Spreads Over Germany Eurozone tensions have dramatically increased funding costs for peripheral sovereigns.9% 12. JP Morgan al or national level. German rates would fall and incremental yields across peripheral and semi-peripheral countries will increase substantially. a limited exposure to peripheral debt is also appropriate given the current level of spreads.1% –6. While such a scenario is not our central case. perhaps more like a 10–15% probability. 2011 Source: Investment Strategy Group.Exhibit 57: Five-Year Government Bond Spreads Over Germany Spreads have widened across all the GIIPS countries.3% 6. In such a scenario. For those who can withstand the volatility. In turn. Basis Points 700 600 500 400 300 200 100 0 Jul-11 Aug-11 Sep-11 France 110 539 3000 2500 5163 6000 5000 4000 3000 2000 1000 Portugal Ireland Greece (RIGHT SCALE) 1502 Italy 330 2000 1500 1000 500 Spain 686 0 –500 0 Oct-11 Nov-11 Dec-11 08 09 10 11 –1000 Data as of December 30.8% –31. we recommend clients maintain German Bunds and other high quality bonds in their sleep well basket. the recession could also be deeper as result of a weaker global backdrop or the unintended consequences of greater austerity measures.9% 12. Exhibit 59: European Sovereign Bond Returns Spread widening has driven negative returns for peripheral bond holders. 20% 10% 0% –10% –20% –30% –40% –50% –60% –70% Germany Ireland Data as of December 30. 2011 Source: Investment Strategy Group.7% 9. 2011 Source: Investment Strategy Group. or the loss of control by any leader due to internal strife arising from austerity measures.5% Spain France EMU Italy Portugal Greece Investment Strategy Group Outlook 51 . In summary. peripheral bonds may then have negative returns approaching what we saw in Portugal in 2011.0% 2.

the 6. especially in emerging Europe and Africa. we have long maintained EMLD is a risky asset class and should not be a substitute for a client’s “sleep-well” money. before climbing back to around 56% currently. several idiosyncratic factors proved more decisive for commodities in the first half. While broader risk aversion was a stronger influence in the latter part of 2011. pushing WTI prices close to $115/barrel and Brent prices close to $125/barrel. evident in many assets last year.2 million barrels per day of Libyan crude oil exports for most of the year. Although we expect the underlying bonds to return 4–8% by the end of 2012. BO__Ex60_v3_010112_jk_v2_sho. Thus. agriculture prices are still down between 20–30% from their peaks. adverse weather and macroeconomic worries led to another volatile year for commodities. we remain structurally positive in the medium term. Notwithstanding its recent volatility. as we discuss next. Spot Price YTD Spot Return YTD Excess Return* 27% 2% –1% Energy 27% 9% 5% Agriculture 34% –18% –19% Industrial Metals 13% –21% –23% Precious Metals 35% 10% 10% Livestock 10% 12% 0% Data as of December 30. performance in the interim could be highly volatile given the unfolding European recession and the high correlation of EM currencies to global risk appetite. Indeed. 2010 Avg. An upward-sloping curve (contango) is negative for returns while a downward slopping curve (backwardation) is positive. is more cautious. the Arab Spring resulted in the loss of 1. 2011 * Excess return is the difference between the actual return from being invested in the front-month contract and the spot return and depends on the shape of the forward curve. For these reasons. soybeans to $14. a wet spring and a summer heat wave in the US sent corn prices close to $8/ bushel. When all was said and done. government debt of the EM countries underlying this asset class is less than half that of the advanced world. Even so. only to weaken in the second half. however. the S&P GSCI’s 180-day correlation to the S&P500 collapsed from 64% to just 11% in June. as commodities rose rapidly in the first half of the year. despite an investable market capitalization of over $800 billion – about the same size as US high yield – EMLD remains a relatively untapped asset class with foreign institutional investors accounting for only about 10% of the universe. the S&P GSCI broad commodity index finished down slightly for the year. This relatively flat finish masked a tale of two halves. Given the interplay of commodity specific factors and general risk appetite. EMLD still benefits from several powerful tailwinds: at 45% of GDP (in 2011). In the first half of the year.pdf The purpose of the hedge is to reduce the effect of any downdrafts emanating from the European sovereign debt crisis. more than offset the 8% gain from the underlying bonds. as shown in Exhibit 60. Our shorter-term view. Source: Investment Strategy Group.5/bushel and wheat to almost $9/bushel. as crop damage turned out to be less than feared. 2012 Global Commodity Outlook A mix of geopolitical instability. we recommend only a modest tactical overweight to EMLD. Spot Price vs. Similarly. the S&P GSCI correlation to the dollar index BO Exhibit 60: Commodity Returns for 2011 S&P GSCI 2011 Avg.january 2012 Emerging Market Local Currency Debt Emerging market local currency debt (EMLD) declined about 2% in dollar terms in 2011 as currency weakness. coupled with a hedge against euro depreciation versus the dollar. in the current volatile environment.6% spread of EM local bonds relative to US and European debt is close to its highest level in a decade.38 Meanwhile. Bloomberg 52 Goldman Sachs . And finally. Second. In energy. the correlation of commodities with equities and the US dollar was quite unstable. droughts in Europe and Russia.

5 million b/d). let us first review Inventories stand at low levels relative to consumption. 32 while Chinese demand is now close to 10 mil31 lion b/d (11% of the world). the key question for oil prices in 2012 is Data as of 2011E Source: Investment Strategy Group.3 analysts expect growth of 5. Indeed. 87 World Demand Investment Strategy Group Outlook 53 . Days of world demand Consensus expectations for global oil demand 35 growth are 0. Middle East demand 32. a look back reveals two consecutive years of demand 86 outpacing supply. On the downside. This correlation instability underscores how rising risk aversion can often trump otherwise positive idiosyncratic factors in shaping the performance of commodities. World Consumption To address this question. Against this backdrop. we have more sympathy for the latter.2–0. Of the two possibilities.0 2012.0–5. finally allowing inventories to stabilize or even build. having grown an estimated 5. China’s 28 Mar-00 Jun-01 Sep-02 Dec-03 Mar-05 Jun-06 Sep-07 Dec-08 Mar-10 Jun-11 demand could exceed expectations on the back of restocking of commercial inventories. OECD demand remains depressed and in some areas is contracting.7% in 2011 (+0. as shown in Exhibit 61. Exhibit 62: OECD Inventories vs. evident World Production in the ratio of OECD inventories to world 84 05 06 07 08 09 10 11e consumption nearing its lowest point since 2007 (Exhibit 62). the developed markets still represent the bulk of absolute demand.3 million b/d (or 1–1.5% for China in 29 29. the demand backdrop. the slowing global growth we expect this year could enable production to overtake demand. While emerging markets are the clearest source of oil demand growth. For example.5 alone is growing 0. On the upside. which is slightly below the five-year average growth rate of 5.5%). concluding that the risks to China’s oil demand are skewed to the downside for 2012. International Energy Agency facilities. International Energy Agency whether this trend of inventory depletion will continue or stabilize.8%. After all.fell from around -45% in January to around -29%. particularly for China. as well Data as of Q4 2011E as filling newly built strategic petroleum reserve Source: Investment Strategy Group. Worryingly. Most 30 29.3 million b/d per year.9–1. 34 with all of the growth coming from emerging 33 market economies. before rising to around -62% currently. The 85 result has been falling inventory levels. Oil: Balancing Act Exhibit 61: Global Oil Supply and Demand Demand outpacing supply has pressured inventories in recent years. China’s demand could disappoint based on a sharper than anticipated slowdown in industrial production and global growth. Millions of Barrels per Day 90 89 88 World consumption exceeded production in the past two years As we look forward to 2012.

natural gas liquids from OPEC. is already about 3% lower (0. Of course. Libyan production is rebounding faster than expected and is now almost half its pre-war level. a series of unplanned outages in the North Sea.22 million b/d). there are notable offsets. barring geopolitical shocks.7 million b/d gap. On this point.7 million b/d supply/ demand imbalance.january 2012 consensus expects a further decline in the United States’ roughly 19 million b/d demand run rate.8 million b/d by the end of 2012. The higher end of this range. there is certainly room for production growth to accelerate relative to last year. which is an estimated 0. total non-OPEC production growth could range from 0. a combination of slower global demand growth. could supplement this growth by +0. Even so. which are not subject to quotas and are used in certain petrochemical applications. At this pace. Argentina. US oil usage represents about 21% of the global total. Russia (+0. and 7% lower than in 2008. Indeed. To remedy this imbalance in 2012. As a result. our economic forecasts accord a greater weight to the downside risks in 2012. a recent study from the International Institute of Finance (IIF) confirms that Saudi Arabia needs an oil price of at least $80/barrel to balance its budget. the recent return of super-majors such as Exxon looks promising. it is likely that some of the growth expected in 2011 would be realized now instead. which increased production in 2011 to offset the loss of Libyan crude.5-0. In order to enforce the 30 million b/d ceiling. For its part.7-1. as evidenced by the decline in inventories and an estimated 0. especially related to Iran and Iraq.4 mil- Putting it all together. However. Turning to supply. Prospects for supply growth are particularly promising for US shale. As has been the case in the past few years. In Iraq. On this point. looks like the most likely candidate to trim production. Moreover. given 54 Goldman Sachs . on December 14. and production is expected to increase by up to 0. this combination makes oil prices reaching the highs of 2011 unlikely. at 14. our base case scenario envisions a range of $75-$105 for WTI and $85-$115 for Brent. there is a possibility that OPEC would actually lower its production. sustained and significant downside price risks. While cuts in OPEC production hurt the supply backdrop. Brazil.3 mm b/d in 2012. in the deepwater of Brazil and China.7 million b/d less than it is currently producing. could be enough to meet demand growth in 2012. Libyan production could grow another 0. look equally unlikely. lion b/d.5 million b/d. and in Russia’s low-cost Siberian fields. European demand.5 million b/d) could potentially be faster than demand growth (1. and positive production prospects within OPEC may rebalance the global oil market in 2012 and put an end to inventory declines.12 million b/d) and Canada (+0. Malaysia and Yemen more than offset this. non-OPEC supply proved particularly disappointing in 2011. barring a global recession. In short. plus or minus any additional mismatch between demand and supply growth. Since nonOPEC production growth (0. OPEC would need to fill that 0.7-1. OPEC decided on a production ceiling of 30 million b/d going forward.3-0.3 million b/d). there are clearly upside as well as downside risks to the ultimate OECD demand numbers. 2011. In our view. despite the fact that it already stands close to the level reach during the 2009 financial crisis. a rebound in non-OPEC supply. such production recovery would need to be counterbalanced through lower output elsewhere to avoid oversupply and excessive price weakness. That said. Saudi Arabia.1 million b/d). providing scope for catch up in 2012. For example. while continued resilience in the US could bolster it. Canadian oil sands. reflecting the multiple sources of uncertainty and their pernicious effects on growth. a recession in Europe or the US could hurt demand.5-0. Notably. To be fair. as many of these disruptions are now being resolved.4 million b/d) than in 2009. production did grow in the US (+0. However. if achieved.3 million b/d in 2011. OPEC production fell short of demand in 2011.0-1.

European demand for physical gold could also benefit from ongoing fears of Eurozone disintegration. as well as a general dash for cash and liquidity. Perhaps a recent Wall Street Journal headline said it best: “With safe havens like these. despite the pervasive macro concerns. this recent softening. Of course. Perhaps this is not surprising. evident in its 23% correlation with the S&P 500. such as gold. gold continues to offer perceived diversification benefits. some of this could simply reflect select hedge funds liquidating their large gold holdings to offset losses elsewhere. whereas gold was positively correlated with risky assets last year. Moreover. In turn. asset growth in ETFs has actually been decelerating over the past few months. the world’s largest consumer of gold jewelry. For example. despite having volatility 3. we note three key differences in today’s demand backdrop compared to the last few years. there are undoubtedly some supportive factors. considering investment demand already represents a historically high 39% of total demand. That said. In fact.921/troy ounce on September 6. gold’s distinction as a safe haven asset has been tarnished. Ever since. Finally. although this thesis has not helped gold prices lately. as shown in Exhibit 63. high gold prices and the 18% depreciation in the Investment Strategy Group Outlook 55 . In the process. theoretically a tailwind for gold prices. The low real interest rates we expect in 2012 continue to limit the opportunity cost of holding no-yield assets.550-1. Even so. the 1980 peak in gold prices corresponded to this ratio reaching 45%. world jewelry demand has held up well thus far. its 200-day moving average of prices. While not our base case. While wide. these ranges reflect a one standard deviation move within oil’s 35%40% annualized volatility. While gold’s increasing downside volatility is troubling in its own right. Moreover. to not only consumers but also central banks. while overall jewelry demand has been stable.the recent increase in social spending. who needs risky assets?” 40 In thinking about the trajectory of gold for this year. oil continues to have a positive correlation with S&P 500. Gold: Tarnished Safe Harbor “Bewitched. trading in a range of $1. implying that our constructive stance on equities in 2012 should also provide some support for oil prices as well. the 26% drop vs. coupled with our medium-term constructive view on the US dollar and expectation that core inflation will remain around 2%.”39 Indeed. bothered and bewildered – that is how many gold investors have felt in recent months. gold collapsed 20% within a month. the World Gold Council’s estimates show that total investment demand (ETFs and physical gold) remained essentially flat year-over-year through 3Q11. Furthermore. Treasuries displayed a negative 73% correlation.750 per troy ounce. the third quarter of 2010 was the largest quarterly decline since early 2008. Chinese demand continues to increase as the country’s gold market is deregulated and households seek alternatives to real estate and stock investments. a concern we discuss further in our Key Risks section. gold broke a three-year uptrend. and inability to recapture. that it comes at a time of intensifying global systemic risks. Finally. is even more so. Notably. its sharpest drop since 1983. US Treasuries outperformed gold by 7% last year. after hitting a record of $1. First. in stark contrast to its consistent growth in the last several years. Putting it all together. In our view. we do not find these explanations persuasive enough to account for the entire shift. In fact. After all. evident in its breach of. realized volatility this year rose to 25% from 15% at the end of 2010. it has remained volatile.5 times less. India. saw its demand fall for the first time in two years. Moreover. In fact. are not supportive of investment demand growth. a significant oil shock resulting from geopolitical unrest in the Middle East could push oil prices meaningfully higher. This dramatic fall reflected a combination of weak growth. our base case scenario envisions a range of $75-$105 for WTI and $85$115 for Brent. Second. the global oil market has also been running a deficit for two years. so prices need to remain high enough to discourage consumption and allow supply to catch up. investment demand appears to be flattening. Specifically.

Going forward. After all. One. unlike previous years. this buying stood in stark contrast to the past two decades.200 $1. when the official sector was actually a net supplier of gold. Two. strong official sector demand actually marked the peak of gold prices in 1980. but also potentially be interpreted as 56 Goldman Sachs NET DEMAND . because central bank purchases are policy-driven. prices continued to fall on the back of collapsing investment demand.000 $800 $600 400 200 0 –200 –400 72 75 78 81 Real Average Gold Price Jan. In the first three quarters of the year. World Gold Council. one needs to go back to 1980 to find net official sector demand in excess of 200 tonnes. Third and finally. 2011 dollars $1. If they became concerned prices might fall further. a right they utilized in the prior decade.800 tonnes of gold. Clearly.400 $1. the Central Bank Gold Agreement permits them to sell as much as 400 tonnes per year. 250 200 150 100 50 0 –50 –100 06 07 08 09 10 11 Monthly Change 12 Month Moving Average Data as of December 30. the risk is that the same high gold prices.600 $1. gold miners have finished removing the price hedges on their forward production. an amount 4. Bloomberg value of the Indian rupee. their attempts to lock in prevailing prices would not only accelerate gold supply (in the form of forward sales). While they have sold virtually none of these holdings in the past two years. these banks own about 10. Eurozone central banks may end up selling some gold reserves to provide funding for various liquidity facilities this year. Tonnes 800 600 NET SUPPLY Official Sector Net Supply / Demand (LEFT SCALE) USD / Troy ounce. slowing global growth. Relative to the shifts in the demand landscape. net central bank purchases were the marginal driver of gold prices in 2011. despite central banks remaining net buyers during that time. In fact. Nevertheless. with mine production growing slowly and scrap supply flat in 2011.january 2012 Exhibit 63: Monthly Change in Gold ETF Holdings Gold ETF flows have been decelerating over the past few months. Consider two observations. 2011 USD (RIGHT SCALE) $400 $200 $0 99 02 05 08 11 84 87 90 93 96 Data as of Q4 2011 Source: Investment Strategy Group.5 times higher than their 2010 purchases (76 tonnes). gold’s supply dynamics appear monotonous in comparison. CPM Gold Yearbook. First. as shown in Exhibit 64. a continuation of current policies of reserve diversification would be a tailwind for gold prices. the official sector accounted for 349 tonnes of known net gold purchases. That said. in Jan. Moreover. Indeed. and weak currency that negatively affected Indian demand could push other emerging market consumers down the same path.800 $1. 2011 Source: Investment Strategy Group. as central banks effectively priced out other gold consumers. it is difficult to assess what might come in the future. there are several key risks on the horizon. Bloomberg Exhibit 64: Net Purchases of Gold by the Official Sector Central Banks tend to be large net buyers of gold around market peaks.

a hard landing here would have negative repercussions across the full spectrum of asset markets. the wide range of interests at play and actors involved. The result is dramatically higher interest rates and difficulty meeting debt servicing costs. disrupt trade and cause an economically damaging spike in oil prices. unions. The risks that follow. and 20 percent of oil traded worldwide. the often mutually ex- Investment Strategy Group Outlook 57 . further exacerbating debt levels. In addition. the penalty for being wrong has risen. Major Geopolitical Event An outbreak of war. if and when sentiment turns. many governments in the developed economies run large deficits and have historically high debt/ GDP ratios. when pushed. several conceivable developments could significantly interrupt oil exports this year. Moreover. Aside from the Straits. as fiscal constraints and many central banks at the zero bound leave policymakers with fewer tools to address any new sources of stress. given the global legal. such as demographics.320 tonnes is roughly the same as a full year of global gold production. while the probability of a truly destabilizing event remains low. Additional Sovereign Debt / Currency Crises As the unfolding crisis in Europe is clearly demonstrating. investors themselves could potentially become a large source of supply. are projected to raise healthcare costs and pension benefits in many of them. Of equal importance. Chief among these is Iran’s recent threat to close the Strait of Hormuz. trade and financial linkages involved. While these bearish supply risks might be longer term in nature. the only sea passage to the open ocean for much of the Persian Gulf and a strategic choke point that represents 35% of the world’s seaborne oil shipments. In fact. the erstwhile stability of Iraq’s oil exports is also at risk. but this year it seems particularly acute. Moreover. the current ETF stockpile of around 2. similar to central banks’ dual role as both a buyer and seller. a forced or unexpected departure of a Eurozone member or a conscious decision by the parties involved to disband the EU could be devastating. as politicians could simply lose control of the process. Hard Landing in China With China a key contributor to global demand and growth. we think they are important considerations for gold buyers today.a sell signal by many investors. given the Key Global Risks In any given year. a disorderly default. clusive interests of the parties further exacerbate the risk of contagion. and various other special interest groups. while by no means exhaustive. In fact. Even worse. citizens. higher volatility. Overall. the market’s safety net is getting threadbare. as we have seen in Europe. Unfortunately. we have argued that Eurozone politicians. a major terrorist act or simply a greater probability of either one could undermine confidence.41 While a closure seems unlikely. Failure to implement credible fiscal consolidation plans could lead to a loss of market confidence. particularly in commodities and other emerging markets. structural factors. In short. markets are losing patience with excessive sovereign debt levels. many of today’s most pernicious threats are political in nature. the strait is still 34 miles wide at its narrowest point after all. Needless to say. investors. prices well above their historical average and erosion in its safe harbor distinction continue to warrant a cautious view toward gold. will ultimately demonstrate the political will necessary to keep the Eurozone intact. the risk that an exogenous shock renders an otherwise thoughtful outlook dead on arrival is present. we believe that an increasingly unbalanced demand picture. Even so. raises the potential for accidents. resulting in asymmetric risks that undermine the value of rigorous fundamental analysis. it could be highly disruptive if the threat materialized. including politicians. represent those that would be most detrimental to our central case view: Escalating Eurozone Crisis Throughout the Outlook.

while the Eurozone should avoid a forced breakup. First. our longstanding position on the US is as strong as ever: it remains not only the best safe harbor in the world for protecting assets. Botched Policy Exit While less of a concern today given the fragile nature of the recovery. such as Europe. the unfolding leadership change in the always-quixotic North Korean regime represents another geopolitical flashpoint. if too late. Lastly. this would decrease household wealth and consumer confidence. as the majority of bank assets remain real estate backed. Elsewhere. If the exit occurs too soon. it can be difficult to accomplish what ought to be a relatively simple task: pausing to scan the horizon and make a clear-eyed assessment of the conditions that could affect the markets and the economy in the year ahead. But a turbulent time like the present is precisely when it is most important to stop. Second. undermining consumption. Trade War / Protectionism Although a variation of a policy error. Japan and US banks. raise the periscope and have a careful look around.” represents a further risk to oil production from the area. Moreover. as it did during the Great Depression. 58 Goldman Sachs . a renewed and meaningful fall in housing prices would. In Closing With abundant volatility in today’s environment. raising their borrowing costs through higher interest rates.january 2012 imminent withdrawal of US forces. as well as the potential inadequacy of the Iraqi security services to contain growing militia violence. In addition. but also a compelling core holding for long-term appreciation. particularly given the power vacuum likely to follow the US military’s departure. it could lead to an inflationary outcome and/or a loss of confidence in the government’s willpower. this would negatively impact the banking system and curtail credit availability. ongoing social revolution in the Middle East. which will limit the impact of that country’s slowdown on the global economy. sparing the world another Lehman moment. but looking through the fog today reveals an interesting – and somewhat encouraging – scenario. the unsustainably loose monetary and fiscal policies of much of the developed world will eventually need to be reversed. No one can predict the future. We think that China is likely to avert a hard landing. US Housing While low-single-digit home price movements up or down are unlikely to have a material impact on our view. a trade war resulting from the implementation of protectionist policies could hobble global trade and thereby hurt growth. And despite a preoccupied and often partisan federal government. a meaningful increase in protectionism could undermine US corporate profitability and pressure US equity markets. given the importance globalization of the supply chain has played in increasing S&P profit margins. we believe there may be some tactical opportunities in areas most disdained by the markets. For all the risks and potential downside. of course. it could derail the recovery. the risk of an outright skirmish between Iran and Israel is non-trivial. embodied in last year’s “Arab Spring.

2011. Terry Belton. March 2008. “Making Sense of China’s Economic Statistics. 33. Federal Reserve Bank of Dallas.” The Economist. 2011. “4Q11 / 1Q12 Macro Outlook. 2011. 25. December 2011. 31. Raymond Ahearn et al. 2010. December 15. December 9.” Bank of America/Merrill Lynch. 2011.” Empirical Research Partners. IMF Working Paper 09/172. 24. Francis Vitek and Tamim Bayoumi. November 30.” Boston Consulting Group. Energy Information Administration. 3. and Commodities Research. 18. Conservatively assuming a recovery rate of 30%. 19. Margins: A Cost Story. Sirkin et. 2011. “Could America Turn Out Worse Than Japan?. December 15. Michael Phillips. 2011. 14. 2011. “The Financial Crisis: Government Bailouts – A US Tradition Dating to Hamilton. August 8. 2011. 23. 2011. 41. July 2011. Jacob Kirkegaard. 2011. 32.P.” Bank of America/Merrill Lynch. 11. “Jefferson County. “World Oil Transit Chokepoints: Strait of Hormuz. Michael L Goldstein. Again: Why Manufacturing Will Return to the US. Norm Ornstein is co-authoring this book with Thomas Mann of the Brookings Institution. CFA.” Journal of Financial Economics. November 16. May 2008. Gabriel Wildau. 2011. As reported by Sun Liping of Tsinghua University in a Chinese weekly publication called Economic Observer. 34. The dislocation was caused in large part by the lack of pipeline export capacity in the US Midwest relative to fast growing oil production.” Center for Economic Policy Research Discussion Paper #8497. European Parliament. “Spillovers from the Euro Area Sovereign Debt Crisis: A Macroeconomic Model Based Analysis. 30.” Bloomberg. “US Economist Analyst: Will the European Storm Cross the Atlantic?” Goldman Sachs’s Economics. 16. “US Fixed Income Markets: 2012 Outlook. “Global Fund Managers Survey. 2008. Thomas J. Francis Vitek and Tamim Bayoumi. “US Daily: Market Movers – Policy News at Home and Abroad. “The Euro Zone’s Double Failure. 2011. December 23. 2011. 35. 27.” JP Morgan. “China Faces 60% Risk of Bank Crisis by Mid-2013. 88. 2011.” J. 2011.” The Washington Post. reaching as much as $28/barrel. Hurun Report and Bank of China Private Banking. Martin Feldstein.” December 16. November 25.Part II. Twice Told. “2011 China Private Wealth Management White Paper”. August 2009. Paul Krugman. 2. “The Company That Ruled the Waves. 21. December 21. 2011.” Financial Times. 2011. 2011. “Where We Stand: Crossroads . 2011. Maya MacGuineas is the President of the Committee for a Responsible Federal Budget. August 2011.” SentimenTrader. Braun. “Gold Experiences an Identity Crisis. Morgan. “Made in America. “News is Positive at Home. below the 35% long-term average. 13. “UBS World Income Workbook. “Obama Threatens to Follow in FDR’s Economic Missteps. Savita Subramanian. 22. 2011.” The Wall Street Journal. 36.” Bank of America/Merrill Lynch. 2011. Additional contributors from the Investment Strategy Group include: Sylvio Castro Managing Director Thomas Devos Vice President Andrew Dubinsky Vice President Harm Zebregs Vice President Maxime Alimi Associate William Carter Analyst Kent Troutman Analyst Outlook 59 . and social security funds) and state and local governments (Source: IMF World Economic Outlook. 17. 2011. July 9. 38. 20. “Macroitis. “China’s 2012 Social Housing Target at 7 Million. December 16.” Congressional Research Service. which consists of the central government (budgetary funds. “Is China’s Export-Oriented Growth Sustainable?”. 5. July 2011. October 2011. 37. December 19. December 19.Footnotes 1. Jeffrey Palma. but Europe Looms.” Reuters.” Center for Economic Policy Research Discussion Paper #8497. November 14. No. As of December 31. Strategy. December 22.” Goldman Sachs Global Economics Investment Research. Mohamed El-Erian. Lee.” 2011. Harrisburg Face Reckoning for Official Hubris. “Global Fund Managers Survey. September 16. 39. 12. 28. December 9. “Financial Markets in Greater Danger Than 2008 – BoE’s Fisher. “The Tide Goes Out. June 13. Vol. December 20. Kai and Papa N’Diaye.com. September 2011). “Daily Sentiment Report. Martin Z.” UBS Research. 26. November 22. September 20.” Empirical Research Partners.” The New York Times.” Financial Times. 8. Bad Macro. 7. March 8. 10. 2011. “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns.” The Peterson Institute for International Economics.” Reuters. 2011. Harold L.” The Wall Street Journal.” Oaktree Capital Management. Shuyan Wu. 29. December 18. December 17. 2. October 31. December 2011. Tom Orlik. “Gold: Haven Turns Riskier but Retains its Appeal. Laura Dix. 9. al. “Thinking About the Euro in 2012. and Longying Zhao. extra budgetary funds.” The Wall Street Journal. The spread is currently down to about $10/barrel due to the adaptation of an existing pipeline and the development of new rail take-away capacity. This number refers to IMF estimates of general government debt. “Will China Break?.” The Wall Street Journal. Andrea Frazzini and Owen A. 2011. Investment Strategy Group 15.” Stifel Nicolaus & Company. July 2011. September 16. The wide discrepancy between the two oil benchmarks was an unusual phenomenon last year. “Spillovers from the Euro Area Sovereign Debt Crisis: A Macroeconomic Model Based Analysis. Howard Marks. Amity Shlaes.” Bloomberg News. 6. Kevin Hamlin. “Good Micro. Lamont. “Portfolio Strategy 2012 Outlook. “IMF Chief Warns Over 1930’s-style Threats. Guo. “The Future of the Eurozone and US Interests. 40. 2011.” Reuters. 4.

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