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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, weve 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.

january 2012

Defining the Concerns

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

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we look at them through a historical lens and make assumptions based on how similar issues played out in the past. For example, given that European policymakers have approached the sovereign debt crisis incrementally over the last two years, we can assume that they will continue with incremental policy responses throughout 2012. Second, diversification is key. We have typically ascribed a 6075% probability to our central case forecast scenarios. At times of heightened uncertainty, that probability diminishes; this year, with non-negligible risks of economic or financial unraveling across some countries and/or regions of the world, the probability of our US central case is down significantly, to 55% (the only recent year lower than that was 2008, at 50%). This makes effective diversification even more important a portfolio must be constructed to withstand the more probable short- and intermediateterm downdrafts, yet still profit from the longterm upswings (which, even with our revised probabilities, remain more likely to occur).

Cyclical and Structural Headwinds Facing the US, 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. This year is no different. As we scan the horizon, 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. What is different now is that the financial markets seem to agree with us. With a total return of 2% on the S&P 500 in 2011, US equities have outperformed all major equity markets: developed markets as measured by MSCI EAFE returned -12% in US dollar terms, with Germany and Japan being two of the worst

performers at -17% and -12%, respectively; emerging markets as measured by MSCI EM returned -18%, with Brazil and India being two of the worst performers at -22% and -37%, respectively. Similarly, US Treasuries provided some of the best returns in global government bond markets. Using a basket of maturities based on the J.P. Morgan Global Bond Index 710 year series, US Treasuries returned about 15%, outperforming German and most other European bonds as well as Japanese bonds in their respective currencies. They barely lagged Swedish bonds and lagged Australian bonds by 3%. 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. With respect to emerging market debt, US bonds outperformed dollardenominated debt by about 8% and local currency debt by 7%. If we were to factor in the depreciation of emerging market currencies, US bonds outperformed local debt by about 17%. US Treasuries also outperformed gold in 2011, with less than a third of the precious metals volatility. Such returns were achieved despite Standard and Poors downgrade of US government debt from AAA to AA+ on August 5. In our 2011 Outlook, we discussed why the US would not face a Japan-style lost decade. Our rationale was that while there are some similarities between the US and Japan, there are far greater and more notable differences. 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 USs peak valuations in 2007; 2) monetary and fiscal policy responses in the US were faster, larger and more extensive than Japans were during the early stages of its crisis; 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; 4) US companies restructured more quickly and more extensively, resulting in productivity growth accelerating in the US after the financial crisis while it decelerated in Japan for several years in the early 1990s; and 5) Japan has unfavorable demographics with a declining working population, while the US has favorable demographics through a combination of higher

Investment Strategy Group

Outlook 5

TableBF/2_v9_123111_v2_sho.pdf Single column january 2012


Exhibit 2: The Key Characteristics of Past Financial Crises The financial crisis in the US shares striking similarities with past severe financial crises.
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.) Duration (Years) Government Debt Increase (% GDP) Duration (Years) 29.1% 5.8 32.3%**** 4.4**** 38%*** 4.0 8.5% 6.6 7.0% 4.8 5.7% 2.5 51.8% 3.2 55.9% 3.4 58% 1.5 37.5% 7.2 35.5% 6.0 33%*** 5.5 4.1% 1.8 9.3% 1.9 5.2% 2.0

US 2007

Data as of 2011 * Spain 1977, Norway 1987, Finland 1991, Sweden 1991, Japan 1992 ** Norway 1899, US 1929, Spain 1977, Norway 1987, Finland 1991, Sweden 1991, Japan 1992, Hong Kong 1997, Indonesia 1997, Malaysia 1997, Philippines 1997, Thailand 1997, Korea 1997, Colombia 1998, Argentina 2001 *** Currently ongoing **** Excludes Hong Kong Source: Investment Strategy Group, Maddison, International Monetary Fund, World Bank, Bloomberg, Datastream, Carmen Reinhart and Kenneth Rogoff, "The Aftermath of Financial Crises." NBER Working Paper #14656, January 2009

fertility rates and immigration. In our view, the US will not only avoid a lost decade, but if history repeats itself it is likely to grow at 2.5% per annum starting sometime in late 2012 or early 2013. In several extensive studies including their recent working paper, The Aftermath of Financial Crises(NBER Working Paper Series, January 2009), 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). In many ways, the US has followed the path of a typical severe financial crisis, and if the downdraft has followed Reinhart and Rogoffs broadly similar patterns across developed and emerging market countries (including two pre-World War II episodes for which data is available), then history suggests the recovery might very well follow suit. As shown in Exhibit 2, 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. While US unemployment is at unfamiliar and uncomfortably high levels, the increase in the unemployment rate to date is less than the averages. The debt-to-GDP increase is greater a cause for concern that should be watched closely. As shown in Exhibit 3, in the first five years following the beginning of a financial crisis, real growth rates dropped by an average of 3%. Importantly, however, in the subsequent five years, growth picked up and approached the average growth rate prior to the financial crisis the one stark exception being Japan. It takes about four years before growth approaches the rate seen before the crisis. If this analogue holds, the US would approach pre-crisis growth rates by late 2012. In the meantime, leading economic indicators point toward moderate growth in 2012 (discussed in detail in Section II of this report). Obviously, history is just a forward-looking guide not a perfect forecast. So we have to weigh the cyclical and structural factors that can boost growth against the cyclical and structural factors that can hinder growth. Starting with the growth-supporting factors, 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, the US would approach pre-crisis growth rates by late 2012.

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balance sheet and earnings backdrop. There are also several structural factors that support growth, everything from superior corporate management to economic diversity, innovation, immigration and rule of law. With respect to factors that can hinder US growth, the Eurozone credit crisis is certainly a cyclical factor that bears concern, but barring a complete meltdown in Europe, we do not expect it to have a materially negative impact on US growth. The structural factor that we believe could hinder US growth the key fault line, if you will is the burgeoning debt-to-GDP ratio in the face of political gridlock. We examine each of these factors in turn below.
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.
Average of 5 Large Financial Crises* Real GDP (Ann.) Prior to Crisis (Prior 10y Ann.) 5 Years Following Crisis Subsequent 5 Years Years to Recover*** Nominal Equity Prices (Ann.) 3 Years Following Trough Subsequent 3 Years Private Debt (% GDP) 5 Years Following Peak (Change pp.) 11% 20% Subsequent 5 Years (Change pp.) 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. Since the beginning of the Source: Investment Strategy Group, Maddison, International Monetary Fund, World Bank, Bloomberg, Datastream, Carmen Reinhart and Kenneth Rogoff, The Aftermath of Financial crisis, real GDP growth has been basically flat, Crises. NBER Working Paper #14656, January 2009 reflecting a peak-to-trough drop of 5.2%, and a * Spain 1977, Norway 1987, Finland 1991, Sweden 1991, Japan 1992 cumulative growth rate of 5.4% since the trough. ** Ongoing, currently 4 years since crisis. Our view is that the overleveraged private sectors *** Spain and Japan never returned to their pre-crisis average growth rates. in the US households and the financial sector have actually deleveraged quite substantially already. Consider the household sector. 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. After peaking since the crisis. at 18.9% in the third quarter of 2007, financial obligations as a percent of personal disposable 19.0% income have dropped to 16.2%. This level is on 18.5% par with that last seen in the fourth quarter of 18.0% 1993 after the deep 199091 recession caused by the savings and loan financial crisis. This 17.5% decrease is partly due to household retrenchment 17.0% through higher savings rates and lower rates 16.5% of new consumer borrowing, and partly due to 16.2% mortgage, credit card and auto loan defaults that 16.0% 15.5% reduce the overall household debt, as well as lower interest rates on the debt that remains. 15.0% 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 45% range which, in turn, Source: Investment Strategy Group, Federal Reserve will be supportive of consumption and hence GDP growth. The Federal Reserve of Dallas has 19% 12% 24% 3.8% 1.0% 3.1% 3.7 2.7% 0.0% -

US 2007**

Investment Strategy Group

Outlook 7

january 2012

Exhibit 5: Financial Corporations Debt to GDP Financial corporations have reduced their debt-to-GDP ratio by 30pp since 2008.
140% 120% 100% 80% 60% 40% 20% 0% 75 80 85 90 95 00 05 10
90% 120%

Data as of Q3, 2011 Source: Investment Strategy Group, Federal Reserve

similarly stated that household de-levering may be nearing an end.2 The financial sector has also made considerable progress in deleveraging. As shown in Exhibit 5, financial corporations debt-to-GDP has decreased from a peak of 120% in 2008 to 90% by the third quarter of 2011. This level is on par with that last seen in 2001. In addition, if we look at financial sector leverage relative to shareholder equity for the financial institutions in the S&P 500, that ratio has declined to the lowest level in over two decades from a peak of 13.0 times to 9.0 times, as shown in Exhibit 6. This two-decade low holds whether we look at equal-weighted or market capitalization-weighted data. We conclude that the more leveraged private sectors of the US economy have already deleveraged to sustainable levels.
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.

14 13 12 11 10


9 8


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, 2011 Source: Investment Strategy Group, Intrinsic Research

Looking at the broader non-financial sector, we also observe low debt levels and close to record cash levels. As shown in Exhibit 7, net longterm debt (including the impact of cash) as a share of balance sheet assets for the 1500 largest US companies is at 10.6%, compared with a 40-year-plus average of 14.6%. This ratio has been lower only 5% of the time since 1970. Cash is at a 40-year high at 11.2%. If we look at all non-financial companies in the US, including small and mid-size companies, this ratio is close to its average at 19.7%. In aggregate, corporate America has a healthy balance sheet. The earnings backdrop for US companies is quite robust as well. S&P operating earnings per share in the third quarter of 2011 reached their highest level ever, eclipsing the 2007 second quarter record by 5%, and full-year 2011 earnings appear on track to reach the highest level on record. This earnings achievement is even more remarkable in the face of zero growth in real GDP since the beginning of the financial crisis. Between low debt levels, strong cash hoards and robust earnings, US companies are entering 2012 in a strong position. We discuss our S&P 500 views in greater detail in Section III.

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The Key Structural Advantage: A Diverse and Innovative Economy

In our 2011 Outlook, we highlighted the inherent structural resiliency of the US and its institutions, which provide a direct and positive impact on the viability, profitability and safety of our clients assets in the long run. We touched upon several advantages that account for US exceptionalism, including demographics, immigration, education, innovation, natural resources and the importance of shareholders as the primary stakeholders. Since then, new research at leading academic institutions has confirmed and quantified the major structural advantages the US enjoys. The first study, 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, respectively, concludes that after a decade of research into global management, American firms are on average the best managed in the world. As shown in Exhibit 8, the United States has the highest management practice scores, followed by Germany and Sweden. Countries in southern Europe, such as Greece and Portugal, and emerging market countries, like Brazil, India and China, have the lowest scores. 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.
20% 18% 16% 14% 12% 10% 8% 6% 4% 70 78 86 94 02 10 Cash

19% Net Long-Term Debt


18% 17% 16% 15% 14% 13% 12% 11% 10% 9%

Data as of November 2011 Note: Based on largest 1,500 stocks excluding autos, financials and utilities; data smoothed on a trailing one-year basis Source: Investment Strategy Group, Empirical Research Partners

management massively outperform their disorganized competitors, making more money, growing faster, having higher stock market values and surviving for longer. Among multinationals, US companies maintain this advantage over their counterparts in other parts of the world, but the gap is less. The second study, The Atlas of Economic

Exhibit 8: Corporate Management Rankings by Country American firms are on average the best managed in the world.
3.4 3.3 3.2 3.1 3.0 2.9 2.8 2.7 2.6
3.00 2.99 2.99 2.98 2.88 2.88 2.79 2.69 2.65 2.65 2.64 3.18 3.18 3.15 3.13 3.33


Germany Sweden



France Australia




Ireland Portugal





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, Nicholas Bloom and John Van Reenen, Why do Management Practices Differ Across Firms and Countries? Journal of Economic Perspectives. Winter 2010.

Investment Strategy Group

Outlook 9

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Complexity: Mapping Paths to Prosperity, by Ricardo Hausmann, Cesar Hidalgo, et al of Harvard University and Massachusetts Institute of Technology, respectively, 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. The more complex an economy, the broader the range of its exports. This economic complexity, in turn, captures information about the complexity of the set of capabilities in a country and closely matches its income per capita, and is also predictive of intermediate to long-term future growth. Japan and Germany rank as #1 and #2 and the US is the next large country at #13. We should note that this study excludes the service sector, where the US is highly competitive. 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, Singapore is ranked #1 and the US is ranked #2. In their Annual 2011 Country Attractiveness Score, Alexander Groh et al ranked the US the #1 destination for venture capital and private equity investments. Of course, none of these various rankings alone tells the whole picture. In aggregate, however, they confirm that US economic capabilities and resources make it a great investment destination well beyond its safe haven status. And what is most interesting is that these strengths are not lost on corporate America; we are seeing an increasing number of large companies moving at least some of their manufacturing back to the US.

Manufacturing Moves Back to the US

Throughout 2011, 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. Examples include some of the largest US companies: Ford Motor Co., General Motors, General Electric, Caterpillar and NCR. Others are the Coleman Company (plastic coolers), Sauder (furniture), Wham-O (maker of such toys as Frisbee and Hula Hoop) and Sleek Audio

(in-ear headphones). In December, Honda Motor Co. announced plans to increase its capacity in North America not just for American consumption but for exports around the world. What explains such an important shift? An August 2011 report by the Boston Consulting Group, Made in America, Again: Why Manufacturing Will Return to the US, highlights the key factors making China less, and the US more, attractive. Rising wages, shipping costs and land prices combined with a strengthening renminbi are rapidly eroding Chinas cost advantages, as are higher utility costs, while the US is becoming a lower- cost country with declining or moderately rising wages, a flexible work force and strong productivity growth. The study also cites shorter lead times, local control over manufacturing costs, fewer supply chain risks (as illustrated by the earthquake in Japan and floods in Thailand) and better quality control. It specifically mentions intellectual property theft and trade dispute concerns with respect to China. Perhaps most strikingly, the authors estimate that by 2015, manufacturing in some parts of the US will be just as economical as manufacturing in China. We do not know if that prediction will materialize, but the facts speak for themselves: at the margin, at least, companies are moving some of their manufacturing to the US. It is an interesting coincidence that 2015 also marks the peak level of the working-age population in China, compared to steady growth of this population in the US, as shown in Exhibit 9. Such a reverse migration back to US shores is also occurring in the oil industry. Oil imports as a share of consumption have declined from a peak of 60% in 2005 to 45% in 2011. 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; this compares

Perhaps most strikingly, the authors estimate that by 2015, manufacturing in some parts of the US will be just as economical as manufacturing in China.

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Exhibit 9: Working Age Population (2000 - 2050) Unlike many emerging markets, the US working age population is projected to expand through 2050.
Index (100=2010)

Exhibit 10: US Exports by Trading Partner (% of GDP) US exports to Europe comprise just 3% of US GDP, of which, just one-tenth go to the GIIPS.
14% 12%

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%
5.5% 4.2%


4% 2% 0%
0.3% GIIPS 1.5% 1.1%

2.5% 1.6% 0.9% China 0.6% Japan Other EM TOTAL TOTAL

Core Rest of Canada Mexico Eurozone Europe

Data as of 2010 Source: Investment Strategy Group, United Nations Population Division

Data as of 2010 Source: Investment Strategy Group, Datastream, International Monetary Fund

to peak imports of 4.1 million barrels a day in October 2005. Such a shift is just another example of the structural advantages of the US, where companies (management and labor) have the freedom to innovate, to leverage technology, to move and adjust to market signals as they deem fit.
Eurozone Sovereign Debt Crisis Unlikely to Pose Major US Threat

The cyclical and structural strengths of the US notwithstanding, the US is not an island; US economic growth is exposed to a significant deterioration in the Eurozone sovereign debt crisis, if it were to materialize. There are four channels by which this crisis can spill over to the US: 1. Direct economic impact through trade; 2. 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; 3. Direct impact on the earnings of US companies with businesses in Europe; and 4. Indirect financial impact through an increased risk premium, which would lower the value of US equities and nongovernment bonds.

Barring a fundamental unraveling of the Eurozone, we believe that the impact through the first three channels will be muted. With respect to the impact of diminished trade, Exhibit 10 shows that US exports account for only 13% of GDP, and US exports to peripheral Europe (defined as Greece, Italy, Ireland, Portugal and Spain) and the rest of Europe are just 0.3% and 2.6%, respectively. A mild recession in Europe, which is our central case, would probably reduce US GDP by 5 basis points or less, according to our colleagues in Goldman Sachs Global Investment Research.3 In terms of the direct financial impact, both US banks and US investment managers have already significantly reduced or hedged their Eurozone exposure. 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, Ireland, Italy, Portugal and Spain (GIIPS) bloc and another $1.2 trillion-plus to German and French banks.4 However, based on data provided by the major globally oriented US banks in their quarterly statements, we estimate the net exposure to the GIIPS to be only about $43 billion, including exposure to multinational corporations. Gross exposure the CRSs figure is substantially reduced through a range of hedges. Some of these hedges are composed of credit protection

Investment Strategy Group

Outlook 11

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purchased from institutions outside the GIIPS region and others involve high quality collateral. It is important to keep in mind that while the headlines focus on notional exposure, 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. Investment management firms have also reduced their exposure substantially. For example, according to a Fitch Report from December 2011, US prime money market funds have reduced their Europe exposure by 45% since May. The biggest reduction has been to French banks at 89%, partially offset by an increase to Dutch, Swiss, and Nordic banks. Current exposure stands at 33.4%, including exposure to the UK. With respect to S&P earnings derived from companies operations in Europe, 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. Estimates of total European exposure among these companies range from 1520%. While some companies have higher exposure and will be affected much more, a mild recession of 1% or less in Europe would probably reduce S&P 500 earnings by 12%. Again, the reason this impact is more muted than the headlines suggest is that many of the largest market capitalization companies in the S&P dont have significant exposure to Europe. The hardest spillover effect to gauge is the indirect financial impact. Fears of a disorderly default in Greece, concerns about some European countries rolling over their debt, inconsistent statements from European policymakers and front page news reports of strikes and protests

in Italy all take their toll on investor confidence; they also tighten financial conditions in the US as result of lower equity prices and higher credit spreads. Surprisingly, however, financial conditions in the US are unchanged from the beginning of the year. In a recent discussion paper, Spillovers From the Euro Area Sovereign Debt Crisis: A Macroeconometric Model Based Analysis, Francis Vitek and Tamim Bayoumi of the International Monetary Fund estimate that through the first quarter of 2011, the cumulative effect of the Eurozone crisis has been -0.1% on US GDP and -0.3% on US equity prices.5 Given our central case of a mild recession in Europe, we do not think the indirect financial impact on the US will be material. Of course, a more serious downside scenario in Europe would have a much greater impact. Vitek and Bayoumi estimate that a much more severe shock with Italian and Spanish 10-year rates at over 11% and 10%, respectively, would detract 1.1% from US GDP and 9% from US equity prices.
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, it is that in a panic or threatened financial collapse governments intervene: every government, every party, every country, every time. Alex J. Pollock
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While we are generally optimistic about the prospects for the US economy and US financial assets, the deteriorating fiscal profile of the US and the absence of any reform is of grave concern; in our view, the lack of fiscal reform due to political gridlock is the only structural fault line the US faces. Over the course of 2011, we hosted four client calls discussing the US fiscal outlook with distinguished former policymakers including Senator Alan Simpson, who co-chaired President Obamas bi-partisan deficit reduction commission, as well as Senators Trent Lott, Senate Majority Leader; Judd Gregg, Chairman of the Budget Committee; and John Breaux, a member of the Finance Committee. Our calls also included key Washington opinion makers on this issue: Norm Ornstein, Resident Scholar at the American Enterprise Institute, and Maya MacGuineas of the Committee for a Responsible Federal Budget. Throughout the year, our goal was to assess the probability of a so-called grand bargain to reduce the long-term debt burden of the US. While Congress did not ultimately go

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 22%

Exhibit 12: Composition of Proposed Deficit Reduction Plans Multiple bipartisan plans to reduce the debt have been put forward.
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
37% 24% 34% 18% 16% 40%



$4.0 6% 5%



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. 2010) (Nov. 2010)

Gang of Six (July 2011)

Data as of December 2011 Data as of November 2011 Source: Investment Strategy Group, CBS/The New York Times, Gallup, The Pew Center Source: Investment Strategy Group, The Committee for a Responsible Federal Budget, National Commission on Fiscal Responsibility and Reform

big in 2011, we can point to three notable achievements. First, deficit reduction has taken center stage in the political arena as policymakers and the electorate acknowledge the scale of the problem, as shown in Exhibit 11. Second, multiple bipartisan efforts have identified the key components of any deficit reduction plan and, as shown in Exhibit 12, there is considerable overlap. This work will provide the basis of future fiscal reform. And finally, the debt ceiling debate, as unpleasant as it was, did result in $900 billion of debt reduction and an additional $1.2 trillion of cuts over 10 years that will be mandated by sequestration if no other action is taken. Although its reasonable to assume these steps may result in less than $2.1 trillion in cuts as Congress tries to ameliorate their impact on the defense budget, they still represent meaningful progress relative to last years expectation of no cuts until 2013. To quote Maya MacGuineas: savings of one to two trillion is clearly a significant step in the right direction.6 As we attempt to assess the probability of policymakers implementing further fiscal reform in 2012, we proceed with great caution. As Alex J. Pollock, Resident Fellow at the American Enterprise Institute and former President and

Chief Executive Officer of the Federal Home Loan Bank of Chicago, said back in 2008, If you would like an empirical law of government behavior, it is that in a panic or threatened financial collapse, governments intervene: every government, every party, every country, every time.7 Applied to Washington in 2012, we can read into this the inverse: no panic, no action. We might even sum up the US governments gridlock as Norm Ornstein does in the title of his forthcoming book: Its Even Worse Than It Looks.8 Thus, 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. However, as the safe haven of the world, and, in our opinion, one of the better core investment opportunities, we believe that there is some time not indefinite, but at least to the end of 2012 before the US has to take up the next round of debt reduction.

Applied to Washington in 2012, we can read into this the inverse: no panic, no action.
Outlook 13

Investment Strategy Group

january 2012

The Eurozone: Will Incremental, Reactive and Inconsistent Policy Persist?

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

14 Goldman Sachs


Exhibit 13: Bank Capital Shortfalls by Country The ECBs three-year refinancing operations should help alleviate funding pressures for European banks.
Capital Shortfall Country Greece Spain Italy Germany France Portugal Belgium Austria Cyprus Norway Slovakia Netherlands Total Level (bn) 30.0 26.2 15.4 13.1 7.3 7.0 6.3 3.9 3.5 1.5 0.3 0.2 115 % 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. 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. To enlist the support of Thomas Jefferson to vote for the proposal (which had already been voted down five times), he agreed to move the new capital to the banks of the Potomac; to ensure Pennsylvanias support, the capital would be moved to Philadelphia for ten years. We applauded Hamiltons vision and his willingness to do what it took to achieve a true fiscal union; we do so again, and hope European policymakers will take his lead!

Data as of December 2011 Source: Investment Strategy Group, European Banking Authority, Financial Times

Banking Sector, Crisis Resources Are Additional Fault Lines in Europe

crisis, and meaningful fiscal union is nowhere in sight. At the December 9 EU Summit, 26 EU members, with the much-publicized exception of the UK, announced their intention to participate in a new Euro-area fiscal compact in which countries will have to incorporate the principle of a 0.5% structural deficit ceiling in their respective constitutions and agree to face automatic sanctions if they breach a 3% deficit limit. Every summit initiative to date has been fraught with implementation difficulties; given that historical precedent, it is reasonable to assume that this will also be the case with the new fiscal compact. It is unclear whether all 26 countries will pass the necessary approvals. 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. While it is certainly a step in the right direction and is necessary for further ECB support during the crisis, it is still far from the fiscal union among states in the US, with a centralized Treasury and national Treasury securities. Last year, we tipped our hat to Alexander Hamilton, who in 1790 realized the newly

Another fault line in Europe is the banking sector. As shown in Exhibit 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. Banks have to raise this capital at a time of higher funding costs and questions about their access to short-term funding. Here there has been an important step in the right direction. 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; banks are now able to borrow from the ECB with up to three-year maturities and can post a broader range of collateral. A third fault line has been the inadequacy of resources set aside to deal with the crisis. Since the beginning of 2010, resources have been allocated incrementally, starting with the first bailout package for Greece at 45 billion (subsequently revised upward several times, with a current estimate of a cumulative bailout of over 200 billion). The initial funding amounts for the European Financial Stability Facility (EFSF) were also inadequate to achieve a AAA rating, and had to be increased by 65%. Even with the latest plan to bring forward the new European Stability Mechanism (ESM)

Investment Strategy Group

Outlook 15

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."

1,400 1,200 1,000 800 600 400 200 0


Potential Resources

Potential Uses
1,190 Spain & Italy bank recapitalization need

450-850? 0 - 200? 440 0 - 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, 2011 * Assuming EFSF and ESM do not overlap Source: Investment Strategy Group, Datastream, International Monetary Fund, European Banking Authority, ECB

to June 2012, 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, Portugal and Ireland; to support bank recapitalization efforts; and to support any financing shortfalls Spain or Italy might face (Spain and Italy alone have about 610 billion of financing needs in 2012). Some expect EFSF/ESM resources to be increased in March 2012; others take Chancellor Merkels statement that no new funds will be forthcoming at face value. In the meantime, the ECBs three-year refinancing operations should provide enough liquidity to banks and indirectly to sovereign government bond purchases to avert a meltdown. We should also note that just as we have seen some real progress at the supra-national level over the last two months, we have also seen some real progress at the national level. Both Italy and Greece have new reform-oriented technocratic governments, and the new Spanish prime minister, whose party has an absolute majority in Parliament, has been introducing

additional fiscal reform. Of course, technocratic governments do not mean either Italy or Greece are out of the woods. In Greece, the question of debt restructuring is still outstanding and the possibility of a disorderly default remains. In summary, while there has been some real progress that could lead to improvements in the financial markets, risks associated with a country or two no longer being part of the Eurozone remain. While ECB President Mario Draghi refers to talk of the Eurozone fragmenting in the foreseeable future as morbid speculation10 many experienced former European policymakers and European policy observers think otherwise. Peter Sutherland, Chairman of Goldman Sachs International and a guest speaker on some of our client calls, has stated that the longer this goes on, the greater the risk of a substantial problem in the Eurozone itself and in particular a country or countries becoming dislocated from it. Jacob Kirkegaard also believes that the risk of a country or two leaving the Eurozone is greater than zero. Obviously, such downside has not been lost on the financial markets. European equities, as measured by MSCI EMU, 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

we find particularly useful as a forward-looking measure of expected returns. Today, this metric stands at a 53% discount. When we consider some of the world-class multinational companies in this universe names like Total, Anheuser-Busch Inbev, Siemens, Sanofi, Telefonica, ENI, LVMH-Mot Hennessy Louis Vuitton, SAP, LOreal, Unilever, Daimler, BMW, and Danone that are trading, in aggregate, at a deep discount to US multinationals, it appears that significant downside has already been priced into the market. In our view, such cheap valuations warrant a small tactical tilt toward European equities.

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, what are the implications for the US, Europe and commodity prices? A hard landing in China would impact other parts of the world through several channels. The most immediate impact would be lower demand for commodities. While China accounts for about 10% of world GDP, it accounts for a substantially greater proportion of world commodity consumption, ranging from a low of 10% of oil demand to 30% of rice demand to 40% of copper and over 50% of iron ore. Clearly, a hard landing in China would lower commodity prices and have the greatest impact on commodity exporting countries. (on the flip side, of course, lower commodity prices would be a boon to global consumers.) A lesser impact would be on exports from the US and Europe. Exports to China account for 0.9% of US GDP and 1.3% of European GDP; of course, as all commodity exporters get affected by lower prices, US and European exports to those countries will also be hit. There is also a direct earnings hit since some US and European companies earn a share of their profits in China. In addition, there will be a portfolio impact for those invested in Chinese financial

assets. Tom Orlik, author of the recently published Understanding Chinas Economic Indicators, went as far as to say: It used to be that when the US sneezed the rest of the world gets a cold. Now the same is true of China.11 What exactly is a hard landing for China? Some define it as a full year of below 7% growth. Others view a hard landing as growth rates below 7% that would prompt market concerns and elicit a strong policy response from Chinese policymakers. Based on fourth quarter estimates from our colleagues in Goldman Sachs Global Investment Research,12 Chinas growth rate for the full year 2011 is expected to be 9.1%. We think the gradual slowdown will continue and estimate 2012 growth around 7.758.75%. 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). They raised the reserve requirement ratio, the deposit rate and base lending rate, as shown in Exhibit 16. Other measures included lending quotas. Their tightening measures had the desired effect of reducing property prices and volume of sales, as well as lowering inflation rates (Exhibit 17 and 18). However, as global growth slowed down in 2011 and the sovereign crisis in Europe worsened, Chinese officials started to ease financial conditions. Now the risk is that property prices drop too steeply; that would reduce local government revenues and affect their ability to repay loans to the major banks. In a country that is heavily dependent on bank financing, a hit to the banks would make the economy quite vulnerable. 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.13 While policymakers can lose control or make mistakes, 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. In our view, it will only take a quarter or two of GDP growth rates below 7% to prompt a very strong policy response. Officials will further ease monetary policy, implement fiscal stimulus and support the development of low income housing and rural

Investment Strategy Group

Outlook 17

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, deposit rates and lending rates have all been raised in recent years.
8% 7% 6% Base 1 Year Lending Rate

35 30 25 20 15 10 5 0 06 07 08 09 10 11 Real Domestic Credit (%YoY)*

100 102 104 China FCI


25% 20% 15% 1 Year Deposit Rate



5% 4% 3% 2%

106 108 110 112

10% 5% 0%

1% 0% 01 02 03 04

Required Reserve Ratio









Data as of November 2011 * Deflated by CPI Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Datastream Data as of December 2011 Source: Investment Strategy Group, CEIC

Exhibit 17: China Property Prices Policy tightening has had the desired effect of reducing property prices and sales in China's largest cities.
50% 40% 30% 20% 10% 0% 10% 20% Jan-07
(National Bureau of Statistics)

Exhibit 18: Chinese Inflation vs. Reserve Requirement Ratio Policy tightening has started to reduce Chinese inflation.
10% 8% 25% 20%
Headline Inflation (YoY%)

Weighted Average of 13 Cities


6% 4% 2%

15% 10% 5% 0%

70 Cities


2% 4% 01 02 03 04

Required Reserve Ratio
















Data as of December 2011 Source: Investment Strategy Group, National Bureau of Statistics of China, Soufun

Data as of December 2011 Source: Investment Strategy Group, CEIC

infrastructure, among other tactics, to avert a hard landing. They have the tools and certainly the financial means to do so: Chinas sovereign debt-to-GDP stands at 27%,14 its budget deficit stands at -1.6% of GDP, its reserves total over $3 trillion, 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).15 In addition, Chinas Communist Party will convene in October 2012 to elect the new party leaders; we expect they will do everything in their power to maintain adequate growth during the change in party leadership. To us, the much graver concern in China is a

18 Goldman Sachs

Exhibit 19: Composition of Chinese GDP Growth China's recent growth has been heavily dependent on exports and investments, not consumption.
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, with the US as their most popular destination.18 Here again, we can use history as a guide. Such transitions are rarely smooth, and we are concerned this one wont be either.

2012 Water Ahead

Linda, need to figure out is Share of total GDP is an axis item Outlook: More Choppy or caption

Data as of August 2009 Source: Investment Strategy Group, International Monetary Fund

longer-term, structural one: How does such a lopsided economy transition from an export- and investment-led economy to a more diversified one without major dislocations? As shown in Exhibit 19, Chinas growth has been heavily dependent on exports and investments related to exports. According to the IMF, during 200108, net exports and the investment which is predominantly linked to building capacity in tradable sectors have accounted for over 60% of Chinas growth, up from 40% in the 1990s. This is much larger than the 200108 average of the G7 (16%), Euro area (30%), and the rest of Asia (35%).16 During this period, private sector consumption in China declined from 47% of GDP in 2000 to 33% in 2010. In the last few years, exports have ceded some ground to real estate investment, which accounted for 13% of GDP in 2010. In order to achieve healthy, sustainable long-term growth, Chinas policymakers have to manage a transition to a balanced economy. Thats a tall order under ideal circumstances; they must accomplish it in the face of weaker global growth, a working-age population that is estimated to peak in 2015, an increasing number of public order disturbances, and an increase in geo-political tensions with some of its neighbors.17 Wealthy Chinese are taking note: an increasing

As we identify and examine the cyclical and structural concerns in key economic centers, we can only conclude that 2012 may be just as choppy as 2011. In the US, election year politics will probably impede progress on fiscal reform. In Europe, the sovereign debt crisis has spread from a few peripheral countries to now include Spain, Italy and even France and increasingly complex and ambitious reform measures are unlikely to pass without at least a few glitches. In China, policymakers have to avert a cyclical hard landing without further compounding the structural problems of an imbalanced economy. However, the financial markets are quick to price such concerns, and all these factors have already been at least partially discounted. Some US financial assets such as high yield fixed income are particularly attractive. Others, such as US equities, are fairly valued and reflect the strong earnings and safe haven status of US companies; they should be a core holding in any equity portfolio at this time. European and Japanese equities are particularly cheap and present an attractive investment opportunity for those who can withstand the volatility. And as unattractive as high quality government bonds are at current interest rates, they are the only consistent and reliable hedge in a portfolio at a time of heightened uncertainty. As we present our full economic and investment outlook in the pages that follow, these themes will be explored in greater detail; and it will be evident why we believe diversification always a fundamental consideration for any investor will be particularly important in the year ahead.

Investment Strategy Group

Outlook 19

january 2012

section ii

Economic Outlook

2012 Global

The Fog of Uncertainty

That said, we are quick to differentiate slowing growth from negative growth. Except for Europe, where we expect a modest recession, our forecast assumes below-trend, but still positive economic expansion. Several factors support this view. First, barring an exogenous shock or buildup of cyclical excesses, the natural state of economies is to grow, as a result of their expanding populations and productivity gains. Having emerged from a very deep economic contraction not long ago, there are few cyclical excesses to correct today, as evidenced by still large output gaps in the developed world and relatively healthy fiscal positions in the emerging markets. Second, slower growth, and hence moderating inflation, will provide cover for governments to undertake monetary and fiscal stimulus. Already, 48 central banks have eased in the last quarter of 2011, China reduced reserve requirements, Japan approved its fourth supplemental budget, the Bank of England announced yet another installment of quantitative easing, and the ECB adopted a host of unconventional measures to support banks, while continuing to buy bonds through its Securities Market Program (SMP). Emerging market countries, in particular, have room to relax macroeconomic policy, given their healthier fiscal positions and high policy rates (which average 5.3%). In short, while the fog of uncertainty is thick, policymakers are not without lights. Exhibit 20 presents a summary of our

by land and sea, the universal practice under conditions of fog is to slacken speed.19 So wrote Lammot du Pont, head of the chemical conglomerate bearing his name, in reference to the fog of uncertainty that was hampering Depression-era businesses. Although he penned these words in 1938, they are just as applicable today, given the bounty of concerns. While the potential for a hard landing in China and a disorderly breakup of the European Union are chief among them, less discussed, but equally unclear, is the outcome of a slew of potential leadership changes in 2012. Indeed, seven of the G20 countries, representing half of the worlds GDP, will face elections or leadership changes this year, including the United States, France, China and Mexico. Against this uncertain future, and true to du Ponts words, our forecasts envision slower global growth in 2012, and in turn, a global economy that is more vulnerable to shocks.

20 Goldman Sachs

GDP, inflation and interest rate forecasts for the developed economies.

Exhibit 21: Capital Spending and Private Sector Debt Growth The excesses that typically precede recessions are not present today.
19% Capital Spending % GDP

12% 10% 8% 6% 4% 2%

United States: Slow but Steady

What the US economic recovery has lacked in vigor, it has made up for in stamina. That is, while real GDP growth at this point in the cycle is only half that of historical recoveries, the economys continued upward trajectory in the face of a variety of destabilizing shocks, including the Arab Spring, Japanese earthquake, European sovereign crisis and US debt ceiling debacle, is a testament to its resilience. Indeed, despite a notable intensification of the European crisis in the latter part of 2011, US GDP growth appears to have accelerated to over 3% in the fourth quarter. We expect this growth to continue in 2012, in spirit if not in magnitude. Our forecast for 1.52.5% real GDP growth is a wider range than usual, largely reflecting uncertainty around US policy outcomes. For instance, failing to extend the payroll tax cut could subtract roughly 0.7pp from GDP growth, while extending unemployment benefit measures would add roughly 0.3pp. Meanwhile, the 2% midpoint of our range TableA_v3_123011.pdf trend, consistent with stands below historical the ongoing headwinds from consumer and financial institution deleveraging. As discussed at the beginning of this Outlook, 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

0% 2% 4%

Data as of Q3 2011 Note: Based on corporate data for the largest 1,500 stocks, excluding financials and utilities. Source: Investment Strategy Group, Empirical Research Partners, US Department of Commerce, Federal Reserve, US Bureau of Labor Statistics

growth is typical in the three to five years following a financial crisis. Of course, despite its resilience thus far, the US economy could still tip into recession, particularly given its below-trend growth path. Nonetheless, there are four reasons recession is not our base case for 2012. First, the collective message from a variety of leading economic indicators we follow is still one of moderate growth, at least for the next few quarters. Second, our stall-speed recession models still signal an

Exhibit 20: ISG Economic Outlook for Developed Markets Our forecast features relatively tame inflation, still-accommodative monetary policy, and some normalization of interest rates.
UNITED STATES 2011 Real GDP* Headline CPI** 10-Year Rate*** Policy Rate
Data as of December 30, 2011 * 2011 Real GDP is based on GIR estimates of yoy growth for the full year. ** For current headline CPI readings we show the year-over-year inflation rate for the most recent month available. *** German 10-year rate shown for Eurozone. Source: Investment Strategy Group, Datastream

EUROZONE 2011 1.5% 3.0% 1.82% 1.0% 2012 Forecast (1.0) - 0.0%
Data as of Q3 2011

JAPAN 2011 0.2% 2012 Forecast 1.75 - 2.25%

UNITED KINGDOM 2011 0.9% 2012 Forecast (0.5) - 0.5% 2.25 - 3.0% 0.5%

2012 Forecast 1.5 - 2.5% 1.5 - 2.5% 2.0 - 2.75% 0.0 - 0.25%

1.7% 3.4% 1.88% 0% - 0.25%

1.25 - Source: Investment Strategy Group, Empirical Research Partners, US Department of Commerce, 2.25% 0.6% (0.5) - 0.0% 4.8% 2.0 - 3.0%
Federal 2.25 - 3.0% Reserve, US Bureau of Labor Statistics 1.75% 0.97% 1.0 -

Note: Based on corporate data for the largest 1,500 stocks, excluding financials and utilities.

1.97% 0.5%

0.5 - 1.0%



Investment Strategy Group

Outlook 21

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 investments 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. Ive 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 and an increase in available jobs in the Labor Departments 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

Im still Employment not convinced that its 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 economys diversity. The upshot is that with job losses in the crisis sectors stabilizing, overall employment growth can improve. Already, real estaterelated 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, 2012s 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 governments 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 todays 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 todays 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

In short, while we have relatively modest expectations for the contribution of residential investment to GDP growth in 2012, we think housing will become an increasingly important economic story, and hence investment theme, in the years ahead. Given this moderate growth backdrop, we expect inflation to remain well anchored, given the still abundant slack in the US economy. Moreover, with unemployment above the Feds comfort level, we expect the Fed to honor its commitment to remain on hold into 2013, despite further economic growth. Even so, interest rates will likely end this year at higher levels, as continued economic expansion raises expectations of eventual monetary policy normalization.

Exhibit 28: Fixed Investment in the Eurozone There are fewer excesses to correct during a downturn, suggesting a moderate recession.
Index (1Q08=100)

105 100 95 90 85 80 75 70 GIIPS

(Greece, Ireland, Italy, Portugal and Spain)

(Eurozone excl. GIIPS) 92 87


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, Datastream, Eurostat

Eurozone: No Silver Bullet

Against a backdrop of political turmoil, a bank- Exhibit 29: Household Savings Rates Consumer balance sheets in the Eurozone are comparatively healthy. ing crisis and a large fiscal drag, the question is no longer whether the Eurozone will experience 16% a recession in 2012, but rather how deep it will 13.9% be. While a deep recession is intuitively appealing 14% given the magnitude of the areas challenges, that 12% is not our base case. Instead, we expect about a 10% 1% peak to trough contraction, a level consistent 8% with the recessions seen in the early 1980s and 6.4% 5.5% 6% 1990s. In turn, weaker growth should temper 4.8% inflation concerns, providing cover for the ECB 4% to reduce interest rates further. Already, grow2% ing excess bank reserves from the ECBs liquidity 0% measures are likely to push short rates lower. Eurozone UK Japan US Our relative optimism, or perhaps lack of unequivocal pessimism, is predicated on several Data as of Q2 2011 factors. As shown in Exhibit 28, Eurozone inSource: Investment Strategy Group, Datastream, Eurostat, OECD, US Bureau of Economic Analysis, vestment the most cyclical element in GDP is UK Office for National Statistics already at very depressed levels, suggesting there are fewer excesses to correct during a downturn. In fact, overall fixed investment has grown just 4% since its financial crisis trough. Fixed investment among the European peripherals, meanwhile, has already contracted significantly, standing 23% below its 2008 peak. In addition, Exhibit 29 shows that Eurozone consumer balance sheets are relatively healthy, providing some scope for savings to offset falling growth. Finally,

Investment Strategy Group

Outlook 25

january 2012

Exhibit 30: Business Funding from Bank Loans and Credit Markets Unlike US companies, European firms rely heavily on bank loans for their funding.
Bank Loans
100% 80% 60% 40% 20% 0%

Bond-Market Funding


Portugal Germany





Data as of 2011 Source: Investment Strategy Group, Bank of America/Merrill Lynch, Haver Analytics

While we expect the Eurozone to remain intact, we have no delusions about the existence of a silver bullet for the regions woes.

an unruly, forced deleveraging of the banking system is far less likely in the wake of the ECBs extraordinary liquidity measures, 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, or Long-Term Refinancing Operations). These measures lessen the extent to which lending conditions would otherwise tighten, a critical consideration given the importance of bank financing to the Eurozone (see Exhibit 30). While our forecast calls for a relatively modest overall Eurozone recession, more severe contractions lurk beneath the surface at the country level. As was the case in the expansion, we expect the core of Europe to fare better than the periphery, given the latters greater debt burdens and higher funding costs. For example, Germanys low budget deficits (12% in 2012) and attractive borrowing costs may enable it to stagnate rather than contract. In addition, Germany, unlike Spain, did not experience a large housing bust and hence does not need to rebalance its economy. In contrast, we expect a combination of austerity measures, uncompetitiveness and elevated borrowing costs to result in deeper contractions in the GIIPS (Greece, Ireland, Italy, Portugal and Spain). While we expect the Eurozone to remain intact, we have no delusions about the existence of a silver bullet for the regions woes. Even with Germany serving as economic ballast, the Eurozones ultimate fate rests in the hands of its own politicians and the patience the market is willing to afford them. As we have highlighted in various client calls and Sunday Night Insights throughout 2011, we expect continued incremental, reactive and occasionally inconsistent policy responses. Meanwhile, these existential challenges are likely to be exacerbated by cyclical pressures resulting from Europes unfolding recession and the implications of slowing growth in China and/or the US. As a result, even though we accord both the US and Europe a 30% downside probability, the bad case for Europe is more severe than the US, given the dangerous interplay between weakening growth and the potential for an adverse tail event (such as a disorderly default or political accident).

26 Goldman Sachs

That said, progress has been made. As mentioned above, the ECBs recent liquidity measures significantly decrease the probability of a Lehmanstyle liquidity crisis and provide politicians time to put more permanent measures in place. Indeed, banks were able to fund nearly twothirds of their entire 2012 funding needs during the ECBs December LTRO. With an additional LTRO available in February, the banks will have little difficulty rolling their maturing 2012 or 2013 debt. Meanwhile, the imposition of technocratic governments in Greece and Italy, the election of a pro-reform party in Spain, and parliamentary approval of austerity measures across the Eurozone make the political commitment to reform more credible. Even so, we expect volatility to remain elevated and headline-driven for the near future, given ongoing debate over the Greek private sector involvement, key EU elections, and elevated sovereign funding needs early in the year. Although by no means a 2012 expectation, any lasting solution to the Eurozone crisis must ultimately provide the following key items: A fiscal integration plan that enables the socialization of losses, through either Eurobond issuance or direct fiscal transfers. A fiscal consolidation plan that improves structural competitiveness and growth in the periphery, as opposed to just curtailing spending through austerity measures. A mechanism to address the funding needs of weaker sovereigns that lack market access. A credible firewall to limit contagion arising from any one members default / exit. We continue to assess any proposed comprehensive solutions against this checklist.

United Kingdom: Sluggish Growth with Downside Risks

We expect UK inflation to moderate gradually from current high levels. While inflation has risen on the back of commodity prices and two VAT hikes in 2010 and 2011, it should fall back to 2.03.0% in 2012 as these effects dissipate. True, this would still be above the Bank of Englands 2% target, but the weakness of the economy should keep the central bank very dovish in 2012. As such, we expect the BoE to keep rates at 0.5% in 2012 and to announce further asset purchases. Despite this already tepid outlook, we think risks are tilted to the downside for three reasons. One, implementation of the fiscal consolidation could veer off track. Two, markets may start to challenge the UKs bond market. Three, inflation could remain resilient, forcing the Bank of England to defend its credibility at the expense of the economy.

Japan: Rebuilding Tailwind

After enjoying a strong growth rebound in 2010 and an encouraging start to 2011, earthquakerelated disruptions pushed the Japanese economy back into recession. In turn, rebuilding efforts led to strong 5.6% QoQ annualized growth in the third quarter of 2011, reflecting a post-earthquake recovery that should endure in 2012. In fact, we expect Japan to grow as fast as the US and outgrow Euroland, and the UK in 2012, a feat that has occurred only once before in the last two decades. Not surprisingly, fixed investment will be the principal driver of this growth, boosted by reconstruction and public investment. A mean reversion tailwind will help, as business investment remains 19% below its 2008 peak. Meanwhile, public investment will be boosted by the three post-earthquake supplementary budgets already approved, amounting to a combined 18tr (3.7% of GDP). Overall, we expect GDP growth of 1.752.25% in 2012, with a modest increase in long-term rates to a range of 1.01.75% by year-end.

Investment Strategy Group

Outlook 27

january 2012

We have long argued that emerging market economies are not immune from the business cycle 10% gyrations of the advanced economies. It should 9% Headline Growth come as little surprise, then, that we expect a 8% slowdown in emerging market growth, given 7% Trend Growth our relatively tepid growth expectations for 6% Base Case the developed world. Even so, we are quick to 5.7% 5% distinguish between slowing growth and negative Downside 4% Case growth. While our forecast calls for a slowdown 3% 4.1% in emerging markets to a below-trend 5.7% in 2% 2012, we do not expect a hard landing. 1% Several factors underpin our view. For one, 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. In turn, our expectation for 1% growth in Data as of September 2011 Source: Investment Strategy Group, International Monetary Fund the advanced economies in 2012 is very different from the nearly 5% economic contraction that occurred in 2009. As a result, the drag on EM growth should be commensurately less. Despite this rebuilding tailwind, Japan reOf equal importance, more temperate growth mains vulnerable to exogenous shocks, particushould ease inflationary pressures, enabling larly a dramatic slowing in global growth. That emerging markets to relax monetary policy. said, we would expect more monetary easing Indeed, in stark contrast to the developed world, 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. Moreover, although high debt levels make (given that average policy rates currently stand at the country susceptible to a sovereign crisis in the 5.3%), while strong budgetary positions permit incremental fiscal stimulus. These measures serve long term, we think this risk is mitigated by at least three factors. First, domestic investors hold as an important counterbalance to the external more than 90% of Japanese government debt, re- growth headwinds we expect. Even so, while we think tail risks have reducing the likelihood of a run on JGBs. Second, Japan does not need external funding, given that ceded, they have not been eliminated. To be sure, a hard landing in China, a US recession or an it runs a current account surplus worth roughly escalation of the European debt crisis could neg34% of GDP. In fact, gross private savings atively impact emerging markets through hamrepresented 14.6% of GDP in 2010, an amount pered trade, diminished access to international that could be channelled toward reducing govcapital markets and lower commodity prices. On ernment debt if necessary. Finally, tax levels are this point, a recent study by two IMF economists low in Japan relative to other OECD countries, providing scope for higher government revenues. found that a downside scenario involving severe market dislocations in European economies and markets could shave 1.6 percentage points (pp) from emerging market growth, in addition to We have long argued that emerging the 1.5pp growth decrement we expect from the advanced economy slowdown.20 If correct, this market economies are not immune would reduce the rate of growth by more than from the business cycle gyrations 3 percentage points, a significant shock, but still of the advanced economies. less than the 6.1pp decline following the Lehman crisis (Exhibit 31).

Exhibit 31: Emerging Markets GDP Growth Our base case envisions below-trend growth, but not a hard landing.

Emerging Markets: Still Coupled

28 Goldman Sachs

Emerging Asia

As home to many of the most open economies in the world, Emerging Asia is particularly vulnerable to slowing global exports and tighter global trade financing, both of which are likely headwinds in 2012. That said, these hurdles should be manageable given continued current account surpluses (with the exception of India) and large foreign exchange reserve balances. In addition, waning inflation from decelerating economic activity should provide scope for looser macroeconomic policy, most likely in the form of rate cuts and slower currency appreciation across the region. China Barring an extreme outcome in Europe, China remains on course for a soft landing. While it is true that Chinese growth has slowed almost 3 percentage points in less than two years, the absolute level of growth is still a robust 9.1% as of the third quarter of 2011. Of equal importance, much of this slowdown was intentional, as the government tightened policy dramatically to forestall a burgeoning property bubble and assuage inflationary pressures. Even so, growth momentum is likely to slow further in China, given decelerating global economic activity. In turn, we expect below-trend GDP growth of 7.758.75% in 2012, supported by consumption growth and a mild pickup in investment, primarily in public housing. On this point, the Chinese government has set a target of building 7 million affordable homes in 2012 and, for the first time ever, made reaching these targets the core criterion for judging local officials job performance.21 Meanwhile, slowing growth should temper inflation and thereby provide scope for policy easing in 2012. In our view, inflation has already peaked and should drop further to around 34% in 2012. The key challenge for Chinas policymakers will be to support domestic demand growth without creating new vulnerabilities in the financial sector. For instance, while the massive stimulus employed during the 2008 financial crisis enabled Chinas economy to rebound quickly,

it also fostered real estate speculation and a surge in local government debt. That said, 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. Of course, as an export-driven economy, China remains vulnerable to a further escalation of the European sovereign debt crisis. After all, Chinas exports of goods and services still make up some 30% of GDP, of which the EU represents one-fifth. In addition, trade financing remains vulnerable, particularly as European banks deleverage their balance sheets. Nonetheless, we believe China has flexibility to employ fiscal and monetary stimulus as a counterbalance, although this flexibility is admittedly less than it was in 200809. India Indias economy is also slowing, largely reflecting declining investment and tight monetary policy. We expect this trend to continue, with GDP growth in 2012 slowing to a below-trend 6.757.75% and inflation falling to 56.5%. Among the larger economies in Asia, India appears most exposed to jitters in global financial markets. Concerns about Indias twin deficits are pressuring the rupee. In turn, this is further tightening the financing conditions of Indian

Barring an extreme outcome in Europe, China remains on course for a soft landing.

Investment Strategy Group

Outlook 29

january 2012

companies, which rely extensively on European banks. Given these budding external headwinds, the key challenge for Indias policymakers will be to revive investment without creating a bigger budget deficit or rekindling inflation. We expect the burden to fall on the central bank, which is likely to cut rates and improve access for foreign portfolio inflows as a means of easing liquidity conditions.
Latin America

We expect sluggish activity in Europe to keep commodity prices in check, and with them, Latin American growth. That said, tight supply conditions in oil, copper and iron ore should continue to support the terms of trade in the region. Moreover, should global activity surprise on the downside, central banks are likely to loosen monetary policy further. As with China, the healthy fiscal balance of countries such as Brazil, Mexico, Colombia and Chile will allow some budgetary stimulus as well.

Brazil Although Brazilian growth ended 2011 at depressed levels, we expect a rebound this year, albeit to a still below-trend 2.53.5%. The uptick will likely reflect the lagged effects of the central banks proactive rate cuts last summer, as well as an expected rise in the minimum wage. In addition, large-scale investments in both oil production and infrastructure to prepare for the 2014 World Cup will provide a further tailwind. Consequently, inflation is likely to remain above its target (for the third year running), settling in a range of 5.56.5% in 2012. In theory, Brazil is relatively insulated from the unfolding Eurozone crisis, with just 2% of its GDP destined for the EU. In practice, however, the impact on commodities prices could transmit the slowdown directly, given that commodity exporters account for 43% of Brazilian market capitalization. In turn, weak equity prices could negatively impact wage growth and wealth, undermining consumer sentiment. On a more positive note, years of experience have improved Brazils macroeconomic management, enabling them to better respond to external shocks.
Europe, Middle East, Africa (EMEA)

Among the larger economies in Asia, India appears most exposed to jitters in global financial markets.

We expect growth in EMEA to slow in 2012, with considerable downside risks. Among emerging market economies, those in EMEA have the largest external financing needs and the closest trade and financial links with the Eurozone (Exhibit 32). Thus, they are far more vulnerable to an adverse outcome in Europe than their Asian and Latin American peers, with the Czech Republic, Hungary and Poland particularly at risk. Turkey is also at risk given its large current account deficit, whereas Russia and South Africa are likely to be more resilient. Unlike other emerging markets, most EMEA countries have limited room to counteract slowing growth with policy stimulus. Therefore, any easing will most likely come in the form of modest interest rate cuts.

30 Goldman Sachs

Russia Although Russias exposure to Europe through trade and financial linkages is the largest among the BRICs, its economy has thus far been resilient. This durability is largely a function of robust domestic consumption and the relative strength of oil and gas prices, Russias main exports. 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 3.254.25% in 2012. Slowing growth should allow inflation to fall in a range of 6.07.5% for the year. Even so, these high absolute levels of inflation curtail Russias policy flexibility, which is further constrained by the depreciation of the ruble since mid-2011 and continued capital outflows. Russia may thus find itself less able to offset a deepening of the global growth slowdown.

Among emerging market economies, those in EMEA have the largest external financing needs and the closest trade and financial links with the Eurozone.

Exhibit 32: EM Trade and Financial Linkages to Eurozone Countries in EMEA have the largest exposure to Eurozone tensions.
Bank Loans From Eurozone as % of Broad Money Supply 140% 120% 100% 80% 60% 40% 20% 0% 0% BRZ

RUS 15% 20% 25% 30% 35% 40% 45% 50%


CHN 5% 10%

Exports to Eurozone as % of GDP

Data as of 2010 Source: Investment Strategy Group, International Monetary Fund

Investment Strategy Group

Outlook 31

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). Accordingly, risk aversion was once again in vogue, evident in the character of asset class returns seen in Exhibit 33. To be sure, few investors will lament the passing of 2011. While the structural nature of todays concerns suggests aftershocks will persist, that should not preclude reasonable equity returns in 2012 (Exhibit 34). For one, valuations, particularly in countries of stress like those in Europe, have become much more enticing. Moreover, positive, albeit below trend, global growth should support further earnings gains. In addition, global central banks are moving more aggressively toward reflation. China and other emerging markets are also joining the fray, a notable shift from their anti-inflationary policy tightening last year. In sum, this combination of high earnings yields and low interest rates results in lofty global equity risk premiums, bolstering the relative attractiveness of stocks. In contrast, most government bonds look unattractive in our view, given a combination of negative real yields, duration risk and some credit risk in select sovereigns. Todays low yields also make it clear that generating attractive returns will require investors to take more risk. As evidence, todays S&P 500 dividend yield is higher than the 10-year Treasury yield, despite

if 2008 represented the epicenter of the financial crisis, 2011 was its aftershock. After all, the financial turbulence of both periods emanates from a similar fault line: an accumulation of debt, whether in the form of US mortgages, Chinese domestic loans or European sovereign bonds. Perhaps it is not surprising, then, that last years renewed focus on these macroeconomic risks engendered the same type of elevated volatility, correlations and contagion risks that characterized the crisis. As 17th century French tragedian Pierre Corneille wrote, The fire which seems extinguished often slumbers beneath the ashes. In the wake of these systemic concerns, policy announcements, not economic reports, drove the largest equity moves in 2011.22 This shift away from fundamentals proved toxic for investment managers, with 75% of large cap core equity mutual funds underperforming the S&P 500 last

32 Goldman Sachs

Exhibit 33: 2011 Asset Class Performance Risk aversion drove returns in 2011.
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)



5.0% 2.1% 0.4% 1.0% 4.7% 11.7% 18.2% Emerging Markets Equity

Non-US Equity

Data as of December 30, 2011 except where indicated Note: Total Returns in USD. Source: Investment Strategy Group, Datastream, Barclays Capital

historically being less than half. Bond sentiment is a contrarian negative as well, as just one third of institutional investors surveyed expect rates to rise in 2012.23 Elsewhere, we e xpect the US dollar to remain broadly stable, while easier policy in emerging markets should limit currency gains there. A combination of a stable greenback and slowing global growth should keep oil and gold range TableF_v7_010212.pdf bound this year. While our forecasts are not grim, we are by no means Pollyannaish. There is little question that the confluence of sovereign developments in

Europe, slowing global growth, political gridlock in the US and the potential for a hard landing in China have raised the risk and severity of adverse outcomes. In fact, it was on this basis that we advised purchasing tail risk protection via S&P 500 puts in July of last year. In addition, our current forecast includes a higher downside probability, around 25%, embedding a low, but non-trivial possibility of a destabilizing outcome in Europe or China. In short, while the likelihood of a truly adverse outcome remains low, the penalty for being wrong has risen. 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 1,325 - 1,400 2,400 - 2,600 5,650 - 5,950 800 - 875 44,000 - 48,000 Implied Upside Current Level 5% - 11% 4% - 12% 1% - 7% 10% - 20% 7% - 17% Current Div. Yield 2.1% 5.0% 3.9% 2.6% 2.9% Implied Total Return 7% - 13% 9% - 17% 5% - 11% 12% - 23% 10% - 20% Volatility Since 1988 15.1% 18.8% 15.0% 19.7% 23.2% Sharpe Ratio* 0.69 0.69 0.53 0.89 0.65

Data as of December 30, 2011 * Sharpe ratio equals the midpoint of the total return range divided by volatility. Source: Investment Strategy Group, Datastream

Investment Strategy Group

Outlook 33

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 Eurozone
Estimate of Debt Losses Based on: %GDP

0% 4% 8% 12% 16% 20%


All Other DebtHolders

Data as of 2011 Source: Investment Strategy Group, Empirical Research Partners

Exhibit 36: S&P 500 Performance vs. VIX Periods of elevated volatility have historically been better buy than sell signals.
1800 1500 1200 900 600 300 0 70 60 50 40 30 20 10 0 S&P 500 Price Index

risks, why not be completely risk averse? We see at least four reasons. The first was best articulated by Oaktrees 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 . . . and chances are high that it will be.24 Second, the 2008 financial crisis demonstrated that loss estimates are fluid and greatly influenced by prevailing sentiment. In fact, the losses ultimately realized in the US were just half of those estimated at the worst point in the crisis (Exhibit 35).25 Consequently, the additional policy steps we expect may dampen todays draconian Eurozone loss estimates. Third, as we have highlighted before, the hurdle for underweighting stocks is high when valuations are undemanding, interest rates are low, corporate earnings are growing, and sentiment on stocks has soured, all conditions that exist today. Finally, Exhibit 36 reminds us that periods of great volatility, and hence heightened uncertainty like we have today, have historically been better buy than sell signals. Thus, we have selectively positioned our portfolio in areas where we find that the prospective returns justify the risks. We discuss these positions further in the pages that follow.

VIX (3M Median)

US Equities: Continued Resilience

86 89 92 95 98 01 04 07 10

Data as of December 30, 2011 Source: Investment Strategy Group, Bloomberg, SentimenTrader

The S&P 500 was clearly the best house in a bad neighborhood last year. As shown earlier in Exhibit 33, despite a relatively flat absolute return, the US was nonetheless the lone bright spot in an otherwise dismal year for global equity markets. This was a remarkable feat, considering the relentless cascade of negative shocks, both homegrown and foreign, that the market endured. At the root of this resilience was the persistence of strong corporate profitability. All told, S&P 500 operating earnings grew roughly 17% in 2011, setting a new all-time high in the process. In fact, top-down consensus estimates for 2011 actually rose 6% over the course of the year. In contrast, valuation multiples moved

34 Goldman Sachs

in the opposite direction, as investors worried about the durability of earnings in the face of countless headwinds (Exhibit 37). This tug of war between resilient earnings on the one hand, and the multiple investors are willing to pay for them on the other, is a theme we expect to endure in 2012. Of course, earnings and valuation represent just two of the four factors that determine our outlook. We discuss each of the four in more detail below:

Exhibit 37: Decomposition of 2011 S&P 500 Return Pervasive uncertainty pressured valuation multiples lower, offsetting impressive earnings growth.
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Earnings Growth Dividend Yield Multiple Compression 2.1% Total Return 15.9% 15.9% 2.1%

With S&P 500 price returns flat in 2011, it is not surprising that valuation multiples would look strikingly similar to those shown in our last Outlook (Exhibit 38). Then, as now, valuations resided around the midpoint of their historical range, regardless of the measure. But while todays middling valuations are unremarkable versus their own history, they remain depressed relative to prevailing interest rates. Indeed, historical periods of similarly low rates saw the price-to-trend earnings multiple (our preferred valuation measure) several points higher. With the Fed committed to low rates into 2013, this environment is likely to persist. As a result, stocks look particularly attractive relative to Treasury bonds. The 10-year Treasury currently yields 1.88% while the S&P offers a 6% real earnings yield and a 2.1% dividend yield. While valuation multiple expansion does not figure prominently in our central case, we do see scope for presidential elections to reduce uncertainty this year. Historically, when the incumbents approval rating was as low as it is today, it actually did not matter who won the election. Instead, simply removing the uncertainty sufficed, as all seven historical instances showed positive returns during the election year, averaging 13%.26

Data as of December 30, 2011 Source: Investment Strategy Group, Datastream

Exhibit 38: Percent of Time US Equity Valuations Have Been Less than Current Since 1974 Regardless of measure, valuations reside around the mid-point of their historical range.
100% 80% 60% 40% 20% 0% Price to Trend Earnings
Data as of December 30, 2011 Source: Investment Strategy Group, Datastream, Robert Shiller




Price to Peak Earnings

Price to Book

The S&P 500 was clearly the best After three years of robust earnings growth, inves- house in a bad neighborhood last year.
tors are rightly concerned about the sustainability of further gains, particularly given already elevated profit margins. This skepticism was clearly on display last year, as stock prices decoupled from record high earnings, a reflection of falling price to earnings (PE) ratios. While the concerns have

Investment Strategy Group

Outlook 35

january 2012

Exhibit 39: US Manufacturing Plants (ex-Oil Refineries): been ill begotten thus far, profit margins have Changes in the Cost Structure from 1997 to 2009 historically been mean reverting, suggesting the
% of Revenue

0.5% 0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 3.0% Cost of Inputs




Fuels and Electricity


Fringe Benefits

Data as of September 2011 Source: Investment Strategy Group, 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.
Energy/Commodities Financials 16% Consumer Staples Spending 18% 14% Medical Spending


21% Business Spending


Consumer Discretionary Spending

Data as of December 2010 Source: Investment Strategy Group, Bank of America Merrill Lynch

skeptics will be proven right eventually. That said, barring an exogenous shock, we do not expect an imminent collapse in profit margins this year. Importantly, mean reversion is not an independent force, but rather a reflection of underlying fundamentals. As shown in Exhibit 39, most of the shift in profit margins over the last decade can be traced to globalization of the manufacturing supply chain. In fact, plant-level costs as a percent of revenue fell nearly 6% over this period, a function of lower labor and other input costs.27 Because these margin gains were not cyclically driven, their pace of mean reversion is likely to be very gradual, despite some manufacturers returning to US shores. After all, even three years from now, Chinese labor costs are expected to be just a quarter of those in the US.28 As such, our assumption of stable margins is not a bet against mean reversion per se, but rather a view on its speed. Closer to home, still-elevated US unemployment and moderating inflation should mitigate two traditional sources of margin pressure as well. Meanwhile, the continued US growth we expect this year also bodes well, since recessions have historically precipitated collapsing margins. Finally, we note that margin up cycles tend to be enduring, with the previous two lasting almost six years. Applying the historical analogue literally suggests margins will not peak until late 2014. Against a backdrop of steady margins, we expect earnings growth to continue to outpace GDP growth. As Exhibit 40 makes clear, the S&P 500 is more leveraged to areas of the economy growing faster than domestic consumption, such as business spending, commodities and exports. For example, equipment & software spending is expected to grow at over three times the pace of GDP. Moreover, the continued industrialization of emerging markets remains a tailwind to US based energy / materials firms. Already, last years strong third-quarter operating earnings run rate suggests a 73% probability that 2012 EPS will be at least $103. If realized, that would equate to profit growth of around 6%, above the level we expect for US GDP.

36 Goldman Sachs


The S&P 500s late 2011 rally has left it at a key technical decision point. On the one hand, the underlying trend is improving, as the S&P 500 is back near its 200-day moving average, considered the dividing line between technical strength and weakness. On the other hand, the market now faces a confluence of overhead resistance, given the 200-day moving average overlaps with a downward-sloping trendline that has ended previous rallies. With the market at a crossroads, two factors argue for prices resolving to the upside. First, the continued strength in the markets breadth (the cumulative number of S&P 500 stocks advancing less those declining) is positive, as this measure moved decisively above its long-term average in October and is approaching previous highs. This paints a very different picture from that of late 2007 to early 2008, where deteriorating breadth foreshadowed subsequent price weakness. Second, the markets strong fourth quarter performance (>10%) suggests further near-term strength. In fact, fourth quarter returns greater than 10% have led to continued gains in the next quarter 92% of the time since 1932. Notably, the median gain was 5%, well above the 2% gain of any random quarter.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

Data as of December 26, 2011 Source: Investment Strategy Group, AMG Data Services

Our View on the US Market

Sentiment / Positioning

History teaches us that when investors are complacent, eager to deploy capital, and oblivious to the downside risks, markets get into trouble. Thankfully, none of these conditions exist in the equity space today. As shown in Exhibit 41, there have been $11.4 billion of outflows from US equity mutual funds in 2011, highlighting retail investors limited appetite for stocks. Indeed, last year was one of only six such years since 1992. Notably, the year following these episodes registered a positive return 83% of the time. This observation echoes the conclusion of a 2008 academic paper, which found a significant negative correlation between sentiment-driven fund inflows and future returns.30

The net message of our equity framework is that stable margins, coupled with mid-single digit revenue growth, will support slower, but still positive earnings gains. This, in turn, provides a rising fundamental floor for equity prices, as the market ultimately follows the path of earnings. As shown in Exhibit 42, this combination suggests price returns of around 8% to the midpoint of our forecast range this year. We continue to like US financials, and US banks in particular, although we have admittedly been early in our enthusiasm. Our view rests on the financials attractive valuations, fortified balance sheets, exposure to the stabilizing / improving US real estate market, improving loan growth, and nearly universal negative sentiment. Of contrarian note, financials have now underperformed the market for five years running, a feat

History teaches us that when investors are complacent, eager to deploy capital, and oblivious to the downside risks, markets get into trouble.

Investment Strategy Group

Outlook 37

january 2012

Exhibit 42: ISG US Equity Scenarios Year-End 2012

End 2012 S&P 500 Earnings

Op. Earnings $112 Rep. Earnings $106 Trend Rep. Earnings $78 18.5 - 20.0x 1443 - 1560 1450

Op. Earnings $97 - 102 Rep. Earnings $92 - 97 Trend Rep. Earnings $78 15.5 - 18.5x 1209 - 1443 1325 - 1400

Op. Earnings $80 Rep. Earnings $64 Trend Rep. Earnings $78 11 - 14x 858 - 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, 2011 Source: Investment Strategy Group

bested only by the utility sector in the run up to the technology bubble. That said, utilities managed to outperform the market by a staggering 62 percentage points in 2000 as the losing streak abruptly ended. While we dont expect a similar magnitude of outperformance, we believe there are catalysts on the horizon this year: the second round of stress tests in March, further clarity on regularly requirements and the expiring statute of limitations on put backs for many of the worst mortgage vintages. While history reminds us that prophecies of doom have been far more plentiful than the profits that arose from positioning for them, we acknowledge that this years outlook is fraught with more risks than usual. Although strong US corporate profitability provides a bulwark, many of the concerns we have discussed are political in nature, resulting in asymmetric risks that undermine fundamental analysis. Moreover, neither valuation nor supportive fundamentals are a binding constraint in the short run, as what is attractively valued today can surely become more so tomorrow.

We acknowledge that this years outlook is fraught with more risks than usual.

Even so, part of our comfort in remaining invested stems from the distinction we draw between a mark-to-market loss, which results from prices being pulled away from fundamental value by investor emotions, and a permanent impairment of capital, which typically results when investors pay excessively high prices or purchase excessively leveraged companies. In our view, the US market is neither excessively leveraged nor overpriced. As such, price volatility notwithstanding, for those investors who have first ensured they have sufficient sleep well money to actually sleep well, we think it makes sense to build toward or maintain ones strategic US equity allocation when valuations are fair, as they are now. On this point, we make two additional observations. One, the next decade of US equity returns is likely to be better than the last, given that 160 of the past 176 years had a higher rolling 10-year compounded annual total return than today.31 Two, starting valuations are a key determinant of these long-run returns. In fact, the normalized PE ratio explains 80% of the variability of market returns over a decade-long period.32 For the patient investor, todays US equity market is priced to deliver 7% normalized annual returns over the next 10 years, lower than historical average returns, but very attractive relative to cash and bond yields. If realized, these returns would double the invested capital over this period.

38 Goldman Sachs

Eurozone Equities: Low Valuations, High Risk

Given the disparate fiscal and economic health of the Eurozones core and periphery, it is not surprising that sovereign fears have been the key driver of Eurozone equities for the better part of two years, as seen in Exhibit 43. A unique feature of 2011, however, was that concerns about peripheral solvency metastasized into existential doubts about the entire Eurozone. In turn, equity markets in the core were no longer immune to the crisis, as evident in Germanys 15% decline in 2011. Given the structural nature of the issues and the lack of straightforward solutions, we expect sovereign developments to remain a source of uncertainty, and hence volatility, for Eurozone equities this year. At the center of this uncertainty stand the Eurozone banks, as they constitute over a fifth of the regions market capitalization. In addition, their large holdings of Eurozone sovereign bonds represent a key fault line in the crisis. Clearly, there is no shortage of headwinds facing the sector, including the risk of nationalization, realization of private and sovereign credit losses, capital raisings, deleveraging, and high funding costs. That said, the market is well aware of these challenges, evident in the sectors distressed 0.4X book value multiple. Even adjusting book value for the prospective losses we expect, the resulting 0.6X price to book multiple remains depressed. Nevertheless, the banks are no longer the only source of cheap valuation in Europe. Instead, 2011s broad-based weakness has pushed Eurozone equities into the bottom quartile of their historical valuation range. As a result, they now trade at a much bigger discount to US equities than they have historically, as seen in Exhibit 44. Given these broadly attractive valuations, we recommend a small tactical overweight to European equities. Of course, a fair question is why own Eurozone equities at a time when the region is not only embroiled in a sovereign crisis, but also a recession? In addition to the margin of safety provided by valuations, we highlight two points. The first is that the Eurozone is home to several of the worlds largest multinational

Exhibit 43: Spanish 3-Year Government Spreads Over German Bunds vs. Euro Stoxx 50 The intensification of credit stresses is mirrored in poor equity performance. Basis Points
3900 Spanish Gov't Spreads to German Bunds

600 500 400 300 200 100 0 100




Euro Stoxx 50

200 300 Sep-10 Jan-11 May-11 Sep-11 400




Data as of: December 31, 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.
0% 10% 20% 30% 40% 50% 60% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Eurozone vs. US P/10yCF


Data as of December 30, 2011 Source: Investment Strategy Group, Datastream, MSCI

companies, with a valuable array of recognizable brands (such as Total and LVMH Moet Hennessy in France, Siemens, SAP, BASF, Daimler, and BMW in Germany). Given their international footprint, many of these firms derive a majority of their sales from outside Europe. For example, only one-third of LVMHs sales emanate from Europe. Anheuser-Busch in Belgium, a more extreme example, derives only 11% of its sales

Investment Strategy Group

Outlook 39

january 2012

from Europe, with the balance coming predominantly from the faster-growing US and emerging markets. In aggregate, approximately 45% of Eurozone companies sales come from overseas. We therefore expect high overseas exposure to mitigate, but not eliminate, the recessionary drag. Notably, todays depressed valuations already imply an earnings decline of around 9-16% for 2012, consistent with the outcome we expect due to falling sales and margin contraction. The second point is that equity markets are forward-looking, as evidenced by their tendency to peak prior to the beginning of recessions and bottom well before GDP and earnings trough. European markets have been no exception, having moved ahead of economic fundamentals consistently in each of the five recessions since 1970. As a result, Eurozone equities may reach their trough level in early 2012, based on our expectation that the recession will likely end by mid-year.

Japanese Equities: Abandoned and Unloved

While the tragic Tohoku earthquake and unfolding global growth slowdown have penalized Japanese equities, along with our overweight position, we continue to believe Japan offers a compelling risk/reward opportunity. This conviction is heavily rooted in Japans valuations, which stand near their lowest levels since 1970 on both an absolute and relative basis (Exhibit 45). In fact, a remarkable 70% of the nearly 1,700 publicly-traded companies in the Topix trade below their book value versus just 16% in the US. Moreover, the Topix stands at a lower level today than it did in January 1984, despite the fact that earnings have grown 45% over the period. These low valuations stand at odds with the rebuilding-led growth we expect in 2012. In fact, the Japanese economy is likely to grow as fast as the US and outgrow the European economies in 2012. In our view, 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- 510% in 2012, a faster rate than we expect in term averages, they are not as attractive as Eurozone equities given their relative outperformance. More specifically, whereas broad UK valuations Exhibit 45: Percent of Time that MSCI Japan have been lower 33% of the time historically, Valuations Have Been Lower than Current Levels the comparable figure for the Eurozone is just Japanese valuations stand near all time lows. 14%. Moreover, while the FTSE 100 stands 17% 100% below its 2007 peak price level, Eurozone equities stand a full 49% below. For these reasons, 80% we do not include UK equities in the Eurozone overweight mentioned above. 60% 5-YR. AVG. Turning to 2012, we expect UK equities to 15.3% 3-YR. AVG. remain caught in the middle. On the one hand, 6.7% 40% a gradual moderation in inflation provides scope for multiples to expand closer to their historical 20% average levels. On the other hand, low domestic growth and already above-trend earnings are 1.7% 0% likely to limit any earnings upside. Moreover, 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 the UKs increasingly intertwined relationship with the Eurozone could overshadow any mod1992 Through December 30, 2011 Note: Based on price to long-term cash flow, price to trailing 12 month cash flow, price to book, eration in inflation, pressuring multiples lower. and price to peak earnings. The percent of time less than current is calculated on a cumulative Taken together, these dynamics suggest less room basis, i.e. at each point in time, the current valuation level is compared to valuations during all periods prior to that point in time. for upside. Source: Investment Strategy Group, Datastream, MSCI

40 Goldman Sachs

any of the other major equity regions. In stark contrast, the market is currently implying an earnings decline of as much as 18%, again highlighting the attractive valuation of the Topix. Future earnings growth could also be supported by Tokyos removal of a decades-old weapons ban, enabling Japanese firms to enter the large international market for advanced weapon systems. Of course, given the persistent underperformance of Japanese equities, a key question is what will stop the recent selling trend among foreign investors, who have historically been the marginal purchasers of Japanese equities? We see several potential triggers. First, Japanese firms have used low valuations to increase share buybacks in recent quarters (Exhibit 46), partially offsetting foreign selling. With about $1 trillion in cash, they have ample resources to continue. These buybacks, coupled with an already attractive dividend yield of 2.6%, resulted in a total shareholder yield of 3.7% in 2011, according to estimates by our colleagues in Goldman Sachs Global Investment Research. Second, Japan is pursuing expansionary fiscal policies at a time when the rest of the developed world is fiscally consolidating. Additionally, the Bank of Japan has become more aggressive in stemming the rise of the yen, having intervened on three occasions in 2011. These actions are important, as global investors perceive yen appreciation to be negative for the Japanese corporate sector. Despite these catalysts, the outlook for Japan is not without risks. Clearly, the Japanese yen could always appreciate further, despite increased intervention efforts. In addition, while Japanese growth is likely to be the fastest in the developed world in 2012, investors will obviously discount its sustainability. Moreover, Japans large government debt load and fiscal deficit leave it susceptible to the same market pressures Europe faces, although as we discussed earlier in our Japanese economic outlook, we believe there are structural differences that mitigate the near-term risk. Finally, although Japan has very limited trade and direct financial exposure to Europe, it would not be immune to the financial market contagion resulting from a Eurozone meltdown.

Exhibit 46: Topix Share Buybacks Japanese firms are more aggressively repurchasing their shares.
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, Goldman Sachs Global Investment Research

Emerging Market Equities: Still Too Early

What a difference a year makes. At the outset of 2011, the emerging market (EM) outlook was a cautionary tale, based on above-average valuations, lofty earnings growth expectations and exuberant sentiment, all against an inflationary backdrop that threatened to pressure margins and multiples alike. After a year of marked underperformance, which saw margins disappoint, valuations de-rate and EM equities fall 20% in dollar terms, many of these imbalances have been rectified. In fact, 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. Moreover, last years roughly $40 billion in EM mutual fund outflows suggests sentiment has cooled, a contrary positive. Finally, slowing global growth has tempered inflationary pressures, providing cover for easier policy in 2012. Against this backdrop, it might be tempting to overweight EM equities, a notion we continue to explore. That said, we think it is still too early. While absolute valuations appear attractive, relative valuations have simply returned to

Investment Strategy Group

Outlook 41

january 2012

neutral levels, standing about 20% below those of the US. This discount is consistent with EMs 20% historical average discount, as well as the 1525% discount our work suggests is justified. While some argue that emerging markets superior growth deserves a premium valuation, we note that not all growth is created equal. The bulk of emerging market earnings growth derives from adding additional capital, rather than generating a higher return on that capital. To wit, over the last seven years, US corporations have produced a return on equity 2.5 percentage points higher than EM. Moreover, a recent study found that while $100 of sales in the US generates $8 of free cash flow available to shareholders, the comparable figure in EM is half that amount.33 This lower-quality growth deserves a lower valuation multiple in our view, as does emerging markets broader lack of transparency, poor governance and greater exposure to European and Chinese tail risks. Relative valuations are not the only factor giving us pause. While this years expected EM returns are consistent with other developed markets, they come with much higher volatility. In addition, there is scope for further negative earnings revisions. Consensus expectations for 12% earnings gains are likely optimistic in our

view, as slowing growth has historically pressured EM margins (Exhibit 47). As a result, our forecast assumes growth in the 5-10% range, more consistent with the 8% average over the last 15 years. Lastly, although positive sentiment toward EM has moderated from the heady levels that prevailed in late 2010, fund managers remain overweight EM relative to other markets based on recent survey data.34 As such, sentiment is not yet offering a contrarian buy signal. In short, EM risk-adjusted expected returns are not yet over our hurdle rate. Moreover, EM tends to outperform other markets only after an inflection point in economic momentum, an event we do not expect until the middle of the year. Consequently, we remain neutral EM equities at present, preferring to take exposure in markets with either better relative valuations, higher yield, or less volatility.

2012 Global Currency Outlook

Last year was a tale of two halves, as the tradeweighted US dollar first depreciated to its weakest post-crisis level by mid-year but then managed to recoup these losses, and then some, by year-end (Exhibit 48). The principal driver behind these shifts was the unfolding crisis in Europe, evident in the strengthening of perceived traditional safe-haven currencies such as the US dollar (USD) and Swiss franc (CHF). Less fortunate, but similarly impacted, were emerging European currencies, particularly those with the strongest trade and financial linkages to the Eurozone. Moreover, the correlation of EM currencies to risky assets reached record highs. In fact, the six-month correlation between EM currencies and the S&P 500 finished last year at 80%. While we expect broader risk appetite to remain a dominant influence on currency movements this year, differentiation is emerging. Asia, our favored currency bloc last year, held up relatively well thanks to their strong fundamentals, continued trade surplus and the stability of the Chinese renminbi (up 5% vs. the US dollar). 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.
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, Datastream

42 Goldman Sachs

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.
110 USD vs. Emerging Markets FX USD Trade-Weighted Index (Broad) USD Trade-Weighted Index (Major Partners)

108 106 104 102 100 98 96 94 92 Dec-10











Data as of December 31, 2011 * Note: US Dollar Trade-Weighted Indecies are as of December 23, 2011Data as of December 31, 2011 Source: Investment Strategy Group, Datastream

ience, especially against a backdrop of decelerating global growth, provides a further tailwind. While these factors, particularly valuation, support our strategically bullish view on the US dollar, several shorter-term headwinds leave us tactically neutral. First, although other global central banks are beginning to ease, they remain well behind the US Federal Reserve. In turn, this negative carry, or difference in local interest rates, places depreciation pressure on the currency. Second, investor sentiment is quite bullish on the dollar already, a contrarian negative. Finally, given the positive equity returns we expect this year, the USDs negative correlation with risky assets in recent years is a further dollar headwind. Longer-term, concern about rising US indebtedness could hurt the dollar, as could an unruly rise in inflation. That said, these remain lowerprobability downside risks, not our central case.

2012, albeit at a slower pace, given moderating global growth and flattening reserve levels. Outside the renminbi, we have few directional currency views this year. We are broadly neutral on the USD and pound sterling (GBP), as belowtrend growth and easier policy offset the lift from investors diversifying away from the euro. For the euro, we expect the unfolding recession and consequently more dovish ECB to neutralize the tailwind resulting from some moderation in sovereign risk this year. In contrast, we remain bearish on the yen, given its continued appreciation and resulting overvaluation. Finally, while we think emerging market currencies offer an attractive mix of supportive valuations, higher short-term interest rates (positive carry) and healthy underlying fundamentals, a better entry point will likely present itself, as we discuss later.


US Dollar

True to its safe haven status, the trade-weighted US dollar has been a benefactor of ongoing European stresses, up almost 9% in the last four months of 2011. Even so, valuations remain attractive, with the USD cheap against most developed currencies, including its roughly 10% undervaluation vs. the euro. In addition, US economic resil-

Much to the chagrin of its numerous detractors, the euro has been, by far, the most resilient European asset during the sovereign crisis. Indeed, despite European equities falling 17% in 2011, the euro was down only 4% on a trade-weighted basis. While the euro is somewhat undervalued on a trade-weighted basis, this statistic masks a more nuanced valuation backdrop relative to other developed currencies. As already discussed, the euro is expensive against the USD, but undervalued against most other developed currencies, especially the Swiss franc, the Japanese yen, and the Australian dollar. Other relevant factors are equally mixed for the euro. On the one hand, short-term interest rates remain about 75 basis points higher in the Eurozone than in the US, providing a positive carry attractive to investors. In addition, sentiment and positioning are already very euro bearish, a contrarian positive. Moreover, some improvement in sovereign tensions in 2012, as well as a mid-year trough in growth, could be euro positive. On the other hand, we expect the ECB to cut rates further in response to the crisis, which in turn erodes this positive carry. Indeed, aggressive ECB action, including unsterilized quantitative

Investment Strategy Group

Outlook 43

january 2012

easing on a scale equivalent to that in the US and the UK, could weaken the euro considerably. In addition, the unfolding Eurozone recession is a clear negative for the euro. Perhaps most importantly, the euro faces a small, but non-trivial probability of extinction, given the ongoing sovereign debt crisis. In turn, this could further pressure the euro as investors diversify their holdings out of the currency. Given these competing tensions, we remain neutral on the euro for 2012.
British Pound

policy is more of a neutral factor. Despite a dovish BOJ, central banks in the US, the Eurozone and the UK are also likely to maintain low interest rates for the foreseeable future. Against this backdrop, we retain a bearish bias on the JPY, reflected in our recommendation to hedge the FX exposure in our Japanese equities tactical tilt.
Emerging Market Currencies

After falling about 25% during the financial crisis and recovering only marginally, the British pound is inexpensive against a range of developed currencies. In fact, it is about 10% undervalued relative to the euro, 25% relative to the yen and Swiss franc and fair value relative to the US dollar. Despite these attractive valuations, we remain neutral on the pound and anticipate another year of broadly range-bound trading. Our view is predicated on several factors. As is often highlighted in the British media, monetary flexibility is a key advantage of not being part of the European Monetary Union. Taking full advantage of this fact, the Bank of England remains committed to easy monetary policy, a stance we expect them to maintain through more quantitative easing measures this year. In addition, persistently high UK inflation should erode the pounds value over time. Moreover, positioning and sentiment suggest investors already expect pound appreciation against the euro, a contrarian negative.

There is much to like about emerging market currency fundamentals, particularly relative to those in the developed world. Namely, their economic growth is faster, their public debt burden is lower and their currencies are relatively undervalued given recent depreciation. Moreover, their higher local interest rates compared to those in the US result in an attractive carry, a comparative advantage in a world of yield-hungry investors facing the zero bound of policy rates in the US, the UK and Japan. This carry, in turn, provides a tailwind for currency appreciation. For instance, short-term government securities in India and Mexico, and several emerging European countries, offer incremental yields of 38% relative to US Treasury bills, as well as exposure to currencies that are 1520% undervalued. Despite these tempting positives, however, we think caution is warranted in the first half of 2012. More specifically, given the numerous sources of European political uncertainty that are likely in early 2012, and the US dollars tendency to act as a safe haven during bouts of risk aversion, we expect better risk-adjusted entry points later this year.
Asian Area Currencies

Like the US dollar, the JPY appreciated last year in response to rising global uncertainty, a testament to its perceived safe-haven status. In response, the Ministry of Finance intervened repeatedly in FX markets to slow yen appreciation. Even so, the yen has remained defiant, finishing 2011 near its all time highs. This persistent strength has made the currency expensive, as it is now about 18% overvalued vs. the US dollar. In addition, sentiment is positive on the yen, a contrarian negative. Monetary

This years challenging external environment will be a serious headwind to the much-needed appreciation of Asian currencies. For example, slowing global growth will reduce demand for Asian exports, thereby eroding the size of the balance of payment surpluses we expect. Moreover, ongoing European uncertainties could threaten capital inflows, despite central banks best efforts to boost domestic demand through easier monetary policy. As such, we expect Asian currencies to remain beholden to broader risk

44 Goldman Sachs

appetite, and hence closely track the path of the S&P 500 well into 2012. Even so, the Chinese renminbi is likely to appreciate further in 2012. Importantly, a meaningful depreciation of the renminbi is unlikely, given the threat of protectionist measures from Congress, as well as a desire to avoid competitive devaluations in Asia. Moreover, even if the European crisis escalates, 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. That said, with reserves stabilizing, export growth slowing and inflation moderating, a slower 14% pace of appreciation is likely this year, as the ever cautious Chinese policymakers wait for the fog over Europe to clear.

2012 Fixed Income Outlook

Fixed income securities, particularly those of the safe harbor governments, were one of the few investment bright spots of 2011. As shown in Exhibit 49, they provided attractive absolute returns, ranging from about 5% in US corporate high yield to as high as 36% in 30-year Treasuries. Their relative returns were equally

impressive, as they outperformed equities across the world. Notably, 2011 was a reminder of the important strategic role bonds serve in a portfolio: they provided a meaningful hedge against equity declines, despite the low level of rates at the beginning of the year, they lowered overall portfolio volatility, and they generated some incomealbeit at modest levels of about 35%, depending on the specific bond sector. As result of this strong performance, 10-year rates are now just below 2% in both the US and Germany. In fact, rates have not been this low in the US since the early 1950s. With such low starting rates, the critical question facing investors is what type of returns can be expected from fixed income securities in 2012. In our view, two countervailing forces will keep high quality fixed income rates close to, or slightly higher than, current rates in the next year. On one hand, the key cyclical and structural concerns discussed earlier will put downward pressure on rates as investors seek safe harbor in US Treasuries, German Bunds and, for taxable US investors, high quality municipal bonds. On the other hand, as concerns about the downside recede, interest rates will start to rise, pulled higher by inflation and the expectation of monetary policy normalization. Despite these near-term competing tensions, 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 17.2% 12.9% 12.3% 9.2% 8.4% 7.3% 35.6%

5.0% High Yield Corporate

2.5% EMU 7-10 year (local)

Data as of December 30, 2011 Source: Investment Strategy Group, Barclays, JP Morgan

Investment Strategy Group

Outlook 45

january 2012

location to their sleep well money. As last year demonstrated, these bonds are a consistently reliable hedge in the portfolio. Second, if the Federal Reserve were to undertake further quantitative easing, clients would forgo some reasonable returns as interest rates fall further. Indeed, if the economic growth and the unemployment rate do not improve soon, even without further downside, there is some chancealbeit small--of further quantitative easing. A recent example was September 2011s announcement of Operation Twist, whereby the Federal Reserve indicated that it would purchase $400 billion of Treasury securities with remaining maturities of 6 years to 30 years, and sell an equal amount of Treasury securities with remaining maturities of 3 years or less. Third, the Federal Reserve has already committed to keep its policy rates on hold through US Treasury Market At the end of 2011, 3-month Treasury bills stood mid-2013. If this policy does not have the desired at 0.01%, 10-year Treasury notes at 1.88% and effect, they might consider extending the period 30-year Treasury bonds were just 2.89%. By the to 2014, which could also result in a further drop in long term rates. Fourth and finally, 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 2.75%. If we assume the mid-point of risks such as increasing tensions in the Persian our range for the end of 2012, the expected Gulf or the Korean Peninsula. returns for 10-year Treasuries are negative as Turning to Treasury Inflation-Protected Secushown in Exhibit 50. The returns are also negarities (TIPS), we do not think they offer particutive over a three-year horizon. In turn, such larly compelling valuations for a few reasons. paltry returns have prompted us to underweight For one, the inflation rate at which they break investment grade fixed income. even with fixed-rate 10-year Treasuries is 2%, in That said, we are not recommending a zero line with our muted 2% inflation expectations weight either. There are four main reasons. TableCT_v4_010112.pdf First, given that our US and European economic for 2012. In addition, as shown in Exhibit 51, 10-year TIPS have had a negative yield over the forecasts include a 30% downside probability last several months. Given the unfavorable tax this year, clients should maintain a sufficient altreatment of TIPS (discussed in great length in our 2011 Outlook), we do not recommend ownCT ing them at this time.
Exhibit 50: Prospective Returns on US Fixed Income and Cash Regardless of duration, prospective returns look unattractive.
1 year Cash Intermediate Duration 10 year Treasury 0.0% 0.6% 2.2% 3 year (Annualized) 0.0% 1.1% 2.5%

several years: at current levels of interest rates and roughly 2% inflation, investors do not even receive a positive real yield. As a result, the question is not if rates will rise, but rather when they will. On this point, we recognize that some may argue that Japan had low rates for decades, so the US and Germany could certainly follow suit. But that comparison is completely invalid in our view: when nominal rates in Japan dropped below 1.7% in 1997 and reached a low of 0.5% in 2003, real rates ranged between 1.2% and 2.8%. In other words, unlike the US today, Japanese rates were never negative during this period due to the countrys deflationary environment. Lets review the specifics of each market.

US Municipal Bond Market

Data as of December 30, 2011 Source: Investment Strategy Group

We think that US municipal rates will generally follow the path of Treasury interest rates during 2012. Whether we look at the absolute after taxyield differentials between municipal bonds and Treasuries, or the more widely used ratio of municipal bonds to Treasury rates, municipal bonds are generally in line with, to slightly cheaper than, Treasury securities. Thus, given the absence of any valuation dislocation, we think changes

46 Goldman Sachs

Exhibit 51: 10-Year TIPS Yield and Breakeven Inflation TIPS negative yield and poor tax treatment make them unattractive, in our view.
3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 0.5% Dec-10 Mar-11 Jun-11 Sep-11 10-Year TIPS Yield

Exhibit 52: US State and Local Government Revenue Growth State and local government revenues have increased eight quarters in a row.

10-Year Breakeven Inflation


20% 15% 10% 5% 0% 5% 10% 15%

State and Local Total Revenues Revenues from Property Taxes

4.1% 1.0%


Data as of December 30, 2011 Source: Investment Strategy Group, Datastream

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, US Census Bureau

in Treasury rates (as discussed above) will be the primary driver of municipal rates. We also think that the systemic risk of deteriorating finances that hovered over the municipal market has dissipated. Most states, through a combination of primarily lower expenditures, higher taxes (revenues from both a better economic backdrop and higher tax rates, including sales taxes), and earlier distributions from 2009s American Recovery and Reinvestment Act (ARRA), have improved their fiscal profiles over the last 2 years. As shown in Exhibit 52, state and local revenues have increased eight quarters in a row. While they still had a $91 billion budget shortfall (mostly a result of the $53 billion drop in ARRA funds in 2012), all states with the exception of Minnesota passed their budgets on time, compared to nine late budgets two years ago. Even Illinois and California, two states with the lowest credit ratings, managed to pass their budgets on time. Lastly, while some have raised concerns about underfunded longterm pension liabilities, we do not think it is an issue for 2012. The supply and demand picture will be supportive of municipal bonds as well. As shown in Exhibit 53, net new issuance in the US was actually a negative $62 billion in 2011, i.e. the volume of new issuance did not offset the volume of bonds that were redeemed. Notably, this was the

Exhibit 53: Municipal Issuance by Year Shrinking net supply is supportive of municipal bonds.

$600 $500 $400 $300


Gross Issuance Net Change in Outstanding Debt

424 386 407 431 334 287 236 168 95

$200 $100 0 $100

155 98

11 62








Data as of December 27, 2011 Source: Investment Strategy Group, Federal Reserve, JP Morgan, Bank of America, Citigroup, Morgan Stanley

Investment Strategy Group



Outlook 47

january 2012

first contraction in the size of the municipal market since 1996, compared with an average annual increase of $104 billion over the last five years. Finally, as municipal finances have improved, the rampant concerns about municipal defaults have also dissipated. Throughout 2010, many commentators forecasted record defaults that never materialized in 2011. That is not to say that the municipal market did not have some defaults and bankruptcies. In fact, there were three Chapter 9 bankruptcy filings that garnered considerable press: Jefferson Country, Alabama due to a sewer system overhaul; Harrisburg, Pennsylvania due to an expensive trash incinerator project; and Central Falls, Rhode Island with a population of just 19k. A November Bloomberg story pointed out that the first two had commonalities in the conditions that brought them to bankruptcy: risky debt structure, political failures and officials who spent taxpayer money with little oversight.35 Despite these headlinegrabbing bankruptcies, overall defaults through November 2011 totaled just $2.1 billion, a mere 0.06% of the total outstanding market value of municipal debt. As before, we dont anticipate any meaningful defaults or bankruptcies among higher quality municipal bonds and those that do occur, will probably be concentrated in the unrated market. One of the few areas that provides an attractive relative return is the high yield sector of the municipal market, which offers an incremental yield of 3.8% over similar maturity, high quality municipal bonds. Adjusting for default rates of between 1% and 2% and conservative recovery rates of about 60%, high yield municipal bonds will most likely outperform similar maturity Treasuries and high quality municipal bonds. Hence, we recommend clients stay fully invested

at their strategic weight in high yield municipals. The only reason we do not recommend an overweight is the fact that high yield municipal bonds tend to have longer maturities. Given our view of generally rising rates at some point over the next few years, we would not recommend an overweight to such long maturity securities. In summary, we think that clients should moderately underweight their high quality municipal bonds to fund various tactical tilts. That said, clients should not go to a zero weighting for the same reasons we would not recommend a zero weighting to Treasuries. Finally, we advise clients to be fully invested in high yield municipal bonds at the customized strategic allocation.
US Corporate High Yield

In summary, we think that clients should moderately underweight their high quality municipal bonds to fund various tactical tilts.

After returning 58% in 2009 and 15% in 2010, corporate high yields 5% gain last year may seem paltry by comparison. But as Exhibit 33 showcased earlier, this mid-single digit return was nonetheless impressive, particularly considering the dismal performance of most risky assets last year. Of course, the most pertinent question for investors now is whether this streak of positive returns is sustainable in 2012, given the pervasive macroeconomic headwinds. We believe it is. Our optimism reflects several factors, not the least of which is our view that todays high yield spreads more than compensate investors for the likely path of defaults. Indeed, despite recent improvement in US economic data, high yield spreads finished last year at 699 basis points (bps), well above the 522bps average over the last decade. Notably, actual defaults would have to be greater than 10% to erode this spread fully.36 Viewed another way, the market seems to be discounting defaults of around 7%, based on the excess spread over actual default losses that investors have demanded historically. As shown in Exhibit 54, this implied default level is more than 3 times the actual trailing default rate, well above the year-ahead base case forecast of Moodys, and in fact, not far from their adverse scenario, which incorporates a double dip recession in the US. Given our view that the US expansion continues in 2012, we see scope for spread compression as macroeconomic fears recede.

48 Goldman Sachs

Exhibit 54: High Yield Corporate Bond Default Rates Even if a recession were to occur, we think Today's spreads look attractive relative to expected defaults. the magnitude of defaults has been reduced in at least three ways. First, high yield companies 12% have aggressively refinanced and extended their 10.7% debt maturities, which lowers their leverage and 10% future debt refinancing risk. Indeed, 67% of all 8.3% 8% 6.8% issuance over the past 3 years has been used to refinance existing debt, vs. only 38% in the three 6% years ending mid-2008.37 As a result, the amount 4% of debt scheduled to mature in the next three 2.4% 2.0% 2% years has dropped by nearly $600 billion since the end 2008, greatly reducing the much feared 0% wall of maturities. Second, underlying credit Required to Implied Given Trailing BASE ADVERSE Fully Erode Historical Excess 12 Month Moody's Twelve Month fundamentals have been bolstered, as high yield Current Spread Spread* Forward Forecast issuers today hold almost $2 in cash for every $1 in short term debt. This ratio stood around 1 in Data as of December 2011 2007. Lastly, 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- Source: Investment Strategy Group, Barclays, Moodys cial crisis, reducing the default loss content of the high yield universe. In addition, we note the high yield technical backdrop is much more favorable today, suggestTodays 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, even in an adverse scenario. As shown in likely path of defaults. Exhibit 55, dealer inventories stand at all time lows today, a very different backdrop from the bloated positions that necessitated forced selling during the financial crisis. Similarly, 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. Finally, the search for yield should continue to benefit high yield bonds, given the negligible returns we expect in cash and most government securities. Taking these factors together, we expect corporate high yield to deliver around 12% returns this year, making it an extremely attractive riskadjusted investment opportunity, in our view.

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Outlook 49

january 2012

Exhibit 55: Primary Dealer Positions as a Share of the Corporate Bond Market Dealer inventories stand at all time lows today, reducing the risk of forced selling.
12% 10% 8% 6% 4% 2%

Eurozone Bonds













Data as of December 21, 2011 Source: Investment Strategy Group, Bank of America Merrill Lynch, Datastream, Federal Reserve Bank of New York

Exhibit 56: Bridge Loans and CLO Warehouses The high yield market's technical backdrop is much better today.
Billions $350 $300 $250 $200 $150 $100 $50 0 Bridge Loan Risk $20 $45 $1.5 CLO Warehouses $330 2007/2008 Today

Data as of November 2011 Source: Investment Strategy Group, JP Morgan

Just as mortgage-backed securities were the epicenter of the financial crisis in 2008, fixed income securities of the peripheral Eurozone countries were the epicenter of the sovereign debt crisis in 2011. As shown in Exhibits 57 and 58, spreads widened across all the GIIPS countries, with the greatest widening in Greece, with yield levels implying almost 100% probability of a deep sovereign bond restructuring in 2012. Even a core eurozone country like France saw some spread widening. As a result, there was a big divergence in returns between German Bunds and other Eurozone country bonds. As shown in Exhibit 59, while Germany had a total return of 12.9% last year, the returns in the much of the periphery were much worse, with Italy -6.9%, Portugal -31.1% and Greece a staggering -57.8%. Spain performed relatively well, returning 9.3% and Ireland generated a 12.7% return. Needless to say, Ireland providing a return that was only 0.2% behind the safe harbor returns of German Bunds was quite the surprise in 2011! Like US Treasuries, German Bunds benefitted from their safe harbor status relative to other European bonds, dropping to their lowest levels in the post-World War II period. And like US Treasuries, German Bund rates are expected to rise modestly from year-end levels of 1.82% to somewhere between 2.25% and 3.00% in 2012. In fact, 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. In our central case of a mild European recession, 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, with Greece and possibly Portugal providing the exception. While this tightening will provide attractive long-term returns, we expect considerable interim volatility as policymakers will continue to pursue an incremental, reactive and inconsistent approach. Of course, the sovereign debt crisis is fraught with risk: any policy mistake at the supra-nation-

50 Goldman Sachs

Exhibit 57: Five-Year Government Bond Spreads Over Germany Spreads have widened across all the GIIPS countries.
Basis Points

Exhibit 58: Five-Year Government Bond Spreads Over Germany Eurozone tensions have dramatically increased funding costs for peripheral sovereigns.
Basis Points

700 600 500 400 300 200 100 0 Jul-11 Aug-11 Sep-11 France
110 539

3000 2500


6000 5000 4000 3000 2000 1000

Portugal Ireland Greece (RIGHT SCALE)



2000 1500 1000 500



0 500









Data as of December 30, 2011 Source: Investment Strategy Group, Bloomberg

Data as of December 30, 2011 Source: Investment Strategy Group, Bloomberg

al or national level, or the loss of control by any leader due to internal strife arising from austerity measures, would have negative consequence for the financial markets. Moreover, the recession could also be deeper as result of a weaker global backdrop or the unintended consequences of greater austerity measures. In such a scenario, German rates would fall and incremental yields across peripheral and semi-peripheral countries will increase substantially. In turn, peripheral bonds may then have negative returns approaching what we saw in Portugal in 2011. While such a scenario is not our central case, it is also not a zero-probability outcome, perhaps more like a 1015% probability. In summary, we recommend clients maintain German Bunds and other high quality bonds in their sleep well basket. For those who can withstand the volatility, a limited exposure to peripheral debt is also appropriate given the current level of spreads.

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, JP Morgan 57.8% 31.1% 6.9% 12.9% 12.7% 9.3%







Portugal Greece

Investment Strategy Group

Outlook 51

january 2012

Emerging Market Local Currency Debt

Emerging market local currency debt (EMLD) declined about 2% in dollar terms in 2011 as currency weakness, especially in emerging Europe and Africa, more than offset the 8% gain from the underlying bonds. Notwithstanding its recent volatility, EMLD still benefits from several powerful tailwinds: at 45% of GDP (in 2011), government debt of the EM countries underlying this asset class is less than half that of the advanced world. Second, the 6.6% spread of EM local bonds relative to US and European debt is close to its highest level in a decade. And finally, 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. For these reasons, we remain structurally positive in the medium term. Our shorter-term view, however, is more cautious. Although we expect the underlying bonds to return 48% by the end of 2012, 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, we have long maintained EMLD is a risky asset class and should not be a substitute for a clients sleep-well money. Thus, in the current volatile environment, we recommend only a modest tactical overweight to EMLD, coupled with a hedge against euro depreciation versus the dollar. BO__Ex60_010412_jk_v5_le.pdfto reduce the effect The purpose of the hedge is of any downdrafts emanating from the European sovereign debt crisis.

2012 Global Commodity Outlook

A mix of geopolitical instability, adverse weather and macroeconomic worries led to another volatile year for commodities. When all was said and done, the S&P GSCI broad commodity index finished down slightly for the year, as shown in Exhibit 60. This relatively flat finish masked a tale of two halves, evident in many assets last year, as commodities rose rapidly in the first half of the year, only to weaken in the second half. While broader risk aversion was a stronger influence in the latter part of 2011, several idiosyncratic factors proved more decisive for commodities in the first half, as we discuss next. In energy, the Arab Spring resulted in the loss of 1.2 million barrels per day of Libyan crude oil exports for most of the year, pushing WTI prices close to $115/barrel and Brent prices close to $125/barrel.38 Meanwhile, droughts in Europe and Russia, a wet spring and a summer heat wave in the US sent corn prices close to $8/ bushel, soybeans to $14.5/bushel and wheat to almost $9/bushel. Even so, agriculture prices are still down between 2030% from their peaks, as crop damage turned out to be less than feared. Given the interplay of commodity specific factors and general risk appetite, the correlation of commodities with equities and the US dollar was quite unstable. In the first half of the year, the S&P GSCIs 180-day correlation to the S&P500 collapsed from 64% to just 11% in June, before climbing back to around 56% currently. Similarly, the S&P GSCI correlation to the dollar index

Exhibit 60: Commodity Returns in 2011
S&P GSCI 2011 Avg. Spot Price vs. 2010 Avg. Spot Price Spot Return Total Return* Energy Agriculture Industrial Metals Precious Metals Livestock

27% 2% 1%

27% 9% 5%

34% 15% 16%

13% 21% 22%

35% 7% 7%

10% 11% 1%

Data as of December 30, 2011 * Total return is the actual return from being invested in the front-month contract and differs from the spot return depending on the shape of the forward curve. An upward-sloping curve (contango) is negative for returns while a downward-sloping curve (backwardation) is positive. Source: Investment Strategy Group, Bloomberg

52 Goldman Sachs

fell from around -45% in January to around -29%, before rising to around -62% currently. This correlation instability underscores how rising risk aversion can often trump otherwise positive idiosyncratic factors in shaping the performance of commodities.
Oil: Balancing Act

Exhibit 61: Global Oil Supply and Demand Demand outpacing supply has pressured inventories in recent years.
Millions of Barrels per Day

90 89 88

World consumption exceeded production in the past two years

As we look forward to 2012, a look back reveals two consecutive years of demand 86 outpacing supply, as shown in Exhibit 61. The 85 result has been falling inventory levels, 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). Against this backdrop, the key question for oil prices in 2012 is Data as of 2011E Source: Investment Strategy Group, International Energy Agency whether this trend of inventory depletion will continue or stabilize. After all, the slowing global growth we expect this year could enable production to overtake demand, finally allowing inventories to stabilize or even build. Exhibit 62: OECD Inventories vs. World Consumption To address this question, let us first review Inventories stand at low levels relative to consumption. the demand backdrop, particularly for China. Days of world demand Consensus expectations for global oil demand 35 growth are 0.91.3 million b/d (or 11.5%), 34 with all of the growth coming from emerging 33 market economies. Indeed, Middle East demand 32.5 alone is growing 0.20.3 million b/d per year, 32 while Chinese demand is now close to 10 mil31 lion b/d (11% of the world), having grown an estimated 5.7% in 2011 (+0.5 million b/d). Most 30 29.3 analysts expect growth of 5.05.5% for China in 29 29.0 2012, which is slightly below the five-year average growth rate of 5.8%. On the upside, Chinas 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, as well Data as of Q4 2011E as filling newly built strategic petroleum reserve Source: Investment Strategy Group, International Energy Agency facilities. On the downside, Chinas demand could disappoint based on a sharper than anticipated slowdown in industrial production and global growth. Of the two possibilities, we have more sympathy for the latter, concluding that the risks to Chinas oil demand are skewed to the downside for 2012. While emerging markets are the clearest source of oil demand growth, the developed markets still represent the bulk of absolute demand. Worryingly, OECD demand remains depressed and in some areas is contracting. For example,


World Demand

Investment Strategy Group

Outlook 53

january 2012

consensus expects a further decline in the United States roughly 19 million b/d demand run rate, despite the fact that it already stands close to the level reach during the 2009 financial crisis. Notably, US oil usage represents about 21% of the global total. Moreover, European demand, at 14.3 million b/d in 2011, is already about 3% lower (0.4 million b/d) than in 2009, and 7% lower than in 2008. Of course, there are clearly upside as well as downside risks to the ultimate OECD demand numbers. For example, a recession in Europe or the US could hurt demand, while continued resilience in the US could bolster it. Even so, our economic forecasts accord a greater weight to the downside risks in 2012, reflecting the multiple sources of uncertainty and their pernicious effects on growth. Turning to supply, there is certainly room for production growth to accelerate relative to last year. On this point, non-OPEC supply proved particularly disappointing in 2011, providing scope for catch up in 2012. To be fair, production did grow in the US (+0.22 million b/d), Russia (+0.12 million b/d) and Canada (+0.1 million b/d). However, a series of unplanned outages in the North Sea, Brazil, Argentina, Malaysia and Yemen more than offset this. However, as many of these disruptions are now being resolved, it is likely that some of the growth expected in 2011 would be realized now instead. Prospects for supply growth are particularly promising for US shale, Canadian oil sands, in the deepwater of Brazil and China, and in Russias low-cost Siberian fields. As has been the case in the past few years, natural gas liquids from OPEC, which are not subject to quotas and are used in certain petrochemical applications, could supplement this growth by +0.3-0.4 mil-

Putting it all together, our base case scenario envisions a range of $75-$105 for WTI and $85-$115 for Brent.

lion b/d. As a result, total non-OPEC production growth could range from 0.7-1.5 million b/d. The higher end of this range, if achieved, could be enough to meet demand growth in 2012. For its part, OPEC production fell short of demand in 2011, as evidenced by the decline in inventories and an estimated 0.7 million b/d supply/ demand imbalance. To remedy this imbalance in 2012, OPEC would need to fill that 0.7 million b/d gap, plus or minus any additional mismatch between demand and supply growth. Since nonOPEC production growth (0.7-1.5 million b/d) could potentially be faster than demand growth (1.0-1.3 million b/d), there is a possibility that OPEC would actually lower its production. Indeed, on December 14, 2011, OPEC decided on a production ceiling of 30 million b/d going forward, which is an estimated 0.5-0.7 million b/d less than it is currently producing. While cuts in OPEC production hurt the supply backdrop, there are notable offsets. Libyan production is rebounding faster than expected and is now almost half its pre-war level. At this pace, Libyan production could grow another 0.5-0.8 million b/d by the end of 2012. In Iraq, the recent return of super-majors such as Exxon looks promising, and production is expected to increase by up to 0.3 mm b/d in 2012. In order to enforce the 30 million b/d ceiling, such production recovery would need to be counterbalanced through lower output elsewhere to avoid oversupply and excessive price weakness. Saudi Arabia, which increased production in 2011 to offset the loss of Libyan crude, looks like the most likely candidate to trim production. In short, a combination of slower global demand growth, a rebound in non-OPEC supply, and positive production prospects within OPEC may rebalance the global oil market in 2012 and put an end to inventory declines. In our view, this combination makes oil prices reaching the highs of 2011 unlikely, barring geopolitical shocks, especially related to Iran and Iraq. That said, sustained and significant downside price risks, barring a global recession, look equally unlikely. On this point, 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, given

54 Goldman Sachs

the recent increase in social spending. Moreover, 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. Finally, oil continues to have a positive correlation with S&P 500, implying that our constructive stance on equities in 2012 should also provide some support for oil prices as well. Putting it all together, our base case scenario envisions a range of $75-$105 for WTI and $85$115 for Brent. While wide, these ranges reflect a one standard deviation move within oils 35%40% annualized volatility. While not our base case, a significant oil shock resulting from geopolitical unrest in the Middle East could push oil prices meaningfully higher, a concern we discuss further in our Key Risks section.

Gold: Tarnished Safe Harbor

Bewitched, bothered and bewildered that is how many gold investors have felt in recent months.39 Indeed, after hitting a record of $1,921/troy ounce on September 6, gold collapsed 20% within a month, its sharpest drop since 1983. In the process, gold broke a three-year uptrend, evident in its breach of, and inability to recapture, its 200-day moving average of prices. Ever since, it has remained volatile, trading in a range of $1,550-1,750 per troy ounce. In fact, realized volatility this year rose to 25% from 15% at the end of 2010. While golds increasing downside volatility is troubling in its own right, that it comes at a time of intensifying global systemic risks, theoretically a tailwind for gold prices, is even more so. In turn, golds distinction as a safe haven asset has been tarnished. After all, US Treasuries outperformed gold by 7% last year, despite having volatility 3.5 times less. Moreover, whereas gold was positively correlated with risky assets last year, evident in its 23% correlation with the S&P 500, Treasuries displayed a negative 73% correlation. Perhaps a recent Wall Street Journal headline said it best: With safe havens like these, who needs risky assets? 40 In thinking about the trajectory of gold for this year, there are undoubtedly some supportive

factors. The low real interest rates we expect in 2012 continue to limit the opportunity cost of holding no-yield assets, such as gold. Moreover, gold continues to offer perceived diversification benefits, to not only consumers but also central banks. For example, Chinese demand continues to increase as the countrys gold market is deregulated and households seek alternatives to real estate and stock investments. Furthermore, European demand for physical gold could also benefit from ongoing fears of Eurozone disintegration, although this thesis has not helped gold prices lately. Finally, world jewelry demand has held up well thus far, despite the pervasive macro concerns. That said, we note three key differences in todays demand backdrop compared to the last few years. First, investment demand appears to be flattening, in stark contrast to its consistent growth in the last several years. Specifically, the World Gold Councils estimates show that total investment demand (ETFs and physical gold) remained essentially flat year-over-year through 3Q11. In fact, asset growth in ETFs has actually been decelerating over the past few months, as shown in Exhibit 63. Perhaps this is not surprising, considering investment demand already represents a historically high 39% of total demand. Notably, the 1980 peak in gold prices corresponded to this ratio reaching 45%. Of course, some of this could simply reflect select hedge funds liquidating their large gold holdings to offset losses elsewhere, as well as a general dash for cash and liquidity. Even so, we do not find these explanations persuasive enough to account for the entire shift. In our view, this recent softening, coupled with our medium-term constructive view on the US dollar and expectation that core inflation will remain around 2%, are not supportive of investment demand growth. Second, while overall jewelry demand has been stable, India, the worlds largest consumer of gold jewelry, saw its demand fall for the first time in two years. In fact, the 26% drop vs. the third quarter of 2010 was the largest quarterly decline since early 2008. This dramatic fall reflected a combination of weak growth, high gold prices and the 18% depreciation in the

Investment Strategy Group

Outlook 55

january 2012

Exhibit 63: Monthly Change in Gold ETF Holdings Gold ETF flows have been decelerating over the past few months.
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, 2011 Source: Investment Strategy Group, Bloomberg

Exhibit 64: Net Purchases of Gold by the Official Sector Central Banks tend to be large net buyers of gold around market peaks.

800 600

Official Sector Net Supply / Demand


USD / Troy ounce, in Jan. 2011 dollars

$1,800 $1,600 $1,400 $1,200 $1,000 $800 $600

400 200 0

200 400 72 75 78 81

Real Average Gold Price


$400 $200 $0 99 02 05 08 11






Data as of Q4 2011 Source: Investment Strategy Group, World Gold Council, CPM Gold Yearbook, Bloomberg

value of the Indian rupee. Going forward, the risk is that the same high gold prices, slowing global growth, and weak currency that negatively affected Indian demand could push other emerging market consumers down the same path. Third and finally, unlike previous years, net central bank purchases were the marginal driver of gold prices in 2011. In the first three quarters of the year, the official sector accounted for 349 tonnes of known net gold purchases, an amount 4.5 times higher than their 2010 purchases (76 tonnes). Moreover, this buying stood in stark contrast to the past two decades, when the official sector was actually a net supplier of gold. Indeed, as shown in Exhibit 64, one needs to go back to 1980 to find net official sector demand in excess of 200 tonnes. Clearly, a continuation of current policies of reserve diversification would be a tailwind for gold prices. Nevertheless, because central bank purchases are policy-driven, it is difficult to assess what might come in the future. Consider two observations. One, strong official sector demand actually marked the peak of gold prices in 1980, as central banks effectively priced out other gold consumers. In fact, despite central banks remaining net buyers during that time, prices continued to fall on the back of collapsing investment demand. Two, Eurozone central banks may end up selling some gold reserves to provide funding for various liquidity facilities this year. After all, these banks own about 10,800 tonnes of gold. While they have sold virtually none of these holdings in the past two years, the Central Bank Gold Agreement permits them to sell as much as 400 tonnes per year, a right they utilized in the prior decade. Relative to the shifts in the demand landscape, golds supply dynamics appear monotonous in comparison, with mine production growing slowly and scrap supply flat in 2011. That said, there are several key risks on the horizon. First, gold miners have finished removing the price hedges on their forward production. If they became concerned prices might fall further, their attempts to lock in prevailing prices would not only accelerate gold supply (in the form of forward sales), but also potentially be interpreted as

56 Goldman Sachs


a sell signal by many investors. In addition, similar to central banks dual role as both a buyer and seller, investors themselves could potentially become a large source of supply, if and when sentiment turns. In fact, the current ETF stockpile of around 2,320 tonnes is roughly the same as a full year of global gold production. While these bearish supply risks might be longer term in nature, we think they are important considerations for gold buyers today. Overall, we believe that an increasingly unbalanced demand picture, higher volatility, prices well above their historical average and erosion in its safe harbor distinction continue to warrant a cautious view toward gold.

clusive interests of the parties further exacerbate the risk of contagion. Needless to say, a disorderly default, a forced or unexpected departure of a Eurozone member or a conscious decision by the parties involved to disband the EU could be devastating, given the global legal, trade and financial linkages involved. Hard Landing in China With China a key contributor to global demand and growth, a hard landing here would have negative repercussions across the full spectrum of asset markets, particularly in commodities and other emerging markets. Additional Sovereign Debt / Currency Crises As the unfolding crisis in Europe is clearly demonstrating, markets are losing patience with excessive sovereign debt levels. Unfortunately, many governments in the developed economies run large deficits and have historically high debt/ GDP ratios. Moreover, structural factors, such as demographics, are projected to raise healthcare costs and pension benefits in many of them, further exacerbating debt levels. Failure to implement credible fiscal consolidation plans could lead to a loss of market confidence. The result is dramatically higher interest rates and difficulty meeting debt servicing costs, as we have seen in Europe. Major Geopolitical Event An outbreak of war, a major terrorist act or simply a greater probability of either one could undermine confidence, disrupt trade and cause an economically damaging spike in oil prices. In fact, several conceivable developments could significantly interrupt oil exports this year. Chief among these is Irans recent threat to close the Strait of Hormuz, the only sea passage to the open ocean for much of the Persian Gulf and a strategic choke point that represents 35% of the worlds seaborne oil shipments, and 20 percent of oil traded worldwide.41 While a closure seems unlikely, the strait is still 34 miles wide at its narrowest point after all, it could be highly disruptive if the threat materialized. Aside from the Straits, the erstwhile stability of Iraqs oil exports is also at risk, given the

Key Global Risks

In any given year, the risk that an exogenous shock renders an otherwise thoughtful outlook dead on arrival is present, but this year it seems particularly acute. Even worse, many of todays most pernicious threats are political in nature, resulting in asymmetric risks that undermine the value of rigorous fundamental analysis. Of equal importance, the markets safety net is getting threadbare, as fiscal constraints and many central banks at the zero bound leave policymakers with fewer tools to address any new sources of stress. In short, while the probability of a truly destabilizing event remains low, the penalty for being wrong has risen. The risks that follow, while by no means exhaustive, represent those that would be most detrimental to our central case view: Escalating Eurozone Crisis Throughout the Outlook, we have argued that Eurozone politicians, when pushed, will ultimately demonstrate the political will necessary to keep the Eurozone intact. Even so, the wide range of interests at play and actors involved, including politicians, investors, citizens, unions, and various other special interest groups, raises the potential for accidents, as politicians could simply lose control of the process. Moreover, the often mutually ex-

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imminent withdrawal of US forces, as well as the potential inadequacy of the Iraqi security services to contain growing militia violence. In addition, the risk of an outright skirmish between Iran and Israel is non-trivial, particularly given the power vacuum likely to follow the US militarys departure. Lastly, ongoing social revolution in the Middle East, embodied in last years Arab Spring, represents a further risk to oil production from the area. Elsewhere, the unfolding leadership change in the always-quixotic North Korean regime represents another geopolitical flashpoint. Trade War / Protectionism Although a variation of a policy error, a trade war resulting from the implementation of protectionist policies could hobble global trade and thereby hurt growth, as it did during the Great Depression. Moreover, given the importance globalization of the supply chain has played in increasing S&P profit margins, a meaningful increase in protectionism could undermine US corporate profitability and pressure US equity markets. US Housing While low-single-digit home price movements up or down are unlikely to have a material impact on our view, a renewed and meaningful fall in housing prices would. First, this would decrease household wealth and consumer confidence, undermining consumption. Second, this would negatively impact the banking system and curtail credit availability, as the majority of bank assets remain real estate backed. Botched Policy Exit While less of a concern today given the fragile nature of the recovery, the unsustainably loose monetary and fiscal policies of much of the developed world will eventually need to be reversed. If the exit occurs too soon, it could derail the recovery; if too late, it could lead to an inflationary outcome and/or a loss of confidence in the governments willpower, raising their borrowing costs through higher interest rates.

In Closing
With abundant volatility in todays environment, 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, raise the periscope and have a careful look around. No one can predict the future, of course, but looking through the fog today reveals an interesting and somewhat encouraging scenario. For all the risks and potential downside, we believe there may be some tactical opportunities in areas most disdained by the markets, such as Europe, Japan and US banks. We think that China is likely to avert a hard landing, which will limit the impact of that countrys slowdown on the global economy, while the Eurozone should avoid a forced breakup, sparing the world another Lehman moment. And despite a preoccupied and often partisan federal government, 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, but also a compelling core holding for long-term appreciation.

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1. IMF Chief Warns Over 1930s-style Threats, Financial Times, December 15, 2011. Financial Markets in Greater Danger Than 2008 BoEs Fisher, Reuters, December 19, 2011. Mohamed El-Erian, Could America Turn Out Worse Than Japan?, Reuters, October 31, 2011. Martin Feldstein, The Euro Zones Double Failure, The Wall Street Journal, December 15, 2011. Paul Krugman, Will China Break?, The New York Times, December 18, 2011. 2. Federal Reserve Bank of Dallas, News is Positive at Home, but Europe Looms. December 16, 2011. 3. US Economist Analyst: Will the European Storm Cross the Atlantic? Goldman Sachss Economics, Strategy, and Commodities Research, September 16, 2011. 4. Raymond Ahearn et al. The Future of the Eurozone and US Interests. Congressional Research Service, September 16, 2011. 5. Francis Vitek and Tamim Bayoumi. Spillovers from the Euro Area Sovereign Debt Crisis: A Macroeconomic Model Based Analysis. Center for Economic Policy Research Discussion Paper #8497, July 2011. 6. Maya MacGuineas is the President of the Committee for a Responsible Federal Budget. 7. Michael Phillips. The Financial Crisis: Government Bailouts A US Tradition Dating to Hamilton. The Wall Street Journal, September 20, 2008. 8. Norm Ornstein is co-authoring this book with Thomas Mann of the Brookings Institution. 9. Jacob Kirkegaard. Thinking About the Euro in 2012. The Peterson Institute for International Economics, December 22, 2011. 10. European Parliament, December 19, 2011. 11. Tom Orlik. Making Sense of Chinas Economic Statistics. The Wall Street Journal, August 8, 2011. 12. As of December 31, 2011. 13. Kevin Hamlin. China Faces 60% Risk of Bank Crisis by Mid-2013. Bloomberg News, March 8, 2011. 14. This number refers to IMF estimates of general government debt, which consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments (Source: IMF World Economic Outlook, September 2011).
Investment Strategy Group

15. The Company That Ruled the Waves. The Economist, December 17, 2011. 16. Guo, Kai and Papa NDiaye. Is Chinas Export-Oriented Growth Sustainable?, IMF Working Paper 09/172, August 2009. 17. As reported by Sun Liping of Tsinghua University in a Chinese weekly publication called Economic Observer. 18. Hurun Report and Bank of China Private Banking, 2011 China Private Wealth Management White Paper, October 2011. 19. Amity Shlaes. Obama Threatens to Follow in FDRs Economic Missteps. The Washington Post, July 9, 2010. 20. Francis Vitek and Tamim Bayoumi. Spillovers from the Euro Area Sovereign Debt Crisis: A Macroeconomic Model Based Analysis. Center for Economic Policy Research Discussion Paper #8497, July 2011. 21. Gabriel Wildau. Chinas 2012 Social Housing Target at 7 Million. Reuters. December 23, 2011. 22. Shuyan Wu. US Daily: Market Movers Policy News at Home and Abroad. Goldman Sachs Global Economics Investment Research, November 22, 2011. 23. Global Fund Managers Survey. Bank of America/Merrill Lynch, December 2011. 24. Howard Marks. The Tide Goes Out. Oaktree Capital Management, March 2008. 25. Macroitis. Empirical Research Partners, December 21, 2011. 26. Thomas J. Lee, CFA. Portfolio Strategy 2012 Outlook. JP Morgan, December 9, 2011. 27. Michael L Goldstein, Laura Dix, and Longying Zhao. Where We Stand: Crossroads - Part II, Margins: A Cost Story, Twice Told. Empirical Research Partners, June 13, 2011. 28. Harold L. Sirkin et. al. Made in America, Again: Why Manufacturing Will Return to the US. Boston Consulting Group, August 2011. 29. Daily Sentiment Report., December 9, 2011. 30. Andrea Frazzini and Owen A. Lamont. Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns. Journal of Financial Economics, Vol. 88, No. 2, May 2008. 31. 4Q11 / 1Q12 Macro Outlook. Stifel Nicolaus & Company. November 30, 2011. 32. Savita Subramanian. Good Micro, Bad Macro. Bank of America/Merrill Lynch, November 14, 2011.

33. Jeffrey Palma. UBS World Income Workbook. UBS Research, July 2011. 34. Global Fund Managers Survey. Bank of America/Merrill Lynch, December 2011. 35. Martin Z. Braun, Jefferson County, Harrisburg Face Reckoning for Official Hubris, Bloomberg. November 16, 2011. 36. Conservatively assuming a recovery rate of 30%, below the 35% long-term average. 37. Terry Belton. US Fixed Income Markets: 2012 Outlook. J.P. Morgan, November 25, 2011. 38. The wide discrepancy between the two oil benchmarks was an unusual phenomenon last year, reaching as much as $28/barrel. The dislocation was caused in large part by the lack of pipeline export capacity in the US Midwest relative to fast growing oil production. 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. 39. Gold: Haven Turns Riskier but Retains its Appeal. Financial Times, December 20, 2011. 40. Gold Experiences an Identity Crisis. The Wall Street Journal, December 16, 2011. 41. Energy Information Administration. World Oil Transit Chokepoints: Strait of Hormuz. 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

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