GS2012Outlook

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Outlook

Scanning the horizon in pursuit o sae harbors and attractive investment opportunities.

Investment Management Division

Investment Strategy Group January 2012

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section 11

2012 Global Economic Outlook United States

Eurozone

United Kingdom

Japan

Emerging Markets

section 111

2012 Financial Markets Outlook United States

Eurozone

United Kingdom

Japan

Emerging Markets

Currencies

Fixed Income

Commodities

Key Global Risks

3

5

14

17

32

34

39

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This material represents the views o the Investment Strategy Group in the Investment Management Division oGoldman Sachs. It is not a product o the Goldman Sachs Global Investment Research Department. The views and

opinions expressed herein may dier rom those expressed by other groups o Goldman Sachs.

Cover photo: US Department o Deense

section 1

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Many investors battened down the hatches in 2008 andhave remained below deck in an attempt to stay clearo the turbulence. But we believe that in the midst o allthis volatility and uncertainty, there lie both sae harborsand attractive investment opportunities.

The US: More Than a Safe Harbor

The US is best positioned or a cyclical recovery aswell as or eventually dealing with its single structuralault line: its growing debt burden at a time o political gridlock.

The Eurozone: Will Incremental, Reactive

and Inconsistent Policy Persist?

The most likely path or 2012 is a continuation o therecent policy approach and accompanying nancialmarket volatility, but concerns about a more adverseoutcome are justied.

China: Cyclical and Structural Concerns

The cyclical risk o a hard landing in China is morelimited than the long-term structural one o avoiding

major dislocations in the transition to a morediversied economy.

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as we formulate our 2012 Outlook andnalize our investment recommendations or ourclients, we are struck by the tremendous amounto uncertainty in the economic and investmentoutlook. Three and a hal years have passed sincethe onset o the nancial and economic crisis o 2008, yet or many investors, the storm eels as i

it has barely diminished.Ater all, we’ve witnessed a record $2.2

trillion o scal stimuli, including about$930 billion in the US, $420 billion in China,$320 billion in Japan, and $270 billion inEurope. There have also been extensive andunconventional monetary policies – rom zero-interest-rate policies to “quantitative easing”measures, which have increased the balancesheets o the US Federal Reserve, the EuropeanCentral Bank, the Bank o Japan and theBank o England by a total o $4.5 trillion.Yet global growth is still not on a certain andsustainable path. On the contrary, concernsabout double-dip recessions and major policymistakes abound.

Not surprisingly, many investors batteneddown the hatches in 2008 and have remainedbelow deck in an attempt to stay clear o theturbulence. But we believe that in the midst o all this volatility and uncertainty, there lie not

only sae harbors, but also attractive investmentopportunities.

Sharmin Mossavar-Rahmani

Chie Investment Ofcer

Investment Strategy Group

Goldman Sachs

Brett Nelson

Managing Director

Investment Strategy Group

Goldman Sachs

Additional Contributors rom the

Investment Strategy Group:

Neeti Bhalla

Managing Director

Leon GoldfeldManaging Director

Jiming Ha

Managing Director

Maziar Minovi

Managing Director

Benoit Mercereau

Vice President

Matthew Weir

Vice President

PHOTO TBD

section i

Up Periscope

Scanning the horizon in pursuit o sae harbors and attractive investment opportunities.



4 Goldman Sachs

january 2012

Deining the Concerns

We are hearing a consistent line o question-ing rom our clients this year: Are we in or yet

another year o ominous scal and nancialdevelopments in 2012? Will things nally start toimprove? Or can we expect the situation to geteven worse?

Recent media headlines have provided littlein the way o comort: “IMF Chie Warns Over1930s-style Threats,” “Financial Markets inGreater Danger than 2008,” “Could AmericaTurn Out Worse than Japan?” “The Eurozone’sDouble Failure” and “Will China Break?” arereminiscent o those seen in the depths o the

crisis.1 It is useul to examine and categorize these

anxieties, so they may be better understoodand addressed. Current concerns all into twocategories: cyclical concerns that ocus on near-term economic growth prospects and structuralconcerns that ocus on long-term sustainabilityo existing political or economic rameworks invarious countries.

Cyclical concerns cover a broad spectrumo issues; they range rom a “lost decade o

growth” in the US as a result o the nancialcrisis o 2008, to a deep recession in theEurozone as a result o austerity measures, todimming prospects or Japan ater the recenttriple whammy o earthquake, tsunami andnuclear accident. They also include worriesabout a hard landing in China as a resulto deterioration in the real estate sectorand slower growth in its export-destinationcountries.

Structural concerns include the long-termscal prole o the US in the ace o politicalgridlock, the very survival o the Eurozone asa monetary union in the absence o real scaland political union, and the ability o Chinato rebalance an investment-led and export-led economy to a more diversied consumer-oriented economy.

In the ace o such cyclical and structuralheadwinds, how should our clients ormulatean investment strategy or 2012? Should they

sit on the sidelines and avoid the storm orshould they trade more actively to try to catchthe big waves?

Here we are reminded o a Sunday Night Insight we published in March 2009 where wequoted Seth Klarman o The Baupost Group:“The ability to remain an investor (and not

become a day-trader or a bystander) conersan almost unprecedented advantage in thisenvironment.” The answer to this question,in other words, is neither: don’t step upyour trading activity because o the marketchoppiness, but don’t exit the market altogether,either. Rather, adopt a long-term investmentperspective and accept that investing involvesmaking rational and enduring decisions at timeso proound uncertainty.

It is with this undamental premise in mind

that we put orth our 2012 investment outlook.In this report, we examine in detail the

cyclical and structural concerns or the majorcountries and regions o the world, and evaluatethe most likely outcome o each one. We thenprovide a more detailed analysis o our economicand investment outlook or 2012.

However, beore we proceed, we think it isimportant to reiterate two key pillars o ourtactical asset allocation investment philosophy(See Exhibit 1).

First, history is a useul guide. When weexamine these cyclical and structural issues,

Fear& Greed DriveMarkets in the

Short andIntermediate

Terms

History

is a Useful

Guide

Valuation

Orientation

and Margin

of Safety

Appropriate

Investment

Horizon

Appropriate

Level of

Diversification

Investment Philosophy

Tactical Asset Allocation

Exhibit 1: The Key Pillars of ISG’s Tactical

Investment Philosophy

Source: Investment Strategy Group



Outlook 5Investment Strategy Group

we look at them through a historical lens andmake assumptions based on how similar issuesplayed out in the past. For example, given thatEuropean policymakers have approached the

sovereign debt crisis incrementally over the lasttwo years, we can assume that they will continuewith incremental policy responses throughout2012.

Second, diversication is key. We havetypically ascribed a 60–75% probability toour central case orecast scenarios. At timeso heightened uncertainty, that probabilitydiminishes; this year, with non-negligible riskso economic or nancial unraveling acrosssome countries and/or regions o the world,

the probability o our US central case is downsignicantly, to 55% (the only recent yearlower than that was 2008, at 50%). This makeseective diversication even more important– a portolio must be constructed to withstandthe more probable short- and intermediate-term downdrats, yet still prot rom the long-term upswings (which, even with our revisedprobabilities, remain more likely to occur).

Cyclical and Structural HeadwindsFacing the US, Europe and EmergingMarkets

The US: More Than a Safe Harbor

Readers o our annual Outlook reports knowthat we have long been optimistic about the USrelative to other markets. This year is no dier-ent. As we scan the horizon, we believe that theUS is best positioned or both a cyclical recoveryand dealing with what we see to be its singlestructural ault line: its growing debt burden at atime o political gridlock.

What is dierent now is that the nancialmarkets seem to agree with us. With a totalreturn o 2% on the S&P 500 in 2011, USequities have outperormed all major equity

markets: developed markets as measured byMSCI EAFE returned -12% in US dollar terms,with Germany and Japan being two o the worst

perormers at -17% and -12%, respectively;emerging markets as measured by MSCI EMreturned -18%, with Brazil and India being twoo the worst perormers at -22% and -37%,

respectively.Similarly, US Treasuries provided some o the

best returns in global government bond markets.Using a basket o maturities based on the J.P.Morgan Global Bond Index 7–10 year series, USTreasuries returned about 15%, outperormingGerman and most other European bonds as wellas Japanese bonds in their respective currencies.They barely lagged Swedish bonds and laggedAustralian bonds by 3%. We should note thatthe US bond market is 80 times the size o the

Swedish bond market and 40 times that o theAustralian market. With respect to emergingmarket debt, US bonds outperormed dollar-denominated debt by about 8% and localcurrency debt by 7%. I we were to actor inthe depreciation o emerging market currencies,US bonds outperormed local debt by about17%. US Treasuries also outperormed goldin 2011, with less than a third o the preciousmetal’s volatility. Such returns were achieveddespite Standard and Poor’s downgrade o US

government debt rom AAA to AA+ on August 5.In our 2011 Outlook, we discussed why the

US would not ace a Japan-style “lost decade.”Our rationale was that while there are somesimilarities between the US and Japan, thereare ar greater and more notable dierences.The dierences we highlighted were: 1) realestate and equity valuations were signicantlyhigher in Japan at the beginning o its crisis in1990 than the US’s peak valuations in 2007;2) monetary and scal policy responses in theUS were aster, larger and more extensive than

Japan’s were during the early stages o its crisis;3) US policymakers were much more aggressivein responding to the crisis in the nancial sectorand the nancial sector has been much quickerto deleverage; 4) US companies restructuredmore quickly and more extensively, resulting inproductivity growth accelerating in the US aterthe nancial crisis while it decelerated in Japanor several years in the early 1990s; and 5) Japan

has unavorable demographics with a decliningworking population, while the US has avorabledemographics through a combination o higher



6 Goldman Sachs

january 2012

ertility rates and immigration.In our view, the US will not only avoid a lost

decade, but – i history repeats itsel – it is likelyto grow at 2.5% per annum starting sometimein late 2012 or early 2013. In several extensivestudies including their recent working paper,“The Atermath o Financial Crises”(NBERWorking Paper Series, January 2009), CarmenReinhart and Kenneth Rogo have analyzedthe depth and duration o economic and asset

market drops ater severe nancial crises across15 developed and emerging market economies

(including the Great Depression in the US).In many ways, the US has ollowed the patho a typical severe nancial crisis, and i thedowndrat has ollowed Reinhart and Rogo’s

“broadly similar patterns” across developedand emerging market countries (including twopre-World War II episodes or which data isavailable), then history suggests the recoverymight very well ollow suit. As shown in Exhibit2, the peak to trough drop in home prices andequity markets in the US are in line with theaverages – both that o the 15 countries overallas well as that o the ve larger developedcountries. While US unemployment is atunamiliar and uncomortably high levels, the

increase in the unemployment rate to date is lessthan the averages. The debt-to-GDP increaseis greater – a cause or concern that should bewatched closely.

As shown in Exhibit 3, in the rst ve yearsollowing the beginning o a nancial crisis,real growth rates dropped by an average o 3%.Importantly, however, in the subsequent veyears, growth picked up and approached theaverage growth rate prior to the nancial crisis– the one stark exception being Japan. It takes

about our years beore growth approaches therate seen beore the crisis. I this analogue holds,the US would approach pre-crisis growth ratesby late 2012. In the meantime, leading economicindicators point toward moderate growth in2012 (discussed in detail in Section II o thisreport).

Obviously, history is just a orward-lookingguide – not a perect orecast. So we have toweigh the cyclical and structural actors that canboost growth against the cyclical and structuralactors that can hinder growth. Starting with thegrowth-supporting actors, we believe there aretwo key cyclical ones that point toward a greaterlikelihood o the US ollowing this historicalanalogue: extensive private sector deleveragingover the last several years and a strong corporate

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** US 2007

Real GDP per Capita

Peak to Trough 4.1% 9.3% 5.2%

Duration (Years) 1.8 1.9 2.0

Real House Prices

Peak to Trough 37.5% 35.5% 33%***


Real Equity Prices

Peak to Trough 51.8% 55.9% 58%


Unemployment Rate

Increase (pp.) 8.5% 7.0% 5.7%


Government Debt

Increase (% GDP) 29.1% 32.3%**** 38%***

Duration (Years) 5.8 4.4**** 4.0

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

I this analogue holds, the US wouldapproach pre-crisis growth rates by

late 2012.




balance sheet and earnings backdrop. Thereare also several structural actors that supportgrowth, everything rom superior corporatemanagement to economic diversity, innovation,

immigration and rule o law.With respect to actors that can hinder US

growth, the Eurozone credit crisis is certainly acyclical actor that bears concern, but barring acomplete meltdown in Europe, we do not expectit to have a materially negative impact on USgrowth. The structural actor that we believecould hinder US growth – the key ault line, i you will – is the burgeoning debt-to-GDP ratio inthe ace o political gridlock. We examine each o these actors in turn below.

Extensive Private Sector Deleveraging

One o the key issues that has been put orthsince the nancial crisis is that deleveragingwill orce US growth to be below trend or theoreseeable uture. Since the beginning o thecrisis, real GDP growth has been basically fat,refecting a peak-to-trough drop o 5.2%, and acumulative growth rate o 5.4% since the trough.Our view is that the overleveraged private sectors

in the US – households and the nancial sector– have actually deleveraged quite substantiallyalready.

Consider the household sector. Exhibit 4probably best shows the extent o the decrease o the nancial burden o households. Ater peakingat 18.9% in the third quarter o 2007, nancialobligations as a percent o personal disposableincome have dropped to 16.2%. This level is onpar with that last seen in the ourth quarter o 1993 ater the deep 1990–91 recession causedby the savings and loan nancial crisis. Thisdecrease is partly due to household retrenchmentthrough higher savings rates and lower rateso new consumer borrowing, and partly due tomortgage, credit card and auto loan deaults thatreduce the overall household debt, as well aslower interest rates on the debt that remains.

We believe that the current low rate o debtpayments as a percent o personal disposableincome is sustainable and will allow the savings

rate to stay in the 4–5% range – which, in turn,will be supportive o consumption and henceGDP growth. The Federal Reserve o Dallas has

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 5Large Financial

Crises* US 2007**

Real GDP (Ann.)

Prior to Crisis (Prior 10y Ann.) 3.8% 2.7%

5 Years Following Crisis 1.0% 0.0%

Subsequent 5 Years 3.1% -

Years to Recover*** 3.7 -

Nominal Equity Prices (Ann.)

3 Years Following Trough 19% 24%

Subsequent 3 Years 12% -

Private Debt (% GDP)

5 Years Following Peak (Change pp.) –11% –20%

Subsequent 5 Years (Change pp.) –6% -

Data as of 2011

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

* Spain 1977, Norway 1987, Finland 1991, Sweden 1991, Japan 1992

** Ongoing, currently 4 years since crisis.

*** Spain and Japan never returned to their pre-crisis average growth rates.

Exhibit 4: Household Financial Obligations Ratio

US households have significantly reduced their financial burden

since the crisis.

Data as of November 2011

Note: Debt and other financial payments as a percent of disposable personal income

Source: Investment Strategy Group, Federal Reserve

16.2%

15.0%

15.5%

16.0%

16.5%

17.0%

17.5%

18.0%

18.5%

19.0%

80 83 86 89 92 95 98 01 04 07 10



8 Goldman Sachs

january 2012

similarly stated that household “de-levering maybe nearing an end.”2

The nancial sector has also madeconsiderable progress in deleveraging. As shown

in Exhibit 5, nancial corporations’ debt-to-GDPhas decreased rom a peak o 120% in 2008 to90% by the third quarter o 2011. This level ison par with that last seen in 2001. In addition,i we look at nancial sector leverage relative toshareholder equity or the nancial institutionsin the S&P 500, that ratio has declined to thelowest level in over two decades – rom a peako 13.0 times to 9.0 times, as shown inExhibit 6. This two-decade low holdswhether we look at equal-weighted or market

capitalization-weighted data.We conclude that the more leveraged

private sectors o the US economy have alreadydeleveraged to sustainable levels.

Strong Corporate Balance Sheet and

Earnings Backdrop

Looking at the broader non-nancial sector, wealso observe low debt levels and close to recordcash levels. As shown in Exhibit 7, net long-

term debt (including the impact o cash) as ashare o balance sheet assets or the 1500 larg-est US companies is at 10.6%, compared witha 40-year-plus average o 14.6%. This ratio hasbeen lower only 5% o the time since 1970. Cashis at a 40-year high at 11.2%. I we look at allnon-nancial companies in the US, includingsmall and mid-size companies, this ratio is closeto its average at 19.7%. In aggregate, corporateAmerica has a healthy balance sheet.

The earnings backdrop or US companiesis quite robust as well. S&P operating earningsper share in the third quarter o 2011 reachedtheir highest level ever, eclipsing the 2007 secondquarter record by 5%, and ull-year 2011earnings appear on track to reach the highestlevel on record. This earnings achievement iseven more remarkable in the ace o zero growthin real GDP since the beginning o the nancialcrisis. Between low debt levels, strong cashhoards and robust earnings, US companies are

entering 2012 in a strong position. We discussour S&P 500 views in greater detail in Section III.

Exhibit 5: Financial Corporations’ Debt to GDP

Financial corporations have reduced their debt-to-GDP ratio by

30pp since 2008.

Data as of Q3, 2011

Source: Investment Strategy Group, Federal Reserve

120%

90%

0%

20%

40%

60%

80%

100%

120%

140%

75 80 85 90 95 00 05 10

Exhibit 6: Financial Sector Leverage Ratio

Leverage among S&P 500 financial firms has fallen to all time lows.

Data as of September 30, 2011

Source: Investment Strategy Group, Intrinsic Research

8

9

10

11

12

13

14

91 92 93 94 91 95 96 97 98 99 00 01 02 03 04 05 06 07 09 10 11

13.0

9.0

R E C E S S I O N




The Key Structural Advantage:A Diverse and Innovative Economy

In our 2011 Outlook, we highlighted the in-herent structural resiliency o the US and itsinstitutions, which “provide a direct and posi-tive impact on the viability, protability andsaety o our clients’ assets in the long run.” Wetouched upon several advantages that accountor US “exceptionalism,” including demograph-ics, immigration, education, innovation, naturalresources and the importance o shareholdersas the primary stakeholders. Since then, newresearch at leading academic institutions has

conrmed and quantied the major structuraladvantages the US enjoys.

The rst study, “Why Do ManagementPractices Dier Across Firms and Countries?”by Nicholas Bloom and John Van Reenen o Stanord University and the London School o Economics, respectively, concludes that atera decade o research into global management,“American rms are on average the bestmanaged in the world.” As shown in Exhibit 8,the United States has the highest management

practice scores, ollowed by Germany andSweden. Countries in southern Europe, suchas Greece and Portugal, and emerging marketcountries, like Brazil, India and China, havethe lowest scores. Companies with better

management “massively outperorm theirdisorganized competitors,” making moremoney, growing aster, having higher stock

market values and surviving or longer. Amongmultinationals, US companies maintain thisadvantage over their counterparts in other partso the world, but the gap is less.

The second study, “The Atlas o Economic

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.


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

4%

6%

8%

10%

12%

14%

16%

18%

20% 19%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

70 78 86 94 02 10

Cash(LEFT SCALE)

Net Long-Term Debt(RIGHT SCALE)

2.692.65 2.65 2.64

2.6

2.7

2.8

2.9

3.0

3.1

3.2

3.3

3.4

3.33

3.18 3.183.15

3.13

3.00 2.99 2.99 2.98

2.88 2.88

2.79

US Germany Sweden Japan Canada France Australia Italy UK Poland Ireland Portugal Brazil Greece India China

Exhibit 8: Corporate Management Rankings by Country

American firms are on average the best managed in the world.

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.



10 Goldman Sachs

january 2012

Complexity: Mapping Paths to Prosperity,”by Ricardo Hausmann, Cesar Hidalgo, et alo Harvard University and MassachusettsInstitute o Technology, respectively, provides a

new approach to measuring the diversity o aneconomy by looking at the number o productsexported by a country and the number o othercountries that also export each o those products.The more complex an economy, the broader therange o its exports. This economic complexity,in turn, captures inormation about thecomplexity o the set o capabilities in a countryand closely matches its income per capita, andis also predictive o intermediate to long-termuture 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 theservice sector, where the US is highly competitive.

When we combine this Economic ComplexityIndex with the Economic Freedom Index romthe Heritage Foundation and the Ease o DoingBusiness Index rom the World Bank, Singapore isranked #1 and the US is ranked #2. In their Annual2011 Country Attractiveness Score, AlexanderGroh et al ranked the US the #1 destination orventure capital and private equity investments.

O course, none o these various rankingsalone tells the whole picture. In aggregate,however, they conrm that US economiccapabilities and resources make it a greatinvestment destination well beyond its saehaven status. And what is most interesting isthat these strengths are not lost on corporateAmerica; we are seeing an increasing number o large companies moving at least some o theirmanuacturing back to the US.

Manufacturing Moves Back to the US

Throughout 2011, a notable range o US com-panies announced their intentions to move someo their manuacturing rom emerging marketcountries – primarily but not exclusively romChina – to the US. Examples include some o thelargest US companies: Ford Motor Co., GeneralMotors, General Electric, Caterpillar and NCR.Others are the Coleman Company (plastic cool-

ers), Sauder (urniture), Wham-O (maker o suchtoys as Frisbee and Hula Hoop) and Sleek Audio

(in-ear headphones). In December, Honda MotorCo. announced plans to increase its capacity inNorth America – not just or American con-sumption but or exports around the world.

What explains such an important shit? AnAugust 2011 report by the Boston ConsultingGroup, “Made in America, Again: WhyManuacturing Will Return to the US,” highlightsthe key actors making China less, and the USmore, attractive. “Rising wages, shipping costsand land prices – combined with a strengtheningrenminbi – are rapidly eroding China’s costadvantages,” as are higher utility costs, whilethe US is becoming a “lower- cost country” withdeclining or moderately rising wages, a fexible

work orce and strong productivity growth. Thestudy also cites shorter lead times, local controlover manuacturing costs, ewer supply chain risks(as illustrated by the earthquake in Japan andfoods in Thailand) and better quality control. Itspecically mentions intellectual property thet andtrade dispute concerns with respect to China.

Perhaps most strikingly, the authors estimatethat by 2015, manuacturing in some parts o theUS will be just as economical as manuacturingin China. We do not know i that prediction will

materialize, but the acts speak or themselves: atthe margin, at least, companies are moving someo their manuacturing to the US.

It is an interesting coincidence that 2015 alsomarks the peak level o the working-age populationin China, compared to steady growth o thispopulation in the US, as shown in Exhibit 9.

Such a reverse migration back to US shoresis also occurring in the oil industry. Oil importsas a share o consumption have declined rom apeak o 60% in 2005 to 45% in 2011. The UShas gone rom being a net importer o renedoil products or over 50 years to a net exportero 742 thousand barrels a day; this compares

Perhaps most strikingly, the authorsestimate that by 2015, manuacturingin some parts o the US will be just as

economical as manuacturing in China.




to peak imports o 4.1 million barrels a dayin October 2005. Such a shit is just anotherexample o the structural advantages o the US,where companies (management and labor) havethe reedom to innovate, to leverage technology,to move and adjust to market signals as they deem t.

Eurozone Sovereign Debt Crisis Unlikely to

Pose Major US Threat

The cyclical and structural strengths o the USnotwithstanding, the US is not an island; USeconomic growth is exposed to a signicant dete-rioration in the Eurozone sovereign debt crisis, i it were to materialize. There are our channels bywhich this crisis can spill over to the US:

1. Direct economic impact through trade;2. Direct nancial impact through the

exposure o the nancial sector (banksand investment portolios) to losses andtighter credit availability rom Europeanbanks to US businesses;

3. Direct impact on the earnings o UScompanies with businesses in Europe; and

4. Indirect nancial impact through anincreased risk premium, which would

lower the value o US equities and non-government bonds.

Barring a undamental unraveling o the Euro-zone, we believe that the impact through the rstthree channels will be muted.

With respect to the impact o diminishedtrade, Exhibit 10 shows that US exportsaccount or only 13% o GDP, and US exports

to peripheral Europe (dened as Greece, Italy,Ireland, Portugal and Spain) and the rest o Europe are just 0.3% and 2.6%, respectively. Amild recession in Europe, which is our centralcase, would probably reduce US GDP by 5 basispoints or less, according to our colleagues inGoldman Sachs Global Investment Research.3

In terms o the direct nancial impact, both USbanks and US investment managers have alreadysignicantly reduced or hedged their Eurozoneexposure. A sobering September 2011 reportrom the Congressional Research Service (CRS)estimated that US banks have about $641 billiono 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 majorglobally oriented US banks in their quarterlystatements, we estimate the net exposure to theGIIPS to be only about $43 billion, includingexposure to multinational corporations. Gross

exposure – the CRS’s gure – is substantiallyreduced through a range o hedges. Some o these hedges are composed o credit protection

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.

0%

2%

4%

6%

8%

10%

12%

14%

1.5%1.1%

2.5%

1.6%0.9% 0.6%

4.2%

5.5%

0.3%

GIIPS Core

Eurozone

Rest of

Europe

Canada Mexico China Japan Other EM

TOTAL

12.7%

TOTAL

Data as of 2010

Source: Investment Strategy Group, Datastream, International Monetary Fund

Exhibit 9: Working Age Population (2000 - 2050)

Unlike many emerging markets, the US working age population is

projected to expand through 2050.

Data as of 2010

Source: Investment Strategy Group, United Nations Population Division

Index (100=2010)

60

70

80

90

100

110

120

130

140

150

00 05 10 15 20 25 30 35 40 45 50

Brazil

China

India

Russia

United States



12 Goldman Sachs

january 2012

purchased rom institutions outside the GIIPSregion and others involve high quality collateral.It is important to keep in mind that while theheadlines ocus on notional exposure, it is the net

exposure that could be a source o loss and a hit tobank capital – and that number is substantially lessthan the trillion dollar headlines.

Investment management rms have alsoreduced their exposure substantially. For example,according to a Fitch Report rom December 2011,US prime money market unds have reduced theirEurope exposure by 45% since May. The biggestreduction has been to French banks at 89%,partially oset by an increase to Dutch, Swiss, andNordic banks. Current exposure stands at 33.4%,

including exposure to the UK.With respect to S&P earnings derived rom

companies’ operations in Europe, we note thatit is very dicult to have a precise number orthe aggregate exposure o the S&P since manycompanies do not break down their earningsgeographically in their nancial reports.Estimates o total European exposure amongthese companies range rom 15–20%. Whilesome companies have higher exposure and willbe aected much more, a mild recession o 1%

or less in Europe would probably reduce S&P500 earnings by 1–2%. Again, the reason thisimpact is more muted than the headlines suggestis that many o the largest market capitalizationcompanies in the S&P don’t have signicantexposure to Europe.

The hardest spillover eect to gauge is theindirect nancial impact. Fears o a disorderlydeault in Greece, concerns about some Europeancountries rolling over their debt, inconsistentstatements rom European policymakers andront page news reports o strikes and protests

in Italy all take their toll on investor condence;they also tighten nancial conditions in theUS as result o lower equity prices and highercredit spreads. Surprisingly, however, nancial

conditions in the US are unchanged rom thebeginning o the year. In a recent discussionpaper, “Spillovers From the Euro Area SovereignDebt Crisis: A Macroeconometric Model BasedAnalysis,” Francis Vitek and Tamim Bayoumi o the International Monetary Fund estimate thatthrough the rst quarter o 2011, the cumulativeeect o the Eurozone crisis has been -0.1% onUS GDP and -0.3% on US equity prices.5

Given our central case o a mild recession inEurope, we do not think the indirect nancial

impact on the US will be material. O course, amore serious downside scenario in Europe wouldhave a much greater impact. Vitek and Bayoumiestimate that a much more severe shock withItalian and Spanish 10-year rates at over 11%and 10%, respectively, would detract 1.1% romUS GDP and 9% rom US equity prices.

The US Structural Fault Line: A Growing Debt

Burden in the Face of Political Gridlock

While we are generally optimistic about theprospects or the US economy and US nancialassets, the deteriorating scal prole o the USand the absence o any reorm is o grave con-cern; in our view, the lack o scal reorm due topolitical gridlock is the only structural ault linethe US aces.

Over the course o 2011, we hosted ourclient calls discussing the US scal outlook withdistinguished ormer policymakers includingSenator Alan Simpson, who co-chaired PresidentObama’s bi-partisan decit reduction commission,as well as Senators Trent Lott, Senate MajorityLeader; Judd Gregg, Chairman o the BudgetCommittee; and John Breaux, a member o theFinance Committee. Our calls also included keyWashington opinion makers on this issue: NormOrnstein, Resident Scholar at the AmericanEnterprise Institute, and Maya MacGuineas o the Committee or a Responsible Federal Budget.Throughout the year, our goal was to assess the

probability o a so-called “grand bargain” toreduce the long-term debt burden o the US.While Congress did not ultimately “go

“I you would like an empirical lawo government behavior, it is that ina panic or threatened nancial collapsegovernments intervene: every govern-ment, every party, every country,

every time.”—Alex J. Pollock




big” in 2011, we can point to three notableachievements. First, decit reduction hastaken center stage in the political arena aspolicymakers and the electorate acknowledge

the scale o the problem, as shown in Exhibit11. Second, multiple bipartisan eorts haveidentied the key components o any decitreduction plan and, as shown in Exhibit 12,there is considerable overlap. This work willprovide the basis o uture scal reorm. Andnally, the debt ceiling debate, as unpleasant as itwas, did result in $900 billion o debt reductionand an additional $1.2 trillion o cuts over 10years that will be mandated by sequestration i no other action is taken.

Although it’s reasonable to assume these stepsmay result in less than $2.1 trillion in cuts asCongress tries to ameliorate their impact on thedeense budget, they still represent meaningulprogress relative to last year’s expectation o nocuts until 2013. To quote Maya MacGuineas:“savings o one to two trillion is clearly asignicant step in the right direction.”6

As we attempt to assess the probability o policymakers implementing urther scal reorm

in 2012, we proceed with great caution. As Alex J. Pollock, Resident Fellow at the AmericanEnterprise Institute and ormer President and

Chie Executive Ocer o the Federal HomeLoan Bank o Chicago, said back in 2008, “I you would like an empirical law o governmentbehavior, it is that in a panic or threatened

nancial collapse, governments intervene: everygovernment, every party, every country, everytime.”7 Applied to Washington in 2012, we canread into this the inverse: no panic, no action. Wemight even sum up the US government’s gridlock asNorm Ornstein does in the title o his orthcomingbook: It’s Even Worse Than It Looks.8

Thus, in the absence o a panic or threatenednancial collapse – and in the presence o upcoming presidential elections – we think it isunlikely that we will see any urther reorm untilater the elections. However, as the sae haven o the world, and, in our opinion, one o the bettercore investment opportunities, we believe thatthere is some time – not indenite, but at least tothe end o 2012 – beore the US has to take upthe next round o debt reduction.

Exhibit 11: Share of US Population Identifying the

Federal Budget Deficit as Their Top National

Economic Worry


Source: Investment Strategy Group, CBS/The New York Times , Gallup, The Pew Center

15%

17%

19%

21%

23%22%

25%

27%

29%

31%

Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11

Exhibit 12: Composition of Proposed Deficit

Reduction Plans

Multiple bipartisan plans to reduce the debt have been put forward.

Data as of December 2011

Source: Investment Strategy Group, The Committee for a Responsible Federal Budget,

National Commission on Fiscal Responsibility and Reform

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Debt Reduction

Task Force(Nov. 2010)

37%

16%

18%

12%

14%

1%

$5.9

TRILLION

Social Security

Other Mandatory

Interest Savings

Health Care

Defense

Non-Defense

Discretionary

Taxes/Revenues

Gang of Six

(July 2011)

34%

66%

$4.4

TRILLION

Unclassified

Spending Cuts

24%

40%

8%

16%

5%

6%

$4.0

TRILLION

Fiscal Commission

(Dec. 2010)

Applied to Washington in 2012,

we can read into this the inverse:no panic, no action.



14 Goldman Sachs

january 2012

The Eurozone: Will Incremental,Reactive and Inconsistent PolicyPersist?

In act, it seems to us that Alex J. Pollock’s“empirical law o government behavior” is mostapplicable to Europe at the present time. SinceMay 2009, when we had our rst client callon the European sovereign debt crisis, we havecharacterized European policymakers as “incre-mental, reactive and inconsistent:” incrementalin that their rst round o policy responses (e.g.the size o the bailouts, unding or new institu-tions and the size o possible haircuts or Greek

debt restructuring) have never been enough;reactive in that they have only acted in responseto heightened market pressures (e.g. wideningo credit spreads or unding pressures in theEURIBOR market); and inconsistent in that theypublicly contradict each other – and sometimesthemselves.

One o the earliest and most notable exampleso their inconsistent approach was when thepresident o the European Central Bank, Jean-Claude Trichet, stated on January 10, 2010,

that the ECB would not change its collateralramework or the sake o an individual country,indirectly reerring to Greece. In less than threemonths, on March 25, 2010, the ECB did anabout-ace and changed its collateral rules toaccept BBB- rated bonds through 2011, includingGreek bonds.

More recently, the communique rom theDecember 9, 2011, European Union (EU)Summit – whose agenda was driven by GermanChancellor Angela Merkel and French PresidentNicolas Sarkozy – stated that EU leaders will“reassess the adequacy o the overall ceilingo the European Financial Stability Facility/ European Stability Mechanism (EFSF/ESM) o €500 billion ($670 billion) in March 2012. Justour days later, Chancellor Merkel stated: “Ihave made my position clear that it should notbe stepped up. The upper limit or the EFSFand ESM remains €500 billion.” It is strikingwhen the inconsistencies are among dierent

policymakers rom the 17 dierent countries; itis more so when the inconsistency comes romthe same person.

This incremental, reactive and inconsistentapproach created tremendous uncertainty ornancial market participants and was a sourceo volatility throughout 2011. Our base case

scenario or Europe in 2012, to which we assigna 50% probability, is that this approach willcontinue, and clients should be prepared orsimilar volatility that will emanate rom Europeand aect all equity markets.

The key concerns with Europe, however, arenot centered on overall volatility, but on the risko signicant economic deterioration and on thenon-negligible risk o the end o the EuropeanMonetary Union as it stands today with its17 members. In our view, these concerns are

justied; we assign a 30% probability to a moreadverse outcome in Europe.

On the cyclical side, the risk is that therecession is deeper than we envision. As austeritymeasures – which in aggregate will be about 2%o Eurozone GDP – are enacted across the GIIPSand now France, there is a real probability thata mild recession spirals into a deep recession,which in turn means higher decits and calls oreven greater austerity. And Germany will not beimmune rom urther economic weakness in the

GIIPS and in France; exports account or nearlyhal o Germany’s GDP, with more than two-thirds o that destined or European markets.

The greater concern, however, is structural:will the Eurozone exist as it stands today with17 member countries, or will a weaker (or,alternatively, stronger) country opt to leave –notwithstanding the rules o the MaastrichtTreaty? As Jacob Kirkegaard, Research Fellowat the Peterson Institute or InternationalEconomics and a requent guest speaker onour client calls in 2011 on the European crisis,has so aptly stated: the Eurozone crisis is anamalgamation o a scal crisis, a competitivenesscrisis (the economic competitiveness o thesouthern periphery), a banking crisis and “adesign crisis (the fawed initial design o euroarea institutions).”9 Dealing with each o theseissues is extremely dicult, and the probabilityo a policy mistake is high.

The biggest ault line in the Eurozone remains

what we highlighted in last year’s Outlook:the absence o scal union in the presence o monetary union. We are another year into the




crisis, and meaningul scal union is nowherein sight. At the December 9 EU Summit, 26 EUmembers, with the much-publicized exception

o the UK, announced their intention toparticipate in a new Euro-area scal compactin which countries will have to incorporate theprinciple o a 0.5% structural decit ceiling intheir respective constitutions and agree to aceautomatic sanctions i they breach a 3% decitlimit.

Every summit initiative to date has beenraught with implementation diculties; giventhat historical precedent, it is reasonable toassume that this will also be the case with thenew scal compact. It is unclear whether all 26countries will pass the necessary approvals. Noris it apparent whether the presence o such ascal compact will calm the markets in 2012 orbe perceived as a long-term solution o limitedvalue or a near-term crisis. While it is certainlya step in the right direction and is necessary orurther ECB support during the crisis, it is stillar rom the scal union among states in theUS, with a centralized Treasury and national

Treasury securities.Last year, we tipped our hat to AlexanderHamilton, “who in 1790 realized the newly

ormed US political union would only survivei it had scal union. He proposed that thenew ederal government assume the debts thatthe individual states had incurred during the

Revolutionary War so that individual stateswould not abandon the union i nancial sel-interest dictated it. To enlist the support o Thomas Jeerson to vote or the proposal (whichhad already been voted down ve times), heagreed to move the new capital to the banks o the Potomac; to ensure Pennsylvania’s support,the capital would be moved to Philadelphia orten years.” We applauded Hamilton’s vision andhis willingness to do what it took to achievea true scal union; we do so again, and hope

European policymakers will take his lead!

Banking Sector, Crisis Resources Are Additional

Fault Lines in Europe

Another ault line in Europe is the banking sec-tor. As shown in Exhibit 13, the European Bank-ing Authority (ormed in November 2010 as aresult o the crisis) has estimated that Europeanbanks have a capital shortall o €115 billion thathas to be lled by June 2012. Banks have to raise

this capital at a time o higher unding costs andquestions about their access to short-term und-ing. Here there has been an important step in theright direction. The ECB announcement that itwill increase the term o its longer-term renanc-ing operations to three years has addressed thiscritical ault line head on and has diminished therisks to the banking sector in a meaningul way;banks are now able to borrow rom the ECBwith up to three-year maturities and can post abroader range o collateral.

A third ault line has been the inadequacyo resources set aside to deal with the crisis.Since the beginning o 2010, resources havebeen allocated incrementally, starting with therst bailout package or Greece at €45 billion(subsequently revised upward several times, witha current estimate o a cumulative bailout o over€200 billion). The initial unding amounts orthe 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 orwardthe new European Stability Mechanism (ESM)

Exhibit 13: Bank Capital Shortfalls by Country

The ECB’s three-year refinancing operations should help

alleviate funding pressures for European banks.

Country Level (€bn) % of Total

Greece 30.0 26%

Spain 26.2 23%

Italy 15.4 13%

Germany 13.1 11%

France 7.3 6%

Portugal 7.0 6%

Belgium 6.3 6%

Austria 3.9 3%

Cyprus 3.5 3%

Norway 1.5 1%

Slovakia 0.3 0%

Netherlands 0.2 0%

Total 115


Source: Investment Strategy Group, European Banking Authority, Financial Times

Capital Shortfall



16 Goldman Sachs

january 2012

to June 2012, it seems that the current resources(as shown in Exhibit 14) along with supportrom the IMF may not have the desired “bazookaeect” (to borrow a phrase US Secretary Treasury

Henry Paulson used during the US nancialcrisis): the total sum does not appear big enoughto provide the bailout unds committed toGreece, Portugal and Ireland; to support bankrecapitalization eorts; and to support anynancing shortalls Spain or Italy might ace(Spain and Italy alone have about €610 billion o nancing needs in 2012).

Some expect EFSF/ESM resources to beincreased in March 2012; others take ChancellorMerkel’s statement that no new unds will beorthcoming at ace value. In the meantime, theECB’s three-year renancing operations shouldprovide enough liquidity to banks and indirectlyto sovereign government bond purchases to avert ameltdown.

We should also note that just as we haveseen some real progress at the supra-nationallevel over the last two months, we have alsoseen some real progress at the national level.Both Italy and Greece have new reorm-oriented

technocratic governments, and the new Spanishprime minister, whose party has an absolutemajority in Parliament, has been introducing

additional scal reorm. O course, technocraticgovernments do not mean either Italy or Greeceare out o the woods. In Greece, the questiono debt restructuring is still outstanding and the

possibility o a disorderly deault remains.In summary, while there has been some

real progress that could lead to improvementsin the nancial markets, risks associated witha country or two no longer being part o the Eurozone remain. While ECB PresidentMario Draghi reers to talk o the Eurozoneragmenting in the oreseeable uture as “morbidspeculation”10 many experienced ormerEuropean policymakers and European policyobservers think otherwise. Peter Sutherland,Chairman o Goldman Sachs International anda guest speaker on some o our client calls, hasstated that “the longer this goes on, the greaterthe risk o a substantial problem in the Eurozoneitsel and in particular a country or countriesbecoming dislocated rom it.” Jacob Kirkegaardalso believes that the risk o a country or twoleaving the Eurozone is greater than zero.

Obviously, such downside has not been loston the nancial markets. European equities, as

measured by MSCI EMU, have historically tradedat a 33% discount to US equities based on price to10-year average cash fow – a valuation metric that

250 250

200 610

(2012)

540

(2013)

0

200

400

600

800

1,000

1,200

1,400

Spain & Italy bankrecapitalization need

1,190

0 - 200?

0 - 200?

450-850?

COMMITTED

EFSF Remaining Funds*

IrelandPortugalGreece

440

New EU funds to IMF

Potential extra IMF & non-EU resources

EFSF leverage and / or ESM increase

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."

Data as of December, 2011

* Assuming EFSF and ESM do not overlap

Source: Investment Strategy Group, Datastream, International Monetary Fund, European Banking Authority, ECB

Potential Resources Potential Uses

(EFSF -----> ESM)

Spain & Italyfinancing

needs




we nd particularly useul as a orward-lookingmeasure o expected returns. Today, this metricstands at a 53% discount. When we consider someo the world-class multinational companies in this

universe – names like Total, Anheuser-Busch Inbev,Siemens, Sano, Teleonica, ENI, LVMH-MoëtHennessy Louis Vuitton, SAP, L’Oreal, Unilever,Daimler, BMW, and Danone – that are trading, inaggregate, at a deep discount to US multinationals,it appears that signicant downside has alreadybeen priced into the market. In our view, suchcheap valuations warrant a small tactical tilt towardEuropean equities.

China: Cyclical and StructuralConcerns

The biggest question on our clients’ minds withrespect to emerging markets is whether Chinawill have a hard landing in 2012 – and i so,what are the implications or the US, Europe andcommodity prices?

A hard landing in China would impact otherparts o the world through several channels.The most immediate impact would be lowerdemand or commodities. While China accountsor about 10% o world GDP, it accounts ora substantially greater proportion o worldcommodity consumption, ranging rom a lowo 10% o oil demand to 30% o rice demandto 40% o copper and over 50% o iron ore.Clearly, a hard landing in China would lowercommodity prices and have the greatest impacton commodity exporting countries. (on the fipside, o course, lower commodity prices wouldbe a boon to global consumers.)

A lesser impact would be on exports romthe US and Europe. Exports to China accountor 0.9% o US GDP and 1.3% o EuropeanGDP; o course, as all commodity exportersget aected by lower prices, US and Europeanexports to those countries will also be hit. Thereis also a direct earnings hit since some US and

European companies earn a share o their protsin China. In addition, there will be a portolioimpact or those invested in Chinese nancial

assets. Tom Orlik, author o the recentlypublished Understanding China’s EconomicIndicators, went as ar as to say: “It used to bethat when the US sneezed the rest o the world

gets a cold. Now the same is true o China.”11

What exactly is a hard landing or China?

Some dene it as a ull year o below 7% growth.Others view a hard landing as growth ratesbelow 7% that would prompt market concernsand elicit a strong policy response rom Chinesepolicymakers. Based on ourth quarter estimatesrom our colleagues in Goldman Sachs GlobalInvestment Research,12 China’s growth rate orthe ull year 2011 is expected to be 9.1%. Wethink the gradual slowdown will continue and

estimate 2012 growth around 7.75–8.75%.It is important to keep in mind that Chinese

policymakers had been in tightening modesince early 2010 to slow down an overheatingeconomy and reduce rising infation (Exhibit15). They raised the reserve requirement ratio,the deposit rate and base lending rate, as shownin Exhibit 16. Other measures included lendingquotas. Their tightening measures had thedesired eect o reducing property prices andvolume o sales, as well as lowering infation

rates (Exhibit 17 and 18).However, as global growth slowed down

in 2011 and the sovereign crisis in Europeworsened, Chinese ocials started to easenancial conditions. Now the risk is thatproperty prices drop too steeply; that wouldreduce local government revenues and aecttheir ability to repay loans to the major banks.In a country that is heavily dependent on banknancing, a hit to the banks would makethe economy quite vulnerable. Fitch Ratingsestimates that China aces a 60% chance o abanking crisis by mid-2013 as a result o therecord lending or property-related investments.13

While policymakers can lose control or makemistakes, we think the likelihood o a sub 7%annual growth hard landing in China – in theabsence o any exogenous shocks rom Europeor the US – is somewhat limited. In our view, itwill only take a quarter or two o GDP growthrates below 7% to prompt a very strong policy

response. Ocials will urther ease monetarypolicy, implement scal stimulus and support thedevelopment o low income housing and rural



18 Goldman Sachs

january 2012

inrastructure, among other tactics, to avert ahard landing. They have the tools and certainlythe nancial means to do so: China’s sovereigndebt-to-GDP stands at 27%,14 its budget decitstands at -1.6% o GDP, its reserves total over

$3 trillion, and the government owns rom 57%to 83% o the our major Chinese banks and63% o the China H-share equity market (The

Economist estimates state-controlled companiesaccount or 80% o the Chinese equity market).15 In addition, China’s Communist Party willconvene in October 2012 to elect the new partyleaders; we expect they will do everything in

their power to maintain adequate growth duringthe change in party leadership.To us, the much graver concern in China is a

Exhibit 18: Chinese Inflation vs. Reserve

Requirement Ratio

Policy tightening has started to reduce Chinese inflation.


Source: Investment Strategy Group, CEIC

–4%

–2%

0%

2%

4%

6%

8%

10%

0%

5%

10%

15%

20%

25%

Headline Inflation (YoY%)(LEFT SCALE)

01 02 03 04 05 06 07 08 09 10 11

Required Reserve Ratio(RIGHT SCALE)


Exhibit 17: China Property Prices

Policy tightening has had the desired effect of reducing property

prices and sales in China's largest cities.


Source: Investment Strategy Group, National Bureau of Statistics of China, Soufun

–20%

–10%

0%

10%

20%

30%

40%

50%

Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11

WeightedAverage of

13 Cities(Soufun)

TIGHTENING

PERIODS

70 Cities(National Bureau

of Statistics)

Exhibit 15: Chinese Financial Conditions

Chinese policymakers have been tightening credit since early 2010.


* Deflated by CPI

Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Datastream

100

102

104

106

108

110

1120

5

10

15

20

25

30

35

06 07 08 09 10 11

Real Domestic Credit (%YoY)*(LEFT SCALE)

China FCI(RIGHT SCALE INVERTED)

F C I T I G H T E N I N G

Exhibit 16: Chinese Policy Rates

Chinese banking reserve requirements, deposit rates and lending

rates have all been raised in recent years.


Source: Investment Strategy Group, CEIC

0%

5%

10%

15%

20%

25%

0%

1%

2%

3%

4%

5%

6%

7%

8%

01 02 03 04 05 06 07 08 09 10 11

1 Year Deposit Rate

(LEFT SCALE)



Base 1 Year Lending Rate(LEFT SCALE)




longer-term, structural one: How does such alopsided economy transition rom an export- andinvestment-led economy to a more diversiedone without major dislocations? As shown inExhibit 19, China’s growth has been heavily

dependent on exports and investments relatedto exports. According to the IMF, “during2001–08, net exports and the investment whichis predominantly linked to building capacity intradable sectors have accounted or over 60%o China’s growth, up rom 40% in the 1990s.This is much larger than the 2001–08 average o the G7 (16%), Euro area (30%), and the rest o Asia (35%).”16 During this period, private sectorconsumption in China declined – rom 47% o GDP in 2000 to 33% in 2010. In the last ewyears, exports have ceded some ground to realestate investment, which accounted or 13% o GDP in 2010.

In order to achieve healthy, sustainablelong-term growth, China’s policymakers haveto manage a transition to a balanced economy.That’s a tall order under ideal circumstances;they must accomplish it in the ace o weakerglobal growth, a working-age population that isestimated to peak in 2015, an increasing number

o “public order disturbances,” and an increase ingeo-political tensions with some o its neighbors.17

Wealthy Chinese are taking note: an increasing

number are looking to emigrate rom China, withthe 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 won’t be either.

2012 Outlook: More ChoppyWater Ahead

As we identiy and examine the cyclical andstructural concerns in key economic centers,

we can only conclude that 2012 may be just aschoppy as 2011. In the US, election year politicswill probably impede progress on scal reorm.In Europe, the sovereign debt crisis has spreadrom a ew peripheral countries to now includeSpain, Italy and even France – and increasinglycomplex and ambitious reorm measures areunlikely to pass without at least a ew glitches.In China, policymakers have to avert a cyclicalhard landing without urther compounding thestructural problems o an imbalanced economy.

However, the nancial markets are quickto price such concerns, and all these actorshave already been at least partially discounted.Some US nancial assets such as high yield xedincome are particularly attractive. Others, suchas US equities, are airly valued and refect thestrong earnings and sae haven status o UScompanies; they should be a core holding inany equity portolio at this time. European and

Japanese equities are particularly cheap andpresent an attractive investment opportunity orthose who can withstand the volatility. And asunattractive as high quality government bondsare at current interest rates, they are the onlyconsistent and reliable hedge in a portolio at atime o heightened uncertainty.

As we present our ull economic andinvestment outlook in the pages that ollow,these themes will be explored in greaterdetail; and it will be evident why we believediversication – always a undamental

consideration or any investor – will beparticularly important in the year ahead.

Exhibit 19: Composition of Chinese GDP Growth

China's recent growth has been heavily dependent on exports and

investments, not consumption.

Data as of August 2009

Source: Investment Strategy Group, International Monetary Fund

1990-2000 2001-2008

Consumption

Net exports andinvestment

0%

20%

40%

60%

80%

100%

Share of total

GDP growth



20 Goldman Sachs

january 2012

“…by land and sea, the universal practiceunder conditions o og is to slacken speed.”19 So wrote Lammot du Pont, head o the chemicalconglomerate bearing his name, in reerence tothe “og o uncertainty” that was hamperingDepression-era businesses. Although he pennedthese words in 1938, they are just as applicabletoday, given the bounty o concerns. While thepotential or a hard landing in China and adisorderly breakup o the European Union arechie among them, less discussed, but equallyunclear, is the outcome o a slew o potentialleadership changes in 2012. Indeed, seven o theG20 countries, representing hal o the world’sGDP, will ace elections or leadership changes thisyear, including the United States, France, Chinaand Mexico. Against this uncertain uture, and

true to du Pont’s words, our orecasts envisionslower global growth in 2012, and in turn, aglobal economy that is more vulnerable to shocks.

That said, we are quick to dierentiate slow-ing growth rom negative growth. Except orEurope, where we expect a modest recession, ourorecast assumes below-trend, but still positiveeconomic expansion. Several actors supportthis view. First, barring an exogenous shock orbuildup o cyclical excesses, the natural state o

economies is to grow, as a result o their expand-ing populations and productivity gains. Havingemerged rom a very deep economic contractionnot long ago, there are ew cyclical excesses tocorrect today, as evidenced by still large outputgaps in the developed world and relativelyhealthy scal positions in the emerging markets.Second, slower growth, and hence moderatinginfation, will provide cover or governments toundertake monetary and scal stimulus. Already,48 central banks have eased in the last quarter o 2011, China reduced reserve requirements, Japanapproved its ourth supplemental budget, theBank o England announced yet another install-ment o quantitative easing, and the ECB adopt-ed a host o unconventional measures to supportbanks, while continuing to buy bonds throughits Securities Market Program (SMP). Emergingmarket countries, in particular, have room torelax macroeconomic policy, given their healthierscal positions and high policy rates (which aver-

age 5.3%). In short, while the og o uncertaintyis thick, policymakers are not without lights.Exhibit 20 presents a summary o our

section ii

2012 GlobalEconomic Outlook

The Fog o Uncertainty




GDP, infation and interest rate orecasts orthe developed economies.

United States: Slow but Steady

What the US economic recovery has lackedin vigor, it has made up or in stamina. Thatis, while real GDP growth at this point in thecycle is only hal that o historical recoveries,the economy’s continued upward trajectory inthe ace o a variety o destabilizing shocks,including the Arab Spring, Japanese earthquake,

European sovereign crisis and US debt ceilingdebacle, is a testament to its resilience. Indeed,despite a notable intensication o the Europeancrisis in the latter part o 2011, US GDP growthappears to have accelerated to over 3% in theourth quarter.

We expect this growth to continue in 2012,in spirit i not in magnitude. Our orecast or1.5–2.5% real GDP growth is a wider range thanusual, largely refecting uncertainty around USpolicy outcomes. For instance, ailing to extend

the payroll tax cut could subtract roughly 0.7pprom GDP growth, while extending unemploy-ment benet measures would add roughly 0.3pp.Meanwhile, the 2% midpoint o our rangestands below historical trend, consistent withthe ongoing headwinds rom consumer andnancial institution deleveraging. As discussedat the beginning o this Outlook, such moderate

growth is typical in the three to ve years ollow-ing a nancial crisis.

O course, despite its resilience thus ar, the

US economy could still tip into recession, par-ticularly given its below-trend growth path.Nonetheless, there are our reasons recession isnot our base case or 2012. First, the collectivemessage rom a variety o leading economic indi-cators we ollow is still one o moderate growth,at least or the next ew quarters. Second, ourstall-speed recession models still signal an

Exhibit 21: Capital Spending and Private

Sector Debt Growth

The excesses that typically precede recessions are not

present today.

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

–4%

–2%

0%

2%

4%

6%

8%

10%

12%

12%

13%

14%

15%

16%

17%

18%

19%

52 57 62 67 72 77 82 87 92 97 02 07

Capital Spending % GDP(LEFT SCALE)

Real Growth ofPrivate Sector DebtYoY%, 3Y Avg. (RIGHT SCALE)

Exhibit 20: ISG Economic Outlook for Developed MarketsOur forecast features relatively tame inflation, still-accommodative monetary policy, and some normalization of interest rates.

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

UNITED STATES EUROZONE JAPAN UNITED KINGDOM

2011 2012 Forecast 2011 2012 Forecast 2011 2012 Forecast 2011 2012 Forecast

Real GDP* 1.7% 1.5 - 2.5% 1.5% (1.0) - 0.0% –0.2% 1.75 - 2.25% 0.9% (0.5) - 0.5%

Headline CPI** 3.4% 1.5 - 2.5% 3.0% 1.25 - 2.25% –0.6% (0.5) - 0.0% 4.8% 2.0 - 3.0%

10-Year Rate*** 1.88% 2.0 - 2.75% 1.82% 2.25 - 3.0% 0.97% 1.0 - 1.75% 1.97% 2.25 - 3.0%

Policy Rate 0% - 0.25% 0.0 - 0.25% 1.0% 0.5 - 1.0% 0.1% 0.1% 0.5% 0.5%



22 Goldman Sachs

january 2012

elevated, but not decisive 30-35% risk o reces-sion. Third, as shown in Exhibit 21, the typicalpreconditions o recession, namely excessivecapital spending and private sector debt growth,are not present. Indeed, the lack o obvious ex-

cesses to expunge would likely temper the deptho any economic contraction, were one to occur.Finally, although an adverse outcome in Europeand/or China could oster a US contraction, theprobability o these outcomes has not risen to alevel that would alter our base case. As such, weplace the odds o recession starting in 2012 ataround 30%.

Accordingly, barring an exogenous shock, weexpect continued economic growth on the backo resilient consumer and business spending, aswell as a small upturn in residential investment.We discuss each o these key components below.

Business Investment

While business investment’s 8.4% annualizedgrowth has already handily outpaced GDP inthis recovery, we believe the trend is sustainableor several reasons. One, rms have ample undsto deploy, with robust corporate protability

underpinning record levels o cash. As o thethird quarter o 2011, cash at non-nancialS&P 500 rms represented 11% o total assets,

the highest level in decades. Although a moreuncertain global environment may justiy tempo-rarily holding higher levels o cash, demandingshareholders will not allow these cash hoards to

persist indenitely. Two, the impressive rate o investment growth is partly a unction o a lowstarting base, refecting how aggressively busi-nesses retrenched during the nancial crisis. Inact, despite robust growth, business investmentremains 8% below its 2007 peak. Lastly, corpo-rations continue to under-invest, as evidenced bydepreciation expense exceeding capital expendi-tures or more than hal the S&P 500. Indeed,our colleagues at Goldman Sachs Global Invest-ment Research ound that adjusting or deprecia-

tion, growth in the real net capital stock is onlyabout 1.5%.

Employment Despite numerous ts and starts throughout theeconomic recovery, a broad mosaic o employ-ment statistics have recently rmed, a trend thatshould continue to benet consumption in 2012.For example, weekly initial jobless claims havereceded to their lowest levels since early 2008

and now stand at a level consistent with ongo-ing employment growth. This improvement isechoed by a host o other measures, includingcollapsing layo announcements in the Chal-lenger survey, the recovery o hiring intentions to2008 levels in the Manpower survey, an uptickin online job advertising at Monster.com and anincrease in available jobs in the Labor Depart-ment’s Job Openings and Labor Turnover Survey(JOLTS). O equal importance, small businesshiring intentions in the National Federation o Independent Business survey recently matchedlevels last seen beore the recession began. This isa critically important development, as rms withewer than 500 employees account or about hal o both private sector employment and non-armprivate sector GDP.

Notably, the mediocre employment gains seenthus ar obscure what is actually a two-speedemployment recovery. As shown in Exhibit 22,the “crisis” sectors o the economy (namely,

construction, nance and government) have con-tinued to shed jobs throughout the expansion,while employment gains outside these areas have

90

91

92

93

94

95

96

97

98

99

100Employment in “Crisis”Sectors: Construction,Government, andFinance (LEFT SCALE)

Total Employmentexcl. Constr, Govt, and Fin.(RIGHT SCALE)

Exhibit 22: Composition of US Employment Growth

Job growth in the healthy sectors of the US economy is offsetting

losses elsewhere.


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

32

33

34

35

36

37

38

39

Millions Millions

97 98 99 00 01 02 03 04 05 06 07 08 09 10




mirrored previous cyclical recoveries. As a result,these healthier sectors are osetting, and therebyacilitating, the necessary structural employmentadjustments o the weaker areas. This counter-

balancing dynamic highlights a key benet o theUS economy’s diversity.

The upshot is that with job losses in the crisissectors stabilizing, overall employment growthcan improve. Already, real estate–related jobshave stopped contracting in 2011, removingone headwind rom the employment recovery.Moreover, whereas scal consolidation will likelynecessitate urther government job losses, themessage rom the nancial sector is less clear.Indeed, the growing burden o regulatory com-

pliance is necessitating headcount additions atmany nancial, law and consulting rms, evenas the nancials reduce their capital marketheadcount. The net, economy-wide job impact o ongoing nancial sector adjustments is thus notas draconian as commonly assumed.

Overall, the impact o an improving labormarket is non-trivial, as each 50K increase inmonthly non-arm payrolls adds about 0.15pp toour GDP growth orecast.

Housing Although our growth orecast assumes only asmall contribution rom residential investment in2012, we believe housing accounts or a signi-cant source o uture economic upside. Ater all,residential investment represents just 2.2% o GDP today, its lowest level in over 60 years (Ex-hibit 23). In act, 2012’s small gain will representthe rst time since 2005 that housing has notdetracted rom US GDP.

While many housing indicators remain atadmittedly depressed levels, a nascent trend o improvement has emerged in recent months. Forexample, housing starts rose 9.3% in Novem-ber 2011, to the highest levels o this recovery.Moreover, the December reading o the NationalAssociation o Home Builders (NAHB) sentimentindex stood at a level last seen in the wake o thegovernment’s homebuyer tax credit in early 2010.

In addition to these recent improvements, we

believe the underpinnings o a structural upturnin housing are coming into ocus. As shownin Exhibit 24, national home prices have now

2.2%

1%

2%

3%

4%

5%

6%

7%

8%

50 55 60 65 70 75 80 85 90 95 00 05 10

Exhibit 23: Private Residential Investment as

a Percent of GDP

Reversion to the mean in residential investment could be a

tailwind for US growth.

Data as of Q3 2011

Source: Investment Strategy Group, Datastream, US Bureau of Economic Analysis

HISTORICAL

AVERAGE

4.5%

75 78 81 84 87 90 93 96 99 02 05 08 11

Exhibit 24: S&P Case-Shiller Home Price Index

National home prices have expunged the excesses of

the housing bubble.

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

0

20

40

60

80

100

120

140

160

180

200

Case-Shiller Home Price Index*

Estimated Equilibrium



24 Goldman Sachs

january 2012

expunged the excesses o the housing bubbleand returned to levels consistent with underlyingundamentals. Falling home prices, coupled withtoday’s low interest rates, have pushed home-

buyer aordability to its highest level on record.As a result, the October 2011 Housing Aord-ability Index reading o 197.8 (see Exhibit 25)

implies that a amily earning the median incomehas 197.8% o the income necessary to qualiyor a conventional mortgage covering 80% o amedian-priced existing single-amily home.

O course, a would-be homebuyer can alwayschoose to rent instead. Even here, the econom-ics avor homeownership, a refection o today’shigher rents, attractive home prices and lownancing costs. Viewed another way, housingspeculation has once again become enticing,since the rental income rom a purchased home issucient to pay the mortgage and still generatea positive return each month. Not surprisingly,investors are increasingly entering the purchase-to-rent market.

To be sure, a large overhang o excess hous-ing supply still exists. Even so, progress is beingmade, arguably at an accelerated pace. As shownin Exhibit 26, the supply o new homes is run-ning signicantly below demographic demand.In turn, the large overhang o unsold homes andoreclosures is clearing. This dynamic is evidentin Exhibit 27, which shows inventory declinesoccurring at a much aster pace than at this pointin 2010. Undoubtedly, any eort by the govern-

ment to rent rather than liquidate its vast stocko oreclosures would be an incremental positiveto this adjustment process.

500

0

1,000

1,500

2,000

750

250

1,250

1,750

2,2502,500

70 75 80 85 90 95 00 05 10

Housing Starts(12-Month Average)

Demographic Demand

for Homes*

Data as of Q3 2011

* 10-year average household formation plus assumed 300,000 demolitions per year.

Source: Investment Strategy Group, Datastream, US Bureau of Economic Analysis

1,237

596

Exhibit 26: Housing Starts vs. Demographic

Demand for Homes

Housing starts well below demographic demand works to reduce

excess inventories.

Exhibit 25: US Housing Affordability Index

With home prices and interest rates falling, homes are now more

affordable than ever.

Data as of October 2011

Source: Investment Strategy Group, Datastream, National Association of Realtors

60%

80%

100%

120%

140%

160%

180%

200%

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

R E C E S S I O N

197.8%

Shadow Inventory

Listed Inventory

12.4

2.3

–8.6

–12.1–13.2

–15.7 –15.5

0.2

6.1 6.6

–4.0–5.2

–15.1 –14.7

Q2-10 Q1-11 Q2-11 Q3-11 Q4-11Q3-10 Q4-10

YoY%

–20%

–15%

–10%

–5%

0%

5%

10%

15%

Exhibit 27: Change in Housing Inventories

The large overhang of unsold homes and foreclosures is clearing.

Data as of Q4 2011

Source: Investment Strategy Group, Empirical Research Partners, National Association of Realtors,

First American CoreLogic, US Census Bureau




In short, while we have relatively modestexpectations or the contribution o residentialinvestment to GDP growth in 2012, we thinkhousing will become an increasingly important

economic story, and hence investment theme, inthe years ahead.

Given this moderate growth backdrop, weexpect infation to remain well anchored, giventhe still abundant slack in the US economy.Moreover, with unemployment above the Fed’scomort level, we expect the Fed to honor itscommitment to remain on hold into 2013, de-spite urther economic growth. Even so, interestrates will likely end this year at higher levels, ascontinued economic expansion raises expecta-

tions o eventual monetary policy normalization.

Eurozone: No Silver Bullet

Against a backdrop o political turmoil, a bank-ing crisis and a large scal drag, the question isno longer whether the Eurozone will experiencea recession in 2012, but rather how deep it will

be. While a deep recession is intuitively appealinggiven the magnitude o the area’s challenges, thatis not our base case. Instead, we expect about a1% peak to trough contraction, a level consistentwith the recessions seen in the early 1980s and1990s. In turn, weaker growth should temperinfation concerns, providing cover or the ECBto reduce interest rates urther. Already, grow-ing excess bank reserves rom the ECB’s liquiditymeasures are likely to push short rates lower.

Our relative optimism, or perhaps lack o unequivocal pessimism, is predicated on severalactors. As shown in Exhibit 28, Eurozone in-vestment – the most cyclical element in GDP – isalready at very depressed levels, suggesting thereare ewer excesses to correct during a down-turn. In act, overall xed investment has grownjust 4% since its nancial crisis trough. Fixedinvestment among the European peripherals,meanwhile, has already contracted signicantly,standing 23% below its 2008 peak. In addition,

Exhibit 29 shows that Eurozone consumer bal-ance sheets are relatively healthy, providing somescope or savings to oset alling growth. Finally,

70

75

80

85

90

95

100

105

87

92

77

Eurozone

Core(Eurozone excl. GIIPS)

GIIPS(Greece, Ireland, Italy,

Portugal and Spain)

Exhibit 28: Fixed Investment in the Eurozone

There are fewer excesses to correct during a downturn, suggesting

a moderate recession.

Data as of Q3 2011

Source: Investment Strategy Group, Datastream, Eurostat

Index (1Q08=100)

2008 2009 2010 2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0%

2%

4%

6%

8%

10%

12%

14%

16%

US

4.8%

Japan

5.5%

UK

6.4%

Eurozone

13.9%

Exhibit 29: Household Savings Rates

Consumer balance sheets in the Eurozone are comparatively healthy.

Data as of Q2 2011

Source: Investment Strategy Group, Datastream, Eurostat, OECD, US Bureau of Economic Analysis,

UK Office for National Statistics



26 Goldman Sachs

january 2012

an unruly, orced deleveraging o the bankingsystem is ar less likely in the wake o the ECB’sextraordinary liquidity measures, particularly itswillingness to accept a wide range o bank col-

lateral in exchange or three-year loans at a 1%borrowing cost (otherwise known as LTROs, orLong-Term Refnancing Operations). These mea-sures lessen the extent to which lending condi-tions would otherwise tighten, a critical consid-eration given the importance o bank fnancingto the Eurozone (see Exhibit 30).

While our orecast calls or a relatively mod-est overall Eurozone recession, more severe con-tractions lurk beneath the surace at the countrylevel. As was the case in the expansion, we

expect the core o Europe to are better than theperiphery, given the latter’s greater debt burdensand higher unding costs. For example, Ger-many’s low budget defcits (1–2% in 2012) andattractive borrowing costs may enable it to stag-nate rather than contract. In addition, Germany,unlike Spain, did not experience a large housingbust and hence does not need to rebalance itseconomy. In contrast, we expect a combina-tion o austerity measures, uncompetitivenessand elevated borrowing costs to result in deeper

contractions in the GIIPS (Greece, Ireland, Italy,Portugal and Spain).

While we expect the Eurozone to remainintact, we have no delusions about the existenceo a silver bullet or the region’s woes. Evenwith Germany serving as economic ballast, theEurozone’s ultimate ate rests in the hands o itsown politicians and the patience the market iswilling to aord them. As we have highlightedin various client calls and Sunday Night Insightsthroughout 2011, we expect continued incre-mental, reactive and occasionally inconsistentpolicy responses. Meanwhile, these “existential”challenges are likely to be exacerbated by cycli-cal pressures resulting rom Europe’s unoldingrecession and the implications o slowing growthin China and/or the US. As a result, even thoughwe accord both the US and Europe a 30% down-side probability, the bad case or Europe is moresevere than the US, given the dangerous interplaybetween weakening growth and the potential or

an adverse tail event (such as a disorderly deaultor political accident).

0%

20%

40%

60%

80%

100%

France Portugal Germany Italy Greece Spain US

Exhibit 30: Business Funding from Bank Loans

and Credit Markets

Unlike US companies, European firms rely heavily on bank loans

for their funding.

Data as of 2011

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

Bond-Market FundingBank Loans

While we expect the Eurozone toremain intact, we have no delusionsabout the existence o a silver bullet

or the region’s woes.




That said, progress has been made. As men-tioned above, the ECB’s recent liquidity measuressignicantly decrease the probability o a Lehman-style liquidity crisis and provide politicians

time to put more permanent measures in place.Indeed, banks were able to und nearly two-thirds o their entire 2012 unding needs duringthe ECB’s December LTRO. With an additionalLTRO available in February, the banks will havelittle diculty rolling their maturing 2012 or2013 debt. Meanwhile, the imposition o tech-nocratic governments in Greece and Italy, theelection o a pro-reorm party in Spain, and par-liamentary approval o austerity measures acrossthe Eurozone make the political commitment to

reorm more credible. Even so, we expect volatil-ity to remain elevated and headline-driven orthe near uture, given ongoing debate over theGreek private sector involvement, key EU elec-tions, and elevated sovereign unding needs earlyin the year.

Although by no means a 2012 expectation,any lasting solution to the Eurozone crisis mustultimately provide the ollowing key items:

• A scal integration plan that enables

the socialization o losses, througheither Eurobond issuance or direct scaltransers.

• A scal consolidation plan that improvesstructural competitiveness and growth inthe periphery, as opposed to just curtail-ing spending through austerity measures.

• A mechanism to address the undingneeds o weaker sovereigns that lackmarket access.

• A credible rewall to limit contagion aris-ing rom any one member’s deault / exit.

We continue to assess any proposed “compre-hensive” solutions against this checklist.

United Kingdom: Sluggish Growthwith Downside Risks

We expect UK infation to moderate graduallyrom current high levels. While infation has risenon the back o commodity prices and two VAThikes in 2010 and 2011, it should all back to2.0–3.0% in 2012 as these eects dissipate. True,this would still be above the Bank o England’s2% target, but the weakness o the economyshould 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 urther asset purchases.

Despite this already tepid outlook, we think

risks are tilted to the downside or three reasons.One, implementation o the scal consolidationcould veer o track. Two, markets may start tochallenge the UK’s bond market. Three, infa-tion could remain resilient, orcing the Bank o England to deend its credibility at the expenseo the economy.

Japan: Rebuilding Tailwind

Ater enjoying a strong growth rebound in 2010and an encouraging start to 2011, earthquake-related disruptions pushed the Japanese economyback into recession. In turn, rebuilding eorts led tostrong 5.6% QoQ annualized growth in the thirdquarter o 2011, refecting a post-earthquake recov-ery that should endure in 2012. In act, we expect

Japan to grow as ast as the US and outgrowEuroland, and the UK in 2012, a eat that hasoccurred only once beore in the last two decades.

Not surprisingly, xed investment will bethe principal driver o this growth, boosted byreconstruction and public investment. A meanreversion tailwind will help, as business invest-ment remains 19% below its 2008 peak. Mean-while, public investment will be boosted by thethree post-earthquake supplementary budgets al-ready approved, amounting to a combined ¥18tr(3.7% o GDP). Overall, we expect GDP growth

o 1.75–2.25% in 2012, with a modest increasein long-term rates to a range o 1.0–1.75% byyear-end.



28 Goldman Sachs

january 2012

Despite this rebuilding tailwind, Japan re-mains vulnerable to exogenous shocks, particu-larly a dramatic slowing in global growth. Thatsaid, we would expect more monetary easingand FX intervention were the economy to slowmaterially and/or the yen to appreciate signi-

cantly. Moreover, although high debt levels makethe country susceptible to a sovereign crisis in thelong term, we think this risk is mitigated by atleast three actors. First, domestic investors holdmore than 90% o Japanese government debt, re-ducing the likelihood o a run on JGBs. Second,

Japan does not need external unding, given thatit runs a current account surplus worth roughly3–4% o GDP. In act, gross private savingsrepresented 14.6% o GDP in 2010, an amountthat could be channelled toward reducing gov-ernment debt i necessary. Finally, tax levels arelow in Japan relative to other OECD countries,providing scope or higher government revenues.

Emerging Markets: Still Coupled

We have long argued that emerging market econ-omies are not immune rom the business cycle

gyrations o the advanced economies. It shouldcome as little surprise, then, that we expect aslowdown in emerging market growth, givenour relatively tepid growth expectations orthe developed world. Even so, we are quick todistinguish between slowing growth and negativegrowth. While our orecast calls or a slowdownin emerging markets to a below-trend 5.7% in2012, we do not expect a hard landing.

Several actors underpin our view. For one,we think recent ECB actions have greatly re-

duced the probability o a Lehman-style growthshock. In turn, our expectation or 1% growth inthe advanced economies in 2012 is very dierentrom the nearly 5% economic contraction thatoccurred in 2009. As a result, the drag on EMgrowth should be commensurately less.

O equal importance, more temperate growthshould ease infationary pressures, enablingemerging markets to relax monetary policy.Indeed, in stark contrast to the developed world,most EM central banks have room to cut rates

(given that average policy rates currently stand at5.3%), while strong budgetary positions permitincremental scal stimulus. These measures serveas an important counterbalance to the externalgrowth headwinds we expect.

Even so, while we think tail risks have re-ceded, they have not been eliminated. To be sure,a hard landing in China, a US recession or anescalation o the European debt crisis could neg-atively impact emerging markets through ham-pered trade, diminished access to internationalcapital markets and lower commodity prices. Onthis point, a recent study by two IMF economistsound that a downside scenario involving severemarket dislocations in European economies andmarkets could shave 1.6 percentage points (pp)rom emerging market growth, in addition tothe 1.5pp growth decrement we expect rom theadvanced economy slowdown.20 I correct, thiswould reduce the rate o growth by more than3 percentage points, a signicant shock, but still

less than the 6.1pp decline ollowing the Lehmancrisis (Exhibit 31).

Base Case5.7%

DownsideCase4.1%

80 83 86 89 92 95 98 01 04 07 10

Trend Growth

Headline Growth

Data as of September 2011


0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10% F O R E C A S T

Exhibit 31: Emerging Markets GDP Growth

Our base case envisions below-trend growth, but not a

hard landing.

12

We have long argued that emergingmarket economies are not immunerom the business cycle gyrationso the advanced economies.




Emerging Asia

As home to many o the most open economies inthe world, Emerging Asia is particularly vulner-able to slowing global exports and tighter global

trade nancing, both o which are likely head-winds in 2012. That said, these hurdles shouldbe manageable given continued current accountsurpluses (with the exception o India) and largeoreign exchange reserve balances. In addition,waning infation rom decelerating economicactivity should provide scope or looser macro-economic policy, most likely in the orm o ratecuts and slower currency appreciation acrossthe region.

China Barring an extreme outcome in Europe,China remains on course or a sot landing.While it is true that Chinese growth has slowedalmost 3 percentage points in less than twoyears, the absolute level o growth is still arobust 9.1% as o the third quarter o 2011. O equal importance, much o this slowdown wasintentional, as the government tightened policydramatically to orestall a burgeoning propertybubble and assuage infationary pressures.

Even so, growth momentum is likely to slow

urther in China, given decelerating global eco-nomic activity. In turn, we expect below-trendGDP growth o 7.75–8.75% in 2012, supportedby consumption growth and a mild pickup ininvestment, primarily in public housing. Onthis point, the Chinese government has set atarget o building 7 million aordable homes in2012 and, or the rst time ever, made reachingthese targets the core criterion or judging localocials’ job perormance.21 Meanwhile, slow-ing growth should temper infation and therebyprovide scope or policy easing in 2012. In ourview, infation has already peaked and shoulddrop urther to around 3–4% in 2012.

The key challenge or China’s policymak-ers will be to support domestic demand growthwithout creating new vulnerabilities in thenancial sector. For instance, while the massivestimulus employed during the 2008 nancial cri-sis enabled China’s economy to rebound quickly,

it also ostered real estate speculation and a surgein local government debt. That said, we do notexpect the resulting non-perorming loans topresent a major challenge to our view in 2012,

as both the banking sector and the governmenthave the resources to absorb potential losses.

O course, as an export-driven economy,China remains vulnerable to a urther escala-tion o the European sovereign debt crisis. Aterall, China’s exports o goods and services stillmake up some 30% o GDP, o which the EUrepresents one-th. In addition, trade nanc-ing remains vulnerable, particularly as Europeanbanks deleverage their balance sheets. Nonethe-less, we believe China has fexibility to employ

scal and monetary stimulus as a counterbalance,although this fexibility is admittedly less than itwas in 2008–09.

India India’s economy is also slowing, largely re-fecting declining investment and tight monetarypolicy. We expect this trend to continue, withGDP growth in 2012 slowing to a below-trend6.75–7.75% and infation alling to 5–6.5%.

Among the larger economies in Asia, Indiaappears most exposed to jitters in global nan-

cial markets. Concerns about India’s twin decitsare pressuring the rupee. In turn, this is urthertightening the nancing conditions o Indian

Barring an extreme outcome in Europe,China remains on course or a sotlanding.



30 Goldman Sachs

january 2012

companies, which rely extensively on Europeanbanks. Given these budding external headwinds,the key challenge or India’s policymakers willbe to revive investment without creating a bigger

budget decit or rekindling infation. We expectthe burden to all on the central bank, which islikely to cut rates and improve access or oreignportolio infows as a means o easing liquidityconditions.

Latin America

We expect sluggish activity in Europe to keepcommodity prices in check, and with them, LatinAmerican growth. That said, tight supply condi-tions in oil, copper and iron ore should continue

to support the terms o trade in the region.Moreover, should global activity surprise onthe downside, central banks are likely to loosenmonetary policy urther. As with China, thehealthy scal balance o countries such as Brazil,Mexico, Colombia and Chile will allow somebudgetary stimulus as well.

Brazil Although Brazilian growth ended 2011at depressed levels, we expect a rebound thisyear, albeit to a still below-trend 2.5–3.5%. Theuptick will likely refect the lagged eects o the

central bank’s proactive rate cuts last summer, aswell as an expected rise in the minimum wage.In addition, large-scale investments in both oilproduction and inrastructure to prepare or the2014 World Cup will provide a urther tailwind.Consequently, infation is likely to remain aboveits target (or the third year running), settling ina range o 5.5–6.5% in 2012.

In theory, Brazil is relatively insulated romthe unolding Eurozone crisis, with just 2% o itsGDP destined or the EU. In practice, however,

the impact on commodities prices could transmitthe slowdown directly, given that commodityexporters account or 43% o Brazilian marketcapitalization. In turn, weak equity prices couldnegatively impact wage growth and wealth,undermining consumer sentiment. On a morepositive note, years o experience have improvedBrazil’s macroeconomic management, enablingthem to better respond to external shocks.

Europe, Middle East, Africa (EMEA)

We expect growth in EMEA to slow in 2012,with considerable downside risks. Among emerg-ing market economies, those in EMEA have thelargest external nancing needs and the clos-est trade and nancial links with the Eurozone(Exhibit 32). Thus, they are ar more vulnerableto an adverse outcome in Europe than theirAsian and Latin American peers, with the CzechRepublic, Hungary and Poland particularly atrisk. Turkey is also at risk given its large currentaccount decit, whereas Russia and South Aricaare likely to be more resilient.

Unlike other emerging markets, most EMEAcountries have limited room to counteract slow-ing growth with policy stimulus. Thereore, anyeasing will most likely come in the orm o mod-est interest rate cuts.

Among the larger economies in Asia,India appears most exposed to jittersin global nancial markets.




Russia Although Russia’s exposure to Europethrough trade and nancial linkages is the largestamong the BRICs, its economy has thus ar beenresilient. This durability is largely a unction

o robust domestic consumption and the rela-tive strength o oil and gas prices, Russia’s mainexports. Our orecast has a similar favor, as weexpect pre-election spending and relatively stabledemand or oil and gas to support GDP growtho 3.25–4.25% in 2012. Slowing growth shouldallow infation to all in a range o 6.0–7.5% orthe year. Even so, these high absolute levels o infation curtail Russia’s policy fexibility, whichis urther constrained by the depreciation o the ruble since mid-2011 and continued capital

outfows. Russia may thus nd itsel less able tooset a deepening o the global growth slow-down.

Exhibit 32: EM Trade and Financial Linkages

to Eurozone

Countries in EMEA have the largest exposure to Eurozone tensions.

Data as of 2010


CZR

TRK

HUN

POL

RUS

Exports to Eurozone as % of GDP

15%0% 5% 10%

0%

20%

40%

60%

80%

100%

120%

140%

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

BRZ

INDCHN

B a n k L o a n s F r o m E u r o z o n e a s % o

f B r o a d M o n e y S u p p l y

Among emerging market economies,those in EMEA have the largestexternal nancing needs and

the closest trade and nancial linkswith the Eurozone.



32 Goldman Sachs

january 2012

if 2008 represented the epicenter o thenancial crisis, 2011 was its atershock. Ater all,the nancial turbulence o both periods emanatesrom a similar ault line: an accumulation o debt, whether in the orm o US mortgages,Chinese domestic loans or European sovereignbonds. Perhaps it is not surprising, then, that lastyear’s renewed ocus on these macroeconomicrisks engendered the same type o elevatedvolatility, correlations and contagion risks thatcharacterized the crisis. As 17th century Frenchtragedian Pierre Corneille wrote, “The re whichseems extinguished oten slumbers beneaththe ashes.”

In the wake o these systemic concerns, policyannouncements, not economic reports, drove thelargest equity moves in 2011.22 This shit away

rom undamentals proved toxic or investmentmanagers, with 75% o large cap core equitymutual unds underperorming the S&P 500 last

year and even hedge unds down mid-single dig-its or the year (as represented by the HFRI FundWeighted Composite). Accordingly, risk aversionwas once again in vogue, evident in the charac-ter o asset class returns seen in Exhibit 33. Tobe sure, ew investors will lament the passing o 2011.

While the structural nature o today’s con-cerns suggests atershocks will persist, thatshould not preclude reasonable equity returns in2012 (Exhibit 34). For one, valuations, particu-larly in countries o stress like those in Europe,have become much more enticing. Moreover,positive, albeit below trend, global growthshould support urther earnings gains. In ad-dition, global central banks are moving moreaggressively toward refation. China and otheremerging markets are also joining the ray, anotable shit rom their anti-infationary policytightening last year. In sum, this combination o high earnings yields and low interest rates resultsin loty global equity risk premiums, bolsteringthe relative attractiveness o stocks.

In contrast, most government bonds lookunattractive in our view, given a combination o negative real yields, duration risk and some cred-it risk in select sovereigns. Today’s low yieldsalso make it clear that generating attractive

returns will require investors to take more risk.As evidence, today’s S&P 500 dividend yield ishigher than the 10-year Treasury yield, despite

PHOTO TBD

section iii

2012 FinancialMarkets Outlook

Atershocks




historically being less than hal. Bond sentimentis a contrarian negative as well, as just one thirdo institutional investors surveyed expect rates torise in 2012.23

Elsewhere, we e xpect the US dollar to remainbroadly stable, while easier policy in emerging

markets should limit currency gains there. Acombination o a stable greenback and slowingglobal growth should keep oil and gold rangebound this year.

While our orecasts are not grim, we are byno means Pollyannaish. There is little questionthat the confuence o sovereign developments in

Europe, slowing global growth, political gridlockin the US and the potential or a hard landing inChina have raised the risk and severity o adverseoutcomes. In act, it was on this basis that we ad-vised purchasing tail risk protection via S&P 500puts in July o last year. In addition, our current

orecast includes a higher downside probability,around 25%, embedding a low, but non-trivialpossibility o a destabilizing outcome in Europeor China. In short, while the likelihood o a trulyadverse outcome remains low, the penalty orbeing wrong has risen.

In the presence o these low probability tail

Exhibit 34: ISG Global Equity Targets – Year-End 2012

We expect positive returns across equity markets in 2012.


* Sharpe ratio equals the midpoint of the total return range divided by volatility.


Current 2012 Target Implied Upside Current Implied Volatility Sharpe

Level Range Current Level Div. Yield Total Return Since 1988 Ratio*

US (S&P 500) 1258 1,325 - 1,400 5% - 11% 2.1% 7% - 13% 15.1% 0.69

Eurozone (Euro Stoxx 50) 2317 2,400 - 2,600 4% - 12% 5.0% 9% - 17% 18.8% 0.69

UK (FTSE 100) 5572 5,650 - 5,950 1% - 7% 3.9% 5% - 11% 15.0% 0.53

Japan (Topix) 729 800 - 875 10% - 20% 2.6% 12% - 23% 19.7% 0.89

Emerging Markets (MSCI Emerging Markets) 41013 44,000 - 48,000 7% - 17% 2.9% 10% - 20% 23.2% 0.65

Exhibit 33: 2011 Asset Class Performance

Risk aversion drove returns in 2011.

Data as of December 30, 2011 except where indicated

Note: Total Returns in USD.

Source: Investment Strategy Group, Datastream, Barclays Capital

0%

5%

–5%

–10%

–15%

–20%

10%

Barclays

Muni 1-10

7.6%

Barclays

Aggregate

5.6%

Barclays

High Yield

5.0%

US Equity

2.1%

US Trade

Weighted

Dollar

0.4%

Multi-Strategy

Hedge Funds

(THROUGH 11/30/11)

–4.7%

Goldman Sachs

Commodities

Index

–1.0%

Non-US

Equity

–11.7%

Emerging

Markets

Equity

–18.2%



34 Goldman Sachs

january 2012

risks, why not be completely risk averse? We seeat least our reasons. The rst was best articulatedby Oaktree’s Howard Marks in his March 2008quarterly letter: “The things one would do to

gird or the demise o the nancial system willturn out to be huge mistakes i the outcome isanything else . . . and chances are high that it willbe.”24 Second, the 2008 nancial crisis demon-strated that loss estimates are fuid and greatlyinfuenced by prevailing sentiment. In act, thelosses ultimately realized in the US were justhal o those estimated at the worst point in thecrisis (Exhibit 35).25 Consequently, the additionalpolicy steps we expect may dampen today’sdraconian Eurozone loss estimates. Third, as we

have highlighted beore, the hurdle or under-weighting stocks is high when valuations areundemanding, interest rates are low, corporateearnings are growing, and sentiment on stockshas soured, all conditions that exist today.Finally, Exhibit 36 reminds us that periods o great volatility, and hence heightened uncertaintylike we have today, have historically been betterbuy than sell signals. Thus, we have selectivelypositioned our portolio in areas where we ndthat the prospective returns justiy the risks. We

discuss these positions urther in the pages thatollow.

US Equities: Continued Resilience

The S&P 500 was clearly the best house in a badneighborhood last year. As shown earlier in Ex-hibit 33, despite a relatively fat absolute return,the US was nonetheless the lone bright spot in anotherwise dismal year or global equity markets.This was a remarkable eat, considering the re-lentless cascade o negative shocks, both home-grown and oreign, that the market endured.

At the root o this resilience was the per-sistence o strong corporate protability. Alltold, S&P 500 operating earnings grew roughly17% in 2011, setting a new all-time high in the

process. In act, top-down consensus estimatesor 2011 actually rose 6% over the course o the year. In contrast, valuation multiples moved

Exhibit 35: Expected and Realized Losses in US and

European Crises

The US financial crisis showed loss estimates are changeable with

sentiment.

Data as of 2011


–20%

–16%

–12%

–8%

–4%

0%

All OtherDebtHolders

Banks

WORSTMARKS

ACTUALLOSSES

The US

Estimate of Debt Losses Based on:JUNE 2011

MARKSDEC. 2011

MARKS

Eurozone

%GDP

Exhibit 36: S&P 500 Performance vs. VIX

Periods of elevated volatility have historically been better buy

than sell signals.


Source: Investment Strategy Group, Bloomberg, SentimenTrader

010203040506070

0

300

600

900

1200

1500

1800 S&P 500 Price Index

VIX (3M Median)

86 89 92 95 98 01 04 07 10




in the opposite direction, as investors worriedabout the durability o earnings in the ace o countless headwinds (Exhibit 37). This tug o war between resilient earnings on the one hand,

and the multiple investors are willing to payor them on the other, is a theme we expect toendure in 2012.

O course, earnings and valuation representjust two o the our actors that determine ouroutlook. We discuss each o the our in moredetail below:

Valuations

With S&P 500 price returns fat in 2011, it is

not surprising that valuation multiples wouldlook strikingly similar to those shown in our lastOutlook (Exhibit 38). Then, as now, valuationsresided around the midpoint o their historicalrange, regardless o the measure. But while today’smiddling valuations are unremarkable versus theirown history, they remain depressed relative to pre-vailing interest rates. Indeed, historical periods o similarly low rates saw the price-to-trend earningsmultiple (our preerred valuation measure) severalpoints higher. With the Fed committed to low

rates into 2013, this environment is likely to per-sist. As a result, stocks look particularly attractiverelative to Treasury bonds. The 10-year Treasurycurrently yields 1.88% while the S&P oers a 6%real earnings yield and a 2.1% dividend yield.

While valuation multiple expansion does notgure prominently in our central case, we do seescope or presidential elections to reduce uncer-tainty this year. Historically, when the incum-bent’s approval rating was as low as it is today,it actually did not matter who won the election.Instead, simply removing the uncertainty suced,as all seven historical instances showed positivereturns during the election year, averaging 13%.26

Fundamentals

Ater three years o robust earnings growth, inves-tors are rightly concerned about the sustainabilityo urther gains, particularly given already elevat-ed prot margins. This skepticism was clearly on

display last year, as stock prices decoupled romrecord high earnings, a refection o alling priceto earnings (PE) ratios. While the concerns have

The S&P 500 was clearly the besthouse in a bad neighborhood last year.


Source: Investment Strategy Group, Datastream, Robert Shiller

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.

Price to TrendEarnings

53.6%

Price to PeakEarnings

49.0%

Price to Book

44.6%

20%

0%

40%

60%

80%

100%

Exhibit 37: Decomposition of 2011 S&P 500 Return

Pervasive uncertainty pressured valuation multiples lower,

offsetting impressive earnings growth.



0%

2%

4%

6%

8%

10%

12%

14%

16%18%

20%

EarningsGrowth

15.9%

–15.9%

DividendYield

2.1%

TotalReturn

2.1%

MultipleCompression



36 Goldman Sachs

january 2012

been ill begotten thus ar, prot margins havehistorically been mean reverting, suggesting theskeptics will be proven right eventually.

That said, barring an exogenous shock, we do

not expect an imminent collapse in prot mar-gins this year. Importantly, mean reversion is notan independent orce, but rather a refection o underlying undamentals. As shown in Exhibit39, most o the shit in prot margins over thelast decade can be traced to globalization o themanuacturing supply chain. In act, plant-levelcosts as a percent o revenue ell nearly 6% overthis period, a unction o lower labor and otherinput costs.27 Because these margin gains werenot cyclically driven, their pace o mean rever-

sion is likely to be very gradual, despite somemanuacturers returning to US shores. Ater all,even three years rom now, Chinese labor costsare expected to be just a quarter o those in theUS.28 As such, our assumption o stable marginsis not a bet against mean reversion per se, butrather a view on its speed.

Closer to home, still-elevated US unemploy-ment and moderating infation should mitigatetwo traditional sources o margin pressure aswell. Meanwhile, the continued US growth we

expect this year also bodes well, since recessionshave historically precipitated collapsing margins.Finally, we note that margin up cycles tend to beenduring, with the previous two lasting almost sixyears. Applying the historical analogue literallysuggests margins will not peak until late 2014.

Against a backdrop o steady margins, weexpect earnings growth to continue to out-pace GDP growth. As Exhibit 40 makes clear,the S&P 500 is more leveraged to areas o theeconomy growing aster than domestic consump-tion, such as business spending, commoditiesand exports. For example, equipment & sot-ware spending is expected to grow at over threetimes the pace o GDP. Moreover, the continuedindustrialization o emerging markets remainsa tailwind to US based energy / materials rms.Already, last year’s strong third-quarter operat-ing earnings run rate suggests a 73% probabilitythat 2012 EPS will be at least $103. I realized,that would equate to prot growth o around

6%, above the level we expect or US GDP.

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.


Source: Investment Strategy Group, Bank of America Merrill Lynch

Business

Spending

Consumer

Staples

Spending

Energy/Commodities Financials

Medical

Spending

Consumer

Discretionary

Spending

21%

18%

17%

16%

14%

14%

Exhibit 39: US Manufacturing Plants (ex-Oil Refineries):

Changes in the Cost Structure from 1997 to 2009

Data as of September 2011


0.5%

–3.5%

–3.0%

–2.5%

–2.0%

–1.5%

–1.0%

–0.5%

0%

–0.2%

FringeBenefits

–2.3%

Wages

0.3%

Fuels andElectricity

–3.0%

Cost ofInputs

% of Revenue




Technicals

The S&P 500’s late 2011 rally has let it at a keytechnical decision point. On the one hand, theunderlying trend is improving, as the S&P 500

is back near its 200-day moving average, consid-ered the dividing line between technical strengthand weakness. On the other hand, the marketnow aces a confuence o overhead resistance,given the 200-day moving average overlaps witha downward-sloping trendline that has endedprevious rallies.

With the market at a crossroads, two actorsargue or prices resolving to the upside. First, thecontinued strength in the market’s breadth (thecumulative number o S&P 500 stocks advancing

less those declining) is positive, as this measuremoved decisively above its long-term averagein October and is approaching previous highs.This paints a very dierent picture rom thato late 2007 to early 2008, where deterioratingbreadth oreshadowed subsequent price weak-ness. Second, the market’s strong ourth quarterperormance (>10%) suggests urther near-termstrength. In act, ourth quarter returns greaterthan 10% have led to continued gains in the nextquarter 92% o the time since 1932. Notably,

the median gain was 5%, well above the 2%gain o any random quarter.29

Sentiment / Positioning

History teaches us that when investors are com-placent, eager to deploy capital, and obliviousto the downside risks, markets get into trouble.Thankully, none o these conditions exist inthe equity space today. As shown in Exhibit41, there have been $11.4 billion o outfowsrom US equity mutual unds in 2011, highlight-ing retail investors’ limited appetite or stocks.Indeed, last year was one o only six such yearssince 1992. Notably, the year ollowing theseepisodes registered a positive return 83% o thetime. This observation echoes the conclusion o a2008 academic paper, which ound a “signicantnegative correlation between sentiment-drivenund infows and uture returns.”30

Our View on the US Market

The net message o our equity ramework is thatstable margins, coupled with mid-single digitrevenue growth, will support slower, but stillpositive earnings gains. This, in turn, provides

a rising undamental foor or equity prices, asthe market ultimately ollows the path o earn-ings. As shown in Exhibit 42, this combinationsuggests price returns o around 8% to the mid-point o our orecast range this year.

We continue to like US nancials, and USbanks in particular, although we have admittedlybeen early in our enthusiasm. Our view rests onthe nancials’ attractive valuations, ortied bal-ance sheets, exposure to the stabilizing / improvingUS real estate market, improving loan growth,and nearly universal negative sentiment. O contrarian note, nancials have now underper-ormed the market or ve years running, a eat

Exhibit 41: 2011 Cumulative Mutual Fund

Flows to US Equities

Negative US equity mutual fund flows is a contrarian positive.


Source: Investment Strategy Group, AMG Data Services

–$15

–$10–$11.4

–$5

$0

$5

$10

$15

$20

$25

$30$35

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11

Billions

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



38 Goldman Sachs

january 2012

bested only by the utility sector in the run up tothe technology bubble. That said, utilities man-aged to outperorm the market by a staggering62 percentage points in 2000 as the losing streakabruptly ended. While we don’t expect a similarmagnitude o outperormance, we believe thereare catalysts on the horizon this year: the secondround o stress tests in March, urther clarity onregularly requirements and the expiring statute

o limitations on put backs or many o the worstmortgage vintages.

While history reminds us that prophecieso doom have been ar more plentiul than theprots that arose rom positioning or them, weacknowledge that this year’s outlook is raughtwith more risks than usual. Although strong UScorporate protability provides a bulwark, manyo the concerns we have discussed are political innature, resulting in asymmetric risks that under-mine undamental analysis. Moreover, neithervaluation nor supportive undamentals are abinding constraint in the short run, as what is at-tractively valued today can surely become moreso tomorrow.

Even so, part o our comort in remaininginvested stems rom the distinction we draw be-tween a mark-to-market loss, which results romprices being pulled away rom undamental valueby investor emotions, and a permanent impair-ment o capital, which typically results wheninvestors pay excessively high prices or purchaseexcessively leveraged companies. In our view, theUS market is neither excessively leveraged nor

overpriced.As such, price volatility notwithstanding, or

those investors who have rst ensured they havesucient “sleep well money” to actually sleepwell, we think it makes sense to build towardor maintain one’s strategic US equity allocationwhen valuations are air, as they are now. Onthis point, we make two additional observations.One, the next decade o US equity returns islikely to be better than the last, given that 160 o the past 176 years had a higher rolling 10-yearcompounded annual total return than today.31 Two, starting valuations are a key determinanto these long-run returns. In act, the normal-ized PE ratio explains 80% o the variability o market returns over a decade-long period.32 Forthe patient investor, today’s US equity market ispriced to deliver 7% normalized annual returnsover the next 10 years, lower than historical av-erage returns, but very attractive relative to cashand bond yields. I realized, these returns would

double the invested capital over this period.

Exhibit 42: ISG US Equity Scenarios – Year-End 2012



GOOD CASE (20%) CENTRAL CASE (55%) BAD CASE (25%)

End 2012 S&P 500 Earnings

S&P 500 Price-to-Trend Reported Earnings

End 2012 Fundamental Valuation Range

End 2012 S&P 500 Price Target

Op. Earnings $112

Rep. Earnings $106

Trend Rep. Earnings $78

Op. Earnings $97 - 102

Rep. Earnings $92 - 97

Trend Rep. Earnings $78

Op. Earnings ≤ $80

Rep. Earnings ≤ $64

Trend Rep. Earnings ≤ $78

1443 - 1560 1209 - 1443 858 - 1092

1450 1325 - 1400 1000

18.5 - 20.0x 15.5 - 18.5x 11 - 14x

We acknowledge that this year’soutlook is raught with more risksthan usual.




Eurozone Equities:Low Valuations, High Risk

Given the disparate scal and economic healtho the Eurozone’s core and periphery, it is notsurprising that sovereign ears have been the keydriver o Eurozone equities or the better part o two years, as seen in Exhibit 43. A unique ea-ture o 2011, however, was that concerns aboutperipheral solvency metastasized into existentialdoubts about the entire Eurozone. In turn, equitymarkets in the core were no longer immune tothe crisis, as evident in Germany’s 15% declinein 2011. Given the structural nature o the issues

and the lack o straightorward solutions, we ex-pect sovereign developments to remain a sourceo uncertainty, and hence volatility, or Eurozoneequities this year.

At the center o this uncertainty stand theEurozone banks, as they constitute over a th o the region’s market capitalization. In addition,their large holdings o Eurozone sovereign bondsrepresent a key ault line in the crisis. Clearly,there is no shortage o headwinds acing the sec-tor, including the risk o nationalization, realiza-

tion o private and sovereign credit losses, capitalraisings, deleveraging, and high unding costs.

That said, the market is well aware o thesechallenges, evident in the sector’s distressed 0.4Xbook value multiple. Even adjusting book valueor the prospective losses we expect, the resulting0.6X price to book multiple remains depressed.Nevertheless, the banks are no longer the onlysource o cheap valuation in Europe. Instead,2011’s broad-based weakness has pushed Euro-zone equities into the bottom quartile o theirhistorical valuation range. As a result, they nowtrade at a much bigger discount to US equitiesthan they have historically, as seen in Exhibit 44.

Given these broadly attractive valuations,we recommend a small tactical overweight toEuropean equities. O course, a air question iswhy own Eurozone equities at a time when theregion is not only embroiled in a sovereign crisis,but also a recession? In addition to the margin o saety provided by valuations, we highlight two

points.The rst is that the Eurozone is home toseveral o the world’s largest multinational

companies, with a valuable array o recognizablebrands (such as Total and LVMH Moet Hen-nessy in France, Siemens, SAP, BASF, Daimler,and BMW in Germany). Given their internationalootprint, many o these rms derive a majorityo their sales rom outside Europe. For example,

only one-third o LVMH’s sales emanate romEurope. Anheuser-Busch in Belgium, a moreextreme example, derives only 11% o its sales

–400

–300

–200

–100

0

100

200

300

400

500

600

Euro Stoxx 50

(LEFT SCALE)

Spanish Gov't Spreadsto German Bunds

(RIGHT SCALE)

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.

Data as of: December 31, 2011

Source: Investment Strategy Group, Bloomberg

Basis Points

1900

2400

2900

3400

3900

Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

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.


Source: Investment Strategy Group, Datastream, MSCI

–52.6%

–60%

–50%

–40%

–30%

–20%

–10%

0%

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Eurozone vs. US P/10yCF

HISTORICAL

AVERAGE

–32.9%



40 Goldman Sachs

january 2012

rom Europe, with the balance coming predomi-nantly rom the aster-growing US and emergingmarkets. In aggregate, approximately 45% o Eurozone companies’ sales come rom overseas.

We thereore expect high overseas exposure tomitigate, but not eliminate, the recessionary drag.Notably, today’s depressed valuations alreadyimply an earnings decline o around 9-16% or2012, consistent with the outcome we expect dueto alling sales and margin contraction.

The second point is that equity markets areorward-looking, as evidenced by their tendencyto peak prior to the beginning o recessions andbottom well beore GDP and earnings trough.European markets have been no exception, having

moved ahead o economic undamentals consis-tently in each o the ve recessions since 1970. Asa result, Eurozone equities may reach their troughlevel in early 2012, based on our expectation thatthe recession will likely end by mid-year.

UK Equities: Caught in the Middle

While UK valuations also stand below their long-term averages, they are not as attractive as Euro-zone equities given their relative outperormance.More specically, whereas broad UK valuationshave been lower 33% o the time historically,the comparable gure or the Eurozone is just14%. Moreover, while the FTSE 100 stands 17%below its 2007 peak price level, Eurozone equi-ties stand a ull 49% below. For these reasons,we do not include UK equities in the Eurozoneoverweight mentioned above.

Turning to 2012, we expect UK equities toremain caught in the middle. On the one hand,a gradual moderation in infation provides scopeor multiples to expand closer to their historicalaverage levels. On the other hand, low domesticgrowth and already above-trend earnings arelikely to limit any earnings upside. Moreover,the UK’s increasingly intertwined relationshipwith the Eurozone could overshadow any mod-eration in infation, pressuring multiples lower.

Taken together, these dynamics suggest less roomor upside.

Japanese Equities:Abandoned and Unloved

While the tragic Tohoku earthquake and unold-ing global growth slowdown have penalized

Japanese equities, along with our overweightposition, we continue to believe Japan oers acompelling risk/reward opportunity. This con-viction is heavily rooted in Japan’s valuations,which stand near their lowest levels since1970 on both an absolute and relative basis(Exhibit 45). In act, a remarkable 70% o thenearly 1,700 publicly-traded companies in theTopix trade below their book value versus just

16% in the US. Moreover, the Topix stands ata lower level today than it did in January 1984,despite the act that earnings have grown 45%over the period.

These low valuations stand at odds with therebuilding-led growth we expect in 2012. In act,the Japanese economy is likely to grow as ast asthe US and outgrow the European economies in2012. In our view, the combination o a support-ive economic backdrop with some prot marginexpansion will yield earnings growth around

5–10% in 2012, a aster rate than we expect in

1992 Through December 30, 2011

Note: Based on price to long-term cash flow, price to trailing 12 month cash flow, price to book,and price to peak earnings. The percent of time less than current is calculated on a cumulative

basis, i.e. at each point in time, the current valuation level is compared to valuations during allperiods prior to that point in time.

Source: Investment Strategy Group, Datastream, MSCI

Exhibit 45: Percent of Time that MSCI Japan

Valuations Have Been Lower than Current Levels

Japanese valuations stand near all time lows.

20%

0%

40%

60%

80%

100%

5-YR. AVG.15.3%

3-YR. AVG.6.7%

1.7%

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11




any o the other major equity regions. In starkcontrast, the market is currently implying anearnings decline o as much as 18%, again high-lighting the attractive valuation o the Topix. Fu-

ture earnings growth could also be supported byTokyo’s removal o a decades-old weapons ban,enabling Japanese rms to enter the large inter-national market or advanced weapon systems.

O course, given the persistent underperor-mance o Japanese equities, a key question iswhat will stop the recent selling trend amongoreign investors, who have historically been themarginal purchasers o Japanese equities? We seeseveral potential triggers.

First, Japanese rms have used low valuations

to increase share buybacks in recent quarters(Exhibit 46), partially osetting oreign sell-ing. With about $1 trillion in cash, they haveample resources to continue. These buybacks,coupled with an already attractive dividend yieldo 2.6%, resulted in a total shareholder yieldo 3.7% in 2011, according to estimates by ourcolleagues in Goldman Sachs Global InvestmentResearch.

Second, Japan is pursuing expansionary scal policies at a time when the rest o the developed

world is scally consolidating. Additionally, theBank o Japan has become more aggressive instemming the rise o the yen, having intervenedon three occasions in 2011. These actions areimportant, as global investors perceive yen ap-preciation to be negative or the Japanese corpo-rate sector.

Despite these catalysts, the outlook or Japanis not without risks. Clearly, the Japanese yencould always appreciate urther, despite increasedintervention eorts. In addition, while Japanesegrowth is likely to be the astest in the developedworld in 2012, investors will obviously discountits sustainability. Moreover, Japan’s large govern-ment debt load and scal decit leave it suscep-tible to the same market pressures Europe aces,although as we discussed earlier in our Japaneseeconomic outlook, we believe there are struc-tural dierences that mitigate the near-term risk.Finally, although Japan has very limited tradeand direct nancial exposure to Europe, it would

not be immune to the nancial market contagionresulting rom a Eurozone meltdown.

Emerging Market Equities:Still Too Early

What a dierence a year makes. At the outset o

2011, the emerging market (EM) outlook was acautionary tale, based on above-average valu-ations, loty earnings growth expectations andexuberant sentiment, all against an infationarybackdrop that threatened to pressure marginsand multiples alike. Ater a year o marked un-derperormance, which saw margins disappoint,valuations de-rate and EM equities all 20%in dollar terms, many o these imbalances havebeen rectied. In act, current EM valuations aretrading at around a 20% discount to their ownhistory and have been cheaper only 12% o thetime in the last 15 years. Moreover, last year’sroughly $40 billion in EM mutual und outfows suggests sentiment has cooled, a contrary posi-tive. Finally, slowing global growth has temperedinfationary pressures, providing cover or easierpolicy in 2012.

Against this backdrop, it might be temptingto overweight EM equities, a notion we continueto explore. That said, we think it is still too

early. While absolute valuations appear attrac-tive, relative valuations have simply returned to

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Data as of August 2011

Source: Investment Strategy Group, Goldman Sachs Global Investment Research

Exhibit 46: Topix Share Buybacks

Japanese firms are more aggressively repurchasing their shares.

¥0

¥50

¥100

¥150

¥200

¥250

¥300

¥350

20092010

2011

Billions



42 Goldman Sachs

january 2012

neutral levels, standing about 20% below thoseo the US. This discount is consistent with EM’s20% historical average discount, as well as the15–25% discount our work suggests is justied.

While some argue that emerging markets’superior growth deserves a premium valuation,we note that not all growth is created equal. Thebulk o emerging market earnings growth derivesrom adding additional capital, rather thangenerating a higher return on that capital. Towit, over the last seven years, US corporationshave produced a return on equity 2.5 percentagepoints higher than EM. Moreover, a recent studyound that while $100 o sales in the US gener-ates $8 o ree cash fow available to sharehold-

ers, the comparable gure in EM is hal thatamount.33 This lower-quality growth deservesa lower valuation multiple in our view, as doesemerging markets’ broader lack o transparency,poor governance and greater exposure to Euro-pean and Chinese tail risks.

Relative valuations are not the only actorgiving us pause. While this year’s expected EMreturns are consistent with other developedmarkets, they come with much higher volatility.In addition, there is scope or urther negative

earnings revisions. Consensus expectations or12% earnings gains are likely optimistic in our

view, as slowing growth has historically pres-sured EM margins (Exhibit 47). As a result, ourorecast assumes growth in the 5-10% range,more consistent with the 8% average over the

last 15 years. Lastly, although positive senti-ment toward EM has moderated rom the headylevels that prevailed in late 2010, und managersremain overweight EM relative to other marketsbased on recent survey data.34 As such, sentimentis not yet oering a contrarian buy signal.

In short, EM risk-adjusted expected returnsare not yet over our hurdle rate. Moreover, EMtends to outperorm other markets only ateran infection point in economic momentum,an event we do not expect until the middle o

the year. Consequently, we remain neutral EMequities at present, preerring to take exposurein markets with either better relative valuations,higher yield, or less volatility.

2012 Global Currency Outlook

Last year was a tale o two halves, as the trade-

weighted US dollar rst depreciated to itsweakest post-crisis level by mid-year but thenmanaged to recoup these losses, and then some,by year-end (Exhibit 48). The principal driverbehind these shits was the unolding crisis inEurope, evident in the strengthening o perceivedtraditional sae-haven currencies such as theUS dollar (USD) and Swiss ranc (CHF). Lessortunate, but similarly impacted, were emergingEuropean currencies, particularly those with thestrongest trade and nancial linkages to the Eu-rozone. Moreover, the correlation o EM curren-cies to risky assets reached record highs. In act,the six-month correlation between EM curren-cies and the S&P 500 nished last year at 80%.

While we expect broader risk appetite toremain a dominant infuence on currency move-ments this year, dierentiation is emerging. Asia,our avored currency bloc last year, held uprelatively well thanks to their strong undamen-tals, continued trade surplus and the stability o

the Chinese renminbi (up 5% vs. the US dollar).We expect the renminbi to appreciate urther in

Exhibit 47: Leading Economic Index and Emerging

Markets Earnings Growth

Leading indicators suggest EM earnings growth is vulnerable

to further slowing.

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

–60%

–40%

–20%

0%

20%

40%

60%

80%

100%

99 00 01 02 03 04 05 06 07 08 09 10 11

OECD EM Leading Index

YoY% Advanced 9 Months(LEFT SCALE)

EM Earnings Growth(RIGHT SCALE)

–15%

–10%

–5%

0%

5%

10%

15%

20%




ience, especially against a backdrop o decelerat-ing global growth, provides a urther tailwind.

While these actors, particularly valuation,support our strategically bullish view on the US

dollar, several shorter-term headwinds leave ustactically neutral. First, although other globalcentral banks are beginning to ease, they remainwell behind the US Federal Reserve. In turn, thisnegative “carry”, or dierence in local interestrates, places depreciation pressure on the curren-cy. Second, investor sentiment is quite bullish onthe dollar already, a contrarian negative. Finally,given the positive equity returns we expect thisyear, the USD’s negative correlation with risky as-sets in recent years is a urther dollar headwind.

Longer-term, concern about rising US indebt-edness could hurt the dollar, as could an unrulyrise in infation. That said, these remain lower-probability downside risks, not our central case.

Euro

Much to the chagrin o its numerous detractors,the euro has been, by ar, the most resilient Eu-ropean asset during the sovereign crisis. Indeed,despite European equities alling 17% in 2011,

the euro was down only 4% on a trade-weightedbasis. While the euro is somewhat undervaluedon a trade-weighted basis, this statistic masksa more nuanced valuation backdrop relative toother developed currencies. As already discussed,the euro is expensive against the USD, but under-valued against most other developed currencies,especially the Swiss ranc, the Japanese yen, andthe Australian dollar.

Other relevant actors are equally mixed orthe euro. On the one hand, short-term inter-est rates remain about 75 basis points higher inthe Eurozone than in the US, providing a posi-tive carry attractive to investors. In addition,sentiment and positioning are already very eurobearish, a contrarian positive. Moreover, someimprovement in sovereign tensions in 2012, aswell as a mid-year trough in growth, could beeuro positive.

On the other hand, we expect the ECB to cutrates urther in response to the crisis, which in

turn erodes this positive carry. Indeed, aggressiveECB action, including unsterilized quantitative

2012, albeit at a slower pace, given moderatingglobal growth and fattening reserve levels.

Outside the renminbi, we have ew directionalcurrency views this year. We are broadly neutralon the USD and pound sterling (GBP), as below-

trend growth and easier policy oset the litrom investors diversiying away rom the euro.For the euro, we expect the unolding recessionand consequently more dovish ECB to neutralizethe tailwind resulting rom some moderation insovereign risk this year. In contrast, we remainbearish on the yen, given its continued apprecia-tion and resulting overvaluation. Finally, whilewe think emerging market currencies oer anattractive mix o supportive valuations, highershort-term interest rates (“positive carry”) andhealthy underlying undamentals, a better entrypoint will likely present itsel, as we discuss later.

US Dollar

True to its sae haven status, the trade-weightedUS dollar has been a beneactor o ongoingEuropean stresses, up almost 9% in the last ourmonths o 2011. Even so, valuations remain attrac-tive, with the USD cheap against most developed

currencies, including its roughly 10% undervalua-tion vs. the euro. In addition, US economic resil-

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.


* Note: US Dollar Trade-Weighted Indecies are as of December 23, 2011Data as of December 31, 2011


92

94

96

98

100

102

104

106

108

110

Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11

USD Trade-Weighted Index (Broad)

USD Trade-Weighted Index(Major Partners)

USD vs. Emerging Markets FX

U S D S T R E N G T

H

U S D W E A K N E S S



44 Goldman Sachs

january 2012

policy is more o a neutral actor. Despite adovish BOJ, central banks in the US, the Euro-zone and the UK are also likely to maintain lowinterest rates or the oreseeable uture.

Against this backdrop, we retain a bearishbias on the JPY, refected in our recommendationto hedge the FX exposure in our Japanese equi-ties tactical tilt.

Emerging Market Currencies

There is much to like about emerging marketcurrency undamentals, particularly relative tothose in the developed world. Namely, their eco-nomic growth is aster, their public debt burden

is lower and their currencies are relatively under-valued given recent depreciation. Moreover, theirhigher local interest rates compared to those inthe US result in an attractive carry, a comparativeadvantage in a world o yield-hungry investorsacing the zero bound o policy rates in the US,the UK and Japan. This carry, in turn, provides atailwind or currency appreciation. For instance,short-term government securities in India andMexico, and several emerging European coun-tries, oer incremental yields o 3–8% relative to

US Treasury bills, as well as exposure to curren-cies that are 15–20% undervalued.

Despite these tempting positives, however,we think caution is warranted in the rst hal o 2012. More specically, given the numeroussources o European political uncertainty thatare likely in early 2012, and the US dollar’s ten-dency to act as a sae haven during bouts o riskaversion, we expect better risk-adjusted entrypoints later this year.

Asian Area Currencies

This year’s challenging external environmentwill be a serious headwind to the much-neededappreciation o Asian currencies. For example,slowing global growth will reduce demand orAsian exports, thereby eroding the size o thebalance o payment surpluses we expect. More-over, ongoing European uncertainties couldthreaten capital infows, despite central banks’

best eorts to boost domestic demand througheasier monetary policy. As such, we expect Asiancurrencies to remain beholden to broader risk

easing on a scale equivalent to that in the US andthe UK, could weaken the euro considerably. Inaddition, the unolding Eurozone recession is aclear negative or the euro. Perhaps most im-

portantly, the euro aces a small, but non-trivialprobability o extinction, given the ongoing sov-ereign debt crisis. In turn, this could urther pres-sure the euro as investors diversiy their holdingsout o the currency.

Given these competing tensions, we remainneutral on the euro or 2012.

British Pound

Ater alling about 25% during the nancial

crisis and recovering only marginally, the Britishpound is inexpensive against a range o devel-oped currencies. In act, it is about 10% under-valued relative to the euro, 25% relative to theyen and Swiss ranc and air value relative to theUS dollar. Despite these attractive valuations,we remain neutral on the pound and anticipateanother year o broadly range-bound trading.

Our view is predicated on several actors. Asis oten highlighted in the British media, mon-etary fexibility is a key advantage o not being

part o the European Monetary Union. Takingull advantage o this act, the Bank o Englandremains committed to easy monetary policy, astance we expect them to maintain through morequantitative easing measures this year. In addi-tion, persistently high UK infation should erodethe pound’s value over time. Moreover, posi-tioning and sentiment suggest investors alreadyexpect pound appreciation against the euro, acontrarian negative.

Yen

Like the US dollar, the JPY appreciated lastyear in response to rising global uncertainty, atestament to its perceived sae-haven status. Inresponse, the Ministry o Finance intervened re-peatedly in FX markets to slow yen appreciation.Even so, the yen has remained deant, nishing2011 near its all time highs.

This persistent strength has made the curren-

cy expensive, as it is now about 18% overvaluedvs. the US dollar. In addition, sentiment is posi-tive on the yen, a contrarian negative. Monetary




impressive, as they outperormed equities acrossthe world. Notably, 2011 was a reminder o theimportant strategic role bonds serve in a port-olio: they provided a meaningul hedge against

equity declines, despite the low level o rates atthe beginning o the year, they lowered overallportolio volatility, and they generated someincome—albeit at modest levels o about 3–5%,depending on the specic bond sector.

As result o this strong perormance, 10-yearrates are now just below 2% in both the US andGermany. In act, rates have not been this lowin the US since the early 1950s. With such lowstarting rates, the critical question acing inves-tors is what type o returns can be expected rom

xed income securities in 2012.In our view, two countervailing orces will

keep high quality xed income rates close to,or slightly higher than, current rates in the nextyear. On one hand, the key cyclical and structur-al concerns discussed earlier will put downwardpressure on rates as investors seek sae harbor inUS Treasuries, German Bunds and, or taxableUS investors, high quality municipal bonds. Onthe other hand, as concerns about the downsiderecede, interest rates will start to rise, pulled

higher by infation and the expectation o mon-etary policy normalization.

Despite these near-term competing tensions,it is inevitable that rates will rise over the next

appetite, and hence closely track the path o theS&P 500 well into 2012.

Even so, the Chinese renminbi is likely to ap-preciate urther in 2012. Importantly, a meaningul

depreciation o the renminbi is unlikely, given thethreat o protectionist measures rom Congress,as well as a desire to avoid competitive devalua-tions in Asia. Moreover, even i the European crisisescalates, we expect the renminbi to trade close toits government-determined target rate against theUS dollar – albeit with a bit more volatility than itexperienced during either the 1997-98 or 2008-10nancial crises. That said, with reserves stabilizing,export growth slowing and infation moderating, aslower 1–4% pace o appreciation is likely this year,

as the ever cautious Chinese policymakers wait orthe og over Europe to clear.

2012 Fixed Income Outlook

Fixed income securities, particularly those o the“sae harbor” governments, were one o the ew investment bright spots o 2011. As

shown in Exhibit 49, they provided attractiveabsolute returns, ranging rom about 5% in UScorporate high yield to as high as 36% in 30-yearTreasuries. Their relative returns were equally

Exhibit 49: Fixed Income Returns by Asset Class


Source: Investment Strategy Group, Barclays, JP Morgan

0%

5%

10%

15%

20%

25%

30%

35%

40%

30 yearUS Treasury

10 yearUS Treasury

Germany 7-10year (local)

Muni 10 year High Yield Muni EM LocalDebt (local)

EM Dollar High YieldCorporate

EMU 7-10 year(local)

35.6%

17.2%

12.9% 12.3%9.2% 8.4% 7.3%

5.0%2.5%



46 Goldman Sachs

january 2012

location to their “sleep well money.” As last yeardemonstrated, these bonds are a consistently reli-able hedge in the portolio. Second, i the FederalReserve were to undertake urther quantitative

easing, clients would orgo some reasonablereturns as interest rates all urther. Indeed, i theeconomic growth and the unemployment rate donot improve soon, even without urther down-side, there is some chance—albeit small--o ur-ther quantitative easing. A recent example wasSeptember 2011’s announcement o “OperationTwist,” whereby the Federal Reserve indicatedthat it would purchase $400 billion o Treasurysecurities with remaining maturities o 6 years to30 years, and sell an equal amount o Treasury

securities with remaining maturities o 3 years orless. Third, the Federal Reserve has already com-mitted to keep its policy rates on hold throughmid-2013. I this policy does not have the desiredeect, they might consider extending the periodto 2014, which could also result in a urtherdrop in long term rates. Fourth and nally,Treasury securities are one o the ew sub-assetclasses to hedge against unoreseen geopoliticalrisks such as increasing tensions in the PersianGul or the Korean Peninsula.

Turning to Treasury Infation-Protected Secu-rities (TIPS), we do not think they oer particu-larly compelling valuations or a ew reasons.For one, the infation rate at which they breakeven with xed-rate 10-year Treasuries is 2%, inline with our muted 2% infation expectationsor 2012. In addition, as shown in Exhibit 51,10-year TIPS have had a negative yield over thelast several months. Given the unavorable taxtreatment o TIPS (discussed in great length inour 2011 Outlook), we do not recommend own-ing them at this time.

US Municipal Bond Market

We think that US municipal rates will generallyollow the path o Treasury interest rates during2012. Whether we look at the absolute ater tax-yield dierentials between municipal bonds andTreasuries, or the more widely used ratio o mu-nicipal bonds to Treasury rates, municipal bonds

are generally in line with, to slightly cheaperthan, Treasury securities. Thus, given the absenceo any valuation dislocation, we think changes

several years: at current levels o interest ratesand roughly 2% infation, investors do not evenreceive a positive real yield. As a result, the ques-tion is not i rates will rise, but rather when they

will. On this point, we recognize that some mayargue that Japan had low rates or decades, sothe US and Germany could certainly ollow suit.But that comparison is completely invalid in ourview: when nominal rates in Japan dropped be-low 1.7% in 1997 and reached a low o 0.5% in2003, real rates ranged between 1.2% and 2.8%.In other words, unlike the US today, Japaneserates were never negative during this period dueto the country’s defationary environment.

Let’s review the specics o each market.

US Treasury Market

At the end o 2011, 3-month Treasury bills stoodat 0.01%, 10-year Treasury notes at 1.88% and30-year Treasury bonds were just 2.89%. By theend o 2012 we expect the 10-year Treasuryrate to rise moderately to somewhere between2% and 2.75%. I we assume the mid-point o our range or the end o 2012, the expectedreturns or 10-year Treasuries are negative as

shown in Exhibit 50. The returns are also nega-tive over a three-year horizon. In turn, suchpaltry returns have prompted us to underweightinvestment grade xed income.

That said, we are not recommending a zeroweight either. There are our main reasons.First, given that our US and European economicorecasts include a 30% downside probabilitythis year, clients should maintain a sucient al-

Exhibit 50: Prospective Returns on US

Fixed Income and Cash

Regardless of duration, prospective returns look unattractive.

3 year

1 year (Annualized)

Cash 0.0% 0.0%

Intermediate Duration –0.6% –1.1%

10 year Treasury –2.2% –2.5%






in Treasury rates (as discussed above) will be theprimary driver o municipal rates.

We also think that the systemic risk o dete-riorating nances that hovered over the munici-pal market has dissipated. Most states, througha combination o primarily lower expenditures,

higher taxes (revenues rom both a better eco-nomic backdrop and higher tax rates, includ-ing sales taxes), and earlier distributions rom2009’s American Recovery and ReinvestmentAct (ARRA), have improved their scal prolesover the last 2 years. As shown in Exhibit 52,state and local revenues have increased eightquarters in a row. While they still had a $91 bil-lion budget shortall (mostly a result o the $53billion drop in ARRA unds in 2012), all stateswith the exception o Minnesota passed theirbudgets on time, compared to nine late budgetstwo years ago. Even Illinois and Caliornia, twostates with the lowest credit ratings, managed topass their budgets on time. Lastly, while somehave raised concerns about underunded long-term pension liabilities, we do not think it is anissue or 2012.

The supply and demand picture will be sup-portive o municipal bonds as well. As shown inExhibit 53, net new issuance in the US was actu-

ally a negative $62 billion in 2011, i.e. the vol-ume o new issuance did not oset the volume o bonds that were redeemed. Notably, this was the

Exhibit 51: 10-Year TIPS Yield and Breakeven Inflation

TIPS’ negative yield and poor tax treatment make them

unattractive, in our view.



–0.1%

2.0%

–0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Dec-10 Mar-11 Jun-11 Sep-11 Dec-11

10-Year TIPS Yield

10-Year Breakeven Inflation

Exhibit 53: Municipal Issuance by Year

Shrinking net supply is supportive of municipal bonds. .


Source: Investment Strategy Group, Federal Reserve, JP Morgan, Bank of America, Citigroup,

Morgan Stanley

383424

386407

431

287

334

168

236

95

155

98

–62

–11

–$100

0

$100

$200

$300

$400

$500

$600

06 07 08 09 10 11 12E

Billions

Gross Issuance

Net Change in Outstanding Debt

Exhibit 52: US State and Local Government

Revenue Growth

State and local government revenues have increased eight

quarters in a row.

Data as of Q3 2011

Source: Investment Strategy Group, US Census Bureau

4.1%

1.0%

–15%

–10%

–5%

0%

5%

10%

15%

20%State and Local Total Revenues

Revenues from Property Taxes

YoY%

2008 2009 2010 2011Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3



48 Goldman Sachs

january 2012

at their strategic weight in high yield munici-pals. The only reason we do not recommend anoverweight is the act that high yield municipalbonds tend to have longer maturities. Given our

view o generally rising rates at some point overthe next ew years, we would not recommend anoverweight to such long maturity securities.

In summary, we think that clients shouldmoderately underweight their high quality mu-nicipal bonds to und various tactical tilts. Thatsaid, clients should not go to a zero weightingor the same reasons we would not recommenda zero weighting to Treasuries. Finally, we adviseclients to be ully invested in high yield municipalbonds at the customized strategic allocation.

US Corporate High Yield

Ater returning 58% in 2009 and 15% in 2010,corporate high yield’s 5% gain last year mayseem paltry by comparison. But as Exhibit 33showcased earlier, this mid-single digit returnwas nonetheless impressive, particularly consid-ering the dismal perormance o most risky assetslast year. O course, the most pertinent ques-tion or investors now is whether this streak o

positive returns is sustainable in 2012, given thepervasive macroeconomic headwinds. We believeit is.

Our optimism refects several actors, not theleast o which is our view that today’s high yieldspreads more than compensate investors or thelikely path o deaults. Indeed, despite recentimprovement in US economic data, high yieldspreads nished last year at 699 basis points(bps), well above the 522bps average over the lastdecade. Notably, actual deaults would have tobe greater than 10% to erode this spread ully.36 Viewed another way, the market seems to bediscounting deaults o around 7%, based on theexcess spread over actual deault losses that in-vestors have demanded historically. As shown inExhibit 54, this implied deault level is more than3 times the actual trailing deault rate, well abovethe year-ahead base case orecast o Moody’s, andin act, not ar rom their adverse scenario, whichincorporates “a double dip recession in the US.”

Given our view that the US expansion continuesin 2012, we see scope or spread compression asmacroeconomic ears recede.

rst contraction in the size o the municipal mar-ket since 1996, compared with an average annualincrease o $104 billion over the last ve years.

Finally, as municipal nances have improved,

the rampant concerns about municipal deaultshave also dissipated. Throughout 2010, manycommentators orecasted record deaults thatnever materialized in 2011. That is not to saythat the municipal market did not have some de-aults and bankruptcies. In act, there were threeChapter 9 bankruptcy lings that garnered con-siderable press: Jeerson Country, Alabama dueto a sewer system overhaul; Harrisburg, Penn-sylvania due to an expensive trash incineratorproject; and Central Falls, Rhode Island with a

population o just 19k. A November Bloombergstory pointed out that the rst two had “com-monalities in the conditions that brought themto bankruptcy: risky debt structure, politicalailures and ocials who spent taxpayer moneywith little oversight.”35 Despite these headline-grabbing bankruptcies, overall deaults throughNovember 2011 totaled just $2.1 billion, a mere0.06% o the total outstanding market value o municipal debt. As beore, we don’t anticipateany meaningul deaults or bankruptcies among

higher quality municipal bonds and those thatdo occur, will probably be concentrated in theunrated market.

One o the ew areas that provides an attrac-tive relative return is the high yield sector o themunicipal market, which oers an incrementalyield o 3.8% over similar maturity, high qualitymunicipal bonds. Adjusting or deault rates o between 1% and 2% and conservative recoveryrates o about 60%, high yield municipal bondswill most likely outperorm similar maturityTreasuries and high quality municipal bonds.Hence, we recommend clients stay ully invested

In summary, we think that clientsshould moderately underweighttheir high quality municipal bondsto und various tactical tilts.




Even i a recession were to occur, we thinkthe magnitude o deaults has been reduced inat least three ways. First, high yield companieshave aggressively renanced and extended their

debt maturities, which lowers their leverage anduture debt renancing risk. Indeed, 67% o allissuance over the past 3 years has been used torenance existing debt, vs. only 38% in the threeyears ending mid-2008.37 As a result, the amounto debt scheduled to mature in the next threeyears has dropped by nearly $600 billion sincethe end 2008, greatly reducing the much eared“wall o maturities.” Second, underlying creditundamentals have been bolstered, as high yieldissuers today hold almost $2 in cash or every $1

in short term debt. This ratio stood around 1 in2007. Lastly, many o the weakest credits havealready deaulted / restructured during the nan-cial crisis, reducing the deault loss content o thehigh yield universe.

In addition, we note the high yield technicalbackdrop is much more avorable today, suggest-ing a repeat o the dramatic increase in spreadsthat occurred during the nancial crisis is lesslikely, even in an adverse scenario. As shown inExhibit 55, dealer inventories stand at all time

lows today, a very dierent backdrop rom thebloated positions that necessitated orced sellingduring the nancial crisis. Similarly, the potentialor orphaned bridge loans and CLO warehousesales to pressure spreads meaningully wider isalso materially lower today, as shown in Ex-hibit 56. Finally, the “search or yield” shouldcontinue to benet high yield bonds, given thenegligible returns we expect in cash and mostgovernment securities.

Taking these actors together, we expect cor-porate high yield to deliver around 12% returnsthis year, making it an extremely attractive risk-adjusted investment opportunity, in our view.

Today’s high yield spreads morethan compensate investors or thelikely path o deaults.

Exhibit 54: High Yield Corporate Bond Default Rates

Today's spreads look attractive relative to expected defaults.


* Implied defaults assume 30% recovery and historical excess premium of approximately 250 bps

Source: Investment Strategy Group, Barclays, Moodys

0%

2%

4%

6%

8%

10%

12%

Required toFully Erode

Current Spread

10.7%

Implied GivenHistorical Excess

Spread*

6.8%

Trailing12 Month

2.0%

BASE

2.4%

ADVERSE

8.3%

Moody's Twelve MonthForward Forecast



50 Goldman Sachs

january 2012

Eurozone Bonds

Just as mortgage-backed securities were theepicenter o the nancial crisis in 2008, xedincome securities o the peripheral Eurozone

countries were the epicenter o the sovereign debtcrisis in 2011. As shown in Exhibits 57 and 58,spreads widened across all the GIIPS countries,with the greatest widening in Greece, with yieldlevels implying almost 100% probability o adeep sovereign bond restructuring in 2012. Evena core eurozone country like France saw somespread widening.

As a result, there was a big divergence inreturns between German Bunds and other Eu-rozone country bonds. As shown in Exhibit 59,

while Germany had a total return o 12.9% lastyear, the returns in the much o the peripherywere much worse, with Italy -6.9%, Portugal-31.1% and Greece a staggering -57.8%. Spainperormed relatively well, returning 9.3% andIreland generated a 12.7% return. Needless tosay, Ireland providing a return that was only0.2% behind the sae harbor returns o GermanBunds was quite the surprise in 2011!

Like US Treasuries, German Bunds benet-ted rom their sae harbor status relative to other

European bonds, dropping to their lowest levelsin the post-World War II period. And like USTreasuries, German Bund rates are expected torise modestly rom year-end levels o 1.82% tosomewhere between 2.25% and 3.00% in 2012.In act, we expect German rates to start normaliz-ing later in 2012 as the German economy recoversand the worst o the sovereign crisis is behind us.

In our central case o a mild European reces-sion, along with a relatively orderly Greek debtrestructuring and urther progress toward scalintegration we think the spreads o the peripheralcountries are likely to tighten relative to GermanBunds, with Greece and possibly Portugal pro-viding the exception. While this tightening willprovide attractive long-term returns, we expectconsiderable interim volatility as policymakerswill continue to pursue an incremental, reactiveand inconsistent approach.

O course, the sovereign debt crisis is raughtwith risk: any policy mistake at the supra-nation-

Exhibit 56: Bridge Loans and CLO Warehouses

The high yield market's technical backdrop is much better today.


Source: Investment Strategy Group, JP Morgan

0

$50

$100

$150

$200

$250

$300

$350

$45

$1.5

CLO Warehouses

$20

Bridge Loan Risk

$330

Today

2007/2008

Billions

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.

1.2%

0%

2%

4%

6%

8%

10%

12%

01 02 03 04 05 06 07 08 09 10 11


Source: Investment Strategy Group, Bank of America Merrill Lynch, Datastream, Federal Reserve

Bank of New York




al or national level, or the loss o control by anyleader due to internal strie arising rom austeritymeasures, would have negative consequence orthe nancial markets. Moreover, the recession

could also be deeper as result o a weaker globalbackdrop or the unintended consequences o greater austerity measures. In such a scenario,German rates would all and incremental yieldsacross peripheral and semi-peripheral countrieswill increase substantially. In turn, peripheralbonds may then have negative returns approach-ing what we saw in Portugal in 2011. While sucha scenario is not our central case, it is also not azero-probability outcome, perhaps more like a10–15% probability.

In summary, we recommend clients maintainGerman Bunds and other high quality bonds intheir sleep well basket. For those who can with-stand the volatility, a limited exposure to periph-eral debt is also appropriate given the currentlevel o spreads.

Exhibit 57: Five-Year Government Bond Spreads

Over Germany

Spreads have widened across all the GIIPS countries.



0

110

330

539

Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11

100

200

300

400

500

600

700

France

Spain

Italy

Basis Points

Exhibit 59: European Sovereign Bond Returns

Spread widening has driven negative returns for peripheral

bond holders.


Source: Investment Strategy Group, JP Morgan

12.9% 12.7%9.3%

6.0%2.5%

–6.9%

–31.1%

–57.8%

–70%

–60%

–50%

–40%

–30%

–20%

–10%

0%

10%

20%

Germany Ireland Spain France EMU Italy Portugal Greece

Exhibit 58: Five-Year Government Bond Spreads

Over Germany

Eurozone tensions have dramatically increased funding

costs for peripheral sovereigns.



1502

686

5163

Portugal

Ireland

Greece (RIGHT SCALE)

–1000

0

1000

2000

3000

4000

5000

6000

08 09 10 11–500

0

1000

500

1500

2000

2500

3000Basis Points



52 Goldman Sachs

january 2012

2012 Global Commodity Outlook

A mix o geopolitical instability, adverse weatherand macroeconomic worries led to another

volatile year or commodities. When all wassaid and done, the S&P GSCI broad commodityindex nished down slightly or the year, asshown in Exhibit 60. This relatively fat nishmasked a tale o two halves, evident in manyassets last year, as commodities rose rapidlyin the rst hal o the year, only to weaken inthe second hal. While broader risk aversionwas a stronger infuence in the latter part o 2011, several idiosyncratic actors proved moredecisive or commodities in the rst hal, as we

discuss next.In energy, the Arab Spring resulted in the

loss o 1.2 million barrels per day o Libyancrude oil exports or most o the year, pushingWTI prices close to $115/barrel and Brent pricesclose to $125/barrel.38 Meanwhile, droughts inEurope and Russia, a wet spring and a summerheat wave in the US sent corn prices close to $8/ bushel, soybeans to $14.5/bushel and wheat toalmost $9/bushel. Even so, agriculture prices arestill down between 20–30% rom their peaks, as

crop damage turned out to be less than eared.Given the interplay o commodity specic

actors and general risk appetite, the correlationo commodities with equities and the US dollarwas quite unstable. In the rst hal o the year, theS&P GSCI’s 180-day correlation to the S&P500collapsed rom 64% to just 11% in June, beoreclimbing back to around 56% currently. Similar-ly, the S&P GSCI correlation to the dollar index

Emerging Market Local Currency Debt

Emerging market local currency debt (EMLD)declined about 2% in dollar terms in 2011 ascurrency weakness, especially in emerging Eu-

rope and Arica, more than oset the 8% gainrom the underlying bonds. Notwithstanding itsrecent volatility, EMLD still benets rom severalpowerul tailwinds: at 45% o GDP (in 2011),government debt o the EM countries underly-ing this asset class is less than hal that o theadvanced world. Second, the 6.6% spread o EMlocal bonds relative to US and European debt isclose to its highest level in a decade. And nally,despite an investable market capitalization o over $800 billion – about the same size as US

high yield – EMLD remains a relatively untappedasset class with oreign institutional investors ac-counting or only about 10% o the universe.

For these reasons, we remain structurallypositive in the medium term. Our shorter-termview, however, is more cautious. Although weexpect the underlying bonds to return 4–8%by the end o 2012, perormance in the interimcould be highly volatile given the unoldingEuropean recession and the high correlation o EM currencies to global risk appetite. Indeed,

we have long maintained EMLD is a risky assetclass and should not be a substitute or a client’s“sleep-well” money. Thus, in the current vola-tile environment, we recommend only a modesttactical overweight to EMLD, coupled with ahedge against euro depreciation versus the dollar.The purpose o the hedge is to reduce the eecto any downdrats emanating rom the Europeansovereign debt crisis.

Exhibit 60: Commodity Returns in 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.


S&P GSCI Energy

Industrial

Metals

Precious

MetalsAgriculture Livestock

2011 Avg. Spot Price vs. 2010 Avg. Spot Price

Spot Return

Total Return*

27% 27% 34% 13% 35% 10%

2% 9% –15% –21% 7% 11%

–1% 5% –16% –22% 7% –1%




ell rom around -45% in January to around-29%, beore rising to around -62% currently.This correlation instability underscores howrising risk aversion can oten trump otherwise

positive idiosyncratic actors in shaping theperormance o commodities.

Oil: Balancing Act

As we look orward to 2012, a look backreveals two consecutive years o demandoutpacing supply, as shown in Exhibit 61. Theresult has been alling inventory levels, evidentin the ratio o OECD inventories to worldconsumption nearing its lowest point since

2007 (Exhibit 62). Against this backdrop,the key question or oil prices in 2012 iswhether this trend o inventory depletion willcontinue or stabilize. Ater all, the slowingglobal growth we expect this year couldenable production to overtake demand, nallyallowing inventories to stabilize or even build.

To address this question, let us rst reviewthe demand backdrop, particularly or China.Consensus expectations or global oil demandgrowth are 0.9–1.3 million b/d (or 1–1.5%),

with all o the growth coming rom emergingmarket economies. Indeed, Middle East demandalone is growing 0.2–0.3 million b/d per year,while Chinese demand is now close to 10 mil-lion b/d (11% o the world), having grown anestimated 5.7% in 2011 (+0.5 million b/d). Mostanalysts expect growth o 5.0–5.5% or China in2012, which is slightly below the ve-year aver-age growth rate o 5.8%. On the upside, China’sdemand could exceed expectations on the backo restocking o commercial inventories, as wellas lling newly built strategic petroleum reserveacilities. On the downside, China’s demandcould disappoint based on a sharper than antici-pated slowdown in industrial production andglobal growth. O the two possibilities, we havemore sympathy or the latter, concluding thatthe risks to China’s oil demand are skewed to thedownside or 2012.

While emerging markets are the clearestsource o oil demand growth, the developed mar-

kets still represent the bulk o absolute demand.Worryingly, OECD demand remains depressedand in some areas is contracting. For example,

Exhibit 62: OECD Inventories vs. World Consumption

Inventories stand at low levels relative to consumption.

Data as of Q4 2011E

Source: Investment Strategy Group, International Energy Agency

28

29

30

31

32

33

34

35Days of world demand

Mar-00 Jun-01 Sep-02 Dec-03 Mar-05 Jun-06 Sep-07 Dec-08 Mar-10 Jun-11

29.0

32.5

29.3

Exhibit 61: Global Oil Supply and Demand

Demand outpacing supply has pressured inventories in recent years.

Data as of 2011E

Source: Investment Strategy Group, International Energy Agency

84

85

86

87

88

89

90

05 06 07 08 09 10 11e

World

Demand

World Production

World consumption exceeded production in

the past two years

Millions ofBarrels per Day



54 Goldman Sachs

january 2012

consensus expects a urther decline in the UnitedStates’ roughly 19 million b/d demand run rate,despite the act that it already stands close tothe level reach during the 2009 nancial crisis.

Notably, US oil usage represents about 21% o 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.

O course, there are clearly upside as well asdownside risks to the ultimate OECD demandnumbers. For example, a recession in Europeor the US could hurt demand, while continuedresilience in the US could bolster it. Even so, oureconomic orecasts accord a greater weight to

the downside risks in 2012, refecting the mul-tiple sources o uncertainty and their perniciouseects on growth.

Turning to supply, there is certainly room orproduction growth to accelerate relative to lastyear. On this point, non-OPEC supply provedparticularly disappointing in 2011, providingscope or catch up in 2012. To be air, produc-tion did grow in the US (+0.22 million b/d), Rus-sia (+0.12 million b/d) and Canada (+0.1 millionb/d). However, a series o unplanned outages in

the North Sea, Brazil, Argentina, Malaysia andYemen more than oset this. However, as manyo these disruptions are now being resolved, it islikely that some o the growth expected in 2011would be realized now instead.

Prospects or supply growth are particularlypromising or US shale, Canadian oil sands, inthe deepwater o Brazil and China, and in Rus-sia’s low-cost Siberian elds. As has been thecase in the past ew years, natural gas liquidsrom OPEC, which are not subject to quotas andare used in certain petrochemical applications,could supplement this growth by +0.3-0.4 mil-

lion b/d. As a result, total non-OPEC productiongrowth could range rom 0.7-1.5 million b/d.The higher end o this range, i achieved, couldbe enough to meet demand growth in 2012.

For its part, OPEC production ell short o demand in 2011, as evidenced by the decline ininventories and an estimated 0.7 million b/d supply/ demand imbalance. To remedy this imbalance in2012, OPEC would need to ll that 0.7 millionb/d gap, plus or minus any additional mismatchbetween demand and supply growth. Since non-OPEC production growth (0.7-1.5 million b/d)could potentially be aster than demand growth(1.0-1.3 million b/d), there is a possibility thatOPEC would actually lower its production.

Indeed, on December 14, 2011, OPEC decidedon a production ceiling o 30 million b/d goingorward, which is an estimated 0.5-0.7 millionb/d less than it is currently producing.

While cuts in OPEC production hurt the sup-ply backdrop, there are notable osets. Libyanproduction is rebounding aster than expectedand is now almost hal its pre-war level. At thispace, Libyan production could grow another0.5-0.8 million b/d by the end o 2012. In Iraq,the recent return o super-majors such as Exxon

looks promising, and production is expected toincrease by up to 0.3 mm b/d in 2012. In orderto enorce the 30 million b/d ceiling, such pro-duction recovery would need to be counterbal-anced through lower output elsewhere to avoidoversupply and excessive price weakness. SaudiArabia, which increased production in 2011 tooset the loss o Libyan crude, looks like themost likely candidate to trim production.

In short, a combination o slower globaldemand growth, a rebound in non-OPEC supply,and positive production prospects within OPECmay rebalance the global oil market in 2012 andput an end to inventory declines. In our view, thiscombination makes oil prices reaching the highso 2011 unlikely, barring geopolitical shocks,especially related to Iran and Iraq.

That said, sustained and signicant down-side price risks, barring a global recession, lookequally unlikely. On this point, a recent studyrom the International Institute o Finance (IIF)

conrms that Saudi Arabia needs an oil price o at least $80/barrel to balance its budget, given

Putting it all together, our basecase scenario envisions a range o $75-$105 or WTI and $85-$115or Brent.




actors. The low real interest rates we expect in2012 continue to limit the opportunity cost o holding no-yield assets, such as gold. Moreover,gold continues to oer perceived diversication

benets, to not only consumers but also centralbanks. For example, Chinese demand contin-ues to increase as the country’s gold market isderegulated and households seek alternatives toreal estate and stock investments. Furthermore,European demand or physical gold could alsobenet rom ongoing ears o Eurozone disinte-gration, although this thesis has not helped goldprices lately. Finally, world jewelry demand hasheld up well thus ar, despite the pervasive macroconcerns.

That said, we note three key dierences intoday’s demand backdrop compared to the lastew years. First, investment demand appears tobe fattening, in stark contrast to its consistentgrowth in the last several years. Specically, theWorld Gold Council’s estimates show that totalinvestment demand (ETFs and physical gold)remained essentially fat year-over-year through3Q11. In act, asset growth in ETFs has actuallybeen decelerating over the past ew months, asshown in Exhibit 63. Perhaps this is not surpris-

ing, considering investment demand alreadyrepresents a historically high 39% o totaldemand. Notably, the 1980 peak in gold pricescorresponded to this ratio reaching 45%.

O course, some o this could simply refectselect hedge unds liquidating their large goldholdings to oset losses elsewhere, as well as ageneral dash or cash and liquidity.

Even so, we do not nd these explanationspersuasive enough to account or the entire shit.In our view, this recent sotening, coupled withour medium-term constructive view on the USdollar and expectation that core infation willremain around 2%, are not supportive o invest-ment demand growth.

Second, while overall jewelry demand hasbeen stable, India, the world’s largest consumero gold jewelry, saw its demand all or the rsttime in two years. In act, the 26% drop vs. thethird quarter o 2010 was the largest quarterlydecline since early 2008. This dramatic all

refected a combination o weak growth, highgold prices and the 18% depreciation in the

the recent increase in social spending. Moreover,the global oil market has also been running a de-icit or two years, so prices need to remain highenough to discourage consumption and allow

supply to catch up. Finally, oil continues to havea positive correlation with S&P 500, implyingthat our constructive stance on equities in 2012should also provide some support or oil pricesas well.

Putting it all together, our base case scenarioenvisions a range o $75-$105 or WTI and $85-$115 or Brent. While wide, these ranges refect aone standard deviation move within oil’s 35%-40% annualized volatility. While not our basecase, a signicant oil shock resulting rom geo-

political unrest in the Middle East could push oilprices meaningully higher, a concern we discussurther in our Key Risks section.

Gold: Tarnished Safe Harbor

“Bewitched, bothered and bewildered – thatis how many gold investors have elt in recentmonths.”39 Indeed, ater hitting a record o $1,921/troy ounce on September 6, goldcollapsed 20% within a month, its sharpest

drop since 1983. In the process, gold broke athree-year uptrend, evident in its breach o,and inability to recapture, its 200-day movingaverage o prices. Ever since, it has remainedvolatile, trading in a range o $1,550-1,750 pertroy ounce. In act, realized volatility this yearrose to 25% rom 15% at the end o 2010.

While gold’s increasing downside volatilityis troubling in its own right, that it comes at atime o intensiying global systemic risks, theo-retically a tailwind or gold prices, is even moreso. In turn, gold’s distinction as a sae havenasset has been tarnished. Ater all, US Treasuriesoutperormed gold by 7% last year, despite hav-ing volatility 3.5 times less. Moreover, whereasgold was positively correlated with risky assetslast year, evident in its 23% correlation with theS&P 500, Treasuries displayed a negative 73%correlation. Perhaps a recent Wall Street Jour-nal headline said it best: “With sae havens likethese, who needs risky assets?” 40

In thinking about the trajectory o gold orthis year, there are undoubtedly some supportive



56 Goldman Sachs

january 2012

value o the Indian rupee. Going orward,the risk is that the same high gold prices,slowing global growth, and weak currencythat negatively aected Indian demand could

push other emerging market consumers downthe same path.

Third and nally, unlike previous years, netcentral bank purchases were the marginal drivero gold prices in 2011. In the rst three quarterso the year, the ocial sector accounted or 349tonnes o known net gold purchases, an amount4.5 times higher than their 2010 purchases (76tonnes). Moreover, this buying stood in starkcontrast to the past two decades, when the o-cial sector was actually a net supplier o gold.

Indeed, as shown in Exhibit 64, one needs to goback to 1980 to nd net ocial sector demand inexcess o 200 tonnes. Clearly, a continuation o current policies o reserve diversication wouldbe a tailwind or gold prices.

Nevertheless, because central bank purchasesare policy-driven, it is dicult to assess whatmight come in the uture. Consider two observa-tions. One, strong ocial sector demand actu-ally marked the peak o gold prices in 1980, ascentral banks eectively priced out other gold

consumers. In act, despite central banks remain-ing net buyers during that time, prices contin-ued to all on the back o collapsing investmentdemand. Two, Eurozone central banks may endup selling some gold reserves to provide undingor various liquidity acilities this year. Ater all,these banks own about 10,800 tonnes o gold.While they have sold virtually none o theseholdings in the past two years, the Central BankGold Agreement permits them to sell as much as400 tonnes per year, a right they utilized in theprior decade.

Relative to the shits in the demand land-scape, gold’s supply dynamics appear monoto-nous in comparison, with mine production grow-ing slowly and scrap supply fat in 2011. Thatsaid, there are several key risks on the horizon.First, gold miners have nished removing theprice hedges on their orward production. I theybecame concerned prices might all urther, theirattempts to lock in prevailing prices would not

only accelerate gold supply (in the orm o or-ward sales), but also potentially be interpreted as

Exhibit 63: Monthly Change in Gold ETF Holdings

Gold ETF flows have been decelerating over the past few months.



–100

–50

50

0

100

150

200

250

06 07 08 09 10 11

Monthly Change

12 MonthMoving Average

Exhibit 64: Net Purchases of Gold by the

Official Sector

Central Banks tend to be large net buyers of gold aroundmarket peaks.

Data as of Q4 2011

Source: Investment Strategy Group, World Gold Council, CPM Gold Yearbook, Bloomberg

Official Sector NetSupply / Demand(LEFT SCALE)

Real AverageGold PriceJan. 2011 USD

(RIGHT SCALE)–400

–200

0

200

400

600

800

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

Tonnes

N E T S U P P L Y

72 75 78 81 84 87 90 93 96 99 02 05 08 11

USD / Troy ounce,in Jan. 2011 dollars

N E T D E M A N D




a sell signal by many investors. In addition, simi-lar to central banks’ dual role as both a buyerand seller, investors themselves could potentiallybecome a large source o supply, i and when sen-

timent turns. In act, the current ETF stockpile o around 2,320 tonnes is roughly the same as a ullyear o global gold production. While these bear-ish supply risks might be longer term in nature,we think they are important considerations orgold buyers today.

Overall, we believe that an increasingly un-balanced demand picture, higher volatility, priceswell above their historical average and erosion inits sae harbor distinction continue to warrant acautious view toward gold.

Key Global Risks

In any given year, the risk that an exogenousshock renders an otherwise thoughtul outlookdead on arrival is present, but this year it seemsparticularly acute. Even worse, many o today’smost pernicious threats are political in nature,

resulting in asymmetric risks that underminethe value o rigorous undamental analysis. O equal importance, the market’s saety net is get-ting threadbare, as scal constraints and manycentral banks at the zero bound leave policymak-ers with ewer tools to address any new sourceso stress. In short, while the probability o a trulydestabilizing event remains low, the penalty orbeing wrong has risen.

The risks that ollow, while by no meansexhaustive, represent those that would be mostdetrimental to our central case view:

Escalating Eurozone Crisis Throughout theOutlook, we have argued that Eurozone politi-cians, when pushed, will ultimately demonstratethe political will necessary to keep the Eurozoneintact. Even so, the wide range o interests atplay and actors involved, including politicians,investors, citizens, unions, and various otherspecial interest groups, raises the potential or

accidents, as politicians could simply lose controlo the process. Moreover, the oten mutually ex-

clusive interests o the parties urther exacerbatethe risk o contagion.

Needless to say, a disorderly deault, a orcedor unexpected departure o a Eurozone member

or a conscious decision by the parties involvedto disband the EU could be devastating, giventhe global legal, trade and nancial linkagesinvolved.

Hard Landing in China With China a keycontributor to global demand and growth, ahard landing here would have negative repercus-sions across the ull spectrum o asset markets,particularly in commodities and other emergingmarkets.

Additional Sovereign Debt / Currency Crises As the unolding crisis in Europe is clearlydemonstrating, markets are losing patience withexcessive sovereign debt levels. Unortunately,many governments in the developed economiesrun large decits and have historically high debt/ GDP ratios. Moreover, structural actors, suchas demographics, are projected to raise health-care costs and pension benets in many o them,urther exacerbating debt levels. Failure to imple-

ment credible scal consolidation plans couldlead to a loss o market condence. The result isdramatically higher interest rates and dicultymeeting debt servicing costs, as we have seen inEurope.

Major Geopolitical Event An outbreak o war,a major terrorist act or simply a greater prob-ability o either one could undermine condence,disrupt trade and cause an economically damag-ing spike in oil prices. In act, several conceiv-able developments could signicantly interruptoil exports this year. Chie among these is Iran’srecent threat to close the Strait o Hormuz, theonly sea passage to the open ocean or much o the Persian Gul and a strategic choke point thatrepresents 35% o the world’s seaborne oil ship-ments, and 20 percent o oil traded worldwide.41 While a closure seems unlikely, the strait is still34 miles wide at its narrowest point ater all, itcould be highly disruptive i the threat material-

ized. Aside rom the Straits, the erstwhile stabil-ity o Iraq’s oil exports is also at risk, given the



58 Goldman Sachs

january 2012

imminent withdrawal o US orces, as well as thepotential inadequacy o the Iraqi security servicesto contain growing militia violence. In addition,the risk o an outright skirmish between Iran

and Israel is non-trivial, particularly given thepower vacuum likely to ollow the US military’sdeparture. Lastly, ongoing social revolution inthe Middle East, embodied in last year’s “ArabSpring,” represents a urther risk to oil produc-tion rom the area. Elsewhere, the unoldingleadership change in the always-quixotic NorthKorean regime represents another geopoliticalfashpoint.

Trade War / Protectionism Although a variation

o a policy error, a trade war resulting rom theimplementation o protectionist policies couldhobble global trade and thereby hurt growth, asit did during the Great Depression. Moreover,given the importance globalization o the sup-ply chain has played in increasing S&P protmargins, a meaningul increase in protectionismcould undermine US corporate protability andpressure US equity markets.

US Housing While low-single-digit home price

movements up or down are unlikely to havea material impact on our view, a renewed andmeaningul all in housing prices would. First,this would decrease household wealth andconsumer condence, undermining consump-tion. Second, this would negatively impact thebanking system and curtail credit availability,as the majority o bank assets remain real estatebacked.

Botched Policy Exit While less o a concerntoday given the ragile nature o the recovery, theunsustainably loose monetary and scal policieso much o the developed world will eventuallyneed to be reversed. I the exit occurs too soon, itcould derail the recovery; i too late, it could leadto an infationary outcome and/or a loss o con-dence in the government’s willpower, raising theirborrowing costs through higher interest rates.

In Closing

With abundant volatility in today’s environment,it can be dicult to accomplish what ought to

be a relatively simple task: pausing to scan thehorizon and make a clear-eyed assessment o the conditions that could aect the markets andthe economy in the year ahead. But a turbulenttime like the present is precisely when it is mostimportant to stop, raise the periscope and have acareul look around.

No one can predict the uture, o course, butlooking through the og today reveals an interest-ing – and somewhat encouraging – scenario. Forall the risks and potential downside, we believe

there may be some tactical opportunities in areasmost disdained by the markets, such as Europe,

Japan and US banks. We think that China is like-ly to avert a hard landing, which will limit theimpact o that country’s slowdown on the globaleconomy, while the Eurozone should avoida orced breakup, sparing the world anotherLehman moment. And despite a preoccupied andoten partisan ederal government, our long-standing position on the US is as strong as ever:it remains not only the best sae harbor in the

world or protecting assets, but also a compellingcore holding or long-term appreciation.




Footnotes

1. “IMF Chie Warns Over 1930’s-styleThreats,” Financial Times ,December 15, 2011.

“Financial Markets in Greater DangerThan 2008 – BoE’s Fisher,” Reuters ,December 19, 2011.

Mohamed El-Erian, “Could AmericaTurn Out Worse Than Japan?,” Reuters ,October 31, 2011.

Martin Feldstein, “The Euro Zone’sDouble Failure,” The Wall Street Journal ,December 15, 2011.

Paul Krugman, “Will China Break?,”The New York Times , December 18, 2011.

2. Federal Reserve Bank o Dallas, “Newsis Positive at Home, but Europe Looms.”December 16, 2011.

3. “US Economist Analyst: Will the EuropeanStorm Cross the Atlantic?” GoldmanSachs’s Economics, Strategy, andCommodities Research, September 16,2011.

4. Raymond Ahearn et al. “The Future o theEurozone and US Interests.” CongressionalResearch Service, September 16, 2011.

5. Francis Vitek and Tamim Bayoumi.“Spillovers rom the Euro Area SovereignDebt Crisis: A Macroeconomic ModelBased Analysis.” Center or EconomicPolicy Research Discussion Paper #8497,

July 2011.6. Maya MacGuineas is the President o

the Committee or a Responsible FederalBudget.

7. Michael Phillips. “The Financial Crisis:Government Bailouts – A US TraditionDating to Hamilton.” The Wall Street

Journal , September 20, 2008.

8. Norm Ornstein is co-authoring this bookwith Thomas Mann o the BrookingsInstitution.

9. Jacob Kirkegaard. “Thinking About the

Euro in 2012.” The Peterson Instituteor International Economics,December 22, 2011.

10. European Parliament, December 19, 2011.

11. Tom Orlik. “Making Sense o China’sEconomic Statistics.” The Wall Street

Journal , August 8, 2011.

12. As o December 31, 2011.

13. Kevin Hamlin. “China Faces 60% Risko Bank Crisis by Mid-2013.” Bloomberg

News , March 8, 2011.

14. This number reers to IMF estimates o

general government debt, which consistso the central government (budgetaryunds, extra budgetary unds, andsocial security unds) and state andlocal governments (Source: IMF WorldEconomic Outlook, September 2011).

15. “The Company That Ruled the Waves.”The Economist , December 17, 2011.

16. Guo, Kai and Papa N’Diaye. “Is China’sExport-Oriented Growth Sustainable?”,IMF Working Paper 09/172, August 2009.

17. As reported by Sun Liping o TsinghuaUniversity in a Chinese weekly publicationcalled Economic Observer.

18. Hurun Report and Bank o ChinaPrivate Banking, “2011 China PrivateWealth Management White Paper”,October 2011.

19. Amity Shlaes. “Obama Threatens toFollow in FDR’s Economic Missteps.”The Washington Post , July 9, 2010.

20. Francis Vitek and Tamim Bayoumi.“Spillovers rom the Euro Area SovereignDebt Crisis: A Macroeconomic Model

Based Analysis.” Center or EconomicPolicy Research Discussion Paper #8497,July 2011.

21. Gabriel Wildau. “China’s 2012 SocialHousing Target at 7 Million.” Reuters .December 23, 2011.

22. Shuyan Wu. “US Daily: Market Movers– Policy News at Home and Abroad.”Goldman Sachs Global EconomicsInvestment Research, November 22, 2011.

23. “Global Fund Managers Survey.” Bank oAmerica/Merrill Lynch, December 2011.

24. Howard Marks. “The Tide Goes Out.”Oaktree Capital Management, March2008.

25. “Macroitis.” Empirical Research Partners,December 21, 2011.

26. Thomas J. Lee, CFA. “Portolio Strategy2012 Outlook.” JP Morgan, December 9,2011.

27. Michael L Goldstein, Laura Dix, andLongying Zhao. “Where We Stand:Crossroads - Part II, Margins: A CostStory, Twice Told.” Empirical ResearchPartners, June 13, 2011.

28. Harold L. Sirkin et. al. “Made in America,Again: Why Manuacturing Will Return tothe US.” Boston Consulting Group, August2011.

29. “Daily Sentiment Report.”SentimenTrader.com, December 9, 2011.

30. Andrea Frazzini and Owen A. Lamont.“Dumb Money: Mutual Fund Flows andthe Cross-Section o Stock Returns.”Journal of Financial Economics , Vol. 88,No. 2, May 2008.

31. “4Q11 / 1Q12 Macro Outlook.” StielNicolaus & Company. November 30, 2011.

32. Savita Subramanian. “Good Micro, BadMacro.” Bank o America/Merrill Lynch,November 14, 2011.

33. Jerey Palma. “UBS World IncomeWorkbook.” UBS Research, July 2011.

34. “Global Fund Managers Survey.” Bank oAmerica/Merrill Lynch, December 2011.

35. Martin Z. Braun, “Jeerson County,

Harrisburg Face Reckoning or OicialHubris,” Bloomberg . November 16, 2011.

36. Conservatively assuming a recovery rate o30%, 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 oilbenchmarks was an unusual phenomenonlast year, reaching as much as $28/barrel.The dislocation was caused in large part bythe lack o pipeline export capacity in theUS Midwest relative to ast growing oil

production. The spread is currently down toabout $10/barrel due to the adaptation oan existing pipeline and the developmento new rail take-away capacity.

39. “Gold: Haven Turns Riskier but Retains itsAppeal.” Financial Times, December 20,2011.

40. “Gold Experiences an Identity Crisis.” The

Wall Street Journal , December 16, 2011.

41. Energy Inormation Administration. “WorldOil Transit Chokepoints: Strait o Hormuz.”2011.

Additional contributors rom theInvestment 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



60 Goldman Sachs

january 2012

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