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Outlook
Investment Management Division
Half Full
“ Everything we hear is an opinion, not a fact. Everything we see is a perspective…”
Attributed to Marcus Aurelius
Investment Strategy Group | January 2017
Sharmin Mossavar-Rahmani
Chief Investment Officer
Investment Strategy Group
Goldman Sachs
Brett Nelson
Head of Tactical Asset Allocation
Investment Strategy Group
Goldman Sachs
Additional Contributors
from the Investment
Strategy Group:
Matthew Weir
Managing Director
Maziar Minovi
Managing Director
Angel Ubide
Managing Director
Farshid Asl
Managing Director
Matheus Dibo
Vice President
Mary Catherine Rich
Vice President
This material represents the views of the Investment Strategy Group in the
Investment Management Division of Goldman Sachs. It is not a product of
Goldman Sachs Global Investment Research. The views and opinions expressed
herein may differ from those expressed by other groups of Goldman Sachs.
2017 OUTLOOK
Dear Clients,
Readers of our previous Outlook publications may recall that this page typically
summarizes the key themes of our economic and financial market prospects for the
coming year. However, for 2017 we decided that a brief overview would not suffice,
given the current environment of high market valuations, great policy uncertainty,
significant geopolitical tensions and, in all likelihood, an unconventional US
presidency.
Since the trough of the global financial crisis, we have consistently emphasized US
preeminence and maintained a strategic overweight to US equities relative to global
market capitalization-weighted benchmarks. Tactically, we have had an overweight
allocation to US equities and US high yield bonds from as early as mid-2008. Even
when US equities became more expensive, we continued to recommend that clients
stay fully invested at their strategic allocations. Indeed, we have reiterated that
recommendation in our past Outlook publications, client calls and Sunday Night
Insight reports as many as 59 times since January 2010.
But now we have crossed into the 10th decile of valuations: US equities have been
more expensive than current levels only 10% of the time in the post-WWII period.
Yet we continue to recommend staying the course. We are duly aware that this
recommendation is long in the tooth, particularly given such high valuations and the
unusually high level of policy uncertainty.
Policy uncertainty, both economic and political, abounds globally: uncertainty with
respect to Brexit (the how and when), upcoming elections in Germany and France
(the who), transitional government in Italy (the how long followed by what) and new
appointments to the Standing Committee in China and their significance (the who and
what of any reform agenda), to name a few.
We are also facing rising geopolitical tensions that could trigger significant market
volatility. Tensions in the Middle East will not abate. Greater Russian involvement
in that region is stabilizing in some respects and destabilizing in others. Further
Russian incursions into Eastern Europe may elicit a more robust reaction from the
West. Terrorism could spread in the US and Europe as ISIL (Islamic State of Iraq and
the Levant) loses territory in Iraq and Syria and foreign fighters return home. North
Outlook
Investment Strategy Group
1
Korea’s nuclear program and missile launches go unchecked. There is rising risk of
military incidents—or accidents—in the South China Sea and across the Taiwan Strait.
China is the most likely source of global economic shocks over the next two to
three years. The country’s leadership continues to prioritize imbalanced economic
growth over structural reforms, thereby increasing debt at an unsustainable pace. Such
increases will eventually prove to be destabilizing.
In Donald Trump, the US has elected an unconventional president in many
respects, including his more US-centric approach to China. If China responds to,
say, imposition of US tariffs on imports of Chinese products by sharply devaluing
the renminbi, significant downside volatility and tighter global financial conditions
will follow.
Given already high US equity valuations, uncertain economic and political policy
prospects and heightened geopolitical risks, readers may well ask why we continue to
recommend staying fully invested in US equities. Among the reasons:
• Our eight-year US preeminence theme is intact and continues into its ninth year.
As Professor Jeremy Siegel of the University of Pennsylvania wrote 23 years ago in
Stocks for the Long Run 1 and recently repeated in a Wall Street Journal interview, 2
“Stocks are the best long-run asset.” We refine that view by saying US equities are
the best long-run asset.
• We think that the policy backdrop in the US will be particularly favorable for
the economy, with looser fiscal policy, relatively easy monetary policy and a less
stringent regulatory environment. We expect US growth to continue through 2017.
• We expect global growth to improve modestly, from 2.5% in 2016 to 2.9% in
2017, with looser fiscal policy and still easy monetary policy in key countries.
• And last but not least, we expect that while President-elect Trump’s initial policy
measures with respect to tariffs and trade agreements risk jolting financial markets,
as a self-described “deal maker” he will likely adjust and change course as necessary
to achieve his desired results.
We may have a bumpy ride, but the US economy will not be derailed.
Over the years, we have viewed the glass as half-full—if not full—when it comes
to the US economy. Many others have seen the glass as half-empty, pointing out that
productivity growth has decreased, US labor demographics are less favorable and
government policies have been ineffective. While it is correct that productivity growth
has decreased and labor demographics are less favorable, it does not follow that the
US economy is in stagnation. Quite the reverse.
2 Goldman Sachs january 2017
We should note that our conviction in US preeminence and US economic growth in
2017 is greater than our conviction in the direction of the equity markets. Just as we
were appropriately humble about how much further equity markets could fall when
we published our 2009 Outlook, we are equally humble today about our financial
market outlook given the significant uncertainties ahead.
Here, we are reminded of Voltaire’s famous words: “Doubt is not an agreeable
condition, but certainty is an absurd one.” A client with a well-diversified portfolio
that is fully invested at its US equity allocation is generally well positioned for these
uncertain and probably volatile times.
We hope our 2017 Outlook is helpful as you evaluate your portfolio allocations.
We also wish you a healthy, happy and productive 2017.
The Investment Strategy Group
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Investment Strategy Group
3
2017 OUTLOOK
Contents
SECTION I
6 Half Full
We continue to view the glass as half-full—if
not full—when it comes to the US economy.
8 This Recovery in Context—An Update
9 A Hangover from a Crisis
10 Secular Stagnation: Unfavorable
Demographics
12 Secular Stagnation: Declining
Productivity Growth
14 Mismeasurement of GDP Statistics
18 Poor Policies in Washington
19 A Steady Onslaught of External Shocks
20 In Summary
20 One- and Five-Year Expected Total Returns
24 Our Tactical Tilts
25 The Risks to Our Outlook
26 Pace of Federal Reserve Tightening
27 Low Expectations of a US Recession
28 Rising Influence of Populist Parties
in the Eurozone
29 Geopolitical Hot Spots Get Hotter
30 Terrorism Escalates
30 Cyberattacks Continue
31 China Submerges Under Its Debt
Burden and Capital Outflows
33 US-China Relations Deteriorate
Under the Trump Administration
35 Key Takeaways
We expect a favorable global economic and
policy backdrop in 2017, but there is no
shortage of risks. We recommend clients stay
invested in US equities with some tactical tilts
to US high yield and European equities.
4 Goldman Sachs january 2017
SECTION II: WINDS OF CHANGE
36 2017 Global
Economic Outlook
SECTION III: THE HORNS OF A DILEMMA
48 2017 Financial
Markets Outlook
The winds of change should fill the sails of
the ongoing global recovery in 2017.
38 United States
42 Eurozone
44 United Kingdom
44 Japan
45 Emerging Markets
We expect the bull market ride to continue,
but we must stay vigilant to avoid the horns.
50 US Equities
56 EAFE Equities
56 Eurozone Equities
57 UK Equities
58 Japanese Equities
59 Emerging Market Equities
60 Global Currencies
64 Global Fixed Income
74 Global Commodities
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Investment Strategy Group
5
Half Full
Since the trough of the global financial crisis in
March 2009, US equities have returned nearly
300%, producing one of the longest bull markets
in the post-WWII period and outperforming all
other major developed and emerging market
country equities. US equities have also exceeded
their pre-crisis peaks of October 2007 and March
2000 by 75% and 103%, respectively, on a total
return basis. This bull market has exceeded all
other bull markets but one in length and exceeded
all but three in magnitude.
US economic growth has also exceeded that of
most other recoveries in length. This recovery is the
fourth-longest recovery in the post-WWII period 3
and if, as we expect, the US economy avoids a
recession in the first half of 2017, this recovery
will become the third-longest. While many critics
correctly point out that it is the slowest recovery
since WWII, it has actually created more economic
growth than some of the stronger recoveries
that lasted for shorter periods. On a cumulative
basis, this recovery ranks sixth out of the last 10
recoveries with respect to GDP growth. What this
recovery has lacked in strength, it has partially
made up for in length.
The slow but steady growth has also exceeded
that of all other major developed economies,
and US GDP per capita has increased more than
the GDP per capita of any major developed or
emerging market country.
This recovery has created over 15 million
jobs. The unemployment rate decreased from
a peak of 10.0% in October 2009 to 4.6% in
November 2016 and is now below its long-term
average of 5.8%. Even the broader U6 measure,
which adds the underemployed (such as parttime
and discouraged workers) to the number of
unemployed, has fallen from a peak of 17.1% to
9.3%, and stands below its long-term average of
10.6%. Unemployment claims are not only lower
than they were during pre-crisis troughs but also
at their lowest since 1973; they are also the lowest
on record as a percentage of the labor force (see
Exhibit 1).
As a result of more robust employment, wages
have increased as well. Wage growth, as measured
by the Atlanta Federal Reserve Bank Wage Growth
Tracker (which, in our opinion, is a better gauge
of the employment backdrop than average hourly
Exhibit 1: US Initial Unemployment Claims as a
Share of the Labor Force
Claims as a share of the labor force are at record lows.
Monthly Average (%)
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
1967 1975 1983 1991 1999 2007 2015
Data through December 2016.
Source: Investment Strategy Group, Datastream.
Exhibit 2: Corporate Profits as a Share of US GDP
Profits have been higher than current levels only 17% of the
time since 1950.
% of GDP
14
12
10
8
6
Corporate Profits
Historical Average
4
1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 2016
Data through Q3 2016.
Note: Showing US corporate profits with inventory valuation adjustment and capital consumption
adjustment.
Source: Investment Strategy Group, Datastream.
earnings, since it is not affected by the changing
composition of the labor force as new entrants are
hired at lower wages), has picked up from a low of
1.6% year-over-year growth in May 2010 to a high
of 3.9% in November 2016—just below the 4.4%
peak of September 2007. More robust employment
and better wage growth have, in turn, led to a
steady increase in consumer confidence, reaching
levels last seen in August 2001, as measured by the
0.2
11.5
9.6
6 Goldman Sachs january 2017
The Declinists at Work
March 1979
Used with permission of Bloomberg L.P.
Copyright© 2016. All rights reserved.
July 2016
Source: Financial Times. Martin Wolf/James Ferguson, 2016. “Global elites must heed the warning
of populist rage.” Financial Times / FT.com, 20 July. Used under licence from the Financial Times. All
Rights Reserved.
Conference Board. Even median household income,
as measured by the US Census Bureau, rose in
2015 at the fastest rate on record.
In the corporate sector, total profits of domestic
corporations as a percentage of GDP, as measured
by the national income and product accounts
(NIPA), are close to all-time highs. At 11.5% of
GDP, profits not only are well above the historical
average of 9.6%, but have been higher than
current levels only 17% of the time since 1950, as
shown in Exhibit 2.
Despite these “glass half-full” facts, the
announcements of US decline that pervaded the
airwaves in the depths of the global financial
crisis have persisted. We continue to be inundated
with analysis of “America’s relative decline,” 4
“America’s slow-growth tailspin” and “sclerotic
growth,” 5 “an economic in-tray full of problems” 6
and, of course, “secular stagnation.” 7 Two books
published in 2016 that have received extensive
coverage epitomize the sentiment: Robert Gordon’s
The Rise and Fall of American Growth 8 and
Marc Levinson’s An Extraordinary Time: The
End of the Postwar Boom and the Return of the
Ordinary Economy. 9
Some of the images are equally telling. We
were struck by a recent image of the Statue of
Liberty on its side that resembles a BusinessWeek
cover of March 1979 with a tear trickling down
Lady Liberty’s face. Since WWII, the waning of US
preeminence has been a topic of recurrent handwringing.
Whether prompted by the flexing of
Soviet muscle, most spectacularly with the launch
of Sputnik in the 1950s; the civil rights upheavals
and growing fallout from the Vietnam War in the
1960s, the Arab oil embargo and the Watergate
scandal of the 1970s, the rise of Japan in the 1980s
or the rise of China in the 2000s, the declinists
have foretold the ebbing of American preeminence.
Typical of the genre is a 2009 book provocatively
titled When China Rules the World 10 by British
columnist Martin Jacques.
Yet, as we wrote in our 2011 Outlook: Stay
the Course, neither the global financial crisis nor
the rise of China will hinder what we described
as “America’s structural resilience, fortitude
and ingenuity” and remove the US from its
preeminent perch.
What explains our difference of opinion, which
has consistently underpinned our investment
recommendation for a greater allocation to US
assets and for remaining invested at such high
valuations? Why do we believe that the US is on
a more solid footing both absolutely and relative
to all other major countries in the world? Is it a
matter of perspective, analytical rigor, bias, review
of longer economic history, or reliance on a big
cadre of external experts in specialized fields?
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Investment Strategy Group
7
Exhibit 3: Growth in US Real GDP Across Post-
WWII Expansions
In this recovery, GDP has grown at half the average pace of
prior expansions.
Exhibit 4: Change in US Household Leverage
Following Recessions
A large reduction in household debt served as a drag on the
pace of this recovery.
Cumulative Growth (%)
60
50
40
Q2 1954
Q2 1958
Q1 1961
Q4 1970
Q1 1975
Q3 1980
Q4 1982
Q1 1991
Q4 2001
Q2 2009
Change in Debt-to-GDP (Percentage Points)
10
Previous Post-WWII Recoveries (Median)
Current Recovery
5
0
4.8
30
-5
20
-10
10
-15
0
0 4 8 12 16 20 24 28 32 36 40
Quarters After Trough
-20
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Quarters After Recession End
-18.3
Data as of Q3 2016.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
Data through Q3 2016.
Source: Investment Strategy Group, National Bureau of Economic Research, Federal Reserve
Economic Data.
We believe that no one factor explains the
difference in opinion. Instead, we rely on a
comprehensive framework of investigation that
blends all of these elements, combining rigorous
fundamental, quantitative and technical analysis,
as well as the insights of an extensive network of
external experts. At the same time, we continually
endeavor to overcome the behavioral biases Nobel
Laureate Daniel Kahneman and his collaborator
Amos Tverksy have shown to affect economic
decision-making and tolerance for risk. These key
characteristics of our investment process not only
underpin our continued view of US preeminence,
but also allow us to form a holistic view across
global economies and asset classes. Of equal
importance, our framework provides us with a
consistent process by which to assess investment
opportunities. While we believe our approach is
robust, we acknowledge that nothing can ensure
we will avoid the next downdraft.
We begin our Outlook with a brief review of
this recovery and place it in the context of past
recoveries showing that the glass is indeed half-full.
We address some of the key concerns regarding
demographics and declining productivity growth.
We show that US labor force demographics have
deteriorated and will continue to do so, especially
in the absence of policy changes. Nonetheless, we
demonstrate why there is room for optimism about
productivity growth. The analysis leads us to a
view of slightly above-trend growth for 2017 with
some upside potential from higher productivity
and fiscal stimulus from a Trump administration.
We then turn to our one- and five-year expected
returns, which are driven by our view of a solid
economic foundation, a well-balanced economy
and a positive growth trajectory in the US. We
conclude our introductory section with the risks
to our view, both upside and downside, including
a low probability of recession in 2017, high policy
uncertainty under a Trump administration, possible
global shocks from economic and currency policies
in China, and the risks of geopolitical mishaps in
Europe, the Middle East and the Far East.
This Recovery in Context—An Update
This recovery has been the slowest of the 10
recovery cycles since WWII, as shown in Exhibit
3. Since the trough, US GDP has grown at an
annualized rate of 2.1% through the third quarter
of 2016, which is half the pace of the median and
average growth rates of all other recoveries. The
slow GDP growth rate stands in stark contrast to
the recovery in the labor market and, most recently,
in wages and household income. Impressively, the
decline in the unemployment rate has been the
second-largest of all post-WWII recoveries.
8 Goldman Sachs january 2017
Exhibit 5: Change in US Personal Savings Rate
Surrounding Historical Recessions
The increase in the personal savings rate in this recovery
has been unusually large.
Exhibit 6: Ratio of US Household Net Worth to
Disposable Income
Real estate price and financial asset gains have boosted the
ratio to near pre-crisis highs.
%
Deviation from Start of Recession (Percentage Points)
8
Historical Range
Median
6
Current
700
639
4
2
3.0
600
0
500
-2
-4
-6
-3.4
400
-8
-6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34
Quarters Relative to Start of Recession
Data through Q3 2016.
Note: Quarter 0 marks the start of each recession since 1950, defined as the NBER recession
cycle start. The cycle is measured from the start of each recession until the beginning of the next
recession.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
300
1951 1959 1967 1975 1983 1991 1999 2007 2015
Data through Q3 2016.
Source: Investment Strategy Group, Datastream.
The anemic (but steady) pace of this recovery
has fueled a debate about its causes. The theories
fall into six categories:
• A “hangover” from the global financial crisis 11
• “Secular stagnation” due to unfavorable
demographics
• “Secular stagnation” due to declining
productivity growth
• Mismeasurement of GDP statistics
• Poor policies in Washington
• A steady onslaught of external shocks
We briefly examine each of these six theories
below—some of which we have touched upon
in our prior Outlook publications. While there
has been further research on the topic over the
past year, the debate has not yet been resolved
and likely never will be to everyone’s satisfaction.
One star-studded group of experts believes that
most contributing factors other than weaker
demographics have dissipated or will dissipate, and
the US economy will remain structurally vibrant.
Another star-studded group believes that the best
days of the US are behind it, contending that even
radical policy changes will not reverse this decline
and that the 2016 election results are a testament
to this “secular stagnation.”
A Hangover from a Crisis
Proponents of the “hangover” theory suggest
that recoveries after a major financial crisis
generally have been slower. In their book, This
Time Is Different: Eight Centuries of Financial
Folly, 12 Carmen Reinhart and Kenneth Rogoff
use historical data from 66 countries between
1810 and 2010 to demonstrate that, historically,
recoveries following a major financial crisis have
been markedly slower than other recoveries.
Fundamentally, one can argue that
households deleverage for a long time to increase
precautionary savings, and corporations limit
capital expenditures to build up precautionary
cash, out of fear that another major financial crisis
is looming. As shown in Exhibit 4, the pace at
which households deleveraged in this most recent
crisis was faster than in any other recovery in the
post-WWII period; commensurately, the increase
in the personal savings rate since the start of the
recession is unusually large relative to previous
cycles (see Exhibit 5).
Along with higher savings, the increase in home
prices to levels matching the February 2007 peak
(as measured by the S&P/Case-Shiller US National
Home Price Index on a seasonally adjusted
basis) and the appreciation in financial assets
have boosted the ratio of household net worth
to disposable income to near pre-crisis levels, as
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Investment Strategy Group
9
shown in Exhibit 6. This improvement in net worth
will enable households to lower their savings
rates going forward and support consumption.
Therefore, even if the “hangover” hypothesis was
partly valid earlier in the recovery, it should have
less impact in the future.
During the current recovery, the financial sector
also deleveraged substantially, partly due to the
unusually high levels of leverage that existed as
the crisis began and partly due to greater financial
regulation resulting from the Dodd-Frank Wall
Street Reform and Consumer Protection Act signed
into federal law by President Barack Obama on
July 21, 2010. As shown in Exhibit 7, the financial
sector began to deleverage even before Dodd-Frank
and has continued to do so through 2016.
However, more recently, the pace of
deleveraging has abated, as shown in Exhibits 4
and 7. Furthermore, such deleveraging may well
be bottoming and soon reverse as households
and the financial sector face a more favorable
fiscal and regulatory policy environment under
President-elect Trump. For all practical purposes,
the “hangover” may now be over.
Secular Stagnation: Unfavorable Demographics
As we discussed in our 2016 Outlook: The Last
Innings, the term “secular stagnation” was first
coined by economist and Harvard professor
Alvin Hansen in 1934 13 and fully described in his
presidential address to the American Economic
Association in 1938. 14 He predicted that poor
demographics, limited innovation and few
trading and investment opportunities would slow
US growth.
The term was more recently popularized
by Lawrence Summers, professor at Harvard
University and former secretary of the Treasury,
when he referred to secular stagnation in a 2013
speech at the International Monetary Fund. 15
Hansen’s dire predictions never came to pass,
and the US experienced close to record levels of
productivity growth in the post-WWII period up
to 1973, along with strong growth in the labor
force. This current cycle, in contrast to the decades
immediately following Hansen’s predictions, has
been hampered by weak demographics and a
decline in the growth rate of the labor force. In a
September 2016 study, aptly called “How Should
We Think About This Recovery?,” Jay Shambaugh,
a member of the Council of Economic Advisers,
shows that when one compares this recovery
Exhibit 7: Change in US Financial Sector Leverage
Following Recessions
A decrease in financial sector indebtedness has contributed
to a slower-than-usual recovery.
Change in Debt-to-GDP (Percentage Points)
30
Previous Post-WWII Recoveries (Median)
Current Recovery
20
10
0
-10
-20
-30
-40
-50
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Quarters After Recession End
Data through Q3 2016.
Source: Investment Strategy Group, National Bureau of Economic Research, Federal Reserve
Economic Data.
with the average of past recoveries, the growth
gap narrows significantly if one accounts for the
number of people in the labor force. 16 Instead of
this recovery growing at about half the pace of
the average of past recoveries, the gap narrows to
83% of the average: GDP per number of people in
the labor force has grown at an annualized rate of
1.9%, compared with an average of 2.3% in past
recoveries. A recovery that appears to be at half
the pace of other recoveries is actually in line with
other recoveries after adjusting for the size of the
labor force, as shown by comparing the red lines in
Exhibits 8 and 9.
There are two components to the unfavorable
demographics story. The first is simply the decline in
the growth rate of the US working-age population,
which is driven by aging, the retirement of the baby
boom generation and slower immigration.
This trend cannot be easily reversed; however,
the pace of decline can potentially be slowed.
For example, the commonly accepted retirement
age of 65 can be extended. In fact, there is some
evidence that baby boomers are working longer
than historical norms. 17 When life expectancy was
about 62 years in 1935, the retirement age for
Social Security was 65. Today, life expectancy in
the US is about 79 years, and the retirement age for
Social Security has been extended to 67 for those
born in 1960 or later. Of course, more broadly, the
retirement age is still regarded as 65. A 65-year-
18.6
-37.1
10 Goldman Sachs january 2017
Exhibit 8: Growth in US Real GDP Across Post-
WWII Expansions
In this recovery, GDP has grown at half the average pace of
prior expansions.
Exhibit 9: Growth in US Real GDP per Person in
the Labor Force Across Post-WWII Expansions
But when adjusted for labor force trends, this recovery has
actually been in line with the average of past expansions.
Cumulative Growth (%)
60
50
40
Q2 1954
Q2 1958
Q1 1961
Q4 1970
Q1 1975
Q3 1980
Q4 1982
Q1 1991
Q4 2001
Q2 2009
Cumulative Growth (%)
60
50
40
Q2 1954
Q2 1958
Q1 1961
Q4 1970
Q1 1975
Q3 1980
Q4 1982
Q1 1991
Q4 2001
Q2 2009
30
30
20
20
10
10
0
0 4 8 12 16 20 24 28 32 36 40
Quarters After Trough
0
0 4 8 12 16 20 24 28 32 36 40
Quarters After Trough
Data as of Q3 2016.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
Data through Q3 2016.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
old today, however, is much healthier and more
vibrant than a 65-year-old in 1935 and has many
more years of active life that can reduce the decline
in the growth rate of the working-age population.
Furthermore, this cohort is quite productive
relative to new entrants into the labor force.
Similarly, immigration reform can help offset the
decline in working-age population growth. Both
factors depend on policy changes, and we do not
have any definitive reason to be either optimistic or
pessimistic at this time.
The second component of the unfavorable
demographics perspective has been the drop in
labor force participation, particularly among
males. Exhibit 10 shows the rapid growth in labor
force participation that occurred as the baby
boom generation reached working age and as
women joined the labor force in growing numbers
after 1950. The labor force participation rate,
however, peaked in 2000 and declined by 0.3%
a year until it troughed at 62.4% in September
2015. Most of the drop was driven by three
factors: significant decline in male labor force
participation, retirement of baby boomers and the
cyclical decline in demand for labor as a result
of the global financial crisis. Some of the cyclical
decline reversed as the economic recovery entered
its eighth year: the participation rate has risen to
62.7% as of November 2016.
The male labor force participation, however,
has been declining, coincidentally also by 0.3%
Exhibit 10: US Labor Force Participation Rate
Both cyclical and structural factors have contributed to a
decline in the participation rate from the 2000 peak.
%
70
68
66
64
62
60
58
56
54
52
50
1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 2016
Data through November 2016.
Source: Investment Strategy Group, Datastream.
per year—but since 1952. The trend has occurred
across all age cohorts. An important driver of this
decline has been reduced demand for lower-skilled
and less-educated males. The US ranks 32 out of
34 OECD countries in participation of prime-age
(between the ages of 24 and 54) males in the labor
force, ahead of only Italy and Israel. 18 A Council of
Economic Advisers report in June 2016 attributed
that low ranking to the fact that the US spends
less than other OECD countries on job search
67.3
62.7
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Investment Strategy Group
11
assistance and job training, and to the fact that the
US has a high rate of incarceration that especially
affects lower-skilled men. 19 According to the
report, several policy measures can boost primeage
male labor force participation, including
• Increased investment in infrastructure
• Systemic reforms in the criminal justice system
and in immigration policies
• Tax reforms
• Investment in education and training
This demographic aspect of secular stagnation is
undeniable. In fact, an October 2016 paper by a
team at the Federal Reserve Board, “Understanding
the New Normal: The Role of Demographics,” 20
shows that the slow pace of economic growth since
1980 and the more pronounced decline in the last
decade could be predicted by a model looking
at “fertility, labor supply, life expectancy, family
composition, and international migration.”
Thus, a glass half-full or half-empty perspective
does not change the facts on the ground. There is
little cause for near-term optimism with respect
to the slower growth rate of the labor force. The
general consensus is that the US labor force will
grow at an average of 0.6% per year in the next
several decades, compared with 1.6% from 1950
to 2000. 21
In the shorter term, infrastructure investment
and other policies highlighted above may boost
the growth rate in the labor force, but it is hard to
imagine growth rates reaching levels that would
support President-elect Trump’s GDP growth
targets of 3–4% on a sustainable basis. 22
Secular Stagnation: Declining
Productivity Growth
Of all the theories put forth to explain the slow
pace of this recovery, the one that has garnered the
most attention is declining productivity growth.
Of all the theories put forth to explain
the slow pace of this recovery, the
one that has garnered the most
attention is declining productivity
growth.
It is also the most important issue in terms of its
impact on future trend growth in the US, which in
turn has the greatest impact on the long-term rate
of earnings growth and equity market returns.
As reviewed in last year’s Outlook, the technooptimists
and the techno-pessimists are on opposite
sides of the debate on declining productivity
growth. Both camps have garnered new members;
even Federal Reserve Chair Janet Yellen and
Vice Chair Stanley Fischer have joined the fray. 23
Most recently, in September 2016, the Brookings
Institution hosted a conference with leading
experts from both camps to debate the issue.
We should note that debates on productivity
are nothing new. They have surfaced during past
periods of slow growth, as was the case in the early
1990s. Even some of the players are the same:
Robert Gordon was a techno-pessimist in the early
1990s and remains so in the 2010s. 24
Part of the productivity debate is philosophical.
For example, one question pertains to the increased
use of free digital services such as Facebook,
Google Maps, Waze and Khan Academy. These
services yield “consumer surplus,” defined as the
benefits consumers derive from various activities
over and above the price they pay. Should they be
included in GDP if they are deemed “non-market”
services—those that are provided free of charge
or at a fee that is well below 50% of production
costs? While social media such as Facebook may
(or may not, depending on your perspective)
provide a service greater than the advertisement
revenues associated with the use of that service,
some will argue that if such services do not have an
associated market price, they are not part of GDP
and therefore should not impact the calculation of
productivity levels. As the volume and the impact
of these non-market services increase, we believe
that the methodology for measuring GDP will
evolve to better reflect the value of these services.
Such improvements in measuring GDP are not
uncommon. The Bureau of Economic
Analysis (BEA) conducts comprehensive
revisions of the national income and
product accounts every five years, with
the goal of reflecting methodological
and statistical improvements. Most
recently, in 2013, the BEA expanded
its definition of fixed investment to
include expenditures on research and
development and expenditures on artistic
originals (e.g., books, music, television
12 Goldman Sachs january 2017
Exhibit 11: Pillars of the Investment Strategy Group’s Investment Philosophy
INVESTMENT STRATEGY GROUP
History is a
Useful Guide
Appropriate
Diversification
Value
Orientation
Appropriate
Horizon
Consistency
ANALYTICAL RIGOR
ASSET ALLOCATION PROCESS IS CLIENT-TAILORED AND INDEPENDENT OF IMPLEMENTATION VEHICLES
series, movies). Combined with some smaller
improvements, these changes added $560 billion to
the level of 2012 GDP, a 3.6% increase relative to
the prior estimate. 25
The more immediate—and important—
question is whether we have entered a new phase
in productivity growth trends that will keep
productivity growth at the low levels seen since
2004. We believe that the answer is unknowable
with any degree of certainty; historically,
productivity forecasts have been notoriously
wrong. In The Age of Diminished Expectations, 26
first published in 1990, Paul Krugman, Nobel
laureate in economics and professor at City
University of New York, wrote that the lower pace
of productivity growth experienced since the early
1970s would most likely persist in the future. In
1995, however, productivity growth rates increased
and were more than double the rate of the prior
12-year period.
Similarly, in 1997, the Congressional Budget
Office estimated that the long-run average annual
growth rate of labor productivity would be 1.1%.
Between 1995 and 2004, the actual average annual
growth rate of labor productivity was 3.2%. 27
As many of our clients know, one of the pillars
of our investment philosophy is that history
is a useful guide (see Exhibit 11). And history
tells us that labor productivity has moved in
cycles, with periods of low productivity growth
followed by periods of high productivity growth.
In a forthcoming and comprehensive paper
titled “Seven Reasons to Be Optimistic About
Productivity,” 28 Professors Lee Branstetter of
Carnegie Mellon University and Daniel Sichel
of Wellesley College show that periods of low
productivity growth have been followed by periods
of high productivity growth since 1889, as seen
in Exhibit 12. There is no reason to believe that
“this time is different”; as many of you also know,
we believe that those words are among the most
dangerous and misused words in our industry.
Olivier Blanchard, senior fellow at the Peterson
Institute for International Economics and former
chief economist at the IMF, has also shown that
the current period of low productivity growth does
not tell us much about future productivity trends.
He states that the correlation of “successive pairs
of five-year averages of total factor productivity
growth is only 0.20” since the mid-1970s. 29
Outlook
Investment Strategy Group
13
Exhibit 12: US Labor Productivity Growth
Periods of slow productivity growth have been followed by
periods of stronger productivity gains.
Average Annual Growth Rate (%)
4.0
Exhibit 13: Correlation of 5-Year US Productivity
Growth Rates With Following 5 Years’
Productivity Growth Rates
Recent productivity trends tell us little about the future.
Correlation
0.25
3.5
3.0
3.4
3.1
3.2
3.2
0.20
2.5
2.0
1.5
1.6
2.0
1.5
1.3
0.15
0.10
0.14
0.08
1.0
0.5
0.05
0.0
1889–1917 1917–1927 1927–1940 1940–1948 1948–1973 1973–1995 1995–2004 2004–2015
0.00
Since 1957 Since 1970
Data through 2015.
Source: Investment Strategy Group, Lee Branstetter and Daniel Sichel, “Seven Reasons to Be
Optimistic About Productivity,” forthcoming Peterson Institute for International Economics
Policy Brief.
Data through Q3 2016.
Source: Investment Strategy Group, Haver Analytics, Olivier Blanchard, “Three Remarks About
the US Treasury Yield Curve,” Peterson Institute for International Economics, June 22, 2016.
We have examined labor productivity growth
rates and, as shown in Exhibit 13, find even
lower correlations.
There are two issues to consider. First, if the
reported productivity growth rates are accurate,
then the exceptionally low rates of the last 10 years
account for part of the slow pace of this recovery.
However, the current low productivity growth rates
do not portend low growth rates going forward.
Just as Hansen was proven wrong on his secular
stagnation theory and Krugman was proven wrong
on his diminished expectations for the US economy
(and they were both influenced by their pessimistic
view on productivity), those who extrapolate
stagnation from the current productivity trends
may be proven wrong as well.
Second, as we discuss below, there is also a high
probability that real GDP may be mismeasured.
If real GDP is mismeasured, it follows that
If real GDP is mismeasured, it follows
that productivity is also mismeasured,
thereby invalidating the whole theory of
secular stagnation and the decline of the
US economy.
productivity is also mismeasured, thereby
invalidating the whole theory of secular stagnation
and the decline of the US economy.
Mismeasurement of GDP Statistics
In addition to the productivity debate, there is
a debate as to whether we are measuring GDP
correctly in the first place. The key argument being
made is that while we correctly measure the value
of nominal GDP based on the value of goods and
services, we mismeasure the value of real GDP
when we convert nominal GDP to real GDP using
various price indices, and this therefore understates
the pace of this recovery. This debate garnered
considerable attention in 2016.
The mismeasurement argument states that
the official price indices do not adequately reflect
significant improvements in many products,
especially in information and communication
technology, due to the methodology
used by the Bureau of Labor
Statistics (BLS) and the BEA. If the
price indices do not adequately
reflect the greater capacity of
an improved product such as a
smartphone or a microprocessor,
then the price index used to convert
nominal GDP to real GDP is too
high. And if the price index is too
high, then real GDP is understated.
14 Goldman Sachs january 2017
It follows that if real GDP is understated, then
what appears to be a slow recovery is not as slow
as reported and what appears to be a period of low
productivity growth is not as low as reported.
We believe that the evidence favors the
mismeasurement argument. At a September 2016
Brookings Institution conference on productivity,
Martin Feldstein, Harvard professor and president
emeritus of the National Bureau of Economic
Research, also concluded that “the official statistics
substantially underestimate the real growth
of output” after studying the methods used to
measure price indices. 30
We point to three examples to illustrate the
mismeasurement argument. First, our colleagues in
Goldman Sachs’ Global Investment Research (GIR)
have pointed out that the official price indices for
information and communication technology show
an implausible gap between the price deflation in
computers and that in communications equipment,
software and other IT equipment (see Exhibit 14).
They question how “a given dollar outlay now
buys about 10 times as much computer in real
terms as 20 years ago, but it only buys about 10%
more software.” 31
Our colleagues’ conclusion that the
official price indices for the information and
communication technology sector are overstated
matches that of a 2015 study of microprocessor
pricing by David Byrne of the Federal Reserve
Board, Professor Stephen Oliner of UCLA, and
Sichel. 32 The trio created an index showing that
prices for microprocessor units used in desktop
personal computers declined by an average
annual rate of 43% between 2008 and 2013,
while the official Producer Price Index (PPI)
for these units declined by an average annual
rate of 8%—substantially mismeasuring the
real value created by this sector of information
technology equipment. They point out that
because microprocessor units represent about half
of US shipments of semiconductors, the rate of
innovation in this sector is inevitably mismeasured.
A second example of mismeasurement that we
can all readily appreciate involves the quality and
product improvements in smartphones. Hal Varian,
chief economist at Google and emeritus professor
at the University of California at Berkeley, has
estimated that globally, people took over 1.6
trillion photos in 2015 using their smartphones,
compared with 80 billion in 2000 using cameras
and film. The price of each photo taken has gone
Exhibit 14: US Technology Price Indices
The implausible gap with hardware suggests IT and
communication price indices are likely overstated.
Q1 1995 = 100
140
120
100
80
60
40
Software
Hardware (Computers and Peripherals)
Communications Equipment
Other IT Equipment
20
9
0
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Data through 2015.
Note: Other IT Equipment represents medical and non-medical equipment and instruments.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bureau of
Economic Analysis.
from 50 cents to zero for smartphone users; 1.6
trillion photos that would have contributed $800
billion to GDP have no impact on GDP in the
current framework. GDP has declined since camera
and film sales have fallen without a commensurate
quality adjustment for smartphones. Of course,
fewer photos would have been taken had the
smartphone not been developed, but the point
still stands. 33
Similarly, Varian shows that with the onset of
the commercial application of GPS technology,
productivity growth in trucking was twice the
aggregate US productivity growth, yet when GPS
functionality was added to smartphones basically
at no additional charge, GDP declined because
sales of stand-alone GPS systems fell. 34
Finally, a third example, also provided by
Varian, shows that, because GDP does not fully
count the export of intangibles such as software
and design, GDP is understated. He shows how an
iPhone manufactured by Foxconn in China using
parts from 28 countries and exported to France
has no direct impact on US GDP. Varian concludes
that in a global supply chain, US design and
software that is replicated outside the US through
offshore manufacturing and exported to a third
country never impacts US GDP measures directly,
particularly if the profits are not repatriated and
redeployed in the US. 35
Our colleagues in GIR continue to estimate that
such mismeasurements lower reported annual real
114
90
44
Outlook
Investment Strategy Group
15
We believe that productivity in
health care is underestimated.
Consider IBM’s Watson Health,
an artificial intelligence system
that can read 200 million pages
of text in 3 seconds. As of 2015,
Watson had amassed 315 billion
data points representing health
records, lab results, genomic
tests and clinical studies. The
system processes patients’ cases
against its ever-growing database
and recommends customized
treatment options. With such
developments, we expect
continued improvement in growth
of productivity in health care.
“If productivity growth
were better measured,
particularly in health and
other services, the growth
rate would look better than
is currently reported.”
Martin Neil Baily and Nicholas Montalbano, “Why Is U.S. Productivity
Growth So Slow? Possible Explanations and Policy Responses,”
Brookings Institution, September 2016.
GDP growth by about 0.7 percentage point, similar
to their estimate reported in our Outlook last year.
Of course, not all experts believe that there is
a mismeasurement problem. Notable among them
is Chad Syverson of the University of Chicago,
who raises four points in making this case. 36
First, he states that the productivity slowdown
has been global in nature and unrelated to
countries’ consumption or production intensities
of information and communication technology.
Second, he states that estimates of consumer surplus
are too small relative to his estimates of lost GDP
due to slower productivity growth. Third, he argues
that if such mismeasurement existed, the growth rate
in the information and communication technology
sector would be a multiple of its stated growth rate.
Finally, while he acknowledges that gross domestic
income has been higher than GDP since 2004 and
the gap might reflect the higher wages of workers
who are producing non-market digital services, he
does not believe that this difference is evidence of
mismeasured GDP because the trend started earlier
than the slowdown in productivity growth.
A somewhat similar line of reasoning has been
presented by Byrne, John Fernald of the Federal
Reserve Bank of San Francisco and Marshall
Reinsdorf of the IMF in a paper titled “Does the
United States Have a Productivity Slowdown or a
Measurement Problem?” 37 While they agree that
productivity growth has been mismeasured in the
past, they argue that the mismeasurement has been
negligible in the 2004–15 period partly because
computer hardware, for which mismeasurement
was once a factor, now makes up a smaller part of
GDP. Therefore, the impact is less in the 2004–15
period than it was in the 1995–2004 period when
productivity growth was much higher. They also
state that free digital products not only are nonmarket
and should not be counted in GDP, but also
are not sizable enough to account for the level of
decline in productivity growth rates.
Experts’ opinions on mismeasurement continue
to evolve. In fact, in a subsequent publication coauthored
with Carol Corrado of the Conference
Board, Byrne found a significantly higher level
of software price mismeasurement than assumed
in his prior paper. 38 He has also co-authored a
study on prices and depreciation for computer
tablets such as iPads, proving that quality-adjusted
price indices for tablets have fallen much faster
than the broader price indices for computers and
peripheral equipment. 39
16 Goldman Sachs january 2017
Exhibit 15: 10-Year Net Survival Rate of Breast and Prostate Cancer Patients
Improved cancer survival rates reflect significant gains in science and technology.
%
100
75
72
76
78
75
84
60
62
50
40
48
34
25
25 25
0
1971–1972 1980–1981 1990–1991 2000–2001 2005–2006 2010–2011 1971–1972 1980–1981 1990–1991 2000–2001 2005–2006 2010–2011
Breast Cancer
Prostate Cancer
Period of Diagnosis
Data as of November 2014.
Note: Based on cancer statistics for the UK. Ten-year survival for 2005–2006 and 2010–2011 is predicted using an excess hazard statistical model.
Source: Investment Strategy Group, Cancer Research UK.
We conclude that there is undoubtedly
some degree of mismeasurement. We know that
information and communication technology has
evolved significantly and innovation is occurring
at a rapid pace. We know that the BEA reviews
its statistical methodologies every five years
and revises them as needed, recognizing that
measurement methodologies have to evolve with
the evolution of the US economy. We also know
that we as consumers carry incredibly powerful
digital equipment in the palms of our hands and
pay less for it than we paid for equipment with
lesser functionalities not so long ago. Common
sense supplemented by extensive research by the
experts on productivity and mismeasurement
reinforces our view of a glass half-full when it
comes to innovation and productivity in the US.
We realize this debate will be resolved only
with the benefit of hindsight, in the same way
that realized productivity growth exceeded the
We realize this debate will be resolved
only with the benefit of hindsight, in
the same way that realized productivity
growth exceeded the prognostications
of Hansen in the late 1930s and
Krugman in the early 1990s.
prognostications of Hansen in the late 1930s and
Krugman in the early 1990s. Our clients will be
inundated with conflicting views from headlines
in the media and books with captivating titles.
Separating fact from fiction remains challenging.
Recently, an article in the Wall Street Journal
highlighted “dwindling gains in science, technology
and medicine.” 40 The article suggested that
improvements in breast cancer mortality have
slowed since 1985. Exhibit 15 shows the 10-year
net survival rate for breast cancer and prostate
cancer since 1971. Maybe it is only a matter of
perspective, but, to us, a 78% 10-year survival rate
for breast cancer and an 84% 10-year survival
rate for prostate cancer represent significant
improvements over the rates of the early 1980s,
48% and 25%, respectively, and are even more
significant for those whose lives have been saved.
Probably one of the more amusing instances
of conflicting perspectives can be seen in the
2016 publication of two books with
diametrically opposed messages:
Progress: Ten Reasons to Look
Forward to the Future 41 and The
Innovation Illusion: How So Little
Is Created by So Many Working So
Hard, 42 both written by authors born
in Sweden in the early 1970s. Our
views, of course, are more aligned
with the first book. The second book,
however, raises important concerns
about excessive regulation and how
Outlook
Investment Strategy Group
17
such regulation is “killing frontier innovation.”
Indeed, some have put forth the prevalence of
poor government policies as one of the theories to
explain the slow pace of this recovery.
Poor Policies in Washington
One of the theories that has been getting more
traction recently attributes the slower recovery
to poor policies enacted in Washington. In a June
2016 article about the US economy, Gregory
Mankiw, professor at Harvard University and
former chair of the Council of Economic Advisers
for President George W. Bush, highlighted “policy
missteps,” 43 including misguided fiscal policy, as
a possible contributor to the slow pace of growth
since the global financial crisis.
One unusual feature of this recovery has, in
fact, been a contractionary fiscal policy. We have
derived an approximate historical measure of
fiscal policy changes by estimating changes in the
cyclically adjusted federal budget as a percentage
of GDP. We note that, by this measure, as far back
as 1890, fiscal policy has been expansionary in all
but three recoveries following a recession—with
the fiscal policy in the current recovery being the
most contractionary, as shown in Exhibit 16. In
this recovery, the budget deficit as a share of GDP
was reduced by 1.0% a year, compared to an
average widening of the budget deficit by 1.3% a
year in all other recoveries after severe recessions.
The average increase in the size of the budget
Two books published in 2016 and written by Swedes born in the early
1970s highlight the conflicting perspectives on productivity.
Johan Norberg’s Progress cover used with permission of Johan Norberg
and Oneworld Publications. All rights reserved.
Fredrik Erixon and Bjorn Weigel’s The Innovation Illusion: How So Little
Is Created by So Many Working So Hard cover used with permission of
Fredrik Erixon, Bjorn Weigel and Yale University Press. All rights reserved.
Exhibit 16: Change in US Budget Balance
Following Recessions
Fiscal policy has been an unusually large headwind to
growth in this recovery.
% of GDP
2
1
0
-1
-2
-3
-4
-5
Average of All Expansions
Average of All Expansions from Severe Recessions*
0.0
-0.1
-0.3
-0.2
-0.4
-0.3
-0.9
-1.1
--1.1
-1.4
-4.7
1894 1908 1921 1933 1938 1954 1958 1961 1970 1975 1982 1991 2001 2009
Year of Expansion Start
Data through 2015.
Note: Shows the change in the cyclically adjusted budget balance as a % of GDP for
each episode.
Source: Investment Strategy Group, Datastream, Global Financial Data.
* We define “severe” recessions according to those identified by Carmen Reinhart and Kenneth
Rogoff in “Recovery from Financial Crises: Evidence from 100 Episodes” (2014), as well as the
1937 recession (a continuation of the 1929 recession) and the two most severe post-WWII
recessions (excluding the 2007 recession).
deficit for all recoveries, including less severe
ones, is -0.8%. A swing of 1.8 percentage points
would have had a material impact on the pace of
this recovery.
Professor Alan Blinder of Princeton University
and former vice chair at the Federal Reserve echoed
the sentiment by stating that partisan politics have
prevented progress in dealing with important
economic issues. 44 Shambaugh has outlined various
measures, such as infrastructure spending proposed
by President Obama in his fiscal year 2017 budget,
that would positively impact productivity and labor
force participation. 45 The budget was not approved.
Summers has similarly called for expansionary fiscal
policy through infrastructure spending, but such
policies have not been pursued. 46
Increased regulation has also been blamed
for some of the slow pace of this recovery. A
September 2016 working paper by Martin
Neil Baily and Nicholas Montalbano of the
Brookings Institution on the slow growth of US
productivity shows that while productivity in the
most productive firms is growing rapidly, their
best practices are not spreading to the rest of the
players in a given industry. 47 Exhibit 17 shows the
widening gap between the productivity growth
rates of firms at the frontier of innovation and
0.5
-0.6
1.0
-0.8
-1.3
18 Goldman Sachs january 2017
Exhibit 17: Labor Productivity Growth for
Different Groups of Firms
Rapid productivity growth of firms at the frontier of
innovation is not spreading to the rest of the industry.
Exhibit 18: US Financial Conditions Index
Conditions tightened significantly due to global shocks
emanating from the Eurozone, oil prices and China.
Index, 2001= 1 (Log Points)
1.5
Frontier Firms—Top 5% in Each Industry/Year
Frontier Firms—Top 100 in Each Industry/Year
Non-Frontier Firms
1.4
1.3
1.39
1.36
US Financial Conditions Index
101.5
101.0
100.5
+142bp
100.0
Tightening
+118bp
+104bp
1.2
99.5
1.1
1.06
99.0
1.0
98.5
0.9
2001 2003 2005 2007 2009 2011 2013
Data through 2013.
Note: Average across 24 OECD countries and 22 manufacturing and 27 market services
industries.
Source: Investment Strategy Group, OECD preliminary results based on Dan Andrews, Chiara
Criscuolo and Peter N. Gal, “Mind the Gap: Productivity Divergence Between the Global Frontier
and Laggard Firms,” OECD Productivity Working Papers, forthcoming.
98.0
2010 2011 2012 2013 2014 2015 2016
Data through year-end 2016.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research.
the rest of the industry. Baily and Montalbano
suggest that increased regulation after the crisis
may be partially responsible for the widening gap
between frontier firms and the rest of the industry,
which lowers overall productivity growth rates
across the economy and hence lowers the pace of
economic growth.
Our colleagues in GIR think that lower capital
investment accounts for the lack of diffusion of
new technologies from more productive firms to
less productive firms. 48 Here, again, it is likely that
a more favorable business environment could have
boosted capital expenditures and increased overall
productivity levels.
We conclude that it is reasonable to assign
some of the weakness in this recovery to less
effective fiscal and regulatory policies out of
Washington rather than to structural shortcomings
in the US economy.
A Steady Onslaught of External Shocks
A sixth theory posits that numerous external
shocks explain the slow pace of this recovery.
Just as the US economy was recovering from the
trough of 2009, the Eurozone sovereign debt crisis
jolted global financial markets. The Eurozone
was a source of uncertainty and financial market
volatility beyond the initial shock in 2010 as the
crisis spread from Greece to Spain and Italy.
The Eurozone crisis was followed by a series
of what the Brookings Institution has called the
“fiscal fights of the Obama administration.” 49 The
first fiscal fight resulted in the Standard and Poor’s
(S&P) downgrade of US Treasury debt in August
2011. The equity markets, as measured by the S&P
500 Index, dropped about 19% between April and
October of 2011.
Taken together, the Eurozone sovereign debt
crisis and the first of the fiscal fights tightened
US financial conditions 50 by 142 basis points (see
Exhibit 18). GIR estimates that a 100 basis point
tightening of financial conditions is equivalent to a
federal funds hike of 150 basis points and a drag
on GDP growth of about one percentage point.
The drop in oil prices from a post-crisis high
of $107 per barrel for West Texas Intermediate
in June 2014 to a trough of $26 per barrel in
February 2016 also provided a shock to the
economy. Employment and capital expenditures
in the oil and gas sector dropped by 29% and
67%, respectively, from peak levels seen in 2014.
The sector’s par-weighted default rate excluding
distressed exchanges reached 14.6% and including
such exchanges 19.8%, in October 2016. 51
Broad-based fear of policy mistakes in China
and unexpected depreciation of the renminbi were
Outlook
Investment Strategy Group
19
Exhibit 19: US Equity Volatility
Spikes in equity volatility have corresponded with major global shocks.
VIX Level
90
80
70
60
50
1 Global Financial Crisis
2 First Greek Bailout
3 Debt Ceiling, S&P Downgrade,
Eurozone Sovereign Debt Crisis
4 Greek Default
5 ISIL, Ebola
6 Renminbi Depreciation
SPX: -42%
80.9
(11/20/08)
1
45.8
(5/20/10)
40.7
(8/24/15)
40
30
20
10
18.8
(8/22/08)
SPX: -12% 2
15.6
(4/12/10)
SPX: -19% 3
26.7
(6/1/12)
SPX: -10% 4
14.7 14.3
(4/21/11) (3/26/12)
28.1
26.3
(2/11/16)
(10/15/14)
SPX: 6
SPX:
SPX: -12% -13%
-7%
6
5
14.5
11.5 12.0 (11/3/15)
(8/22/14) (7/17/15)
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Data through December 31, 2016.
Note: The red arrows show the S&P 500's (SPX's) peak-to-trough declines around each episode.
Source: Investment Strategy Group, Bloomberg.
48.0
(8/8/11)
another shock to the financial markets, resulting
in the tightening of financial conditions in the
US in mid-2015 and early 2016, with US equities
dropping by more than 10% in both periods.
Exhibit 19 provides a time line of shocks,
which, in all likelihood, dampened the pace of the
US recovery.
In Summary
As we review the six theories that could account
for the notably slow pace of this recovery, we
believe that all have some merit. Recovering
from the hangover from the deepest recession
since the Great Depression took a little longer.
Demographics have not been favorable.
Productivity growth appears lower, but that fact
does not portend weak productivity growth in the
future. Productivity growth is also probably not as
weak as it appears, given some mismeasurement
of GDP. Fiscal and regulatory policies hampered
the economic recovery. And the global backdrop
provided a steady source of shocks that slowed
growth in the US.
That said, we feel confident that the US
continues to progress on a solid footing, that the
recovery is intact and, as we argued in our 2016
Outlook: The Last Innings, that this recovery and
bull market have another inning or two left to run.
The glass is still half-full.
We now turn to our expected returns for the
next one and five years.
One- and Five-Year Expected
Total Returns
The Investment Strategy Group began producing
one- and five-year annualized expected total
returns for major asset classes in our 2013
Outlook. Since then, our key message has been
to stay invested in US equities despite the low
returns we have expected for the asset class.
Our recommendation has been driven by a low
probability of recession, a reasonable probability
of upside for equities, zero expected returns for
cash and negative expected returns for bonds.
We have presented these one- and five-year
annualized expected returns to: a) provide more
context for our investment recommendations; b)
encourage our clients to have a longer investment
horizon; and c) increase the odds that our clients
have greater staying power to withstand market
downdrafts.
Fulfilling these three priorities is even
more imperative moving forward. Our return
expectations are lower than in prior years after
several years of outsized returns in equities
and high yield, and, at the same time, we are
confronted with tremendous economic policy and
geopolitical uncertainty. We have been faced with
such uncertainty in the past, but today (in contrast
with periods such as 2008), we no longer have the
wind at our back with the benefit of cheap equity
and high yield valuations. In 2008, we believed
that attractive valuations would eventually lead to
high prospective returns in US equities and high
20 Goldman Sachs january 2017
yield, notwithstanding short-term uncertainty.
At the dawn of 2017, we face uncertainty, but
US equities and high yield are expensive, and
valuations no longer provide much margin of
safety and protection from the downside. Similarly,
other asset classes such as fixed income provide
negligible returns but come with downside risk,
e.g., if the incoming Trump administration’s fiscal
policy is more stimulative than we expect or if the
Federal Reserve raises interest rates at a more rapid
pace than we expect.
As we prepared our one- and five-year
annualized expected returns for this Outlook and
finalized our investment recommendations for
2017, we were struck by two observations.
First, the general recommendations and
volatility warnings in our Outlook publications
over the last several years have been similar, have
been directionally correct and have generally
added value to our clients’ portfolios. We have
continuously recommended that clients stay
invested in their strategic US equity allocation. We
have also recommended maintaining some tactical
tilts such as an allocation to high yield. Yet we
have warned clients to be prepared for bouts of
volatility. Last year, our exact message to clients
with respect to volatility was that “markets will
be volatile, so an asset class that performs well in
the first half of the year may perform particularly
poorly in the latter part of the year; however,
investors—unlike traders—should not try to time
such short-term moves.” 52 It is very important that
clients heed this warning—not just for 2017 but
for their entire investing lives.
Exhibit 20 illustrates the point. We have
compared the performance of some of the bestperforming
asset classes and sectors for the year
with the performance of those assets at their worst
The general recommendations and
volatility warnings in our Outlook
publications over the last several
years have been similar, have been
directionally correct and have
generally added value to our clients’
portfolios.
Exhibit 20: Returns in 2016
Some of the best-performing assets in 2016 experienced
significant declines before recovering.
Total Return (%)
50
40
30
20
10
0
-10
-20
-30
-10.3
Return Through Year-End 2016
Return Through 2016 Low (2/11/16)
12.0
S&P 500 Total Return Index
-19.1
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
point of the year. Energy high yield provides an
excellent example. On February 11, 2016, the
US energy high yield sector (as measured by the
Bloomberg Barclays High Yield Energy Total
Return Index) was down 19.1% year to date—one
of the worst-performing sub-asset classes at that
time. Similarly, the US bank sector (as measured by
the S&P Banks Select Industry Total Return Index)
was down 21.7% over the same period. We had
in place tactical tilts in both sectors. As oil prices
recovered, high yield energy securities rallied, with
the benchmark index ending the year up 37.4%—a
wild swing of 56 percentage points from low to
high. US banks also rallied initially in response
to prospects of higher interest rates and later in
anticipation of less regulation under a Trump
administration. The bank sector index rallied to
end the year 31.3% higher than at the start—an
equally wild swing of 53 percentage
points from low to high.
We have to be realistic: we cannot
anticipate such market swings on
a consistent basis. Therefore, it is
imperative that clients maintain a
long investment horizon, be tactical
when investment opportunities present
themselves—usually at times of extreme
stress in the financial markets—and
37.4
Bloomberg Barclays High
Yield Energy Total Return
Index
-21.7
31.3
S&P Banks Select Industry
Total Return Index
otherwise stay invested in the appropriate
strategic asset allocation.
Our second observation was that
our five-year annualized return forecasts
Outlook
Investment Strategy Group
21
Exhibit 21: Historical Total Returns vs. ISG’s 2013 Outlook 5-Year Prospective Total Returns
Our 5-year return forecasts have so far been relatively accurate for the bulk of assets in our diversified model portfolio, but
we have not been right across the board.
% Annualized
20
15
5-Year Annualized Projected Return—As of December 31, 2012
Actual Annualized Returns—Since December 31, 2012
14
18
14
15
19
10
5
0
-5
0
1
0
2
4
5
5
3
6 6
7
-5
8
11
11
-2
10
-10
10-Year
Treasuries
Muni 1–10 US High Yield Hedge Funds S&P 500 Japanese
Equity
Emerging Market
Local Debt
EAFE Equity EM Equity (US$) Euro Stoxx 50 US Banks
Data through December 31, 2016.
Note: Rounded to the nearest whole integer.
Source: Investment Strategy Group, Datastream.
have also been relatively accurate for the bulk
of assets in our diversified model portfolio. In
Exhibit 21, we compare the five-year annualized
expected total returns published in our 2013
Outlook to what transpired over the last four
years. Our forecasts for 1) fixed income returns
including both investment grade and high yield,
2) hedge fund returns, and 3) EAFE equity returns
were close to the mark. Directionally, we were
also right about US equity returns but off in terms
of magnitude. We were also struck by how close
our US bank sector return forecasts were to the
realized returns—approximately a quarter of which
were realized after the November election. This
observation has reinforced our belief in one of the
pillars of our investment philosophy: having the
appropriate horizon for various strategies is critical
to long-term success.
Not surprisingly, we have not been right
across the board. We underestimated Japanese
equity returns by 11.4 percentage points on an
annualized basis and we overestimated emerging
market equity and emerging market local debt
returns, by sizable 13.5 and 12.1 percentage
points, respectively, on an annualized basis.
Japanese equities realized an annualized 18%
return and EM equity and local debt realized
negative returns, at -2% and -5% annualized,
respectively. While our forecasts were off
the mark, our emerging market investment
recommendations were on the mark. In mid-2013,
we recommended clients reduce their strategic
allocation to emerging market assets. Even though
we had forecast expected returns that were
nearly double those of US equities, we became
22 Goldman Sachs january 2017
Exhibit 22: ISG Prospective Total Returns
Expected returns over the next one and five years are below historical realized averages.
%
8
7
2017 Prospective Return
5-Year Prospective Annualized Return
7
6
5
4
3
2
1
0
0
2
10-Year
Treasury
2
1 1
Muni 1–10 US Cash 5-Year
Treasury
2
1
2
2
4
EM Local
Debt
3
4
Hedge
Funds
3
3
S&P 500
3
3
Euro
Stoxx 50
4
4
US Corporate
High Yield
4 4
3
UK Equity
5
Muni High
Yield
5
EAFE
Equity
5
3 3
Japan
Equity
5
EM Equity
(US$)
3
3
Taxable
Moderate
Portfolio
Data as of December 31, 2016.
Note: For informational purposes only. There can be no assurance the forecasts will be achieved.
Source: Investment Strategy Group. See endnote 53 for list of indices used.
increasingly concerned about the structural fault
lines of emerging market countries. These fault
lines were discussed in detail in our December
2013 Insight, Emerging Markets: As the
Tide Goes Out.
We continue to recommend a zero allocation
to emerging market debt (dollar-denominated
and local currency debt) and a 2% allocation
to emerging market equities in a moderate-risk
diversified portfolio. We highlight emerging market
assets because, yet again, our base case returns,
especially for emerging market equities, appear
compelling, but we are not recommending a
tactical allocation to this asset class. As we discuss
below in our review of the risks to our economic
and financial market outlook, China is our biggest
source of concern in 2017 and for the next few
years. Emerging markets are the countries that
would be most negatively impacted by any shocks
emanating from China.
China is our biggest source of
concern in 2017 and for the next
few years. Emerging markets are
the countries that would be most
negatively impacted by any shocks
emanating from China.
Our 2017 expected returns, shown in Exhibit
22, are the lowest returns we have published since
the global financial crisis. Not a single broad asset
class is expected to have double-digit returns. Cash
has an expected return of 1%. Expected returns
for intermediate investment grade fixed income
securities range between 0% and 1% depending
on maturities, an expectation driven by our view of
rising rates as the Federal Reserve hikes the federal
funds rate two or three times in 2017. US equities,
which are the most expensive of global equities,
have an expected return of about 3%, and we
expect slightly higher returns in other developed
market equities. Hedge funds, an asset class for
which we have had modest single-digit return
expectations since our 2013 Outlook (as shown in
Exhibit 21), should continue to have modest returns;
we expect a 3% return before taxes, compared to a
5% annualized return expectation in 2013 and an
annualized return of 3% over the last four years.
In aggregate, a moderate-risk diversified
portfolio for taxable clients is expected to
have a return of about 3%. We must note
that our return expectations are not meant
to promote a specific investment, and
that their basis on current capital market
assumptions implies they will likely
change over the course of the year.
At this point, our clients may well be
asking why they should remain invested
in a diversified portfolio with such paltry
Outlook
Investment Strategy Group
23
return expectations, given all the economic policy
and geopolitical uncertainty mentioned earlier. We
believe there are three compelling arguments.
First, there is potential for upside
surprises in 2017:
• Saudi Arabia and the rest of the oil producers
may stick to the announced oil production cuts,
thereby boosting energy sector earnings.
• A Trump administration fiscal stimulus could
boost growth by more than we expect.
• Corporate tax cuts could increase corporate
sector profitability.
• A possible tax holiday could encourage US
multinational corporations to repatriate
some of their earnings and deploy them for
stock buybacks.
We assign a 25% probability of such upside
surprises relative to a 60% probability of our base
case scenario and a 15% downside probability.
(Please see Section III, 2017 Financial Markets
Outlook, for a more detailed discussion.)
Second, we recommend staying invested
because we believe that the probability of a
recession in the US is about 15% over the next
year. There is an 85% chance that the economy
will grow at a rate of about 2% or higher. Absent
a recession, equities are more likely to generate
positive returns. Obviously, the probability of
a recession is substantially higher over the next
five years, and our five-year annualized expected
returns incorporate a 70–80% probability of a
recession.
Third, and most importantly, we do not see
better investment alternatives. Cash will provide
negligible returns with no upside, and we expect
investment grade bonds to have equally negligible
returns with little upside, if any. We also expect
hedge funds, in aggregate, to lag equities on an
after-tax basis.
We expect similarly modest returns from our
tactical tilts.
As equities, high yield and the dollar
have rallied over the course of the
year, we have continued to reduce the
overall risk level of our tactical tilts.
Our Tactical Tilts
As equities, high yield and the dollar have rallied
over the course of the year, we have continued to
reduce the overall risk level of our tactical tilts. At
the beginning of 2016, we had already reduced our
exposures by 50% relative to peak levels in 2015, as
measured by value at risk. By the end of 2016, we had
reduced exposures further, based on our investment
discipline of averaging in and out of our tactical tilts.
Underweight Fixed Income: We continue to
recommend underweighting US fixed income assets
as the Federal Reserve slowly but steadily raises the
federal funds rate. We expect the 10-year Treasury
bond yield to range between 2.5% and 3.0%. As
a result, we forecast a 1% return across short- and
intermediate-maturity fixed income assets and a
near zero return for the 10-year Treasury. Longer
maturities are expected to have negative returns.
We also recommend underweighting fixed income
assets to fund tactical tilts given their higher
expected returns.
Overweight to High Yield: While we reduced
our tactical allocation to high yield assets by half
throughout 2016, we continue to recommend an
allocation to general high yield bonds, high yield
energy bonds and high yield bank loans. The
incremental yield in such securities, adjusted for
defaults, is still compelling, with expected returns
of about 4% for high yield bonds and high yield
energy bonds and about 5% for bank loans.
We forecast that crude oil prices will stay in the
$45–65 range, partly owing to some production
discipline by Saudi Arabia as the largest swing
producer. Our bank loan tilt is further supported
by a rising rate environment; the coupon rate on
bank loans will be reset higher as LIBOR rises. 54
Modest Overweight to US Banks: We maintain
a modest overweight to US banks despite their
31% return in 2016. Banks will benefit from rising
rates, especially if the increase is greater in the
short end of the yield curve. About 60%
of changes in the net interest margin of
banks is typically driven by changes in
short rates since they are used for setting
the banks’ prime lending rate. Banks will
also likely benefit from a more favorable
regulatory environment under a Trump
administration. We forecast a return
of about 7%.
24 Goldman Sachs january 2017
Overweight US Energy Infrastructure Master
Limited Partnerships (MLPs): We initiated a
direct allocation to energy MLPs in late January
2016 and have maintained that tilt. Given our
assumptions about oil prices, we believe that the
cash distributions from MLPs are generally secure
and provide a yield to investors of just over 7%.
In the absence of any valuation changes, the yield
translates into a high single-digit tax-advantaged
return. Any growth in cash flow distribution or
improvements in valuation relative to the S&P 500
would provide some upside.
Overweight Spanish Equities: We maintain an
overweight to Spanish equities on a currencyhedged
basis. This tactical tilt was introduced in
August 2013, and we have adjusted the size of
the overweight about a dozen times since. Spanish
equities offer some of the cheapest valuations
across the developed markets, attractive dividend
yields, expected earnings growth of 4.6%, aided
by healthy domestic growth, and a particularly
well-capitalized 55 banking sector that has a lower
nonperforming loan ratio than the Eurozone bank
average. Furthermore, Spain is unlikely to face the
same political uncertainty as Germany, France and
Italy in 2017. We expect high single-digit returns
for Spanish equities.
Short Five-Year German Bunds: We recommend
a short position in five-year German bunds as
the ECB embarks upon the process of shifting
its monetary policy. After the December 2016
meeting, the ECB announced that it would reduce
its monthly purchases of bonds from €80 billion to
€60 billion starting in March 2017 and continuing
through December 2017. We expect the ECB to
end all purchases sometime in 2018, barring any
shocks. As a result, we think interest rates for
Eurozone sovereign debt will rise gradually over
the course of the year, which in the case of German
bunds means they will become less negative. We
expect a modest 2% return from this tilt.
Short Chinese Renminbi: We have increased our
bearish position on the Chinese renminbi over
the course of 2016. China is under pressure from
multiple sides: the need for loose monetary policy
to achieve the leadership’s 6.5% target GDP
growth rate, 32 months of capital outflows that
have accelerated in late 2016, a strong dollar and
an incoming Trump administration that will likely
pursue a US-centric policy toward China. Risks are
exacerbated by the leadership’s lack of experience
in handling financial market volatility, as evidenced
by China’s policy response to its equity market
collapse in June 2015 and its approach to shifting
the currency regime to a more flexible one in
August 2015 and January 2016. We expect the
currency to depreciate about 7% in 2017; since
4% is already priced in the forward markets, we
expect a return of about 3%. There is considerable
scope for further upside from this tilt if China
abandons its current control of the currency,
a move that could lead to depreciation in the
renminbi of about 20%.
Our tactical tilts are based on above-trend growth
of 2.3% in the US, global growth of 2.9%,
generally favorable monetary policy and more
stimulative fiscal policy across developed and
emerging market countries. We expect returns to
be muted across asset classes, resulting in modest
returns in a diversified portfolio with a modest
enhancement from tactical tilts. Of course, our
views are not without risks. As we discuss below,
some are low-probability risks with the potential
for high impact while others are high-probability
risks with low impact potential.
The Risks to Our Outlook
When we think about the risks to our economic
and financial market outlook, we are reminded of
the words of French writer Jean-Baptiste Alphonse
Karr: Plus ça change, plus c’est la même chose—the
more things change, the more they stay the same.
This year’s list of risks overlaps with those of the
last several years. As far back as 2011, investors
have worried about a hard landing in China. From
the inception of the European sovereign debt
crisis in 2010 through the Brexit vote in 2016, the
potential breakup of the Eurozone has been a source
of concern. As soon as the Federal Reserve raised
the federal funds rate in December 2015, investors
worried about tightening policy causing a recession.
Cybersecurity and terrorism are constant threats.
And geopolitical risks have grown over time. This
year, we are adding trade policy uncertainty and US-
China geopolitical relations as new risks.
As we said in our 2013 Outlook, there is no
shortage of concerns as markets climb a wall
of worry. In our view, there are eight risks that
Outlook
Investment Strategy Group
25
We do not believe this tightening cycle will lead to a US recession in 2017.
could derail the last innings of this recovery and
bull market. The first three are low-probability
risks in our view, the next three risks have a
high probability of occurring but their impact is
uncertain and the last two are high-probability and
high-impact risks beginning as early as 2017.
Low-Probability but High-Impact Risks:
• The pace of Federal Reserve tightening
is disruptive and financial markets
react negatively.
• The economy slips into recession.
• Populist parties in the Eurozone
gain greater influence.
offing. Interest rates have increased from
a low of 1.3% for the 10-year Treasury
in July 2016 to 2.4% by year-end. While
this increase in interest rates would
ordinarily tighten financial conditions,
it has been partially offset by stronger
equity markets and tighter corporate
bond spreads. In fact, financial conditions
were looser at the end of the year than
they were at the beginning of 2016
despite expectations of a slow but steady
increase in the federal funds rate.
We share the market view that the
pace of monetary policy tightening will
accelerate but remain benign. As shown
in Exhibit 23, the difference between
the Federal Reserve dots, the view implied by the
bond market, the forecast by our colleagues in
GIR and our view is negligible. The bond market
has priced two hikes, the Federal Reserve and GIR
expect three hikes, and we think two or three hikes
are equally likely in 2017. We assume that the
Federal Reserve will slow down the pace of interest
High-Probability but Uncertain-Impact Risks:
• Geopolitical hot spots get hotter.
• Terrorism escalates.
• Cyberattacks continue.
High-Probability and High-Impact Risks:
• China submerges under its debt burden and
capital outflows.
• US-China relations deteriorate under the Trump
administration.
Pace of Federal Reserve Tightening
Unlike the December 2015 interest rate hike that
prompted a vocal response from naysayers but had
limited impact on the bond market, the December
2016 hike has elicited a muted response from
market commentators but has had a larger impact
on the bond market. The underlying strength of the
labor market and the steady improvement in the
economy have led to a change of sentiment toward
more interest rate hikes, which are clearly in the
There is no shortage of concerns as markets climb a wall of worry.
26 Goldman Sachs january 2017
Exhibit 23: Policy Rate Path Projections
We expect the pace of monetary policy tightening to
accelerate but remain benign.
Federal Funds Rate (%)
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
ISG View
GIR View
Market Implied
Median Federal Reserve Projection
1.4
1.4
1.3
1.2
0.0
Dec-16 Dec-17 Dec-18 Dec-19
Data as of December 31, 2016.
Note: For informational purposes only. There can be no assurance that the forecasts will
be achieved.
Source: Investment Strategy Group, Bloomberg, Goldman Sachs Global Investment Research,
Federal Reserve.
rate hikes should the economy weaken, and will
pick up the pace later in 2017 or 2018 if the
fiscal package under the Trump administration is
bigger than we expect (see Section II, 2017 Global
Economic Outlook, for a more detailed discussion).
Irrespective of the realized pace, this tightening
cycle will not result in a US recession in 2017,
in our view.
Recession Is Highly Unlikely
“Depression Bread Line,” Bronze, 1991, George Segal at the Franklin D. Roosevelt
Memorial. Art © The George and Helen Segal Foundation/Licensed by VAGA,
New York, NY.
3.4
2.9
2.8
2.0
Low Expectations of a US Recession
Recessions in the US have been triggered by
Federal Reserve tightening of monetary policy; by
economic imbalances such as the bursting of the
dot-com and housing bubbles in 2000 and 2008,
respectively; or by external shocks such as the Arab
oil embargo in 1973. The first two triggers are
unlikely to occur in 2017, and the third, a shock,
is not something that we can typically anticipate.
However, we do think that China will be a
source of downside risk sometime over the next
three years.
First, as we mentioned in last year’s Outlook,
there have been five tightening cycles in the post-
WWII period that have not triggered a recession.
Four of those cycles occurred during the three
longest recoveries, as shown in Exhibit 24. Those
cycles have been characterized by an early start
to the tightening cycle, a slow pace relative to
historical averages (220 basis points per year for
nonrecessionary tightening and 330 basis points per
year in recessionary cycles), low core inflation and
slack in the labor market. This cycle shares those
characteristics: the tightening cycle started in 2015,
the pace has been 25 basis points per year, the core
personal consumption expenditures (PCE) index—
the Federal Reserve’s preferred benchmark for
inflation—is at 1.6% year over year as of November
2016, and our colleagues in GIR estimate that the
labor market still has about 0.3% slack.
Second, the US economy does not
suffer from any imbalances in which one
sector of the economy has become the
sole driver of growth or equity market
returns. Before the global financial crisis,
residential investment as a percentage
of GDP had peaked at 6.7% in 2005,
compared to a long-term average of
4.7%, and the credit-to-GDP gap as a
measure of nonfinancial sector leverage
had peaked at 12.4% in 2007 compared
to a long-term average of -1%, leading
to meaningful imbalances. Similarly, in
2000, technology and telecommunication
sector valuations were more than three
standard deviations higher than the
average of other sectors. Such imbalances
do not exist in the US at this time.
Third, while we cannot anticipate an
external shock—otherwise it would not
be a shock—we do not see imbalances in
other large economies except in China.
Outlook
Investment Strategy Group
27
Exhibit 24: US Real GDP During the Longest Post-WWII Recoveries
Four of the five tightening cycles that did not trigger a recession occurred during the three longest recoveries in the
post-WWII period.
Beginning of Recovery = 100
160
Mar-61
Dec-82
150
Mar-91
Current (Jun-09)
140
Aug-61–Nov-66
Did NOT Trigger
Recession
Dec-86–Mar-89
Triggered Recession
CAGR: 4.4%
Aug-67–Aug-69
Triggered Recession
CAGR: 4.9%
CAGR: 3.6%
130
120
Mar-83–Aug-84
Did NOT Trigger
Recession
CAGR: 2.1%
Jun-99–Jul-00
Did NOT Trigger
Recession
110
Dec-15–?
100
90
Feb-94–Apr-95
Did NOT Trigger
Recession
Denotes Beginning of Fed Tightening Cycle
Denotes End of Fed Tightening Cycle
0 4 8 12 16 20 24 28 32 36 40
Quarters After Recession Trough
Data as of December 2016.
Source: Investment Strategy Group, Bloomberg, National Bureau of Economic Research.
In our 2016 Outlook and our 2016 Insight report,
Walled In: China’s Great Dilemma, we stated that
China was unlikely to have a hard landing over the
next two years (i.e., 2016 and 2017). We believe
the view still holds. We do not expect a hard
landing in China that would destabilize the US
economy in 2017, but the risks grow significantly
in 2018 and 2019. As we discuss below, China may
nevertheless represent a geopolitical risk in 2017.
Historically, since WWII, the odds of a
recession occurring over a 12-month period
have been 18%. Our composite recession model,
incorporating end-of-year financial and economic
data, estimates the probability of a recession in
2017 at 23%. Once we incorporate the likely
passage of a fiscal stimulus package of tax cuts
and infrastructure investments in the latter half
of 2017, the probability of a recession this year
declines to about 15%.
Rising Influence of Populist Parties in
the Eurozone
Since the election of Prime Minister Alexis Tsipras
and the Syriza Party in Greece in January 2015,
populism has been gaining momentum across
Europe. The support for populist parties has
increased to varying degrees in Spain, Greece, Italy,
France, the Netherlands, Germany and Austria.
The common themes among populists have been
anti-immigration and anti-European Union.
Outside the Eurozone, the 2016 Brexit vote in
Great Britain has been interpreted as a populist
vote against immigration from Eastern Europe, the
Middle East and North Africa, as well as against
the bureaucracy of the European Union.
The increasing enthusiasm for populist parties
in Europe raises two questions. First, will any of
the more extremist parties win enough support to
break away from the European Union? In France,
for example, upcoming elections in May 2017 are
likely to pit François Fillon of Les Républicains
against Marine Le Pen of the far right Front
National. Le Pen has promised a referendum on
whether France should stay in the European Union,
and, should she win, questions about the viability
of the Eurozone will surface immediately. 56 While
polls show Fillon well ahead of Le Pen, polls
have been wrong on the UK and Italian referenda
and the US election. The Eurasia Group, for one,
assigns a 30% probability to a Le Pen victory. 57
Second, to what extent will the rise of populism
influence policies in the Eurozone? Here, Germany
will probably provide a litmus test. Chancellor
Angela Merkel and her coalition government are
likely to respond to recent terrorist attacks there by
proposing a stronger police and military presence,
according to the Eurasia Group. Security checks
will probably be increased as well, since at least
800,000 asylum-seekers entered Germany with
minimal security checks and terrorist suspects have
already been arrested among them. 58 With German
elections scheduled for September 2017, it remains
to be seen whether Chancellor Merkel will adjust
her immigration policy.
28 Goldman Sachs january 2017
While populism is on the rise and the support
for such parties has increased, we do not think that
these movements will threaten the viability of the
Eurozone in 2017. In fact, in response to Brexit,
we believe that Eurozone policymakers will take a
hard line with Britain to make sure other countries
do not think it realistic to manage an exit that
retains all the benefits while shouldering none of
the costs.
The Wall Street Journal reports that the
“Obama administration considers North Korea
to be the top national security priority for the
incoming administration.” 65 Nuclear weapons
already in place, long-range ballistic missile
capabilities in development, and an unpredictable
and provocative leader are a deadly combination.
North Korea will remain a serious risk for the
foreseeable future.
Geopolitical Hot Spots Get Hotter
We rely on the insights of external experts
to formulate our geopolitical views. They
include members of prominent research groups,
think tanks and universities as well as former
government officials, both in the US and abroad.
So informed, we highlight activity in North Korea,
Russia and the Middle East among our group of
risks with high probability but uncertain impact.
North Korean Belligerence Continues: North
Korea’s unpredictable and belligerent military
activities have continued unabated. In early 2016,
North Korea announced that it had tested its first
hydrogen bomb. 59 By the end of 2016, North Korea
had conducted nine other military actions, including
the launch of a ballistic missile from a submarine, 60
launches of long-range ballistic missiles toward
Japan 61 and additional nuclear tests. 62
We can only expect further tests in 2017, given
the estimates by a Council on Foreign Relations
task force chaired by retired Admiral Michael
Mullen that North Korea may have between 13
and 21 nuclear weapons as of June 2016. 63
Even more troubling is a pattern highlighted by
David Gordon, adjunct senior fellow at the Center
for a New American Security. Gordon points out
that North Korea makes a habit of testing new
presidents, as it did in May 2009, early in President
Obama’s first term, and again in February 2013
after South Korean President Park Geun-hye was
inaugurated. 64
While populism is on the rise and
the support for such parties has
increased, we do not think that these
movements will threaten the viability
of the Eurozone in 2017.
Russian Adventurism Intensifies: While attention
has been focused on Russia’s adventurism in Syria,
the frozen conflict in Ukraine remains intact, with
increasing violations of the Minsk agreements
of 2014 and 2015. 66 Since the first agreement
in September 2014, nearly 10,000 people have
been killed, 67 and most recently, Russian-backed
separatists attempted to break through Ukrainian
government lines. 68 In response to such lack of
progress and concerns about further Russian
aggression in the region, the heads of North
Atlantic Treaty Organization (NATO) member
countries agreed, at a summit in Warsaw in
July 2016, to deploy as many as 4,000 troops
to the Baltic States and Poland in early 2017 as
a deterrent to further adventurism in Eastern
Europe. 69 The risks of accidents and intentional
skirmishes will inevitably rise.
Furthermore, the direction of foreign policy
in the region under a Trump administration is
uncertain given President-elect Trump’s July 2016
statement that the US would not automatically
defend the Baltic States. 70
Russia is likely to stay involved in the Middle
East as well. Russia has been a constructive force
with respect to the fight against the Islamic State of
Iraq and the Levant (ISIL) and a stabilizing force
with respect to keeping Syrian President Bashar
al-Assad in place in the absence of any attractive
alternatives. Syria would not have made as much
progress in pushing back ISIL and the rebels
without Russian air power support. Russia has also
hosted a meeting in Moscow with Iran
and Turkey to work toward an accord
to end the war in Syria 71 —a six-year war
that has resulted in 400,000 72 to 470,000
fatalities 73 and an estimated economic
cost of $250 billion to $275 billion. 74
Given the prospects of continued
geopolitical turmoil in the region,
Russian involvement in the Middle East
will not be reduced anytime soon.
Outlook
Investment Strategy Group
29
Middle East Conflicts and Tensions Persist: The
Middle East will remain a source of conflict for
years to come. Many countries have weak or
collapsing nation-state structures with varying
degrees of civil war. As Zalmay Khalilzad,
former ambassador to Afghanistan, Iraq and
the United Nations, and president of Gryphon
Partners, wrote recently, “the national borders
devised by Western powers for Iraq and Syria, in
particular, are not standing up well to the test of
time … and Pakistan’s policies have contributed
to Afghanistan’s precarious condition.” 75 Iran
and Saudi Arabia compete for influence in the
region, and the Sunni-Shia divide that was not a
geopolitical factor 40 years ago will continue to
escalate tensions in the region.
Another potential risk in the region is the
dismantling of the Iran nuclear deal by the Trump
administration. 76 In the absence of a deal, Iran
would return to building its nuclear capabilities,
thereby increasing the risks of a military strike by
Israel or the US.
We assign a low probability to such an event
for two reasons. First, we point to comments made
by secretary of defense nominee retired General
James Mattis, which suggest a different approach
in dealing with Iran. 77 In a speech in April 2016 at
the Center for Strategic and International Studies,
Mattis said “there is no going back” on the deal
“absent a clear and present violation.” 78 Second,
other signatories to the deal, including Russia and
China, would not support a unilateral dismantling
of the deal by the new administration. 79 That is not
to say that tensions between the US and Iran will
not continue this year.
Turmoil in the region will continue into 2017
and beyond. While the direct impact of such
conflicts on global growth and world equity
markets is limited outside a war among major
powers, the threat posed by terrorism is significant
and growing.
Terrorism Escalates
Another high-probability but uncertain-impact
risk is increased terrorism. The Middle East has
been the main source of terrorism even before the
September 11, 2001, attack on the World Trade
Center. The majority of the 9/11 perpetrators,
15 out of 19, were from Saudi Arabia, with the
rest from other Arab countries in the region. 80
Since then, the spread of ISIL, the Syrian civil
war, extremism in Pakistan and Afghanistan, and
the immigration of Arabs and North Africans
to Europe and, to a lesser extent, the US, have
increased the incidence of terrorism in the West.
In 2016, there were five key terrorist incidents
in the US and 15 in Europe, including a December
19 attack when a truck rammed into a Christmas
market in Berlin. 81 Some of the terrorists
responsible were inspired by ISIL, 82 and some were
lone-wolf Islamic extremists who had lived in their
respective countries for years. 83 With a growing
number of refugees in Europe, it is highly likely
that this pace of terrorism will continue.
Terrorist attacks and geopolitical tensions in
the Middle East take more than their immediate
human toll. While consumer confidence in the
US is now above the pre-global financial crisis
peak of July 2007 (see Exhibit 25), Gallup Poll
data shows that dissatisfaction remains at a very
high level, similar to that at the beginning of
the global financial crisis. As shown in Exhibit
26, the dissatisfaction rate increased steadily in
the aftermath of the 9/11 terrorist attacks and
the US wars in Afghanistan and Iraq. It had
already reached current levels before the global
financial crisis.
Former Federal Reserve Chairman Ben
Bernanke has named traumatic national shocks
such as 9/11 along with political polarization
and “shrill” political debates as possible culprits
of the contradictory signals between the high
levels of consumer confidence as measured by
the Conference Board and the high levels of
dissatisfaction as measured by Gallup Polls. 84
Risks of continued terrorism are very high,
but the broader economic impact of the type of
terrorist acts we witnessed in 2016 is limited. We
can only hope that large attacks such as 9/11 do
not occur again.
Cyberattacks Continue
High-profile cyberattacks or cyberattack
announcements were a regular feature of 2016.
The highest-profile attacks were those perpetrated
by the Russian government on the Democratic
National Committee computer network, according
to a joint statement from the Department of
Homeland Security and Office of the Director
of National Intelligence on Election Security. 85
The US government expelled 35 Russian officials
and imposed sanctions on four high-ranking
members of the Russian military intelligence unit
as a result. 86
30 Goldman Sachs january 2017
Exhibit 25: Conference Board Consumer
Confidence Index
The labor market recovery has led to a steady increase in
consumer confidence.
Index Points
160
140
Exhibit 26: Gallup Poll on Satisfaction With the
Direction of the US
Dissatisfaction remains at a very high level, similar to that at
the beginning of the global financial crisis.
% of Respondents
100
90
120
113.7
80
70
71
100
91.5
60
80
60
75.1
50
40
Beginning of Global
Financial Crisis
40
20
Conference Board Consumer Confidence
Historical Average
Post-Global Financial Crisis Average
30
20
10
September 11th
War in Iraq
War in Afghanistan
0
1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
Data through December 2016.
Note: Series starts in January 1978. Post-GFC average begins in July 2009.
Source: Investment Strategy Group, Datastream.
0
1979 1983 1987 1991 1995 1999 2003 2007 2011 2015
Data through December 2016.
Note: The poll asks, “In general, are you satisfied or dissatisfied with the way things are going in
the United States at this time?”
Source: Investment Strategy Group, Gallup.
Other high-profile cyberattacks included
• The announced theft of the account
information of 1 billion Yahoo users in 2013
and 500 million Yahoo users in 2014 87
• The theft of information from as many
as 700,000 accounts at the Internal
Revenue Service 88
• A suspected Chinese military hack into the
Federal Deposit Insurance Corporation 89
• The theft of 117 million LinkedIn passwords
(stolen in 2012 but announced in 2016) 90
The risks of cyberattacks continue to increase.
The risks of cyberattacks continue to increase.
To date, the attacks have had limited detrimental
impact on the broad US economy, but the impact
could be far-reaching if foreign governments such
as Russia or China, criminal entities, or lone actors
attack critical infrastructure in the US or any other
major country.
China Submerges Under Its Debt Burden and
Capital Outflows
At $11.4 trillion, China is the second-largest
economy in the world, with a 13.8% share of
global exports and a 9.7% share of global imports.
It accounts for nearly half of global
demand for zinc, tin, steel, copper and
nickel, and more than half for thermal
coal, aluminum and iron ore. Any major
slowdown or volatility across bond,
currency and equity markets in China,
including Hong Kong, would have major
ramifications for the rest of the world.
While the US has limited direct
economic exposure to China—only 0.6%
of exports as a share of GDP, 0.6%
of bank assets and 0.7% of corporate
profits—any shocks in China will
reverberate through US financial markets.
As shown earlier in Exhibit 18 on page
19, US financial conditions tightened by
118 basis points in the summer of 2015
Outlook
Investment Strategy Group
31
when China’s leadership intervened in the local
equity markets and adjusted the trading band
around the renminbi, and by 104 basis points in
late 2015 and early 2016 when the leadership
changed the reference currency from the dollar to a
basket of 13 currencies. If US financial conditions
had stayed at those levels for over a year, US
GDP growth would have slowed by about one
percentage point, all else being equal. Financial
conditions are the mechanism by which shocks
from China would have the most immediate
impact on key developed economies such as the US.
As mentioned above, one of the triggers of
US recessions has been economic imbalances.
While we do not see such imbalances in the US,
or in other major developed economies, at this
time, we see significant imbalances in China. Such
imbalances have led to crises in other countries,
and there is no reason to believe that they will not
lead to a financial crisis in China. In our view, it is
not a question of if—it is only a question of when.
The biggest imbalance in China is the high level
of debt relative to GDP. The Bank for International
Settlements (BIS) has a series of early warning
indicators. One of the more widely followed
and reliable measures is the credit-to-GDP gap,
measured as the total credit extended to the
private nonfinancial sector as a percentage of GDP
compared with its long-term trend. As shown in
Exhibit 27, China breached the high-risk threshold
in June 2012, when its credit-to-GDP gap rose
above the 10% level. At 30.1% as of March
2016 (latest data available) and rising, China’s
gap exceeds the 10% threshold by 20 percentage
points, levels previously seen in Spain before the
European sovereign debt crisis. Major developed
and emerging market countries have experienced a
financial crisis within three years of their credit-to-
GDP gap exceeding 10%.
In our 2016 Outlook and our 2016 Insight
report, Walled In: China’s Great Dilemma, we
stated that we did not expect a hard landing in
China over the next two years—2016 and 2017.
We continue to assign a low probability to a hard
landing in China in 2017. However, it is unlikely
that China can avoid a financial crisis over the
next three years. In prior years, we have pointed to
China’s high savings rate and government control
of many aspects of the economy as reasons for
its ability to avert a hard landing. However, the
country’s debt levels have risen rapidly, the pace
of capital outflows has picked up, and net foreign
Exhibit 27: Credit-to-GDP Gap Across Economies
China’s gap reached the high-risk threshold in June 2012 and
has continued to rise.
Credit-to-GDP Gap (% of GDP)
50
30
10
-10
-30
High Risk
UK
Elevated Risk
Eurozone
-50
US
Japan
Spain
China
Russia
-70
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data through Q1 2016.
Note: Estimates based on series of total credit to the private nonfinancial sector. Credit-to-GDP
gap is defined as the difference between the credit-to-GDP ratio and its long-term trend in
percentage points. Long-term trend is calculated using an HP filter.
Source: Investment Strategy Group, Bank for International Settlements.
direct investment has reversed and is now negative.
In our view, neither China’s high savings rate nor
its increasing government control of financial
markets and capital flows will be sufficient to avert
a hard landing over the next several years. Keep
in mind that even the US was not able to avert a
financial crisis after its credit-to-GDP gap briefly
breached the 10% high-risk threshold in December
2006 and peaked at 12.4% in December 2007.
The US has the highest GDP per capita of any
major country in the world. The large countries
that come closest to the US on this score have
GDP per capita levels that stand at about 70% of
US levels on a nominal basis and slightly higher
on a purchasing power parity (PPP) basis. The US
dollar is also the unquestioned reserve currency
of the world; its reserve-currency status has only
been fortified after the Eurozone sovereign debt
crisis and the British referendum for Brexit. Thus,
the US is able to access the excess savings of the
entire world. The US also receives the largest share
of world foreign direct investment flows, capturing
14% of global flows between 2011 and 2015.
The US now accounts for 20% of the stock of all
foreign direct investment. Yet, despite all these
major advantages, it did not avert a financial crisis
in 2008. It defies logic to assume that China will
be the one major country that avoids a financial
crisis and a hard landing when it does not enjoy
such advantages. As we often say, stating that “this
32 Goldman Sachs january 2017
Exhibit 28: Total Foreign Currency Holdings of
China’s Official Sector
If the recent pace of decline continues, China’s reserves
could soon fall below the IMF’s adequacy threshold.
US$ billions
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
PBOC FX reserves
Other official FX holdings
Scenario 1 (avg. pace since Aug-2015)
Scenario 2 (avg. pace in 2016)
0
Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17
Data through November 2016.
Source: Investment Strategy Group, CEIC, Bloomberg, IMF.
IMF FX reserve threshold
(without capital controls)
2,800
1,700
IMF FX reserve threshold
(with capital controls)
time is different” is extremely dangerous for the
investment well-being of our clients’ portfolios.
China, in fact, faces greater risk of a financial
crisis because of growing capital outflows. An
astounding $1.3 trillion of capital has flowed out
of China since August 2015, when it broadened the
trading range for its currency against the US dollar.
The outflows averaged $64 billion per month in
2016. At that pace, China’s total official foreign
currency holdings could drop below the IMF’s
reserve threshold of $2.8 trillion by mid-2017, as
shown in Exhibit 28.
Of course, China’s leadership has not stood on
the sidelines. Since September 2015, the People’s
Bank of China and the State Administration of
Foreign Exchange have introduced a series of
measures to limit capital outflows. These measures
have included orders to financial institutions
to carefully check and strengthen controls on
all foreign exchange transactions 91 and strict
oversight of Chinese companies’ outward
investment in overseas property, hotels, cinemas
and the entertainment and sports industries. 92
According to reports, leadership has also ordered
increased oversight of trade activities to make
sure companies are not over-invoicing the value
of their imports or under-invoicing the value of
their exports as a means of circumventing capital
controls. 93 Exports and imports are 20% and
15%, respectively, of China’s GDP. It is virtually
impossible for China to halt capital flows in such
a porous economy without slowing GDP growth
rates. Thus, China will not be able to completely
stem outflows despite all its measures to slow the
pace as much as possible.
Irrespective of the success of such capital
controls, China’s growing debt problem poses
significant risks to China’s growth
trajectory. We estimate that the risk
of a hard landing is only about 25%
in 2017 but will increase rapidly to
about 50% in 2018 and be closer to
75% in 2019. Therefore, while China
is not a near-term risk, there is a high
probability of an intermediate-term crisis
that will reverberate through financial
markets. We also know that we cannot
anticipate the exact timing of such crises,
especially given the uncertainty of how
US-China relations will unfold under a
Trump administration.
According to the Center for Strategic and International Studies, China has installed
anti-aircraft guns and other weapons systems on seven man-made islands in the
South China Sea, including the Johnson Reef, shown above.
Map data: Google, DigitalGlobe
US-China Relations Deteriorate Under
the Trump Administration
There is no doubt that US strategy
toward China will shift; the only
question is when and how. There are
two channels by which the Trump
administration could affect US-China
relations: trade and foreign policy.
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Investment Strategy Group
33
We may see some fireworks in US-China relations during the Trump administration.
With respect to trade, President-elect Trump
can use any one of six US statutes, including the
Trading with the Enemy Act of 1917 and the
International Emergency Economic Powers Act of
1977, to shift trade policy. The latter two statutes
give him latitude to change foreign commerce
without interference from Congress or the courts.
President-elect Trump has advocated
imposing tariffs and labeling China a “currency
manipulator.” While he has continued to
threaten tariffs of 45% on imports from China,
there is considerable uncertainty as to what
his administration will actually impose. If the
US and China engage in a full trade war, the
Peterson Institute for International Economics has
estimated a notable drag on US GDP growth over
three years. 94
Any of these actions by the Trump
administration may provoke a strong reaction
from China, including a sizable depreciation of the
renminbi. Such depreciation would certainly be
disruptive to financial markets.
With respect to foreign policy, many policy
experts have been calling for a change in strategy
toward China. In April 2015, the Council on
Foreign Relations published a special report on
China, suggesting that Washington needed “a
new grand strategy toward China that centers
on balancing the rise of Chinese power rather
than continuing to assist its ascendancy.” 95 The
militarization of the seven artificial islands in the
South China Sea (see image on page 33), according
to the Asia Maritime Transparency Initiative at the
Center for Strategic and International Studies, 96
will only expedite such a shift in strategy.
If President-elect Trump’s actions to date,
such as the telephone conversation with Taiwan
President Tsai Ing-wen 97 and his response to the
recent Chinese seizure of a US Navy drone, 98 are
any indication, we may see some fireworks in US-
China relations during the Trump administration.
34 Goldman Sachs january 2017
Key Takeaways
As we mentioned in last year’s Outlook, forecasting is difficult under the
best of circumstances but particularly so in the last innings of an eightyear-long
economic expansion and bull market. This year brings the
additional challenge of a new president whose policies are likely to follow an
unconventional script.
Nevertheless, there are seven key takeaways from our 2017 Outlook:
• Improving growth: We expect global economic activity to accelerate
this year, with modestly higher GDP growth rates in the US, Eurozone,
Japan and many emerging market economies. We expect a small
slowdown in China.
• Low recession risk: Favorable monetary and fiscal policies substantially
reduce the probability of a recession in key developed and emerging
market countries.
• Still accommodative monetary policy: US monetary conditions will still
be relatively easy because of the slow and steady pace of tightening of
the federal funds rate by the Federal Reserve. At the same time, other
developed central banks are still expanding their balance sheets.
• Remain vigilant: Despite a favorable economic and policy backdrop, there
is no shortage of global risks, including rising populism in Europe, growing
geopolitical tensions, the spread of terrorism and the proliferation of
serious cyberattacks.
• China concerns: China is the biggest source of uncertainty given its
growing debt burden, accelerating capital outflows and potential for a
notable deterioration in the US-China relationship driven by changing US
trade and foreign policy toward China.
• Stay invested: The collective impact of these various risks is not yet sizable
enough to undermine our core view: that we are in a longer-than-normal
US recovery that supports equity returns, which are likely to exceed those
of cash and bonds. Thus, we recommend staying invested in US equities
with some tactical tilts to US high yield bonds and European equities.
• Modest returns: While we recommend clients remain invested, we
have modest return expectations. We expect that a moderate-risk welldiversified
taxable portfolio will have a return of about 3% in 2017.
Outlook
Investment Strategy Group
35
SECTION II
2017 Global
Economic Outlook:
Winds of Change
for most of the last eight years, global policy makers
have been buffeted by the gale force headwinds generated by
the financial crisis. In response, central banks around the world
have expanded their balance sheets by a staggering $12.5
trillion, 99 while fiscal austerity measures in the G-7 economies
have reduced the general government budget deficit from 10%
of GDP to just 3.6% today.
Although this mix of policies may have helped avoid a
second Great Depression, it has fallen short of fostering a
robust economic recovery. According to the IMF, the nominal
GDP of advanced economies has grown at just a 1.6%
annualized pace in US dollar terms since its 2009 trough,
making it among the slowest expansions on record. The
overt reliance on monetary policy has also had unintended
consequences. Persistently low interest rates have crippled
bank profitability and penalized savers. Moreover, the boost
that low rates provide to stock prices primarily benefited a
narrow segment of the income distribution, exacerbating
inequality concerns. Not surprisingly, populism has been on
the rise globally.
36 Goldman Sachs january 2017
Outlook
Investment Strategy Group
37
Last year witnessed a growing repudiation of
this status quo, evident in the surprise outcome
of the UK and Italian referenda, as well as US
presidential election. As we begin 2017, these
winds of change are gaining force. Central banks
are acknowledging the often counterproductive
impact of ultra-easy monetary policy and
shifting attention to the eventual withdrawal of
accommodation. At the same time, the recovery
in commodity prices and recent firming in global
growth is shifting the focus from deflation to
reflation. The same could be said of the increasing
focus on expansionary fiscal policy.
While this change brings hope, it also carries
risk. In the US, fiscal stimulus arrives eight years
into an economic expansion that is already near
full employment, increasing the danger of the
economy overheating. Although the Federal
Reserve could respond by hastening the pace
of rate hikes, it might overdo it. Similarly, an
overzealous negotiating stance on existing trade
relationships or imposition of protectionist policies
by the incoming US administration could staunch
the flow of trade—an outcome that would be
particularly damaging to emerging markets. And
in Europe, a victory of the far right in the French
presidential election could unleash fears about
France exiting the European Union and endanger
the survival of the euro.
Still, we do not yet accord a high enough
probability to these risks to alter our base case,
which assumes these winds of change fill the sails
of the ongoing global recovery, rather than capsize
it (see Exhibit 29).
Exhibit 30: Duration of Post-WWII Expansions
This expansion is already the fourth-longest since WWII.
Recovery Duration (Quarters)
45
40
35
30
25
20
15
10
5
0
40
35
31
30
Mar-91 Feb-61 Nov-82 Jun-09 Nov-01 Mar-75 May-54 Nov-70 Apr-58 Jul-80
Business Cycle Trough
Data as of December 2016.
Note: The recovery is measured from the business cycle trough.
Source: Investment Strategy Group, National Bureau of Economic Research.
United States: Age Is Just a Number
24
The US economic expansion is getting old by
historical standards. At nearly eight years, it is
already the fourth-longest in post-WWII history
and poised to be among the top three by the
middle of this year (see Exhibit 30). Concern that
the economy’s vigor is finally succumbing to its
advanced age was only bolstered by anemic 1.6%
real GDP growth in 2016, close to the weakest of
any year during the recovery.
But as we have argued in the past and as
Federal Reserve Chair Janet Yellen recently noted,
“it’s a myth that expansions die of old age.” 100
Instead, business cycles are typically derailed by
19
13
12
8
4
Exhibit 29: ISG Outlook for Developed Economies
United States Eurozone United Kingdom Japan
2016 2017 Forecast 2016 2017 Forecast 2016 2017 Forecast 2016 2017 Forecast
Real GDP Growth* Annual Average 1.60% 1.90–2.70% 1.60% 1.20–1.90% 2.10% 0.50–1.50% 1.00% 0.75–1.50%
Policy Rate** End of Year 0.75% 1.25–1.50% 0.00% (0.50)–(0.30)% 0.25% 0.00–0.50% -0.10% -0.10%
10-Year Bond Yield*** End of Year 2.44% 2.50–3.00% 0.21% 0.50–1.00% 1.24% 1.50–2.25% 0.05% 0.00%
Headline Inflation**** Annual Average 1.70% 1.80–2.60% 0.60% 0.80–1.60% 1.20% 2.00–3.00% 0.50% –
Core Inflation**** Annual Average 2.10% 1.80–2.60% 0.80% 0.90–1.40% 1.40% 1.50–2.00% -0.40% 0.25–1.0%
Data as of December 31, 2016.
Note: The above forecasts have been generated by ISG for informational purposes as of the date of this publication. They are based on ISG’s proprietary macroeconomic framework, and there can be
no assurance the forecasts will be achieved.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bloomberg.
* 2016 real GDP is based on Goldman Sachs Global Investment Research estimates of year-over-year growth for the full year.
** The US policy rate refers to the top of the Federal Reserve’s target range. The Japan policy rate refers to the BOJ deposit rate.
*** For Eurozone bond yield, we show the 10-year German bund yield.
**** For 2016 CPI readings, we show the latest year-over-year CPI inflation rate (November). Japan core inflation excludes fresh food, but includes energy.
38 Goldman Sachs january 2017
Exhibit 31: US Cyclical Spending
There is scope for business and consumer spending to
increase in the US economy.
Exhibit 32: US Inflation
Normalizing energy prices account for much of the inflation
increase we expect.
% of Potential GDP
32
30
US Cyclical Spending
Average
Recession
% YoY
4
3
Energy Contribution to Headline Inflation
Headline Inflation
Core Inflation*
Forecast
28
2
2.4
26
24
22
20
25.6
23.6
1
0
-1
18
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data through Q3 2016.
Note: 4-quarter average. Cyclical spending is business fixed investment plus consumer
durables spending.
Source: Investment Strategy Group, Datastream.
-2
2011 2012 2013 2014 2015 2016 2017
Data as of Q3 2016.
Note: ISG forecasts from Q4 2016. For informational purposes only. There can be no assurance
the forecasts will be achieved.
Source: Investment Strategy Group, Datastream.
* Core inflation excludes food and energy.
three culprits: economic imbalances, excessive
Federal Reserve tightening and/or exogenous
shocks (most commonly in the form of spiraling
oil prices).
As we survey these risks today, none are
particularly alarming. The depth of the financial
crisis and the lackluster pace of the recovery have
allowed the US to avoid the imbalances that would
typically be evident this far into an expansion (see
Section I of this year’s Outlook). If anything, there
is scope for spending in cyclical parts of the US
economy relative to overall GDP to move toward
its long-term average (see Exhibit 31).
There is also less risk of disruptive Federal
Reserve tightening, given how few signs we see
of economic overheating. Headline inflation
remains below the Federal Reserve’s 2.0% target,
and though we expect it to move higher this year,
normalizing energy prices are a key driver (see
Exhibit 32). Further, while the November 2016
unemployment rate of 4.6% suggests the economy
is near full employment, broader measures of labor
slack, as well as today’s depressed labor force
participation rate, argue that the central bank is
not “behind the curve” (see Exhibit 33). Lastly,
our expectation for continued modest gains for the
US dollar and a rebound in productivity growth
from generational lows (see Exhibit 34) provides a
natural offset to inflation pressures, even as wages
continue to rise.
Exhibit 33: US Unemployment Indicators
There are still signs of slack in the labor market.
%
14
Overall Employment Population Ratio (Right, Inverted)
Unemployment Rate
%
55
12
Natural Rate of Unemployment*
57
10
8
6
4
2
0
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
Data through November 2016.
Source: Investment Strategy Group, Federal Reserve Economic Data, Datastream.
* Long-term rate.
Of equal importance, the Federal Reserve is
acutely aware of the risks that tighter monetary
policy poses to the business cycle, which is
apparent in both its willingness to step back
from planned rate hikes last year as well as
Chair Yellen’s acknowledgment that an “abrupt
tightening would risk disrupting financial markets
and perhaps even inadvertently push the economy
into recession.” 101 With neutral real interest rates
59
61
63
65
67
Outlook
Investment Strategy Group
39
Exhibit 34: US GDP per Hour Worked
We expect a rebound in productivity growth from
generational lows.
% YoY
4
Exhibit 35: Goldman Sachs US Current
Activity Indicator
Economic activity accelerated in the second half of 2016.
Annualized % Change
3.0
3
2.5
2.5
2
2.0
1.5
1.6
2.1
1
0.6
1.0
0
0.5
-1
1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015
0.0
Average: January–May Average: June–November November Reading
Data through 2015.
Source: Investment Strategy Group, OECD.
Data as of November 2016.
Note: The current activity indicator is the first principal component of real-activity indicators,
expressed in GDP-equivalent units. This is the growth signal in the main high-frequency
indicators for the US economy.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research.
near zero and inflation expectations still below
levels compatible with its inflation target, the
Federal Reserve is likely to hike rates two or three
times in 2017, below the historical average pace.
On this point, it is worth remembering that the
Federal Reserve originally projected four hikes by
the end of 2016, yet enacted only one in December.
Thus, even if the Federal Reserve does raise rates
three times this year, it will have delivered those
four hikes over two years instead of just one.
Lastly, although a recession created by an
external shock is always a risk, the probability we
place on a hard landing in Europe and/or China
or a destabilizing increase in oil prices is not
currently high enough to alter our base-case view.
Indeed, even with the recent cut in oil production
coordinated between OPEC and non-OPEC
members, the size of today’s oil-supply glut and the
historical tendency for producers to exceed their
quotas greatly reduce the risk of a price spike (see
With none of the typical signs of
economic contractions flashing red,
we accord a 15% probability of a
recession in 2017.
Section III, Global Commodities). With none of
the typical signs of economic contractions flashing
red, we accord a 15% probability of a recession in
2017, roughly in line with historical average risk.
Against this backdrop, we expect US real GDP
growth to accelerate from last year’s moderate
1.6% pace, reaching 1.9–2.7% in 2017. There are
three key drivers to this story: fading headwinds,
a resilient US consumer and supportive policy. We
discuss each below.
Fading Headwinds
The combination of falling oil prices and a
rising dollar that began in mid-2014 has been a
meaningful drag on US growth, with energy-related
capital spending falling by more than 60% over
this period. In addition, exports have softened,
the S&P 500 has suffered almost two years of
contracting profits, and inventories throughout the
supply chain have ballooned as activity has slowed.
Such broad-based weakness has rarely
occurred outside a recession.
The silver lining to last year’s
slowdown, however, is that growth is
now poised to improve from depressed
levels. A modest recovery in oil prices
and stabilization of the dollar enabled
US economic activity to accelerate
notably in the second half of last year
(see Exhibit 35). This boost will be aided
40 Goldman Sachs january 2017
Exhibit 36: Contribution from Change in
Inventories to US GDP Growth
Inventories should support growth after five quarters of
subtracting from GDP.
Exhibit 37: National Association of Home Builders
US Housing Market Index
The post-crisis high in builder confidence bodes well for US
residential investment.
Percentage Points, 5-Quarter Moving Total
Contribution
Recession
Index Level
14
80
10
6
70
60
50
70
2
40
-2
-6
30
20
10
-10
1981 1986 1991 1996 2001 2006 2011 2016
0
2002 2004 2006 2008 2010 2012 2014 2016
Data through Q3 2016.
Source: Investment Strategy Group, Haver Analytics.
Data through December 2016.
Note: Based on a monthly survey of NAHB members who rate market conditions for the sale of
new homes, as well as the traffic of prospective buyers of new homes.
Source: Investment Strategy Group, Datastream.
Exhibit 38: US GDP Growth Impulse from
Goldman Sachs Financial Conditions Index
The persistent drag from tight financial conditions over the
last two years should reverse in 2017.
Percentage Points, 4-Quarter Moving Average
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
Forecast
-1.2
2012 2013 2014 2015 2016 2017 2018
Data as of Q3 2016.
Note: The financial conditions index is a weighted average of riskless interest rates, credit
spreads, equities and FX, based on effects on 1-year forward US GDP growth. Historical
estimates and forecasts by Goldman Sachs Global Investment Research. For informational
purposes only. There can be no assurance the forecasts will be achieved.
Source: Goldman Sachs Global Investment Research.
by inventory restocking, which looks ready to help
GDP growth again after five quarters of negative
contributions (see Exhibit 36). Similarly, residential
investment is set to contribute, reflected in the
National Association of Home Builders (NAHB)
housing market index reaching a post-crisis high in
December of last year (see Exhibit 37). Overall, we
expect this momentum to continue as the erstwhile
easing in financial conditions provides a growth
tailwind throughout 2017 (see Exhibit 38).
A Resilient US Consumer
The stars are aligned for US consumers in 2017,
as they enter the year with rising wages, higher
net worth from asset price gains, historically
low debt-servicing costs, ample savings and
confidence at a 12-year high. They also stand to
benefit directly from potentially lower tax rates
and indirectly from higher fiscal spending, a
topic we discuss in the next section. The abovementioned
factors should mitigate the headwind
from higher inflation. Overall, we expect private
consumption—a key driver of our GDP forecast—
to expand at a pace of approximately 2.5%.
Supportive Policy
While government policy is always a source of
uncertainty, it is even more so in 2017 given
potential changes to tax, trade and immigration
policies in the wake of last year’s presidential
election. Nonetheless, our base case is that policy
ultimately supports growth this year, with some
fiscal expansion and a measured pace of Federal
Reserve rate hikes. Although the final contours of
Outlook
Investment Strategy Group
41
Exhibit 39: CFO Optimism About the US Economy
Chief financial officers’ confidence is at its highest level
in a decade.
Exhibit 40: Eurozone Real GDP Growth
Economic activity has been surprisingly resilient and higher
than expected.
% YoY
%
90
% of CFOs More Optimistic Than Previous Quarter
Recession
2.5
Real GDP Growth
Consensus Estimate*
60
64.1
2.0
1.8
2.0
1.9
2.0
1.7 1.7 1.7
1.5
1.3
1.0
30
0.5
0
2004 2006 2008 2010 2012 2014 2016
0.0
4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16
Data through December 2016.
Note: The survey questionnaire is delivered online to senior financial executives and subscribers
of CFO Magazine from both private and public companies.
Source: Investment Strategy Group, Haver Analytics.
Data through Q3 2016.
Source: Investment Strategy Group, Bloomberg.
* One quarter prior to release.
the new administration’s policies remain uncertain,
a moderate-sized stimulus package of around
$200 billion per year seems likely. 102 While the
direct impact of such a package is estimated to
boost GDP growth by only 0.3 percentage point
in 2017, the positive indirect impact of tax cuts
and stronger anticipated GDP on household and
business confidence is arguably more important.
Indeed, both consumer and CFO confidence have
recently hit their highest readings in over a decade
(see Exhibit 39).
Our View on US Growth
As the expansion enters its eighth year, it is natural
to question its durability. But far from showing
its age, the US economy begins 2017 at an abovetrend
growth pace, with little evidence of cyclical
imbalances or other excesses that typically portend
the end of the business cycle. If anything, the slow
pace of this recovery has elongated its life span, a
dynamic that is likely to persist this year. Perhaps
in macroeconomics, as in life, age is just a number.
Eurozone: Weathering the Storm
The Eurozone has faced its share of challenges in
recent years. Not only did it relapse into recession
in 2011, but it also endured a domestic sovereign
bond and banking crisis at the same time. More
recently, it has been buffeted by a spate of tragic
terrorist attacks, an immigration crisis, the Brexit
vote, a failed Italian constitutional referendum
and renewed concerns about the solvency of its
banking system.
Yet despite this onslaught of headwinds, the
real economy has been remarkably stable in the
last two years. That fact is evident in Exhibit 40,
which shows real GDP growth has sustained an
above-trend pace over this period, an outcome
that clearly exceeded consensus forecasts. Business
sentiment has remained equally steadfast over this
period, suggesting that the rapidity of shocks may
have effectively inured confidence to bad news (see
Exhibit 41). Meanwhile, real household disposable
income grew by 2.3% over the past year—the
fastest pace since 2007.
We expect this stability to persist in 2017,
with our forecast calling for 1.2–1.9% real GDP
growth. Keep in mind that there is ample scope
for above-trend growth to continue, as the level
of Eurozone GDP still stands below its potential.
On this point, the OECD, IMF and European
Commission each currently estimate an output gap
of around 2%, indicating slack in the economy.
The Eurozone’s still elevated 9.8% unemployment
rate corroborates this point.
42 Goldman Sachs january 2017
Exhibit 41: European Commission Industrial
Confidence Survey
Eurozone business sentiment has remained steady despite
recent shocks, including Brexit.
Exhibit 42: Drivers of Eurozone 2-Year Capital
Spending Plans
Key factors that influence business investment stand at their
highest levels in years.
Index Level
10
0
-10
-1.1
-6.0
Z-Score
1.2
1.0
0.8
0.6
0.4
2013
2014
2015
2016
0.4
0.7
0.5
0.8
1.1
0.8
-20
0.2
-30
-40
Industrial Confidence
Average Since 1985
-50
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
0.0
-0.2
-0.4
-0.6
-0.8
-0.1
-0.1
-0.2
-0.2
-0.2
-0.6
Expected Demand Financial Conditions Technical Factors*
Data through November 2016.
Source: Investment Strategy Group, Datastream.
Data through 2016.
Note: Based on the European Commission investment survey.
Source: Investment Strategy Group, Datastream.
* Technical factors include technological developments, the availability of labor and government
incentives to invest.
As a result, Eurozone policy is likely to remain
accommodative, keeping financial conditions
supportive of growth. While we expect the
European Central Bank (ECB) to gradually shift
to a more neutral stance that is less punitive to
bank profitability and acknowledges the uptrend
in headline inflation, this shift does not imply the
removal of accommodation. Indeed, the ECB has
already announced an extension of quantitative
easing through December 2017. Meanwhile, the
European Commission has endorsed a moderate
fiscal easing of 0.5% of GDP for the Eurozone.
Given that fiscal policy is typically loosened ahead
of major elections, this guidance could soon be
embraced in France and Germany.
Of equal importance, both consumption and
business investment are well positioned as we enter
2017. On the former, continued improvement in
the labor market and ongoing GDP growth should
Ongoing uncertainty regarding Brexit,
the banking sector and upcoming
elections remains a potential
downside risk.
encourage consumers to spend a bit from their
precautionary savings, particularly given today’s
relatively high savings rate. At the same time, the
fundamental justifications for increased business
spending, such as higher demand and easy credit
conditions, stand at their best levels in years (see
Exhibit 42). Perhaps not surprisingly, a late 2016
survey of manufacturing firms revealed their
investment intentions stood at all-time highs. 103
Of course, ongoing uncertainty regarding
Brexit, the banking sector and upcoming elections
remains a potential downside risk, particularly
for an investment recovery. As a result, we
acknowledge a greater-than-normal range of
potential outcomes, both positive and negative. For
example, the victory of the far right in the French
presidential election could unleash fears about
France exiting the European Union and endanger
the survival of the euro, while the new government
in Italy could speed up the long-overdue
resolution of the banking sector’s
problems and change the electoral law to
reduce political uncertainties.
For now, our base case assumes
that Italy will avoid a populist party in
government and that a centrist candidate
will win the French presidential election.
Thus, we expect the Eurozone to again
weather the storm in 2017.
Outlook
Investment Strategy Group
43
Exhibit 43: Japan Consumer Prices
Core inflation and inflation expectations remain low.
% YoY
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Core Inflation*
Expectations of Average Inflation Over Following 10 Years**
BOJ Inflation Target
-1.0
2011 2012 2013 2014 2015 2016
Data through November 2016.
Source: Investment Strategy Group, Datastream, QUICK Bond Investors Survey.
* Core inflation excludes fresh food and VAT impact.
** Based on the QUICK Bond Investors Survey.
United Kingdom: A Fork in the Road
Much like the Eurozone, the UK economy is
notable for its resilience, evident in 15 consecutive
quarters of positive quarterly growth averaging
2.5% annualized. This streak is even more
impressive considering last year’s Brexit vote and
the resulting consensus view that the UK was
destined for recession. Although the 20% decline
in the trade-weighted sterling and rapid easing
by the Bank of England were no doubt pivotal in
avoiding that fate, the immediate impact of the
Brexit referendum has been far less destructive
than feared.
But as we begin 2017, the UK is rapidly
approaching a fork in the road. The government
must choose which path Brexit will take once it
triggers Article 50 of the Lisbon Treaty, which
formally sets the process of the UK exit in motion.
Here, the government’s current objectives—limiting
freedom of movement into the UK while retaining
full access to the European Union’s single market—
UK authorities will have little room
to cushion a downturn given today’s
large fiscal deficits and already highly
accommodative central bank.
2.0
0.9
-0.4
seem mutually exclusive and likely to engender a
politically charged negotiation process. This road
is made all the more dangerous by the fact that
UK authorities will have little room to cushion a
downturn given today’s large fiscal deficits and
already highly accommodative central bank.
Of course, a softer stance on the issues is also a
possible path, one that could elongate the effective
transitional period beyond two years and lead to a
far more benign outcome for the UK.
The uncertainty around the government’s
ultimate choices significantly increases the range of
GDP outcomes in the medium term. Our current
base case assumes GDP will expand by 0.5–1.5%
in 2017. This notable slowdown from last year’s
2% pace reflects the likelihood that both hiring
and investment activity will become more cautious
once the Brexit negotiations start. Even worse, this
slowdown arrives just as consumer price inflation
is accelerating from past sterling depreciation,
creating a lower growth/higher inflation backdrop
that is set to erode real income growth. For these
reasons, the risks to our central case are skewed to
the downside.
That said, the fate of the UK economy is not
preordained, even after the government chooses
its path. As with any other negotiation, the result
will ultimately reflect the reasonableness of the
parties, the concessions of both parties and how
the discussions evolve over time. Or in the words
of golf legend Arnold Palmer: “The road to success
is always under construction.” 104
Japan: Same Battle, Different Year
For Japan, the decades-long battle against deflation
never seems to end. Despite two years of abovetrend
GDP growth, including last year’s 1% gain,
core inflation remains negative, having fallen 0.4%
in 2016 (see Exhibit 43). This comes despite a tight
labor market and record profits that should have
encouraged companies to increase base
wages. These already muted inflationary
pressures were exacerbated by low
energy prices and the appreciation of
the yen, once again pushing the Bank
of Japan’s (BOJ’s) 2% inflation target
further into the future.
But far from waving the white flag,
Japan’s policymakers responded with
a range of bold measures, including a
44 Goldman Sachs january 2017
Exhibit 44: Emerging Market GDP Growth
We expect growth roughly in line with potential.
% YoY (PPP Weighted)
10
9
8
7
6
5
4
Actual GDP
Potential GDP
Forecast
4.6
These pro-growth policies, coupled with less
slack in the economy and a boost from higher
energy prices and past yen appreciation, should
enable core inflation (excluding fresh food) to
reach our expected range of 0.25–1.0%. While
Japan may have lost its battles against deflation
over the years, it has not yet lost the war.
Emerging Markets: Competing Forces
3
2
1
0
1993 1996 1999 2002 2005 2008 2011 2014 2017
Data as of 2016.
Note: ISG forecasts for 2016–17. For informational purposes only. There can be no assurance the
forecasts will be achieved.
Source: Investment Strategy Group, IMF.
large fiscal stimulus package last August and a
shift by the BOJ away from ever-higher purchases
of Japanese government bonds (JGBs). Instead,
the BOJ will now use a “yield-curve control”
framework, wherein it sets the short rate and
targets a yield of about 0% on 10-year JGBs. This
novel approach should afford the government
low real interest rates with which to finance its
fiscal expansion, while also providing Japanese
financial institutions with a sufficiently steep yield
curve to remain profitable. To augment these
deflation-fighting measures, the government also
implemented some modest structural reforms and
called for a substantial increase in the minimum
wage in order to support faster income growth.
Against this backdrop of supportive policies,
we expect that GDP will grow by 0.75–1.5%
in 2017. Our forecast is supported by three key
drivers. First, the fiscal stimulus announced in
August is poised to contribute 0.4 percentage point
to 2017 GDP growth, and the government has
indicated a willingness to do more if necessary.
Second, the BOJ remains very accommodative,
thereby providing easy financial conditions that
should foster an uptick in business investment.
While the central bank may consider a modest
rate increase in late 2017, we expect it to maintain
its negative interest rate policy (NIRP) for short
rates and a 0% target for 10-year JGB yields in the
interim. Lastly, the government is likely to push
for further wage increases during the spring wage
negotiations.
Emerging market economies failed to live up
to expectations once again in 2016, with GDP
expanding by an estimated 3.9% versus original
expectations closer to 5.0%. This marked the
second-slowest growth rate in 15 years; only the
2.6% expansion at the depth of the global financial
crisis in 2009 was slower. Yet this disappointing
headline belies the economic recovery that
unfolded over the course of 2016. Consider that
growth actually troughed during a challenging
first quarter, with economic activity gradually
improving thereafter on the back of recovering
commodity prices, the Federal Reserve’s willingness
to delay any further rate hikes and stable Chinese
growth. These tailwinds were bolstered into the
final quarter by early signs of recovery in Brazil
and Russia, both of which had suffered deep
recessions in 2015.
We expect this momentum to persist, with GDP
increasing by 4.3–4.8% (purchasing power parity
[PPP] weighted) this year, roughly in line with
potential (see Exhibit 44). The pickup we expect
is the product of two opposing forces. On the one
hand, growth should benefit from the ongoing
recoveries in Brazil and Russia, and somewhat
stronger activity in developed economies should
provide a small tailwind to emerging market
exports. On the other hand, the further moderation
in Chinese growth we expect is likely to weigh on
activity across emerging markets, particularly if the
US imposes tariffs.
Indeed, the policy agenda of the incoming US
administration remains a critical unknown for
emerging markets. Even if protectionist tariffs
were directed only at China and Mexico—which
account for 23% and 15% of US imports of
manufactured goods, respectively—they would still
negatively impact all emerging markets given the
sensitivity of these countries to Chinese growth and
fluctuations in the Chinese currency. This being the
case, countries with substantial trade exposure to
Outlook
Investment Strategy Group
45
Exhibit 45: China Economic Activity Measures
Actual growth is likely lower than official figures.
% YoY, 3-Month Moving Average
18
16
14
12
10
8
6
4
Real GDP Growth
2
Emerging Advisors Group China Activity Index
Goldman Sachs China Activity Indicator
0
2000 2002 2004 2006 2008 2010 2012 2014 2016
Data through Q3 2016.
Source: Investment Strategy Group, Emerging Advisors Group, Goldman Sachs Global
Investment Research.
both China and the US, such as Korea, Taiwan and
Malaysia, would be particularly vulnerable.
While the net effect of these competing forces
is positive in our base case, the risks are tilted to
the downside.
China
China continues to drive its economy with
one foot on the gas pedal and the other on the
brake. Consider that the government reached its
official GDP growth target of 6.5–7% last year
only by increasing public spending and allowing
rampant credit growth. But these measures also
exacerbated real estate bubble concerns and
hastened capital outflows, forcing the government
to apply the brakes through new restrictions within
the property market and more stringent capital
controls. This focus on dual-footed driving has also
come at the expense of much-needed structural
reforms. As a result, China continues to suffer from
considerable excess capacity in industrial sectors,
such as steel and coal, while its financial sector
risks have increased.
Even so, we expect this approach to continue
in 2017. Structural reforms are likely to stay
on the back burner because China’s leaders
will not risk slower growth ahead of important
leadership changes at the 19th Communist Party
of China National Congress in the fall. In turn,
the government is likely to use further fiscal easing
and rapid credit expansion to target growth of
around 6.5%. As a result, we expect official GDP
6.7
5.6
4.8
to expand by 6.0–6.75% in 2017, although actual
GDP growth will likely be lower (see Exhibit 45).
The risks to our outlook are skewed to the
downside for two reasons. First, the new direction
of US trade policy remains uncertain and could
have a sizable impact. For instance, a 15% tariff
would mechanically reduce China’s GDP by 0.9%.
China could respond by ramping up leverage,
letting its currency depreciate faster and injecting
more fiscal stimulus, but that could risk further
imbalances in the economy while also disrupting
global financial markets. Second, striking the right
balance between stimulative and contractionary
measures is a hazardous endeavor. On the road,
as in government policy, accelerating and braking
at the same time greatly increases the risk of
an accident.
India
India’s streak of strong growth continues. The
economy expanded by an estimated 6.5% in
2016, making it the fourth consecutive year of
GDP growth in excess of 6.0%, a rare feat that
India’s economy shares only with China’s. Growth
would likely have been even higher, were it not
for the “demonetization” scheme the government
introduced in November 2016. In a surprise
move, the government announced that largedenomination
bank notes, representing 86% of
cash in circulation, would no longer be accepted
as legal tender. The scheme—intended to root out
illegal income stored in cash—had the unfortunate
side effect of starving households of liquidity and
thereby thwarting consumption, the main engine of
growth. Although the severity of the consumption
shock remains uncertain, it should be temporary.
The silver lining for 2017 is that India will
probably benefit from a meaningful recovery in
household spending. Moreover, fiscal policy will
likely be eased ahead of the 15 state elections
occurring in 2017 and 2018, while investment
should receive a modest boost as the Reserve Bank
of India lowers borrowing costs. Accordingly, we
expect GDP growth of 6.5–7.5% in 2017.
46 Goldman Sachs january 2017
China continues to suffer from
considerable excess capacity in
industrial sectors, such as steel and
coal, while its financial sector risks
have increased.
Brazil
Brazil has had its share of hard times in recent
years. After being among the fastest-growing
economies in the world in 2010, it has more
recently suffered its worst recession in a
century, evident in seven consecutive quarters of
contraction. In turn, GDP fell an estimated 3.3%
last year, leaving it on par with 2010 levels. Even
worse, industrial production now stands where it
did in 2004.
Fortunately, there are already tentative signs
of a recovery. Inflation has peaked; the current
account deficit has shrunk; and confidence
indicators, while still weak, have stabilized. Of
equal importance, the financial markets have
welcomed a new government amid expectations
that it will finally tackle Brazil’s fiscal problems
and steer the economy out of recession.
But despite these promising green shoots,
our base case does not call for a robust recovery
in 2017. While the new administration is off to
a promising start, it is facing resistance to key
structural reforms while also navigating ongoing
corruption probes. Moreover, the recovery in
household consumption and business investment
is likely to be hamstrung by continuing high real
interest rates, a function of falling inflation and a
simultaneously easing central bank. Meanwhile,
fiscal policy will continue to tighten given a
new spending cap and proposed pension reform
measures. Finally, the modest commodity price
gains we expect are unlikely to foster a meaningful
rise in exports for Brazil. Accordingly, we expect
a tepid recovery, with GDP expanding just
0–1% in 2017.
Russia
Russia is also slowly recovering from a
deep recession. Although the economy
contracted for its second consecutive year
in 2016, headwinds are now receding
thanks to a recovery in real wages,
rising oil prices and a related increase in
oil production. The economy has also
received support from both fiscal and
monetary policy, with the central bank
cutting the policy rate by 100 basis points last
year as inflation moderated. Still, the economy has
likely suffered some permanent damage from the
combination of depressed oil prices and Western
sanctions, which have pushed down Russia’s longrun
growth potential.
While the cyclical recovery should continue in
2017, it is apt to be measured. The government is
planning to reduce the fiscal deficit by 1% of GDP
this year, which will limit fiscal support. That said,
elections in March 2018 could ultimately temper
such fiscal prudence. Meanwhile, the central bank
will likely deliver more rate cuts, but their size and
pace will depend on the path of inflation, which
could be stickier than anticipated.
Against this uncertain backdrop, we expect the
Russian economy to return to modest growth in
2017, expanding 0.5–1.5%. While not our base
case, growth could quicken if oil prices increase
more than we expect or if sanctions are lifted.
Outlook
Investment Strategy Group
47
SECTION III
2017 Financial Markets
Outlook: The Horns of
a Dilemma
investors have had an amazing bull run. Including last
year’s 12% total return, the S&P 500 is nearly 3.5 times as high
as its financial crisis trough. The advance has been equally longlasting,
second in length only to the almost-decade-long period
that preceded the technology bubble in 2000. These impressive
gains are not limited to just equities or US assets. US corporate
high yield has gained 177% over the same time span, while the
total return of the MSCI All Country World Index excluding
the United States has been higher only 5% of the time over
comparable eight-year periods since 1994.
But as we begin a new year, these gains have left investors
on the horns of a dilemma. Put simply, they must now choose
to either remain invested at high valuations and bear the
associated risk of loss or exit the market and forgo the potential
for upside surprises as well as returns that are attractive
compared to the alternatives.
48 Goldman Sachs january 2017
Outlook
Investment Strategy Group
49
To be sure, there are good reasons to be
cautious, as we discussed in Section I, The Risks to
Our Outlook. Even worse, investors are exposed to
these dangers at a time when most asset valuations
are expensive by historical standards, providing
them with a narrow margin of safety to absorb
such adverse developments. This is particularly
true in the US, where valuations have been cheaper
at least 90% of the time historically. 105 Even in
Europe, where valuations are more attractive, that
fact is counterbalanced by greater geopolitical risks
and deeper structural fault lines.
Still, as we highlighted in Section I of this
Outlook, there are three reasons why remaining
invested in risk assets is still warranted despite
what are likely to be uninspiring returns. First,
we see only a 15% probability of a US recession,
which has historically been the key driver of
losses in risk assets. Indeed, the S&P 500 has
generated positive annual total returns 86% of
the time during economic expansions in the post-
WWII period. Second, the comparable returns
of investment alternatives—such as cash and
bonds—are unappealing, particularly in the rising
interest rate environment that we expect. Third,
risk assets can surprise us to the upside, as last year
demonstrated. The potential for returns to exceed
our expectations is especially true in the US, given
the possibility of tax reforms, fiscal expansion
and deregulation. The same could be said for
our tactical positions across various asset classes,
which we discussed in Section I, Our Tactical Tilts.
While we have suggested that the dilemma
should be resolved in favor of remaining invested,
we are not Pollyannaish. Investors have ridden
this bull market for eight years, and while we
don’t expect the ride to end in 2017, we must stay
vigilant to avoid the horns.
Exhibit 47: US Equity Price Returns from Each
Valuation Decile
In the past, subsequent returns from high valuation levels
have been muted.
% Annualized
5-Year Annualized Price Return
%
14
13.0
% Observations With Positive Returns (Right) 100
90
12
11.2
80
10
9.5
70
8
8.3
7.0
6.6 6.6
7.1
60
50
6
4.5
40
4
30
2
0
1 2 3 4 5 6 7 8 9 10
Less Expensive
Valuation
Decile
More Expensive
Data as of December 31, 2016.
Note: Based on 5 valuation metrics for the S&P 500, beginning in September 1945: Price/Trend
Earnings, Price/Peak Earnings, Price/Trailing 12m Earnings, Shiller Cyclically Adjusted Price/
Earnings Ratio (CAPE) and Price/10-Year Average Earnings. These metrics are ranked from least
expensive to most expensive and divided into 10 valuation buckets (“deciles”). The subsequent
realized, annualized 5-year price return is then calculated for each observation and averaged
within each decile. Past performance is not indicative of future results.
Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.
US Equities: Life in the Fast Lane
US stocks have been driving in the fast lane since
2009. Over this nearly eight-year period, the S&P
500 has generated a stunning 16.5% annualized
price return, a pace exceeded only 3% of the time
since 1945. As a result, the 500 companies in the
index are collectively worth $20 trillion today,
about 3.5 times as high as they were at the trough
of the financial crisis. Needless to say, investors
have had a good ride.
Yet such a fast drive also raises the question of
whether US equities are now running on empty.
0.2
20
10
0
Exhibit 46: ISG Global Equity Forecasts—Year-End 2017
2016 YE
End 2017 Central Case
Target Range
Implied Upside from
Current Levels
Current Dividend
Yield Implied Total Return
S&P 500 (US) 2,239 2,225–2,300 -1–3% 2.1% 1–5%
Euro Stoxx 50 (Eurozone) 3,291 3,250–3,400 -1–3% 3.6% 2–7%
FTSE 100 (UK) 7,143 7,050–7,310 -1–2% 4.0% 3–6%
TOPIX (Japan) 1,519 1,530–1,590 1–5% 1.9% 3–7%
MSCI EM (Emerging Markets) 862 880–925 2–7% 2.6% 5–10%
Data as of December 31, 2016.
Note: Forecast for informational purposes only. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this Outlook.
Source: Investment Strategy Group, Datastream, Bloomberg.
50 Goldman Sachs january 2017
Exhibit 48: S&P 500 Price-to-Trend Earnings vs.
Subsequent Calendar-Year Price Return
Starting valuation multiples tell us little about equity returns
over the following year.
Exhibit 49: S&P 500 Valuation Multiples by
Inflation Environment
Periods of low and stable inflation have supported higher
equity multiples.
S&P 500 Returns 1 Year Forward (%)
50
40
30
20
10
0
-10
R 2 = 5.2%
Multiple (x)
30
25
20
15
16.7
Unconditional Average Over Entire Period
Average During Periods in Which Inflation Is 1–3% and Stable
22.5 22.6
18.6
16.6
19.5
-20
-30
10
-40
5
-50
0 5 10 15 20 25 30 35 40
Price-to-Trend Earnings Multiple
0
Shiller CAPE: 1881–2016 Shiller CAPE: 1945–2016 Price-to-Trend: 1945–2016
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.
This bull market is already quite old by historical
standards, second in length only to the almost 10-
year period that preceded the technology bubble
in 2000. Moreover, valuations now stand in their
10th decile, indicating they have been cheaper
at least 90% of the time historically. In the past,
starting from such a high base has led to muted
equity returns over the subsequent five years, with
only a third of those episodes generating a profit
(see Exhibit 47).
Even so, high valuations should not be
confused with certainty of loss, especially over
short periods. As seen in Exhibit 48, today’s
equity multiples tell us very little about potential
gains over the next year, explaining only 5% of
their variation historically. Moreover, history
teaches us that a strategy of selling equities based
solely on expensive valuations has been a losing
approach over time. As we noted in our 2014
Outlook, research conducted by three professors
at the London Business School concluded that
Investors have ridden this bull market
for eight years, and while we don’t
expect the ride to end in 2017, we
must stay vigilant to avoid the horns.
underweighting equities based exclusively on high
valuations underperformed a strategy of remaining
invested across every one of the 20 countries and
three country aggregates they examined. 106 In
short, valuations alone are a poor tactical timing
signal. Indeed, the S&P 500 has returned more
than 36% since first entering its 9th valuation
decile in November 2013, a time when many
were already suggesting that US equities were
in a bubble.
Valuations must also be considered in
the context of the prevailing macroeconomic
environment. Consider that periods of low and
stable inflation, such as we expect for the year
ahead, have supported higher valuations in the past
(see Exhibit 49). The same could be said for lower
taxes and deregulation—were they to materialize
later this year—as both would boost real returns
on invested capital and justify higher equity values.
Similarly, today’s structurally lower interest rates—
reflecting slower population and productivity
growth—reduce the rate at which
all future cash flows are discounted,
increasing their present value.
Here, it’s helpful to remember that the
S&P 500’s long-term average P/E ratio—
which many investors use to gauge
fair value—was forged over a period
when risk-free rates averaged 4.5%. In
contrast, the risk-free rate now is just
0.5–0.75% and the Federal Reserve
Outlook
Investment Strategy Group
51
Exhibit 51: ISM Manufacturing Index and S&P
500 Returns
Equity market performance is closely related to the
business cycle.
Index
65
% YoY
60
Exhibit 52: Estimated Incremental S&P 500
Earnings per Share by Tax Rate
Proposals for lower corporate tax rates could lead to
higher earnings.
Incremental EPS ($)
16
60
55
50
40
20
0
14
12
10
8
7
8
9
10
11
12
13
14
45
40
-20
6
4
3
5
6
35
ISM Manufacturing Index
S&P 500 Return (Right)
30
1995 2000 2005 2010 2015
-40
-60
2
0
30 29 28 27 26 25 24 23 22 21 20
US Effective Tax Rate (%)
Data through November 30, 2016.
Source: Investment Strategy Group, Bloomberg.
Data as of December 31, 2016.
Note: The current US effective tax rate for the S&P 500 companies is 33.3%.
Source: Investment Strategy Group, Standard & Poor’s.
estimates its new long-run equilibrium level has
fallen to 3%, a full 1.5 percentage points below
the historical average. 107 Of equal importance, the
Federal Reserve is not expected to reach that 3%
target for six years based on current market pricing
in Eurodollar futures.
A similar valuation tailwind emerges from the
market’s current sector composition. The combined
technology and health-care sectors constitute about
40% of S&P 500 earnings today, almost three
times as high as their 15% share in the late 1980s.
Because these faster-growing, higher-margin sectors
are generally accorded premium valuations, their
higher representation in the index today justifies a
higher S&P 500 P/E multiple.
Although current valuations may be
fundamentally justified, that does not mean
they are impervious to downward pressure. Our
central-case equity view for 2017 acknowledges
this, calling for some contraction in P/E multiples
given the uncertainty associated with a new
administration and continued Federal Reserve
interest rate hikes. Even so, that headwind will be
more than offset by the 6–10% earnings growth
we forecast, resulting in a 1–5% total return for US
equities this year (see Exhibit 50).
Investors might rightly ask whether it is worth
bearing equity risk for such meager returns. Our
read of the evidence suggests it is. The linchpin
of this view is our expectation of a continued
Exhibit 50: ISG S&P 500 Forecast—Year-End 2017
2017 Year-End Good Case (25%) Central Case (60%) Bad Case (15%)
End 2017 S&P 500 Earnings
Op. Earnings $140
Rep. Earnings $124
Trend Rep. Earnings $113
Op. Earnings $125–130
Rep. Earnings $113–117
Trend Rep. Earnings $113
Op. Earnings ≤ $102
Rep. Earnings ≤ $78
Trend Rep. Earnings ≤ $113
S&P 500 Price-to-Trend Reported Earnings 21–23x 18–21x 15–16x
End 2017 S&P 500 Fundamental Valuation Range 2,375–2,600 2,040–2,375 1,700–1,810
End 2017 S&P 500 Price Target (based on a combination of
trend and forward earnings estimate)
2,450 2,225–2,300 1,800
Data as of December 31, 2016.
Note: Forecasts and any numbers shown for informational purposes only and are estimates. There can be no assurance the forecasts will be achieved and they are subject to change. Please see
additional disclosures at the end of this Outlook.
Source: Investment Strategy Group.
52 Goldman Sachs january 2017
Exhibit 53: US Equity Performance Relative to
Fixed Income
Stocks have outperformed bonds following periods of muted
return differences.
Exhibit 54: US Equity and Bond Fund Flows
Equities could benefit from rebalancing out of bonds given
lopsided flows since 2009.
Total Return Difference Between
S&P 500 and 10-Year Treasury (%)
10
Cumulative Fund Flows ($ bn)
1,600
Bonds
Equities
1,400
1,467
8
6
7.8
6.8
1,200
1,000
800
4
2
2.0
600
400
200
0
Difference Over Last 20 Years
(19th Percentile Since 1945)
3 Years 5 Years
Median Return Difference Over Subsequent Time
Period When Starting from Bottom 20th Percentile
0
-200
-400
2009 2010 2011 2012 2013 2014 2015 2016
-177
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Leuthold Group.
Data through November 30, 2016.
Note: Beginning in March 2009.
Source: Investment Strategy Group, Bloomberg, ICI.
expansion in the US economy (see Section II,
United States). The state of the business cycle is a
key driver of market performance, evident in the
tight linkage between the S&P 500 and the ISM
Manufacturing Index (see Exhibit 51). Notably, the
S&P 500 has generated positive annual total returns
86% of the time during economic expansions in the
post-WWII period, while suffering annual declines
of greater than 10% just 4% of the time. During
the same postwar period, nearly three-fourths of the
bear markets—defined here as declines of 20% or
more—occurred during US recessions.
With few signs of an economic contraction
on the horizon, the high odds of positive returns
and low odds of large losses raise the hurdle
for underweighting equities significantly. This is
particularly true because the risks are not onesided:
markets often surprise to the upside, too,
even at high valuations. Last year was a case in
point: the S&P 500’s 12% return matched our
good-case scenario, although at the start of 2016
we had attached only 20% odds to it occurring.
As we consider the potential for similar upside
surprises in 2017, earnings growth tops the list for
three reasons. First, we expect the sizable profit
drag from energy earnings to reverse in 2017,
with scope for a greater than $4–5 contribution
to S&P 500 EPS if recently announced global oil
production cuts are realized. Keep in mind that this
contribution was closer to $15 prior to the collapse
in oil prices. Second, a shift to a 25% corporate tax
rate could add $9–10 to S&P 500 EPS in 2017 if
enacted retroactively (see Exhibit 52). Finally, a tax
holiday for the estimated $1 trillion of cash held
overseas could lead to an additional $1–2 of EPS
upside from repatriation-driven buybacks.
There are also other, less visible potential
catalysts for equities. Over the last 20 years, the
total return of stocks has exceeded that of 10-year
Treasury bonds by only 2 percentage points, well
below the historical average of 4.4 percentage
points and a result that ranks in the bottom 20%
of all post-WWII observations. But after similar
periods of underperformance, stocks generated
well above average relative returns over the
next three and five years (see Exhibit 53). Said
differently, history suggests stock returns will
outpace those of bonds, even if expected equity
returns are uninspiring.
A related source of upside stems from the
lopsided investor flows evident in Exhibit 54. Here,
even moderate rebalancing out of bonds by retail
investors—who represent 80% of mutual fund
owners—would represent a sizable tailwind to
equities. Historically, a shift in flows from bonds
into equities has been motivated by three factors:
confidence in the durability of the economic
recovery, unattractive prospects for bond returns
and higher equity prices (see Exhibit 55). Our
central case features all three factors, suggesting the
Outlook
Investment Strategy Group
53
Exhibit 55: US Equity Fund Flows and Change in
10-Year Treasury Yield
Bond returns can influence flows into equity funds.
Percentage Points, YoY
4
3
Change in 10-Year Yield
Equity Minus Bond Flows (Right)
% of Assets, 3-Month Moving Average
8
6
Exhibit 56: The AAII Bullish Investor Sentiment
Lack of investor euphoria is a contrarian positive for stocks.
% Bullish, 52-Week Average
60
55
2
1
0
-1
-2
-3
-4
-5
1984 1989 1994 1999 2004 2009 2014
4
2
0
-2
-4
-6
-8
50
45
40
35
30
25
20
1988 1993 1998 2003 2008 2013
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg, ICI.
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg, American Association of Individual Investors.
Exhibit 57: Non-Dealer US Equity Index Futures
Positioning
There is scope for increased US equity positions.
$ bn
140
120
100
80
60
40
20
0
-20
-40
-60
-80
2011 2012 2013 2014 2015 2016
Data through December 31, 2016.
Source: Investment Strategy Group, CFTC, Goldman Sachs Securities Division Equity
Strats Group.
incipient uptick in bond outflows seen in late 2016
may persist, especially with “risk-free” Treasuries
delivering a notable loss in the fourth quarter.
Today’s visible lack of market euphoria
represents another potential positive for stocks.
Exhibit 56 shows the proportion of investors
classifying themselves as “bullish” near its lowest
level in decades. Meanwhile, non-dealer positions
in US index futures stand well below the levels
seen in 2013–14, providing scope for upside (see
Exhibit 57). If bull markets “die on euphoria” as
Sir John Templeton observed, then these measures
argue we have not yet reached the apex.
A rare technical analysis signal corroborates
that view. As shown in Exhibit 58, the Coppock
curve—an intermediate-length momentum signal—
has generated only 17 buy signals over the past 71
years, but collectively they have provided attractive
low-risk entry points for long-term investors. If
we took the median path of S&P 500 prices after
past signals, it would imply the market gains 9%
this year with 88% odds of a positive outcome. Of
particular note, Coppock buy signals on the NYSE,
Russell 2000 and FTSE All-World Index were also
triggered in November, even before the post-election
rally. For all the reasons discussed above, we accord
a 25% probability to our good-case scenario of the
S&P 500 reaching 2,450 by year-end.
Of course, we are equally aware of the myriad
downside risks investors face, including growing
unease about a disorderly backup in bond yields.
But here, our work suggests that rates have scope
to increase further before becoming a headwind for
stocks, even if adjusted for today’s lower long-run
equilibrium nominal rate (see Exhibit 59). Keep
in mind that 88% of S&P 500 debt has a fixed
interest rate and only about 10% matures each
year. The impact of higher rates will be spread over
many years as a consequence.
54 Goldman Sachs january 2017
Exhibit 58: Coppock Curve S&P 500 Buy Signals
One of only 17 post-WWII buy signals was triggered in
July 2016.
Exhibit 59: Inflection Point for Negative
Correlation Between Bond Yields and Stock Prices
Typically stocks and interest rates move in the same
direction until yields reach levels far above those seen today.
S&P 500 Index (Log Scale)
10,000
US 10-Year Treasury Yield (%)
6
5
5.1
1,000
4
3
2
2.4
3.9
100
1
0
Current Historical Since 1962 Adjusted for Today’s
Lower Equilibrium Rate*
10
1945 1955 1965 1975 1985 1995 2005 2015
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
Yield at Which Stock Prices and
Bond Yields Become Negatively Correlated
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Federal Reserve.
* Adjusts for the reduction of 1.25 percentage points in the long-run equilibrium nominal rate, in
line with the shift in Federal Reserve projections since 2012.
Some have taken a less sanguine view, arguing
that the “taper tantrum” of 2013 suggests bond
yields have already reached a troublesome level for
stocks. However, the tantrum primarily reflected
concerns that by tightening policy prematurely, the
Federal Reserve was committing a mistake that
would undermine growth—a fact evident in the
episode’s widening credit spreads and declining
breakeven inflation rates. Despite a similarly
rapid increase in rates this time around, we have
seen the opposite market reaction, with credit
spreads tightening and breakeven inflation rates
moving higher alongside growth expectations.
This contrast reminds us that the reason rates are
increasing is as important as their resulting level.
Aside from rates, ongoing concern about a
hard landing in China and a banking or political
crisis in Europe remain top of mind (see Section
I, The Risks to Our Outlook). We also start the
year with less of a buffer to absorb such adverse
developments, given today’s high valuations. Even
worse, this narrower margin of safety arrives
at a time when policy uncertainty in the US is
particularly acute, given upcoming changes to
tax, trade and immigration policies under the new
administration. A destination tax, for example,
could be particularly damaging to S&P 500
margins given the growth of global supply chains
in the last decade, not to mention the sizable
Exhibit 60: US Dollar Index
Even if the dollar stays unchanged, it will still act as a drag
on US multinational earnings in early 2017.
YoY %
40
30
20
10
0
-10
US Dollar Index
US Dollar Index Assuming Constant from 12/31/16 Level
-20
2006 2008 2010 2012 2014 2016
Data through December 31, 2016, with illustrative projection through 2017.
Source: Investment Strategy Group, Bloomberg.
upward pressure it would place on the US dollar.
Even at current levels, the dollar will represent a
renewed drag on US multinational earnings in the
first quarter (see Exhibit 60).
That said, the collective impact of these various
risks is not yet sizable enough to undermine our
core view: we are in a longer-than-normal US
recovery that supports equity returns that are
14
26
11
Outlook
Investment Strategy Group
55
Exhibit 61: EAFE Price to 10-Year Average Cash
Flow Discount to the US
Today’s larger-than-average discount provides a margin of
safety to EAFE equities.
Exhibit 62: MSCI EMU Trailing 12-Month
Earnings per Share
Profits have been range-bound for almost four years.
Discount (%)
60
40
20
MSCI EAFE Discount to MSCI US
Average Since 1982
Average Since 1992
Trailing 12-Month EPS (€)
20
18
16
14
12
0
-20
-40
-19
-33
-40
10
8
6
4
2
Sideways
Since 2012
-60
1982 1987 1992 1997 2002 2007 2012
Data through December 31, 2016.
Source: Investment Strategy Group, MSCI, Datastream.
0
1969 1974 1979 1984 1989 1994 1999 2004 2009 2014
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
likely to exceed those of cash and bonds. In turn,
we recommend that clients maintain their strategic
weight in US equities, although we acknowledge
that risks have risen at the same time that returns
appear likely to be lower going forward. While US
equities are not yet running on fumes, we should
keep a close eye on the fuel gauge.
EAFE Equities: Priced for Imperfection
There is no shortage of concerns surrounding the
various countries that comprise Europe, Australasia
and the Far East (EAFE) equity markets. The
list is both long and valid, including persistently
low economic growth, a slow pace of structural
reforms and incessant political uncertainty, as well
as incremental, reactive and inconsistent policy
responses. Ongoing questions about the health of
the banking system only compound these worries.
But these concerns are also not new and are
consequently well understood by the market.
In turn, the key question facing investors is not
whether EAFE exposure subjects them to downside
risks. As the preceding list demonstrates, it clearly
does. The question instead is whether investors are
being fairly compensated to bear these risks.
One can never know precisely what equity
markets are discounting, but the above concerns
are almost certainly a key driver of EAFE
underperformance and the main reason behind
today’s larger-than-normal valuation discount to
US equities (see Exhibit 61). While this margin
of safety does not guarantee outperformance,
it may provide investors with a larger buffer to
absorb adverse developments and miscalculations
in their forecasts. In our view, the risk/return
profile of EAFE equities is more attractive than it
first appears.
As a result, we do not recommend that
investors underweight EAFE equities. In fact, there
are reasons to believe that EAFE equities will
outperform US equities in local currency terms
this year. In the sections that follow, we explore
these reasons by examining the three main EAFE
markets, beginning with the Eurozone.
Eurozone Equities: The Onus Is
on Earnings
Earnings have been going nowhere fast for
Eurozone equities. That’s apparent in Exhibit
62, which shows that profits have been rangebound—at
nearly half their 2007 peak level—for
almost four years. As a result, rising valuation
multiples have accounted for all of the 25% price
appreciation over this period.
This seeming contradiction between stagnant
earnings and rising multiples reflects the copious
liquidity provided by the ECB’s quantitative
easing. By depressing interest rates, ECB policy
56 Goldman Sachs january 2017
Exhibit 63: Relative Performance of ”Stable” and
“Volatile” EAFE Stocks
Investors have recently shifted toward firms more exposed
to the business cycle.
Exhibit 64: Spain 5-Year Credit Default Swap and
Relative Equity Performance
The dramatic reduction in Spanish default risks suggests
equity valuations have scope for upside.
Relative Return (%)
8
Stable
Volatile
6
Price Ratio (July 24, 2012 = 100)
150
140
Basis Points
0
100
4
130
200
2
0
-2
-4
120
110
100
300
400
500
600
-6
Last 3
Months
2016-to-Date 5 Years 10 Years 1987–2007 Since 1987
Annualized Returns
90
MSCI Spain vs. MSCI EMU (Sector-Adjusted)
Spanish CDS Spread (Right, Inverted)
80
2009 2010 2011 2012 2013 2014 2015 2016
700
800
Data as of October 31, 2016.
Note: Equally weighted USD-hedged returns relative to the developed markets (ex-US). Stable
and volatile stocks are drawn from the large-cap universe. Stability is measured using a model
based on return on equity, earnings growth, financial leverage and beta.
Source: Investment Strategy Group, Empirical Research Partners.
Data through December 31, 2016.
Source: Investment Strategy Group, MSCI, Datastream.
has both hobbled bank profits—which represent
a third of EuroStoxx 50 earnings—and boosted
equity valuations. But with ECB policy unlikely
to become any more accommodative, additional
valuation expansion can no longer be taken for
granted. Instead, the onus for Eurozone equity
upside now rests with earnings.
Here, the prospects are favorable for several
reasons. First, above-trend Eurozone GDP growth
is likely to lead to boosted domestic sales and
reduced economic slack, both of which have lifted
Eurozone earnings in the past. Second, the broader
pickup in global GDP growth we expect should
benefit the 45% of the EuroStoxx 50’s sales that
are generated outside Europe. Higher revenue
is particularly beneficial to these EuroStoxx
firms given their operating leverage, as small
improvements in sales spread over their sizable
fixed costs also push profit margins higher. Finally,
financial sector earnings stand to benefit from the
higher interest rates we foresee.
Against this backdrop, we expect earnings
to expand 5% in 2017. Meanwhile, valuation
multiples are likely to contract slightly as interest
rates normalize higher and investor focus shifts
toward eventual ECB tapering late this year.
Combining these elements with a 3.6% dividend
yield implies EuroStoxx 50 total returns of
3% in 2017.
The risks to our base case are skewed mildly
to the upside. After underperforming most equity
markets in 2016, Eurozone equities have room to
play catch-up. Moreover, the passing of long-feared
French and German elections could compress
today’s elevated equity risk premium, although
political uncertainty is likely to remain high in the
interim. Finally, investors’ recent shift toward firms
more exposed to the business cycle should benefit
Eurozone firms given their greater operating
leverage (see Exhibit 63).
Within the Eurozone, we are overweight
Spanish equities. Here, we are drawn to attractive
valuations (see Exhibit 64), domestic growth
momentum and embedded overweight to banks.
UK Equities: Scaling the Wall of Worry
While the Brexit vote was surprising, the
subsequent performance of the UK stock market
was even more so. Despite the tremendous
political and social uncertainty engendered by the
referendum’s outcome, UK equities generated one
of the strongest returns of any major equity market
last year in local currency terms.
Several factors at the root of this
outperformance should continue to work in favor
of UK equities in 2017. First, FTSE 100’s global
Outlook
Investment Strategy Group
57
Exhibit 65: FTSE 100 Price Level and British Pound
A weaker pound benefits FTSE 100 companies, which
generate 75% of sales outside the UK.
Exhibit 66: TOPIX Price Level
Japanese equities have traded in a large-butcontained
range.
Index Level
7,300
7,100
6,900
6,700
FTSE 100 Price Level
GBP/USD (Right, Inverted)
Brexit
Vote
Exchange Rate
1.15
1.20
1.25
1.30
Price Level
3,500
3,000
2,500
6,500
1.35
2,000
Flat
6,300
6,100
5,900
GBP
Depreciation
1.40
1.45
1.50
1,500
1,000
Fat
5,700
1.55
500
5,500
Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
1.60
0
1980 1985 1990 1995 2000 2005 2010 2015
Data through December 31, 2016.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bloomberg.
footprint—75% of sales come from outside the
UK economy—should benefit from the accelerating
global GDP growth we expect this year, just
as this exposure profited from last year’s 16%
depreciation of the British pound (see Exhibit
65). Second, last year’s best-performing sectors—
commodities and financials—are well positioned
to extend their run. Financials—the largest UK
sector—stands to benefit from rising interest rates,
while the commodity sectors should get a boost
from higher oil prices. Notably, these two sectors
account for nearly half of FTSE 100 market
capitalization.
With these tailwinds in mind, we forecast UK
earnings growth of 11% this year, the highest of
our estimates across EAFE markets. That said,
continued uncertainty around the implications
of Brexit coupled with higher interest rates will
likely weigh on FTSE 100’s well-above-average
valuations. This view, combined with the UK equity
market’s hefty dividend yield of 4.0%, results in a
4% total return projection for the FTSE 100.
Although this return is attractive on its face,
We project UK earnings growth of
11% this year, the highest of our
estimates across EAFE markets.
we do not believe it offers investors a large enough
margin of safety to justify a tactical overweight.
Keep in mind that significant uncertainties remain
around the final contours of Brexit. Moreover,
a shift by the Bank of England toward raising
interest rates this year could reverse much of the
British pound’s depreciation, to the detriment of
UK earnings. Finally, FTSE 100’s global footprint
could magnify any disruption to global trade
volumes resulting from protectionist policies.
Japanese Equities: Scaling a Familiar Peak
Japanese equities have experienced their fair share
of booms and busts over the last 25 years. As seen
in Exhibit 66, this pattern of offsetting swings has
resulted in a “fat and flat” 108 trading range. With
the TOPIX price level again in the upper third of
its historical band, it is natural to ask whether
2017 will mark yet another market top in Japan.
The earnings outlook is pivotal to answering
this question. While our forecast for accelerating
global GDP growth points toward higher
earnings, near-peak profit margins are
a headwind (see Exhibit 67). Moreover,
with less central bank easing given the
BOJ’s already sizable balance sheet, yen
depreciation—a key driver of Japanese
revenue growth since 2012—is expected
to moderate this year. Even so, the
58 Goldman Sachs january 2017
Exhibit 67: Japanese Profit Margins
Near-peak profit margins could be a headwind for
Japanese equities.
Exhibit 68: Japanese Equity Valuations
Valuations are near the median level of Japan’s deflationary
period since 1999.
Trailing 12-Month Net Income (% of Sales)
6
5
Percentile
80
70
65
69
4
3
2
60
50
40
38
43
Average: 52%
47
1
30
0
20
-1
10
-2
1980 1985 1990 1995 2000 2005 2010 2015
0
Price to 10-Year
Average Earnings
Price-to-Peak
Earnings
Price-to-Book
Value
Price to 10-Year
Average Cash
Flow
Price-to-Peak
Cash Flow
Data through November 30, 2016.
Source: Investment Strategy Group, Datastream.
Data as of December 31, 2016.
Note: Based on data since 1999.
Source: Investment Strategy Group, Datastream, MSCI.
interplay of these inputs should still lead to positive
earnings growth of 6% in 2017.
The direction of valuation multiples is equally
important. As shown in Exhibit 68, Japanese
valuations are middling based on their history
since 1999, which we believe is the relevant
evaluation period given the deflationary headwinds
that emerged thereafter. For equity multiples
to move significantly higher from here would
require sustainable above-trend earnings growth
or a sizable increase in direct equity purchases
by the Japanese central bank. But with the BOJ
already holding a remarkable 60% of Japanese
ETF market assets 109 and profit margins near
their peak levels, neither of these upside catalysts
seems probable. In fact, P/E multiples are forecast
to contract in our base case, as the 6% earnings
growth we expect will likely disappoint current
market expectations of 12%.
Putting these pieces together, we expect neither
a boom nor a bust for Japanese equities. Instead,
the combination of mid-single-digit earnings
growth, slight compression in valuation multiples
and a 1.9% dividend yield should generate a
5% total return. While this return is attractive
from an absolute standpoint, it also comes with
significant downside risks given the country’s
poor demographics, declining labor force and
high government debt load. Consequently, we are
tactically neutral on Japanese equities currently.
Emerging Market Equities: Finally in Gear,
but Potholes Ahead
Emerging market equities as a whole finally moved
forward in 2016 after three years in reverse:
multiples expanded, earnings estimates improved
and currencies appreciated, generating a 12%
total return. Politics and commodity prices were
key performance differentiators among emerging
markets last year, leading Brazil and Russia to the
winners’ podium while leaving Turkey and Mexico
in last place.
We expect emerging market equities to remain
on track in 2017. Our central case calls for
earnings growth of 5% in US dollar terms, driven
by faster nominal GDP growth and the lagged
impact of easier financial conditions and higher
commodity prices. But with multiples already at
post-crisis highs in an environment of rising global
rates and heightened risks, we see little scope for
further expansion. Combining these two inputs
with a dividend yield of 2.6%, our forecast implies
a total return of about 7% this year.
However, the uncertainty around this forecast
is quite large, as emerging market equities face
several potential potholes on the road ahead.
Chief among these is the ultimate policy agenda
of the incoming US administration. On the one
hand, a policy mix that favors US growth over
trade restrictions would support emerging market
exports and boost profits and equity returns.
Outlook
Investment Strategy Group
59
Exhibit 69: EM Equity Valuations
Aggregate valuations are near neutral levels.
Normalized Composite Z-Score
1.0
0.8
0.6
0.4
0.2
0.0
0.0
-0.1
-0.2
-0.4
-0.3
-0.2 -0.2 -0.2 -0.2
Russia (4.5%)
Taiwan (12.2%)
Chile (1.2%)
Korea (14.4%)
Turkey (1.0%)
Malaysia (2.5%)
Thailand (2.3%)
0.1
EM
On the other hand, a harsher US stance on trade
and foreign policy would hurt emerging market
earnings, sentiment and valuation multiples.
China, Korea, Mexico and Taiwan—which
account for about 60% of MSCI emerging market
capitalization and earnings—seem particularly
vulnerable in the latter scenario. In comparison,
countries with less exposure to the US economy
and already strong domestic demand, such as India
and Indonesia, would likely fare better.
0.2
China (26.5%)
0.2 0.2
Data as of December 31, 2016.
Note: Based on monthly data since 1994 for Price/Forward Earnings, Price/Book Value, Price/
Cash Flow, Price/Sales, Price/Earnings-to-Growth Ratio, Dividend Yield and Return on Equity.
Numbers in parentheses denote the country’s weight in MSCI EM. Only showing countries with a
weight greater than 1%.
Source: Investment Strategy Group, Datastream, I/B/E/S, MSCI.
Mexico (3.5%)
Philippines (1.2%)
0.4
Poland (1.1%)
0.4
Indonesia (2.6%)
0.5
India (8.3%)
0.7
South Africa (7.1%)
0.9
Brazil (7.7%)
Against this uncertain backdrop and
considering today's uninspiring valuations (see
Exhibit 69), we remain tactically neutral on
emerging market equities. That said, we continue
to explore relative investment opportunities that
exploit the significant domestic activity, external
vulnerability and valuation differences among
individual emerging countries.
2017 Global Currency Outlook
In a notable departure from recent years, the
US dollar did not enjoy unequivocal dominance
in 2016 (see Exhibit 70). The yen, for example,
ended a four-year slide against the greenback as
the market questioned the BOJ’s commitment
to monetary easing. Certain emerging market
currencies—such as the Russian ruble and Brazilian
real—also outperformed the dollar on the back of
stronger commodity prices and favorable political
developments at home. And while the dollar did
make notable gains against the euro, pound and
Mexican peso in particular, these currencies enter
2017 with a more balanced risk/reward profile
as a result.
The upshot is that while tightening monetary
policy and potential fiscal expansion in the US
will continue to favor dollar strength, those
gains are likely to be more modest and reflected
in a narrower set of currencies as the dollar bull
market enters its fifth year. Our tactical positioning
Exhibit 70: 2016 Currency Moves (vs. US Dollar)
For the first time in several years, the US dollar did not appreciate against all major currencies.
2016 Spot Return (%)
G10 EM Asia EM EMEA EM Latin America
25
20
15
10
5
0
-5
-10
-15
-20
-16
USD
Appreciation
-7
-3
-2 -1
2 2 3 3
-6
-5 -4
-3 -3 -2
1
2 2
-17
-6
-3
-1
13
20
-17
2
6 6
22
UK
Sweden
Euro
Switzerland
Australia
New Zealand
Norway
Japan
Canada
China
Philippines
Malaysia
India
Korea
Singapore
Thailand
Taiwan
Indonesia
Turkey
Poland
Czech Republic
Hungary
South Africa
Russia
Mexico
Peru
Chile
Colombia
Brazil
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
60 Goldman Sachs january 2017
incorporates this view, as we are neutral on the
euro, yen and pound versus the US dollar, but
remain bearish on the Chinese renminbi.
We discuss our view on the broader US dollar,
as well as each of these currencies, next.
Exhibit 71: US Dollar Real Effective Exchange Rate
Dollar valuations are near their long-term average but below
levels reached in past bull cycles.
Z-Score
4
US Dollar
Following three consecutive years of dollar
outperformance, it would be reasonable to assume
the up-cycle is nearing an end. After all, dollar
valuation is now close to its historic average level
relative to the currencies of US trade partners, after
adjusting for inflation. Moreover, the length of this
dollar bull market is approaching that of the two
prior episodes shown in Exhibit 71 and shares a
similar underlying driver—tighter monetary policy
in the US relative to its global peer group.
But while we expect the pace of US dollar
appreciation to slow, there are many reasons
to believe the greenback’s outperformance can
continue this year. Dollar valuation remains
below the peaks reached in the 1985 and 2002
bull cycles, suggesting it is not yet prohibitively
expensive. The dollar should also benefit from
solid US macroeconomic fundamentals relative to
other developed economies. President-elect Trump
ran on a platform that includes fiscal expansion
and corporate tax reform. Although his economic
team’s spending plan is still forthcoming, the
package could represent an economic tailwind that
may justify tighter US monetary conditions at a
time when foreign central banks have committed
to easier policy. In turn, relatively higher US yields
may entice global investors to favor US dollar
assets over lower-yielding foreign-denominated
alternatives.
Furthermore, some elements of the new
administration’s desired corporate tax reform
could present material upside risk to the US dollar.
For example, the destination-based tax system
supported by several House Republicans disallows
deductions for any imported good or service—
Dollar gains are likely to be more
modest and reflected in a narrower
set of currencies as the dollar bull
market enters its fifth year.
3
2
1
0
-1
-2
6.3 Years 6.8 Years 5.4 Years
-3
1973 1978 1983 1988 1993 1998 2003 2008 2013
Data through November 30, 2016.
Note: Z-score is calculated on data since 1973 and represents the number of standard deviations
from the mean. Shaded areas highlight periods of dollar strength.
Source: Investment Strategy Group, Datastream.
effectively supporting US goods by making them
more competitive. Economic theory suggests that
free-floating currencies such as the US dollar
would need to adjust higher by the amount of
the tax to create equilibrium with similar goods
sourced across foreign borders. Taken at face
value, this implies a 20% destination tax would
require a simultaneous—and potentially very
disruptive—20% increase in the US dollar. A tax
holiday for cash held abroad could be similarly
dollar positive, in spirit if not in magnitude. While
it is true that a majority of the $2.6 trillion of US
corporate earnings trapped overseas are already
held in US dollar assets, the greenback would still
enjoy a tailwind if corporates elected to repatriate
some portion of the foreign currency balance.
That said, the risks to the US dollar are not
exclusively to the upside, as much of the good
news is embedded in current prices (see Exhibit
72). Consider that the bulk of last year’s dollar
advance occurred in the two weeks following the
US presidential election in November, as
the market quickly discounted a portion
of potential policy changes. Moreover,
Federal Reserve rate hike expectations
for 2017 have increased following
stronger US activity data during the
second half of 2016. Lastly, we expect
the BOJ and ECB to maintain their
highly accommodative policies again
this year. With these tailwinds already
0.6
Outlook
Investment Strategy Group
61
Exhibit 72: Trade-Weighted US Dollar Index
The recent dollar rally implies much of the good news has
already been priced in.
January 1997 = 100
140
Exhibit 73: Eurozone Net Portfolio Flows
Policy divergences could continue to drive portfolio
investment out of the Eurozone.
12-Month Rolling Sum, % of GDP
6
130
120
110
4
2
0
-2
Capital Into Eurozone
= Euro Appreciation
100
90
80
1995 2000 2005 2010 2015
Data through December 31, 2016.
Note: Shaded areas denote periods of US recession.
Source: Investment Strategy Group, Datastream.
-4
Capital Out of Eurozone
= Euro Depreciation
Net Equity
-6
Net Debt
Net Portfolio Flows
-8
2011 2012 2013 2014 2015 2016
Data through October 31, 2016.
Note: Q3 2016 data used to calculate Q4 2016 share of GDP.
Source: Investment Strategy Group, Haver Analytics.
partly reflected in current exchange rates, the US
dollar is vulnerable to both domestic and foreign
disappointments.
In sum, we expect the dollar to appreciate
further, but at a slower pace and with greater
volatility than in recent years.
Euro
The euro was on the losing side of the US
dollar’s strength again in 2016, marking the third
consecutive year of underperformance and the
longest stretch of annual declines since 2001. Last
year’s modest 3.2% decline actually masked a
much larger 10% drop from the euro’s intra-year
peak, half of which came in the weeks following
the US elections in November. Needless to say, the
combination of potentially expansionary fiscal
policy put in place by the new administration
coupled with tighter US monetary policy represents
a stiff headwind to the euro, particularly since
We should not lose sight of the fact
that after such persistent weakness
versus the US dollar, the euro is
undervalued and investors are now
positioned for further weakness.
the ECB just extended quantitative easing until
December 2017.
We expect these transatlantic policy divergences
to persist, driving European investors to continue
seeking higher-yielding, non-euro-denominated
assets abroad (see Exhibit 73). This preference
will likely be bolstered by uncertainty surrounding
upcoming national elections in Germany, France,
the Netherlands and possibly Italy and Spain.
While our central case assumes mainstream parties
prevail, any result that raises questions about the
long-term viability of the European Monetary
Union could push the euro even lower.
Still, we should not lose sight of the fact that
after such persistent weakness versus the US dollar,
the euro is undervalued and investors are now
positioned for further weakness. Additionally, the
above-trend Eurozone growth and normalizing
inflation we expect could justify the ECB shifting
toward a more neutral stance later this year.
Such a move would narrow the interest
rate differential between the US and
Eurozone, weakening a linchpin of the
weaker euro thesis.
Given this balance of risks, we
removed our tactical short positions in
the euro relative to the dollar following
the November US presidential election,
returning to a neutral view.
62 Goldman Sachs january 2017
Exhibit 74: Japanese Net Purchases of Foreign
Long-Term Debt by Investor Type
Additional buying of foreign assets by Japanese investors
could put further downward pressure on the yen.
12-Month Rolling Sum, % of GDP
-2
0
2
4
6
Banks
Pension Trusts
Insurers
All Other*
Capital Into Japan
= Yen Appreciation
Capital Out of Japan
= Yen Depreciation
2013 2014 2015 2016
Data through November 30, 2016.
Note: Q3 2016 data used to calculate Q4 2016 share of GDP.
Source: Investment Strategy Group, Haver Analytics.
* All Other defined as central banks, general government, financial instruments firms, investment
trust management companies and others.
Yen
For yen investors, last year was a reminder that
markets often take an escalator up but an elevator
down. After steadily appreciating almost 20%
against the US dollar over the first nine months
of 2016, the currency forfeited those gains in
just weeks after the surprising US presidential
election. Although the net effect was a small 2.8%
appreciation last year—breaking a four-year streak
of yen weakness—we do not believe further yen
strength is likely.
There are two reasons for this view. First, the
BOJ will likely keep rates negative or close to zero
this year by maintaining highly accommodative
monetary policy. In turn, Japanese investors will
continue to sell low-yielding domestic assets—
placing downward pressure on the yen—in order
to fund purchases of higher-yielding offshore assets
(see Exhibit 74). Japan’s Government Pension
Investment Fund (GPIF)—which manages the
world’s largest public pension—is a case in point,
as it will need to sell domestic fixed income assets
to reach its stated targets for foreign investments.
Similarly, Japanese life insurers may increase
their exposure to foreign currencies if interest
rate differentials between the US and Japan
remain wide.
Second, Japanese corporations are likely
to sell yen to invest in foreign operations with
better growth prospects, which will also place
downward pressure on the Japanese currency; such
announcements are already on the rise. 110
This is not to suggest that the prospects for the
yen are completely one-sided. The higher global
rates we expect may make it difficult for the BOJ
to maintain such low domestic yields, which would
alleviate some of the downward pressure on the
currency. Moreover, the many sources of global
uncertainty in the year ahead could lead investors
back into the yen as a liquid hedge, as we saw in
the first half of 2016. Finally, after four years of
weakness, the yen has reached undervalued levels.
Given this more balanced risk profile, we
currently have no tactical position in the yen.
British Pound
While broader financial markets were unperturbed
by the UK’s decision to leave the European Union,
the same cannot be said for currencies. Here,
the Brexit vote sent the pound tumbling to its
lowest level versus the US dollar since the 1985
Plaza Accord. 111 Although the pound has since
recovered some of those losses, its 16.3% decline
relative to the US dollar last year still ranks as the
worst performance among all developed market
currencies.
The trajectory of the pound will be largely
shaped by the evolution of Brexit negotiations.
Even though six months have passed since the
vote, there is no greater clarity on how the UK
will ultimately exit the European Union and on
what terms. Clearly a combative stance could see
the pound weaken further as the market discounts
lower potential growth in the UK. Alternatively, a
more conciliatory negotiating position could lead
to upside from today’s depressed levels.
Barring a hostile negotiating tack from the
UK government, the pound also has several other
factors working in its favor. First, foreigners
continue to buy pounds to invest in UK-domiciled
assets and firms, which is vital to funding the UK’s
sizable 5.2% of GDP current account deficit. In
fact, one of the largest cross-border acquisitions
last year was announced less than one month
following the EU referendum. 112 Importantly,
higher-frequency data shows this merger and
acquisition (M&A) momentum is continuing (see
Exhibit 75).
Second, the Bank of England may need to raise
interest rates sooner than markets now expect, as
erstwhile sterling depreciation is quickly feeding
Outlook
Investment Strategy Group
63
Exhibit 75: UK Cash Merger and Acquisition
Announcement Pipeline
Continued inbound M&A activity could benefit the pound.
6-Month Rolling Sum, $ bn
150
100
50
0
-50
-100
-150
Inbound M&A
Outbound M&A
Net M&A
Capital Into the UK
= Pound Appreciation
Capital Out of the UK
= Pound Depreciation
May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16
Data through December 31, 2016.
Note: October 2016 outbound M&A adjusted to exclude stock portion of British American
Tobacco’s takeover of Reynolds.
Source: Investment Strategy Group, Bloomberg.
through to higher domestic inflation. In turn,
higher UK interest rates would make sterlingdenominated
assets more appealing to foreign
investors and support the currency.
Finally, while sterling certainly has scope to
depreciate, market participants are already wellpositioned
for further weakness. Those positions
may become vulnerable if the UK’s negotiations
with its trade partners turn more amicable and the
domestic UK economy remains resilient.
With these upside risks being tempered by the
unknowable evolution of Brexit negotiations for
now, we see balanced risks for the pound this year
and thus remain tactically neutral.
Emerging Market Currencies
Emerging market currencies caught a welcome
updraft last year, following a 45% freefall since
mid-2011. The flight was not without turbulence,
however. Following a 12% rally in the first half of
the year—reflecting a dovish shift in US monetary
policy and waning fears about Chinese capital
outflows—emerging market currencies hit an air
pocket that erased much of these gains following
the surprise outcome of the US elections.
We believe this downdraft is likely to persist.
The prospect of higher US interest rates, a stronger
dollar and China’s bumpy deceleration spells
tighter global financial conditions and a risk
of capital outflows from emerging markets—
conditions that have historically constituted a stiff
headwind to their currencies.
These risks are magnified by the uncertainty
surrounding the incoming US administration’s
trade policies. Fears of protectionism have already
negatively impacted the currencies of China and
Mexico—the two largest sources of manufacturing
exports to the US—with the peso and Chinese
renminbi down 11.6% and 2.3%, respectively,
since the election.
Even so, we do not think a broad tactical short
in emerging market currencies is appealing at this
stage. Despite the small rally last year, emerging
market currencies remain attractively valued (see
Exhibit 76), particularly given their enticing 5%
yield differential to the US dollar. Moreover, the
new US administration may prove to be more
measured in its actions than its rhetoric—a nonnegligible
risk that could revive sentiment and
improve prospects for emerging market currencies.
The Mexican peso, in particular, could benefit in
that event.
For now, we remain tactically positioned to
benefit from further renminbi weakness given our
long-standing concerns about China’s economic
vulnerabilities and the likelihood of looser policy,
policy mistakes and capital outflows. The potential
for US trade protectionism directed at China,
though not our base case, would further benefit
this position.
2017 Global Fixed Income Outlook
Last year witnessed a notable reversal of fortune
for global interest rates. Despite reaching all-time
closing lows shortly after the surprise Brexit vote,
10-year yields in developed markets had reclaimed
much—if not all—of those declines by year-end.
In the US, a more than one percentage point swing
was sufficient to turn the 10-year bond’s 9% gain
into a loss.
While some have portrayed this reversal as
just another setback in the now three-decade-old
bond bull market, we are more skeptical. The
policy mix that has depressed interest rates in
the post-crisis period—a combination of fiscal
austerity, negative or near-zero central bank policy
rates and large-scale asset purchases—is losing
favor, as even policymakers acknowledge the often
counterproductive impact of these policies. At
64 Goldman Sachs january 2017
Exhibit 76: Emerging Market Currency Valuation
Despite the recent rally, emerging market currencies remain
undervalued against the US dollar.
Exhibit 77: Estimated Duration of US Bond Market
The bond market’s sensitivity to rising rates is the highest
on record.
Average Deviation from Fair Value vs. US Dollar (%)
20
15
10
5
0
-5
-10
EM Currencies
Overvalued
on Average
Duration (Years)
7
6
5
4
-15
-20
-25
2008 2009 2010 2011 2012 2013 2014 2015 2016
-15
3
2
1989 1994 1999 2004 2009 2014
Data through November 30, 2016.
Note: Average of Goldman Sachs Dynamic Equilibrium Exchange Rate, 5-year moving average,
and Fundamental Equilibrium Exchange Rate misalignments of currencies in the JP Morgan
Government Bond Index—Emerging Markets Global Diversified.
Source: Investment Strategy Group, Bloomberg, Datastream, Goldman Sachs Global Investment
Research, Peterson Institute for International Economics.
Data through December 31, 2016.
Note: Based on the Barclays US Aggregate Bond Index.
Source: Investment Strategy Group, Bloomberg.
the same time, the recovery in commodity prices,
recent firming in global growth and potential for
expansionary fiscal policy are shifting the focus
from deflation to reflation.
This shift in perspective arrives at a time when
the market’s vulnerability to rising rates is the
highest on record (see Exhibit 77). Losses from
these long-duration positions in response to higher
rates could beget more bond sales, creating a
vicious cycle. That yields are still extremely low
by historical standards does little to assuage these
fears. Consider that 10-year government bond
yields in all G-7 countries have been higher at least
90% of the time since 1958. Given all the above,
For now, we remain tactically
positioned to benefit from further
renminbi weakness given our longstanding
concerns about China’s
economic vulnerabilities and the
likelihood of looser policy, policy
mistakes and capital outflows.
we believe the ascent of interest rates remains in
its infancy.
Still, it is important to differentiate between
a normalization of interest rates and a disorderly
backup. While we expect higher interest rates over
the coming years, secular headwinds—like aging
demographics and slower productivity growth—
suggest the terminal point of that increase will be
lower than the historical average. This fact is not
lost on the Federal Reserve, which has reduced
its estimate of the long-run equilibrium nominal
rate—the rate consistent with full employment and
stable inflation in the medium term—from 4.25%
to 3% over recent years.
With a lower interest rate target
to reach, the Federal Reserve is likely
to proceed slowly, particularly given
uncertainty around its estimate of the
economy’s equilibrium rate and lingering
international risks. Even if the Federal
Reserve were to raise rates three times in
2017, that pace would still be less than
half of the historical median tightening
pace. 113 Thus far in this cycle, the
Federal Reserve has raised rates only
once per year.
Against this backdrop, we recommend
investors favor credit over duration risk
Outlook
Investment Strategy Group
65
by remaining overweight US corporate high yield
credit versus investment grade fixed income and by
funding various tactical tilts from their high-quality
bond allocation. While most investment grade
bonds may have uninspiring tactical prospects, we
emphasize that investors should not completely
abandon their bond allocation in search of higher
yields. As the last several years have reminded
us, investment grade fixed income serves a vital
strategic role in the portfolio, due to its ability to
hedge against deflation, reduce portfolio volatility
and generate income.
In the sections that follow, we review the
specifics of each fixed income market.
US Treasuries
While 2016 began as a bumper year for US
Treasuries, it ended in a rout. The yield on 10-year
Treasury bonds, for example, reached an all-time
low of just 1.36% by the middle of last year before
jolting higher by more than one percentage point
by year-end. As a result, investors’ nearly doubledigit
gains devolved into a small loss. Even worse,
the bulk of the rate increase occurred in just the
last three months of 2016, generating a 7% loss for
the quarter that has been exceeded less than 1% of
the time historically since 1981.
We expect rates to continue to increase, albeit
at a slower pace in 2017, as many of the forces
that have restrained yields are slowly fading.
Inflation, in particular, has been a persistent drag,
reflecting a toxic combination of excess labor slack
that depressed wages, a strong dollar that lowered
import prices and a significant decline in oil prices
that weighed on breakeven inflation rates. But
as we begin the eighth year of the US expansion,
labor slack has been largely absorbed, evident in
today’s firming wages. Moreover, the impact of the
dollar is diminishing as its pace of ascent slows,
while the recovery in oil is boosting breakeven
inflation rates.
Other headwinds are also receding. The fiscal
austerity among the advanced economies that
has dampened economic growth and decreased
sovereign bond issuance—both of which depress
interest rates—is now reversing (see Exhibit 78).
Indeed, US fiscal spending is expected to add
0.3–0.5 percentage points to GDP growth in each
of the next two years. 114
At the same time, there is reduced demand
for risk-free assets, like US Treasuries, given
the unexpectedly sanguine reaction to negative
Exhibit 78: Fiscal Stance of Advanced Economies
Fiscal austerity in developed markets has reversed in
recent years.
Number of Countries
35
30
25
20
15
10
5
0
5 6
6
6
23 22 22
8
4
10 9
9 12
2011 2012 2013 2014 2015 2016
Data as of December 31, 2016.
Source: Investment Strategy Group, IMF.
Tightened Remained Neutral Loosened
geopolitical events—such as the UK and Italian
referenda—and the results of the US election.
Finally, the deleterious impact of depressed interest
rates on banking sector profitability has raised the
hurdle for global central banks to cut interest rates
further and/or increase the scale of QE programs. In
turn, market focus has shifted toward the eventual
tapering of BOJ, ECB and BOE accommodation,
which has helped lift bond term premiums and
boosted long-term yields (see Exhibit 79).
In light of these waning headwinds, the Federal
Reserve is likely to hike two or three times in 2017,
with upside risks from a larger-than-anticipated
fiscal expansion. Combined with some further
normalization in the term premium, we expect 10-
year rates to increase to 2.50–3.00% by year-end.
Given the balance of risks, we remain comfortable
funding tactical tilts out of investment grade
fixed income.
Treasury Inflation-Protected Securities (TIPS)
TIPS fared better than nominal bonds in 2016,
delivering a positive mid-single-digit return. Their
outperformance was driven by the recovery in
breakeven inflation rates, which began the year at
very depressed levels consistent with only 1.5%
annual inflation over the next 10 years—well
below long-run forecasts (see Exhibit 80). In fact,
our work suggests that breakeven inflation rates
were reflecting high odds of a deep recession over
the course of 2016, well above the risk suggested
by our recession models.
15
13
16
9
9
66 Goldman Sachs january 2017
Exhibit 79: US 10-Year Yields and Term Premium
Expected tapering from major central banks has contributed
to higher long-term yields and bond term premiums.
Exhibit 80: US 10-Year Breakeven Inflation Rate
and Consensus Inflation Rate Forecasts
TIPS benefited from a recovery in breakeven inflation
rates in 2016.
%
4
3
10-Year Treasury Yield
Risk-Neutral Yield
Term Premium
% Annualized
3.0
2.5
10-Year Breakeven Inflation
10-Year Ahead Inflation Forecast
2.0
2
1.5
1
1.0
0
0.5
-1
2011 2012 2013 2014 2015 2016
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
0.0
2011 2012 2013 2014 2015 2016
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
We think that breakeven inflation rates have
further room to rise as the concerns that depressed
them last year fade. First, oil prices are recovering,
reversing the persistent drag they had exerted
throughout much of early 2016. Second, wages are
firming and fiscal policy is being eased, dampening
deflation worries. Finally, recession odds are
falling as the drag from oil weakness and dollar
strength fades.
With breakeven inflation rates still below longterm
consensus forecasts and the Federal Reserve’s
target, we expect positive total returns from TIPS
in 2017. Still, TIPS’ absolute returns are likely to
be modest, as their eight-year duration will make it
difficult for coupon income to meaningfully exceed
principal losses as rates rise. Moreover, given TIPS’
unfavorable tax treatment (discussed at length
in our 2011 Outlook), we continue to advise US
clients with taxable accounts to use municipal
bonds for their strategic allocation.
We expect rates to continue to
increase, albeit at a slower pace in
2017, as many of the forces that have
restrained yields are slowly fading.
US Municipal Bond Market
Municipal bond holders were not immune from
2016’s about-face in US Treasury yields. Last
October, municipal bonds were enjoying some of
their best returns in years, only to be hit by losses
arising from both rising interest rates and budding
concerns about tax changes in the wake of the US
presidential election. The abrupt redemptions of
municipal bond mutual funds only exacerbated
these losses, with the pace of outflows second only
to the mid-2013 taper tantrum (see Exhibit 81).
All told, municipal bonds suffered one of their
worst years in recent history, with intermediate
municipal bonds actually experiencing a rare loss
(see Exhibit 82).
Unfortunately, the near-term outlook remains
challenging. As Exhibit 81 reminds us, mutual
fund flows tend to be sticky in this asset class,
with persistent periods of both buying and selling
depending on the trajectory of interest rates. Based
on historical episodes, there is scope for the current
string of outflows to extend further.
Moreover, clarity on tax policy will
remain elusive for months, during which
time headline risk will be significant.
Even worse, a sizable reduction in the
top individual tax rate for municipal
bonds—if ultimately passed—could
significantly shift the economics of
owning them, leading to further sales.
These fresh worries on tax policies
Outlook
Investment Strategy Group
67
Exhibit 81: Municipal Bond Mutual Fund Flows
The pace of outflows at the end of 2016 was surpassed in
recent history only by the 2013 taper tantrum.
4-Week Rolling Average, $ bn
3
Exhibit 82: Annual Municipal Bond Returns
Since 1994
Intermediate municipal bonds experienced a rare
loss in 2016.
Ranked Annual Returns (%)
15
2
1
10
0
-1
5
-2
-3
0
-4
-5
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-5
1995
2002
2000
2011
1997
2009
1998
2001
2007
2014
1996
2003
2008
2006
2012
2010
2004
2015
2005
1999
2016
2013
1994
Data through December 31, 2016.
Source: Investment Strategy Group, ICI.
Data as of December 31, 2016.
Source: Investment Strategy Group, Barclays.
only add to existing concerns about pension
funding levels.
While there is clearly no shortage of risks, the
silver lining to last year’s rout is that we begin
2017 with a much larger valuation buffer to help
absorb them. As seen in Exhibit 83, the ratio
of municipal yields to Treasury yields is above
average for both 5- and 10-year maturities. In
turn, investors can currently earn an extra 70
basis points of after-tax yield by owning fiveyear
municipal bonds instead of same-maturity
Treasuries—a yield pickup more than double the
post-crisis median of 31 basis points. Moreover,
this incremental after-tax yield would still be
around 50 basis points if the top individual tax on
investment income were reduced by 10 percentage
points—from 43.4% with the Affordable
Care Act (ACA) tax to 33% under new policy
recommendations. In short, municipal spreads
currently offer a potential offset to rising rates and
potential tax changes.
Also keep in mind that municipal fundamentals
remain stable. Major state and local tax revenues
have continued to increase at a moderate 3% pace,
which should be supported by the above-trend
US economic growth and rising home prices we
forecast. Meanwhile, governments have exercised
restraint on capital spending. Consider that net
issuance expectations of $30 billion for 2017 stand
well below the pre-crisis 10-year annual average
of $110 billion. 115 This restraint has not only kept
net supply low—as new issuance has been largely
offset by maturing debt—but has also helped
municipal finances. Ratings trends have improved
as a result of both stable revenue and spending
discipline, with upgrades in the Moody’s universe
seeing a notable uptick in last year’s third quarter
(see Exhibit 84).
Of course, underfunded long-term pension
liabilities remain a source of concern. But with
aggregate funding levels holding steady at around
74%, we do not think this will be a primary focus
in 2017, particularly given last year’s increase in
stock prices. While rising equity values will do
little to remedy municipals’ inadequate funding
contributions, they will help increase the value
of pension assets. Moreover, these medium-term
concerns are not the primary driver of recent
municipal bond weakness. After all, today’s
funding levels are no worse than they were in
October of last year, a time when municipal bonds
were enjoying some of their best returns ever.
All told, we expect intermediate municipal
strategies to gain about 1% in 2017. With
this return close to that of cash but with more
downside potential, we still think it makes sense
for clients to fund various tactical tilts from their
high-quality municipal bond allocation. This
recommendation is motivated primarily by rate
risk and not credit concerns, since we expect
municipal defaults to be rare events. Outside
tilt funding, we recommend clients target their
68 Goldman Sachs january 2017
Exhibit 83: Ratio of Municipal Bond Yields to
Treasury Yields
Current municipal bond yields offer a larger valuation buffer
to absorb risks than in the past.
Exhibit 84: Municipal Issuer Rating Changes
Stable revenue and spending discipline have led to recent
issuer rating upgrades.
Ratio (%)
100
90
80
Current Average Since 2000 Average Since 1987
95
93
91
85
80
85
Share of Rating Changes (%)
100
90
80 37
49
70
60
56
42
56 54
Upgrades
50
39
Downgrades
63
50
70
40
60
30
20
63
51
44
58
44 46
50
61
37
10
50
5-Year Ratio
10-Year Ratio
0
3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Thomson MMD.
Data as of Q3 2016.
Source: Investment Strategy Group, Moody’s.
benchmark duration. Given their important
portfolio hedging characteristics, municipal bonds
should remain the bedrock of the “sleep-well”
portion of a US-based client’s portfolio.
The same can be said for high yield municipal
bonds. Despite their almost 10-year duration, these
bonds currently offer attractive spreads of close to
3%, a level that has been higher only 29% of the
time since 2000. This spread provides a substantial
buffer that could partially offset higher Treasury
yields, enabling the high yield municipal market
to deliver positive returns of around 4% in our
base case. Therefore, we recommend clients stay
invested at their customized strategic weight.
US Corporate High Yield Credit
Even for the bullish among us, last year’s
17% total return in corporate high yield was
surprisingly strong. Not only was it the largest gain
within US fixed income, but it also ranked among
While there is clearly no shortage of
risks, the silver lining to last year’s
rout in municipal bonds is that
we begin 2017 with a much larger
valuation buffer to help absorb them.
the top annual returns of all time for the asset
class. What makes this performance even more
impressive is that high yield was down about 5%
at its worst point in early 2016.
But these sizable gains have come at a cost.
Spreads—which compensate investors for the risk
of default losses—now stand well below their longterm
average. In fact, the level of spreads has been
lower only a third of the time in the last 30 years.
Moreover, yields have fallen from above 10%
early last year to less than 7% now, diminishing
the allure of these bonds to investors searching for
high returns.
Even so, we think the strong fundamentals
underpinning the asset class still warrant an
overweight, though returns are almost certain to
be more modest going forward. At the heart of
this stance is our benign view on default losses,
which are the primary risk to high yield investors.
Here, several factors support our below-historicalaverage
2.5% par-weighted default
forecast for 2017.
First, high yield firms stand to benefit
directly from the strengthening US
economy we expect this year, considering
almost three-quarters of their sales
originate domestically. 116 Second, leading
indicators of defaults—such as Moody’s
liquidity and covenant stress indexes—
are trending downward, suggesting
fewer speculative-grade companies are
Outlook
Investment Strategy Group
69
Exhibit 85: Moody’s Liquidity Stress Index and
Default Rates
Leading indicators suggest the path of defaults for high
yield is lower.
Exhibit 86: Cumulative US High Yield Debt
Maturity by Year
Less than 10% of existing debt matures in the next
two years.
Index (%) Trailing 12-Month Rate (%)
25
Composite Liquidity Stress Index
16
Speculative-Grade Issuer-Weighted Default Rate (Right)
14
Cumulative Maturity (%)
100
High Yield Bonds
90
Bank Loans
86
100 100
20
15
12
10
80
70
60
67
63
8
10
6
4
5
2
0
0
2002 2004 2006 2008 2010 2012 2014 2016
50
40
30
20
10
0
47
42
33
20 19
10
7
4
1
2017 2018 2019 2020 2021 2022 2023 or later
Data through November 30, 2016.
Note: Moody’s Liquidity Stress Indexes fall when corporate liquidity appears to improve and rise
when it appears to weaken.
Source: Investment Strategy Group, Moody’s.
Data as of December 31, 2016.
Source: Investment Strategy Group, JP Morgan.
experiencing liquidity problems or are at risk of
breaching financial covenants. As seen in Exhibit
85, Moody’s composite Liquidity Stress Index
(LSI) began to deteriorate in advance of previous
default cycles. Third, the commodity sectors of the
high yield universe—which collectively generated
a staggering 85% of last year’s defaults—are
recovering along with oil prices. Keep in mind
that the par-weighted default rate excluding
these sectors was just 0.5% last year, a fraction
of the 3.2% long-run average. 117 Finally, our
default model—which incorporates the leading
characteristics of the Federal Reserve’s Senior Loan
Officer Opinion Survey and the percentage of
distressed bonds—is projecting 2–3% par-weighted
defaults in the year ahead.
Other factors corroborate our low-default view.
As seen in Exhibit 86, there is very little refinancing
We think the strong fundamentals
underpinning US corporate high yield
still warrant an overweight, though
returns are almost certain to be more
modest going forward.
risk, given that less than 10% of existing debt
matures in the next two years. Of equal importance,
interest coverage stands near all-time highs today,
in stark contrast to the period preceding the
financial crisis (see Exhibit 87). This point is further
illustrated by Exhibit 88, which shows that today’s
high yield universe is much healthier than the precrisis
cohort, regardless of measure. Keep in mind
that low-rated CCC bonds represented just 8% of
high yield issuance last year, a 14-year low. 118
We also note that high yield may be a better
interest rate hedge than many investors realize.
Consider that during unexpected interest rate
backups in the past, high yield has generated a
positive return 69% of the time and a return that
exceeded investment grade fixed income 85%
of the time (see Exhibit 89). This last point is
important, as our high yield overweight is funded
out of investment grade fixed income.
High yield’s hedging qualities were
apparent last year, as the asset class
appreciated nearly 7% in the second
half of the year despite an increase in
Treasury yields of more than 100 basis
points. Although we assume that any
further increase in 10-year Treasury
rates this year will not be offset by high
yield spreads, this historical relationship
suggests that may be overly conservative.
70 Goldman Sachs january 2017
Exhibit 87: High Yield Par-Weighted Interest
Coverage Ratio
Interest coverage today stands near all-time highs,
unlike the pre-crisis period.
Exhibit 88: Characteristics of US High
Yield Issuance
Today’s high yield universe is much healthier than the
pre-crisis cohort.
Coverage Ratio
Use of New Issuance Proceeds (%)
5
4.5
4.6
4.4
60
2006–07 Average 2015–16 Average
4
50
48
40
3
30
27
29
2
20
1
10
12
10
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
1Q16
2Q16
3Q16
0
LBO and M&A Low-Rated Companies Aggressive Securities
(PIK/Toggle Bonds)
0
Data through Q3 2016.
Source: Investment Strategy Group, Barclays.
Data as of December 31, 2016.
Source: Investment Strategy Group, JP Morgan.
Of course, a more constructive view of high
yield fundamentals does not necessarily suggest
robust returns. In high yield bonds, today’s belowaverage
spreads already reflect our subdued default
expectations and are less likely to offset any further
increase in rates. We thus expect returns of around
4% in the year ahead. Although high yield energy
is likely to generate similar gains, the potential
upside is more significant given wider starting
spreads and the potential for distressed bonds to
pull to par amid higher oil prices. Finally, with a
5% return, bank loans should perform marginally
better than bonds, reflecting their attractive
0.25-year duration and continued investor demand
for floating rates—a feature that is back in vogue
now that 3-month LIBOR is almost above the
1% LIBOR floor that more than 90% of bank
loans possess.
While these returns may pale in comparison to
those of last year, they remain attractive relative to
investment grade fixed income, where we expect
rising rates to generate lower returns. Even if rates
stagnate while US growth remains positive, the
default-adjusted return in high yield should still
trump high-quality bonds. Said differently, US
corporate high yield credit remains a better house
in a bad fixed income neighborhood, supporting
our modest overweight recommendation.
Exhibit 89: High Yield Credit Performance During
Periods of Rising Rates
High yield has historically outperformed investment grade
bonds during episodes of rising rates.
Average Return (%)
5
Average Total Return During
Episodes of Rising Rates*
4
% of Time Positive (Right)
3
2
1
0
-1
-2
Inv. Grade Fixed
Income (IGFI)
High Yield
High Yield
Less IGFI Return
Bank Loans
% of Time Positive
100
Bank Loans
Less IGFI Return
Data as of December 31, 2016.
Source: Investment Strategy Group, Barclays, Credit Suisse.
* Defined as 5-year Treasury yield rising more than 70 basis points over a 3-month period.
European Bonds
Unlike their US counterparts, European fixed
income markets did not forfeit all their gains by
the end of last year. This served as a poignant
reminder of how divergent monetary policies
can shape returns. Three ECB actions in March
drove this robust relative performance. First,
the ECB reversed its prior commitment to avoid
75
50
25
0
Outlook
Investment Strategy Group
71
further rate cuts and lowered the deposit rate to
-0.40%. Second, it increased the size of its asset
purchase program from €60 billion to €80 billion
per month, effectively buying more Eurozone
bonds each year than are actually issued (see
Exhibit 90). Finally, it continued to limit its buying
to bonds with yields above the deposit rate,
which concentrated its purchases toward longmaturity
bonds.
These measures created an extreme scarcity
effect in long-term German bunds, as investors
scrambled to buy today for fear of even lower
interest rates tomorrow. In response, German
10-year rates fell to an all-time low of -18 basis
points in July of 2016. During these same summer
months, all German government bonds with less
than a 15-year maturity offered negative yields.
However, monetary policy does not operate in
a vacuum. With negative interest rates impairing
the profitability of the European banking system,
the ECB has already begun to alter its policy mix.
At its December 2016 meeting, the ECB reversed
the increase in asset purchases mentioned above,
targeting €60 billion per month for the upcoming
March–December 2017 period. Moreover, it lifted
the restriction on purchasing bonds with yields
below the deposit rate, alleviating the scarcity
premium attached to long-maturity bonds meeting
this criterion. While these adjustments are well
short of QE “tapering,” they have shifted the
market focus toward the eventual end of asset
purchases and the timing of the first ECB rate
hike—currently priced for late 2018.
With less ECB policy pressure on long-maturity
bonds, coupled with continued above-trend
Eurozone growth and some further normalization
in global term premiums, we expect 10-year bund
yields to increase to 0.5–1.0% by the end of 2017.
While overall peripheral bond spreads should be
mostly range-bound in 2017, political woes in
Italy and France pose upside risks to the spreads of
those countries.
In the UK, we expect gilt yields to reach 1.5–
2.25%. Here, persistently high headline inflation
induced by the depreciation of sterling and a
less-than-feared economic drag from Brexit thus
far could encourage the BOE to unwind a portion
of the preemptive easing it deployed in response to
the surprise referendum outcome.
Given this outlook and today’s still depressed
bond yields, we remain underweight UK and
Eurozone government bonds for European
Exhibit 90: European Government Bond Issuance
and ECB Purchases
ECB buying is outpacing net issuance of Eurozone bonds.
€ bn
400
200
0
-200
-400
-600
-800
Net Issuance ECB Purchases Net Issuance Including ECB Purchases
240 211
-626
Data as of December 31, 2016.
Source: Investment Strategy Group, JP Morgan.
investors. After all, just a 2 basis point increase in
German 10-year bund yields generates a capital
loss sufficient to offset an entire year of income.
That said, we should not confuse an underweight
with a zero weighting, as European clients should
retain some exposure to German bunds and other
high-quality Eurozone bonds in the “sleep-well”
portion of their portfolios. These high-quality
bonds would provide an attractive hedge in the
event of a Eurozone recession or the return of
deflationary concerns.
Emerging Market Local Debt
Last year’s 10% return for emerging market local
debt (EMLD) provided some solace to those who
have suffered through nearly three years of losses
totaling more than 30%. But investors had to
endure considerable volatility to realize this gain,
as returns fluctuated between -4% and +18% in
2016. In fact, the asset class lost roughly 5% in just
the last two months of the year.
This last point is important, since many of the
tailwinds that drove EMLD’s strong returns in the
first half of 2016 reversed toward year-end and are
likely to impact the asset class again in 2017. Here,
we refer specifically to the resumption of Federal
Reserve rate hikes, renewed US dollar appreciation
and a resumption of Chinese renminbi depreciation
against the dollar. Just as falling global interest
rates helped the asset class for the first part of
2016, so too should the rising rates we expect
-386
-511
2016 2017
-300
72 Goldman Sachs january 2017
Exhibit 91: EM Local Debt Currencies and
Developed Market Interest Rates
Rising global interest rates would be a headwind to EM
local debt.
Exhibit 92: S&P Goldman Sachs Commodity Total
Return Index
Commodities generated their first double-digit return
since 2009.
%
1.2
1.0
Average G3 10-Year Rate
EM Local Debt FX (Right, Inverted)
1/1/2016 = 100
94
96
Annual Returns (%)
60
40
98
0.8
100
20
2016 Return: 11%
0.6
102
0
0.4
104
-20
106
0.2
108
-40
0.0
Jan-16 Apr-16 Jul-16 Oct-16
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Datastream.
110
-60
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
represent a headwind this year (see Exhibit
91). Meanwhile, any boost to emerging market
exports from the modest pickup in global growth
we expect is likely to be dwarfed by ongoing US
trade policy uncertainty, European political risk
and China fears. Lastly, an acceleration of recent
outflows from EMLD markets could magnify these
risks, particularly since 60% of the cumulative
inflows into the asset class since 2004 are
experiencing losses at current market levels.
Although the number of concerns is large, so is
the risk premium of the asset class. As previously
seen in Exhibit 76, the currencies in the EMLD
index are 15% undervalued. From this starting
point, the asset class could deliver attractive total
returns if US trade policy proves to be more benign
than feared and China worries abate.
Considering this balance of risks, our central
case calls for low single-digit returns. While
positive, this return is not sufficient to justify
a tactical long position in EMLD in our view,
given the still considerable downside risks
discussed above.
Emerging Market Dollar Debt
Emerging market dollar debt (EMD) returned 10%
in 2016, capping a surprising four-year period
of outperformance that has greatly benefited
from stable US rates and dollar strength. But the
prospects for a fifth year of upside are questionable
for several reasons.
First, EMD’s almost seven-year duration is
a liability in a rising-rate environment. This is
particularly true now that the Federal Reserve
has resumed tightening policy, a fact evident in
EMD’s 4.3% drop in response to increasing rate
hike expectations late last year. Second, with
spreads standing near two-year lows, there is scope
for spread widening based on US and European
policy uncertainty and renewed China growth
fears. Third, countries accounting for 37% of
EMD—including Mexico, China, South Africa
and Brazil—have negative outlooks from at least
two rating agencies, raising the potential for
downgrades. 119 A potential default by Venezuela
and its national oil company could also sour
sentiment, as could unfavorable tariffs or trade
restrictions from the new US administration.
Finally, the backup in interest rates we expect
could raise funding costs for EM corporate issuers,
which could also heighten concerns about spillover
into EMD. Indeed, a recent stress test by Standard
& Poor’s revealed that EM corporate borrowers—
who must repay $200 billion per year through
2020 120 —are twice as susceptible to downgrades
as US corporates if dollar funding costs rise by
a third. 121
Based on the above, we do not recommend a
tactical position in EMD at this time.
Outlook
Investment Strategy Group
73
Exhibit 94: US Crude Oil Production
Supply has stabilized after declining by 1 million barrels/day
from its peak.
Exhibit 95: OPEC Crude Oil Production
OPEC producers have exceeded their quota 90% of the time
since 2000.
Million Barrels/Day
2.0
1.5
9.6
Million Barrels/Day
10
Million Barrels/Day
36
34
OPEC Production Subject to Quota
Historical OPEC Quota Levels
8.8
9
32
1.0
8.6
30
0.5
8
28
0.0
26
7
24
-0.5
YoY US Crude Production Change
US Crude Production Levels (Right)
22
-1.0
Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16
6
20
2000 2002 2004 2006 2008 2010 2012 2014 2016
Data through November 30, 2016.
Source: Investment Strategy Group, US Department of Energy.
Data through November 30, 2016.
Source: Investment Strategy Group, Bloomberg.
2017 Global Commodity Outlook
After losing more than half its value in the span
of two years, the S&P GSCI broke its downward
trend with an 11% gain in 2016, its first doubledigit
return since 2009 (see Exhibit 92). The
rebound in oil prices was a key contributor, as oil
finished the year with a staggering 52% spot price
gain—an outcome made all the more remarkable
by the fact that oil was down 25% at its worst
point early last year. This strength was not limited
to the oil patch, as industrial metals rallied 17%
on average and precious metals advanced 8% (see
Exhibit 93).
Despite last year’s broad-based gains, we are
more circumspect about the outlook for 2017.
While we expect oil to advance, it begins the
year closer to the midpoint of our target range,
providing a more balanced risk/reward profile.
Meanwhile, we believe the key elements of
our macroeconomic forecast—Federal Reserve
tightening, rising interest rates, modest US dollar
gains and average inflation—represent continued
headwinds to gold prices. Comparable headwinds
exist for industrial metals and agricultural goods,
given the continued slowdown we expect in
Chinese growth.
We discuss the specifics of our outlook for oil
and gold in the sections that follow.
Oil: Regaining Its Balance
Oil is finding its footing again after having
stumbled dramatically over the last two years.
While the market is still awash in oil inventories,
the sizable reductions in capital expenditures by
the largest international oil and gas companies
Exhibit 93: Commodity Returns in 2016
Most commodity subcomponents saw positive returns in 2016, reversing several years of declines.
S&P GSCI Energy Agriculture Industrial Metals Precious Metals Livestock
Spot Price Average, 2016 vs. 2015 -10% -14% 0% -6% 8% -17%
Spot Price Return 28% 48% 3% 19% 9% -10%
Excess Return* 11% 18% -5% 17% 8% -8%
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
* Excess return corresponds to the actual return from being invested in the front-month contract and differs from spot price 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.
74 Goldman Sachs january 2017
Exhibit 96: OPEC 2016 Production Cut Agreement
and Recent Changes
If fully implemented, OPEC’s proposed cut would reverse
production growth from the prior 6 months.
Exhibit 97: US Energy Sector Ratio of Capital
Spending (Capex) to Depreciation
Low capex levels suggest there is upside to investment.
Million Barrels/Day
1.4 Production Change in 6 Months Leading up to
the November 2016 OPEC Meeting
1.2
November 2016 Agreed Cut
1.0
1.2
Ratio
3.5
3.0
Capex-to-Depreciation Ratio
Long-Term Average
0.8
2.5
0.6
0.4
0.2
0.0
-0.2
0.1 0.1
-0.1
0.2
0.1
0.5
0.1
0.1
-0.4
Algeria
Angola
Ecuador
Iran
Iraq
Kuwait
Libya
Nigeria
Qatar
Saudi
UAE
Venezuela
Total
2.0
1.5
1.0
1.04
0.89
0.5
0.0
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data as of November 30, 2016.
Source: Investment Strategy Group, Bloomberg, OPEC.
Data through September 30, 2016.
Source: Investment Strategy Group, Empirical Research Partners.
suggest the transition toward a balanced market is
underway. The same could be said for the dramatic
cuts in US drilling budgets, which have precipitated
notable declines in US shale output (see Exhibit
94). Lower oil prices have also supported aboveaverage
global demand growth, helping to absorb
excess inventories. Lastly, OPEC agreed to
lower production in November 2016, while also
securing a promise from its significant non-OPEC
counterparts to do the same. Taken together, these
developments support our forecast for moderately
higher oil prices in 2017.
This balancing act is still precarious, however.
Oil inventories stand well above seasonal averages,
so failure to honor the announced production
cuts could delay the recovery in oil prices or, even
worse, cause renewed declines. The risk of poor
compliance is not trivial, given that producers
have exceeded their quota 90% of the time by an
average of 1 million barrels per day (mmbd) since
2000 (see Exhibit 95). The pledges from Russia
and certain smaller non-OPEC producers are
particularly suspect, as similar promises to cut their
Oil is finding its footing again after
having stumbled dramatically over
the last two years.
own output along with OPEC have been broken
in the past.
Moreover, while the announced cuts are
significant—the OPEC agreement would reduce
production by up to 1.2 mmbd, equivalent to
about one year of average global demand growth—
they are largely a reversal of production growth
seen over the last six months (see Exhibit 96).
Meanwhile, Libya and Nigeria were excluded from
these new OPEC quotas given sizable domestic
disruptions that have depressed their production.
Recent signs of improvement, however, suggest a
rebound in their production cannot be dismissed.
Therefore, the announced cuts are not a panacea to
the current oil imbalance, particularly if US shale
output increases meaningfully in response.
This last point is important, as US shale
accounted for 60% of global production growth
between 2012 and 2015 despite representing
less than 5% of the total output. Although US
production is now declining, two factors may
arrest its slide in 2017. First, the breakeven price
for shale drilling has fallen to an average of $50
per barrel, reflecting a 20% decline in
production costs and improvements to
the shale model, including faster drilling,
larger wells and better resource recovery.
In response, more than 200 oil rigs have
been placed in service since their number
troughed in May 2016. 122 Second, capital
spending by the US energy sector is
Outlook
Investment Strategy Group
75
Exhibit 98: Full-Year Average Global Crude Oil
Supply and Demand
Oil consumption in 2017 could exceed supply for the first
time since 2013.
Exhibit 99: Gold Prices and US 10-Year Real
Interest Rates
Gold prices and real interest rates are closely linked.
Million Barrels/Day
100
98
96
94
92
World Production
World Consumption
Production
Exceeded
Consumption
Between 2014 and 2016
World
Consumption
Exceeded
Production
Average Forecast
Supply/Demand
Forecasts Point to
Small Deficit in 2017
$/Ounce
2,000
1,600
1,200
%
-1.5
-1.0
-0.5
0.0
0.5
1.0
90
800
1.5
88
86
400
Gold Price
10-Year US Real Rate (Right, Inverted)
2.0
2.5
3.0
84
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016e 2017f
0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
3.5
Data through December 31, 2016.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, International
Energy Agency, OPEC, US Department of Energy, Energy Aspects, PIRA, Bloomberg, Barclays,
JP Morgan.
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
very depressed despite the recent uptick in rigs,
providing scope for further increases (see Exhibit
97). As a result, we expect shale production to
recover in 2017, partially offsetting cuts elsewhere.
Despite these potentially destabilizing forces,
we still think the oil market can swing to a small
deficit this year. While lower input costs create
upside risks to US shale production, these costs are
highly correlated with oil itself. As a result, today’s
$50 average breakeven level for shale is likely to
move higher with oil prices, limiting the rebound
in US production. Moreover, even if just half of
the proposed production cuts are realized, our
work suggests the oil market will still switch into a
deficit this year. Finally, OPEC spare capacity has
been largely exhausted by the production increases
of the last year, while Iran’s production has now
returned to pre-sanction levels. In turn, the risk of
another disorderly market-share battle has declined
significantly.
Against this backdrop, we expect oil supply
growth to moderate and enable oil demand to
again exceed oil production, creating the first
deficit since 2013 (see Exhibit 98). With balance
restored, we expect oil to trade in a $45–65 range
in the year ahead. Thus we continue to recommend
an overweight to US high yield energy bonds
and US MLPs.
Gold: Still Searching for Its Luster
Gold was not immune from the reversal of fortune
that befell interest rates last year, reminding us
that their fates are fundamentally linked (see
Exhibit 99). Put simply, higher interest rates raise
the opportunity cost of holding gold, since the
yellow metal generates no cash flow and must
be physically stored, often at a cost. A similarly
inverse relationship exists with the US dollar, as
investors often purchase gold as a hedge against
the debasement of fiat currencies; gold has traded
inversely to the dollar index 73% of the time on an
annual basis over the last 40 years.
Given these relationships, we believe the key
elements of our macroeconomic forecast—Federal
Reserve tightening, rising interest rates, modest US
dollar gains and average inflation—will represent
headwinds for the yellow metal in 2017. Keep in
mind that gold prices have declined in four of the
last five Federal Reserve tightening cycles, with
the only exception occurring during a period of
dollar weakness in the mid-2000s. Based on these
precedents, our expectation of two or three Federal
Reserve rate increases in 2017 does not bode well
for gold prices.
76 Goldman Sachs january 2017
Exhibit 100: Average Annual Gold Prices
Gold remains expensive relative to its inflation-adjusted
long-term average price.
2016 US $/Ounce
2,000
Annual Average Price
Long-Term Average
Post Bretton Woods Average
1,788
1,743
1,600
1,200
12/31/16
800
822
547
400
0
1871 1885 1899 1913 1927 1941 1955 1969 1983 1997 2011
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
The same could be said of continued outflows
from gold exchange-traded funds (ETFs). We
estimate that a net 280 tonnes of gold ETF
holdings—an amount even larger than the 210
tonnes of ETF outflows that pressured gold prices
in late 2016—were purchased over the past year
at levels above today’s price. Absent a rebound
in gold prices, these ETF holders might prefer to
realize their losses and rotate into instruments with
a yield component. Value-minded investors should
also consider that gold prices remains well above
their long-term average (see Exhibit 100).
Despite this challenging outlook, a number
of factors could still buoy gold prices in the year
ahead. Emerging market central banks have
continued to buy gold to diversify their reserves.
Moreover, the stronger global growth we expect
could lift jewelry demand, particularly in gold’s
two largest end markets—China and India. Finally,
gold’s allure as an inflation hedge could come back
into focus if the market begins to worry about
economic overheating in the US, although this is
not our base case.
In light of these crosscurrents, we are tactically
neutral on gold at this time.
Outlook
Investment Strategy Group
77
78 Goldman Sachs january 2017
2017 OUTLOOK
In Closing
we do not believe the coming year will bring an end
to the prolonged run of positive performance for either the
US economy or the bull market for equities. Despite greater
uncertainties, including those tied to a new US administration,
the policy backdrop in the US will likely prove particularly
favorable for the economy, with looser fiscal policy, still easy
monetary policy and a lighter regulatory burden. As these
factors diminish the probability of recession in 2017, they
also support the case for clients remaining invested in global
equities at their strategic allocation. We believe US equity
gains are likely to be modest but still more attractive than the
comparable returns of investment alternatives such as cash
and bonds. And, as last year demonstrated, US equities often
surprise to the upside.
While we see the glass as half-full, there is no shortage of
risks—some of which have high probability and uncertain
impact for the year ahead—that could cause our forecasts for
the economy and asset class returns to miss the mark.
As always, we will adjust and communicate our views
accordingly should the economic, financial or geopolitical
backdrop change materially over the course of 2017.
Outlook
Investment Strategy Group
79
Abbreviations Glossary
ACA: Affordable Care Act
BEA: Bureau of Economic Analysis
BIS: Bank for International Settlements
BLS: Bureau of Labor Statistics
BOE: Bank of England
BOJ: Bank of Japan
CAGR: compound annual growth rate
CDS: credit default swap
CFO: chief financial officer
CFTC: Commodity Futures Trading Commission
CPI: consumer price index
EAFE: Europe, Australasia and the Far East
ECB: European Central Bank
EM: emerging market
EMD: emerging market dollar debt
EMLD: emerging market local debt
EMEA: Europe, the Middle East and Africa
EMU: European Monetary Union
EPS: earnings per share
ETF: exchange-traded fund
FTSE: Financial Times Stock Exchange
FX: Foreign Exchange
GBP: British pound
GDP: gross domestic product
GFC: global financial crisis
GIR: [Goldman Sachs] Global Investment Research
GPIF: Government Pension Investment Fund
GSCI: Goldman Sachs Commodity Index
NAHB: National Association of Home Builders
NATO: North Atlantic Treaty Organization
NBER: National Bureau of Economic Research
NIPA: national income and product accounts
NIRP: negative interest rate policy
OECD: Organisation for Economic Co-operation and Development
OPEC: Organization of the Petroleum Exporting Countries
PBOC: People’s Bank of China
PCE: personal consumption expenditures
PE: price to earnings
PPI: Producer Price Index
PPP: purchasing power parity
QE: quantitative easing
S&P: Standard and Poor’s
TIPS: Treasury Inflation-Protected Securities
TOPIX: Tokyo Price Index
UK: United Kingdom
US: United States
VAT: value-added tax
YoY: year-over-year
IGFI: Investment grade fixed income
IMF: International Monetary Fund
ISIL: Islamic State of Iraq and the Levant
ISM: Institute of Supply Management
JGB: Japanese government bond
LBO: leveraged buyout
LIBOR: London Interbank Offered Rate
LSI: Liquidity Stress Index
M&A: merger and acquisition
MLP: master limited partnership
mmbd: million barrels per day
MSCI: Morgan Stanley Capital International
Notes
1. Jeremy J. Siegel, Stocks for the
Long Run: The Definitive Guide
to Financial Market Returns
and Long-Term Investment
Strategies, McGraw-Hill, 1994.
2. Lisa Beilfuss, “As Dow Nears
20000, Stock-Market Believer
Jeremy Siegel Gets a ‘Told
You So’ Moment,” Wall Street
Journal, December 10, 2016.
3. Throughout the text, “post-
WWII cycles” refers to
expansions beginning in Q2
1954. We exclude two prior
expansions, beginning in Q4
1945 and Q4 1949, to ensure
consistent data across all
variables used to analyze
the duration and strength
of recoveries (some data
series are only available since
1950) as well as to avoid
contaminating summary
statistics given idiosyncratic
economic policies that followed
the end of WWII (such as the
sharp reduction in military
spending or the GI Bill). Our
takeaway from the analysis
would not change if 1945
and 1949 were included for
the series for which data is
available.
4. Edward Luce, “Goodbye to
Barack Obama’s World,”
Financial Times, November 27,
2016.
5. John H. Cochrane, “Ending
America’s Slow-Growth
Tailspin,” Wall Street Journal,
May 2, 2016.
6. Martin Wolf, “New President
Has an Economic In-Tray Full
of Problems,” Financial Times,
November 8, 2016.
7. Michael Heath, “Summers
Urges U.S. to Spend 1% of GDP
Annually on Infrastructure,”
Bloomberg, October 18, 2016.
8. Robert J. Gordon, The Rise and
Fall of American Growth: The
U.S. Standard of Living Since the
Civil War, Princeton University
Press, 2016.
9. Marc Levinson, An Extraordinary
Time: The End of the Postwar
Boom and the Return of the
Ordinary Economy, Basic Books,
2016.
10. Martin Jacques, When China
Rules the World: The End of the
Western World and the Birth of
a New Global Order, Penguin
Press, 2009.
11. N. Gregory Mankiw, “One
Economic Sickness, Five
Diagnoses,” New York Times,
June 17, 2016.
12. Carmen M. Reinhart and
Kenneth S. Rogoff, This Time
Is Different: Eight Centuries
of Financial Folly, Princeton
University Press, 2011.
13. Alvin H. Hansen, “Capital
Goods and the Restoration of
Purchasing Power,” Academy of
Political Science, 1934.
14. Alvin H. Hansen, “Economic
Progress and Declining
Population Growth,” American
Economic Review, 1939.
15. Lawrence H. Summers,
“Remarks,” speech delivered at
the Fourteenth Jacques Polak
International Monetary Fund
Annual Research Conference,
Washington, D.C., November
8, 2013.
16. Jay Shambaugh, “How
Should We Think About This
Recovery?” Macroeconomic
Advisers’ 26th Annual Policy
Seminar, Washington, D.C.,
September 14, 2016.
17. Michael E. Porter, Jan W.
Rivkin, Mihir A. Desai and
Manjari Raman, “Problems
Unsolved and a Nation
Divided,” Harvard Business
School, September 2016.
18. Council of Economic Advisers,
“The Long-Term Decline in
Prime-Age Male Labor Force
Participation,” June 2016.
19. Ibid.
20. Etienne Gagnon, Benjamin
K. Johannsen and David
Lopez-Salido, “Understanding
the New Normal: The Role
of Demographics,” Board
of Governors of the Federal
Reserve System, October 3,
2016.
21. Mitra Toossi, “A Century of
Change: The U.S. Labor Force,
1950-2050,” Monthly Labor
Review, Bureau of Labor
Statistics, May 2002.
22. Donald J. Trump, “Remarks,”
speech delivered at the New
York Economic Club, September
15, 2016.
23. Chair Janet L. Yellen, “Current
Conditions and the Outlook
for the U.S. Economy,” June 6,
2016. Vice Chairman Stanley
Fischer, “Remarks on the U.S.
Economy,” August 21, 2016.
24. Robert J. Gordon, The Rise and
Fall of American Growth: The
U.S. Standard of Living Since the
Civil War, Princeton University
Press, 2016.
25. Stephanie H. McCulla, Alyssa
E. Holdren and Shelly Smith,
“Improved Estimates of the
National Income and Product
Accounts: Results of the 2013
Comprehensive Revision,”
Bureau of Economic Analysis,
September 2013.
26. Paul Krugman, The Age of
Diminished Expectations: U.S.
Economic Policy in the 1990s,
MIT Press, 1990.
27. Lee Branstetter and Daniel
Sichel, “Seven Reasons to Be
Optimistic About Productivity,”
forthcoming.
28. Ibid.
29. Olivier Blanchard, “The State
of Advanced Economies and
Related Policy Debates: A Fall
2016 Assessment,” Peterson
Institute for International
Economics, September 2016.
30. Martin Feldstein, “Remarks,”
speech delivered at the
Brookings Institution
Conference on Productivity,
Washington, D.C., September
8, 2016.
31. Jan Hatzius, “Productivity
Paradox v2.0 Revisited,”
Goldman Sachs Global
Investment Research,
September 2, 2016.
32. David M. Byrne, Stephen D.
Oliner and Daniel E. Sichel,
“How Fast Are Semiconductor
Prices Falling?” Federal Reserve
Board, March 2015.
33. Hal Varian, “A Microeconomist
Looks at Productivity: A View
from the Valley,” September
2016.
34. Ibid.
35. Hal Varian, “Notes on
Productivity and Intangibles,”
November 2016.
36. Chad Syverson, “Challenges to
Mismeasurement Explanations
for the U.S. Productivity
Slowdown,” University of
Chicago Booth School of
Business, June 2016.
37. David M. Byrne, John G.
Fernald and Marshall B.
Reinsdorf, “Does the United
States Have a Productivity
Slowdown or a Measurement
Problem?” Brookings
Institution, March 1, 2016.
38. David Byrne and Carol Corrado,
“ICT Prices and ICT Services:
What Do They Tell Us About
Productivity and Technology?”
Conference Board, July 2016.
39. David Byrne, Wendy Dunn and
Eugenio Pinto, “Prices and
Depreciation in the Market for
Tablet Computers,” Federal
Reserve Board, December 2016.
40. Greg Ip, “The Economy’s Hidden
Problem: We’re Out of Big
Ideas,” Wall Street Journal,
December 5, 2016.
41. Johan Norberg, Progress: Ten
Reasons to Look Forward to the
Future, Oneworld Publications,
2016.
42. Fredrik Erixon and Björn Weigel,
The Innovation Illusion: How
So Little Is Created by So
Many Working So Hard, Yale
University Press, 2016.
43. N. Gregory Mankiw, “One
Economic Sickness, Five
Diagnoses,” New York Times,
June 17, 2016.
44. Alan S. Blinder and Mark W.
Watson, “Presidents and the
U.S. Economy: An Econometric
Exploration,” Princeton
University, July 2014.
45. Jay Shambaugh, “How
Should We Think About This
Recovery?” Macroeconomic
Advisers’ 26th Annual Policy
Seminar, Washington, D.C.,
September 14, 2016.
46. Lawrence H. Summers, “When
the Best Umps Blow a Call,”
Washington Post, July 14, 2016.
47. Martin Neil Baily and Nicholas
Montalbano, “Why Is US
Productivity Growth So Slow?
Possible Explanations and
Policy Responses,” Brookings
Institution, September 1, 2016.
48. Kevin Daly, “Arrested
Development: EMs Are Still
Converging, but Productivity
Growth Is Lower Everywhere,”
Goldman Sachs Global
Investment Research,
December 20, 2016.
49. Molly E. Reynolds and Philip A.
Wallach, “The Fiscal Fights of
the Obama Administration: An
Interactive Timeline,” Brookings
Institution, December 8, 2016.
50. As measured by the Goldman
Sachs Financial Conditions
Index.
51. “Default Monitor,” JP Morgan,
December 1, 2016.
52. Investment Strategy Group,
Outlook: The Last Innings,
January 2016.
53. These forecasts have
been generated by ISG for
informational purposes as of
the date of this publication.
Total return targets are
based on ISG’s framework,
which incorporates historical
valuation, fundamental and
technical analysis. Dividend
yield assumptions are based on
each index’s trailing 12-month
dividend yield. They are based
on proprietary models and
there can be no assurance
that the forecasts will be
achieved. Please see additional
disclosures at the end of this
publication. The following
indices were used for each
asset class: Barclays Municipal
1-10Y Blend (Muni 1-10); BAML
US T-Bills 0-3M Index (Cash);
JPM Government Bond Index
Emerging Markets Global
Diversified (Emerging Market
Local Debt); HFRI Fund of Funds
Composite (Hedge Funds);
MSCI EM US$ Index (Emerging
Market Equity); Barclays US
Corporate High Yield (US High
Yield); Barclays US High Yield
Loans (Bank Loans); MSCI UK
Local Index (UK Equities); MSCI
EAFE Local Index (EAFE Equity);
S&P Banks Select Industry
Index (US Banks); TOPIX Index
(Japan Equity); Barclays High
Yield Municipal Bond Index
(Muni High Yield).
54. LIBOR, the London Interbank
Offered Rate, is calculated as
the average of leading banks’
estimates of the interest rates
that they would be charged
were they to borrow from other
banks. It is one of the primary
benchmarks for global shortterm
interest rates.
55. Spain is the only Eurozone
country in which all banks clear
all of the following capital
hurdles: (1) CET1 ratio >100 bps
above each bank’s hurdle rate
(5.5% + GSIB buffer, where
applicable); (2) 4% leverage
ratio in the ECB stress test
base case scenario; and (3)
2% leverage ratio in the ECB
stress test adverse scenario.
Jernej Omahen, “Stress Test:
Worst Fears Avoided; Capital
Divergence Widens,” Goldman
Sachs Global Investment
Research, July 31, 2016.
56. Gideon Rachman, “Marine Le
Pen Looms Over a Trumpian
World,” Financial Times,
November 21, 2016.
57. Charles Lichfield, “Fillon
Presidency Now More Likely
Than a Juppé One,” Eurasia
Group, November 21, 2016.
58. Charles Lichfield, “Attack
Demonstrates Merkel’s
Vulnerability in 2017,” Eurasia
Group, December 20, 2016.
59. Alastair Gale and Kwanwoo
Jun, “North Korea Says It
Successfully Conducted
Hydrogen-Bomb Test,” Wall
Street Journal, January 6, 2016.
60. Kwanwoo Jun, “North Korea
Launches Missile From
Submarine,” Wall Street
Journal, April 24, 2016.
61. Alastair Gale and Gordon
Lubold, “North Korea Missile
Launch Portends Growing
Capabilities,” Wall Street
Journal, June 22, 2016.
62. Alastair Gale and Carol E. Lee,
“North Korea Conducts Fifth
Nuclear Test,” Wall Street
Journal, September 9, 2016.
63. Mike Mullen, Sam Nunn and
Adam Mount, “A Sharper
Choice on North Korea:
Engaging China for a Stable
Northeast Asia,” Council on
Foreign Relations, Independent
Task Force Report No. 74,
September 2016.
64. David Gordon (adjunct senior
fellow at the Center for a
New American Security), in
a conference call with the
Investment Strategy Group,
December 15, 2016.
65. Gerald F. Seib, Jay Solomon and
Carol E. Lee, “Barack Obama
Warns Donald Trump on North
Korea Threat,” Wall Street
Journal, November 22, 2016.
66. Andrew E. Kramer, “As New
Ukraine Talks Begin, What
Is the State of Europe’s Only
Active War?” New York Times,
October 19, 2016.
67. Warsaw Summit Communiqué,
issued by the heads of state
and government participating
in the meeting of the North
Atlantic Council in Warsaw,
July 8–9, 2016.
68. Thomas Gibbons-Neff, “2,900
Explosions in a Day. Heavy
Artillery and Tank Fire Returns
to the Front Lines in Ukraine.”
Washington Post, December
20, 2016.
69. Warsaw Summit Communiqué,
issued by the heads of state
and government participating
in the meeting of the North
Atlantic Council in Warsaw,
July 8–9, 2016.
70. “Transcript: Donald Trump on
NATO, Turkey’s Coup Attempt
and the World,” New York
Times, July 21, 2016.
71. Ben Hubbard and David E.
Sanger, “Russia, Iran and
Turkey Meet for Syria Talks,
Excluding US,” New York Times,
December 20, 2016.
72. John Davison and Stephanie
Nebehay, “Syrian Peace Talks
Limp on to Next Week with
Opposition Absent,” Reuters,
April 22, 2016.
73. Anne Barnard, “Death Toll From
War in Syria Now 470,000,
Group Finds,” New York Times,
February 11, 2016.
74. Jessica Hartogs, “Syria War
Could Cost Country $1.3T by
2020: Study,” CNBC, March
8, 2016.
75. Zalmay Khalilzad, “America
Needs a Bipartisan Foreign
Policy. Donald Trump Can Make
It Happen,” National Interest,
December 21, 2016.
76. Geoff Dyer, “Trump’s CIA
Nominee Mike Pompeo
Promises to Roll Back Iran
Deal,” Financial Times,
November 18, 2016.
77. General (Ret.) James N.
Mattis, speech delivered at a
conference at the Center for
Strategic and International
Studies, “The Middle East at
an Inflection Point with Gen.
Mattis,” April 22, 2016.
78. Ibid.
79. Carol E. Lee and Jay Solomon,
“Obama Seeks to Fortify Iran
Nuclear Deal,” Wall Street
Journal, November 20, 2016.
80. Kristina Peterson, “House
Passes 9/11 Bill That Would
Let Victims’ Families Sue Saudi
Arabia,” Wall Street Journal,
September 9, 2016.
81. Melissa Eddy and Alison Smale,
“Berlin Crash Is Suspected to
Be a Terror Attack, Police Say,”
New York Times, December
19, 2016.
82. Tom Burgis, Arthur Beesley and
Anne-Sylvaine Chassany, “ISIS
Claims Responsibility for Attack
in Nice,” Financial Times, July
17, 2016.
83. Pervaiz Shallwani and Devlin
Barrett, “How Police Tracked
Down Bombing Suspect Ahmad
Khan Rahami,” Wall Street
Journal, September 20, 2016.
84. Ben S. Bernanke, “How Do
People Really Feel About
the Economy?” Brookings
Institution, June 30, 2016.
85. Joint Statement, Department of
Homeland Security and Office
of the Director of National
Intelligence on Election
Security, October 7, 2016.
86. Courtney Weaver, Sam Fleming
and Kathrin Hille, “US Expels
Russian Spies over Election
Hacking,” Financial Times,
December 29, 2016.
87. Vindu Koel and Nicole Perlroth,
“Yahoo Says 1 Billion User
Accounts Were Hacked,” New
York Times, December 14, 2016.
88. Laura Sanders, “IRS Says
Cyberattacks on Taxpayer
Accounts More Extensive Than
Previously Reported,” Wall
Street Journal, February 26,
2016.
89. Dustin Volz and Jason Lange,
“Exclusive: FBI Probes FDIC
Hack Linked to China’s Military
– Sources,” Reuters, December
23, 2016.
90. Daniel Victor, “LinkedIn Says
Hackers Are Trying to Sell Fruits
of Huge 2012 Data Breach,”
New York Times, May 18, 2016.
91. Jamil Anderlini, “Beijing Clamps
Down on Forex Deals to Stem
Capital Flight,” Financial Times,
September 9, 2015.
92. Frank Tang, “China’s Foreign
Reserves Fall Again in
November Even as Beijing
Tightens Screws on Capital
Outflows,” South China Morning
Post, December 7, 2016.
93. Wendy Wu, “What China Has
Done to Stop Massive Amounts
of Cash from Fleeing the
Country,” South China Morning
Post, December 9, 2016.
94. Marcus Noland, Gary Clyde
Hufbauer, Sherman Robinson
and Tyler Moran, “Assessing
Trade Agendas in the US
Presidential Campaign,”
Peterson Institute for
International Economics,
September 2016.
95. Robert D. Blackwill, Henry
Kissinger and Ashley J. Tellis,
“Revising U.S. Grand Strategy
Toward China,” Council on
Foreign Relations Press, April
2015.
96. David Brunnstrom, “China
Installs Weapons Systems on
Artificial Islands,” Reuters,
December 15, 2016.
97. Mark Landler and David E.
Sanger, “Trump Speaks with
Taiwan’s Leader, an Affront
to China,” New York Times,
December 2, 2016.
98. Kate O’Keeffe and Damian
Paletta, “Tensions Linger Over
Seizure of Survey Drone in
South China Sea,” Wall Street
Journal, December 18, 2016.
99. Based on aggregated balance
sheet data for the Federal
Reserve, European Central
Bank, Bank of Japan, Bank
of England, Swiss National
Bank and People’s Bank of
China. Source: Bloomberg,
Datastream.
100. Federal Reserve Board Chair
Janet Yellen, exchange with
ABC News reporter Rebecca
Jarvis, December 2015.
101. Federal Reserve Chair Janet
Yellen, ”The Economic Outlook
and Monetary Policy,” speech
delivered at the Economic Club
of Washington, December 2,
2015.
102. Based on Goldman Sachs
Global Investment Research
estimates.
103. Based on the European
Commission investment survey.
104. Arnold Palmer, www.
arnoldpalmer.com/bio.
105. Beginning in September 1945.
106. Elroy Dimson, Paul Marsh and
Mike Staunton, Triumph of the
Optimists: 101 Years of Global
Investment Returns, Princeton
University Press, 2002. © 2013
Elroy Dimson, Paul Marsh and
Mike Staunton. As cited in
Credit Suisse Global Investment
Returns Yearbook 2013,
February 2013.
107. December 2016 FOMC
Statement of Economic
Projections.
108. Peter Oppenheimer, “‘Fat &
Flat’ with a Resurgence of
Divergence,” Goldman Sachs
Global Investment Research,
December 5, 2015.
109. Anna Kitanaka, Yuji Nakamura
and Toshiro Hasegawa, “The
Bank of Japan’s Unstoppable
Rise to Shareholder No. 1,”
Bloomberg, August 14, 2016.
110. As evidenced by SoftBank’s
recent pledge to invest $50
billion in the US. Michael J.
de la Merced, “After Meeting
Trump, Japanese Mogul
Pledges $50 Billion Investment
in the U.S.,” New York Times,
December 6, 2016.
111. The Plaza Accord was an
agreement between the
governments of France, West
Germany, Japan, the United
States and the United Kingdom
to depreciate the US dollar in
relation to the Japanese yen
and German Deutsche Mark
by intervening in currency
markets. Source: Jeffrey
Frankel, “The Plaza Accord, 30
Years Later,” Harvard Kennedy
School, December 10, 2015.
112. Stu Wood, Rick Carew and Eva
Dou, “SoftBank to Buy ARM
Holdings for $32 Billion,” Wall
Street Journal, July 18, 2016.
113. Since April 1946.
114. Karen Reichgott, “Fiscal Policy:
A Modest Boost to Global
Growth in 2017,” Goldman
Sachs Global Investment
Research, December 8, 2016.
115. Sources: Citi, Barclays, Morgan
Stanley, JP Morgan.
116. Bank of America, “2016
Outlook: May the Odds Be Ever
in Your Favor,” November 24,
2015.
117. Matthew Jozoff and Alex
Roever, “US Fixed Income
Markets – 2017 Outlook,” JP
Morgan, November 23, 2016.
118. Lofti Karoui, “Credit Notes:
2016: The Year of Extremes
in 20 Charts,” Goldman Sachs
Global Investment Research,
December 20, 2016.
119. Rating agencies referenced are
Moody’s, Standard & Poor’s
and Fitch Ratings.
120. Yang-Myung Hong, Alisa
Meyers and Zubair K. Syed,
“2017 Outlook – Clouds of
Uncertainty Shroud the Outlook
in Fat Tails,” JP Morgan,
November 2016.
121. Standard & Poor’s,“Rising
Interest Spreads, US
Corporates Would Fare Better
than Others,” December 2016.
122. Data is from Baker Hughes rig
counts.
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The co-authors give special thanks to:
Paul Swartz
Vice President
Amneh AlQasimi
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Michael Murdoch
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David Hulme
Analyst
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