Outlook PDF

8/8/2019 Outlook PDF

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For Private WealthManagement Clients

Outlook InvestmentStrategy Group January 2010

Take Stock o America

We believe that 2010 will see the continuing emergence o ast-growing economiessuch as China and India, but we dont think their success will cost the US itsleadership position. The underlying strength and infuence o America is intact.


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Take Stock o America

Much has been written about how the

recent nancial and economic crisis has dealta critical blow to US nancial hegemony.We disagree.

The Shape o RecoveryWhat can be expected as the US economyrecovers this year? We look to previouscycles or guidance and explain whyconsumption is critical to this recoveryssuccess.

Key Concerns or the US OutlookTwin worries o rising public debt and anexpected spike in infation have raisedquestions about the US recovery andwhether the dollar can remain the worldsreserve currency.

2010 Global Economic OutlookEuroland

United Kingdom Japan Emerging Markets

2010 Financial Markets OutlookUS Equities

Euroland and the UK Japan Emerging Markets BRICs High Yield

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Outlook 3Investment Strategy Group

Take Stocko America

Sharmin Mossavar-RahmaniChie Investment O fcerGoldman Sachs PrivateWealth Management

Brett NelsonManaging DirectorGoldman Sachs PrivateWealth Management

Additional Contributors romGoldman Sachs PrivateWealth Management:

Neeti BhallaManaging Director Maziar MinoviManaging Director Benoit MercereauVice President Matthew WeirVice President

The greatness o America lies not in being moreenlightened than any other nation, but rather inher ability to repair her aults.- Alexis de Tocqueville1

It seems that a day doesnt go by withoutsome commentary about the rise o the East,particularly China, and the all o the West,particularly the United States o America.Captivating newspaper headlines about Chinasuch as The Decade the World Tilted East,or Wheel o Fortune Turns as China OutdoesWest, or China Makes Gains in its Bid to bethe Next Top Dog stand in sharp contrast tothose about the US: The Dollar Adri t, TheMessage o Dollar Disdain, The ComingDe cit Disaster. 2

Many market observers are quick to pointout that the nancial crisis and deep recession o 2008-09 have dealt a atal blow to US hegemony.They note that the US budget de cit, at over10% o GDP in scal 2009, has compoundedthe twin problems o a leveraged consumerand unencumbered entitlement programs likeSocial Security, Medicare and Medicaid. The USeconomy, says their argument, will be burdenedby this debt overhang or the oreseeable utureand grow at sub-par levels, and the descent o the US will be expedited by the unwillingness o the politicians in Washington to make the toughdecisions to cut government spending.

Thus, they say, the USs dominating infuenceends, and that o China which is sitting on anestimated $2.3 trillion o central bank reserves,has weathered the global nancial crisis with a8% GDP growth rate in 2009 and has a cur-rent account surplus o 6.5% o GDP begins.Chinas centrally managed governing process willbe e ective in maintaining high growth rates,the argument goes, which will cause China tobecome the largest world economy sometime inthe next 20 or so years, thereby removing the US

rom the economic perch upon which it has satsince the late 19th century.

Just in case the furry o articles and researchreports throughout 2009 touting the rise o China and the all o the US were not enough to

infuence all rational thinking about allocatingassets, two new books were published to rein-orce these changing hegemonies. The titles are


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4 Goldman Sachs

the dollar, are similarly unwarranted. China maywell experience impressive growth over the nextseveral decades in act, we expect it to. Butthat growth, in our opinion, will not come at theexpense o the US.

Our view is based on two premises. The rstis an extension o what we presented a year agoin our 2009 Outlook, where we stated that this

nancial and economic crisis was not as unprec-edented or uncharted as it appeared. Clearly,the recession was deeper than the 3.1% declineo 1973-74, and the equity market decline wasgreater than either the 48% drop o 1973-74 orthe 50% all o the 2000-02 bear market. But thecredit market did not are as poorly in the recentcrisis as it did in the 1973-74 period, and it re-covered much more rapidly. And unemployment,which may well continue to rise, is not expectedto exceed the 10.8% peak reached in 1982.

Given our view held a year ago and main-tained today that the current crisis is not as un-precedented as it was claimed to be at the depthso the recession, our rst premise states that theUS economy will recover along the path o pastrecoveries. We will examine the path o the cur-rent recovery and compare it to past recoveriesin the next section. We will demonstrate whywe believe this recovery is likely to have more incommon with past recoveries than most peopleexpect. Furthermore, with an economic recovery

underway, we will show how the budget de citcan be addressed without resorting to infation toreduce the debt burden. We will show, in other

219%; the Japanese economy has had an annualgrowth rate o 1% while the US economy hasgrown at 2.5% a year. Clearly, neither theoptimism about Japan nor the pessimism about

the US was warranted. And the re-allocation o assets out o the US into Japanese assets was notruit ul.

We believe that history is repeating itsel . Thecurrent pessimism about the US economy, unem-ployment, infation and government de cits, aswell as the concerns about the reserve status o

sel -explanatory: When China Rules the World:The End o the Western World and the Birth o aNew Global Order by Martin Jacques and WhenGiants Fall: An Economic Roadmap or the End

o the American Era by Michael J. Panzner.This cascade o in ormation inevitably a ectsinvestors. As Nobel Laureate Pro essor DanielKahneman and the late Amos Tversky said: Aproposition can become irresistible simply by themedia repeating it. Assets have fown out o USequity unds and dollar-based investments intoemerging market unds; assets have also beenallocated into gold unds as a sa e haven againsta weaker dollar. We are surprised at the extentto which clients have asked about whether theyshould allocate some o their sleep well moneyinto more risky emerging market debt. Based onthe latest data available, about $42 billion hasbeen taken out o US equity mutual unds andnon-commodity exchange traded unds while$80 billion has been put into emerging market

unds and $10 billion into gold unds. 3 (For ourviews on commodities, please see the January2010 Investment Strategy Group Insight publi-cation, Commodities: A Solution in Search o aStrategy .)

As we read through the articles and booksproclaiming the end o the USs reign, we arereminded o the late 1970s and 1980s, whensimilar themes were pervasive: the US coulddo no right while Japan and the Asian Tigerscould do no wrong. Books like Japan as No. 1:Lessons or America by Ezra Vogel and TheEnigma o Japanese Power by Karel VanWol eren epitomized the thinking o the time.

Vogel wrote in his book about the decline o our con dence in government ... our di culty incoping with problems such as ... unemployment,infation and government de cits, and suggestedadopting the Japanese model due to its sub-stantial progress in dealing with problems whichseemed so intractable in America. The March12, 1979 cover o BusinessWeek captured themood o the times: a tear trickling down the aceo the Statue o Liberty and a headline statingThe Decline o US Power.

It all sounds amiliar: the rise o the East

and the all o the US. Well, since its peak inDecember 1989, the Japanese equity market hasdeclined 73%, while US equities have rallied

january 2010

Our irst premise states that the USeconomy will recover along the path

o previous recoveries.


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words, how the current crisis has not dealt aatal blow to the US as the preeminent economic

and geopolitical power.The second premise is driven by a rigorous

assessment o the various actors that, in com-bination, have accounted or the unique successand dominance o the US over the last century. Acare ul review o the data has led us to concludethat these actors are all intact; and in act, noone country is even close to approaching the USon this range o actors.

So, again, this crisis has not dealt a atal blowto US hegemony. And our clients should not tilttheir assets in a well-diversi ed global port olio

urther away rom the US in ear o such a decline.It is important to note that the waning o the

US has been a topic o serious debate multipletimes, and in all cases, the US has recovered andmaintained its preeminence. Indeed, the casementioned above, o Japan challenging the USin the 1970s and 1980s, was just one o six suchepisodes in the post-World War II period. In1988, the late American political scientist SamuelHuntington outlined ve in a Foreign A airs article titled The U.S. Decline or Renewal? 4 More recently, Jose Jo e, publisher-editor o theGerman weekly Die Zeit and visiting pro essorat Stan ord University, reviewed the current andthere ore sixth prophecy o the USs decline. 5

Reviewing these episodes shows several varia-tions on a theme. In the late 1950s, as a result o Soviet missile launches and the success o Sput-nik (the rst orbital satellite), the declinists, asthey are called, stated that the Soviet Union wasestablishing an unchallengeable lead in missilesand outpaced the US in producing scientists andengineers; US education and military power werein decline. Lo and behold, our decades later,the Soviet Union is no more. In the late 1960s,the declinists said that the bipolar world wascoming to an end and Europe and Japan wouldemerge as equals o the US and the Soviet Union.Lo and behold, the world became unipolar, withthe US as the sole, preeminent power. The 1970ssaw a number o events the Kent State Univer-sity shootings in 1970, the Arab Oil Embargoin 1973, Watergate in 1974 (which resulted in

President Richard Nixons resignation) and theUS de eat in Vietnam in 1975 that led to ageneral eeling o malaise about US power and

US moral standing, and subsequent pressure onthe dollar. In the 1980s, the competitive threatcame rom Japan. And now, many are expectingthat China will replace the US as the preeminent

power o the 21st century.Lets look at US strengths in three criticalareas the economy, the military and generalmeasures o prosperity and see i any othermajor country comes close. We have leveragedthe work done by the Legatum Institute, aLondon-based organization that has designed aprosperity index to measure actors beyond eco-nomic wealth such as innovation, education,governance and democratic institutions whichare important to the long-term sustainability o the economic and military might o a country.

Economic StrengthAt $14.3 trillion as o December 2009, the USaccounts or 24.9% o world GDP. Its economyis 2.8 times larger than the next largest economy,

Japan; 3 times larger than the third-largesteconomy, China; and 4.4 times larger than the

ourth-largest economy, Germany. To put thesenumbers in perspective, the United States has ahigher GDP than the next three largest econo-mies combined. The only entity to come closeto the US is Euroland, a union o 16 countrieswith a common currency and monetary policy. Areminder that Euroland includes countries thathave their own signi cant economic challengeswill quickly dispel any notion that it will chal-lenge USs economic preeminence anytime soon.

For a di erent perspective, we can lookat GDP per capita. The US GDP per capita is$46,400. That is not only the highest amongmajor world powers, it is also one o the highestoverall; only a ew small countries (such asLuxembourg with a population o 500,000,Norway with a population o 4.8 million,Qatar with a population o 1.2 million and theNetherlands with a population o 16.8 million)top it. Among major countries, the next highestGDP per capita is that o France at $42,000,

Japan at $39,600 and Germany at $39,400.Among major emerging market countries,Russias GDP per capita is $8,800, Brazils is

$7,700, Chinas is $3,600 and Indias is $1,000.The USs GDP per capita is nearly 13 times thato China and 46 times that o India.


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O course, some point out that withcertain growth rate and currency appreciationassumptions, Chinas overall GDP will surpassthat o the US in the next 20 or so years. Even

then, though, Chinas GDP per capita willprobably be about a quarter o that o the US.Furthermore, even the Chinese themselves arerealistic about the di culties o sustaining suchhigh growth rates without major structuralre orm over the next decade or so. Some o there orms that Chinese o cials have identi ed are:

nancial re orm (including a more developedcapital market system, market-driven interestrates and a convertible foating exchange rate);economic re orm (including a shi t away

rom an export-oriented and investment-led economy to a domestic consumption-oriented economy; a di cult task becausewhile consumption has grown 7.5% per yearbetween 2000 and 2008, it has dropped as apercentage o GDP rom 42% to 36%);enterprise re orm and privatization to reducestate support o the private sector (currently,the government has a stake in 17 o thelargest companies in the MSCI China Indexwith an ownership interest that amounts toabout 16% o the total market capitalizationin China; that compares to less than 1.5% inthe US, even a ter the governments increasedinvolvement during the recent crisis);price re orm (the government, or example,has controls on the prices o uel, electricity,water and land); andsocial re orm to introduce health insuranceand a pension system so that households saveless and consume more (the current savingsrate, which includes corporate savings throughretained earnings, is about 51%).

This is a long list o Herculean re orms thatChina has embarked upon. While it is highlylikely that China will success ully implementthese re orms over the next decade or two, it istoo early to prophesize that China will bump theUS rom its economic perch when such re ormsare in their in ancy. We quote Chinese PremierZhou En-Lai who was reported to have re-marked to Henry Kissinger in 1976 when asked

or his opinion o the French Revolution, It istoo soon to tell.

Military StrengthWhile the gap between total GDP and GDP percapita o the US and that o other countries isquite signi cant, the gap in military power is

even greater. As Jose Jo e has pointed out, theUnited States plays in a league o its own. Basedon 2008 data rom the Stockholm InternationalPeace Research Institute, the US spends $616billion or about 4.2% o its GDP annuallyon its military, accounting or close to hal o the worlds total military spending. Even thesum total o the next 14 countries (includingAustralia as the 14 th) does not add up to theUSs annual outlay. Number 2 on the list isChina at $84.9 billion (though Chinas NationalBureau o Statistics o cial military budgetstands at $67 billion, or 1.4% o its GDP). It isinteresting that as the debate about the end o the US century and the beginning o the Chinesecentury continues, the Chinese are contemplatingbuilding an aircra t carrier nearly a century a terthe US built its rst aircra t carrier, USS Langley,in 1922. 6 It would seem that or a shi t roma unipolar to a bipolar or multipolar world tooccur, the balance o world military power has toundergo some seismic shi ts o its own. For the

oreseeable uture, such shi ts do not appear onthe horizon.

Recent articles have talked about the drainon the US military o the Iraq and A ghanistanwars as well as the broader war on terror. Theyclaim that these wars are weakening the US andwill contribute urther to its decline. Again, wethink it is important to have some perspectiveon the military history o the US since WorldWar II. The US prevailed during the Cold Waragainst the Soviet Union. At the time, the SovietUnions stockpile o nuclear warheads topped40,000, with over 10,000 o them sitting atopintercontinental strategic missiles capable o targeting major US and European cities. TheVietnam War that lasted rom 1965 to 1975 cost$686 billion in 2008 dollars and 58,000 service-men were killed. Given that the US has survivedmultiple wars and gone on to prosper, it is hardto imagine that Iraq and A ghanistan will derailthe US to the extent that it is no longer the major

economic and military power in the world.


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and Brazil are at $14 billion each and India isat $8 billion. The US spends 4.4 times as muchas all the BRIC countries combined on researchand development. Money in, money out. Take

Apples iPod as an example. Researchers at thePaul Merage School o Business and the PersonalComputing Industry at the University o Cali ornia, Irvine indicate that about 5% o theoverall economic value rom iPod production isretained by the manu acturer o the hardware,in this case, China, with the balance going to thedesigners, retailers and suppliers o sophisticatedcomponents. 7 Add in applications and otherso tware, and the bulk o the value created andthen captured is overwhelmingly American.

Lets look at the number o Nobel Laureates.Since the inception o the Nobel Prize, the UShas garnered 320, compared to the UK, thenext highest-ranking country, at 116. Russiahas 23, India 9, China 6, and Brazil has none atthis time. Over the last decade, 46% o NobelLaureates have been US-based winners. We sayUS-based only because some o winners live inthe US but are not US citizens a reminder o the brain drain and immigration that occurs allover the world with some o the greatest talentsettling in the US. Interestingly, Robert Lucas,a Nobel laureate in economics, argues that theclustering o talent is the primary driver o eco-nomic growth. 8 It seems that given the size o thecluster in the US, it will be many decades be oreany country shi ts the technology and innovationbalance away rom the US.

There is substantially more that can be saidabout the so t actors that contribute to USspreeminent status. John Steele Gordon devotesa 450-page book, An Empire o Wealth: TheEpic History o American Economic Power, tothe topic, covering the USs national territorywith ronts on both the Atlantic and Paci cOceans in a world o global trade, to its richnatural resources, to its borders with two

riendly countries. The book addresses the ruleo law and importance o personal liberty andsa ety as an incentive or entrepreneurial spiritsto start new companies, build new productsand create their own wealth. It talks about a

system o government where, i one group o politicians doesnt address the issues at hand,the electorate votes that group out o o ce and

ProsperityLets now turn to the so ter actors thatcontribute to USs preeminent status. Since itsinception over 200 years ago, the US has had an

extremely resilient and dynamic economy anda stable political system. It is an open societyand an open economy with immigration as acore principle o its existence. Its technologicalachievements, in aggregate, outpace those o any other country. The question is how canone measure the actors that account or suchresilience, dynamism and stability and usethem to make comparisons between the US andother countries. The Legatum Prosperity Indexattempts to capture some o these actors. Thisindex is comprised o 79 di erent variables,which are distilled into nine di erent sub-indexes; each countrys score is an equal weighto the sub-indexes. The nine sub-indexes areeconomic undamentals, entrepreneurship andinnovation, democratic institutions, education,health, sa ety and security, governance, personal

reedom, and social capital.Among major countries, the US ranks number

one. Overall, it is ranked ninth out o 104countries a ter Finland, Switzerland, Sweden,Denmark, Norway, Australia, Canada and theNetherlands. The only country with a GDP o greater than $1 trillion in the top nine is Canadaat $1.3 trillion. Japan, the worlds second largesteconomy, is ranked 16 th. Brazil is ranked 41 st,India 45 th, Russia 69 th and China 75 th.

What are some tangible examples thataccount or the US ranking? Education is a goodplace to start. Among the top 50 universitiesin the world as ranked by the 2009 Times o London Higher Education ranking, 18, or 36%,are American universities; eight, or 15%, areUK universities; and six, or 12%, are Australianuniversities. One, Tsinghua University, isChinese.

In terms o research and development, theUS spent about $377 billion on R&D based onthe latest data available rom the Organisation

or Economic Co-operation and Development(OECD); the next highest number is $148 billionby Japan, ollowed by Germany at $84 billion

and France at $54 billion. Again, to comparethese numbers to those o major emergingmarket countries, China is at $49 billion, Russia


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selects a new set o o cials. It goes on to talkabout the diverse ethnicities o the country andthe avorable demographics. Countries such as

Japan, Russia and those in Europe ace declining

populations, while even China is expected to seeits population level o by 2030, according to theUnited Nations Population Division. The US isthe only developed country expected to have agrowing population. 9

So as you worry about your US-basedinvestments, urther declines in the dollar and theUSs burgeoning debt and loose monetary policy,it is worth remembering Alexis de Tocquevillesinsight rom almost 200 years ago. His wordsstill ring true: The US has ample economicwherewithal, political might and prosperity

actors to repair her current aults.

The Shape o Recovery

As we have written be ore, we believe that thisrecovery, and its impact on nancial markets,can be better understood in the context o past recoveries. With that in mind, what doeshistory tell us about the orward path o the USeconomy?

What Goes Down, Must Come Up But How Much?While there are ew immutable laws ineconomics, an apparent candidate is the stronghistorical symmetry between the depth o a USeconomic contraction and the strength o itssubsequent recovery, as shown in Exhibit 1 . In

act, given the 3.8% GDP decline in this cycle,blindly applying this historical relationshipwould suggest growth close to 8% this year,signi cantly higher than the 2.7% consensusexpectations. Thus ar, the economy is ollowingthis historical trajectory, in spirit i not exactmagnitude, as Q4 2009 growth appears to betracking north o 4%, up substantially rom theprior quarters 2.2% result.

That said, there are good reasons to believethis recovery will be more tepid than historywould suggest. A recent International Monetary

Fund (IMF) study ound that recessions associ-ated with a nancial crisis tend to have moremuted recoveries, on the order o 2% in the year

ollowing the recessions end. In addition, twoo the three typical engines o recovery growth,namely consumption and residential investment,

ace larger than typical headwinds in this cycle.

Their potential drag on growth is material, asconsumption typically contributes 3.7 percent-age points to real GDP growth in the rst year o recovery, while residential investment contributesabout 0.8 percentage points. Inventory restock-ing, the third recovery driver, typically contrib-utes roughly 0.8%.

A Benchmarking ExerciseO course, to orecast such a muted recovery istantamount to saying its di erent this time, acardinal sin o investing. Which begs the question:How unique has this crisis been? As shown inExhibit 2 , the truly unique aspect o this crisishas been the magnitude o the governmentsresponse. In contrast, the decline in equity prices,home prices and the employment rate has beenquite consistent with previous banking crises.Moreover, the recent 65% advance in US equi-ties since the March 2009 low closely mirrorsthe 63% nine-month advance seen a ter another

Exhibit 1: Real GDP Growth in the Year FollowingRecession EndDeeper recessions have historically been ollowed by strongerrecoveries. In contrast, the shallower the recession, the weakerthe recovery.

Based on US recessions during 1950-2009Source: Department o Commerce (Bureau o Economic Analysis), Investment Strategy Group

G r o w t h

D u r i n g

1 Y e a r

A f t e r G

D P T r o u g

h ( % )

0

1

2

3

4

5

6

7

8

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Average Rebound After 1 Year = 4.8%

Average RecessionDepth = 2.0%

2001

1970

1990/91

1960/61

1980

1981/821973/75

1953/541957/58

Peak-to-Trough Decline in GDP (%)


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data shows that negative equity and loss o employment together precipitate about three-quarters o all oreclosures.10 As such, theturn o leading labor market indicators and

the recent stabilization in the housing marketare noteworthy. Already, with just a smallimprovement in national home prices, the shareo mortgages with negative equity has declined

rom a peak o roughly 33% in Q2 2009 toaround 22% currently, a signi cant reduction.

In our view, this cycle also has a ew uniqueactors working in its avor. The rst refects

the potential or a rebound in durable goodsspending, as the collapse here has detracted more

rom economic growth than during any otherrecession in the modern era. According to data

rom the Federal Reserve Board, US consumerspending on durable goods (e.g., appliances,automobiles, etc.) is coming dangerously close to

alling below the imputed depreciation expenseo those goods. In other words, consumers areliterally waiting to the very end o a goodsli e to replace it. The same is true or publiccompanies outside o the commodities sector.This dual collapse in capital outlays has createda large pool o liquidity, which represents a

uture source o spending power. Indeed, thecombined ree cash fow o consumers and publiccompanies over the rst three quarters o 2009was 7.5% o GDP, a level last seen in 1982. Theimplication is that such anemic levels o capitalexpenditures are unlikely to persist and shouldresolve in avor o increased spending.

The second actor has to do with the healtho the marginal consumer in this cycle. Today,the top third o the income distribution in theUS represents roughly 60% o discretionaryspending, making this groups attitudes vital inunderstanding the consumption outlook. Forthem, deleveraging is not a major headwind, asdebt equates to just 6% o their assets vs. 42%

or the bottom two-thirds. In addition, theirbalance sheets are more equity-heavy, with stockownership representing ve times more o theirnet worth than that o the bottom two-thirds.In act, households led by those 55 and older,a heavy weighting in the top third, hold almost

70% o all US households equity holdings.The upshot is that spending and savingspatterns are more closely linked to equity

i it hasnt already, given that initial claimsusually lead it by around seven months. Thisnotion is corroborated by The Con erenceBoards Employment Expectations Index, as it

troughed in March; it typically leads the peakin the unemployment rate by nine months.Other leading employment indicators, suchas corporate earnings, credit market spreads,temporary hiring and manu acturing hoursworked also show gains consistent with animproving labor market. To this end, thereturn o private sector services employment topositive growth in November a ter two yearso consistent losses was very encouraging,particularly since almost 70% o US payrollemployment is concentrated in this category.

We are also encouraged by the stabilizationin housing, which has important implications orconsumers net worth, and provides a positivetailwind to residential investments contributionto GDP. As mentioned above, the rebound hereis roughly tracking the historical analoguesalready. However, there is potential or upside,particularly since residential investment ellmore than 56% rom its peak over the last 14quarters, substantially more than the typicalrecessionary decline o 20%. More importantly,we have started to see stabilization in thehousing markets that epitomized the excessesin this cycle. To wit, just our states, namelyFlorida, Cali ornia, Arizona and Nevada,accounted or 75% o the nationwide home pricedecline and still represent roughly hal o allmortgages with negative equity. Encouragingly,sales volumes in these areas have risen about60% rom the trough. In turn, this surge involume has stabilized prices, with median homeprices up roughly 20% in Cali ornia in 2009and up 6% rom the trough nationally. Just asthe housing crisis originated in these our statesand emanated to the rest, we think the recoveryhere will ultimately reverberate nationally. Inthis spirit, it is welcome news that nationwideexisting home sales rose in July or the rst timesince 2005 and have advanced strongly since.

The interplay between employment andhousing could also have implications or the

oreclosure overhang, which many highlight asthe Achilles heel o the housing recovery.Recent research based on loan-level mortgage


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prices than in previous cycles. Indeed, thevolatility in this groups spending refects theequity exposure o their balance sheets, as thelargest spenders cut their charges by ve times

more than others during the market downturn,according to data rom American Express.Moreover, University o Michigan surveysshowed that the con dence o this group plunged

urther than those o lesser means as the stockmarket ell, a rst in the modern era. As such,the recovery in global equities since the troughshould disproportionately bene t this groups networth, creating a potential upside bias to theirconsumption going orward.

Against these relative positives, the trajectoryo savings rates remains a wild card to theconsumption outlook, especially given itsrecent substantial increase rom 0.8% to 4.4%.Intuitively, consumers look to o set declinesin their net worth by increasing their savings,which can, in turn, temper their spending. Thehistorical relationship between net worth andsavings suggests the current savings rate shouldbe somewhere between 4% and 8 %. The goodnews is that we have pierced the bottom o therange. The critical questions acing investorsnow are where we settle in the range and alsohow quickly we reach that destination.

On this debate, there are several points worthkeeping in mind. For one, the improvement inconsumer net worth seen in Q2 and Q3 2009and likely to continue in Q4 on the back o

urther equity gains and stabilizing home pricesshould temper the tailwind to rising savingsrates. Second, according to some interestinganalysis by Macroeconomic Advisors, led by

ormer Federal Reserve member Larry Meyer,or savings rates to revert back to the high end o

the historical range would require a signi cant permanent reduction in net worth and/or trans erpayments (e.g., unemployment bene ts, etc.).With asset markets recovering and the currentadministrations agenda supporting increased trans er payments, neither seems a likelyoutcome. Lastly, analysis by Empirical ResearchPartners, a port olio strategy rm, led them toconclude that much o the rise in savings is

attributable to [ nancially] unconstrained, higherincome households that absorbed a big hit towealth later in li e. I this thesis is true, the

recovery in the equity markets may dampen aurther rise in the savings rate, given this groups

equity-heavy balance sheet.

Our View on the US RecoveryUltimately, we expect US real GDP growth willbe better than whats ollowed other nancial cri-sis recoveries, but fatter than the recovery roma typical recession. As such, our orecast calls

or 2.5-3.0% growth this year, with risk skewedto the upside. This growth will be supported byresidential investment growth o 10-15% and astronger than typical inventory rebound. Giventhis economic recovery, we expect the 10-yearTreasury yield to normalize, settling within our4.25-4.75% orecast range. As discussed in moredetail in the next section o the report, we expectcore infation o 1.0-1.5% in 2010, with headlineinfation o around 1.75-2.25%.

It is also worth noting that credit availabilityshould not hamper our recovery orecast. Whatmatters or GDP growth is not the amount o credit outstanding, but its rate o change. On thispoint, the pace o banks loss recognition in thiscycle is noteworthy, as part o what elongatesrecoveries ollowing nancial crises is the persis-tent drag o credit losses on banks appetite tolend, as was the case with Japan in the 1990s.With roughly two-thirds o estimated ull-cyclecredit losses already taken, that drag shouldabate much aster than in previous crises. Indeed,both the price and the availability o credit haveimproved in recent months.

Lastly, while a recovery in the US appearsunderway, it is admittedly di cult to separatethe purely cyclical orces o improvement

rom those created by the governments scaland monetary spending. Many assert thatthis recovery is not sel -sustaining because itwill only last as long as government stimuluscontinues. We dont agree. In our view, whetherthe economic growth seen thus ar is primarilystimulus-based or not is less important thanwhether it creates a perception o recovery that,in turn, becomes a sel -sustaining reality byboosting con dence. The improvement seen in avariety o asset markets, as well as nascent gains

in various orward-looking consumer con dencemeasures, suggests this transition may already beunderway.


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Key Concerns or the US Outlook

Recalling the old axiom that markets climb awall o worry, perhaps we shouldnt be surprised

by the spirited 65% rally we have seen in USequities since their March 2009 lows; a terall, there is no shortage o worries regardingthe United States. Two concerns in particular,however, have recently become the ocus o investor unease: rising public debt and anexpectation o runaway infation. Taken together,these concerns have led many to conclude thatthe US dollar is doomed and its days as theworlds reserve currency are numbered. In the

ollowing pages, we examine the legitimacy o theseconcerns and their implications or the greenback.

De cits as Far as the Eye Can SeeThere is no question that scal de cits are high,as seen in Exhibit 4 . Weak economic growthcoupled with a nancial crisis has conspiredto reduce tax revenues and necessitate a hosto scal stimulus measures that have increasedgovernment spending. As a result, the US scalde cit grew to 10.1% o GDP in scal 2009, thehighest level since World War II and well abovethe historical average o 3%. Such high de cits,in turn, are compounding an already above-average public debt burden, as a governmentsdebt load is essentially an accumulation o itsde cits. For instance, the US public debt rose to53% o GDP in 2009 rom 40% the year be ore,the result o a 10% scal de cit combined with a3% contraction in GDP. Forecasts have the scalde cit as a percentage o GDP slowly alling overthe next 10 years but settling above its 3% long-term average. Consequently, US public debt isexpected to accrete to over 70% o GDP overthe next 10 years ( Exhibit 5 ).

The good news is that de cits tend to becyclical. A 2008 IMF study ound that amongthe G7 economies, about 60% o the de citdeterioration they expected was due to cyclical

actors which would eventually reverse aseconomic activity normalized. In the caseo the US, the decline in tax revenues due tolower household income and corporate pro ts

accounted or approximately two-thirds o the$1 trillion increase in the scal debt, with thebalance accounted or by the governments scal

stimulus and nancial market intervention. Thus,renewed US economic growth will decrease thede cit in two ways: by increasing tax receiptsvia rising income and corporate pro ts and by

decreasing the need or urther scal stimulus.This combination is potent, as history showsthat or every 1% o nominal GDP growth, taxrevenues tend to grow by 2.6% in the ollowingyear. Given an upside skew to our GDP growthview, we are com ortable that the cyclicalportion o the de cit should improve.

O course, the growing structural de cits aremore troublesome. An aging population andincreasing ratio o pensioners to working taxpayerscreate a major secular tailwind to expanding publicdebt. In act, growth in spending on mandatoryprograms (including Social Security, Medicaidand Medicare) is expected to outgrow GDPby 2.2% on an annualized basis over the nextdecade. Rising debt service costs just exacerbatethe problem. Taken together, estimates have netinterest expense and spending on mandatoryprograms growing to 14.2% o GDP over thenext 10 years rom just 10.8% currently.

Against the sobering reality o these growingde cits, we nd several reasons or optimism. Asmentioned, the cyclical nature o de cits suggeststhat part o the current budget short all willnaturally correct as economic growth resumes.In addition, budget orecasts are inherently inac-curate. In 2000, the Congressional Budget O ce(CBO) projected 10 years o scal surpluses,with a surplus o 5.3% in 2009. Instead, what

ollowed was nine years o de cits, including a10.1% de cit in 2009. Furthermore, in 1995the CBO projected a de cit o 3% or 2000, butwhat resulted was a surplus o 2.4%! Finally,there is scope or a rising tax base. Federal taxrevenues stand at the lowest level relative to GDPsince 1950. A reversion to more typical postwarlevels would equate to several percentage pointso de cit reduction. Moreover, the total tax baseo the US relative to GDP stands well below thelevel in any other developed country and theOECD average. Thus, there is capacity or theUS to increase taxes without jeopardizing itscomparative position in the global economy.

Lastly, its worth remembering that bothpersonal and corporate tax rates are low byhistorical standards. While there is raging debate


13/36


about the impact o such increases on prospec-tive growth, three points bear mentioning. First,higher tax rates have not historically been animpediment to economic growth, as many o

the aster-growing periods in American historyoccurred with tax rates much higher than todayslevels. Second, levels matter. I the ederal marginaltax rate on the highest income bracket were torevert to its pre-Bush level o 39.5%, it wouldstill stand below the 50% threshold that someexperts consider highly detrimental to growth.Third, timing matters. The mistake o both theUS as it was exiting the Great Depression and

Japan early in their Lost Decade was raisingtax rates during the nascent phases o economicrecovery. Given the approaching midterm elec-tions, any broad tax hikes are unlikely to comeuntil 2011, a point at which the economy shouldbe on strong enough ooting to absorb them. Inshort, while undoubtedly not welcome news orindividual tax payers, the near certainty o taxhikes should bene t de cit levels going orward.

The Inevitability o Runaway Infation?Current concerns about infation generally comein one o two favors. The rst contemplates ascenario where policy makers, lacking the politi-cal will to cut entitlement spending and acedwith ever-spiraling de cits, let infation rise asa means o reducing the debt burden (as pricesrise, the value o the debt would all relative tonominal GDP). The second nds its roots in theWeimar Republic o Germany during the early1920s; namely, that the Feds rapidly expandingbalance sheet will ultimately increase the moneysupply well beyond the growth o output, caus-ing hyperinfation, which destroys con dencein the dollar itsel . While neither scenario isinconceivable, we place low odds on both.

On the rst point, we are encouraged by theconclusions o a recent academic paper thatexamined the relationship between scal de citsand infation in six industrialized nations in thepostwar period. 11 The authors concluded thatthe relation between scal imbalances andinfation suggests extremely modest interactionsbecause such imbalances are mainly removed

through adjustments in the primary de cit. In other words, governments ultimately tookremedial action to close budget gaps be ore

U S B u

d g e t

B a

l a n c e

( % o

f G D P )

05009590858075706560555045403530

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%10%

Average of Goldman Sachs US Economics Research,Office of Management and Budget, and CongressionalBudget Office 2019 Budget Deficit Forecasts

Budget Surplus

Budget Deficit

Exhibit 4: US Budget Balance (% o GDP)At 10.1% o GDP, the US iscal de icit is the largest de icit sinceWorld War II and stands well above the historical average o 3%.

Actual Data Through 2009; Forecast Data as o December 22, 2009

Source: Investment Strategy Group, Goldman Sachs US Economics Research, Congressional BudgetO ice, O ice o Management and Budget

0%

20%

40%

60%

80%

100%

120%

15100500959085807570656055504540

Goldman Sachs US Economic Research ForecastOffice of Management and Budget ForecastCongressional Budget Office Forecast

Exhibit 5: US Public Debt (% o GDP)Continuing budget de icits coupled with spending on mandatoryprograms is projected to push US public debt well above long-termaverages.

Actual Data Through 2009; Forecast Data as o December 22, 2009

Source: Investment Strategy Group, Goldman Sachs US Economics Research, Congressional BudgetO ice, O ice o Management and Budget


14/36

14 Goldman Sachs

january 2010

structural shi ts in infation occurred. Forinstance, policymakers success ully worked ona bipartisan basis during election years to bringabout scal re orm amid the high de cit years o

1984 and 1986. Also, in 1993 when Democratscontrolled the House, Senate and White House similar to todays backdrop policymakerspassed a scal re orm bill that helped swing the

scal balance rom a de cit o 4.7% in 1992 to asurplus by 1998. Today, growing voter concernabout government indebtedness suggests that i current incumbents lack the political willpowerto exercise scal restraint, their constituents willultimately elect a replacement who will. Indeed,congressional approval ratings are lower todaythan when Congress fipped parties in 1994 and2006. Given the strong sel -preservation instinctso elected o cials, we suspect remedial actiontoward the de cits will ultimately be taken.

On the second point, unlike Germany in the1920s, very little o the rapid growth in the Fedsbalance sheet has actually ltered into currencyin circulation. In act, broader monetaryaggregates such as M2 have been fat over thelast six months. On this point, our colleagues atGoldman Sachs Global Economics, Commoditiesand Strategy Research concluded that high rateso monetary growth are less likely to result ininfation as long as that growth is not sustained

or long periods. Importantly, the vast majorityo the Feds monetary stimulus sits on banksbalance sheets as excess reserves on which theynow earn interest. True, these reserves couldultimately nd their way into the real economyi banks began aggressively lending. However,given that loan growth typically lags economicrecovery by several quarters not to mentionboth banks and households current desire todeleverage their balance sheets we nd amassive lending binge unlikely.

O equal importance, the Fed now has manytools at its disposal to withdraw this excessliquidity be ore it becomes problematic, includ-ing paying interest on reserve balances, removingreserves through reverse repos and term deposits,raising short-term interest rates and selling assetsin order to shrink the size o its balance sheet.

O course, the Fed could also bring orward thetightening cycle i there were signs that infationand/or infation expectations were rising sharply.

In act, it can be argued that the FederalReserve has already started tightening byannouncing its intentions to end its securitiespurchase programs (such as mortgage-backed

securities and treasuries) and some o thevarious liquidity acilities it created during thecrisis. Moreover, because the Fed charges marketparticipants a premium to access its variousliquidity acilities, many, such as the commercialpaper acility, have naturally dwindled as theirunderlying markets normalized. While weacknowledge that the loss o Fed independence

We believe a combination o iscal

restraint, economic slack and a viable Fedexit strategy will temper realized in lation,keep in lation expectations anchored andultimately rein in the primary de icit.

through Congressional audit schemes couldnegatively impact infation expectations, wedont think the risk warrants positioning aport olio or that outcome.

In considering the credibility o any infationaryscenario above, it is also crucial to acknowledgethe large number o disinfationary impulses thatexists presently. For one, the US economy acessigni cant economic slack, with some estimat-ing that the output gap (the di erence betweenpotential and actual GDP) in the US is as largeas 11%. Our view is that real-time estimates o the output gap are di cult to measure and moreimportantly, they tend to explain only a smallportion o subsequent infation. Even so, othermeasures o slack lend credence to the disinfa-tionary theme, such as the unemployment rate atclose to its 26-year high and capacity utilizationnear its lowest levels ever. Thus, while there isconsiderable debate about the correct measureo this slack, each is signi cantly large enough tocorroborate the conclusion.

As a result o this slack in the economy, unitlabor costs remain depressed, creating a very di -

erent environment than what existed during theinfationary 1970s. Moreover, the disinfationary

impulse rom globalization remains alive andwell and could arguably increase as emergingeconomies look to sustain their growth through


15/36


competitively-priced exports. Weighting theabove, we expect core infation to moderate slightly

rom its current reading to a range o 1.0-1.5%in 2010, with headline infation o around 1.75-

2.25%. Our view refects the inherent stickinesso core infation, as well as the act that infationexpectations remain well anchored.

Implications or the DollarAgainst the above conclusions, we nd thereports o the dollars demise greatly exaggerated.Realistically, there are no alternative currenciesthat can challenge the reserve currency status o the US in the oreseeable uture. At $14 trilliondollars, the US has the largest GDP share inthe world, as well as the deepest and broadestcapital markets, with US equities accounting orover 40% o global equities and US bonds not

ar behind at roughly 40% o worldwide debtsecurities. For comparison, all Euroland equitiesaggregate to 13.1% o global equities and 28.7%o global debt securities. O course, US marketsare also open and ree o capital controls.

The dollar also meets the necessary reservecurrency requirements o being reely tradableand convertible, and o belonging to a stablecountry with a working democracy and anestablished rule o law. Deep recessions, highinfation and multiple wars have never broughtinto question the convertibility o the dollaror raised concerns about any orm o capitalcontrols. In act, the recent economic crisis justcon rmed the sa e haven status o the US dollar:It rose 24.3% on a trade-weighted basis as worldmarkets collapsed rom March 2008 to March 2009. Moreover, as highlighted in a March 2008Harvard Faculty Research Paper there is a strongbias in avor o using whatever currency has beenthe reserve currency o the past. 12 This inertialbias, the paper notes, avors the continuedcentral role o the dollar, particularly against abackdrop where, as o year-end 2008, 64% o total allocated oreign exchange reserves wereheld in dollars. International trade, urthermore,continues to be invoiced and quoted in dollars.

Notwithstanding these positives, we notethat the dollars currently depressed valuation

is a testament to the negative sentiment towardit that prevails in the currency markets. Indeed,the dollars current valuation is close to its

lowest levels since 1973. Importantly, whenvaluations have reached such levels historically(1979, 1988, 1995 and 2008), the US dollarhas generally gone on to appreciate over the

subsequent three to ve years. As such, our long-term view o the US dollar is generally avorable,particularly relative to currencies o otherdeveloped countries.

From a tactical perspective, we currentlyrecommend that clients increase their exposureto the US dollar vs. those developed currenciesagainst which it is most undervalued, such as the

Japanese yen. In addition to the valuation signal,the yen aces signi cant uncertainties emanating

rom Japans worst-o -breed scal position, aswell as its growth and defation outlook.Similarly, while we havent implemented aspeci c tactical recommendation at the presenttime, we also nd the dollar attractive relative tothe euro, based on both valuation and underlying

undamentals. We discuss these views, as well asour emerging market currency ideas, in more detaillater in this report.

Our ViewpointIn short, we believe a combination o scalrestraint, economic slack and a viable Fed exitstrategy will temper realized infation, keepinfation expectations anchored and ultimatelyrein in the primary de cit. Even i de cits wereto remain elevated, empirical evidence suggeststhat the historical link between the US dollar andthe scal de cit is tenuous at best. As such, weexpect neither signi cant US dollar depreciationnor a change in the status o the US dollar asthe worlds reserve currency. In act, given that

scal de cits are large in most major developedeconomies, we think that the US dollar couldappreciate relative to select currencies in thecoming years.

In our view, the issues surrounding the USde cit, infation and the dollar ultimately refectconcern about the credibility o the US govern-ment itsel : Will it have the political will to actwhen necessary? Last year, our view was that theUS would success ully navigate the challenges it

aced with strong support rom various policy

actions, no matter how imper ect they may haveseemed. Against the myriad concerns discussedabove, we continue to take that view.


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16 Goldman Sachs

january 2010

Even or the more optimistic among us, it is hardto believe that today we are tasked with chart-ing the shape o the global recovery, when just12 months earlier our ocus was on gauging thepotential or a second Great Depression. For thetime being, however, it seems the global economyhas sidestepped that ate, as leading economicindicators have surged, manu acturing andexports are on the mend and credit markets haveimproved. In act, most countries are reportingpositive GDP growth again, in many cases at orabove trend levels.

While we are aware o the many potentialgrowth impediments that will ultimately comeinto ocus, such as large budget de cits andthe removal o monetary stimulus, we expectthe cyclical orces already in motion to sustaingrowth this year. Our view is predicated onseveral actors. As already discussed, US growthcould surprise to the upside, which wouldhave positive implications or exports globally.Moreover, stronger growth in the US and abroadwould mitigate some o the structural pressures

acing the developed economies in particular.Similarly, the highly synchronized, global

nature o the downturn should work the samein reverse, to the bene t o global growth. Onthis point, a recent IMF study ound that syn-chronous global downturns historically have hadbetter growth outcomes than those associated

with a nancial crisis alone. As seen in Exhibit 6 ,the current episode certainly quali es, as emerg-ing economies have been highly correlated withthe advanced world during both the collapse and

subsequent recovery o economic activity. Inaddition, the average correlation o quarterlyGDP growth among emerging market countriesthemselves is near 80%, similar to the levelamong developed economies. Both readings aresigni cantly higher than previous cycles, atestament to the synchronicity o this cycle.

Although the resumption o growth wouldtypically be a harbinger o infation, the eco-nomic slack in many developed nations shouldtemper price increases while also providingcover or accommodative policy and a measuredwithdrawal o liquidity. As we discuss below,rising infation could be more o an issue orselect emerging markets, given their commod-ity exposure and xed exchange rates. Finally,global interest rates are likely to migrate higherover the course o the year, a unction o both thelow starting level o policy rates globally and animproving growth backdrop. A summary o ourGDP, infation and interest rate orecasts or thedeveloped economies is presented in Exhibit 7 .

2010

GlobalEconomicOutlook

Exhibit 6: Highly Synchronized Global GrowthEmerging economies have been highly correlated with the developedworld during both the collapse and subsequent recovery o economicactivity.

1995 1997 1999 2001 2003 2005 2007 2009

Data as of December 31, 2009; ISG forecasts through 2010

Source: Investment Strategy Group, Goldman Sachs Global Investment Research

Y e a r -

O v e r -

Y e a r

G r o w t h

( % )

G-3EM AllEM ex. ChinaBRICs-6%

-4%

-2%

0%

2%

4%

6%

8%10%

12%


17/36


Euroland

A ter a staggering 5.1% peak-to-trough declinein Euroland GDP, we expect a return to mod-

erate growth in 2010. Just as the credit crisishurt both European exports and investment,which together accounted or over 80% o theeconomic contraction, the moderation o theseheadwinds should help growth this year. Even so,although exports should bene t rom a revivalo world demand and a rming o trade nanc-ing, investment is likely to remain sluggish givenlow capacity utilization and still-spotty bank

nancing. Furthermore, as in the US, governmentspending is likely to wane in the back hal o theyear, only partially o set by mild consumptiongrowth. As such, we expect GDP growth o 1.25-1.75% and mild infation.

With Euroland GDP returning to positivegrowth, the ECB might start withdrawing liquid-ity in the rst hal o the year and raising itspolicy rate later in the year. These policy actions,coupled with still-high scal de cits, will likelypressure long term rates higher. Overall, weexpect Euroland 10-year rates to rise to 3.75%to 4.25%, with spreads widening urther withinthe zone.

We expect the euro to depreciate. Severalactors are likely to weigh on the euro, leading

to its depreciation over the medium term. Forone, valuations are unattractive, as the euro isabout 20% overvalued relative to the dollar and10-15% relative to the British pound. Second,

the resumption o US growth this year shouldtemper concerns about the dollars reserve status,diminishing the euros appeal as an alternative.Meanwhile, the ongoing negative toll o a strong

euro on the regions exports makes a weakercurrency politically desirable, with rising de aultrisks in troubled euro economies like Greeceserving as the impetus or action. Taken together,these actors bias us toward being short theeuro, subject to a catalyst. In our view, that cata-lyst will be the willingness o emerging marketcountries, especially in Asia, to appreciate theircurrencies against the dollar, as this will removean important source o support rom the euro.

United Kingdom

The resumption o economic growth inEuroland, the UKs main trading partner, shouldhelp bolster the export tailwind that alreadyexists rom the countrys weak currency. Atroughly 20% o GDP, exports have a materialimpact on UK growth. That said, high debtlevels, persistent unemployment and low savingsrates will likely temper consumption growth.Furthermore, low capacity utilization willpressure capital investment. Weighing these

actors, our expectation is or moderate growtho around 1.5% to 2.0% this year.

Unlike many other developed nations, whereoutput slack is suppressing price increases,

United States United Kingdom Euroland Japan

Current 2010 Forecast Current 2010 Forecast Current 2010 Forecast Current 2010 Forecast

Real GDP* -2.5% 2.5 3.0% -4.5% 1.50 2.00% -3.8% 1.25 1.75% -5.4% 1.25 1.75%

Headline CPI** 1.9% 1.75 2.25% 1.9% 2.25 2.75% 0.9% 1 1.5% -1.9% (0.75) (1.25)%

10-Year Rate 3.84% 4.25 4.75% 4.01% 4.5 5.0% 3.39% 3.75 4.25% 1.29% 1.25 1.75%

Policy Rate 0 0.25% 0.25 0.50% 0.50% 0.5 1.0% 1.00% 1 1.25% 0.10% 0.10%

Data as o December 31, 2009

* Real GDP levels are consensus estimates or 2009 real GDP growth.** For current headline CPI readings we show the year-over-year in lation rate or the most recent month available.Source: Investment Strategy Group, Bloomberg

Exhibit 7: ISG Economic Outlook Scenarios or Developed MarketsAcross the developed markets, we expect moderate growth, relatively tame in lation, still-accommodativemonetary policy and normalization in 10-year rates.


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18 Goldman Sachs

january 2010

infation has proven resilient in the UK. Forexample, reported infation has been strongerthan the Bloomberg consensus 12 out o thelast 15 months. Looking orward, both the

weak pound and the reversal o the temporaryValue Added Tax (VAT) hiatus will add to theseinfationary pressures. The implication is thatsuch persistent infation, urther stoked by theresumption o economic growth, could lead theBank o England to tighten early, particularlygiven its strict infation targets.

As such, we expect long term rates to movehigher. While expanded quantitative easingpresents a risk to this view, we suspect the BOEsinfation mandate and burgeoning de cits willpush long rates to 4.5-5% by the end o the year.

The pound sterling is likely to remainrange-bound against the dollar and to appreciatemoderately against the euro . The pound has beenamong the weakest developed market currencies,

alling 25% on a trade weighted basis over thelast two years. Given this underper ormance,it now screens as about 10-15% undervaluedagainst the euro, although only airly valuedrelative to the dollar. Consequently, weexpect the pound to slowly appreciate againstthe euro as concerns over the UK economydissipate. Because we also anticipate the dollarstrengthening against the euro, the pound islikely to remain range bound relative to thedollar as a result. The upcoming electionsand resulting uncertainty about scal re ormsrepresent a clear risk to this view.

JapanThe Japanese economy was one o the primarycasualties o the global slowdown, as GDPcontracted 8.6% peak to trough during the crisisas exports collapsed. The governments appar-ent apathy toward the strengthening yen onlyexacerbated the decline, while the breakdown inoutput rekindled defationary orces. In turn, thestronger yen and rise in real rates due to defa-tion dramatically tightened nancial conditions,

urther undermining economic growth.In considering the likely path o Japansrecovery, the lynchpin is ultimately the govern-

ments policy response and its eventual impact onthe yen. I the Bank o Japan (BOJ) succeeds inweakening the yen through quantitative easing,that would provide a clear tailwind to export

growth, the principle driver o Japans economy.Furthermore, the Democratic Party o Japansrecent scal stimulus should help consumptiongrowth, although it is unclear how much is likelyto be saved vs. spent.

Against this uncertain policy backdrop, weexpect the Japanese economy to expand 1.25%to 1.75%, an admittedly tepid growth orecastgiven the magnitude o the contraction. Parto this guarded outlook refects the myriadstructural headwinds that Japan aces, includingits large budget de cits, alling savings ratesand shrinking work orce. O equal importance,political uncertainty remains high, particularlywith the July election o the House o Councilors. Such uncertainty is likely to weighon investment and consumer con dence.

Given relatively slow growth and persistentdefationary pressures, we expect that the Banko Japan will keep its policy rate near zerothroughout 2010. In addition, it is likely totarget tight nancial conditions through somecombination o committing to low rates or anextended time period and urther quantitativeeasing. As such, despite large scal de citsthat will pressure rates higher, we expectcountervailing policy initiatives to keep 10-yearyields in the 1.25-1.75% range.

In our view, the yen will depreciate over themedium term. Based on several measures, the yenis substantially overvalued, especially against theUS dollar. In addition, the persistence o sluggishgrowth and defation suggests the BOJ is likelyto tighten much later than other central banks.The resulting interest rate di erential will likelyweigh on the yen. Moreover, large budget de citscoupled with a alling household savings rate willput downward pressure on the countrys currentaccount, weakening a orce that has traditionallysupported the yen. Accordingly, we recommendclients remain short the yen against currenciesassociated with improving economic undamen-tals, namely the US dollar, Swedish krona and

Australian dollar.


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Emerging MarketsAgainst the backdrop o global economicrecovery, we expect emerging market growthto rebound to almost trend levels this year.A combination o improved trade, renewedaccess to credit and the impact o aggressivepolicy responses will underpin this growth.Far rom being de-coupled, emerging marketeconomies stand as prime bene ciaries o stronger developed world growth, particularly inthe US. That said, with many emerging countriesusing scal and monetary stimulus or the rsttime during the crisis, this renewal o growthcould quickly make their policy settings tooaccommodative. The resulting interactionsbetween growth, policy and infation willhave important implications or emergingmarket currencies, many o which we expect toexperience appreciation pressures. A summaryo our GDP and infation orecasts or theemerging markets is presented in Exhibit 8 .

Emerging AsiaDominated by two o the largest and astest-growing emerging markets, China and India,Asian growth should outper orm in 2010.Even excluding these giants, we expect growthin the Asian economies to rebound to pre-crisis levels o around 5% as global conditionsstabilize. While the rise in intra-Asian trade willcontribute to this growth, the region remains

heavily dependent on nal demand outside o Asia. As such, until the regions policy makersare con dent about the sustainability o the US

recovery, they will likely lean against signi cantcurrency appreciation to protect their exporters.

China Chinas massive two-year stimulusprogram should ensure robust growth o about 8.5-10.5% in 2010. While government-infuenced demand accounts or hal o theprojected expansion, residential investment andconsumption should also contribute. Both willbe aided by Chinas very loose monetary policy,which includes a 30% expansion in lending thatshould extend into this year. The infationaryimpact o Chinas expanding money supply willlikely be tempered by monetary tightening andthe defationary impact o the excess capacityo large state enterprises. Our resulting base caseis a moderate increase in infation o roughly2-3.5% this year.

India Indian growth should accelerate by an im-pressive 7-8.5% in 2010. Although its capacity

or scal and monetary stimulus lagged that o China, Indias large and relatively closed econ-omy partially insulated it rom the global crisis.Indeed, Indias domestic demand kept growthabove 6% in 2009. With such persistent growth,Indias output gap is expected to close much

aster than the advanced economies. As such, weexpect elevated infation o 5-6.5% in 2010 to

orce the central bank to meaning ully tightenmonetary policy.

Asian Area Currencies Select Asian currencies

should provide attractive risk-adjusted returns in2010. More speci cally, we avor the currencieso India and Indonesia as both weakened

Exhibit 8: ISG Economic Outlook Scenarios or Emerging MarketsWith the exception o China, we expect higher growth and high in lation in the BRICs.

China Brazil India Russia

Current 2010 Forecast Current 2010 Forecast Current 2010 Forecast Current 2010 Forecast

Real GDP* 8.2% 8.5 10.5% 0% 5.0 6.5% 5.5% 7.0 8.5% -7% 3.0 5.0%

Headline CPI** 0.6% 2.0 3.5% 4.2% 4.0 5.0% 4.8% 5.0 6.5% 8.8% 6.0 9.0%


*Current real GDP levels are consensus estimates or 2009 real GDP growth.**For current headline CPI readings we show the year-over-year in lation rate or the most recent month available. WPI is shown or India.Source: Investment Strategy Group, Bloomberg


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20 Goldman Sachs

january 2010

signi cantly during the crisis. In addition, bothrely more heavily on domestic demand thanexports, a characteristic which not only bu eredthem during the crisis but should also allow

them to be among the rst to raise rates or allowappreciation in 2010. As the US recovery takeshold, we expect opportunities to emerge in otherAsian currencies whose central banks have thus

ar resisted capital infows so as to allow onlymoderate strengthening o their currencies. Thistheme will come increasingly into ocus i , as weexpect, China decides to resume the renminbisappreciation later in the year.

Emerging Europe

Emerging Europe (including Central and EasternEurope (CEE) countries, Russia, Turkey andSouth A rica) was the developing region hitthe hardest during the recent global nancialcrisis. Underlying this weakness was the regionsreliance on external nancing to support itsrapid expansion and its recent integration intothe EU, both o which made it particularlyvulnerable to the cessation o global capitalfows. Indeed, the downturn could have beeneven worse were it not or the IMFs overallquadrupling o its lendable unds. On theback o this support and the broader globalrecovery, region-wide growth should reboundto almost 4% in 2010, slightly below its pre-crisis trend. That said, risks remain elevated orthe peripheral countries such as the Ukraine,Romania and the Baltics.

Russia Even the combination o a $600 billionwar chest o reserves and virtually no sovereignexternal debt could not insulate the Russianeconomy rom the per ect storm o collapsingoil prices, the invasion o Georgia and thetermination o external nancing during thecrisis. The subsequent rebound in oil prices andthe governments rapid injection o scal andmonetary stimulus thanks to its sizable oilstabilization und should allow the country torecover rom one o the deepest recessions in theworld and grow 3-5% in 2010. Nevertheless,progress remains ragile, and the direction

o oil prices and pace o credit growth willbe key indicators to monitor in gauging thesustainability o the recovery.

Emerging European Currencies Emerging Europesrelatively loose monetary policy and reliance ongrowth in Europe make it a less attractive region

or meaning ul currency appreciation vs. the euro

in 2010. Our ocus will be on currencies that haveunderper ormed but whose underlying economiesexpect to see strong growth in the year ahead,such as the Polish zloty.

Latin AmericaThe global crisis has had a more selective impacton Latin America than elsewhere. While Mexicoregistered a severe recession o about -7% in2009 due to its reliance on the US economy,Chile emerged relatively unscathed, experiencinga shallow recession and now a robust 2010outlook. The delineating characteristic seemsto be how much economic prudence a countryexercised in the past decade. For example, Chile,which had saved most o its excess copperexport revenue, ared in nitely better than ellowcommodity exporters Argentina and Venezuela,which had spent most o their resource wind alls.

Brazil As the regions largest economy, Brazil allsin the ormer category. A combination o resilientdomestic demand and loose policy should drivestrong growth o 5%-6.5% in 2010. That said,this growth comes with correspondingly highinfation risks. Particularly in an election year,Brazils pro-growth stance may unhinge infationaryexpectations and lead to price pressures.

Latin Currencies The direction and pace o currencymovements in Latin America should broadly

ollow the path o commodity prices, which weanticipate to be range-bound. Among the majorregional currencies, our ocus will be on whether

aster-than-expected US growth translates intooutper ormance o the Mexican peso vs. theregion. As or the Brazilian real, we see the posi-tive drivers balanced against a host o negatives,including a widening current account de cit,election year volatility, increased use o currencyintervention and capital controls, as well as themost expensive valuation in emerging markets.


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2009 returns by major asset class is presented inExhibit 9 .

With those valuation dislocations largelyin the rearview mirror, investment success

will require an increasingly nuanced read o market variables. While there are dominantidiosyncratic actors in each market, we noticedseveral recurring themes that transverse them.Taken together, these themes should reward

undamental analysis and active managementthis year:

The Ascendancy o Earnings With valuation multiples largely back to long-term average levels, the ocus will shi t towardearnings growth to drive the next stage o marketappreciation. Historically, this phase avors lowerbeta, large-capitalization growth companies (e.g.,many modern-day technology stocks).

Operating Leverage Corporations reacted to the global downturnaggressively, cutting xed costs and loweringcapital expenditures. The result is thatsmall increases in revenue now generatedisproportionately sized earnings growth. Assuch, even tepid GDP growth could still ostermeaning ul pro t growth.

It may sound surprising, but in many ways theequity landscape o 2010 is much murkier thanthat o last year. In 2009, the investment thesisrested on the notion that the world was notdestined or another Great Depression. I thatsupposition proved correct, assets priced orsuch an outcome would o er very attractivereturns as they began to discount more normal

undamentals. In essence, depressed valuationmultiples at the time provided an attractivemargin o sa ety or investors, even against abackdrop o highly uncertain political, economicand corporate undamentals. A summary o

2010FinancialMarketsOutlook

EmergingMarkets

Equity

BarclaysHighYield

LeveragedLoans*

Non-USEquity

-20%-10%

0%10%20%30%40%50%

60%70%80%90%

US Equity Multi-StrategyHedgeFunds*

S&P/GSCI

CommoditiesIndex

BarclaysMuni 1-10

BarclaysAggregate

US TradeWeighted

Dollar

Mortgage-Backed

Securities

58%

41%32% 26%

15% 13%7%

-6% -13%6%

79%

Data as of December 31, 2009, except where indicated

* Performance through November 2009.

Source: Investment Strategy Group, Datastream, Barclays Capital, Credit Suisse, Markit, Bloomberg

Exhibit 9: 2009 Asset Class Per ormance


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Falling Correlations Much to the chagrin o decoupling proponents,correlations between the major developed andemerging markets remain historically high. In

act, as shown in Exhibit 10 , Euroland andemerging market correlations to the US are 93%and 87%, respectively, among the highest read-ings on record. Moreover, the average sectorcorrelation or the 10 S&P 500 sectors is nearly80%. Because correlations tend to be mean-reverting and generally all as economic stressabates, we expect alling correlations to providea more target-rich environment or relative valueand cross-sector trades this year. Merger & Acquisition Rebound With global corporations cash rich and in searcho ways to bolster organic growth, increasedmerger and acquisition activity is likely,particularly with many rms still trading belowprivate market value. Indeed, we have alreadystarted to see M&A activity increase in thetechnology and consumer product sectors.

Contrary Sentiment It pays to track retail investment fow, as recentacademic work has demonstrated empiricallythat fows have a negative correlation withsubsequent returns. In 2009, retail investorsoverwhelmingly avored bonds over stocks, andwithin equities, international over the US. Inturn, emerging markets, and the BRICs (Brazil,Russia, India and China) in particular, have seenthe lions share o international fows.

As is typical in market recoveries, a good portiono the expected three-to- ve-year annual returnsimplied at the March trough were pulled orwardin 2009 as prices rallied. Exhibit 11 highlightshow as US prices rallied, expected returns have

allen. Thus, while the pure directional bet onthe market has likely come and gone, equitiesbroadly still seem priced or reasonable returns,particularly relative to bonds.

Exhibit 10: Correlations to US Equities(Rolling 24 Month)No sign o decoupling, as correlations between US equities and bothdeveloped and emerging market equities stand near all-time highs.

0.2

0.0

0.2

0.4

0.6

0.8

1.0

71 73 7 5 77 7 9 81 83 8 5 87 89 9 1 93 9 5 97 99 0 1 03 05 07 0 9

0.93

0.87

EAFE

EM


Source: Investment Strategy Group, Datastream


Source: Investment Strategy Group

S&P 500 Starting Level

0%

5%

10%

15%

20%

25%

30%

35%

13501300125012001150110010501000950900850800750700650600

A n n u a

l i z e

d R e t u r n s

32%29%

26%23%

20%18%

15%13%

11% 10%8%

6% 5%3% 2%

1%

Exhibit 11: Implied US Equity Returns Fallas Prices RallyStarting valuations matter, as a return to trend earnings and atrend multiple rom todays S&P 500 level implies about 7% annualgains vs. the roughly 30% implied at the March 2009 low.


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US Equities: The Disdained Rally

Perhaps its not surprising that investors havegreeted the 2009 US equity rally with more than

a dose o skepticism, i not outright disdain,considering it ollowed the second equity marketdecline o greater than 50% in the last decade.Indeed, among the most striking eatures o thisrally, at least as ar as the US market is concerned,has been the lack o retail participation. O course, sentiment and positioning is just oneaspect o our market view. In our work, our

actors determine our market outlook:

Valuations As can be seen in Exhibit 12 , todaysvaluation measures reside around the middle o their historical postwar ranges, suggesting mucho the multiple compression seen at the March2009 lows has been normalized. Importantly,

airly valued does not mean over-valued. Instead,with valuations near air levels, the markets

ocus will increasingly shi t toward corporateundamentals.

Fundamentals In considering the path o corporate earnings, its worth noting thatStandard & Poors reported earnings ell astaggering 92% in this cycle, greater than the75% decline seen during the Great Depression.Similarly, even operating earnings, whichostensibly exclude all non-recurring expenses,declined 57%, the worst decline in the postwarperiod. As such, the progression o currentearnings back toward trend levels representsa sizable tailwind or earnings growth.

This is not simply a blind mean-reversionargument, however, as there are several

undamental underpinnings. For one, thescope and pace o management cost cuttinghas been dramatic, with Selling, Generaland Administrative costs (SGA) alling at a9% yearly rate in the third quarter. O equalimportance, the truly aggressive cuts were madein the most cyclically exposed sectors, suggestingthe entire earnings base today is more leveredto economic recovery than in previous cycles.Secondly, while mark-to-market accounting may

have exacerbated the earnings collapse, it alsohastened the inevitable loss-recognition process.With roughly two-thirds o estimated ull-cycle

credit losses already recognized, earnings shouldbene t meaning ully as this drag abates. Lastly,low corporate borrowing costs and a steepyield curve are providing a tailwind to earnings

recovery.The resulting operating leverage is alreadyevident in net margin resilience. Unlike previousrecessions which invariably saw net margins(excluding nancials) trough between 4-5%, thecurrent episode bottomed at roughly 6% andhas already recovered to an estimated 6.8% or2009. What was made clear in this downturnis that corporate America has bene ttedtremendously rom globalization. By outsourcinglower value-added activities, US rms havelowered capital intensity and increased laborproductivity, both o which bolster cash fow andincrease margins. That margins held up this wellduring the worst economic and nancial crisisin the postwar period highlights the structuralnature o the improvement. The upshot is thatwhile many are concerned about tepid economicgrowth being a drag on pro tability, US GDPo 2-4% would likely be su cient to crystallizethis latent operating leverage. As such, weexpect reported earnings to come very close torecapturing trend levels in 2010.

0%10%20%30%40%50%60%70%80%90%

100%

Price to PeakEarnings

Price to ForwardEarnings

Price to BookValue

Price to TrendEarnings

59%

40%

57%50%

% T

i m e s

V a

l u a t i o n L e s s

T h a n

C u r r e n t

Exhibit 12: US Equity Valuations MetricsCurrent valuations or the US equity market appear neutral relative totheir historical levels.


Source: Investment Strategy Group, Standard and Poors, Robert Shiller


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Technicals The technical backdrop remains avor-able, in our view. For one, the S&P 500 remainsin an uptrend, demonstrated by a series o higherlows in price and continued trade above the key

50- and 200-day moving averages. Secondly,there is precedence or the current resistance at1,121, the 50% retracement level o the entireS&P 500 decline, to ultimately lead to higherprices. In both the 1990 and 2002 recovery ana-logues, the market initially struggled to surpassthe 50% retracement level but ultimately movedhigher a ter a period o consolidation. In addi-tion, the S&P 500 registered a monthly MACD(a momentum-based technical indicator) buysignal with its monthly close o 1,020 in Augusto 2009. In the postwar period, this indicatorhas never generated a alse buy signal rom suchoversold levels. The average maximum gainwithin 12 months o the historical buy signalswas 17%, implying an S&P target o around1,200. Lastly, excluding the current episode,there have been 16 distinct 10-year periods since1871 where real equity returns were negative.Importantly, the average annual real return orthe subsequent decade was around 11%, witha maximum o 17% and a minimum o 6.2%.In short, the mean-reverting tendency o equityreturns suggests the next decade o returns shouldbe materially better than the preceding one.

While many have highlighted the low volumeo the rally as evidence o technical weakness, wethink this could be evidence o retail investorsoverwhelming pre erence or bonds vs. stocksin this cycle, a potential contrarian positive orequities which we discuss in greater depth below.

Sentiment/Positioning Among the most strikingeatures o this rally, at least as ar as the US

market is concerned, has been the lack o retailparticipation. Despite the market being up26% in 2009, US equity mutual unds and non-commodity exchange traded unds saw outfowso roughly $42 billion. Moreover, globaloutfows were roughly double this amount at$85 billion according to EPFR Global. Instead o stocks, retail investors poured their money intobond unds and xed income ETFs, which saw

infows o about $268 billion. Interestingly, thistrend persisted throughout last year. Whereasonly 40% o the weeks in 2009 saw positive

equity infows, 94% had positive bond fows. Inact, the Pimco Total Return Fund, run by Bill

Gross, is set to become the largest mutual undin the industrys history with over $200 billion in

assets.Thus, at a time when the ree cash fowyield o stocks is near parity with Baa yields (abene cial stock condition that has existed lessthan 2% o the time since 1970), householdbond holdings stand at all-time highs, representingaround 21% o total discretionary nancialassets (a level exceeded only 3% o the timesince 1970). Tellingly, a recent academic paperdetermined that its not wise to ollow the crowdwhen it comes to mutual und fows, highlightingsigni cant negative correlation betweensentiment-driven und infows and uturereturns. 13 Indeed, even moderate rebalancingtoward stocks by retail investors, who represent85% o mutual und owners, would represent asizable tailwind to equities this year.

Our View on the US Market

Whereas we had expressed a bias towardsimply owning the S&P 500 last year givenbroadly compressed valuations, we suspect amore di erentiated, sector-speci c approachwill be better rewarded this year. As such, wecontinue to like technology, which bene ts

rom high operating leverage, global exposureand still-attractive relative ree-cash-fowyields. Despite being the strongest per ormingsector in 2009, we think investors continue tounderestimate the durability o ree-cash-fowmargins in this cycle. We also still avor exposureto the homebuilding sector. Here, normalizedvaluations remain attractive, undamentalshave stabilized and several rms could return topro tability a ter several years o losses. Lastly,the telecommunication sector is an area we areinvestigating, as valuations look reasonable,dividend yields are attractive, and alreadyattractive ree-cash-fow yields are set to expandgiven anticipated capital spending cuts in 2010.

This sector also stands to bene t rom telecom-related stimulus spending which will begin inearnest this year.


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Source: Investment Strategy Group

Good Case (25%) Central Case (60%) Bad Case (15%)

End 2010 Op. Earnings $85 Op. Earnings $7075 Op. Earnings $55S&P 500 Earnings Rep. Earnings $75 Rep. Earnings $6064 Rep. Earnings $45

Trend Rep. Earnings $69 Trend Rep. Earnings $69 Trend Rep. Earnings $69

S&P 500 18.520.0x 15.518.5x 1011xPrice-to-Trend Reported Earnings

End 2010 12771380 10701277 690760S&P 500 FundamentalValuation Range

End 2010 1330 11501225 760S&P 500 Price Target (based on acombination o trend and orwardearnings estimates)

Exhibit 13: ISG US Equity Scenarios Year-End 2010In our central case, the S&P 500 will reach a price range o 1150 to 1225 by years end.

Overall, the market is now priced to deliveraverage annual returns o about 7% per year.While this return remains attractive relative torisk- ree assets, it is roughly in line with long-run historical equity returns. As such, while themarket dislocation that warranted our tacticaloverweight to the S&P 500 has normalized, wecontinue to recommend clients build toward (ormaintain) their strategic allocation to equities.Our US equity scenarios or this year arepresented in Exhibit 13 .

Euroland and the UK

While most global equity markets have seentheir valuations revert to trend levels or better,Euroland multiples have lagged. This is largely arefection o lingering concerns about nancial-sector exposure and the ongoing di cultyo coordinating policy or multiple membercountries with varying degrees o economichealth. Indeed, the rising de ault risks o peripheral Eurozone economies like Greece andSpain, exacerbated by the persistent strength o the euro, have crystallized these concerns.

With these issues arguably refected in current

valuation discounts, the risk/reward to Eurolandequities looks interesting. Aside rom valuationswhich remain below average on an absolute basis

and neutral to cheap relative to the US, Eurozoneequities have a high beta to global growth, giventhat exports account or about a quarter o theareas GDP. As such, any upside surprises in USor emerging market growth should translate tobetter equity returns or Eurozone stocks. Bythe same token, any weakening o the alreadyovervalued euro would augment this export-ledrecovery.

In addition, earnings stand about 15-30%below trend, providing some uel or meanreversion. The transition should be aided bythe current operating leverage o Eurozonecompanies, whose pro ts should there orebene t rom an uptick in global growth. Thisearnings tailwind is complemented by thepotential or positive investment fows, asboth retail and institutional investors equityallocations stand below historical averages.Technicals also look supportive: Eurolandequities remain about 40% below their peak,which translates to 15-20% upside i they wereto rebound as much as other developed markets.

While the UK market also bene ts romglobal growth and screens attractively on abso-lute valuation measures, it is neutral to slightlyexpensive relative to the US. Moreover, its larger

nancial-sector weighting magni es the risks o

de-leveraging, regulation and dilution. Althoughthe aggressiveness o scal and monetary stimu-lus is creating a avorable liquidity backdrop, it


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26 Goldman Sachs

january 2010

seems analyst earnings expectations are alreadyhigh and positive revision momentum has stalled.With the compelling valuations and currencytailwind that led us to overweight the UK mar-

ket having diminished, we now nd Eurolandequities more appealing. A list o global equitymarket valuations is presented in Exhibit 14 .

Japan

In theory, Japan should b

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