Outlook Investment

Strategy Group
January 2011

Stay the Course

The American Evolution: Much like George Washington crossing the Delaware
River in the winter of 1776-77, America’s structural resilience, fortitude and
ingenuity will carry the economy and financial markets in 2011 – and beyond.

For Private Wealth 

Management Clients
 Stay the Course

3 We have been optimistic about the US as an

investment story since the depths of the financial
crisis. We remain so for the year ahead.

5 The US Will Not Face a “Lost Decade”

The current economic environment has led some to
question whether the US will face a “lost decade”
akin to Japan’s in the 1990s. We believe that is
highly unlikely.

7 Faster Growth Does Not Result in Higher Returns

Some emerging markets are likely to continue seeing
higher GDP growth rates than the US. But that does not
necessarily make their equity markets more attractive.

9 Structural Benefits of the US

The US’s inherent resilience, flexibility and
dynamism continue to make it uniquely attractive
from an investment perspective.

16 2011 Global Economic Outlook 26 2011 Financial Markets Outlook

17 United States 29 United States

21 Eurozone 32 Eurozone

22 United Kingdom 34 United Kingdom

22 Japan 35 Japan

22 Emerging Markets 37 Emerging Markets

38 Currencies

42 Fixed Income

47 Commodities

51 Key Global Risks

This material represents the views of the Investment Strategy Group in the Investment Management Division of
Goldman Sachs. It is not a product of the Goldman Sachs Global Investment Research department. The views and
opinions expressed herein may differ from those expressed by other groups of Goldman Sachs.

Cover photo © Art Resource, NY.

Stay the
Course
Sharmin Mossavar-Rahmani “America boosters!” That is how one of our
Chief Investment Officer most sophisticated and well-informed clients
Goldman Sachs Private Wealth sarcastically concluded what was to be our last
Management client meeting of 2010.
His exclamation was all in good fun, but also
based in truth: Since the depths of the financial
Brett Nelson and economic crisis, we have stood against the
Managing Director crowd in our optimistic view of a US recovery,
Goldman Sachs Private Wealth US investment opportunities and the US dollar
Management as the reserve currency of the world for the
foreseeable future. That outlook, unpopular
as it was, led us to two key investment
Additional Contributors from recommendations: overweight US high yield
Goldman Sachs Private Wealth bonds and US equities in our clients’ portfolios.
Management: Market returns and the US economic recovery
have proven us correct. At a total return of 83%
Neeti Bhalla since March 2009 (as measured by the Barclays
Managing Director Capital US Corporate High Yield Index), US
high yield bonds have offered not only extremely
Leon Goldfeld attractive absolute returns (over 100% from
Managing Director their trough), but also the most attractive
investment return per unit of risk as measured
Maziar Minovi by volatility, far surpassing any other asset class.
Managing Director If one were to include other measures of risk
such as safety of assets and capital controls, the
Thomas Devos risk/reward is even more attractive. Similarly,
Vice President US equities have returned 93% (as measured by
the S&P 500 Index) with annualized volatility
Benoit Mercereau of 17% in spite of annualized economic growth
Vice President of only 2%. Over the same period, emerging
markets returned 100% (as measured by the
Matthew Weir MSCI Emerging Markets Index) with annualized
Vice President volatility of 18% and annualized economic
growth of 7%. And the US dollar is actually
Harm Zebregs about 7% higher than its pre-crisis levels.
Vice President Our favorable inclination toward the US is
longstanding. In our 2009 Outlook, Uncertain
but not Uncharted, we argued that while the
financial crisis was more severe than anything in
recent memory, one only had to go back a little

Investment Strategy Group Outlook 3

january 2011
further in time to the deep recessions of 1973-
74 and 1980-82 to find a road map for the US
recovery. In our May 31, 2009 report, The US
Dollar: As Good as Gold?, we argued that no
other currency or basket of currencies, including
the euro (this was well before the Eurozone
sovereign debt crisis) or the International
Monetary Fund’s Special Drawing Rights, would
unseat the US dollar as the reserve currency of
choice (notwithstanding clamors by Russian and
Chinese authorities for alternatives).
In our 2010 Outlook, Take Stock of America,
we argued that the US economy would recover
along the paths of previous US recoveries and
that the crisis had not dealt a fatal blow to the
US as the preeminent economic and geopolitical
power; one only had to go back to similar
rhetoric about Japan and the Asian Tigers in
the late 1980s and early 1990s and about Soviet
scientists and engineers in the late 1950s to find
a road map for the US proving the “declinists”
wrong yet again.
Our view for 2011 is still constructive US
high yield bonds and US equities for our clients’
core assets. We remain optimistic about the US
on a longer term structural basis, as well. As
we discuss below, we believe the strength of
government and private sector institutions, the
resilience of the economy, the rule of law and
the respect for property rights will carry the day
for the foreseeable future. The 100% increase
in corporate earnings since their trough, the 6%
increase in productivity levels relative to pre-
crisis levels, and the historic November 2010
mid-term elections are but three examples of this
exceptional and unparalleled resilience.
As we have said before, Alexis de Tocqueville
was particularly astute some 200 years ago when
he wrote: “the greatness of America lies not in
being more enlightened than any other nation,
but rather in her ability to repair her faults”1 –
to which we would add: “quickly.”
In this year’s issue of Outlook, we carefully
examine our optimism about the US economy,
US investments and the role of US assets as a
core holding in any well-structured portfolio.
We will begin with some of the key themes
supporting our view: why the US will not face
a so-called “lost decade” similar to what Japan
suffered in the 1990s; why faster economic
4 Goldman Sachs
growth does not translate into higher equity
returns; and why the long-term structural
advantages of the US relative to other
economies – developed and emerging – lead us
to conclude that US assets should remain as the
core holding of our clients’ portfolios.
Following this thematic discussion, we present
our 2011 outlook for US and global economies,
our investment outlook for the capital markets
globally, and the multiple risks to our outlook.
As usual, we put forth our views with a strong
dose of humility, knowing full well that there is
no proverbial crystal ball.
Before we proceed, it is very important that
we highlight two key pillars of our investment
philosophy: 1) history repeats itself in many
ways and helps to provide a useful forward-
looking guide; and 2) fear and greed drive
markets to extremes, and it is those extremes
that provide the most attractive – and most
unattractive – investment opportunities. It is also
at those extremes – positive and negative – that
we often hear the expression: “This Time is
Different.” We urge our clients to be particularly
cautious when they hear those words.  They
were spoken to justify lofty Japanese equity
valuations in the late 1980s and internet stocks
in the late 1990s. Today, they are used to posit a
lost decade – or more – for the US, to justify gold
at $1400 per ounce and to allocate substantially
more assets away from US equities to emerging
market equities. Our response to this was first
said by Ecclesiastes: “There is nothing new under
the sun.”
Our view for 2011 is still constructive
US high yield bonds and US equities for
our clients’ core assets.
The US Will Not Face a “Lost Decade”
Over the last year or so, many credible – and
some not-so-credible – researchers, economists,
journalists and television commentators have
warned about the US repeating the “lost decade” in Tokyo was worth more than all the land in
of Japan. Articles with titles such as “Lost
Decade Looming?”2 and “Will the US be Jealous at 8.5 times disposable income in 2005, and had
of Japan’s Lost Decade?”3 have cascaded upon
us, prompting some clients to express concern
about their US-based investments.
During Japan’s lost decade (which, in fact, has and a greater correction was warranted.
been two decades and counting) GDP has grown
at an annualized rate of 1%, equity markets
declined by 76% peak to trough, inflation has
measured 0.4%, overnight rates have been
less than 0.25% for half the time and 10-year
bonds have been below 2% for more than half
of the time. In our view, the likelihood of the
US experiencing one or two such decades is
negligible, if not zero.
While on the surface there may be some
similarities between the US and Japan, there
are far greater and more significant differences.
The similarities are that both countries faced
a big drop in commercial and residential real
estate markets, a big decline in equity markets,
and high private sector leverage (corporate
and financial sectors in Japan, and household
and financial sectors in the US) that required
deleveraging. It is the specific prospect of
further deleveraging in the US, especially in the
household sector, that weighs on the minds of
the lost decade proponents.
The differences are the starting valuation
levels in the equity and real estate markets,
the monetary and fiscal policy responses,
government policies to address the financial
sector difficulties, productivity and demo-
graphics. These bear further discussion.
Difference One: Starting Valuation Levels
One of the most important factors to consider
is the starting level of valuations in both the real stimulus package of $787 billion, equivalent
estate and equity markets when the downturns
began. While no one valuation measure tells the
whole story, all metrics point to substantially
greater starting valuation levels in Japan than in
the US.
Investment Strategy Group
Real estate values in Japan peaked at 17 times
disposable income in 1990, having appreciated
by 182% over the prior five years. You may
remember the oft-repeated comment that at its
peak in value, the land in the Imperial Palace
California. In the US, real estate values peaked
appreciated by 77% over the prior five years.
Therefore, one can say that Japanese real estate
was 100% more overvalued than US real estate,
Similarly, Japanese stocks were more
overvalued than US stocks at the beginning of
the crisis. At the peak in Japanese equity markets
in December 1989, the Topix’s price to trailing
12-month earnings stood at 52 times; while
at its peak in October 2007, US equities’ (as
represented by the S&P 500) price to trailing
12-month earnings stood at 21 times. One can
assert that Japanese equities were as much as
250% overvalued if we compare price to trailing
12-month earnings; alternatively, one can deduce
a 60% overvaluation if we compare price to
book measures. Just like real estate, Japanese
equities had a lot further to fall.
Difference Two: Monetary and Fiscal
Policy Responses
The US monetary and fiscal policy responses
have been faster, larger and more extensive than
Japan’s were during the early stages of its crisis.
While both central banks reduced interest rates,
the Federal Reserve cut the Federal Funds rate to
1% in 14 months from peak interest rates and
to 0% within 2 months after that. The Bank of
Japan took 46 months to cut to 1% and then
another 77 months after that to cut rates to 0%.
With respect to quantitative easing, it took the
US one year from its peak in interest rates to
raise its money supply to 14% of GDP; it took
Japan nine years.
Similarly, the US announced a fiscal
to 5.6% of GDP, within a year and a half of
the equity market peak. In Japan, the actual
fiscal stimulus in the first three years was $100
billion, equivalent to 2.3% of GDP. While some
might say that the policy response in Japan
was appropriate given the growth rates and the
Outlook 5
 january 2011

Exhibit 1: US Demographics Are More limited changes in unemployment at the time,

Favorable Than Japan’s Japan’s equity and real estate markets had both
Since their respective market peaks, the workforce continues fallen further in the first downdraft than US
to grow in the US and shrink in Japan. markets. With the benefit of hindsight, we now
know that officials misread the price signals from
115
the market. In addition, a key economic indicator
Japan*
US (forecast) – the unemployment rate – was unreliable, since
110
Population of Working Age (15-64)

Japanese companies were reluctant to lay off

Indexed to Equity Market Peak**

105 workers as a matter of corporate policy.

100 We also believe that the Federal Reserve has
95 been more responsive than the Bank of Japan
because 1) it has a dual mandate of price stability
90
and stable growth, and 2) its chairman has been
85
steeped in lessons learned from both the Great
80 Depression and the lost two decades of Japan.
0 5 10 15 20 25 Chairman Ben Bernanke certainly heeds the
Years from Equity Market Peak 1905 warning of Spanish American philosopher
George Santayana: “Those who cannot
Data as of December 2010
remember the past are condemned to repeat it.”4
*Japan forecast for 2015
**Japan equity market (Topix) peaked in December 1989;
US equity market (S&P 500) peaked in October 2007 Difference Three: Government Response
Source: Investment Strategy Group, UN World Population Prospects 2008
to Financial Sector
Again, US policy makers were much more
aggressive in responding to the crisis in the
financial sector than their Japanese counterparts.
In the US, within a year of the equity market
Exhibit 2: Correlation Between Equity Returns
peak, the first financial institution failed, five
and GDP Growth
major financial institutions including Merrill
There is no stable relationship between growth and equity returns
Lynch, Wachovia and Washington Mutual
regardless of timeframe.
were sold, and the government authorized
$700 billion dollars or 5% of GDP through
0 .5 the Troubled Asset Relief Program (TARP) to
0.43
0 .4 stabilize financial institutions. In Japan, with
0 .3
0.33 government forbearance, no major banks failed
until eight years into the downdraft and the
0 .2
government only authorized 2.3% of GDP for
0 .1 0.07 funds to recapitalize the banks.
- 0 .0 Not only were Japanese policy makers slower
- 0 .1 to respond, they had a bigger problem to contend
- 0 .2
-0.12 with: financial sector leverage in Japan stood at
157% of GDP at its peak compared with 121%
-0.25
in the US. Soon, Japanese banks became known
105 Yrs 43 Yrs 42 Yrs 26 Yrs 20 Yrs 15 Yrs 10 Yrs
as zombie banks. While the term was bandied
Number of Years for Which Data is Available
about with regard to US banks when TARP Uwas S
launched, it is worthy to note 1 1 5that within two
Data as of 2005 Japan*
years of TARP, all major US1 banks
10 have repaid
Source: Investment Strategy Group, ABN-AMRO Global Investment Returns
Yearbook 2005 these funds – and all have done1 0 5 so with a profit
to the US government. Leverage 1 0 0 levels have also
been reduced to 98% of GDP since the onset of
95
the US crisis, while leverage in Japanese banks
90
85
6 Goldman Sachs 80
declined only marginally to 152% over the same
three-year window.
Difference Four: Productivity
Another key difference is changes in labor
productivity following the real estate and equity
market drops. Productivity growth decelerated
significantly in Japan in the first three years after
its real estate and equity markets collapsed.
In the US, productivity growth has actually
accelerated. This divergence can be attributed
to the faster pace of restructuring in American
companies versus the slower pace in Japan. US
companies reduced their labor force rapidly,
driving up the unemployment rates from
4.7% to over 10% in two years. In Japan, the
unemployment rate remained unchanged at
2.1% in the first two years and reached 5.5%
over the next ten years.
US productivity was also boosted by a drop in
unit labor costs of about 3% through the crisis
while in Japan, unit labor costs were actually
15% higher four years into their crisis. Aggregate
non-financial corporate leverage levels, which
peaked at 152% compared to US companies at
80%, also hampered the pace of restructuring in
Japan.
In the US, trailing 12-month corporate default
rates reached 14.7%. In Japan, default rates as
reported by Moody’s in 2010 for rated corporate
bonds stood at zero for nearly ten years into the
crisis.
The key message here is that US companies,
just like US policy makers, restructured
faster and more extensively and were able to
increase earnings by 100% – US resilience and
responsiveness at work.
Difference Five: Demographics
The last factor is perhaps one of the simplest
to identify, but virtually impossible to rectify
quickly: the unfavorable demographics in Japan
and the much more favorable demographics in
the US. As shown in Exhibit 1, Japan’s working
population has declined by more than 5% over
the last 20 years, and is expected to decline an
additional 5% over the next five years. The
working population in the US, on the other
hand, is expected to grow by more than 10%
over the next 25 years through a combination of
Investment Strategy Group
US fertility rates and immigration. In November
2010, the governor of the Bank of Japan
“crucially attributed” Japan’s lost decade to
declining productivity and declining working
population.5
Given the global significance of both
economies and the severity of their respective
crises, it is easy to see how comparisons between
the Japanese and US downturns get drawn. But
the multitude of differences between the two far
outweigh the similarities, and thus the chances
of the US experiencing a “lost” decade – or
any other significant period of time – similar to
Japan’s are very remote, indeed.
Faster Economic Growth
Does Not Result in Higher Equity
Market Returns
One of the questions we are asked most
frequently is whether our clients should allocate
an increasing share of their assets to the faster
growing emerging markets. Over the last 20
years, emerging market countries have grown
at double the rate of the US: 4.9% versus 2.5%.
Will this faster economic growth result in higher
equity returns?
All the data we have examined point to the
absence of any such relationship, and in many
cases, the data actually point to a negative
correlation. In our view, maintaining market
capitalization weighting on a strategic basis,
tactically adjusting based on valuations and
taking advantage of opportunities in the private
equity market is a more effective emerging
market investment strategy.
The most extensive authoritative studies
we have seen are those of Elroy Dimson, Paul
Marsh, and Mike Staunton from the London
Business School and of Jay Ritter from the
University of Florida. Jay Ritter, in fact, not only
provides compelling empirical evidence but also
provides rigorous theoretical analysis as to why
economic growth does not necessarily benefit
stockholders.6 The studies have examined data
across developed and emerging markets since
1900.
Outlook 7
january 2011

Dimson et al have concluded that there is no Exhibit 3: Total Annualized Equity Returns by
stable relationship between growth and equity GDP Growth Cohort
returns, as shown in Exhibit 2. The correlations Stocks in slower growing economies have actually outperformed
vacillate between virtually zero and -0.25 for the historically.
first 30 years or so and then rise to 0.43 over 42
years only to drop to virtually zero again over 43
9%
years. The point of highlighting such odd years 8% 8.0%
is to demonstrate that within the investment 7%
horizon of our clients, the relationship is negative 6% 5.9%
and beyond the investment horizon of our clients 5% 5.0%
– let’s say 40 to 100 years – the relationship is 4%
completely unstable. 3%
Similarly, our own analysis within the US 2%
has shown no statistical significance in the 1%
relationship between equity returns and pace 0%
of economic growth. A recent report published Lowest 20% Middle 60% Highest 20%

by our colleagues in Goldman Sachs Global

Economics, Commodities, and Strategy Research Data as of 2005
Note: Based on 105 years of data from 17 countries as of 2005
also showed that there was no statistically Source: Investment Strategy Group, ABN-AMRO Global Investment Returns
significant relationship between growth Yearbook 2005
conditions, as identified by a country’s growth
environment score, and subsequent equity
returns (equity valuations, on the other hand,
were more significant).7
The divergence between equity returns and Exhibit 4: GDP Growth and Equity Performance:
economic growth is even more stark when we China vs. US
look at actual returns of slower growth versus Chinese equity returns have been lower and more volatile than
faster growth countries. Dimson et al have those of the US despite better growth.
shown that if one invested in the slowest growing
quintile of countries during this hundred-year-
40%
plus period, the equity returns would have 35%
US 37.1%
China
outperformed the fastest growing quintile by 30%
3% a year as shown in Exhibit 3. Our own 25%
analysis for emerging market countries since 20%
1991 showed the equity markets of the slowest 15%
15.3%
growing countries within emerging markets 10%
10.4%
6.1%
outperformed those of the fastest growing 5% 2.6%
5.4%

countries by nearly 5% a year. 0%

China probably provides one of the best -5% -2.3% -0.9%

examples of the lack of correlation between GDP Growth* Equity Market EPS Growth** Volatility
Return
strong economic growth and equity returns.
As shown in Exhibit 4, China’s economy has
Data as of December 31, 2010
outgrown that of the US by about 8% a year The MSCI China Index is an index of H, B, Red and P Chip share
since the end of 1992 (the inception date of the classes available to foreign investors.
MSCI China equity market index). Its equity All figures are annualized.
* GDP growth through 2009
market, however, has lagged that of the US by ** EPS growth October 1995-December 2010
about 8% a year. Over the last 15 years, earnings Source: Investment Strategy Group, IMF WEO October 2010, Datastream, MSCI
per share growth in China has been negative
0.9% while that of the S&P 500 companies has
been 5.4% a year. Most recently, in 2010, China

8 Goldman Sachs
has outgrown the US by an estimated 7% but
the MSCI China Index has returned just 4.8%
(the local Shanghai Composite Index is actually
down 12.8%). On the other hand, US equities
have returned 15.1%. Since the peak of US and
Chinese equities in October 2007, China has
outgrown the US by an estimated 10% a year,
but Chinese equities have lagged the US by 2.7%
a year.
Whether it is 1 year, 3 years or 18 years,
economic growth has not translated into better
investment returns in China. That is not to say
that Chinese equities have not outperformed
US equities significantly over specific periods of
time; Chinese equities provided an annualized
return of 46.0% a year compared with US
returns of 15.0% a year between October 2002
and October 2007, during which China grew
at 11.1% a year compared with US growth of
2.6%. In general, however, the timing of entering
and exiting a market, as well as its valuations,
are much more important than faster economic
growth.
The evidence shows that faster economic
growth rates do not result in higher equity
returns. In fact, if faster growth is priced into
the equity markets, the equity markets are
most likely going to lag those of slower growth
economies. Rather, it is the unexpected changes
in economic growth rates (and earnings growth
rates) that affect stock prices. As such, we think
allocating more assets to the faster growing
emerging markets beyond market capitalization
levels is not prudent given current market
expectations and the higher valuations.
Faster growth is but one of the
arguments made to sway investors to
reduce exposure to US assets in favor
of emerging market countries. We
believe that argument is misplaced.
Investment Strategy Group
The Major Structural Advantages of
the US from an Investment Perspective
Faster growth is but one of the arguments made
to sway investors to reduce exposure to US
assets in favor of emerging market countries.
A second and more nebulous argument is that
the US is undergoing a structural decline in the
face of the emerging BRIC countries (Brazil,
Russia, India, China) – and, more specifically,
China as the dominant economy and power
of the 21st century. There is no doubt that the
annual economic growth rates of China and
India at 10.3% and 6.8% over the last 10 years
are phenomenal absolute rates. Over the same
time period, the US has grown by 1.8% per year
and the Eurozone by 1.6% per year. However,
we believe the argument that this makes the US
less attractive from an investment perspective is
misplaced.
First, we have to look at these growth rates
and see if these rates are as unprecedented as
they seem, or are they following in the footsteps
of other “Asian Tigers” who grew rapidly as they
moved from developing to advanced economies?
It is important to review the historical track
record to see whether China and, to a much
lesser extent, other emerging market countries,
are experiencing the kind of seismic shift that
would justify a significant shift in strategic asset
allocation away from the US towards emerging
market countries. In the absence of such a
fundamental turn, we believe clients should stay
the course with their US assets. Economics Nobel
Laureate Gary Becker8 and Professor Alwyn
Young of the London School of Economics have
shown that these higher growth rates are, in fact,
similar to those experienced by other countries
in a similar stage of development and by “no
means extraordinary.”9 As shown in Exhibit 5,
China has followed the export-led growth model
of other Asian economies – namely Japan and
Taiwan starting in the 1950s, Hong Kong and
Singapore in the 1960s, and Korea starting in
1960 – while relying on cheap labor. And like the
other Asian economies, it has also accumulated
huge reserves. These countries maintained 8+%
growth rates for about two decades after which
growth tapered off to the 6-8% levels. It is
important to note that the growth of these other
Outlook 9
january 2011

countries co-existed with growth, productivity Exhibit 5: 10-Year Average Annual GDP Growth Rate
and prosperity in the US. Chinese growth today is similar to other countries at a comparable
What is different about China is that it stage of development.
has maintained higher growth rates for three
decades on a substantially larger scale, and 12% Japan (1950-Present)
expectations are for 8+% annual growth for at Taiwan (1951-Present)
least another 5-10 years. But as you can note 10% Korea (1960-Present)
Singapore (1960-Present)
from Exhibit 6, China started from a lower 8%
China (1978 -2010)
Hong Kong (1960-Present)
level of GDP per capita than any other country; China (GIR Forecast)
6%
the poorer the country as measured by GDP
per capita, the higher the growth rates that can 4%
be maintained. According to the Conference
2%
Board, China’s GDP per capita started at $973
in 1978 while that of the other Asian Tigers 0%

started at anywhere from $1,568 for Taiwan +10 +15 +20 +25 +30 +35 +40 +45 +50 +55 +60 +65 +70

to $4,907 for Hong Kong (all in 2009 US Years Into Development

dollars). At its current level of $4,283 in current

nominal dollars, China’s GDP per capita is still
substantially below that of other Asian Tigers.
The second reason we believe the argument to
re-allocate assets away from the US is misplaced
is that it presumes the cyclical decline of the
US due to the financial and economic crisis will
lead to a structural decline of the US itself. Such
misplaced extrapolation has occurred repeatedly
in the US in past cyclical downturns (1973-74,
1980-82, 1990-92 are just a few recent examples
and one can find similar commentary even as
far back as 1907 after that year’s stock market
crash). The 2008-09 crisis is no different.
The argument, moreover, completely ignores
Data as of December 30, 2010
Note: GDP based on purchasing power parity
Source: Investment Strategy Group, The Conference Board Total Economy Database,
September 2010, Goldman Sachs Global Investment Research
Exhibit 6: Lower GDP Per Capita Generally Yields
Higher Growth
Poorer countries can maintain higher growth rates given their
low starting point.
12% Japan
Taiwan
10-Year Average Annual Growth Rate

Korea
the inherent structural resiliency of the US and 10%
Singapore
its institutions – which provides a direct and 8%
China
Hong Kong
positive impact on the viability, profitability, and Linear (All)
safety of our clients’ investments in the long run. 6%

The system’s fundamental structure is unique 4%

among global markets – developed or emerging
2%
– and offers distinct advantages. Below we
review each of these in detail. 0%
10,000 20,000 30,000 40,000 50,000 60,000
Advantage One: Political Structure and GDP Per Capita (2009 Dollars)
its Resilience
We think the most important structural advan- Data as of December 30, 2010
Note: GDP per capita based on Purchasing Power Parity
tage of the US – from which all other advantages Source: Investment Strategy Group, The Conference Board Total Economy Database,
emanate – is its strong, robust and resilient September 2010
system of government and governance.  Over the
course of the last 3 years, we have seen several
examples of how this structural advantage has
benefitted the US and how its absence has nega-
tively impacted other countries or regions.

10 Goldman Sachs
 We can start with the easy example of fiscal
and monetary union. As those who have been
following the European sovereign debt crisis
know, one of the biggest problems in dealing
with this crisis is the absence of fiscal union in
the presence of monetary union. Germany on its
own cannot impose its austerity standards on
Greece, Ireland or any of the other peripheral
Eurozone countries, and yet the German
electorate will have to bear the brunt of the
financing requirements of these countries. We
have to tip our hat to Alexander Hamilton, who
in 1790 realized the newly formed US political
union would only survive if it had fiscal union.
He proposed that the new federal government
assume the debts that the individual states had
incurred during the Revolutionary War so that
individual states would not abandon the union
if financial self-interest dictated it. To enlist
the support of Thomas Jefferson to vote for
the proposal (which had already been voted
down five times), he agreed to move the new
capital to the banks of the Potomac; to ensure
Pennsylvania’s support, the capital would be
moved to Philadelphia for ten years.10 Europe is
just now debating fiscal union 220 years after the
United States, with no resolution in sight!
The historic 2010 mid-term elections are
another example of de Tocqueville’s observation
that the US has a unique ability to self-correct
– that’s just what happened when the political
pendulum swung too far for a centrist nation
following the 2008 Presidential election. A
wealthy, educated and free electorate formed
advocacy groups like American Crossroads and
American Action Network to supplement the
work of the U.S. Chamber of Commerce, the
Tea Party and other Republican political groups
to change the political landscape. In November,
the Republicans gained 63 seats in the House
of Representatives; such a win was last seen in
1938. They also gained six seats in the Senate.
Similar organizations such as MoveOn.org and
Center for American Progress have been set up
in the past by Democrats to offset Republican
influence.
While many observers are concerned that
a divided government cannot deal with the
deteriorating fiscal profile in the US, we should
Investment Strategy Group
point out that five of the last six major fiscal
reforms occurred under a split government,
where each party controlled at least one house
of Congress or the White House. The December
2010 report from the National Commission on
Fiscal Responsibility and Reform, as well as the
tax compromise in the same month, both provide
some optimism that history might very well
repeat itself with both parties working together
on much needed fiscal reform.
Another very recent example of the resilience
and ingenuity of US government institutions is
the responsiveness of the Federal Reserve and
other financial regulators during the financial
crisis. It may well be too early to tell whether
all their measures were successful, but from the
rapid lowering of interest rates, to a dozen or
so other programs instituted within a month
of Lehman’s bankruptcy in 2008, to additional
liquidity facilities, temporary guarantee
programs and swap agreements with other
central banks, to the latest round of quantitative
easing, the US has acted rapidly, extensively and
decisively.
We have already contrasted US responsiveness
to that of the Bank of Japan above. The US also
stands in sharp contrast to Europe. As the US
was lowering rates rapidly in 2008, the European
Central Bank actually raised rates in August
2008. Only when the financial system was in
disarray did the ECB begin to ease. Similarly,
since the beginning of the sovereign debt crisis,
the response by the ECB and the European
Union has been somewhat “piecemeal” (as
described by IMF Managing Director Dominique
Strauss-Kahn),11 whether it is in setting up
liquidity facilities or providing emergency aid.
There are many other examples of how
the strength, stability and resilience of US
government institutions and the US system of
checks and balances have served the country in
good stead for 230 years. What major emerging
market country’s system of governance has
stood this test of time? Again, while allocating
some assets to these emerging market countries
is appropriate, one should be realistic about the
structural stability and risks inherent in all these
countries.
Outlook 11
january 2011
Advantage Two: Shareholders Are the Primary
Stakeholders
We have already discussed corporate resilience
in our discussion above comparing the US to Ja-
pan. However, it is also important to emphasize
the freedom of corporate boards and company
management to act in the best interest of share-
holders. US companies’ primary stakeholders are
their shareholders; companies are not owned by
the government and when the government has
become involved, as we have seen in this crisis,
both the companies and the government have
sought to disengage from each other as quickly
as possible. Witness the speed with which finan-
cial institutions repaid US Treasury capital, the
intensity with which AIG is seeking to return
such capital, and GM’s efforts to revive itself as
a publicly traded company with its $23.2 billion
IPO this November.
With the divestments to date, we estimate
that the US government currently owns only
2.2% of the market capitalization of US
equities. At the height of the financial crisis,
government ownership was about 3.7%. In
key emerging market countries, we estimate
that in various forms (directly and indirectly),
government ownership as a share of total market
capitalization ranges from a high of 67% in
China to 35% in Russia, 29% in India and 14%
in Brazil.
A brief review of the oil industry will best
illustrate the impact of government ownership
on shareholders in emerging market countries.
According to Ian Bremmer, President of the
Eurasia Group, three quarters of the world’s
oil reserves are now owned by state owned
enterprises, e.g. Petrobras (Brazil), CNPC
(China), and Gazprom (Russia).12 Just a
brief examination of two of these companies
demonstrates that the economic and political
interests of governments can be served ahead of
the interest of private sector shareholders.
Let’s begin with Petrobras. With its latest
rights offering in September 2010, the Brazilian
government and its affiliates own about 64%
of common voting shares and 48% of total
shares outstanding. The offering documents
state that “the Brazilian federal government,
as our principal shareholder, has pursued,
and may pursue in the future, certain of its
12 Goldman Sachs
macroeconomic and social objectives through
us.” Some have seen Petrobras’s decision to
invest in refineries in the Northeast of the
country an indication of the company being
used to serve the government’s broader interests.
According to The Economist, the government
is also drawing up requirements that Petrobras
will have to procure its oil servicing equipment
locally in an effort to create a national oil
servicing industry.13
Similarly, in China, our equity analysts in
Goldman Sachs Global Investment Research
have pointed out that due to PetroChina’s
state-owned enterprise background, “it has the
responsibility to ensure the sufficiency of supply
to the market … As such, PetroChina will likely
experience a gradual structural shift toward
relatively heavier refining exposure that has
lower returns.”14 About 86% of PetroChina is
owned by the Chinese government.
And in the context of the oil industry, we
can also highlight the risk of confiscation,
nationalization or changing production sharing
agreements in some emerging market countries.
We cannot imagine the US government
interfering in Exxon’s operations other than
in a state of national emergency. In our view,
investing in such government-dominated equity
markets requires a significant risk premium and
extremely attractive valuations – neither of
which exists at this time.
Advantage Three: Demographics, Immigration,
Education and Innovation
In a comprehensive discussion of world demo-
graphics, Nicholas Eberstadt of the American
Enterprise Institute describes how most OECD
countries and many emerging market economies
are set to experience shrinking working age
populations. The problem is most acute in Japan
and some Western European countries, but
China, Russia, Eastern European countries and
former Soviet Republics will all have the same
problem. According to Eberstadt, the biggest
drop in young working age population is “set to
take place in China,” a result of its one-child pol-
icy. Interestingly enough, he mentions the US as
the demographic exception due to the “country’s
relatively high fertility rates and its continuing
influx of immigrants.”15 Here again, the US has a
major structural advantage.
Immigration has not only enhanced US
demographics, but it has also been a source of
innovation and increased output per worker.16
According to the newly formed Partnership for
a New American Economy, immigrants were
responsible for 25% of America’s high tech start-
up companies between 1995 and 2005 and 25%
of America’s international patents were based on
the work of immigrants.
With the US having the largest influx of
immigration both on an absolute basis and
relative to any other country, we expect this
major structural advantage will continue for
the foreseeable future. As Lee Kuan Yew,
Singapore’s founding father who served as Prime
Minister for 30 years, recently said to a US
television interviewer: “You are attracting all the
adventurous minds from all over the world and
embracing them and they become part of your
team.” He goes on to mention the fact that other
cultures are not as embracing of immigrants as
the US.17
A major source of highly educated immigrants
has been US universities. 33% of all Ph.Ds
and 57% of all post-doctorates in science and
engineering from US universities were awarded
to foreign students. What is most astonishing is
that 60% of these foreign students stay in the
US for at least 10 years.18 What we found most
surprising in this educational data was that the
highest stay rate is among Chinese students: 92%
of those who received science and engineering
degrees in 2002 were still in the US in 2007.
We expect this trend to continue given
that most of the world’s top universities are
in the United States. According to the highly-
respected Times Higher Education latest
rankings, 15 of the top 20 universities in the
world are American. In the top 50, only three
are based in emerging market countries: a
Korean university ranked 28th, and two Chinese
universities ranked 37th and 49th respectively.
With the highest ranked university system, the
US has the ability to not only attract some of the
world’s greatest talent, but as the high stay rate
indicates, it also has the ability to retain most of
this talent. Of course, some emerging countries
have made significant attempts to improve their
universities: Project 985, named after the date it
Investment Strategy Group
Exhibit 7: Gross Expenditure on Research and
Development Across Regions
The US is the global leader in R&D spending.
2010 % of
2010 GERD 2010 GERD Total R&D
(PPP*, $bn) (% of GDP) Spending
Americas 446.7 2.2% 38.8%
US 395.8 2.7% 34.4%
Asia 400.4 1.9% 34.8%
Japan 142.0 3.3% 12.3%
China 141.4 1.4% 12.3%
India 33.3 0.9% 2.9%
Europe 268.6 1.6% 23.3%
Rest of World 34.8 1.2% 3.0%
Total 1150.6 1.90% 100%
Data as of December 2010
*PPP = purchasing power parity
Source: Investment Strategy Group, Battelle
was announced (May 1998), was an effort to raise
Chinese universities to the level of US Ivy League
schools.19
The US continues to dominate R&D
spending, as well. As shown in Exhibit 7, at
an estimated $396 billion, the US accounts for
34.4% of global R&D spending; all of Asia
including Japan, China and India account
for 34.8%. But it is important to note that in
an increasingly global world, R&D will be
shared more globally. Many US companies
have multiple R&D centers throughout Asia.
China has increased its R&D spending by about
10% a year over the last decade and has made
technology a cornerstone of the next phase of
the country’s growth, to the point of requiring
foreign companies who want to do business in
China to share their technology.
Nevertheless, the US still maintains a
substantial R&D lead over other countries. The
number of Nobel laureates is but one measure:
with 326 Nobel Laureates, the US accounts for
over 40% of all Nobel laureates in the world and
over 58% in the last decade. Russia stands at
25, China at 12 (two were Peace laureates; nine
received their awards while living outside
of China), India at nine, and Brazil at one.20
Outlook 13
january 2011
Advantage Four: Wealth, Natural Resources,
and Great Location
The US is an “empire of wealth.”21 At $14.6
trillion, its GDP is the highest of any country in
the world; at $47 thousand, its GDP per capita
is the highest of any country with a population
over 25 million people. It has a wealth of natural
resources and arable land as shown in Exhibit 8,
so its growth will not be hampered by a lack of
resources. No major emerging market country,
with the exception of Russia, has the same depth
and breadth of resources on a per capita basis.
The US also has the good fortune of having
an ocean on each side and a friendly and stable
Canada to the north. To the south, Mexico is
friendly, but the drug-torn border may become
a bigger problem in the future. The same can-
not be said about Asia as has been brought to
the fore most recently with North Korea’s attack
on South Korea, with Japan’s increased concern
about disputed islands in the East China Sea and
with India’s border disputes with China.
And, of course, the political and regulatory
climate in the US provides a wealth of freedom
for entrepreneurs and venture capitalists to take
advantage of the wealth of opportunities.
Some Risks
There is no doubt that the US faces its own list
of risks, with the fiscal deficit being one of the
most important, followed by concerns about
political partisanship, immigration restrictions,
geopolitics and housing. Gross government debt
in the US currently stands at 84% of GDP and
is forecasted to rise to over 100% in five years.
While this is a legitimate concern, the US has a
demonstrated ability to reduce its debt burden.
After World War II, the US reduced its debt
burden from 120% of GDP to 32% by 1981.
Over the last several decades, the government
has enacted fiscal reform multiple times – and at
each one, the process was exceedingly difficult,
as it no doubt will be now. But the recent
mid-term elections have provided some further
impetus to needed fiscal reform, and most
importantly, the US has what the International
14 Goldman Sachs
Monetary Fund has called “fiscal space.” Given
its reserve currency status and deep and liquid
financial markets, the US has the fiscal space
to have at least some time to tackle its debt
problems.
With respect to the great concerns about too
much partisanship in Washington, Joseph Nye of
Harvard University notes that the “sourness of
current US politics” needs to be considered in the
context of history, and is arguably less serious
than that of the past during McCarthyism, the
civil right movements and abolition of slavery.22
More recent examples include the Vietnam
era and Nixon era. In other words, the US has
experienced much more extreme partisanship in
the past and that did not sideline the growth and
prosperity of the country.
Nye warns, however, that if the country
were to turn inward and curtail immigration,
it would be of “grave concern.” Immigration
has generally been a bi-partisan issue; while
current high unemployment rates have increased
anti-immigration sentiment, the majority of
Americans still favor immigration. To that
effect, the likes of Rupert Murdoch and Mayor
Bloomberg have gathered forces to form a new
private sector advocacy group – Partnership for
a New American Economy – to influence the
political process in favor of immigration.
Geopolitical risks are another important
worry. In addition to armed conflicts – ongoing
or potential – around the world, there is a real
threat from non-nation-state factors described by
Nye as “terrorists who traffic weapons, hackers
who threaten cybersecurity and challenges such
as pandemics.” We also recognize that there
is still uncertainty with respect to the housing
market (touched upon later in this report).
The overhang of inventory and the volume of
foreclosures could contribute to weaker growth;
however, we believe the housing sector is at or
close to the bottom of its cycle.
To our readers who are responding to our
clear US optimism in this year’s Outlook by
wondering – like our client mentioned above
– if we are a group of Pollyanna-ish “America
boosters,” let us provide a demographic
snapshot of the Investment Strategy Group.
Our team is comprised primarily of investment
professionals born outside the United States.
 Exhibit 8: The US Has a Wealth of Natural Resources and Arable Land
The United States’ proven reserves per capita are among the highest in the world.

Energy Unit United States China Brazil India Russia World

Oil Barrels 92 11 64 5 532 197
Natural Gas Thousand cubic meters 22 1.8 2 1 318 28
Coal Tonnes 768 86 35 50 1,126 122
Uranium Kilograms 1.5 0.1 – – – 0.6
Metals and Minerals
Copper Kilograms 113 23 – – 143 80
Zinc Kilograms 45 25 – 9 – 30
Nickel Kilograms – 0.8 22 – 47 10.5
Gold Grams 9.7 1.4 10 – 36 6.9
Potash Kilograms 290 150 1,492 – 12,913 1,256
Rare Earths Kilograms 42 27 0 – – 15
Agriculture
Total renewable water resources Cubic meters 9,893 2,127 40,939 1,626 32,269 n/a*
Irrigated land Square meters 722 410 145 476 330 n/a*
Arable land Square meters 5,705 1,098 2,934 1,368 8,795 n/a*

Data as of December 31, 2010

*CIA data not provided
Resources per capita are immaterial where fields are left blank.
Source: BP Statistical Review of the World, World Energy Council Survey of Energy Resources 2010, USGS Annual Mineral Commodity Summaries, CIA

In fact, many harken back to emerging

market countries: Brazil, Bulgaria, China,
Colombia, Czech Republic, India/Kenya, Iran,
Lebanon, Lithuania and Morocco to name
a few. We have lived in these countries and
compare and contrast the strength, stability
and sustainability of their private sector and
government institutions to those of the US.
We conclude that the unique combination of
factors discussed above – the very same ones
that underlie “American exceptionalism” – is
alive and well; hence our recommendation to
maintain core assets in the US while having a
measured strategic allocation to emerging market
equities and opportunistically looking for tactical
exposures to emerging market equities and debt,
much like our current emerging market local
debt tilt. n

Investment Strategy Group Outlook 15

 january 2011

2011 Global
Economic Outlook

This year’s global economic landscape contains policy and currency appreciation. In contrast,
a simple paradox: while the direction of the the large output gaps and tepid growth in most
world’s economies has rarely been more syn- of the developed world have made deflation the
chronized, the level of their growth has seldom more prevalent fear, providing ample cover for
been more divergent. Indeed, in the spirit of accommodative monetary policy and fostering
Dickens’ A Tale of Two Cities, the growth a desire for weaker currencies. Within the
differential between emerging and developed Eurozone, the challenge is even more daunting,
economies, or Europe’s core and peripheral given the disparate health of the core and
economies, is striking (Exhibit 10). As a result, periphery. The one-size-fits-all position of the
nominal GDP has already exceeded its 2008 European Central Bank (ECB) is likely to remain
peak in much of the emerging world, while it problematic, especially while the unemployment
remains below that level in most of Eurozone, rate in Spain is 20% versus only 7% in Germany.
as well as Japan. In a rare sliver of commonality, we expect
These different axes of growth have interest rates to trend higher this year in most
important implications for each region’s markets around the world, a function of both
economic outlook. As shown in Exhibit 11, better growth and historically low policy rates.
above-trend growth in emerging markets has Against this backdrop, we believe the
already reduced much of their excess capacity, interplay between growth, inflation and policy
fueling inflationary pressures, tighter monetary will not only drive economic developments

Exhibit 9: ISG Economic Outlook for Developed Markets

Our forecast features relatively tame inflation, still-accommodative monetary policy, and continued normalization of interest rates.

United States Eurozone Japan United Kingdom

Current 2011 Forecast Current 2011 Forecast Current 2011 Forecast Current 2011 Forecast
Real GDP* 2.8% 3.0 – 3.5% 1.7% 1.0 – 2.0% 3.2% 1.5 – 2.0% 1.7% 1.25 – 2.25%
Headline CPI** 1.1% 1.25 – 2.0% 1.9% 1.25 – 2.0% 0.1% (0.5) – 0.25% 3.3% 3.0 – 3.75%
10-Year Rate 3.29% 3.5 – 4.25% 2.96% 3.00 – 3.75% 1.12% 1.25 – 2.0% 3.40% 3.75 – 4.5%
Policy Rate 0.0 – 0.25% 0.0 – 0.25% 1.0% 1.0% 0.1% 0.1% 0.5% 0.5 – 1.0%

Data as of December 31, 2010

Current real GDP are Economist consensus estimates for 2010 real GDP growth.
* For current headline CPI readings we show the year-over-year inflation rate for the most recent month available.
** Source: Investment Strategy Group, The Economist

16 Goldman Sachs
 Exhibit 10: “A Tale of Two Cities” within regions, but across them as well. Even
The expected GDP growth differential between emerging and now, better US growth visibility is providing
developed economies or Europe’s core and periphery is striking. a catalyst for additional emerging market
tightening, as fear of a US double-dip recession
7%
likely kept emerging market policy easier than
6.4% domestic growth warranted.
6%
A summary of our GDP, inflation and interest
5% rate forecasts for the developed economies is
4% presented in Exhibit 9, while our emerging
3% market views are presented later in Exhibit 17.
2.0% 1.8%
2%

1% 0.6%
0%
Emerging Developed Core* Periphery** US Economic Outlook
Markets Markets

Global Eurozone In thinking about the resilience of the US econo-

my, and the US consumer in particular, we were
Data as of December 28, 2010 reminded of Mark Twain’s famous quip, “The
Note: Growth expectations are IMF forecasts (purchasing power parity weighted)
reports of my death are greatly exaggerated.”
Source: Investment Strategy Group, Datastream, IMF WEO October 2010
* Eurozone core = Germany, France, Austria, Belgium, and the Netherlands For despite numerous macroeconomic assaults
** Eurozone periphery = Portugal, Ireland, Italy, Greece, and Spain last year, US consumers nonetheless managed
to push adjusted retail and food service sales to
within 1% of their 2007 high.
Given that consumption constitutes 70% of
US GDP, its trajectory is naturally vital to any
Exhibit 11: Economic Slack Is Being Reduced Much US economic forecast. But this recent pickup
Faster in Emerging vs. Developed Economies in spending is important for another reason:
Rapidly narrowing output gaps in emerging markets are leading to it marks a critical shift in the mix of growth
inflationary pressures, monetary tightening, and currency appreciation. away from purely transient drivers. Indeed,
the lion’s share of growth since mid-2009 has
4% come from inventory re-stocking and fiscal
Forecast stimulus, not core consumption. Encouragingly,
2%
Actual GDP Less Potential GDP as a

growth excluding these temporary factors rose

dramatically in late 2010, laying the foundation
Percent of Potential GDP

0%
for more enduring gains this year.
-2%
As shown in Exhibit 12, our forecast builds
-4% on this theme. Whereas consumption represented
-6%
less than half of 2010 GDP growth, we expect
Developed Markets it to contribute about two-thirds this year,
-8% Emerging Markets
with the balance of growth arising from capital
Jan-07 Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10 Feb-11 Sep-11 Apr-12
investment. Moving in the opposite direction,
inventories are forecast to have no growth
Data as of Q3 2010
impact in 2011. This marks a noteworthy change
Source: Investment Strategy Group, Goldman Sachs Global Investment Research
from last year, when they represented over half
of total growth.
Our optimism is rooted in the prospect for
higher business investment and improvements
in the key drivers of consumption. Namely,
we think strengthening employment and

Investment Strategy Group Outlook 17

january 2011

accommodative fiscal/monetary policy will Exhibit 12: US Real GDP by Component

benefit consumer spending, while the upward Our forecast features a notable shift away from transient
trend in the savings rate, a significant drag on inventory gains toward consumption and investment.
consumption since the financial crisis began, will
stabilize. For their part, businesses are expected Share of ISG Central ISG Central
to unlock their cash coffers, supporting higher Component GDP* Case 2010 Case 2011
investment levels and better employment growth. Consumption 70% 1.2% 2.0%
Below we discuss our expectations for each of Residential Investment 2% -0.1% 0.1%
these key components of 2011 growth. Non-Residential Investment 10% 0.6% 0.9%
Change in Inventories 1% 1.5% 0.0%
Business Investment Government 20% 0.2% 0.1%
After massive retrenchment in response to the Net Trade -4% -0.6% 0.0%
financial crisis, business investment turned Total 100% 2.5 – 3.0% 3.0 – 3.5%
decisively higher in the second quarter of 2010
and accelerated in the third. We believe this  Data as of December 21, 2010
trend is likely to continue for several reasons. * Shares may not add up to 100% due to rounding
First, corporations are under-investing now, as Source: Investment Strategy Group

capital expenditures are less than depreciation

expenses for 70% of the S&P 500. Partly as a
result, firms have ample funds to deploy, with
cash representing 11% of total assets, the highest
level in decades. Second, recent fiscal stimulus,
including R&D and depreciation credits,
provides an additional investment incentive.
Third, the economic and political uncertainty
that has hindered business investment continues
to dissipate, especially with perceptions of a
more business-friendly tone emanating from
Washington now. Finally, and perhaps most
importantly, profit growth has historically been
a leading indicator for investment, as seen in
Exhibit 13. Given the strong profit gains of this
cycle, there is ample scope for investment growth
to follow.
In fact, this robust profit growth is one of the
key differences between this financial crisis and
its predecessors, as it has led to a tremendous
pool of investable capital (Exhibit 14). Of
course, profits tend to lead not only to capital
investment, but also to employment gains. No
wonder, then, that the historical correlation
between the two has been over 80%.
Perhaps former German chancellor Helmut
Schmidt said it best, “Today’s profits are
tomorrow’s investments and the jobs of the day
after.”
Employment
While there is little question that employment
gains have been paltry thus far, we see ample
scope for improvement in 2011. For example,
temporary help jobs, aggregate hours worked,
and corporate profits – all leading indicators of
employment – continue on a strong upward tra-
jectory. In addition, the 4-week moving average
of initial unemployment claims, another leading
indicator, has fallen to its lowest level since July
of 2008. Coupled with ongoing improvement
in continuing claims, the upshot is that overall
claimants are now falling, an important shift in
trend. This message was echoed by November
2010’s ISM non-manufacturing employment
index, which recaptured a pre-crisis level last
seen in October 2007. Not to be left out, small
businesses, often considered the engine of job
growth in the US, have also recently increased
their hiring plans, according to the NFIB Small
Business Hiring Plans Index.
Of equal importance, the number of available
jobs is increasing, with 3 million job vacancies
reported in the latest Bureau of Labor Statistics
Job Openings and Labor Turnover Survey
(JOLTs), the highest level since late 2008. Even
so, many have questioned this improvement,
arguing that the available unemployed cannot
be “matched” with these open positions. While

18 Goldman Sachs
 Exhibit 13: Profit Growth Tends to Lead Business Perhaps former German chancellor
Investment Helmut Schmidt said it best: “Today’s
Today’s strong profit gains bode well for further non-residential
investment growth.
profits are tomorrow’s investments and
the jobs of the day after.”
60% Corporate Profits*
50% Non-Residential Investment
40%
Year over Year Percent Change

30%
20% 26.4%
10% 8.2%
0%
-10%
-20%
-30%
-40%
54 58 62 66 70 74 78 82 86 90 94 98 02 06 10

Data as of Q3 2010
* Profits include inventory valuation and capital consumption adjustments
Source: Investment Strategy Group, Datastream

Exhibit 14: Profits are Higher Today Than During

Previous Financial Crises
Corporate profits as a percent of GDP now stand well above the
levels seen in Japan during the 1990’s or the US Great Depression.

12% 11.2%

10%

8%

6%
4.8%
4% 3.3%

2%

0%
US: 1930s Japan: 1990s US: Q3 2010

Data as of Q3 2010
Note: US profits include inventory valuation and capital consumption adjustments.
Source: Investment Strategy Group, Datastream, Empirical Research Partners,
US Department of Commerce

Investment Strategy Group Outlook 19

january 2011

Exhibit 15: Share of Unemployment Rate it’s clear from Exhibit 15 that such matching
Attributable to “Matching Inefficiencies” inefficiencies are higher than normal in this cycle,
The ability of today’s labor market to match the unemployed with we note that they are less than 1982, a period
open jobs is no worse than in 1982, a year followed by impressive when unemployment nonetheless fell from
employment gains. 10.6% to 7.3% over two years. As such, it is
still too soon to call this a “jobless” recovery, in
our view.
12%
11.0%
10.0%
10% Savings
8% Despite the incessantly negative headlines
6.5% about deleveraging, US consumers may be
6%
further along in repairing their balance sheets
4% than many think. Over the last three years, the
savings rate in the US has more than tripled,
2%
from 1.7% to its current 5.7%. This fits neatly
0% with the conclusions of two recent International
1982 2009 Average Monetary Fund (IMF) reports that found that
1976 – 2009
an appropriate savings level, incorporating
consumers’ need to further reduce debt, was
Source: Investment Strategy Group, Empirical Research Partners
between 4.75-7%.23 In other words, the current
level is already close to the median of the IMF
range. Meanwhile, other measures suggest
the savings rate may already be too high. For
example, household assets to GDP have had
a 90% negative correlation with the savings
rate in the post-World War II period (as asset
values rise, the need to save falls). Currently, this
relationship suggests that lower end of the IMF
range is more appropriate.

Despite the incessantly negative

headlines about deleveraging, US
consumers may be further along in
repairing their balance sheets than
many think.

20 Goldman Sachs
 In addition to improved savings, several other
indicators suggest that consumer deleveraging
is well advanced, including the ongoing decline
in banks’ non-performing consumer loans, the
marked decline in early stage delinquencies and
the resulting relaxation of lending standards.
Taken together, these improvements support our
view that the savings rate will stabilize around
current levels. Bear in mind that it’s the change
in the saving rate, not the level, that matters for
GDP growth. In other words, it is only when
the savings rate is rising that it acts as a drag on
growth. Once it stabilizes, the pace of income
growth is what matters.
On this last point, we are comforted by
the fact that 51% of income is comprised of
wages, which should benefit from our more
optimistic view on employment. In addition,
capital income, which represents another 26%,
should increase given strong market gains and
increasing dividend payments by corporations.
Thus, roughly 80% of the individual income
components should benefit from the positive
tailwinds we expect.
Of equal importance, we think the extension
of the Bush tax cuts and unemployment benefits
removes the biggest downside risk to income
growth and, in fact, adds about $175 billion
or 1.5% to disposable income growth this
year. Indeed, we have said since 2008 that our
greatest concern was a policy error, but the US
appears to be effectively avoiding the Depression
era blunders of premature fiscal and monetary
tightening by implementing more fiscal stimulus
and a second round of quantitative easing. In
turn, these easier financial conditions should
manifest themselves in stronger economic growth
this year, given their historically strong leading
relationship. Against this backdrop, consumer
and business confidence should improve, as fears
of a double-dip recession fade.
On the back of these views, we expect above
consensus real GDP growth of 3.0-3.5% this
year, as shown in Exhibit 9. Despite stronger
growth, our inflation views remain tame, given
the still-excessive slack in the US economy. As
just two examples, capacity utilization stood
at around 75.2% as of November 2010, well
below its long-term average of 80.9%, while
the unemployment rate has only been higher
Investment Strategy Group
2% of the time since 1950. With inflation
below the Federal Reserve’s comfort level, and
unemployment above, we expect the Fed to
remain on hold this year, despite better growth.
In our view, it will likely take many years
of sustained real GDP growth of 3-4% to
return unemployment to its long-term average
of around 6%. Even so, interest rates should
move higher this year, as stronger growth
raises expectations of eventual monetary policy
tightening, and inflation expectations advance
toward their longer-term averages.
Eurozone
Our economic growth outlook for Eurozone is
best summarized as a strong core, combined with
a weak periphery, yielding a mediocre average.
Regardless of the measure, the differences
between these two cohorts are stark. Spain’s
unemployment rate, for example, is around
20%, while Germany’s is just 7%. And whereas
Germany need only reduce its deficit by three
percentage points to achieve fiscal sustainability
by 2030, the comparable threshold for Ireland
is 12 percentage points, according to IMF
estimates.
Not surprisingly, the resulting growth profile
of the region is mixed, with Germany growing
3.6% in the first three quarters of 2010, while
Italy and Spain grew just 1.1% and 0.4%,
respectively. As a result, Germany accounted
for 60% of Eurozone growth since the second
quarter of 2009, despite representing only 30%
of the area’s GDP.
We expect these divergences to persist in
2011, with Germany outperforming the region
and peripheral Europe struggling with anemic
growth. Overall, our forecast calls for 1-2%
GDP growth this year. As in the US, we expect
inflation to be subdued, as likely hikes in the
VAT and rising oil prices counterbalance the
deflationary impulse from the implementation of
various austerity measures. Despite this, German
long-term rates should rise, given the better
growth profile we expect. A summary of our
views for Eurozone is presented in Exhibit 9.
Outlook 21
january 2011
United Kingdom
Given that net exports constitute 20% of the
UK’s GDP, improving global growth should
disproportionately benefit the UK, especially
with the sterling arguably cheap. But while
we expect positive contributions from net
trade this year, the relatively tepid growth we
envision for Eurozone (the UK’s main trading
partner, representing 50% of exports) serves
as a headwind. In addition, the newly formed
coalition government has made cutting the
budget deficit a key priority. As a result,
government spending, which grew at an 11.5%
annual rate last year, is set to be flat to slightly
down this year and contract about £81bn (~6%
of GDP) over the next five years.
Against this backdrop, we expect moderate
GDP growth of 1.25-2.25% this year (Exhibit
9). Unlike many of its developed market
counterparts, however, inflation is likely to
remain a problem in the UK. The main culprits
have been higher value-added taxes (VAT) and
energy prices, which together have kept inflation
above the Bank of England’s (BOE) 2% target
for the last 11 months. Unfortunately, this
upward pressure is unlikely to abate soon, as a
further VAT increase and higher gas prices from
UK utilities are on the docket for this year. As a
result, we expect the BOE to start hiking rates
in late 2011, although at 0.5-1.0%, the absolute
level will remain low by historical standards. In restocking cycle, emerging market growth has
turn, we think long-term interest rates should
rise over the course of the year.
Japan
As we highlighted last year, the Japanese
economy was one of the primary casualties of the (Exhibit 16).
global crisis, as exports collapsed a remarkable
36.5%, contributing to an 8.6% peak to trough
decline in GDP. But as global growth has
improved, this same dynamic has worked in the
opposite direction: exports have risen close to
50% from their first quarter 2009 trough, with
exports to Asian countries now close to pre-crisis a problem magnified by food’s 28% share of
levels last seen in 2007. Furthermore, although
22 Goldman Sachs
net trade is only 5% of Japanese GDP, it
represented over half of last year’s total growth.
Another third of Japanese growth arose from
fiscal stimulus, which boosted consumption
directly by subsidizing durable goods purchases.
With exports approaching pre-crisis levels
where they will likely level off, we believe net
trade will contribute significantly less to GDP
growth this year. Moreover, while the govern-
ment is considering new stimulus measures,
they are likely to be limited by the magnitude of
Japan’s budget deficits and public debt. Acting
as an offset, fixed investment should strengthen
on the back of strong corporate earnings and the
recovery in exports. Weighing these factors
against each other, we expect GDP to grow 1.5-
2.0% this year, as shown in Exhibit 9.
Against this backdrop of low growth and
persistent deflation, we expect monetary policy
to remain accommodative. As a result, we
think long bond rates should remain anchored,
particularly with the Bank of Japan likely to
resume Japanese Government Bond (JGB)
purchases.
Emerging Markets
On the back of a pronounced global inventory
recovered more rapidly, and to higher levels,
than that of developed economies. Indeed,
emerging markets real GDP expanded nearly 5
percentage points faster than developed markets
in 2010. Confirming our intuition from last year,
the highly synchronized nature of the downturn
has also worked in reverse, with exports to the
developed world serving as a key transmission
mechanism for emerging market recovery
But with growth come challenges. Many
emerging markets have now recaptured, and
in many cases exceeded, their trend growth
levels. In turn, these positive “output gaps”
have stoked inflationary pressures. To date,
much of the rise in prices is attributable to food,
emerging market consumer price index (CPI)
 baskets, a weighting close to double that in
the G-10 CPI. While overall inflation has only
returned to average pre-crisis levels, the concern
is that stronger global growth coupled with
monetary policy that is arguably too loose in
many emerging markets could push inflation
still higher. Not surprisingly, a variety of
emerging market countries have already begun
to tighten monetary policy, and have allowed
their currencies to appreciate. This interaction
between above-trend growth, price pressures,
and monetary policy emerges as a clear theme in
the individual country and regional discussions
that follow. A summary of our emerging market
Exhibit 16: Emerging Market Growth Remains
growth views is presented in Exhibit 17.
Synchronized to the Developed World
Despite different levels of real GDP growth, emerging and
Emerging Asia
developed economies have not decoupled.
As home to both China and India, it’s not
surprising that Emerging Asia is both the largest
and fastest growing region in the emerging 12%
Forecast*
markets. While growth should moderate 10%

somewhat as the global restocking cycle wanes 8%

6%
this year, strong domestic demand provides
4%
an offset. With continuing growth, inflation
2%
pressures will persist. In response, we expect
0%
further policy tightening, most likely in the form
-2%
of rate hikes and currency appreciation, but with -4%
G-3 EM ex. BRICs
EM All World
the potential for additional capital controls. -6% BRICs
Policy will also be shaped by capital inflows, 1995 1997 1999 2001 2003 2005 2007 2009 2011
which are likely to remain substantial given the
region’s strong GDP growth and undervalued Data as of December 30, 2010
exchange rates. Even so, as long as inflation does Note: G-3 is comprised of the US, Eurozone, and Japan.
*Average of IMF and Goldman Sachs Global Investment Research forecasts
not accelerate or become more broad-based, Source: Investment Strategy Group, IMF WEO October 2010,
policymakers are likely to move cautiously, at least Goldman Sachs Global Investment Research
until they see clearer evidence of an entrenched
recovery in the United States and Europe.

Exhibit 17: ISG Economic Outlook for Emerging Markets

We expect high growth to lead to increased inflationary pressures.

China Brazil India Russia

Current 2011 Forecast Current 2011 Forecast Current 2011 Forecast Current 2011 Forecast
Real GDP* 10.2% 8.75% – 9.75% 7.5% 4.0% – 5.0% 8.8% 8.0% – 9.0% 4.0% 3.5% – 5.0%
Headline CPI** 5.1% 4.0% – 5.0% 5.6% 5.0% – 6.5% 7.5% 5.5% – 7.5% 8.1% 7.0% – 9.0%

Data as of December 31, 2010

* Current real GDP are Economist consensus estimates for 2010 real GDP growth.
** For current headline CPI readings we show the year-over-year inflation rate for the most recent month available. WPI is shown for India. IPCA Inflation is shown for Brazil.
Source: Investment Strategy Group, The Economist, CEIC Database

Investment Strategy Group Outlook 23

january 2011
China We expect Chinese GDP growth of
around 8.75-9.75% in 2011, reflecting a mix of
still-strong domestic demand and government
investment tempered by fading government
stimulus. While a hard landing remains unlikely
despite China’s numerous structural challenges,
we do worry about the recent trajectory of infla-
tion. Indeed, inflation rose to 5.1% year-over-
year in late 2010, above the government’s – and
markets’ – comfort zone.
While the authorities have already begun to
tighten monetary policy in response to the rise
in inflation, we expect further action, including
reserve requirement increases, interest rate hikes,
loan guidance, and possibly measures directed
at the property sector. More unconventional
measures, such as direct price controls, are
also possible and have been alluded to by
policymakers. Against this backdrop, we expect
inflation to be 4.0-5.0% in 2011.
While we remain concerned about the
medium-term risks to China’s development,
near-term risks are more balanced. While
stronger than expected US growth could
boost China’s GDP, it could also intensify
pricing pressures. In response, the authorities
might inadvertently tighten too much as they
implement progressively more blunt monetary
tools. While this is not our base case, it’s a risk inflation will reside with the central bank, as
we are carefully monitoring given the negative
implications for growth, commodity prices and
market sentiment.
India The Indian economy staged a strong re-
covery in 2010, supported by investment, ample see inflation in the 5.0-6.5% range in 2011, close
credit, rising consumption and, to a lesser extent, to the upper band of Brazil’s inflation target.
a recovery in exports. As liquidity conditions
tighten and investment moderates, we expect
GDP growth to ease to 8-9% this year. Even so,
with demand outpacing output, we think infla-
tion is likely to remain elevated at 5.5-7.5%.
In addition to inflation, India’s widening
current account deficit is worrisome, as the
capital flows financing it are increasingly
investment related. As a result, India is now
more susceptible to sudden stops in external
financing, should investors lose their appetite
for India.
24 Goldman Sachs
Latin America
Latin America made an impressive recovery
in 2010, helped by rising commodity prices,
the global restocking cycle and surging credit.
Although we expect the global restocking cycle
to wane, continued domestic demand and
loan growth should still support healthy GDP
growth. As a result, central banks are likely to
further tighten monetary policy to keep inflation
expectations in check. However, as in Asia,
policymakers will move cautiously to avoid
attracting additional speculative capital inflows,
especially as this could fuel currency appreciation
pressures. As such, additional capital controls are
possible, but given the region’s need for external
financing, they are less likely to be stringent, in
our view.
Brazil After an exceptionally strong recovery last
year, we expect GDP growth to decelerate to a
more normal 4%-5% in 2011. This is helpful,
as the current heady pace of domestic demand
growth is fueling inflationary pressures (which
have started to creep into core CPI) and a widen-
ing current account deficit. The latter is trou-
bling, as it is placing upward pressure on Brazil’s
already over-valued currency.
As is typical in Brazil, the burden of curbing
fiscal policy has remained somewhat loose and
is unlikely to be meaningfully tightened under
the new administration. The central bank will
probably move cautiously, not wanting to invite
more capital inflows. Against this backdrop, we
Europe, Middle East, Africa (EMEA)
EMEA has lagged the strong recovery seen
in other emerging markets – especially the
countries in Central and Eastern Europe – given
its dependence on external financing during
the 2009 crisis and close links to the European
Union (EU) business cycle. While ongoing fiscal
consolidation and the region’s large exposure
to the troubled EU will act as a headwind,
we expect the recovery that began in 2010 to
continue, supported by improving labor markets
and low real interest rates. Even so, with growth
still well below trend, EMEA should avoid the
inflationary pressures facing most of its emerging
market brethren, in our view.
Within the region, we believe Turkey stands
out as best-positioned to outgrow expectations.
Domestic demand is accelerating, fueled by high
wage growth. Meanwhile, currency appreciation,
which has helped to contain inflation, is likely
to decelerate, as the Turkish lira has become
overvalued. On the other hand, Hungary is
most likely to disappoint, as the country is most
vulnerable to further escalation of the sovereign
debt crisis in peripheral Europe.

Russia
Among the BRICs, Russia has underperformed
in both directions, suffering the sharpest
slowdown in 2009 and recording only a
modest recovery last year. While the economy
did benefit from the rebound in global energy
prices and expansionary fiscal policy last year,
overall growth lagged as the summer draught
undermined domestic consumption. Looking
forward, we believe consumption is unlikely to
recapture pre-crisis levels this year, as banks have
recently tightened lending standards, thereby
limiting consumer credit.
On a more positive note, fixed investment
in Russia has begun to recover and is expected
to be an important driver of GDP growth in
2011, which we forecast to be 3.5%-5%. While
the level of inflation is high at around 8% as of
late 2010, it has remained well below pre-crisis
levels, a reflection of moderate demand pressures
and more proactive monetary policy that is
steadily moving toward an inflation-targeting
framework. As such, our expected inflation
range is 7-9% this year. n

Investment Strategy Group Outlook 25

january 2011
2011 Financial
Markets Outlook
The equity market has an uncanny ability of
changing the locks right when investors think
they have found the keys. Consider the March
2009 low, when portfolios positioned for the
next Great Depression were caught wrong-
footed by forceful policy action. More recently,
at the April 2010 high, renewed concerns about
fiscal sustainability in Europe punished investors
who had just begun to wade begrudgingly
back into stocks. Both instances emphasize the
interplay between policy and positioning in
response to systemic fears, a central feature of
the market backdrop of the last few years. As
a result, investment success has had more to
do with anticipating the various “risk on, risk
off” phases than with traditional fundamental
analysis, despite the resilience of global growth
and corporate profitability over this period.
We believe the uncertainty, defensive
positioning and high correlations across assets
that this “risk-on, risk-off” mentality engendered
have important implications for this year’s
investment landscape. In particular, we think the
transition to a self-sustaining economic recovery
will ease some of this uncertainty and support
the following key themes:
Stocks over Bonds and Cash
Accelerating growth coupled with accommoda-
tive policy is a powerful elixir for stocks, espe-
cially given current undemanding valuations.
At the same time, this backdrop is negative for
bonds, as normalizing interest rates penalize
duration. Cash returns are even worse, given
the Federal Reserve’s commitment to keeping
26 Goldman Sachs
short-rates low. The low opportunity cost hurdle
of cash and bonds, paired against the improv-
ing backdrop for equities, suggests stocks can
continue to outperform, just as they have for the
last two years (Exhibit 19).
Falling Correlations
When macroeconomic risks dominate the invest-
ment landscape, as they did last year, correla-
tions across all assets increase, as idiosyncratic
fundamentals are trumped by systemic fears. For
example, the percentage of S&P 500 stocks mov-
ing in the same direction over the last six months
of 2010 was close to 80%, a level exceeded
only 2% of the time since 1972. This dynamic
was not limited to equities, however, as correla-
tions among the majority of ISG’s strategic asset
classes remain near all time highs (Exhibit 18).
Despite their elevated current levels, we expect
the mean-reverting nature of correlations, in ad-
dition to their tendency to fall as economic stress
abates, to reward fundamental analysis and ac-
tive management going forward.
Active over Passive Management
The investment landscape described above has
been particularly toxic for active managers, as
stock picking became secondary to market tim-
ing. To make matters worse, the performance
differential between individual stocks, a crucial
driver of active manager alpha, was historically
low last quarter, as the best 50 S&P 500 stocks
outperformed the worst 50 by around 40 per-
centage points, well below the 50% long-term
average. This combination contributed to the
Exhibit 18: Correlations Across Assets Remain
Elevated

1.0 Last 12-Months Cross-Correlation*

0.9 Average
0.8 0.78
0.7
0.6 0.58
0.5
0.4
0.3
0.2
0.1
0.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Data as of November 30, 2010

* Average 1 year correlation between the following asset classes: High Yield, US
Large Cap Value, US Large Cap Growth, US Small Cap, Non-US Equity, EM Equity,
Relative Value Hedge Funds, Event Driven Hedge Funds, Equity Long/Short Hedge
Funds, Macro/Tactical Trading Hedge Funds, Buyout Private Equity (Proxy),
Mezzanine Private Equity (Proxy), Distressed Private Equity (Proxy), Venture Private
Equity (Proxy), Energy Private Equity (Proxy), Private Real Estate (Proxy)
Source: Investment Strategy Group, Datastream, MSCI

Exhibit 19: 2010 Asset Class Performance

Risk assets outperformed again in 2010.

20% 19.2%

15.7%
15.1% 15.1%
15%

10% 9.0%
8.2%
7.2%
6.5%
5%
3.1%

0%

-0.9%
-5%
Emerging Emerging Barclays US Equity Goldman Non-US Multi- Barclays Barclays US Trade
Markets Markets Debt High Sachs Equity Strategy Aggregate Muni 1-10 Weighted
Equity (Local) Yield Commodities Hedge Dollar
Index Funds*

Note: Returns are total returns in USD.

* Performance through November 30, 2010
Source: Investment Strategy Group, Datastream, Barclays Capital, Credit Suisse
Indices used: Emerging Markets (MSCI Emerging Markets Index); Emerging Markets Debt (JP Morgan GBI EM Global Diversified Index); US Equity (S&P 500 Index);
Goldman Sachs Commodities Index (S&P GSCI Total Return Index); Non-US Equity (MSCI EAFE Index); Multi-Strategy Hedge Funds (modeled using the following mix
of styles: 10% Relative Value (Blend of CSFB/Tremont Indices: 20% Convertible Arbitrage, 40% Equity Market Neutral, 40% Fixed Income Arbitrage Indices), 35%
Event Driven (CSFB/Tremont Event Driven Index), 35% Equity Long/Short (CSFB/Tremont Equity Long/Short Index), and 20% Macro/Tactical Trading (Blend of CSFB/Tremont
Indices: 50% Global Macro, 50% Managed Futures Indices)

Investment Strategy Group Outlook 27

january 2011

worst year on record for active managers, with
just a quarter of them topping their benchmark.
As a result, retail and institutional investors have
pulled almost $750 billion from active managers
since the beginning of 2008, representing nearly
10% of assets under management, according to
Empirical Research Partners.
Against this backdrop, we see two catalysts
Exhibit 20: Abundant Free Cash Flow Provides Ample
Fodder for Increased Spending
The combined free cash flow of US consumers and businesses as a
percent of GDP stands at a 50-year high.
12%
10.2%
10%

that should favor active management going 8%

forward. The first is the historical tendency for
6%
active stock selection to outperform for several
years after periods of high correlations and low 4%
performance spreads.24 Secondly, we note that
2%
correlations typically fall rapidly in the third year
of equity market recoveries, as classic business 0%
cycle dynamics replace systemic fears. Taken 54 58 62 66 70 74 78 82 86 90 94 98 02 06 10

together, we think these tendencies will provide

a positive tailwind to active management going 1952 Through Q3 2010
Note: Based on 1500 largest US stocks, excluding financials and utilities
forward. Source: Investment Strategy Group, Empirical Research Partners, US Department of
Commerce, Corporate Reports

Shareholder-Friendly Capital Deployment

There is little question that global corporations
are cash-rich. In the US, non-financial companies
had nearly $2 trillion in cash and equivalents
at the end of September 2010, according to the
Federal Reserve. Among the S&P 500 non-
financials, cash levels have grown almost 40%
since 2008 and now represent around 11%
of total corporate assets, the highest level in
decades. In fact, based on projected free cash
flow this year, corporations must spend an
additional $300 billion just to keep their cash
Exhibit 21: Percent of Time US Valuations Have Been
Less than Current Levels Since 1974
Regardless of measure, today’s US valuations stand around the
mid-point of their historical ranges.
100%
90%
80%

coffers from growing. Including the positive 70%

60% 54.1%
contribution from consumer deleveraging we 50%
49.4%
53.4%

discussed earlier, Exhibit 20 shows that total 40%

business and consumer cash flow has reached a 30%
staggering 10.2% of GDP, by far the highest level 20%
in over 50 years. 10%

As the uncertainty that has thus far served 0%

Price to Trend Price to Peak Price to Book
as an impediment to capital deployment recedes Earnings Earnings
this year, we expect firms to increase their pace
of capital deployment. On this point, we note Data as of December 30, 2010
that the current 28% dividend payout ratio Source: Investment Strategy Group, Datastream, Robert Shiller
stands well below its long term average of 43%.
Moreover, almost 80% of S&P 500 companies
reduced their share count through buybacks in
2010, a trend we expect to intensify this year.
Indeed, given still-low borrowing costs and high
earnings yields, it is actually accretive to earnings
for about one-fifth of S&P 500 firms to issue

28 Goldman Sachs
debt to repurchase shares (a so-called “leveraged
recap” strategy). Lastly, as corporations search
for ways to bolster organic growth, we think
increased merger and acquisition activity is
likely, particularly with many companies still
trading at attractive valuations.
US Equities: The Ascendancy
of Earnings
Perhaps one of the biggest surprises of 2010 was
the endurance of corporate profitability. Despite
anemic developed market growth, a European
sovereign debt crisis and global political uncer-
tainty, US companies managed to top consensus
earnings expectations by some 8-10% each
quarter. The result has been remarkable earnings
growth, with trailing twelve-month S&P 500 op-
erating earnings doubling since the third quarter
of 2009. In fact, economy-wide profits, includ-
ing both public and private companies, stood at
an all-time high as of the third quarter of 2010.
The big question, of course, is where do we
go from here? To develop our equity market
outlook, we consider four major factors:
Valuations
As shown in Exhibit 21, today’s S&P 500 valu-
ations are not demanding, residing around the
mid-point of their historical ranges, on aver-
age. Thus, while the valuation dislocation that
characterized the March 2009 low has passed,
we are far from reaching lofty multiples. In fact,
multiples could potentially expand further from
current levels, given the prevailing low interest
rate environment. Based on our analysis, dur-
ing similar historical periods of low interest
rates, the price-to-trend earnings multiple (our
preferred valuation measure) generally resided
several points above its current level.
That said, our willingness to assume that
multiples expand in our central case is tempered
by several factors. One, rising interest rates are
often a headwind to expanding multiples, as
was the case in 2003-2006. Our central case
assumes that rates continue to normalize this
year, as economic growth strengthens. Two, the
Investment Strategy Group
Fed traditionally has not raised short rates until
loan growth resumes, just as it did in both 1994
and 2004. With leading indicators suggesting
that loan growth will resume in mid-2011,
market participants’ memory of the Fed’s actions
may keep multiples in check, even if the Fed
ultimately breaks precedence by keeping rates
low. Finally, several provisions in the broader tax
reform bill will expire at the end of 2011, which
could rekindle fears of a fiscal drag on growth
in early 2012, thereby reducing the multiple
investors are willing to pay at the end of this
year.
Fundamentals
Naturally, the pace of the earnings recovery de-
scribed above has led to concerns about its sus-
tainability, with investors troubled by a potential
peak in profit margins and/or earnings growth.
On the latter concern, the level of earnings is
more important than the growth rate, since the
market ultimately follows the path of profits,
as seen in Exhibit 22. As a result, even if profit
growth did peak in 2010, it has historically taken
another two to three years before the level of
earnings fell. This dynamic was clear in the last
cycle, as earnings growth peaked in July of 2004,
more than three years before market prices did.
Exhibit 22: The Market Ultimately Follows the Path
of Earnings
1800 S&P 500 Price (LHS) 100
Operating Earnings Level (RHS) 90
1600
1400 80
1200
70
1000
60
800
50
40
600
30
400 20
200 10
0 0
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Data as of December 31, 2010
Source: Investment Strategy Group, Intrinsic Research
Outlook 29
january 2011

Exhibit 23: Today’s High Incremental Margins costs currently, supporting margin durability.
Enable S&P 500 Firms to Spend More Without Lastly, the yield curve tends to lead corporate
Destroying Profitability profitability by two to three quarters. As such,
Every dollar of new sales generated around 25 cents of net profit we believe the steep slope of today’s yield curve
in the third quarter of 2010. relative to history suggests a meaningful profit
contraction is not yet in sight.
40%
35.0%
Base Margin* Technicals
35% Incremental Margin**
The S&P 500’s technical configuration is consis-
30% tent with a strong uptrend in underlying prices,
25.3%
25% as the 50-day moving average is comfortably
20% above the 200-day moving average, and both are
15% rising. Importantly, the market’s late-2010 push
10.3%
10% 9.4% 2.8% to new highs was broad-based, as evidenced by
5% the cumulative advancing-less-declining issues
0% index simultaneously making fresh highs. In con-
Q2 2010 Q3 2010 trast, market peaks, such as those in 2000 and
2007, are characterized by a notable contraction
Data as of Q3 2010 in the number of advancing shares.
* Net income/sales There are also two historically reliable
** Change in net income/change in sales
Source: Investment Strategy Group, Bloomberg, Empirical Research Partners technical patterns that may prove consequential
this year. First, 2011 is the third year of the
presidential cycle. Looking at data since 1900,
this period has generated positive returns 95%
of the time when the economy was expanding,
Moreover, with global economic growth set to with price gains of around 21%, almost double
accelerate in 2011, it is hard to imagine the level the full period average. Second, it is often
of earnings declining, in our view. noted that the best gains of the year occur from
Of course, earnings could still falter if November to April. Less discussed is whether
margins collapse, but significant margin erosion the returns preceding this period shape the
is unlikely for several reasons. First, S&P 500 subsequent outcome. Based on an interesting
40
companies are still benefitting from a high study by SentimenTrader,25 it appears they do.
35
degree of operating leverage. As can be seen in If the market navigates the traditionally volatile
30
Exhibit 23, every dollar of new sales generated September-October period without a hiccup,
25 25
cents of net profit in the third quarter. This as it did in 2010, then 80% of the following
20 “incremental” margin provides firms with
large November-April periods experienced a positive
15
a healthy buffer from which to hire and increase return, with a median gain at the best point
10 expenditures without significantly
capital of nearly +13% and not one instance of a
5
compromising their profitability. Second, correction greater than -10%.
margins
0 tend to follow the business cycle, falling
just as new recessions begin, generally at a
time when unemployment is at low levels and
unit labor costs are high. The absence of these
conditions today makes a significant decline
in margins unlikely. In fact, corporate pricing
power appears to be rising faster than unit labor

30 Goldman Sachs
 Exhibit 24: Cumulative US Mutual Fund Flows Sentiment / Positioning
Since Market Bottom in March 2009 While much has been made of the upturn in
Despite the S&P 500’s almost 90% rally since the trough, investors equity sentiment late in 2010, it is hard to argue
have pulled over $100 billion out of US equity mutual funds. that investors are bullish on US equities when
considering Exhibit 24. Remarkably, despite the
S&P 500’s 80%+ rally since the March 2009
700 US Equity Flows
US Fixed Income Flows 596 trough, there have been over $100 billion of
Net Inflows to Mutual Funds ($ Billion)

600
500
outflows from US equity mutual funds over that
400
time. In fact, US household bond holdings now
300 represent around 21% of total discretionary
200 financial assets, a level that has been higher only
100 10% of the time since 1952. In addition, the
0 ratio of money market funds to equities remains
-100 above its long-term average, suggesting scope
-200 -113 for further flows out of cash and into the stock
Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 market (Exhibit 25).
For their part, institutions have been no
Data as of December 21, 2010 warmer toward stocks, with large endowments
Source: Investment Strategy Group, Datastream, ICI
now having just 15% of their assets allocated
to long equities, down from 25% in 2006,
according to Cambridge Associates. Not to
be left out, sell side analysts have also joined
the retreat. Of the roughly 160,000 analyst
Exhibit 25: There Is Still Plenty of Sidelined Cash
recommendations compiled by Bloomberg on US
That Could Flow Into Equities
stocks, only 29% represent buy ratings, a far cry
The ratio of cash to S&P 500 market cap remains above its
from the 75% that prevailed at the height of the
long-term average, providing scope for further equity flows.
internet bubble in June of 2000.
Historically, the catalysts for a shift in
70% Money Market Mutual Funds Net Assets flows back into equities have been threefold:
as % of S&P 500 Market Cap
60% Average
confidence in the durability of the economic
50%
recovery, negative returns in bonds as rates
normalize higher and, paradoxically, higher
40%
equity prices. Our central case scenario features
30%
26% all three, suggesting the incipient uptick in equity
20% 21% fund flows late in 2010 may persist, especially
10% with ostensibly “risk-free” Treasuries delivering
0%
a notable loss in the fourth quarter. In fact,
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
fixed income mutual funds saw their fourth-
largest redemption on record in late 2010,
1990 Through November 2010 while broader fixed income was on course for
Source: Investment Strategy Group, Datastream, ICI its worst quarterly performance in a decade.26
Our conclusion at the end of 2009 is as relevant
today: even moderate rebalancing toward stocks
by retail investors, who represent 85% of mutual
fund owners, would represent a sizable tailwind
to equities this year. Indeed, given the data just
presented, capitulation from bond funds may
have already begun.

Investment Strategy Group Outlook 31

january 2011

Our View on the US Market Eurozone

Taking these four factors together, our work
suggests the market is poised to deliver around
8% total returns to the mid-point of our forecast
range this year, as shown in Exhibit 28. This
return is underpinned by mid-to-high single digit
earnings growth, a level roughly in line with the
trend over the last 30 years. The upside to our
central case could come about through higher
valuation multiples, to which we assign a 25%
probability in our good case.
Turning to sectors, we continue to like
large capitalization US banks, where attractive
valuations, falling credit costs, negative
sentiment and resumed capital deployment
via dividends/buybacks should support higher
share prices, in our view. Moreover, the stronger
employment trajectory we expect this year
should boost bank profits, especially since
credit costs are already falling despite extremely
elevated unemployment. The pharmaceutical
sector is another area we are investigating, as
valuations appear reasonable and dividend
yields are attractive. We think clarity on what
the growth profile of the industry will be after
patent expirations could provide a catalyst for
outperformance around mid-year. Until then, we
continue to prefer more cyclical sectors.
Beyond 2011, we think the market is priced
to deliver average total returns of about 7% per
year, assuming earnings and multiples normalize
over the next three to five years. While below
As seen in Exhibit 26, the core of Europe dra-
matically outperformed the periphery last year.
At issue stands the uneven fiscal health of the
various sovereigns within the EU, and for the
weaker among them, their ability to honor
austerity measures. Related to this, we believe
the condition of each country’s banking system
remains a key equity performance driver. More
fundamentally, investors’ question whether
having monetary union without fiscal union is
inherently flawed.
Given the structural nature of these concerns,
European equities do appear somewhat
undervalued on a few measures. Even so, when
we take the average of our preferred valuation
metrics, Europe is priced around the midpoint of
its historical range over the last 35 years, having
been cheaper about 50% of the time. The signal
is more favorable relative to US valuations,
however, as Europe currently trades at about
a 40% discount, compared to its long-term
average of 34%.
Exhibit 26: Equity Markets in the Core of Europe
Dramatically Outperformed the Periphery in 2010
50%
39.0
40%

the historical average for US equities, this return 30%

23.6
remains attractive relative to investment grade 20%
13.4 14.514.8
fixed income and cash. As such, we continue to 10% 8.1 8.5 8.6
4.6 6.3
recommend clients build toward (or maintain) 0%
their strategic allocation to equities. -1.0 -0.3
-10%
-8.7
-20% -14.1-11.9
-20.2
-30%

-40%

-50% -42.6
Portugal

U.K.
Belgium
Ireland

Switzerland

Sweden
Austria
Finland
Spain
Greece

Germany
Italy

France

Netherlands

Stoxx 600
Norway

Denmark

Data as of December 31, 2010

Source: Investment Strategy Group, Datastream

32 Goldman Sachs
Exhibit 27: ISG US Equity Scenarios – Year-End 2011

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

End 2011 Op. Earnings $96 Op. Earnings $88 – 93 Op. Earnings ≤ $70
S&P 500 Earnings Rep. Earnings $85 Rep. Earnings $75 – 79 Rep. Earnings ≤ $53
Trend Rep. Earnings $74 Trend Rep. Earnings $74 Trend Rep. Earnings ≤ $74
S&P 500 18.5 – 20.0x 15.5 – 18.5x 12 – 14x
Price-to-Trend Reported Earnings
End 2011 1376 – 1487 1153 – 1376 892 – 1041
S&P 500 Fundamental
Valuation Range
End 2011 1450 1300 – 1375 1000
S&P 500 Price Target (based on a
combination of trend and forward
earnings estimates)

Data as of December 31, 2010

Source: Investment Strategy Group

It is important to note, however, that the

region’s relative undervaluation is concentrated We continue to recommend clients
in the financial sector. In total, financials build toward (or maintain) their
account for almost a quarter of total market
capitalization in Europe, the largest sector by
strategic allocation to equities.
far. In addition, the least expensive countries in
the Eurozone, Spain and Italy, have the largest
financial sector market cap concentration, at
42% and 34%, respectively.
Notably, our analysis suggests Eurozone
financials may not be as undervalued as they
appear. Although European financials trade at
an attractive 0.9 times book value, adjusting this
for likely losses suggests a multiple closer to 1.2
times, not far from fair value given a normalized
ROE expectation of 8-10%. Moreover, we think
bank multiples should be lower now, given the
inability of many ailing European sovereigns
to continue to financially support their banks.
Finally, European banks are by far the largest
holders of troubled peripheral debt, increasing
their risk profile. According to the Bank of
International Settlements, European banks have
some $2.2 trillion of exposure to Greece, Ireland,
Italy, Portugal and Spain.

Investment Strategy Group Outlook 33

january 2011

Exhibit 28: ISG Global Equity Targets – Year-End 2011

While we expect global equity markets to be higher this year, risk-adjusted returns favor the developed markets.

Implied Upside from Current Implied Volatility

Country Reference Index Current Level 2011 Target Range Current Levels Dividend Yield Total Return Since 1988
US S&P 500 1258 1300 – 1375 3 – 9% 1.8% 5 – 11% 15.1%
Europe Stoxx 600 276 300 – 320 9 – 16% 3.1% 12 – 19% 16.2%
UK FTSE 100 5900 6200 – 6600 5 – 12% 3.1% 8 – 15% 15.1%
Japan Topix 899 1080 – 1180 20 – 31% 2.0% 22 – 33% 19.8%
Emerging Markets MSCI Emerging Markets 48171 48700 – 53500 1 – 11% 3.0% 4 – 14% 23.4%

Data as of December 31, 2010

Source: Investment Strategy Group, Datastream

Given the disparate health of various EU
members, we think the wide dispersion in
individual country returns will likely persist.
While we are mindful that significant fiscal
adjustments do not necessarily entail equity
underperformance – as is clearly shown in
Exhibit 29 – we think ongoing financial
concerns could remain a headwind for valuation
multiples. As a result, we are tactically neutral
on European equities, but think investors should
maintain their strategic weight. Tactically, our
preference is to gain exposure to Europe through
our Eurostoxx 50 dividend swap tilt. While we
are still exposed to dividend risk in this tilt, its
returns are driven by dividend levels, not stock
price levels; as a result, it allows us to participate
in earnings-driven upside without having to bear
the risk of multiples contracting.
In our view, Japan offers the most
compelling risk/reward trade-off of the
global equity markets.
United Kingdom
With middling valuation levels compared to both
its own history and the US’s, the case for UK
equity investment does not rest with cheapness,
especially since valuation multiples are likely to
be kept in check by persistent inflation that has
remained above the government’s 2% inflation
target for 11 months. Instead, UK equities largely
reflect a view on both the financial and com-
modity sectors, as these together represent over
half the FTSE 100 market cap. On this score, the
message is mixed. While energy and financials
appear attractively valued, and UK banks seem
to have manageable exposure to peripheral Eu-
rope, the materials sector, which comprises about
15% of the country’s market capitalization, is
now the most expensive.
Thus, while the valuation backdrop is not
clear-cut, the country’s exposure to global
growth is attractive given our constructive
cyclical outlook. Indeed, over 80% of FTSE
100 sales come from outside the UK, with
two-thirds of that emanating from the faster
growing economies of the US, Asia and emerging
markets. Given this global orientation, the 10%
undervaluation of the sterling relative to the euro
is a strong export tailwind, as 32% of FTSE
100 sales originate in Europe. Our equity
return expectations for the UK are presented in
Exhibit 28.

34 Goldman Sachs
Exhibit 29: Fiscal Austerity Plans Do Not Necessarily Lead to Poor Equity Performance
Countries undertaking fiscal adjustment actually saw their equity markets outperform on a relative and absolute basis historically.

Annualized Performance
Fiscal Adjustment Absolute vs. MSCI World
Starting Ending Local USD Local USD
Denmark 1982 1986 10% 10% -8% -9%
Belgium 1984 1998 16% 19% 4% 6%
Greece 1989 2001 18% 10% 12% 4%
Ireland 1988 1996 12% 12% 4% 4%
Sweden 1983 1988 23% 27% 6% 5%
Finland 1993 2000 49% 46% 37% 34%
Italy 1989 1997 7% 4% 0% -4%
UK 1993 1999 13% 14% -3% -2%
France 1993 1997 12% 10% -1% -3%
Austria 1995 2001 0% -5% -9% -12%
Netherlands 1990 2000 14% 12% 7% 5%

Average 16% 14% 4% 3%

Median 13% 12% 4% 4%

Data as of December 31, 2010

Source: Investment Strategy Group, Datastream, BCA

Japan Exhibit 30: Japanese Valuations Have Rarely

Been Cheaper
In our view, Japan offers the most compelling Since 1992, MSCI Japan valuations have only been lower than current
risk/reward trade-off of the global equity mar- levels 6.5% of the time.
kets, as all four of our investment pillars are
supportive. As shown in Exhibit 30, we find
Percent of Time MSCI Japan Valuations Have

100%
that absolute valuations provide an attractive
90%
margin of safety, having been lower than cur- 80%
Been Less than Current

rent levels only 6.5% of the time since 1992. 70%

Furthermore, on a relative basis, Japan is trading 60%
at a bigger discount to the US and Australasia, 50%

Europe and Far East (EAFE) than it has histori- 40%

30%
cally. Importantly, if multiples returned just to 23.7%
20%
their 12-month highs, which themselves stand 10% 8.9%
30% below long-term averages, the Topix would 0% 6.5%
generate a double-digit return. 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
We think such a scenario is likely, given
the better than expected progression of 1992 through December 30, 2010
Note: Based on price to long-term cash flow, price to trailing 12 month cash flow,
fundamentals. Japanese earnings have exceeded
price to book, and price to peak earnings. The percent of time less than current is
expectations in each quarter of the recovery so calculated on a cumulative basis, i.e. at each point in time, the current valuation
far, despite Japanese yen (JPY) appreciation. level is compared to valuations during all periods prior to that point in time.
Source: Investment Strategy Group, Datastream, MSCI

Investment Strategy Group Outlook 35

january 2011

In fact, investors may systematically overreact medium-term indicators suggesting that the
to JPY strength, as our work suggests global underlying price trend is rotating higher.
demand is a far more important driver of Against this backdrop, we see three potential
Japanese profits (Exhibit 31). On this point, catalysts on the horizon. One, the divergence
accelerating global growth this year should between Japan’s consistently positive earnings
directly benefit Japan’s export-driven earnings, revisions and market performance should
which constitute more than half of corporate resolve in favor of fundamentals, with the
profit growth. In addition, we believe the high market ultimately following the path of higher
operating leverage resulting from cost cutting, earnings. Two, policy in Japan, both monetary
coupled with margins that stand well below and fiscal, is likely to remain accommodative,
historical peaks, provide ample scope for a comparative benefit as other Asian exporters
continued positive earnings surprises. facing inflationary pressures are likely to tighten.
In addition to supportive fundamentals, we Moreover, the anticipated cut in corporate
see several other reasons for optimism. Global tax rates should help corporate Japan’s
active managers are broadly underweight relative competitiveness. And three, our more
Japanese stocks, a potential tailwind as these constructive view on the US should strengthen
positions are reversed. In addition, foreign the US dollar relative to JPY, a positive tailwind
buyers, historically the marginal purchasers of to Japanese equities given the recent strong
Japanese equities, have recently showed renewed negative correlation.
interest. Lastly, we think the technical profile This year’s expectations for the Topix are set
of the market is improving, with short- and forth in Exhibit 28.

Exhibit 31: Global Demand Is Far More Important to Exhibit 32: Despite Higher Growth Last Year, BRIC
Japanese Corporate Profits Than Yen Fluctuations Equities Underperformed the US

25% 23.7% 16% 15.1%

BRICs
21.7%
14% US
Percent Explained by Each Factor

20%
12%

15% 10%
8.3%
8% 7.4%
10% 9.0% 6%
4%
5% 2.8%
2%
0.6%
0% 0%
Goldman Sachs US Retail JPY 2010 Equity Performance 2010 GDP Growth
China Activity Sales (Consensus Forecast)
Index

1992 Through Q3 2010 Data as of December 31, 2010

Source: Investment Strategy Group, Goldman Sachs Global Investment Source: Investment Strategy Group, Datastream, IMF WEO October 2010, The Economist
Research, Datastream

36 Goldman Sachs
Emerging Markets: Growth,
But At What Price?
It may come as a surprise that despite signifi-
cantly higher emerging market (EM) economic
growth last year, emerging market equities
did little better than their counterparts in the
Exhibit 33: Emerging Markets Look Expensive on a
Relative Basis
On average, emerging markets have been cheaper than current
relative to developed markets about 77% of the time historically.
100%

Percent of Time EM Multiple/DM Multiple

90%
slower-growing US. In fact, this unexceptional 80% 77.8% 78.9% 78.8% 77.3%
73.7%

Has Been Less than Current

performance came despite emerging markets’ 70%
impressive 30% earnings growth. As can be seen 60%
in Exhibit 32, the BRIC markets, in particular, 50%
40%
lagged. As a group, they returned around 7.4%
30%
in local currency terms, less than a half of the 20%
S&P 500’s total return, despite growth that was, 10%
on average, over five percentage points higher. 0%
While there is little question that the Price to Price to Dividend Price to Average
structural growth profile of emerging markets Book Long-Term Yield* Forward
Cash Flow Earnings
is attractive, the more pertinent investment
consideration is what one is paying for that Data as of December 30, 2010
growth. A large part of the performance drag * Percent of time EM dividend yield – DM dividend yield has been greater than current.
this year resulted from valuation compression, Source: Investment Strategy Group, Datastream, MSCI

as emerging markets started the year with lofty

valuations. Unfortunately, valuations remain
unattractive today, in our view. On an absolute
basis, EM valuations are roughly 8% overvalued
and have been lower about 70% of the time Exhibit 34: Inflationary Pressures Have Not Been
historically. Compared to developed markets, Good for Emerging Market Valuations Historically
valuations are even more stretched, sitting some
20% above traditional levels. As shown in 15 Median 12M Change in P/E* (LHS) 8%
Exhibit 33, these relative valuations, regardless Median 12M Change in Inflation Led 5 Months**
6%

12 Month Change in Inflation (pp.)

10 (RHS inverted)
of measure, have been cheaper about 77% of the
4%
time. 5
At least part of this valuation premium 2%
0
has rested on the scarcity value of growth, 0%
especially in a “new normal” environment, -5
-2%
where developed markets offered limited growth -10 -4%
prospects. But the recent upward revision to
-15 -6%
mature economies’ outlooks, especially the US’s,
02 03 04 05 06 07 08 09 10
has narrowed this differential and may well
pressure EM valuations further. After all, equity
Data as of December 2010
returns are far more sensitive to surprises in *Median 12M Change in P/E among MSCI EM Index constituents
growth than absolute growth levels. It stands to **Median 12M Change in CPI among MSCI EM Index constituents
reason, then, that better US growth expectations Source: Investment Strategy Group, Datastream

in late 2010 drove its relative outperformance,

even though EM economic expansion remained
considerably faster.

Investment Strategy Group Outlook 37

january 2011
This growth sensitivity is particularly acute
in emerging markets, given already elevated
expectations. For example, consensus long-
term earnings growth forecasts stand at 18%,
leaving little margin for error. Moreover, as
we highlighted in last year’s Outlook, long-
term structural growth trends are frequently
eclipsed by cyclical factors over a shorter time
horizon. As such, stronger growth in emerging
markets today is fueling inflationary concerns,
with the upward pressure on policy rates a clear
headwind to valuation multiples, as shown in
Exhibit 34.
Against this backdrop, we think the
exuberant sentiment toward EM equities
provides a cautionary signal to contrarians.
Investors’ thirst for growth exposure has fueled
significant inflows into EM mutual funds. In
fact, EPFR Global estimates that 70% of all
global equity fund flows (both mutual and
institutional funds) have accrued to emerging
markets, a remarkable statistic. In addition, the
combined net assets of the two largest emerging
market ETFs now exceed the size of the S&P 500
SPDR (SPY), despite the fact that the US equity
market is some 4 times the size of the investable
EM universe. For their part, institutional
investors have followed suit, with a recent
survey showing a record percentage of portfolio
managers overweight. This bullish positioning
is very similar to the start of 2008 and 2010 –
both periods preceding bouts of risk-adjusted
emerging market underperformance.
This is not to suggest that there aren’t pockets
of opportunity in the emerging markets. Russia
continues to screen well in our work, benefitting
from an undervalued currency and equity
market, as well as earnings that remain below
trend. Moreover, Russia can be seen as a natural
vehicle to express a bullish oil view, given that
the energy sector constitutes nearly 60% of the
MSCI Russia Index. Across EM more broadly,
the energy, technology and telecom sectors also
appear attractive.
While the structural story behind growing
EM domestic demand is alluring, the investment
vehicles to capture it are hard to access and/or
very expensive. Consumer staple stocks in India,
for example, currently trade at around 8 times
book value! Furthermore, we find purchasing the
38 Goldman Sachs
EM index outright is too general an approach,
as just 14% of market cap is represented by
domestic-facing sectors. For these reasons, we
continue to believe an investor can get cheaper,
more transparent and less volatile access to
underlying emerging market growth by owning
fairly valued multinationals. These firms actually
sell into emerging market regions, as opposed to
the local indices which largely capture the profits
of emerging market exporters.
In summary, although our expected EM
returns are in line with our US forecasts, risk-
adjusted returns are less attractive, given the
higher volatility of emerging markets. As a result,
we retain our neutral weighting as our generally
constructive growth view makes meaningful
emerging market underperformance less likely.
As was the case last year, we prefer to express
our positive stance on long-term emerging
market growth through our currency and EM
local debt tilts, as well as selective exposure
through EM private equity funds, rather than
EM equities outright.
2011 Global Currency Outlook
Although exchange rates have always been an
instrument of monetary policy, fears that they
are becoming a weapon of trade have intensified
recently. To be sure, provocative headlines such
as “G20 Currency Fist Fight Rolls into Town”27
or “Currency Wars: A Fight to be Weaker”28
haven’t helped. At the core of the issue is
whether large global trade imbalances and
the uneven growth trajectories of the world’s
economies will result in the type of full-scale
competitive currency devaluations prevalent
during the Great Depression. Indeed, recent
quantitative easing in the developed world,
as well as greater capital controls in emerging
markets, are seen by many as the opening salvo
of a brewing currency war.
Notwithstanding further sensationalist
headlines, we think it’s unlikely that currency
wars or widespread trade protectionism will
erupt this year. Such events typically result
during periods of very weak global demand –
such as that seen during the Great Depression
– when countries desperately tried to resuscitate
domestic demand through competitive
devaluation. In contrast to the 1930’s, today’s
global growth remains relatively resilient, despite
expansion that is still below potential in much
of the developed world. Moreover, stronger US
growth recently has lifted the dollar, at least
partially easing global exchange rate tensions
that followed the greenback’s weakness (from
“flight to quality” flows) into early November
2010.
We note that exchange rates also benefit
from a natural self-correcting tendency. Thus,
even if many emerging countries wished to
devalue, their faster growth, rising inflation
and faster policy normalization necessitates
currency appreciation instead. While some
have fretted about various emerging markets’
use of capital controls to prevent overheating,
such controls are nothing new, as nearly every
emerging country has some form of them in
place. Importantly, most of these controls have
represented more market-friendly restrictions by
taxing, rather than banning, inflows. As long as
large net inflows to emerging markets continue,
we expect both incremental capital controls
and further currency intervention in 2011.
While these may slow down appreciation and
reduce short-term speculative inflows, we do not
expect such measures to reverse the moderate
currency appreciation trend in emerging markets,
especially in Asia.
It is also important to recall that globalization
itself has reduced the potential for currency wars.
By significantly increasing the interdependency of
countries, the cost of a serious escalation is much
higher for everyone, particularly the US and
China. Furthermore, countries today have more
constructive ways of addressing trade disputes
than resorting to competitive devaluation. To
wit, the World Trade Organization (WTO) now
represents most of the global economy, enabling
members to voice protectionist concerns on the
debate floor without causing a major impact
on the underlying currency flows. Thus, while
the “Currency War” proclamations are likely to
continue, we do not expect them to materially
disrupt the currency views we present next.
Investment Strategy Group
US Dollar
Despite alarming newspaper headlines calling
for the imminent collapse of the US dollar
(USD), we see several factors supporting its
appreciation over the medium term, primarily
relative to developed currencies. Chief among
these is valuation. With the dollar having already
depreciated close to 40% since 2002, it now
stands about one standard deviation below its
long-term average on a real trade-weighted basis.
Historically, such valuation levels have preceded
nominal appreciation over the subsequent 3-5
years.
Of equal importance, all currencies reflect
relative and not absolute fundamentals. Thus,
while it is true the US has high budget deficits,
so do most developed economies. In fact, the
reserve currency status of the USD affords the
government more time to address its fiscal issues
before the market challenges them, particularly
with roughly two-thirds of the world’s total
allocated foreign exchange reserves held in
dollars. Most developed economies also have
historically low interest rates, have employed
some form of quantitative easing and face
substantial slack in their economies. Indeed,
because of this excess slack, we put very low
odds on hyperinflation, since the Federal Reserve
has both the time and the tools available to
extract the liquidity it has provided. As such, we
view these frequently cited dollar concerns as
necessary, but not sufficient, conditions for USD
weakness.
If anything, recent upward revisions to US
growth and the widening growth differential to
the bulk of the developed world supports further
dollar strength, particularly against the euro.
In contrast, many emerging markets’ tighter
monetary policies in response to overheating
Although exchange rates have always
been an instrument of monetary policy,
fears that they are becoming a weapon
of trade have intensified recently.
Outlook 39
january 2011
risks provide scope for some relative dollar
weakness, especially to Asia. We are tactically
positioned for both euro weakness and Asian
currency strength.
Of course, while the dollar might be the
“best house in a bad neighborhood” among
major developed currencies, many have begun
to question the legitimacy of all fiat money. To
them, the solution lies in returning to the “gold
standard” under which each country’s currency
is backed by a fixed amount of gold. In theory,
this would assure long-term price stability and
curtail central bankers’ self-directed money
printing, thereby minimizing excess leverage
and credit bubbles – the root causes of financial
crises.
But whatever accolades the gold standard
wins for its simplicity, it loses for its
impracticality. First, implementation would be
highly deflationary, since world GDP growth
would be limited by annual gold production
growth, which is currently just 1.5%. Second,
short-term prices would be extremely unstable,
as each major gold discovery would translate
into a global price shock. Third, macroeconomic
volatility would increase and unemployment
would rise, given the limits on central bankers
to offset shocks through policy adjustments.
Notably, as seen in Exhibit 35, GDP volatility
was higher when the gold standard was in place,
averaging about 5.8% in 1900-1944, vs. only
1.2% in 1984-2010.
On this point, Barry Eichengreen, a leading
expert on the gold standard, argues that far
from being the stabilizing influence it was
perceived to be, the gold standard was itself the
main threat to financial stability and prosperity
between World Wars I and II. Indeed, the gold
standard contributed to the Great Depression
by forcing central banks to raise interest rates to
maintain parity between their currency and gold,
even though their economies were already in
recession. Finally, like a cartel, the gold standard
only works if all members adhere to it. But as
history has repeatedly shown, members are likely
to abandon the standard during times of crisis,
defeating its very purpose. As such, we think
restoring the gold standard is as ill-advised as it
is unlikely.
40 Goldman Sachs
Euro
As mentioned above, we are tactically short the
euro relative to the USD, a reflection of several
underlying factors. For one, the euro is some 10-
15% overvalued compared to the dollar, making
valuations unattractive, in our view. Second,
relative fundamentals in the US are improving,
particularly with the US expected to outgrow
Europe in the medium-term. Moreover, risks to
Eurozone growth are skewed to the downside, as
political uncertainty in four of the most fragile
European economies (Ireland, Portugal, Italy
and Belgium) could undermine necessary fiscal
reform there.
Meanwhile, financial contagion remains
a concern, as Portugal will likely need to be
bailed out, while existing mechanisms such as
the European Financial Stability Facility (EFSF)
and the related European Financial Stability
Mechanism (EFSM) are insufficient to save Spain
if it were to follow suit. In short, continued
uncertainties around Eurozone’s fiscal challenges,
in addition to better relative fundamentals in the
US, do not justify the euro’s valuation premium,
in our view.
Pound Sterling
The pound remains fairly valued against the
US dollar, while about 10% undervalued rela-
tive to the euro. As such, we expect the pound
to remain relatively range-bound compared to
the USD, despite the small positive carry likely
to result from the Bank of England tightening
before the Fed. In contrast, we think the pound
should slowly appreciate against the euro, given
supportive valuations and ongoing political and
economic uncertainty in the Eurozone. Higher
interest rates and our expectation that the Bank
of England tightens ahead of the ECB are also
positive catalysts. Of course, renewed concerns
around UK fiscal sustainability could hurt the
pound, as they did during the 2010 election cam-
paign, but this is not our central case.
Yen Exhibit 35: GDP Volatility Was Higher Under the
The valuation signal for the JPY is mixed. While Gold Standard
the currency appears somewhat overvalued rela- The 20-quarter rolling annualized volatility of US GDP growth has
tive to the dollar on some measures, the extent of fallen significantly over time.
this overvaluation differs significantly. Moreover,
on a trade-weighted basis, valuation is neutral. 12%
Turning to fundamentals, the yen is highly corre-
lated with the yield differential between Japanese 10% 1900-1944
government bonds and US Treasuries: as Trea- 8% Average = 5.8%
sury yields declined from their April 2010 highs,
6%
the JPY appreciated. Given our expectation for
1945-1983
better growth and rising rates in the US, we think 4% Average = 2.9%
the resulting yield differential will likely weigh 1984-Current
2% Average = 1.2%
on the yen, as will further BOJ intervention in
the currency market. That said, intervention did 0%
not prevent the yen from appreciating further in 00 10 20 30 40 50 60 70 80 90 00 10
the 1990’s and again in 2003-04. Taking these
various cross currents together, we expect the yen Data as of Q3 2010
Source: Investment Strategy Group, NBER
to depreciate against the dollar, but not enough
to warrant a tactical view at this time.

Asian Area Currencies

While emerging market currencies in aggregate
have appreciated to around fair value, Asia re- While emerging market currencies in
mains the most undervalued region, in our view. aggregate have appreciated to around
China is a case in point, with the yuan some
15-25% undervalued relative to the USD. As we
fair value, Asia remains the most
speculated in last year’s Outlook, the Chinese undervalued region, in our view.
decided to resume appreciation of the renminbi
(CNY) roughly 6 months ago, with the currency
rising almost 3% since.
Although relative fundamentals and
valuation could certainly justify it, we think
rapid appreciation is unlikely, given pressure
from China’s exporters, political concerns about
appearing to have bowed to US trade pressures,
and fears that brisk appreciation could duplicate
the mistakes of Japan in 1985-1987. Instead,
we expect the CNY to strengthen gradually by
4-6% this year, with the Chinese authorities
searching for a rate that is fast enough to ward
off protectionist pressures, but slow enough to
facilitate a gradual rebalancing of their economy
from exports to domestic consumption.
Despite expecting currency appreciation in
Asia, we do not think the renminbi is the best
vehicle to capture it, as China’s strict capital
controls ultimately erode much of the potential
gains. Instead, we recommend a basket of
Asian currencies that we believe are most likely

Investment Strategy Group Outlook 41

january 2011
to appreciate in tandem with the CNY, are
undervalued and face large capital inflows that
should necessitate further currency appreciation. Even with the dramatic backup in US yields in
In this regard, our favorite Asian currencies
include the Singapore dollar, Malaysian ringgit,
Indonesian rupiah, Indian rupee, and the Korean
won, all of which are part of our Chinese
Appreciation Proxy Currency Basket.
Other Emerging Market Currencies
Outside of Asia, we think the risk-adjusted
returns of emerging market currencies are
more balanced. For example, Latin American
currencies, like the Brazilian real, offer very
attractive yields and large foreign exchange
reserves to buffer against shocks. However,
these positives are offset by a host of negatives, paltry returns over the next three years, as seen
including overvaluation, more prevalent use
of currency intervention, higher volatility and
exuberant investor sentiment. Similarly, the
potential offered by the impressive recovery
in countries like Poland, Israel and perhaps
Turkey is balanced against the greater volatility to maintain overweight positions in corporate
associated with ongoing sovereign debt issues in
Europe.
Perhaps not surprisingly, these offsetting
characteristics leave us broadly neutral on
emerging market currencies outside of Asia. Even with modest local currency appreciation yield
so, we are watching Hungary as a potential risk
to ex-Asia emerging market currencies, as the
new government’s pursuit of populist policies
could not only be jeopardizing the country’s
existing IMF/EU aid package, but also increasing
its vulnerabilities to further debt concerns in
peripheral Europe.
42 Goldman Sachs
2011 Fixed Income Outlook
late 2010, interest rates remain extremely low
by historical standards, a reflection of the depth
of the recession, the resulting aggressiveness of
monetary policy and the relatively tepid pace of
recovery in much of the developed world thus
far. Ten-year Treasury yields, for instance, have
been lower only 2.5% of the time since 1962,
with the bulk of those occurrences in the last
decade. From such low starting levels, it is not
difficult to imagine rates normalizing higher,
particularly as economic growth resumes and
policy accommodation is withdrawn. Against
this backdrop, we expect fixed income to have
in Exhibit 36.
Our tactical positioning reflects this view,
as all of our current tilts are funded out of
investment grade fixed income. Even so, we
find some fixed income alluring, as we continue
high yield and emerging market local debt. On
the former, we think spreads are still wider than
the likely path of defaults warrants, while on
the latter, attractive coupon payments coupled
high single-digit returns. These tilts also have
shorter duration than their funding source – a
comparative benefit in the rising interest rate
environment we expect.
But for our US portfolios, our tactical
underweight to investment grade municipal
bonds should not be construed as an indictment
of their safety. Indeed, we continue to see this
asset class as the bedrock of the “sleep well”
portion of a client’s portfolio and think concerns
about an imminent municipal crisis are likely
overblown.
US Municipal Bond Market
There has been no shortage of negative headlines
concerning the municipal bond market in
recent years. Put simply, they reflect the fear
that states’ budgetary shortfalls, high debt
burdens, waning Federal assistance and massive
unfunded pension liabilities will soon conspire
to produce widespread municipal defaults.
While we acknowledge the intuitive appeal of
this reasoning, we disagree with the conclusion. Exhibit 36: Expected 3-Year Returns on Fixed
In our view, it is the failure to address these Income and Cash Are Paltry
concerns that precipitates defaults, not their
mere existence – and we think the states still
1.4% 1.31%
have many options available to remedy these
1.2%
shortcomings.
Below, we examine the key reasons for our 1.0%
less pessimistic view. 0.8%

0.6%
Budgetary shortfalls are cyclical and improving
0.4% 0.33%
The good news for deficits is that tax revenues
0.18%
are highly cyclical. In New York, for example, 0.2%

economically-sensitive personal income, sales 0.0%

and corporate income taxes account for 89% of
revenues; in California, it’s 95%. Consequently,
tax revenues continue to benefit from improve-
ments in the US labor markets, as shown in
Exhibit 37. As a result, each of the first three
quarters of 2010 showed sequential improve-
ment in state tax receipts – a trend likely to
continue, given the improving US growth and
Cash Short Intermediate
Return* Duration** Duration***
Data as of December 30, 2010
Note: Returns are ISG forecasts based on current and forward yield curves,
assuming portfolio duration is constantly rebalanced.
* Portfolio of 3-month Treasury bills
** Portfolio of 2-year Treasury notes
*** Treasury portfolio with 4.6 year duration
Source: Investment Strategy Group, Bloomberg

employment levels we expect.

Against this improving cyclical backdrop,
states have already taken aggressive steps to close
budgetary gaps. Since fiscal year 2008, spending
has been reduced by about $42 billion. Even so, Exhibit 37: State Deficits Tend to Be Highly Cyclical
states continue to implement further measures,
including additional spending cuts, wage freezes, 15% State Tax Revenue Growth (LHS) 0
deficit financing, new taxes and asset sales. Initial Jobless Claims (RHS Inverted)
State Tax Revenue Growth (YoY%)

100

Initial Jobless Claims (Thousands)

10%
Arizona, for instance, raised $1 billion by selling
200
state buildings and leasing them back. Indeed, 5%
projected budgetary shortfalls do not take into 300
0%
consideration the numerous assets that states 400
own, including roads, sewers, buildings and -5%
500
water reservoirs, which could be privatized, if -10% 600
necessary.
In addition, we note that the alarming $160- -15% 700

$200 billion state deficit numbers that are

Mar-06

Sep-06

Mar-07

Sep-07

Mar-08

Sep-08

Mar-09

Sep-09

Mar-10

Sep-10

frequently cited in the press include projected

spending increases. Excluding these increases, Data as of Q3 2010
the shortfall is closer to $50 billion, a non- Source: Investment Strategy Group, US Census Bureau, Datastream

trivial but more manageable sum. New Jersey

Governor Christie, for instance, was able to close
an $11 billion budget gap by simply preventing
automatic spending increases. While doing so
is no easy political task, it is much easier, and
significantly less disruptive to the economy, than
cutting $11 billion worth of jobs.

Investment Strategy Group Outlook 43

january 2011
States are not like troubled European Sovereigns
Despite frequently made comparisons between
the two, we think there are material differences.
Unlike sovereigns, US states are required to
operate under balanced budgets, thus preventing
them from routinely issuing debt to fund deficits.
Moreover, because municipal debt tends to be
project specific, it has little rollover risk, is gener-
ally long-term, has a fixed rate and is paid down
over the life of the bond. As a result of these
differences, the average state debt/GDP ratio
is just 2.4%, compared to triple-digit levels in
many troubled sovereigns. In fact, state and local
governments constitute just 10% of total bonded
debt in the US, while the average state spends a
mere 3.7% of its revenues annually servicing its
debt.
Deficits even without fiscal stimulus are
improving Although states are set to lose about
$16 billion of federal aid in the second half of
2011, this is equivalent to roughly 2.5% rev-
enue growth, a number that could be achieved
through stronger US growth and some tax in-
creases. In fact, state budgets were set during last
year’s mid-cycle slowdown, making it probable
that this year’s revenues exceed expectations. As
seen in Exhibit 38, even when we remove fiscal
stimulus, state and local deficits have already
improved some $50 billion since Q2 2009 and
seem to be following a trajectory similar to the
last recovery.
Unfunded pensions are not a source of near-
term default risk While pension costs are a
significant long-term credit issue, they are
not a source of near-term default risk, in our
view. States have many years to address these
costs, and nearly three-quarters of states have
already implemented some form of pension
reform since 2007, according to PEW Center
on the States report. Perhaps most importantly,
growing public concern over this issue is
providing governments with political cover to
bring stakeholders to the table and implement
difficult but necessary structural changes, such as
increasing the retirement age, reducing program
benefits, raising contribution rates and even
converting to defined contribution plans.
44 Goldman Sachs
Exhibit 38: State Deficits Even Without Federal Aid
Are Improving
State and local governments’ budget deficits without Federal aid as
a percentage of GDP have improved in each of the last 3 quarters.
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
-2.5%
-3.0%
-3.3%
-3.5%
-4.0%
-4.5%
99 00 01 02 03 04 05 06 07 08 09 10
Data as of Q3 2010
Source: Investment Strategy Group, Bureau of Economic Analysis
Defaults have historically been low…for good
reason By any measure, municipal defaults have
been extremely rare historically. According to a
recent Fitch report, the cumulative default rate
over the past ten years for all rated municipal
bonds – including non-investment grade – ranges
from 0.04%-0.29%, based on estimates from
all three major rating agencies. By comparison,
Moody’s found 2.5% of investment grade and
0.5% of AAA-rated corporate bonds default
over a similar time frame. Even during the Great
Depression, the worst single-year default rate
was only 1.8% in 1935. Within 2 years, nearly
all the defaults by larger municipalities had been
cured, with an average recovery rate close to
97%!29 High recovery rates persist today, with an
average of nearly 70%.
This low default rate is not historical
happenstance. States are constitutionally
bound to balance their budgets and meet their
municipal debt obligations, as creditors can sue
for failure to pay. Moreover, states cannot legally
file for bankruptcy and would be reluctant to do
so anyway, given their ongoing need for public
financing. Although other public entities can file
under Chapter 9, city managers are averse to
doing so given the financial and political costs,
as well as the uncertainty of the outcome. Lastly,
 municipalities have several options available to
address short-term cash deficits, such as issuing
cash-flow notes, delaying vendor and state-aid
payments, arranging lines of credit and allowing
inter-fund borrowing.
Our View
With muni-treasury valuation ratios now close
to their historical averages and Treasury yields
expected to move higher, we expect intermediate
muni total returns of around 1% this year. While
headline risk will surely persist, particularly
around the potential expiration of the Build
America Bond program (BAB) which diverted
supply to the taxable market last year, we think
states still have many options to eventually
bring about the required fiscal consolidation.
Moreover, the recent uptick in US growth
provides a positive tailwind to state and local
finances. As a result, we think defaults are likely
to remain uncommon, situation-specific events.
Against this backdrop, we recommend that
clients maintain their muni exposure. For those
who remain very concerned about municipal
risk, however, we suggest a move into Treasuries
and/or a national muni portfolio. We do not
recommend, however, diversifying into non-
US government bonds (on either a hedged or
unhedged basis), as the tax considerations and
transaction costs make this unattractive.
TIPS (Treasury Inflation-Protected Securities)
By design, TIPS benefit from higher-than-
expected inflation. Thus, if inflation over the
next decade turns out to be greater than the
2.2% currently expected by the bond market,
10-year TIPS will outperform 10-year Treasuries.
While our forecast calls for tame inflation given
still-excessive slack in the US economy, there is
0.0
-0.5 some risk that the Fed’s actions ultimately prove
-1.0 inflationary. In this context, longer maturity
-1.5 TIPS, such as the 10-year, do offer clients a
-2.0 valid inflation hedge, particularly given the low
-2.5 breakeven inflation point (2.2%).
-3.0 Of course, this relatively simplistic analysis
-3.5 comes with two significant caveats. First,
-4.0 breakeven rates only apply if the bonds are
-4.5
held to maturity; but in the meantime, investors
face mark-to-market risk. In particular, TIPS
decline in value when real yields rise. Thus, even
Investment Strategy Group
if inflation increases, TIPS could still generate
negative returns over shorter periods if the Fed
raised policy rates sooner or more than expected.
Second, TIPS are better suited for tax-deferred
accounts and those who are not dependent
on bond income for current spending. This is
because as inflation rises, the increase in the
TIPS principal is considered taxable federal
income, even though this increased principal is
not received until the bond is sold or matures. As
a result, the after-tax coupon payment for TIPS
will usually be less than a nominal Treasury, a
disadvantage for income-dependent investors.
Thus, a client must consider both the tax and
income ramifications of TIPS, in addition to the
inflation view, before proceeding. For clients
who remain particularly concerned about higher
inflation, we recommend purchasing a mix of
T-bills and TIPS. For their part, T-bills reduce the
portfolio’s duration risk, while enabling clients
to more frequently roll their maturing principal
into new bonds at progressively higher interest
rates. In fact, during the unexpected bout of UK
inflation between 1988-90, a strategy of buying
the UK 3-month T-Bill actually outperformed
UK inflation-linked securities, although both
outperformed nominal bonds. While only a
single example, it’s something clients should
consider in choosing the mix of securities for
their inflation-hedged portfolio.
A client must consider both the tax
and income ramifications of TIPS, in
addition to the inflation view, before
proceeding.
Outlook 45
january 2011
Corporate High Yield Outlook
With high yield spreads now around their long
term average since 1994, this year is unlikely
to register the same double-digit gains to which
investors have become accustomed over the last
two years. Even so, we retain a 2% overweight
to corporate high yield bonds based on several
investment positives. For one, recoveries on
defaulted bonds are running higher than their
historical average: the recent 3-month recovery
rate is around 51%, compared to a long-term
average of 45%. Moreover, as shown in
Exhibit 39, the compression in spreads continues
to track the improvement in defaults. Indeed,
even assuming 30% recoveries, (a conservative
assumption given the current run rate), today’s
spread level implies defaults of around 7.5%.
This is over two times higher than the recent
three-month annualized default rate of 3.1% and
comfortably above the year-ahead forecasts of
either Moody’s, at 2.1%, or S&P, at 2.4%.
Furthermore, we think the likelihood of
future defaults has been reduced, as companies
have aggressively refinanced and extended
their debt maturities. As a result, the amount
of debt scheduled to mature in the next three
years has dropped by nearly $250 billion. Thus,
although the well publicized “wall of maturities”
still peaks in 2014, the intervening years now
represent a more manageable refinancing hurdle.
Of equal importance, strong bottom-up
fundamentals continue to underpin spread
compression. Among high yield companies
reporting in Q3 2010, revenues were 15% higher
than last year, the fastest pace in four years and
the third consecutive quarterly gain. In addition,
gross margins improved to 32%, also the highest
level in four years. Remarkably, high yield issuers
have now fully recovered the entire EBITDA
shortfall they experienced during the recession.
We believe that stronger US growth should
further bolster high yield credit metrics.
Taking these factors together, we expect
corporate high yield to deliver around 6%
returns this year, with risks to the upside if
stronger fundamentals push spreads tighter from
current levels.
46 Goldman Sachs
Exhibit 39: High Yield Spreads Have Scope to Follow
Defaults Lower
2000 High Yield Spread (LHS) 16%
Actual High Yield Default Rate* (RHS) Forecast
1800 14%
1600
Moody’s Forecast High Yield Default Rate (RHS)
High Yield Default Rate (%)
12%
High Yield Spread (bps)
1400
1200 10%
1000 8%
800 6%
600
4%
400
200 2%
0 0%
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Data as of December 31, 2010
*Default Rate Data as of November 30, 2010.
Source: Investment Strategy Group, Barclays Capital, Moody’s
Emerging Market Local Currency Debt Outlook
We continue to recommend clients overweight
EM local currency debt,30 based on several
supporting factors. First, EM local debt boasts a
yield of almost 7%, while its spread to US debt
remains close to its widest levels since 2002.
Second, the relative fiscal health of emerging
economies compared to developed ones favors
EM bonds. While the debt burden of emerging
markets is projected to remain flat at around
33% of GDP by 2015, it is expected to rise to
106% for developed countries, according to
the IMF. Third, according to JP Morgan, global
institutional investors account for only 7% of
the EM local bond universe compared to 80%
of the more traditional EM dollar-denominated
bond market, providing scope for reallocation
flows. Finally, EM bonds offer diversification
benefits to a global portfolio, as they have about
half the volatility of EM equities and a favorable
correlation profile: the combination of US and
EM equities only explains about 40-50% of the
returns of EM local bonds.
Although we expect inflationary forces in
many EM markets to pressure local interest
rates higher, currency appreciation in these same
markets will provide an offset. Netting the two,
we expect a small to moderate boost to our
expected returns from currency appreciation, Exhibit 40: Total Returns on Commodities
resulting in a full-year total return target in Although it was a bumpy ride, commodity returns were mostly positive
the mid-to-high single-digit range. Despite our last year.
positive disposition, we caution that EM local
bonds are risky, with annual volatility of 11%
140 GSCI
and a peak-to-trough decline of 28% during the GSCI Gold 134.2
130
recent crisis. As such, we believe they should not GSCI Oil 128.7
GSCI Agriculture
be considered a substitute for the “sleep well” 120
GSCI Industrial Metals 116.7
portion of clients’ portfolios. 110 109.0
100 99.9

90

80

Commodities
There is little question that a combination of
improving global demand, force majeure, the US
Fed’s second round of quantitative easing (QE2),
low rates, and fears of higher inflation provided
a potent mix for commodities in 2010 (Exhibit
40). Indeed, out of a basket of 73 different
commodities, including everything from metals
to fibers, a remarkable 90% were up last year,
well above the typical 50-70% range that has
prevailed since 1974. Price gains were equally
impressive, with commodities as diverse as
cotton, silver and coffee all rallying more than
50%.
Perhaps not surprisingly, the consensus
expects a continuation of these themes this
year. While our own forecast features better
global growth, a positive for commodity
demand, our view on the dollar and inflation is
less supportive. As discussed earlier, we think
excessive slack in much of the developed world
will temper inflationary pressures, while better
US growth is more likely to support dollar
appreciation, particularly given today’s valuation
levels. Moreover, better US growth makes
another round of quantitative easing unlikely,
removing a key source of downward pressure on
the dollar.
More fundamentally, we note that the
connections between commodities and either the
dollar or inflation have historically been very
tenuous. To wit, while commodities have had
a 38% correlation with inflation since 1974,
the range is wide at +82% to -44%. In our
view, an effective hedge should have a higher
and more stable correlation. Furthermore,
70
Dec-09 Mar-10 May-10 Jul-10 Sep-10 Nov-10
Data as of December 31, 2010
Source: Investment Strategy Group, Datastream
since 60% of the US CPI basket is composed of
services, commodities offer less protection from
generalized inflation – precisely what investors
are trying to hedge against. For its part, the
dollar has been little better in driving commodity
returns, as movements in the greenback explain
only 16% of the changes in the price of oil and
gold, on average.
This is not to suggest that financial
factors (e.g., the dollar) don’t sway near-term
commodity price movements, but rather that
they are an unstable foundation on which to
build an investment case. Instead, we have found
idiosyncratic factors to be the more important
drivers of commodity prices over time.
We expect commodity markets to remain
volatile for the foreseeable future, but are not
expecting prices to shift enough to warrant
a tactical tilt at this point. In our view, better
risk-adjusted returns can be found in other
asset classes such as US equities, high yield and
emerging market local debt. In the following
pages, we examine the fundamentals for oil, gold
and agriculture.

Investment Strategy Group Outlook 47

january 2011

Oil this demand growth, however, necessitating some

Despite the fairly anemic economic recovery in further reduction of inventories and/or spare
much of the developed world thus far, global capacity via a higher call on OPEC production,
oil consumption nevertheless overtook its 2007 in our view.
peak last year. While non-OECD countries, Because both inventories and spare capacity
China in particular, represented the bulk of remain high by historical standards, we do not
the stronger demand, the resilience of US oil expect a major supply shortage (Exhibit 41).
consumption was more surprising, contribut- Even so, near-term uncertainties remain. For
ing nearly all of the OECD growth for the year. instance, it is unclear at what price level OPEC
The combined demand actually exceeded supply will increase its production quotas, and if it
growth, resulting in a reduction of “floating stor- does so, whether this will further stoke bullish
age” inventory – oil that had been temporarily sentiment if it is perceived as a sign of tighter
stockpiled on ocean tankers during the recession. supply and lower spare capacity. Ultimately, we
While inventories in total remain above their think a combination of some further inventory
5-year average, floating storage inventory, which draw-down, some non-OPEC production growth
served as an effective buffer to absorb improving and some increase in OPEC production should
demand, has now fallen to 60 million barrels or be sufficient to meet demand. But higher oil price
less, one-third of its peak level during the recent volatility is likely, as this dynamic unfolds.
crisis, according to International Energy Agency. As a result, we think a slightly higher oil price
As such, a key question for the oil price range of $75-100/bbl makes sense this year,
outlook is how quickly still-elevated inventory compared to last year’s expectation of $60-85/
and OPEC spare capacity will be drawn down. bbl and the current NYMEX future price of
In our view, oil demand growth of about 1.7%- about $94/bbl. Our forecast range implies 21%
2.3% seems reasonable and would be consistent downside to 6% upside relative to the forward
with global GDP growth of around 4.0-4.5%. curve. As we have highlighted before, however,
Supply growth from non-OPEC and natural gas because the curve remains upward sloping (i.e.,
liquids (NGL) production will likely fall short of in contango), actual investor returns to our

Exhibit 41: Historically High OPEC Spare Capacity Exhibit 42: Real Rates, Inflation and the Dollar
Should Limit Any Potential Supply Shortages Explain Less Than Half of Gold Returns Historically

7
6.1 6.0 Trade-Weighted
6
5.3 5.5 5.5 US Dollar
Millions of Barrels per Day

5 4.7 16%
4.2
4 Real Rates
3.2 (%MoM)
3 2.7 12%
2.6 Idiosyncratic
1.9 54%
2 1.8 1.8
CPI Inflation
1 (%MoM)
18%
0
98 99 00 01 02 03 04 05 06 07 08 09 10

Data as of December 20, 2010

Note: Excluding Iraq.
Source: Investment Strategy Group, IEA, Bloomberg Data from February 1973 through November 30, 2010
Source: Investment Strategy Group, Bureau of Labor Statistics, Datastream

48 Goldman Sachs
upside target would be less than implied. For materialize, as we expect, could lead to downside
example, while spot oil prices rose about 13% risk. In addition, gold has volatility similar to
last year, total returns were negative 0.1%. With equities, and has, in fact, experienced a larger
oil price volatility around 30%, we do not find peak-to-trough decline in price when compared
the risk/reward compelling enough to justify a to equities over rolling three-year windows since
tactical tilt at present. 1969 (-64.5% for gold vs. -56.8% for equities).
In short, gold is not an appropriate substitute for
Gold the “sleep well” portion of a client’s portfolio, in
We realize that, for many, discussing gold is our view.
tantamount to debating religion: each side is The shifting composition of gold demand
likely to have deeply held views, neither side is is another important consideration. In just
likely to concede despite persuasive arguments, the last 3 years, investment demand increased
and one’s ultimate viewpoint is largely a matter from 17% to an estimated 34% in 2010, while
of faith. Part of this mystique reflects the jewelry demand (gold’s natural buyer) now
difficulty in determining what gold is actually represents less than half of the total, according
worth, since it is a non-productive asset that to the World Gold Council. As a result, the
generates no cash flows to value. It also reflects investment demand for gold is reaching
the unstable nature of gold’s price drivers: euphoric proportions, with a recent press report
sometimes it responds intuitively to supply/ announcing the availability of gold-dispensing
demand dynamics like most commodities, while ATMs in select markets this year! Already, the
other times it reacts more like a financial asset, SPDR Gold Trust has become the second largest
taking its direction from the dollar or inflation ETF in the world and now represents the 5th
expectations. largest stockpile of gold globally, exceeding the
However, while investors may trade gold gold reserves of China and Switzerland.
as a dollar or inflation hedge, its performance The demand characteristics of gold producers
in that capacity has been spotty historically. have changed as well. Indeed, the major
More specifically, changes in the dollar explain gold miners have spent the last several years
only 16% of the changes in gold, while shifts repurchasing their gold hedges. With that process
in real rates explain another 12% and CPI now near completion, another source of natural
accounts for a mere 18% (Exhibit 42). Thus, demand will be absent from the market this year.
these typically cited justifications for owning The obvious risk in all this is that investors
gold account for less than half its historical tend to be fickle, suggesting that gold demand
price movements! Furthermore, in 60% of the could quickly evaporate, leaving few natural
episodes when inflation surprised to the upside in buyers at today’s elevated prices. In fact, jewelry
the post-World War II period, gold has actually demand tends to be negatively correlated with
underperformed inflation. As a result, gold has gold prices, which leaves fewer buyers should
not been a consistent inflation hedge, although it investment demand falter. For their part, gold
is purchased as one en masse.
Of equal importance, investors purchasing
gold as a form of tail risk insurance against
monetary debasement should appreciate
the potential effectiveness and costs of that While investors may trade gold as
insurance. For instance, during the recent a dollar or inflation hedge, its
financial crisis, gold actually declined over
30% from its peak in March 2008 through its
performance in that capacity has
trough in November 2008, while the dollar been spotty historically.
served as the better safe haven, rallying 24.3%.
Furthermore, gold prices have already advanced
on expectations of high inflation and dollar
weakness, suggesting that the failure of either to

Investment Strategy Group Outlook 49

january 2011
producers could start re-hedging their books
if prices fell, pressuring gold further. Notably,
investment demand levels similar to today have
tended to correspond with peaking gold prices,
as seen in Exhibit 43.
While some have suggested central banks
could fill any void in demand, we do not expect
them to be a swing factor for several reasons.
First, developed market central banks hold the
vast majority of gold reserves. Thus, unless
there is a significant global move away from
the dollar into gold, which we don’t expect,
the marginal shifts among emerging market
central banks will not prove decisive. Second,
central bank activity has been a poor predictor
of gold prices historically. For instance, central
banks were net buyers in the early 1980s as gold
prices collapsed. Lastly, it’s not clear whether
central banks will continue to be net buyers, as
they were last year. For example, the average
Eurozone member has gold reserves in excess
of 30% (with some countries’ reserves well in
excess of 50%), despite an ECB target ratio of
15%.
For our part, we expect a combination of
stronger US growth, a strengthening dollar,
temperate inflation and generally higher risk-
asset prices to raise the opportunity cost of
holding gold, particularly as real rates normalize
higher. Even so, momentum is a powerful market
force, and it’s unclear how long strong investor
demand will persist. Given these competing
tensions, gold does not screen as a compelling
tactical opportunity in our framework.
Agriculture
While it has been a banner year for most com-
modities, agriculture in particular stands out.
The S&P GSCI agriculture spot index rose 41%
last year, the strongest sector within the com-
modity complex. What has made the space so al-
luring to investors is an intuitive structural story
coupled with weather-induced supply shortages
in 2010. Structurally, industrialization and
growing per-capita income in emerging markets
is providing a tailwind to agricultural demand,
particularly grains. Last year, weather provided
a further stimulant, given the combination of a
Russian drought, downward revisions to the US
corn crop yield and concerns surrounding the La
50 Goldman Sachs
Exhibit 43: High Investment Demand Has
Corresponded With Gold Price Peaks Historically
Investment Share of Physical Gold Demand (%)
50% Investment Share of Gold Demand (LHS) 1800
45% 45% Real Gold Price (RHS) 1600
40% 39%
Real Gold Price ($/Troy Ounce)
1400
35% 34% 34%
1200
30%
1000
25%
800
20%
15% 600
10% 400
5% 200
0% 0
1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010e
Data as of December 31, 2010
Source: Investment Strategy Group, Bloomberg, World Gold Council, CPM Group
Niña meteorological phenomenon.
The result has been a notable reduction in
inventories, which makes prices vulnerable to
further increases this year. Corn is especially
susceptible, with the global corn stock-to-use
ratio at 16%, well below its long-term average
of 24% (Exhibit 44). Because the correlation
between grain price movements is high, a
function of a producer’s ability to substitute
acreage, we believe the bullish backdrop for
corn is in many ways the outlook for grains in
general.
While the foregoing narrative would point
toward a long opportunity, several factors leave
us tactically neutral on agriculture. First, these
developments are arguably already reflected
in current corn prices, which have been above
current levels only 1.7% of the time in nominal
terms in the past 20 years. Second, prices
would have to rise more than 5% per year
for investors to just break even, given the
contango currently present in the forward curve.
Third, while weather is difficult to predict,
the exceptional events of last year are unlikely
to repeat this year. Finally, despite the below
average stock-to-use ratio today, corn yields
could surprise to the upside, particularly given
their history of doing so.
Key Global Risks confidence in the government’s willpower. Either
scenario could increase the risk premium of gov-
Throughout this year’s Outlook, we have dis- ernment debt, thereby raising interest rates and
cussed our reasons for relative optimism: accel- borrowing costs.
erating US growth, continued global economic
expansion, stronger equity markets, and reduced Sovereign Debt/Currency Crisis Many govern-
likelihood of extreme near-term “tail-risks,” ments in the developed economies run large defi-
to name a few. This last item, in particular, is cits and have historically high debt/GDP ratios.
important, as we have said since 2008 that the Moreover, structural factors, such as demograph-
greatest risk to the recovery was a major policy ics, are projected to raise healthcare costs and
error. While this remains the case, the collective pension benefits in many of them, further exacer-
actions of global governments in recent years bating debt levels.
have decreased the probability of extremely This dynamic creates two potential risks.
negative outcomes in the near future (e.g. the First, these countries now have little ammunition
US’s deliberate attempts to avoid the Depression- left to react to adverse economic shocks. Second,
era blunders of premature fiscal and monetary failure to implement credible fiscal consolidation
tightening through quantitative easing and exten- plans could lead to a loss of market confidence.
sion of Bush tax cuts, or the European Union’s As we saw in much of the European periphery
creation of lending mechanisms, such as the last year, the result is dramatically higher interest
EFSF, to its troubled periphery). rates, a depreciating currency and difficulty
Even so, significant risks remain. While the rolling maturing debt. Moreover, given global
policy actions taken to date have positive near- financial linkages, loss of confidence in one
term benefits, their potential risks are back-end area of the world can be quickly transmitted to
loaded. While by no means an exhaustive list, the another, as we saw in April of 2010.
risks
50 below represent those that would be most
detrimental
45 to our view: Federal Reserve’s Loss of Independence US
40 Federal Reserve credibility is a key component of
35
Mismanaged Policy Exit The unsustainably controlled inflation expectations. Were the Fed to
30
loose
25 monetary and fiscal policies of much of lose its independence through political interven-
the
20 developed world will eventually need to be tion, concerns about persistently loose monetary
reversed,
15 in our view. If the exit occurs too soon, policy and debt monetization could proliferate,
it10could derail the recovery; if too late, it could resulting in unanchored inflation expectations
5 to an inflationary outcome and/or a loss of
lead and higher interest rates.
0

Exhibit 44: Low Stock-to-Use Ratios Make1800 Prices Vulnerable to Upside Pressure
Low inventories, especially in the US, could lead to higher
1600prices this year.
1400
United States 1200 World
2010-11 Marketing Year 1000
Long-Term Average 2010-11 Marketing Year Long-Term Average
Corn 6.2%
80021% 16% 24%
600
Soybeans 5.5% 12% 24% 16%
400
Wheat 37% 41% 27% 29%
200
0
Data as of December 2010
Source: Investment Strategy Group, US Department of Agriculture, World Agricultural Supply and Demand Estimates

Investment Strategy Group Outlook 51

january 2011

Even outside the US, inflation expectations

becoming unanchored, either from central bank
misdeeds or more generally from spiraling costs,
could prove disruptive to the markets.

US Housing While low-single-digit home price

movements up or down are unlikely to have a mate-
rial impact on our view, a renewed and meaningful
fall in housing prices would. First, this would de-
crease household wealth and consumer confidence,
undermining consumption. Second, this would
negatively impact the banking system and curtail
credit availability, as the majority of bank assets
remain backed by real estate.

Major Geopolitical Event An outbreak of war or a

major terrorist act could undermine confidence and
disrupt trade with negative repercussions for finan-
cial markets.

Hard Landing in China With China being a key

source of marginal global demand and growth, we
believe a hard landing there would have negative
repercussions across the full spectrum of asset
markets, particularly in the emerging markets.

Trade War Although a variation of a policy error,

a trade war resulting from the implementation of
protectionist policies could hobble global trade
and thereby hurt growth, as it did during the Great
Depression.

in closing, we’ll reiterate what we said earlier:

we have no crystal ball. We offer our views with
a measure of humility, knowing full well that
2011 will likely bring issues and circumstances we
didn’t expect. But it is a year we look forward to
with confidence that the US will continue on as the
world’s financial and economic leader.
This is what we hope to convey to our clients
in this issue of Outlook: America, in our view, is
well on the road to recovery and should continue to
improve steadily from here. Stay the course. n

52 Goldman Sachs
Footnotes

1. Alexis de Tocqueville, Democracy in America, Volume I, 1835
2. Paul Krugman, The New York Times, May 20, 2010
3. Megan McArdle, The Atlantic, October 5, 2010
4. George Santayana, Reasons in Common Sense, Volume I of The
Life of Reason, 1905
5. “Japan’s Tale of Caution on Fed Monetary Policy,” The Wall
Street Journal, 11/22/2010
6. Jay Ritter, “Economic Growth and Equity Returns,” Pacific-Basic
Finance Journal, October 2004
7. Dominic Wilson and Stacy Carlson, “Our 2010 GES: The Links
Between Growth Conditions, Growth and Markets,” Goldman
Sachs Global Economics, Commodities and Strategy Research,
December 15, 2010
8. “China’s Next Leap Forward,” The Wall Street Journal, Sept. 29,
2010
9. Alwyn Young, “Gold into Base Metals: Productivity Growth in the
People’s Republic of China during the Reform Period,” Journal of
Political Economy 111, Dec 2003
10. John Steele Gordon, Hamilton’s Blessing: The Extraordinary Life
and Times of Our National Debt, Walker & Company, 2010
11. Jan Strupczewski, Ingrid Melander, “IMF Critical of Eurozone
Crisis Management,” Reuters, December 7, 2010)
12. Ian Bremmer, “The End of the Free Market: Who Wins the War
Between States and Corporations?” Portfolio, 2010
13. “In Lula’s Footsteps,” The Economist, July 1, 2010
14. Anton Sychev, Geydar Mamedov, Arjun Murti, Nilesh Banarjee,
“Rosneft vs. BRIC NOCs: Up to Neutral on cross-regional
comparison,” Goldman Sachs Global Investment Research, July
12, 2010
15. Nicholas Eberstadt, “The Demographic Future,” Foreign Affairs,
Nov/Dec 2010
16. Giovanni Peri, “The Effects of Immigrants on US Employment
and Productivity,” Federal Reserve Bank of San Francisco,
August 2010
17. Interview with Charlie Rose, October 2009
18. Michael G. Finn, “Stay Rates of Foreign Doctorate Recipients
from US Universities, 2007,” Oak Ridge Institute for Science and
Education, 2010
19. Battelle, “2011 Global R&D Funding Forecast,” R&D Magazine,
Dec 2010
20. Laureates are counted in all countries in which they have lived
or worked for a significant period of time.
21. John Steele Gordon, An Empire of Wealth: the Epic History of
American Power, Harper Collins, 2004
22. Joseph S. Nye, Jr., “The Future of American Power: Dominance
and Decline in Perspective,” Foreign Affairs, November-
December 2010
23. Sommer Martin, “Prospects for the U.S. Household Savings
Rate,” IMF Article IV Report on the United States, Selected
Issues Paper, July 2010
Jaewoo Lee et al., “U.S. Consumption after the 2008 Crisis,”
IMF Staff Position Note SPN/10/01, January 2010
24. Savita Subramanian “Quantitative Strategy Update: Diagnosis
of a tough 2010; what’s next?” Bank of America/Merrill Lynch,
November 16, 2010
25. www.SentimenTrader.com Morning Report, November 30, 2010
26. Bank of America / Merrill Lynch Global Strategy Weekly,
December 10, 2010
27. Financial Times, October 11, 2010
28. Wall Street Journal, September 29, 2010
29. “Municipal Market Update,” AB Bernstein Global Wealth
Management, June 2010
30. As represented by the JP Morgan Government Bond Index-
Emerging Markets (GBI-EM) Global Diversified.

Investment Strategy Group Outlook 53

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