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 ?C 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. 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. 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. Structural Benefits of the US The US??s inherent resilience, flexibility and dynamism continue to make it uniquely attractive from an investment perspective.
2011 Global Economic Outlook
2011 Financial Markets Outlook
17 United States 21 Eurozone 22 United Kingdom 23 Japan 23 Emerging Markets
29 United States 32 Eurozone 34 United Kingdom 35 Japan 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 Chief Investment Officer Goldman Sachs Private Wealth Management
Brett Nelson Managing Director Goldman Sachs Private Wealth Management
Additional Contributors from Goldman Sachs Private Wealth Management: Neeti Bhalla Managing Director Leon Goldfeld Managing Director Maziar Minovi Managing Director Thomas Devos Vice President Benoit Mercereau Vice President Matthew Weir Vice President Harm Zebregs Vice President
??America boosters!?? That is how one of our most sophisticated and well-informed clients sarcastically concluded what was to be our last client meeting of 2010. His exclamation was all in good fun, but also based in truth: Since the depths of the financial and economic crisis, we have stood against the crowd in our optimistic view of a US recovery, US investment opportunities and the US dollar as the reserve currency of the world for the foreseeable future. That outlook, unpopular as it was, led us to two key investment recommendations: overweight US high yield bonds and US equities in our clients?? portfolios. Market returns and the US economic recovery have proven us correct. At a total return of 83% since March 2009 (as measured by the Barclays Capital US Corporate High Yield Index), US high yield bonds have offered not only extremely attractive absolute returns (over 100% from their trough), but also the most attractive investment return per unit of risk as measured by volatility, far surpassing any other asset class. If one were to include other measures of risk such as safety of assets and capital controls, the risk/reward is even more attractive. Similarly, US equities have returned 93% (as measured by the S&P 500) with annualized volatility of 17% in spite of annualized economic growth of only 2%. Over the same period, emerging markets returned 100% (as measured by the MSCI Emerging Market Index) with annualized volatility of 18% and annualized economic growth of 7%. And the US dollar is actually about 7% higher than its pre-crisis levels. 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
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further in time to the deep recessions of 197374 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 precrisis 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 ?C 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
growth does not translate into higher equity returns; and why the long-term structural advantages of the US relative to other economies ?C developed and emerging ?C 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 forwardlooking guide; and 2) fear and greed drive markets to extremes, and it is those extremes that provide the most attractive ?C and most unattractive ?C investment opportunities. It is also at those extremes ?C positive and negative ?C 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 ?C or more ?C 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.
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Real estate values in Japan peaked at 17 times disposable income in 1990, having appreciated by 182% over the prior five years. You may Over the last year or so, many credible ?C and remember the oft-repeated comment that at its some not-so-credible ?C researchers, economists, peak in value, the land in the Imperial Palace journalists and television commentators have warned about the US repeating the ??lost decade?? in Tokyo was worth more than all the land in California. In the US, real estate values peaked 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 appreciated by 77% over the prior five years. of Japan??s Lost Decade???3 have cascaded upon Therefore, one can say that Japanese real estate us, prompting some clients to express concern was 100% more overvalued than US real estate, about their US-based investments. During Japan??s lost decade (which, in fact, has and a greater correction was warranted. Similarly, Japanese stocks were more been two decades and counting) GDP has grown overvalued than US stocks at the beginning of at an annualized rate of 1%, equity markets the crisis. At the peak in Japanese equity markets declined by 76% peak to trough, inflation has in December 1989, the Topix??s price to trailing measured 0.4%, overnight rates have been 12-month earnings stood at 52 times; while less than 0.25% for half the time and 10-year at its peak in October 2007, US equities?? (as bonds have been below 2% for more than half represented by the S&P 500) price to trailing of the time. In our view, the likelihood of the 12-month earnings stood at 21 times. One can US experiencing one or two such decades is assert that Japanese equities were as much as negligible, if not zero. 250% overvalued if we compare price to trailing While on the surface there may be some 12-month earnings; alternatively, one can deduce similarities between the US and Japan, there a 60% overvaluation if we compare price to are far greater and more significant differences. book measures. Just like real estate, Japanese The similarities are that both countries faced equities had a lot further to fall. a big drop in commercial and residential real estate markets, a big decline in equity markets, and high private sector leverage (corporate Difference Two: Monetary and Fiscal and financial sectors in Japan, and household Policy Responses and financial sectors in the US) that required The US monetary and fiscal policy responses deleveraging. It
is the specific prospect of have been faster, larger and more extensive than further deleveraging in the US, especially in the Japan??s were during the early stages of its crisis. household sector, that weighs on the minds of While both central banks reduced interest rates, the lost decade proponents. the Federal Reserve cut the Federal Funds rate to The differences are the starting valuation 1% in 14 months from peak interest rates and levels in the equity and real estate markets, to 0% within 2 months after that. The Bank of the monetary and fiscal policy responses, Japan took 46 months to cut to 1% and then government policies to address the financial another 77 months after that to cut rates to 0%. sector difficulties, productivity and demoWith respect to quantitative easing, it took the graphics. These bear further discussion. US one year from its peak in interest rates to raise its money supply to 14% of GDP; it took Japan nine years. Difference One: Starting Valuation Levels Similarly, the US announced a fiscal One of the most important factors to consider is the starting level of valuations in both the real stimulus package of $787 billion, equivalent to 5.6% of GDP, within a year and a half of estate and equity markets when the downturns the equity market peak. In Japan, the actual began. While no one valuation measure tells the fiscal stimulus in the first three years was $100 whole story, all metrics point to substantially billion, equivalent to 2.3% of GDP. While some greater starting valuation levels in Japan than in might say that the policy response in Japan the US. was appropriate given the growth rates and the
The US Will Not Face a ??Lost Decade??
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Exhibit 1: US Demographics Are More Favorable Than Japan??s Since their respective market peaks, the workforce continues to grow in the US and shrink in Japan.
115 Population of Working Age (15-64) Indexed to Equity Market Peak** 110 105 100 95 90 85 80 0 5 10 15 20 25 Years from Equity Market Peak
Data as of December 2010 *Japan forecast for 2015 **Japan equity market (Topix) peaked in December 1989; US equity market (S&P 500) peaked in October 2007 Source: Investment Strategy Group, UN World Population Prospects 2008
Japan* US (forecast)
limited changes in unemployment at the time, Japan??s equity and real estate markets had both fallen further in the first downdraft than US markets. With the benefit of hindsight, we now know that officials misread the price signals from the market. In addition, a key economic indicator ?C the unemployment rate ?C was unreliable, since Japanese companies were reluctant to lay off workers as a matter of corporate
policy. We also believe that the Federal Reserve has been more responsive than the Bank of Japan because 1) it has a dual mandate of price stability and stable growth, and 2) its chairman has beensteeped in lessons learned from both the Great Depression and the lost two decades of Japan. Chairman Ben Bernanke certainly heeds the 1905 warning of Spanish American philosopher George Santayana: ??Those who cannot remember the past are condemned to repeat it.??4
Difference Three: Government Response to Financial Sector
Exhibit 2: Correlation Between Equity Returns and GDP Growth There is no stable relationship between growth and equity returns regardless of timeframe.
0 .5 0 .4 0 .3 0 .2 0 .1 - 0 .0 - 0 .1 - 0 .2 -0.25 105 Yrs 43 Yrs 42 Yrs 26 Yrs 20 Yrs 15 Yrs 10 Yrs -0.12 0.07 0.43 0.33
Number of Years for Which Data is Available
Data as of 2005 Source: Investment Strategy Group, ABN-AMRO Global Investment Returns Yearbook 2005
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 peak, the first financial institution failed, five major financial institutions including Merrill Lynch, Wachovia and Washington Mutual were sold, and the government authorized $700 billion dollars or 5% of GDP through the Troubled Asset Relief Program (TARP) to stabilize financial institutions. In Japan, with government forbearance, no major banks failed until eight years into the downdraft and the government only authorized 2.3% of GDP for funds to recapitalize the banks. Not only were Japanese policy makers slower to respond, they had a bigger problem to contend with: financial sector leverage in Japan stood at 157% of GDP at its peak compared with 121% in the US. Soon, Japanese banks became known as zombie banks. While the term was bandied about with regard to US banks when TARPUwas S 11 launched, it is worthy to note5that within two Japan* 1 banks have repaid years of TARP, all major US 1 0 these funds ?C and all have done so with a profit 105 to the US government. Leverage levels have also 100 been reduced to 98% of GDP since the onset of 95 the US crisis, while leverage in Japanese banks
90 85 80
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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% ?C US resilience and responsiveness at work.
Difference Five: Demographics
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 ?C or any other significant period of time ?C 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.
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
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Dimson et al have concluded that there is no stable relationship between growth and equity returns, as shown in Exhibit 2. The correlations vacillate between virtually zero and -0.25 for the first 30 years or so and then rise to 0.43 over 42 years only to drop to virtually zero again over 43 years. The point of highlighting such odd years is to demonstrate that within the investment horizon of our clients, the relationship is negative and beyond the investment horizon of our clients ?C let??s say 40 to 100 years ?C the relationship is completely unstable. Similarly, our own analysis within the US has shown no statistical significance in the relationship between equity returns and pace of economic growth. A recent report published by our colleagues in Goldman Sachs Global Economics, Commodities, and Strategy Research also showed that there was no statistically significant relationship between growth 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 economic growth is even more stark when we look at actual returns of slower growth versus faster growth countries. Dimson et al have shown that if one invested in the slowest growing quintile of countries during this hundred-yearplus period, the equity returns would have outperformed the fastest growing quintile by 3% a year as shown in Exhibit 3. Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly 5% a year. China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns. As shown in Exhibit 4, China??s economy has outgrown that of the US by about 8% a year since the end of 1992 (the inception date of the MSCI China equity market index). Its equity market, however, has lagged that of the US by about 8% a year. Over the last 15 years, earnings 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
Exhibit 3: Total Annualized Equity Returns by GDP Growth Cohort Stocks in slower growing economies have actually outperformed historically.
9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Lowest 20% Middle 60% Highest 20% 5.9% 5.0% 8.0%
Data as of 2005 Note: Based on 105 years of data from 17 countries as of 2005 Source: Investment Strategy Group, ABN-AMRO Global Investment Returns Yearbook 2005
Exhibit 4: GDP Growth and Equity Performance: China vs. US Chinese equity returns have been lower and more volatile than those of the US despite better growth.
40% 35% 30% 25% 20% 15% 10% 5% 0% -5% GDP Growth* -2.3% Equity Market Return -0.9% EPS Growth** Volatility 10.4% 6.1% 2.6% 5.4% 15.3%
Data as of December 31, 2010 The MSCI China Index is an index of H, B, Red and P Chip share classes available to foreign investors. All figures are annualized. * GDP growth through 2009 ** EPS growth October 1995-December 2010 Source: Investment Strategy Group, IMF WEO October 2010, Datastream, MSCI
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has outgrown the US by an estimated 7% but the MSCI China Index has returned just 4.8% (the local Shanghai Composite Price Index is actually down 14.3%). 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.
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) ?C 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 ?C namely Japan and Taiwan starting in the 1950s, Hong Kong and Singapore in the 1960s, and Korea starting in 1960 ?C 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
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.
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countries co-existed with growth, productivity and prosperity in the US. What is different about China is that it has maintained higher growth rates for three decades on a substantially larger scale, and expectations are for 8+% annual growth for at least another 5-10 years.