Outlook
Investment Management Division
Half Full
“ Everything we hear is an opinion, not a fact. Everything we see is a perspective…”
Attributed to Marcus Aurelius
Investment Strategy Group | January 2017
Sharmin Mossavar-Rahmani
Chief Investment Officer
Investment Strategy Group
Goldman Sachs
Brett Nelson
Head of Tactical Asset Allocation
Investment Strategy Group
Goldman Sachs
Additional Contributors
from the Investment
Strategy Group:
Matthew Weir
Managing Director
Maziar Minovi
Managing Director
Angel Ubide
Managing Director
Farshid Asl
Managing Director
Matheus Dibo
Vice President
Mary Catherine Rich
Vice President
This material represents the views of the Investment Strategy Group in the
Investment Management Division of Goldman Sachs. It is not a product of
Goldman Sachs Global Investment Research. The views and opinions expressed
herein may differ from those expressed by other groups of Goldman Sachs.
2017 OUTLOOK
Dear Clients,
Readers of our previous Outlook publications may recall that this page typically
summarizes the key themes of our economic and financial market prospects for the
coming year. However, for 2017 we decided that a brief overview would not suffice,
given the current environment of high market valuations, great policy uncertainty,
significant geopolitical tensions and, in all likelihood, an unconventional US
presidency.
Since the trough of the global financial crisis, we have consistently emphasized US
preeminence and maintained a strategic overweight to US equities relative to global
market capitalization-weighted benchmarks. Tactically, we have had an overweight
allocation to US equities and US high yield bonds from as early as mid-2008. Even
when US equities became more expensive, we continued to recommend that clients
stay fully invested at their strategic allocations. Indeed, we have reiterated that
recommendation in our past Outlook publications, client calls and Sunday Night
Insight reports as many as 59 times since January 2010.
But now we have crossed into the 10th decile of valuations: US equities have been
more expensive than current levels only 10% of the time in the post-WWII period.
Yet we continue to recommend staying the course. We are duly aware that this
recommendation is long in the tooth, particularly given such high valuations and the
unusually high level of policy uncertainty.
Policy uncertainty, both economic and political, abounds globally: uncertainty with
respect to Brexit (the how and when), upcoming elections in Germany and France
(the who), transitional government in Italy (the how long followed by what) and new
appointments to the Standing Committee in China and their significance (the who and
what of any reform agenda), to name a few.
We are also facing rising geopolitical tensions that could trigger significant market
volatility. Tensions in the Middle East will not abate. Greater Russian involvement
in that region is stabilizing in some respects and destabilizing in others. Further
Russian incursions into Eastern Europe may elicit a more robust reaction from the
West. Terrorism could spread in the US and Europe as ISIL (Islamic State of Iraq and
the Levant) loses territory in Iraq and Syria and foreign fighters return home. North
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Investment Strategy Group
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Korea’s nuclear program and missile launches go unchecked. There is rising risk of
military incidents—or accidents—in the South China Sea and across the Taiwan Strait.
China is the most likely source of global economic shocks over the next two to
three years. The country’s leadership continues to prioritize imbalanced economic
growth over structural reforms, thereby increasing debt at an unsustainable pace. Such
increases will eventually prove to be destabilizing.
In Donald Trump, the US has elected an unconventional president in many
respects, including his more US-centric approach to China. If China responds to,
say, imposition of US tariffs on imports of Chinese products by sharply devaluing
the renminbi, significant downside volatility and tighter global financial conditions
will follow.
Given already high US equity valuations, uncertain economic and political policy
prospects and heightened geopolitical risks, readers may well ask why we continue to
recommend staying fully invested in US equities. Among the reasons:
• Our eight-year US preeminence theme is intact and continues into its ninth year.
As Professor Jeremy Siegel of the University of Pennsylvania wrote 23 years ago in
Stocks for the Long Run 1 and recently repeated in a Wall Street Journal interview, 2
“Stocks are the best long-run asset.” We refine that view by saying US equities are
the best long-run asset.
• We think that the policy backdrop in the US will be particularly favorable for
the economy, with looser fiscal policy, relatively easy monetary policy and a less
stringent regulatory environment. We expect US growth to continue through 2017.
• We expect global growth to improve modestly, from 2.5% in 2016 to 2.9% in
2017, with looser fiscal policy and still easy monetary policy in key countries.
• And last but not least, we expect that while President-elect Trump’s initial policy
measures with respect to tariffs and trade agreements risk jolting financial markets,
as a self-described “deal maker” he will likely adjust and change course as necessary
to achieve his desired results.
We may have a bumpy ride, but the US economy will not be derailed.
Over the years, we have viewed the glass as half-full—if not full—when it comes
to the US economy. Many others have seen the glass as half-empty, pointing out that
productivity growth has decreased, US labor demographics are less favorable and
government policies have been ineffective. While it is correct that productivity growth
has decreased and labor demographics are less favorable, it does not follow that the
US economy is in stagnation. Quite the reverse.
2 Goldman Sachs january 2017
We should note that our conviction in US preeminence and US economic growth in
2017 is greater than our conviction in the direction of the equity markets. Just as we
were appropriately humble about how much further equity markets could fall when
we published our 2009 Outlook, we are equally humble today about our financial
market outlook given the significant uncertainties ahead.
Here, we are reminded of Voltaire’s famous words: “Doubt is not an agreeable
condition, but certainty is an absurd one.” A client with a well-diversified portfolio
that is fully invested at its US equity allocation is generally well positioned for these
uncertain and probably volatile times.
We hope our 2017 Outlook is helpful as you evaluate your portfolio allocations.
We also wish you a healthy, happy and productive 2017.
The Investment Strategy Group
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2017 OUTLOOK
Contents
SECTION I
6 Half Full
We continue to view the glass as half-full—if
not full—when it comes to the US economy.
8 This Recovery in Context—An Update
9 A Hangover from a Crisis
10 Secular Stagnation: Unfavorable
Demographics
12 Secular Stagnation: Declining
Productivity Growth
14 Mismeasurement of GDP Statistics
18 Poor Policies in Washington
19 A Steady Onslaught of External Shocks
20 In Summary
20 One- and Five-Year Expected Total Returns
24 Our Tactical Tilts
25 The Risks to Our Outlook
26 Pace of Federal Reserve Tightening
27 Low Expectations of a US Recession
28 Rising Influence of Populist Parties
in the Eurozone
29 Geopolitical Hot Spots Get Hotter
30 Terrorism Escalates
30 Cyberattacks Continue
31 China Submerges Under Its Debt
Burden and Capital Outflows
33 US-China Relations Deteriorate
Under the Trump Administration
35 Key Takeaways
We expect a favorable global economic and
policy backdrop in 2017, but there is no
shortage of risks. We recommend clients stay
invested in US equities with some tactical tilts
to US high yield and European equities.
4 Goldman Sachs january 2017
SECTION II: WINDS OF CHANGE
36 2017 Global
Economic Outlook
SECTION III: THE HORNS OF A DILEMMA
48 2017 Financial
Markets Outlook
The winds of change should fill the sails of
the ongoing global recovery in 2017.
38 United States
42 Eurozone
44 United Kingdom
44 Japan
45 Emerging Markets
We expect the bull market ride to continue,
but we must stay vigilant to avoid the horns.
50 US Equities
56 EAFE Equities
56 Eurozone Equities
57 UK Equities
58 Japanese Equities
59 Emerging Market Equities
60 Global Currencies
64 Global Fixed Income
74 Global Commodities
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5
Half Full
Since the trough of the global financial crisis in
March 2009, US equities have returned nearly
300%, producing one of the longest bull markets
in the post-WWII period and outperforming all
other major developed and emerging market
country equities. US equities have also exceeded
their pre-crisis peaks of October 2007 and March
2000 by 75% and 103%, respectively, on a total
return basis. This bull market has exceeded all
other bull markets but one in length and exceeded
all but three in magnitude.
US economic growth has also exceeded that of
most other recoveries in length. This recovery is the
fourth-longest recovery in the post-WWII period 3
and if, as we expect, the US economy avoids a
recession in the first half of 2017, this recovery
will become the third-longest. While many critics
correctly point out that it is the slowest recovery
since WWII, it has actually created more economic
growth than some of the stronger recoveries
that lasted for shorter periods. On a cumulative
basis, this recovery ranks sixth out of the last 10
recoveries with respect to GDP growth. What this
recovery has lacked in strength, it has partially
made up for in length.
The slow but steady growth has also exceeded
that of all other major developed economies,
and US GDP per capita has increased more than
the GDP per capita of any major developed or
emerging market country.
This recovery has created over 15 million
jobs. The unemployment rate decreased from
a peak of 10.0% in October 2009 to 4.6% in
November 2016 and is now below its long-term
average of 5.8%. Even the broader U6 measure,
which adds the underemployed (such as parttime
and discouraged workers) to the number of
unemployed, has fallen from a peak of 17.1% to
9.3%, and stands below its long-term average of
10.6%. Unemployment claims are not only lower
than they were during pre-crisis troughs but also
at their lowest since 1973; they are also the lowest
on record as a percentage of the labor force (see
Exhibit 1).
As a result of more robust employment, wages
have increased as well. Wage growth, as measured
by the Atlanta Federal Reserve Bank Wage Growth
Tracker (which, in our opinion, is a better gauge
of the employment backdrop than average hourly
Exhibit 1: US Initial Unemployment Claims as a
Share of the Labor Force
Claims as a share of the labor force are at record lows.
Monthly Average (%)
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
1967 1975 1983 1991 1999 2007 2015
Data through December 2016.
Source: Investment Strategy Group, Datastream.
Exhibit 2: Corporate Profits as a Share of US GDP
Profits have been higher than current levels only 17% of the
time since 1950.
% of GDP
14
12
10
8
6
Corporate Profits
Historical Average
4
1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 2016
Data through Q3 2016.
Note: Showing US corporate profits with inventory valuation adjustment and capital consumption
adjustment.
Source: Investment Strategy Group, Datastream.
earnings, since it is not affected by the changing
composition of the labor force as new entrants are
hired at lower wages), has picked up from a low of
1.6% year-over-year growth in May 2010 to a high
of 3.9% in November 2016—just below the 4.4%
peak of September 2007. More robust employment
and better wage growth have, in turn, led to a
steady increase in consumer confidence, reaching
levels last seen in August 2001, as measured by the
0.2
11.5
9.6
6 Goldman Sachs january 2017
The Declinists at Work
March 1979
Used with permission of Bloomberg L.P.
Copyright© 2016. All rights reserved.
July 2016
Source: Financial Times. Martin Wolf/James Ferguson, 2016. “Global elites must heed the warning
of populist rage.” Financial Times / FT.com, 20 July. Used under licence from the Financial Times. All
Rights Reserved.
Conference Board. Even median household income,
as measured by the US Census Bureau, rose in
2015 at the fastest rate on record.
In the corporate sector, total profits of domestic
corporations as a percentage of GDP, as measured
by the national income and product accounts
(NIPA), are close to all-time highs. At 11.5% of
GDP, profits not only are well above the historical
average of 9.6%, but have been higher than
current levels only 17% of the time since 1950, as
shown in Exhibit 2.
Despite these “glass half-full” facts, the
announcements of US decline that pervaded the
airwaves in the depths of the global financial
crisis have persisted. We continue to be inundated
with analysis of “America’s relative decline,” 4
“America’s slow-growth tailspin” and “sclerotic
growth,” 5 “an economic in-tray full of problems” 6
and, of course, “secular stagnation.” 7 Two books
published in 2016 that have received extensive
coverage epitomize the sentiment: Robert Gordon’s
The Rise and Fall of American Growth 8 and
Marc Levinson’s An Extraordinary Time: The
End of the Postwar Boom and the Return of the
Ordinary Economy. 9
Some of the images are equally telling. We
were struck by a recent image of the Statue of
Liberty on its side that resembles a BusinessWeek
cover of March 1979 with a tear trickling down
Lady Liberty’s face. Since WWII, the waning of US
preeminence has been a topic of recurrent handwringing.
Whether prompted by the flexing of
Soviet muscle, most spectacularly with the launch
of Sputnik in the 1950s; the civil rights upheavals
and growing fallout from the Vietnam War in the
1960s, the Arab oil embargo and the Watergate
scandal of the 1970s, the rise of Japan in the 1980s
or the rise of China in the 2000s, the declinists
have foretold the ebbing of American preeminence.
Typical of the genre is a 2009 book provocatively
titled When China Rules the World 10 by British
columnist Martin Jacques.
Yet, as we wrote in our 2011 Outlook: Stay
the Course, neither the global financial crisis nor
the rise of China will hinder what we described
as “America’s structural resilience, fortitude
and ingenuity” and remove the US from its
preeminent perch.
What explains our difference of opinion, which
has consistently underpinned our investment
recommendation for a greater allocation to US
assets and for remaining invested at such high
valuations? Why do we believe that the US is on
a more solid footing both absolutely and relative
to all other major countries in the world? Is it a
matter of perspective, analytical rigor, bias, review
of longer economic history, or reliance on a big
cadre of external experts in specialized fields?
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Investment Strategy Group
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Exhibit 3: Growth in US Real GDP Across Post-
WWII Expansions
In this recovery, GDP has grown at half the average pace of
prior expansions.
Exhibit 4: Change in US Household Leverage
Following Recessions
A large reduction in household debt served as a drag on the
pace of this recovery.
Cumulative Growth (%)
60
50
40
Q2 1954
Q2 1958
Q1 1961
Q4 1970
Q1 1975
Q3 1980
Q4 1982
Q1 1991
Q4 2001
Q2 2009
Change in Debt-to-GDP (Percentage Points)
10
Previous Post-WWII Recoveries (Median)
Current Recovery
5
0
4.8
30
-5
20
-10
10
-15
0
0 4 8 12 16 20 24 28 32 36 40
Quarters After Trough
-20
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Quarters After Recession End
-18.3
Data as of Q3 2016.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
Data through Q3 2016.
Source: Investment Strategy Group, National Bureau of Economic Research, Federal Reserve
Economic Data.
We believe that no one factor explains the
difference in opinion. Instead, we rely on a
comprehensive framework of investigation that
blends all of these elements, combining rigorous
fundamental, quantitative and technical analysis,
as well as the insights of an extensive network of
external experts. At the same time, we continually
endeavor to overcome the behavioral biases Nobel
Laureate Daniel Kahneman and his collaborator
Amos Tverksy have shown to affect economic
decision-making and tolerance for risk. These key
characteristics of our investment process not only
underpin our continued view of US preeminence,
but also allow us to form a holistic view across
global economies and asset classes. Of equal
importance, our framework provides us with a
consistent process by which to assess investment
opportunities. While we believe our approach is
robust, we acknowledge that nothing can ensure
we will avoid the next downdraft.
We begin our Outlook with a brief review of
this recovery and place it in the context of past
recoveries showing that the glass is indeed half-full.
We address some of the key concerns regarding
demographics and declining productivity growth.
We show that US labor force demographics have
deteriorated and will continue to do so, especially
in the absence of policy changes. Nonetheless, we
demonstrate why there is room for optimism about
productivity growth. The analysis leads us to a
view of slightly above-trend growth for 2017 with
some upside potential from higher productivity
and fiscal stimulus from a Trump administration.
We then turn to our one- and five-year expected
returns, which are driven by our view of a solid
economic foundation, a well-balanced economy
and a positive growth trajectory in the US. We
conclude our introductory section with the risks
to our view, both upside and downside, including
a low probability of recession in 2017, high policy
uncertainty under a Trump administration, possible
global shocks from economic and currency policies
in China, and the risks of geopolitical mishaps in
Europe, the Middle East and the Far East.
This Recovery in Context—An Update
This recovery has been the slowest of the 10
recovery cycles since WWII, as shown in Exhibit
3. Since the trough, US GDP has grown at an
annualized rate of 2.1% through the third quarter
of 2016, which is half the pace of the median and
average growth rates of all other recoveries. The
slow GDP growth rate stands in stark contrast to
the recovery in the labor market and, most recently,
in wages and household income. Impressively, the
decline in the unemployment rate has been the
second-largest of all post-WWII recoveries.
8 Goldman Sachs january 2017
Exhibit 5: Change in US Personal Savings Rate
Surrounding Historical Recessions
The increase in the personal savings rate in this recovery
has been unusually large.
Exhibit 6: Ratio of US Household Net Worth to
Disposable Income
Real estate price and financial asset gains have boosted the
ratio to near pre-crisis highs.
%
Deviation from Start of Recession (Percentage Points)
8
Historical Range
Median
6
Current
700
639
4
2
3.0
600
0
500
-2
-4
-6
-3.4
400
-8
-6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34
Quarters Relative to Start of Recession
Data through Q3 2016.
Note: Quarter 0 marks the start of each recession since 1950, defined as the NBER recession
cycle start. The cycle is measured from the start of each recession until the beginning of the next
recession.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
300
1951 1959 1967 1975 1983 1991 1999 2007 2015
Data through Q3 2016.
Source: Investment Strategy Group, Datastream.
The anemic (but steady) pace of this recovery
has fueled a debate about its causes. The theories
fall into six categories:
• A “hangover” from the global financial crisis 11
• “Secular stagnation” due to unfavorable
demographics
• “Secular stagnation” due to declining
productivity growth
• Mismeasurement of GDP statistics
• Poor policies in Washington
• A steady onslaught of external shocks
We briefly examine each of these six theories
below—some of which we have touched upon
in our prior Outlook publications. While there
has been further research on the topic over the
past year, the debate has not yet been resolved
and likely never will be to everyone’s satisfaction.
One star-studded group of experts believes that
most contributing factors other than weaker
demographics have dissipated or will dissipate, and
the US economy will remain structurally vibrant.
Another star-studded group believes that the best
days of the US are behind it, contending that even
radical policy changes will not reverse this decline
and that the 2016 election results are a testament
to this “secular stagnation.”
A Hangover from a Crisis
Proponents of the “hangover” theory suggest
that recoveries after a major financial crisis
generally have been slower. In their book, This
Time Is Different: Eight Centuries of Financial
Folly, 12 Carmen Reinhart and Kenneth Rogoff
use historical data from 66 countries between
1810 and 2010 to demonstrate that, historically,
recoveries following a major financial crisis have
been markedly slower than other recoveries.
Fundamentally, one can argue that
households deleverage for a long time to increase
precautionary savings, and corporations limit
capital expenditures to build up precautionary
cash, out of fear that another major financial crisis
is looming. As shown in Exhibit 4, the pace at
which households deleveraged in this most recent
crisis was faster than in any other recovery in the
post-WWII period; commensurately, the increase
in the personal savings rate since the start of the
recession is unusually large relative to previous
cycles (see Exhibit 5).
Along with higher savings, the increase in home
prices to levels matching the February 2007 peak
(as measured by the S&P/Case-Shiller US National
Home Price Index on a seasonally adjusted
basis) and the appreciation in financial assets
have boosted the ratio of household net worth
to disposable income to near pre-crisis levels, as
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9
shown in Exhibit 6. This improvement in net worth
will enable households to lower their savings
rates going forward and support consumption.
Therefore, even if the “hangover” hypothesis was
partly valid earlier in the recovery, it should have
less impact in the future.
During the current recovery, the financial sector
also deleveraged substantially, partly due to the
unusually high levels of leverage that existed as
the crisis began and partly due to greater financial
regulation resulting from the Dodd-Frank Wall
Street Reform and Consumer Protection Act signed
into federal law by President Barack Obama on
July 21, 2010. As shown in Exhibit 7, the financial
sector began to deleverage even before Dodd-Frank
and has continued to do so through 2016.
However, more recently, the pace of
deleveraging has abated, as shown in Exhibits 4
and 7. Furthermore, such deleveraging may well
be bottoming and soon reverse as households
and the financial sector face a more favorable
fiscal and regulatory policy environment under
President-elect Trump. For all practical purposes,
the “hangover” may now be over.
Secular Stagnation: Unfavorable Demographics
As we discussed in our 2016 Outlook: The Last
Innings, the term “secular stagnation” was first
coined by economist and Harvard professor
Alvin Hansen in 1934 13 and fully described in his
presidential address to the American Economic
Association in 1938. 14 He predicted that poor
demographics, limited innovation and few
trading and investment opportunities would slow
US growth.
The term was more recently popularized
by Lawrence Summers, professor at Harvard
University and former secretary of the Treasury,
when he referred to secular stagnation in a 2013
speech at the International Monetary Fund. 15
Hansen’s dire predictions never came to pass,
and the US experienced close to record levels of
productivity growth in the post-WWII period up
to 1973, along with strong growth in the labor
force. This current cycle, in contrast to the decades
immediately following Hansen’s predictions, has
been hampered by weak demographics and a
decline in the growth rate of the labor force. In a
September 2016 study, aptly called “How Should
We Think About This Recovery?,” Jay Shambaugh,
a member of the Council of Economic Advisers,
shows that when one compares this recovery
Exhibit 7: Change in US Financial Sector Leverage
Following Recessions
A decrease in financial sector indebtedness has contributed
to a slower-than-usual recovery.
Change in Debt-to-GDP (Percentage Points)
30
Previous Post-WWII Recoveries (Median)
Current Recovery
20
10
0
-10
-20
-30
-40
-50
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Quarters After Recession End
Data through Q3 2016.
Source: Investment Strategy Group, National Bureau of Economic Research, Federal Reserve
Economic Data.
with the average of past recoveries, the growth
gap narrows significantly if one accounts for the
number of people in the labor force. 16 Instead of
this recovery growing at about half the pace of
the average of past recoveries, the gap narrows to
83% of the average: GDP per number of people in
the labor force has grown at an annualized rate of
1.9%, compared with an average of 2.3% in past
recoveries. A recovery that appears to be at half
the pace of other recoveries is actually in line with
other recoveries after adjusting for the size of the
labor force, as shown by comparing the red lines in
Exhibits 8 and 9.
There are two components to the unfavorable
demographics story. The first is simply the decline in
the growth rate of the US working-age population,
which is driven by aging, the retirement of the baby
boom generation and slower immigration.
This trend cannot be easily reversed; however,
the pace of decline can potentially be slowed.
For example, the commonly accepted retirement
age of 65 can be extended. In fact, there is some
evidence that baby boomers are working longer
than historical norms. 17 When life expectancy was
about 62 years in 1935, the retirement age for
Social Security was 65. Today, life expectancy in
the US is about 79 years, and the retirement age for
Social Security has been extended to 67 for those
born in 1960 or later. Of course, more broadly, the
retirement age is still regarded as 65. A 65-year-
18.6
-37.1
10 Goldman Sachs january 2017
Exhibit 8: Growth in US Real GDP Across Post-
WWII Expansions
In this recovery, GDP has grown at half the average pace of
prior expansions.
Exhibit 9: Growth in US Real GDP per Person in
the Labor Force Across Post-WWII Expansions
But when adjusted for labor force trends, this recovery has
actually been in line with the average of past expansions.
Cumulative Growth (%)
60
50
40
Q2 1954
Q2 1958
Q1 1961
Q4 1970
Q1 1975
Q3 1980
Q4 1982
Q1 1991
Q4 2001
Q2 2009
Cumulative Growth (%)
60
50
40
Q2 1954
Q2 1958
Q1 1961
Q4 1970
Q1 1975
Q3 1980
Q4 1982
Q1 1991
Q4 2001
Q2 2009
30
30
20
20
10
10
0
0 4 8 12 16 20 24 28 32 36 40
Quarters After Trough
0
0 4 8 12 16 20 24 28 32 36 40
Quarters After Trough
Data as of Q3 2016.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
Data through Q3 2016.
Source: Investment Strategy Group, Datastream, National Bureau of Economic Research.
old today, however, is much healthier and more
vibrant than a 65-year-old in 1935 and has many
more years of active life that can reduce the decline
in the growth rate of the working-age population.
Furthermore, this cohort is quite productive
relative to new entrants into the labor force.
Similarly, immigration reform can help offset the
decline in working-age population growth. Both
factors depend on policy changes, and we do not
have any definitive reason to be either optimistic or
pessimistic at this time.
The second component of the unfavorable
demographics perspective has been the drop in
labor force participation, particularly among
males. Exhibit 10 shows the rapid growth in labor
force participation that occurred as the baby
boom generation reached working age and as
women joined the labor force in growing numbers
after 1950. The labor force participation rate,
however, peaked in 2000 and declined by 0.3%
a year until it troughed at 62.4% in September
2015. Most of the drop was driven by three
factors: significant decline in male labor force
participation, retirement of baby boomers and the
cyclical decline in demand for labor as a result
of the global financial crisis. Some of the cyclical
decline reversed as the economic recovery entered
its eighth year: the participation rate has risen to
62.7% as of November 2016.
The male labor force participation, however,
has been declining, coincidentally also by 0.3%
Exhibit 10: US Labor Force Participation Rate
Both cyclical and structural factors have contributed to a
decline in the participation rate from the 2000 peak.
%
70
68
66
64
62
60
58
56
54
52
50
1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 2016
Data through November 2016.
Source: Investment Strategy Group, Datastream.
per year—but since 1952. The trend has occurred
across all age cohorts. An important driver of this
decline has been reduced demand for lower-skilled
and less-educated males. The US ranks 32 out of
34 OECD countries in participation of prime-age
(between the ages of 24 and 54) males in the labor
force, ahead of only Italy and Israel. 18 A Council of
Economic Advisers report in June 2016 attributed
that low ranking to the fact that the US spends
less than other OECD countries on job search
67.3
62.7
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assistance and job training, and to the fact that the
US has a high rate of incarceration that especially
affects lower-skilled men. 19 According to the
report, several policy measures can boost primeage
male labor force participation, including
• Increased investment in infrastructure
• Systemic reforms in the criminal justice system
and in immigration policies
• Tax reforms
• Investment in education and training
This demographic aspect of secular stagnation is
undeniable. In fact, an October 2016 paper by a
team at the Federal Reserve Board, “Understanding
the New Normal: The Role of Demographics,” 20
shows that the slow pace of economic growth since
1980 and the more pronounced decline in the last
decade could be predicted by a model looking
at “fertility, labor supply, life expectancy, family
composition, and international migration.”
Thus, a glass half-full or half-empty perspective
does not change the facts on the ground. There is
little cause for near-term optimism with respect
to the slower growth rate of the labor force. The
general consensus is that the US labor force will
grow at an average of 0.6% per year in the next
several decades, compared with 1.6% from 1950
to 2000. 21
In the shorter term, infrastructure investment
and other policies highlighted above may boost
the growth rate in the labor force, but it is hard to
imagine growth rates reaching levels that would
support President-elect Trump’s GDP growth
targets of 3–4% on a sustainable basis. 22
Secular Stagnation: Declining
Productivity Growth
Of all the theories put forth to explain the slow
pace of this recovery, the one that has garnered the
most attention is declining productivity growth.
Of all the theories put forth to explain
the slow pace of this recovery, the
one that has garnered the most
attention is declining productivity
growth.
It is also the most important issue in terms of its
impact on future trend growth in the US, which in
turn has the greatest impact on the long-term rate
of earnings growth and equity market returns.
As reviewed in last year’s Outlook, the technooptimists
and the techno-pessimists are on opposite
sides of the debate on declining productivity
growth. Both camps have garnered new members;
even Federal Reserve Chair Janet Yellen and
Vice Chair Stanley Fischer have joined the fray. 23
Most recently, in September 2016, the Brookings
Institution hosted a conference with leading
experts from both camps to debate the issue.
We should note that debates on productivity
are nothing new. They have surfaced during past
periods of slow growth, as was the case in the early
1990s. Even some of the players are the same:
Robert Gordon was a techno-pessimist in the early
1990s and remains so in the 2010s. 24
Part of the productivity debate is philosophical.
For example, one question pertains to the increased
use of free digital services such as Facebook,
Google Maps, Waze and Khan Academy. These
services yield “consumer surplus,” defined as the
benefits consumers derive from various activities
over and above the price they pay. Should they be
included in GDP if they are deemed “non-market”
services—those that are provided free of charge
or at a fee that is well below 50% of production
costs? While social media such as Facebook may
(or may not, depending on your perspective)
provide a service greater than the advertisement
revenues associated with the use of that service,
some will argue that if such services do not have an
associated market price, they are not part of GDP
and therefore should not impact the calculation of
productivity levels. As the volume and the impact
of these non-market services increase, we believe
that the methodology for measuring GDP will
evolve to better reflect the value of these services.
Such improvements in measuring GDP are not
uncommon. The Bureau of Economic
Analysis (BEA) conducts comprehensive
revisions of the national income and
product accounts every five years, with
the goal of reflecting methodological
and statistical improvements. Most
recently, in 2013, the BEA expanded
its definition of fixed investment to
include expenditures on research and
development and expenditures on artistic
originals (e.g., books, music, television
12 Goldman Sachs january 2017
Exhibit 11: Pillars of the Investment Strategy Group’s Investment Philosophy
INVESTMENT STRATEGY GROUP
History is a
Useful Guide
Appropriate
Diversification
Value
Orientation
Appropriate
Horizon
Consistency
ANALYTICAL RIGOR
ASSET ALLOCATION PROCESS IS CLIENT-TAILORED AND INDEPENDENT OF IMPLEMENTATION VEHICLES
series, movies). Combined with some smaller
improvements, these changes added $560 billion to
the level of 2012 GDP, a 3.6% increase relative to
the prior estimate. 25
The more immediate—and important—
question is whether we have entered a new phase
in productivity growth trends that will keep
productivity growth at the low levels seen since
2004. We believe that the answer is unknowable
with any degree of certainty; historically,
productivity forecasts have been notoriously
wrong. In The Age of Diminished Expectations, 26
first published in 1990, Paul Krugman, Nobel
laureate in economics and professor at City
University of New York, wrote that the lower pace
of productivity growth experienced since the early
1970s would most likely persist in the future. In
1995, however, productivity growth rates increased
and were more than double the rate of the prior
12-year period.
Similarly, in 1997, the Congressional Budget
Office estimated that the long-run average annual
growth rate of labor productivity would be 1.1%.
Between 1995 and 2004, the actual average annual
growth rate of labor productivity was 3.2%. 27
As many of our clients know, one of the pillars
of our investment philosophy is that history
is a useful guide (see Exhibit 11). And history
tells us that labor productivity has moved in
cycles, with periods of low productivity growth
followed by periods of high productivity growth.
In a forthcoming and comprehensive paper
titled “Seven Reasons to Be Optimistic About
Productivity,” 28 Professors Lee Branstetter of
Carnegie Mellon University and Daniel Sichel
of Wellesley College show that periods of low
productivity growth have been followed by periods
of high productivity growth since 1889, as seen
in Exhibit 12. There is no reason to believe that
“this time is different”; as many of you also know,
we believe that those words are among the most
dangerous and misused words in our industry.
Olivier Blanchard, senior fellow at the Peterson
Institute for International Economics and former
chief economist at the IMF, has also shown that
the current period of low productivity growth does
not tell us much about future productivity trends.
He states that the correlation of “successive pairs
of five-year averages of total factor productivity
growth is only 0.20” since the mid-1970s. 29
Outlook
Investment Strategy Group
13
Exhibit 12: US Labor Productivity Growth
Periods of slow productivity growth have been followed by
periods of stronger productivity gains.
Average Annual Growth Rate (%)
4.0
Exhibit 13: Correlation of 5-Year US Productivity
Growth Rates With Following 5 Years’
Productivity Growth Rates
Recent productivity trends tell us little about the future.
Correlation
0.25
3.5
3.0
3.4
3.1
3.2
3.2
0.20
2.5
2.0
1.5
1.6
2.0
1.5
1.3
0.15
0.10
0.14
0.08
1.0
0.5
0.05
0.0
1889–1917 1917–1927 1927–1940 1940–1948 1948–1973 1973–1995 1995–2004 2004–2015
0.00
Since 1957 Since 1970
Data through 2015.
Source: Investment Strategy Group, Lee Branstetter and Daniel Sichel, “Seven Reasons to Be
Optimistic About Productivity,” forthcoming Peterson Institute for International Economics
Policy Brief.
Data through Q3 2016.
Source: Investment Strategy Group, Haver Analytics, Olivier Blanchard, “Three Remarks About
the US Treasury Yield Curve,” Peterson Institute for International Economics, June 22, 2016.
We have examined labor productivity growth
rates and, as shown in Exhibit 13, find even
lower correlations.
There are two issues to consider. First, if the
reported productivity growth rates are accurate,
then the exceptionally low rates of the last 10 years
account for part of the slow pace of this recovery.
However, the current low productivity growth rates
do not portend low growth rates going forward.
Just as Hansen was proven wrong on his secular
stagnation theory and Krugman was proven wrong
on his diminished expectations for the US economy
(and they were both influenced by their pessimistic
view on productivity), those who extrapolate
stagnation from the current productivity trends
may be proven wrong as well.
Second, as we discuss below, there is also a high
probability that real GDP may be mismeasured.
If real GDP is mismeasured, it follows that
If real GDP is mismeasured, it follows
that productivity is also mismeasured,
thereby invalidating the whole theory of
secular stagnation and the decline of the
US economy.
productivity is also mismeasured, thereby
invalidating the whole theory of secular stagnation
and the decline of the US economy.
Mismeasurement of GDP Statistics
In addition to the productivity debate, there is
a debate as to whether we are measuring GDP
correctly in the first place. The key argument being
made is that while we correctly measure the value
of nominal GDP based on the value of goods and
services, we mismeasure the value of real GDP
when we convert nominal GDP to real GDP using
various price indices, and this therefore understates
the pace of this recovery. This debate garnered
considerable attention in 2016.
The mismeasurement argument states that
the official price indices do not adequately reflect
significant improvements in many products,
especially in information and communication
technology, due to the methodology
used by the Bureau of Labor
Statistics (BLS) and the BEA. If the
price indices do not adequately
reflect the greater capacity of
an improved product such as a
smartphone or a microprocessor,
then the price index used to convert
nominal GDP to real GDP is too
high. And if the price index is too
high, then real GDP is understated.
14 Goldman Sachs january 2017
It follows that if real GDP is understated, then
what appears to be a slow recovery is not as slow
as reported and what appears to be a period of low
productivity growth is not as low as reported.
We believe that the evidence favors the
mismeasurement argument. At a September 2016
Brookings Institution conference on productivity,
Martin Feldstein, Harvard professor and president
emeritus of the National Bureau of Economic
Research, also concluded that “the official statistics
substantially underestimate the real growth
of output” after studying the methods used to
measure price indices. 30
We point to three examples to illustrate the
mismeasurement argument. First, our colleagues in
Goldman Sachs’ Global Investment Research (GIR)
have pointed out that the official price indices for
information and communication technology show
an implausible gap between the price deflation in
computers and that in communications equipment,
software and other IT equipment (see Exhibit 14).
They question how “a given dollar outlay now
buys about 10 times as much computer in real
terms as 20 years ago, but it only buys about 10%
more software.” 31
Our colleagues’ conclusion that the
official price indices for the information and
communication technology sector are overstated
matches that of a 2015 study of microprocessor
pricing by David Byrne of the Federal Reserve
Board, Professor Stephen Oliner of UCLA, and
Sichel. 32 The trio created an index showing that
prices for microprocessor units used in desktop
personal computers declined by an average
annual rate of 43% between 2008 and 2013,
while the official Producer Price Index (PPI)
for these units declined by an average annual
rate of 8%—substantially mismeasuring the
real value created by this sector of information
technology equipment. They point out that
because microprocessor units represent about half
of US shipments of semiconductors, the rate of
innovation in this sector is inevitably mismeasured.
A second example of mismeasurement that we
can all readily appreciate involves the quality and
product improvements in smartphones. Hal Varian,
chief economist at Google and emeritus professor
at the University of California at Berkeley, has
estimated that globally, people took over 1.6
trillion photos in 2015 using their smartphones,
compared with 80 billion in 2000 using cameras
and film. The price of each photo taken has gone
Exhibit 14: US Technology Price Indices
The implausible gap with hardware suggests IT and
communication price indices are likely overstated.
Q1 1995 = 100
140
120
100
80
60
40
Software
Hardware (Computers and Peripherals)
Communications Equipment
Other IT Equipment
20
9
0
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Data through 2015.
Note: Other IT Equipment represents medical and non-medical equipment and instruments.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bureau of
Economic Analysis.
from 50 cents to zero for smartphone users; 1.6
trillion photos that would have contributed $800
billion to GDP have no impact on GDP in the
current framework. GDP has declined since camera
and film sales have fallen without a commensurate
quality adjustment for smartphones. Of course,
fewer photos would have been taken had the
smartphone not been developed, but the point
still stands. 33
Similarly, Varian shows that with the onset of
the commercial application of GPS technology,
productivity growth in trucking was twice the
aggregate US productivity growth, yet when GPS
functionality was added to smartphones basically
at no additional charge, GDP declined because
sales of stand-alone GPS systems fell. 34
Finally, a third example, also provided by
Varian, shows that, because GDP does not fully
count the export of intangibles such as software
and design, GDP is understated. He shows how an
iPhone manufactured by Foxconn in China using
parts from 28 countries and exported to France
has no direct impact on US GDP. Varian concludes
that in a global supply chain, US design and
software that is replicated outside the US through
offshore manufacturing and exported to a third
country never impacts US GDP measures directly,
particularly if the profits are not repatriated and
redeployed in the US. 35
Our colleagues in GIR continue to estimate that
such mismeasurements lower reported annual real
114
90
44
Outlook
Investment Strategy Group
15
We believe that productivity in
health care is underestimated.
Consider IBM’s Watson Health,
an artificial intelligence system
that can read 200 million pages
of text in 3 seconds. As of 2015,
Watson had amassed 315 billion
data points representing health
records, lab results, genomic
tests and clinical studies. The
system processes patients’ cases
against its ever-growing database
and recommends customized
treatment options. With such
developments, we expect
continued improvement in growth
of productivity in health care.
“If productivity growth
were better measured,
particularly in health and
other services, the growth
rate would look better than
is currently reported.”
Martin Neil Baily and Nicholas Montalbano, “Why Is U.S. Productivity
Growth So Slow? Possible Explanations and Policy Responses,”
Brookings Institution, September 2016.
GDP growth by about 0.7 percentage point, similar
to their estimate reported in our Outlook last year.
Of course, not all experts believe that there is
a mismeasurement problem. Notable among them
is Chad Syverson of the University of Chicago,
who raises four points in making this case. 36
First, he states that the productivity slowdown
has been global in nature and unrelated to
countries’ consumption or production intensities
of information and communication technology.
Second, he states that estimates of consumer surplus
are too small relative to his estimates of lost GDP
due to slower productivity growth. Third, he argues
that if such mismeasurement existed, the growth rate
in the information and communication technology
sector would be a multiple of its stated growth rate.
Finally, while he acknowledges that gross domestic
income has been higher than GDP since 2004 and
the gap might reflect the higher wages of workers
who are producing non-market digital services, he
does not believe that this difference is evidence of
mismeasured GDP because the trend started earlier
than the slowdown in productivity growth.
A somewhat similar line of reasoning has been
presented by Byrne, John Fernald of the Federal
Reserve Bank of San Francisco and Marshall
Reinsdorf of the IMF in a paper titled “Does the
United States Have a Productivity Slowdown or a
Measurement Problem?” 37 While they agree that
productivity growth has been mismeasured in the
past, they argue that the mismeasurement has been
negligible in the 2004–15 period partly because
computer hardware, for which mismeasurement
was once a factor, now makes up a smaller part of
GDP. Therefore, the impact is less in the 2004–15
period than it was in the 1995–2004 period when
productivity growth was much higher. They also
state that free digital products not only are nonmarket
and should not be counted in GDP, but also
are not sizable enough to account for the level of
decline in productivity growth rates.
Experts’ opinions on mismeasurement continue
to evolve. In fact, in a subsequent publication coauthored
with Carol Corrado of the Conference
Board, Byrne found a significantly higher level
of software price mismeasurement than assumed
in his prior paper. 38 He has also co-authored a
study on prices and depreciation for computer
tablets such as iPads, proving that quality-adjusted
price indices for tablets have fallen much faster
than the broader price indices for computers and
peripheral equipment. 39
16 Goldman Sachs january 2017
Exhibit 15: 10-Year Net Survival Rate of Breast and Prostate Cancer Patients
Improved cancer survival rates reflect significant gains in science and technology.
%
100
75
72
76
78
75
84
60
62
50
40
48
34
25
25 25
0
1971–1972 1980–1981 1990–1991 2000–2001 2005–2006 2010–2011 1971–1972 1980–1981 1990–1991 2000–2001 2005–2006 2010–2011
Breast Cancer
Prostate Cancer
Period of Diagnosis
Data as of November 2014.
Note: Based on cancer statistics for the UK. Ten-year survival for 2005–2006 and 2010–2011 is predicted using an excess hazard statistical model.
Source: Investment Strategy Group, Cancer Research UK.
We conclude that there is undoubtedly
some degree of mismeasurement. We know that
information and communication technology has
evolved significantly and innovation is occurring
at a rapid pace. We know that the BEA reviews
its statistical methodologies every five years
and revises them as needed, recognizing that
measurement methodologies have to evolve with
the evolution of the US economy. We also know
that we as consumers carry incredibly powerful
digital equipment in the palms of our hands and
pay less for it than we paid for equipment with
lesser functionalities not so long ago. Common
sense supplemented by extensive research by the
experts on productivity and mismeasurement
reinforces our view of a glass half-full when it
comes to innovation and productivity in the US.
We realize this debate will be resolved only
with the benefit of hindsight, in the same way
that realized productivity growth exceeded the
We realize this debate will be resolved
only with the benefit of hindsight, in
the same way that realized productivity
growth exceeded the prognostications
of Hansen in the late 1930s and
Krugman in the early 1990s.
prognostications of Hansen in the late 1930s and
Krugman in the early 1990s. Our clients will be
inundated with conflicting views from headlines
in the media and books with captivating titles.
Separating fact from fiction remains challenging.
Recently, an article in the Wall Street Journal
highlighted “dwindling gains in science, technology
and medicine.” 40 The article suggested that
improvements in breast cancer mortality have
slowed since 1985. Exhibit 15 shows the 10-year
net survival rate for breast cancer and prostate
cancer since 1971. Maybe it is only a matter of
perspective, but, to us, a 78% 10-year survival rate
for breast cancer and an 84% 10-year survival
rate for prostate cancer represent significant
improvements over the rates of the early 1980s,
48% and 25%, respectively, and are even more
significant for those whose lives have been saved.
Probably one of the more amusing instances
of conflicting perspectives can be seen in the
2016 publication of two books with
diametrically opposed messages:
Progress: Ten Reasons to Look
Forward to the Future 41 and The
Innovation Illusion: How So Little
Is Created by So Many Working So
Hard, 42 both written by authors born
in Sweden in the early 1970s. Our
views, of course, are more aligned
with the first book. The second book,
however, raises important concerns
about excessive regulation and how
Outlook
Investment Strategy Group
17
such regulation is “killing frontier innovation.”
Indeed, some have put forth the prevalence of
poor government policies as one of the theories to
explain the slow pace of this recovery.
Poor Policies in Washington
One of the theories that has been getting more
traction recently attributes the slower recovery
to poor policies enacted in Washington. In a June
2016 article about the US economy, Gregory
Mankiw, professor at Harvard University and
former chair of the Council of Economic Advisers
for President George W. Bush, highlighted “policy
missteps,” 43 including misguided fiscal policy, as
a possible contributor to the slow pace of growth
since the global financial crisis.
One unusual feature of this recovery has, in
fact, been a contractionary fiscal policy. We have
derived an approximate historical measure of
fiscal policy changes by estimating changes in the
cyclically adjusted federal budget as a percentage
of GDP. We note that, by this measure, as far back
as 1890, fiscal policy has been expansionary in all
but three recoveries following a recession—with
the fiscal policy in the current recovery being the
most contractionary, as shown in Exhibit 16. In
this recovery, the budget deficit as a share of GDP
was reduced by 1.0% a year, compared to an
average widening of the budget deficit by 1.3% a
year in all other recoveries after severe recessions.
The average increase in the size of the budget
Two books published in 2016 and written by Swedes born in the early
1970s highlight the conflicting perspectives on productivity.
Johan Norberg’s Progress cover used with permission of Johan Norberg
and Oneworld Publications. All rights reserved.
Fredrik Erixon and Bjorn Weigel’s The Innovation Illusion: How So Little
Is Created by So Many Working So Hard cover used with permission of
Fredrik Erixon, Bjorn Weigel and Yale University Press. All rights reserved.
Exhibit 16: Change in US Budget Balance
Following Recessions
Fiscal policy has been an unusually large headwind to
growth in this recovery.
% of GDP
2
1
0
-1
-2
-3
-4
-5
Average of All Expansions
Average of All Expansions from Severe Recessions*
0.0
-0.1
-0.3
-0.2
-0.4
-0.3
-0.9
-1.1
--1.1
-1.4
-4.7
1894 1908 1921 1933 1938 1954 1958 1961 1970 1975 1982 1991 2001 2009
Year of Expansion Start
Data through 2015.
Note: Shows the change in the cyclically adjusted budget balance as a % of GDP for
each episode.
Source: Investment Strategy Group, Datastream, Global Financial Data.
* We define “severe” recessions according to those identified by Carmen Reinhart and Kenneth
Rogoff in “Recovery from Financial Crises: Evidence from 100 Episodes” (2014), as well as the
1937 recession (a continuation of the 1929 recession) and the two most severe post-WWII
recessions (excluding the 2007 recession).
deficit for all recoveries, including less severe
ones, is -0.8%. A swing of 1.8 percentage points
would have had a material impact on the pace of
this recovery.
Professor Alan Blinder of Princeton University
and former vice chair at the Federal Reserve echoed
the sentiment by stating that partisan politics have
prevented progress in dealing with important
economic issues. 44 Shambaugh has outlined various
measures, such as infrastructure spending proposed
by President Obama in his fiscal year 2017 budget,
that would positively impact productivity and labor
force participation. 45 The budget was not approved.
Summers has similarly called for expansionary fiscal
policy through infrastructure spending, but such
policies have not been pursued. 46
Increased regulation has also been blamed
for some of the slow pace of this recovery. A
September 2016 working paper by Martin
Neil Baily and Nicholas Montalbano of the
Brookings Institution on the slow growth of US
productivity shows that while productivity in the
most productive firms is growing rapidly, their
best practices are not spreading to the rest of the
players in a given industry. 47 Exhibit 17 shows the
widening gap between the productivity growth
rates of firms at the frontier of innovation and
0.5
-0.6
1.0
-0.8
-1.3
18 Goldman Sachs january 2017
Exhibit 17: Labor Productivity Growth for
Different Groups of Firms
Rapid productivity growth of firms at the frontier of
innovation is not spreading to the rest of the industry.
Exhibit 18: US Financial Conditions Index
Conditions tightened significantly due to global shocks
emanating from the Eurozone, oil prices and China.
Index, 2001= 1 (Log Points)
1.5
Frontier Firms—Top 5% in Each Industry/Year
Frontier Firms—Top 100 in Each Industry/Year
Non-Frontier Firms
1.4
1.3
1.39
1.36
US Financial Conditions Index
101.5
101.0
100.5
+142bp
100.0
Tightening
+118bp
+104bp
1.2
99.5
1.1
1.06
99.0
1.0
98.5
0.9
2001 2003 2005 2007 2009 2011 2013
Data through 2013.
Note: Average across 24 OECD countries and 22 manufacturing and 27 market services
industries.
Source: Investment Strategy Group, OECD preliminary results based on Dan Andrews, Chiara
Criscuolo and Peter N. Gal, “Mind the Gap: Productivity Divergence Between the Global Frontier
and Laggard Firms,” OECD Productivity Working Papers, forthcoming.
98.0
2010 2011 2012 2013 2014 2015 2016
Data through year-end 2016.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research.
the rest of the industry. Baily and Montalbano
suggest that increased regulation after the crisis
may be partially responsible for the widening gap
between frontier firms and the rest of the industry,
which lowers overall productivity growth rates
across the economy and hence lowers the pace of
economic growth.
Our colleagues in GIR think that lower capital
investment accounts for the lack of diffusion of
new technologies from more productive firms to
less productive firms. 48 Here, again, it is likely that
a more favorable business environment could have
boosted capital expenditures and increased overall
productivity levels.
We conclude that it is reasonable to assign
some of the weakness in this recovery to less
effective fiscal and regulatory policies out of
Washington rather than to structural shortcomings
in the US economy.
A Steady Onslaught of External Shocks
A sixth theory posits that numerous external
shocks explain the slow pace of this recovery.
Just as the US economy was recovering from the
trough of 2009, the Eurozone sovereign debt crisis
jolted global financial markets. The Eurozone
was a source of uncertainty and financial market
volatility beyond the initial shock in 2010 as the
crisis spread from Greece to Spain and Italy.
The Eurozone crisis was followed by a series
of what the Brookings Institution has called the
“fiscal fights of the Obama administration.” 49 The
first fiscal fight resulted in the Standard and Poor’s
(S&P) downgrade of US Treasury debt in August
2011. The equity markets, as measured by the S&P
500 Index, dropped about 19% between April and
October of 2011.
Taken together, the Eurozone sovereign debt
crisis and the first of the fiscal fights tightened
US financial conditions 50 by 142 basis points (see
Exhibit 18). GIR estimates that a 100 basis point
tightening of financial conditions is equivalent to a
federal funds hike of 150 basis points and a drag
on GDP growth of about one percentage point.
The drop in oil prices from a post-crisis high
of $107 per barrel for West Texas Intermediate
in June 2014 to a trough of $26 per barrel in
February 2016 also provided a shock to the
economy. Employment and capital expenditures
in the oil and gas sector dropped by 29% and
67%, respectively, from peak levels seen in 2014.
The sector’s par-weighted default rate excluding
distressed exchanges reached 14.6% and including
such exchanges 19.8%, in October 2016. 51
Broad-based fear of policy mistakes in China
and unexpected depreciation of the renminbi were
Outlook
Investment Strategy Group
19
Exhibit 19: US Equity Volatility
Spikes in equity volatility have corresponded with major global shocks.
VIX Level
90
80
70
60
50
1 Global Financial Crisis
2 First Greek Bailout
3 Debt Ceiling, S&P Downgrade,
Eurozone Sovereign Debt Crisis
4 Greek Default
5 ISIL, Ebola
6 Renminbi Depreciation
SPX: -42%
80.9
(11/20/08)
1
45.8
(5/20/10)
40.7
(8/24/15)
40
30
20
10
18.8
(8/22/08)
SPX: -12% 2
15.6
(4/12/10)
SPX: -19% 3
26.7
(6/1/12)
SPX: -10% 4
14.7 14.3
(4/21/11) (3/26/12)
28.1
26.3
(2/11/16)
(10/15/14)
SPX: 6
SPX:
SPX: -12% -13%
-7%
6
5
14.5
11.5 12.0 (11/3/15)
(8/22/14) (7/17/15)
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Data through December 31, 2016.
Note: The red arrows show the S&P 500's (SPX's) peak-to-trough declines around each episode.
Source: Investment Strategy Group, Bloomberg.
48.0
(8/8/11)
another shock to the financial markets, resulting
in the tightening of financial conditions in the
US in mid-2015 and early 2016, with US equities
dropping by more than 10% in both periods.
Exhibit 19 provides a time line of shocks,
which, in all likelihood, dampened the pace of the
US recovery.
In Summary
As we review the six theories that could account
for the notably slow pace of this recovery, we
believe that all have some merit. Recovering
from the hangover from the deepest recession
since the Great Depression took a little longer.
Demographics have not been favorable.
Productivity growth appears lower, but that fact
does not portend weak productivity growth in the
future. Productivity growth is also probably not as
weak as it appears, given some mismeasurement
of GDP. Fiscal and regulatory policies hampered
the economic recovery. And the global backdrop
provided a steady source of shocks that slowed
growth in the US.
That said, we feel confident that the US
continues to progress on a solid footing, that the
recovery is intact and, as we argued in our 2016
Outlook: The Last Innings, that this recovery and
bull market have another inning or two left to run.
The glass is still half-full.
We now turn to our expected returns for the
next one and five years.
One- and Five-Year Expected
Total Returns
The Investment Strategy Group began producing
one- and five-year annualized expected total
returns for major asset classes in our 2013
Outlook. Since then, our key message has been
to stay invested in US equities despite the low
returns we have expected for the asset class.
Our recommendation has been driven by a low
probability of recession, a reasonable probability
of upside for equities, zero expected returns for
cash and negative expected returns for bonds.
We have presented these one- and five-year
annualized expected returns to: a) provide more
context for our investment recommendations; b)
encourage our clients to have a longer investment
horizon; and c) increase the odds that our clients
have greater staying power to withstand market
downdrafts.
Fulfilling these three priorities is even
more imperative moving forward. Our return
expectations are lower than in prior years after
several years of outsized returns in equities
and high yield, and, at the same time, we are
confronted with tremendous economic policy and
geopolitical uncertainty. We have been faced with
such uncertainty in the past, but today (in contrast
with periods such as 2008), we no longer have the
wind at our back with the benefit of cheap equity
and high yield valuations. In 2008, we believed
that attractive valuations would eventually lead to
high prospective returns in US equities and high
20 Goldman Sachs january 2017
yield, notwithstanding short-term uncertainty.
At the dawn of 2017, we face uncertainty, but
US equities and high yield are expensive, and
valuations no longer provide much margin of
safety and protection from the downside. Similarly,
other asset classes such as fixed income provide
negligible returns but come with downside risk,
e.g., if the incoming Trump administration’s fiscal
policy is more stimulative than we expect or if the
Federal Reserve raises interest rates at a more rapid
pace than we expect.
As we prepared our one- and five-year
annualized expected returns for this Outlook and
finalized our investment recommendations for
2017, we were struck by two observations.
First, the general recommendations and
volatility warnings in our Outlook publications
over the last several years have been similar, have
been directionally correct and have generally
added value to our clients’ portfolios. We have
continuously recommended that clients stay
invested in their strategic US equity allocation. We
have also recommended maintaining some tactical
tilts such as an allocation to high yield. Yet we
have warned clients to be prepared for bouts of
volatility. Last year, our exact message to clients
with respect to volatility was that “markets will
be volatile, so an asset class that performs well in
the first half of the year may perform particularly
poorly in the latter part of the year; however,
investors—unlike traders—should not try to time
such short-term moves.” 52 It is very important that
clients heed this warning—not just for 2017 but
for their entire investing lives.
Exhibit 20 illustrates the point. We have
compared the performance of some of the bestperforming
asset classes and sectors for the year
with the performance of those assets at their worst
The general recommendations and
volatility warnings in our Outlook
publications over the last several
years have been similar, have been
directionally correct and have
generally added value to our clients’
portfolios.
Exhibit 20: Returns in 2016
Some of the best-performing assets in 2016 experienced
significant declines before recovering.
Total Return (%)
50
40
30
20
10
0
-10
-20
-30
-10.3
Return Through Year-End 2016
Return Through 2016 Low (2/11/16)
12.0
S&P 500 Total Return Index
-19.1
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
point of the year. Energy high yield provides an
excellent example. On February 11, 2016, the
US energy high yield sector (as measured by the
Bloomberg Barclays High Yield Energy Total
Return Index) was down 19.1% year to date—one
of the worst-performing sub-asset classes at that
time. Similarly, the US bank sector (as measured by
the S&P Banks Select Industry Total Return Index)
was down 21.7% over the same period. We had
in place tactical tilts in both sectors. As oil prices
recovered, high yield energy securities rallied, with
the benchmark index ending the year up 37.4%—a
wild swing of 56 percentage points from low to
high. US banks also rallied initially in response
to prospects of higher interest rates and later in
anticipation of less regulation under a Trump
administration. The bank sector index rallied to
end the year 31.3% higher than at the start—an
equally wild swing of 53 percentage
points from low to high.
We have to be realistic: we cannot
anticipate such market swings on
a consistent basis. Therefore, it is
imperative that clients maintain a
long investment horizon, be tactical
when investment opportunities present
themselves—usually at times of extreme
stress in the financial markets—and
37.4
Bloomberg Barclays High
Yield Energy Total Return
Index
-21.7
31.3
S&P Banks Select Industry
Total Return Index
otherwise stay invested in the appropriate
strategic asset allocation.
Our second observation was that
our five-year annualized return forecasts
Outlook
Investment Strategy Group
21
Exhibit 21: Historical Total Returns vs. ISG’s 2013 Outlook 5-Year Prospective Total Returns
Our 5-year return forecasts have so far been relatively accurate for the bulk of assets in our diversified model portfolio, but
we have not been right across the board.
% Annualized
20
15
5-Year Annualized Projected Return—As of December 31, 2012
Actual Annualized Returns—Since December 31, 2012
14
18
14
15
19
10
5
0
-5
0
1
0
2
4
5
5
3
6 6
7
-5
8
11
11
-2
10
-10
10-Year
Treasuries
Muni 1–10 US High Yield Hedge Funds S&P 500 Japanese
Equity
Emerging Market
Local Debt
EAFE Equity EM Equity (US$) Euro Stoxx 50 US Banks
Data through December 31, 2016.
Note: Rounded to the nearest whole integer.
Source: Investment Strategy Group, Datastream.
have also been relatively accurate for the bulk
of assets in our diversified model portfolio. In
Exhibit 21, we compare the five-year annualized
expected total returns published in our 2013
Outlook to what transpired over the last four
years. Our forecasts for 1) fixed income returns
including both investment grade and high yield,
2) hedge fund returns, and 3) EAFE equity returns
were close to the mark. Directionally, we were
also right about US equity returns but off in terms
of magnitude. We were also struck by how close
our US bank sector return forecasts were to the
realized returns—approximately a quarter of which
were realized after the November election. This
observation has reinforced our belief in one of the
pillars of our investment philosophy: having the
appropriate horizon for various strategies is critical
to long-term success.
Not surprisingly, we have not been right
across the board. We underestimated Japanese
equity returns by 11.4 percentage points on an
annualized basis and we overestimated emerging
market equity and emerging market local debt
returns, by sizable 13.5 and 12.1 percentage
points, respectively, on an annualized basis.
Japanese equities realized an annualized 18%
return and EM equity and local debt realized
negative returns, at -2% and -5% annualized,
respectively. While our forecasts were off
the mark, our emerging market investment
recommendations were on the mark. In mid-2013,
we recommended clients reduce their strategic
allocation to emerging market assets. Even though
we had forecast expected returns that were
nearly double those of US equities, we became
22 Goldman Sachs january 2017
Exhibit 22: ISG Prospective Total Returns
Expected returns over the next one and five years are below historical realized averages.
%
8
7
2017 Prospective Return
5-Year Prospective Annualized Return
7
6
5
4
3
2
1
0
0
2
10-Year
Treasury
2
1 1
Muni 1–10 US Cash 5-Year
Treasury
2
1
2
2
4
EM Local
Debt
3
4
Hedge
Funds
3
3
S&P 500
3
3
Euro
Stoxx 50
4
4
US Corporate
High Yield
4 4
3
UK Equity
5
Muni High
Yield
5
EAFE
Equity
5
3 3
Japan
Equity
5
EM Equity
(US$)
3
3
Taxable
Moderate
Portfolio
Data as of December 31, 2016.
Note: For informational purposes only. There can be no assurance the forecasts will be achieved.
Source: Investment Strategy Group. See endnote 53 for list of indices used.
increasingly concerned about the structural fault
lines of emerging market countries. These fault
lines were discussed in detail in our December
2013 Insight, Emerging Markets: As the
Tide Goes Out.
We continue to recommend a zero allocation
to emerging market debt (dollar-denominated
and local currency debt) and a 2% allocation
to emerging market equities in a moderate-risk
diversified portfolio. We highlight emerging market
assets because, yet again, our base case returns,
especially for emerging market equities, appear
compelling, but we are not recommending a
tactical allocation to this asset class. As we discuss
below in our review of the risks to our economic
and financial market outlook, China is our biggest
source of concern in 2017 and for the next few
years. Emerging markets are the countries that
would be most negatively impacted by any shocks
emanating from China.
China is our biggest source of
concern in 2017 and for the next
few years. Emerging markets are
the countries that would be most
negatively impacted by any shocks
emanating from China.
Our 2017 expected returns, shown in Exhibit
22, are the lowest returns we have published since
the global financial crisis. Not a single broad asset
class is expected to have double-digit returns. Cash
has an expected return of 1%. Expected returns
for intermediate investment grade fixed income
securities range between 0% and 1% depending
on maturities, an expectation driven by our view of
rising rates as the Federal Reserve hikes the federal
funds rate two or three times in 2017. US equities,
which are the most expensive of global equities,
have an expected return of about 3%, and we
expect slightly higher returns in other developed
market equities. Hedge funds, an asset class for
which we have had modest single-digit return
expectations since our 2013 Outlook (as shown in
Exhibit 21), should continue to have modest returns;
we expect a 3% return before taxes, compared to a
5% annualized return expectation in 2013 and an
annualized return of 3% over the last four years.
In aggregate, a moderate-risk diversified
portfolio for taxable clients is expected to
have a return of about 3%. We must note
that our return expectations are not meant
to promote a specific investment, and
that their basis on current capital market
assumptions implies they will likely
change over the course of the year.
At this point, our clients may well be
asking why they should remain invested
in a diversified portfolio with such paltry
Outlook
Investment Strategy Group
23
return expectations, given all the economic policy
and geopolitical uncertainty mentioned earlier. We
believe there are three compelling arguments.
First, there is potential for upside
surprises in 2017:
• Saudi Arabia and the rest of the oil producers
may stick to the announced oil production cuts,
thereby boosting energy sector earnings.
• A Trump administration fiscal stimulus could
boost growth by more than we expect.
• Corporate tax cuts could increase corporate
sector profitability.
• A possible tax holiday could encourage US
multinational corporations to repatriate
some of their earnings and deploy them for
stock buybacks.
We assign a 25% probability of such upside
surprises relative to a 60% probability of our base
case scenario and a 15% downside probability.
(Please see Section III, 2017 Financial Markets
Outlook, for a more detailed discussion.)
Second, we recommend staying invested
because we believe that the probability of a
recession in the US is about 15% over the next
year. There is an 85% chance that the economy
will grow at a rate of about 2% or higher. Absent
a recession, equities are more likely to generate
positive returns. Obviously, the probability of
a recession is substantially higher over the next
five years, and our five-year annualized expected
returns incorporate a 70–80% probability of a
recession.
Third, and most importantly, we do not see
better investment alternatives. Cash will provide
negligible returns with no upside, and we expect
investment grade bonds to have equally negligible
returns with little upside, if any. We also expect
hedge funds, in aggregate, to lag equities on an
after-tax basis.
We expect similarly modest returns from our
tactical tilts.
As equities, high yield and the dollar
have rallied over the course of the
year, we have continued to reduce the
overall risk level of our tactical tilts.
Our Tactical Tilts
As equities, high yield and the dollar have rallied
over the course of the year, we have continued to
reduce the overall risk level of our tactical tilts. At
the beginning of 2016, we had already reduced our
exposures by 50% relative to peak levels in 2015, as
measured by value at risk. By the end of 2016, we had
reduced exposures further, based on our investment
discipline of averaging in and out of our tactical tilts.
Underweight Fixed Income: We continue to
recommend underweighting US fixed income assets
as the Federal Reserve slowly but steadily raises the
federal funds rate. We expect the 10-year Treasury
bond yield to range between 2.5% and 3.0%. As
a result, we forecast a 1% return across short- and
intermediate-maturity fixed income assets and a
near zero return for the 10-year Treasury. Longer
maturities are expected to have negative returns.
We also recommend underweighting fixed income
assets to fund tactical tilts given their higher
expected returns.
Overweight to High Yield: While we reduced
our tactical allocation to high yield assets by half
throughout 2016, we continue to recommend an
allocation to general high yield bonds, high yield
energy bonds and high yield bank loans. The
incremental yield in such securities, adjusted for
defaults, is still compelling, with expected returns
of about 4% for high yield bonds and high yield
energy bonds and about 5% for bank loans.
We forecast that crude oil prices will stay in the
$45–65 range, partly owing to some production
discipline by Saudi Arabia as the largest swing
producer. Our bank loan tilt is further supported
by a rising rate environment; the coupon rate on
bank loans will be reset higher as LIBOR rises. 54
Modest Overweight to US Banks: We maintain
a modest overweight to US banks despite their
31% return in 2016. Banks will benefit from rising
rates, especially if the increase is greater in the
short end of the yield curve. About 60%
of changes in the net interest margin of
banks is typically driven by changes in
short rates since they are used for setting
the banks’ prime lending rate. Banks will
also likely benefit from a more favorable
regulatory environment under a Trump
administration. We forecast a return
of about 7%.
24 Goldman Sachs january 2017
Overweight US Energy Infrastructure Master
Limited Partnerships (MLPs): We initiated a
direct allocation to energy MLPs in late January
2016 and have maintained that tilt. Given our
assumptions about oil prices, we believe that the
cash distributions from MLPs are generally secure
and provide a yield to investors of just over 7%.
In the absence of any valuation changes, the yield
translates into a high single-digit tax-advantaged
return. Any growth in cash flow distribution or
improvements in valuation relative to the S&P 500
would provide some upside.
Overweight Spanish Equities: We maintain an
overweight to Spanish equities on a currencyhedged
basis. This tactical tilt was introduced in
August 2013, and we have adjusted the size of
the overweight about a dozen times since. Spanish
equities offer some of the cheapest valuations
across the developed markets, attractive dividend
yields, expected earnings growth of 4.6%, aided
by healthy domestic growth, and a particularly
well-capitalized 55 banking sector that has a lower
nonperforming loan ratio than the Eurozone bank
average. Furthermore, Spain is unlikely to face the
same political uncertainty as Germany, France and
Italy in 2017. We expect high single-digit returns
for Spanish equities.
Short Five-Year German Bunds: We recommend
a short position in five-year German bunds as
the ECB embarks upon the process of shifting
its monetary policy. After the December 2016
meeting, the ECB announced that it would reduce
its monthly purchases of bonds from €80 billion to
€60 billion starting in March 2017 and continuing
through December 2017. We expect the ECB to
end all purchases sometime in 2018, barring any
shocks. As a result, we think interest rates for
Eurozone sovereign debt will rise gradually over
the course of the year, which in the case of German
bunds means they will become less negative. We
expect a modest 2% return from this tilt.
Short Chinese Renminbi: We have increased our
bearish position on the Chinese renminbi over
the course of 2016. China is under pressure from
multiple sides: the need for loose monetary policy
to achieve the leadership’s 6.5% target GDP
growth rate, 32 months of capital outflows that
have accelerated in late 2016, a strong dollar and
an incoming Trump administration that will likely
pursue a US-centric policy toward China. Risks are
exacerbated by the leadership’s lack of experience
in handling financial market volatility, as evidenced
by China’s policy response to its equity market
collapse in June 2015 and its approach to shifting
the currency regime to a more flexible one in
August 2015 and January 2016. We expect the
currency to depreciate about 7% in 2017; since
4% is already priced in the forward markets, we
expect a return of about 3%. There is considerable
scope for further upside from this tilt if China
abandons its current control of the currency,
a move that could lead to depreciation in the
renminbi of about 20%.
Our tactical tilts are based on above-trend growth
of 2.3% in the US, global growth of 2.9%,
generally favorable monetary policy and more
stimulative fiscal policy across developed and
emerging market countries. We expect returns to
be muted across asset classes, resulting in modest
returns in a diversified portfolio with a modest
enhancement from tactical tilts. Of course, our
views are not without risks. As we discuss below,
some are low-probability risks with the potential
for high impact while others are high-probability
risks with low impact potential.
The Risks to Our Outlook
When we think about the risks to our economic
and financial market outlook, we are reminded of
the words of French writer Jean-Baptiste Alphonse
Karr: Plus ça change, plus c’est la même chose—the
more things change, the more they stay the same.
This year’s list of risks overlaps with those of the
last several years. As far back as 2011, investors
have worried about a hard landing in China. From
the inception of the European sovereign debt
crisis in 2010 through the Brexit vote in 2016, the
potential breakup of the Eurozone has been a source
of concern. As soon as the Federal Reserve raised
the federal funds rate in December 2015, investors
worried about tightening policy causing a recession.
Cybersecurity and terrorism are constant threats.
And geopolitical risks have grown over time. This
year, we are adding trade policy uncertainty and US-
China geopolitical relations as new risks.
As we said in our 2013 Outlook, there is no
shortage of concerns as markets climb a wall
of worry. In our view, there are eight risks that
Outlook
Investment Strategy Group
25
We do not believe this tightening cycle will lead to a US recession in 2017.
could derail the last innings of this recovery and
bull market. The first three are low-probability
risks in our view, the next three risks have a
high probability of occurring but their impact is
uncertain and the last two are high-probability and
high-impact risks beginning as early as 2017.
Low-Probability but High-Impact Risks:
• The pace of Federal Reserve tightening
is disruptive and financial markets
react negatively.
• The economy slips into recession.
• Populist parties in the Eurozone
gain greater influence.
offing. Interest rates have increased from
a low of 1.3% for the 10-year Treasury
in July 2016 to 2.4% by year-end. While
this increase in interest rates would
ordinarily tighten financial conditions,
it has been partially offset by stronger
equity markets and tighter corporate
bond spreads. In fact, financial conditions
were looser at the end of the year than
they were at the beginning of 2016
despite expectations of a slow but steady
increase in the federal funds rate.
We share the market view that the
pace of monetary policy tightening will
accelerate but remain benign. As shown
in Exhibit 23, the difference between
the Federal Reserve dots, the view implied by the
bond market, the forecast by our colleagues in
GIR and our view is negligible. The bond market
has priced two hikes, the Federal Reserve and GIR
expect three hikes, and we think two or three hikes
are equally likely in 2017. We assume that the
Federal Reserve will slow down the pace of interest
High-Probability but Uncertain-Impact Risks:
• Geopolitical hot spots get hotter.
• Terrorism escalates.
• Cyberattacks continue.
High-Probability and High-Impact Risks:
• China submerges under its debt burden and
capital outflows.
• US-China relations deteriorate under the Trump
administration.
Pace of Federal Reserve Tightening
Unlike the December 2015 interest rate hike that
prompted a vocal response from naysayers but had
limited impact on the bond market, the December
2016 hike has elicited a muted response from
market commentators but has had a larger impact
on the bond market. The underlying strength of the
labor market and the steady improvement in the
economy have led to a change of sentiment toward
more interest rate hikes, which are clearly in the
There is no shortage of concerns as markets climb a wall of worry.
26 Goldman Sachs january 2017
Exhibit 23: Policy Rate Path Projections
We expect the pace of monetary policy tightening to
accelerate but remain benign.
Federal Funds Rate (%)
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
ISG View
GIR View
Market Implied
Median Federal Reserve Projection
1.4
1.4
1.3
1.2
0.0
Dec-16 Dec-17 Dec-18 Dec-19
Data as of December 31, 2016.
Note: For informational purposes only. There can be no assurance that the forecasts will
be achieved.
Source: Investment Strategy Group, Bloomberg, Goldman Sachs Global Investment Research,
Federal Reserve.
rate hikes should the economy weaken, and will
pick up the pace later in 2017 or 2018 if the
fiscal package under the Trump administration is
bigger than we expect (see Section II, 2017 Global
Economic Outlook, for a more detailed discussion).
Irrespective of the realized pace, this tightening
cycle will not result in a US recession in 2017,
in our view.
Recession Is Highly Unlikely
“Depression Bread Line,” Bronze, 1991, George Segal at the Franklin D. Roosevelt
Memorial. Art © The George and Helen Segal Foundation/Licensed by VAGA,
New York, NY.
3.4
2.9
2.8
2.0
Low Expectations of a US Recession
Recessions in the US have been triggered by
Federal Reserve tightening of monetary policy; by
economic imbalances such as the bursting of the
dot-com and housing bubbles in 2000 and 2008,
respectively; or by external shocks such as the Arab
oil embargo in 1973. The first two triggers are
unlikely to occur in 2017, and the third, a shock,
is not something that we can typically anticipate.
However, we do think that China will be a
source of downside risk sometime over the next
three years.
First, as we mentioned in last year’s Outlook,
there have been five tightening cycles in the post-
WWII period that have not triggered a recession.
Four of those cycles occurred during the three
longest recoveries, as shown in Exhibit 24. Those
cycles have been characterized by an early start
to the tightening cycle, a slow pace relative to
historical averages (220 basis points per year for
nonrecessionary tightening and 330 basis points per
year in recessionary cycles), low core inflation and
slack in the labor market. This cycle shares those
characteristics: the tightening cycle started in 2015,
the pace has been 25 basis points per year, the core
personal consumption expenditures (PCE) index—
the Federal Reserve’s preferred benchmark for
inflation—is at 1.6% year over year as of November
2016, and our colleagues in GIR estimate that the
labor market still has about 0.3% slack.
Second, the US economy does not
suffer from any imbalances in which one
sector of the economy has become the
sole driver of growth or equity market
returns. Before the global financial crisis,
residential investment as a percentage
of GDP had peaked at 6.7% in 2005,
compared to a long-term average of
4.7%, and the credit-to-GDP gap as a
measure of nonfinancial sector leverage
had peaked at 12.4% in 2007 compared
to a long-term average of -1%, leading
to meaningful imbalances. Similarly, in
2000, technology and telecommunication
sector valuations were more than three
standard deviations higher than the
average of other sectors. Such imbalances
do not exist in the US at this time.
Third, while we cannot anticipate an
external shock—otherwise it would not
be a shock—we do not see imbalances in
other large economies except in China.
Outlook
Investment Strategy Group
27
Exhibit 24: US Real GDP During the Longest Post-WWII Recoveries
Four of the five tightening cycles that did not trigger a recession occurred during the three longest recoveries in the
post-WWII period.
Beginning of Recovery = 100
160
Mar-61
Dec-82
150
Mar-91
Current (Jun-09)
140
Aug-61–Nov-66
Did NOT Trigger
Recession
Dec-86–Mar-89
Triggered Recession
CAGR: 4.4%
Aug-67–Aug-69
Triggered Recession
CAGR: 4.9%
CAGR: 3.6%
130
120
Mar-83–Aug-84
Did NOT Trigger
Recession
CAGR: 2.1%
Jun-99–Jul-00
Did NOT Trigger
Recession
110
Dec-15–?
100
90
Feb-94–Apr-95
Did NOT Trigger
Recession
Denotes Beginning of Fed Tightening Cycle
Denotes End of Fed Tightening Cycle
0 4 8 12 16 20 24 28 32 36 40
Quarters After Recession Trough
Data as of December 2016.
Source: Investment Strategy Group, Bloomberg, National Bureau of Economic Research.
In our 2016 Outlook and our 2016 Insight report,
Walled In: China’s Great Dilemma, we stated that
China was unlikely to have a hard landing over the
next two years (i.e., 2016 and 2017). We believe
the view still holds. We do not expect a hard
landing in China that would destabilize the US
economy in 2017, but the risks grow significantly
in 2018 and 2019. As we discuss below, China may
nevertheless represent a geopolitical risk in 2017.
Historically, since WWII, the odds of a
recession occurring over a 12-month period
have been 18%. Our composite recession model,
incorporating end-of-year financial and economic
data, estimates the probability of a recession in
2017 at 23%. Once we incorporate the likely
passage of a fiscal stimulus package of tax cuts
and infrastructure investments in the latter half
of 2017, the probability of a recession this year
declines to about 15%.
Rising Influence of Populist Parties in
the Eurozone
Since the election of Prime Minister Alexis Tsipras
and the Syriza Party in Greece in January 2015,
populism has been gaining momentum across
Europe. The support for populist parties has
increased to varying degrees in Spain, Greece, Italy,
France, the Netherlands, Germany and Austria.
The common themes among populists have been
anti-immigration and anti-European Union.
Outside the Eurozone, the 2016 Brexit vote in
Great Britain has been interpreted as a populist
vote against immigration from Eastern Europe, the
Middle East and North Africa, as well as against
the bureaucracy of the European Union.
The increasing enthusiasm for populist parties
in Europe raises two questions. First, will any of
the more extremist parties win enough support to
break away from the European Union? In France,
for example, upcoming elections in May 2017 are
likely to pit François Fillon of Les Républicains
against Marine Le Pen of the far right Front
National. Le Pen has promised a referendum on
whether France should stay in the European Union,
and, should she win, questions about the viability
of the Eurozone will surface immediately. 56 While
polls show Fillon well ahead of Le Pen, polls
have been wrong on the UK and Italian referenda
and the US election. The Eurasia Group, for one,
assigns a 30% probability to a Le Pen victory. 57
Second, to what extent will the rise of populism
influence policies in the Eurozone? Here, Germany
will probably provide a litmus test. Chancellor
Angela Merkel and her coalition government are
likely to respond to recent terrorist attacks there by
proposing a stronger police and military presence,
according to the Eurasia Group. Security checks
will probably be increased as well, since at least
800,000 asylum-seekers entered Germany with
minimal security checks and terrorist suspects have
already been arrested among them. 58 With German
elections scheduled for September 2017, it remains
to be seen whether Chancellor Merkel will adjust
her immigration policy.
28 Goldman Sachs january 2017
While populism is on the rise and the support
for such parties has increased, we do not think that
these movements will threaten the viability of the
Eurozone in 2017. In fact, in response to Brexit,
we believe that Eurozone policymakers will take a
hard line with Britain to make sure other countries
do not think it realistic to manage an exit that
retains all the benefits while shouldering none of
the costs.
The Wall Street Journal reports that the
“Obama administration considers North Korea
to be the top national security priority for the
incoming administration.” 65 Nuclear weapons
already in place, long-range ballistic missile
capabilities in development, and an unpredictable
and provocative leader are a deadly combination.
North Korea will remain a serious risk for the
foreseeable future.
Geopolitical Hot Spots Get Hotter
We rely on the insights of external experts
to formulate our geopolitical views. They
include members of prominent research groups,
think tanks and universities as well as former
government officials, both in the US and abroad.
So informed, we highlight activity in North Korea,
Russia and the Middle East among our group of
risks with high probability but uncertain impact.
North Korean Belligerence Continues: North
Korea’s unpredictable and belligerent military
activities have continued unabated. In early 2016,
North Korea announced that it had tested its first
hydrogen bomb. 59 By the end of 2016, North Korea
had conducted nine other military actions, including
the launch of a ballistic missile from a submarine, 60
launches of long-range ballistic missiles toward
Japan 61 and additional nuclear tests. 62
We can only expect further tests in 2017, given
the estimates by a Council on Foreign Relations
task force chaired by retired Admiral Michael
Mullen that North Korea may have between 13
and 21 nuclear weapons as of June 2016. 63
Even more troubling is a pattern highlighted by
David Gordon, adjunct senior fellow at the Center
for a New American Security. Gordon points out
that North Korea makes a habit of testing new
presidents, as it did in May 2009, early in President
Obama’s first term, and again in February 2013
after South Korean President Park Geun-hye was
inaugurated. 64
While populism is on the rise and
the support for such parties has
increased, we do not think that these
movements will threaten the viability
of the Eurozone in 2017.
Russian Adventurism Intensifies: While attention
has been focused on Russia’s adventurism in Syria,
the frozen conflict in Ukraine remains intact, with
increasing violations of the Minsk agreements
of 2014 and 2015. 66 Since the first agreement
in September 2014, nearly 10,000 people have
been killed, 67 and most recently, Russian-backed
separatists attempted to break through Ukrainian
government lines. 68 In response to such lack of
progress and concerns about further Russian
aggression in the region, the heads of North
Atlantic Treaty Organization (NATO) member
countries agreed, at a summit in Warsaw in
July 2016, to deploy as many as 4,000 troops
to the Baltic States and Poland in early 2017 as
a deterrent to further adventurism in Eastern
Europe. 69 The risks of accidents and intentional
skirmishes will inevitably rise.
Furthermore, the direction of foreign policy
in the region under a Trump administration is
uncertain given President-elect Trump’s July 2016
statement that the US would not automatically
defend the Baltic States. 70
Russia is likely to stay involved in the Middle
East as well. Russia has been a constructive force
with respect to the fight against the Islamic State of
Iraq and the Levant (ISIL) and a stabilizing force
with respect to keeping Syrian President Bashar
al-Assad in place in the absence of any attractive
alternatives. Syria would not have made as much
progress in pushing back ISIL and the rebels
without Russian air power support. Russia has also
hosted a meeting in Moscow with Iran
and Turkey to work toward an accord
to end the war in Syria 71 —a six-year war
that has resulted in 400,000 72 to 470,000
fatalities 73 and an estimated economic
cost of $250 billion to $275 billion. 74
Given the prospects of continued
geopolitical turmoil in the region,
Russian involvement in the Middle East
will not be reduced anytime soon.
Outlook
Investment Strategy Group
29
Middle East Conflicts and Tensions Persist: The
Middle East will remain a source of conflict for
years to come. Many countries have weak or
collapsing nation-state structures with varying
degrees of civil war. As Zalmay Khalilzad,
former ambassador to Afghanistan, Iraq and
the United Nations, and president of Gryphon
Partners, wrote recently, “the national borders
devised by Western powers for Iraq and Syria, in
particular, are not standing up well to the test of
time … and Pakistan’s policies have contributed
to Afghanistan’s precarious condition.” 75 Iran
and Saudi Arabia compete for influence in the
region, and the Sunni-Shia divide that was not a
geopolitical factor 40 years ago will continue to
escalate tensions in the region.
Another potential risk in the region is the
dismantling of the Iran nuclear deal by the Trump
administration. 76 In the absence of a deal, Iran
would return to building its nuclear capabilities,
thereby increasing the risks of a military strike by
Israel or the US.
We assign a low probability to such an event
for two reasons. First, we point to comments made
by secretary of defense nominee retired General
James Mattis, which suggest a different approach
in dealing with Iran. 77 In a speech in April 2016 at
the Center for Strategic and International Studies,
Mattis said “there is no going back” on the deal
“absent a clear and present violation.” 78 Second,
other signatories to the deal, including Russia and
China, would not support a unilateral dismantling
of the deal by the new administration. 79 That is not
to say that tensions between the US and Iran will
not continue this year.
Turmoil in the region will continue into 2017
and beyond. While the direct impact of such
conflicts on global growth and world equity
markets is limited outside a war among major
powers, the threat posed by terrorism is significant
and growing.
Terrorism Escalates
Another high-probability but uncertain-impact
risk is increased terrorism. The Middle East has
been the main source of terrorism even before the
September 11, 2001, attack on the World Trade
Center. The majority of the 9/11 perpetrators,
15 out of 19, were from Saudi Arabia, with the
rest from other Arab countries in the region. 80
Since then, the spread of ISIL, the Syrian civil
war, extremism in Pakistan and Afghanistan, and
the immigration of Arabs and North Africans
to Europe and, to a lesser extent, the US, have
increased the incidence of terrorism in the West.
In 2016, there were five key terrorist incidents
in the US and 15 in Europe, including a December
19 attack when a truck rammed into a Christmas
market in Berlin. 81 Some of the terrorists
responsible were inspired by ISIL, 82 and some were
lone-wolf Islamic extremists who had lived in their
respective countries for years. 83 With a growing
number of refugees in Europe, it is highly likely
that this pace of terrorism will continue.
Terrorist attacks and geopolitical tensions in
the Middle East take more than their immediate
human toll. While consumer confidence in the
US is now above the pre-global financial crisis
peak of July 2007 (see Exhibit 25), Gallup Poll
data shows that dissatisfaction remains at a very
high level, similar to that at the beginning of
the global financial crisis. As shown in Exhibit
26, the dissatisfaction rate increased steadily in
the aftermath of the 9/11 terrorist attacks and
the US wars in Afghanistan and Iraq. It had
already reached current levels before the global
financial crisis.
Former Federal Reserve Chairman Ben
Bernanke has named traumatic national shocks
such as 9/11 along with political polarization
and “shrill” political debates as possible culprits
of the contradictory signals between the high
levels of consumer confidence as measured by
the Conference Board and the high levels of
dissatisfaction as measured by Gallup Polls. 84
Risks of continued terrorism are very high,
but the broader economic impact of the type of
terrorist acts we witnessed in 2016 is limited. We
can only hope that large attacks such as 9/11 do
not occur again.
Cyberattacks Continue
High-profile cyberattacks or cyberattack
announcements were a regular feature of 2016.
The highest-profile attacks were those perpetrated
by the Russian government on the Democratic
National Committee computer network, according
to a joint statement from the Department of
Homeland Security and Office of the Director
of National Intelligence on Election Security. 85
The US government expelled 35 Russian officials
and imposed sanctions on four high-ranking
members of the Russian military intelligence unit
as a result. 86
30 Goldman Sachs january 2017
Exhibit 25: Conference Board Consumer
Confidence Index
The labor market recovery has led to a steady increase in
consumer confidence.
Index Points
160
140
Exhibit 26: Gallup Poll on Satisfaction With the
Direction of the US
Dissatisfaction remains at a very high level, similar to that at
the beginning of the global financial crisis.
% of Respondents
100
90
120
113.7
80
70
71
100
91.5
60
80
60
75.1
50
40
Beginning of Global
Financial Crisis
40
20
Conference Board Consumer Confidence
Historical Average
Post-Global Financial Crisis Average
30
20
10
September 11th
War in Iraq
War in Afghanistan
0
1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
Data through December 2016.
Note: Series starts in January 1978. Post-GFC average begins in July 2009.
Source: Investment Strategy Group, Datastream.
0
1979 1983 1987 1991 1995 1999 2003 2007 2011 2015
Data through December 2016.
Note: The poll asks, “In general, are you satisfied or dissatisfied with the way things are going in