the United States at this time?”
Source: Investment Strategy Group, Gallup.
Other high-profile cyberattacks included
• The announced theft of the account
information of 1 billion Yahoo users in 2013
and 500 million Yahoo users in 2014 87
• The theft of information from as many
as 700,000 accounts at the Internal
Revenue Service 88
• A suspected Chinese military hack into the
Federal Deposit Insurance Corporation 89
• The theft of 117 million LinkedIn passwords
(stolen in 2012 but announced in 2016) 90
The risks of cyberattacks continue to increase.
The risks of cyberattacks continue to increase.
To date, the attacks have had limited detrimental
impact on the broad US economy, but the impact
could be far-reaching if foreign governments such
as Russia or China, criminal entities, or lone actors
attack critical infrastructure in the US or any other
major country.
China Submerges Under Its Debt Burden and
Capital Outflows
At $11.4 trillion, China is the second-largest
economy in the world, with a 13.8% share of
global exports and a 9.7% share of global imports.
It accounts for nearly half of global
demand for zinc, tin, steel, copper and
nickel, and more than half for thermal
coal, aluminum and iron ore. Any major
slowdown or volatility across bond,
currency and equity markets in China,
including Hong Kong, would have major
ramifications for the rest of the world.
While the US has limited direct
economic exposure to China—only 0.6%
of exports as a share of GDP, 0.6%
of bank assets and 0.7% of corporate
profits—any shocks in China will
reverberate through US financial markets.
As shown earlier in Exhibit 18 on page
19, US financial conditions tightened by
118 basis points in the summer of 2015
Outlook
Investment Strategy Group
31
when China’s leadership intervened in the local
equity markets and adjusted the trading band
around the renminbi, and by 104 basis points in
late 2015 and early 2016 when the leadership
changed the reference currency from the dollar to a
basket of 13 currencies. If US financial conditions
had stayed at those levels for over a year, US
GDP growth would have slowed by about one
percentage point, all else being equal. Financial
conditions are the mechanism by which shocks
from China would have the most immediate
impact on key developed economies such as the US.
As mentioned above, one of the triggers of
US recessions has been economic imbalances.
While we do not see such imbalances in the US,
or in other major developed economies, at this
time, we see significant imbalances in China. Such
imbalances have led to crises in other countries,
and there is no reason to believe that they will not
lead to a financial crisis in China. In our view, it is
not a question of if—it is only a question of when.
The biggest imbalance in China is the high level
of debt relative to GDP. The Bank for International
Settlements (BIS) has a series of early warning
indicators. One of the more widely followed
and reliable measures is the credit-to-GDP gap,
measured as the total credit extended to the
private nonfinancial sector as a percentage of GDP
compared with its long-term trend. As shown in
Exhibit 27, China breached the high-risk threshold
in June 2012, when its credit-to-GDP gap rose
above the 10% level. At 30.1% as of March
2016 (latest data available) and rising, China’s
gap exceeds the 10% threshold by 20 percentage
points, levels previously seen in Spain before the
European sovereign debt crisis. Major developed
and emerging market countries have experienced a
financial crisis within three years of their credit-to-
GDP gap exceeding 10%.
In our 2016 Outlook and our 2016 Insight
report, Walled In: China’s Great Dilemma, we
stated that we did not expect a hard landing in
China over the next two years—2016 and 2017.
We continue to assign a low probability to a hard
landing in China in 2017. However, it is unlikely
that China can avoid a financial crisis over the
next three years. In prior years, we have pointed to
China’s high savings rate and government control
of many aspects of the economy as reasons for
its ability to avert a hard landing. However, the
country’s debt levels have risen rapidly, the pace
of capital outflows has picked up, and net foreign
Exhibit 27: Credit-to-GDP Gap Across Economies
China’s gap reached the high-risk threshold in June 2012 and
has continued to rise.
Credit-to-GDP Gap (% of GDP)
50
30
10
-10
-30
High Risk
UK
Elevated Risk
Eurozone
-50
US
Japan
Spain
China
Russia
-70
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data through Q1 2016.
Note: Estimates based on series of total credit to the private nonfinancial sector. Credit-to-GDP
gap is defined as the difference between the credit-to-GDP ratio and its long-term trend in
percentage points. Long-term trend is calculated using an HP filter.
Source: Investment Strategy Group, Bank for International Settlements.
direct investment has reversed and is now negative.
In our view, neither China’s high savings rate nor
its increasing government control of financial
markets and capital flows will be sufficient to avert
a hard landing over the next several years. Keep
in mind that even the US was not able to avert a
financial crisis after its credit-to-GDP gap briefly
breached the 10% high-risk threshold in December
2006 and peaked at 12.4% in December 2007.
The US has the highest GDP per capita of any
major country in the world. The large countries
that come closest to the US on this score have
GDP per capita levels that stand at about 70% of
US levels on a nominal basis and slightly higher
on a purchasing power parity (PPP) basis. The US
dollar is also the unquestioned reserve currency
of the world; its reserve-currency status has only
been fortified after the Eurozone sovereign debt
crisis and the British referendum for Brexit. Thus,
the US is able to access the excess savings of the
entire world. The US also receives the largest share
of world foreign direct investment flows, capturing
14% of global flows between 2011 and 2015.
The US now accounts for 20% of the stock of all
foreign direct investment. Yet, despite all these
major advantages, it did not avert a financial crisis
in 2008. It defies logic to assume that China will
be the one major country that avoids a financial
crisis and a hard landing when it does not enjoy
such advantages. As we often say, stating that “this
32 Goldman Sachs january 2017
Exhibit 28: Total Foreign Currency Holdings of
China’s Official Sector
If the recent pace of decline continues, China’s reserves
could soon fall below the IMF’s adequacy threshold.
US$ billions
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
PBOC FX reserves
Other official FX holdings
Scenario 1 (avg. pace since Aug-2015)
Scenario 2 (avg. pace in 2016)
0
Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17
Data through November 2016.
Source: Investment Strategy Group, CEIC, Bloomberg, IMF.
IMF FX reserve threshold
(without capital controls)
2,800
1,700
IMF FX reserve threshold
(with capital controls)
time is different” is extremely dangerous for the
investment well-being of our clients’ portfolios.
China, in fact, faces greater risk of a financial
crisis because of growing capital outflows. An
astounding $1.3 trillion of capital has flowed out
of China since August 2015, when it broadened the
trading range for its currency against the US dollar.
The outflows averaged $64 billion per month in
2016. At that pace, China’s total official foreign
currency holdings could drop below the IMF’s
reserve threshold of $2.8 trillion by mid-2017, as
shown in Exhibit 28.
Of course, China’s leadership has not stood on
the sidelines. Since September 2015, the People’s
Bank of China and the State Administration of
Foreign Exchange have introduced a series of
measures to limit capital outflows. These measures
have included orders to financial institutions
to carefully check and strengthen controls on
all foreign exchange transactions 91 and strict
oversight of Chinese companies’ outward
investment in overseas property, hotels, cinemas
and the entertainment and sports industries. 92
According to reports, leadership has also ordered
increased oversight of trade activities to make
sure companies are not over-invoicing the value
of their imports or under-invoicing the value of
their exports as a means of circumventing capital
controls. 93 Exports and imports are 20% and
15%, respectively, of China’s GDP. It is virtually
impossible for China to halt capital flows in such
a porous economy without slowing GDP growth
rates. Thus, China will not be able to completely
stem outflows despite all its measures to slow the
pace as much as possible.
Irrespective of the success of such capital
controls, China’s growing debt problem poses
significant risks to China’s growth
trajectory. We estimate that the risk
of a hard landing is only about 25%
in 2017 but will increase rapidly to
about 50% in 2018 and be closer to
75% in 2019. Therefore, while China
is not a near-term risk, there is a high
probability of an intermediate-term crisis
that will reverberate through financial
markets. We also know that we cannot
anticipate the exact timing of such crises,
especially given the uncertainty of how
US-China relations will unfold under a
Trump administration.
According to the Center for Strategic and International Studies, China has installed
anti-aircraft guns and other weapons systems on seven man-made islands in the
South China Sea, including the Johnson Reef, shown above.
Map data: Google, DigitalGlobe
US-China Relations Deteriorate Under
the Trump Administration
There is no doubt that US strategy
toward China will shift; the only
question is when and how. There are
two channels by which the Trump
administration could affect US-China
relations: trade and foreign policy.
Outlook
Investment Strategy Group
33
We may see some fireworks in US-China relations during the Trump administration.
With respect to trade, President-elect Trump
can use any one of six US statutes, including the
Trading with the Enemy Act of 1917 and the
International Emergency Economic Powers Act of
1977, to shift trade policy. The latter two statutes
give him latitude to change foreign commerce
without interference from Congress or the courts.
President-elect Trump has advocated
imposing tariffs and labeling China a “currency
manipulator.” While he has continued to
threaten tariffs of 45% on imports from China,
there is considerable uncertainty as to what
his administration will actually impose. If the
US and China engage in a full trade war, the
Peterson Institute for International Economics has
estimated a notable drag on US GDP growth over
three years. 94
Any of these actions by the Trump
administration may provoke a strong reaction
from China, including a sizable depreciation of the
renminbi. Such depreciation would certainly be
disruptive to financial markets.
With respect to foreign policy, many policy
experts have been calling for a change in strategy
toward China. In April 2015, the Council on
Foreign Relations published a special report on
China, suggesting that Washington needed “a
new grand strategy toward China that centers
on balancing the rise of Chinese power rather
than continuing to assist its ascendancy.” 95 The
militarization of the seven artificial islands in the
South China Sea (see image on page 33), according
to the Asia Maritime Transparency Initiative at the
Center for Strategic and International Studies, 96
will only expedite such a shift in strategy.
If President-elect Trump’s actions to date,
such as the telephone conversation with Taiwan
President Tsai Ing-wen 97 and his response to the
recent Chinese seizure of a US Navy drone, 98 are
any indication, we may see some fireworks in US-
China relations during the Trump administration.
34 Goldman Sachs january 2017
Key Takeaways
As we mentioned in last year’s Outlook, forecasting is difficult under the
best of circumstances but particularly so in the last innings of an eightyear-long
economic expansion and bull market. This year brings the
additional challenge of a new president whose policies are likely to follow an
unconventional script.
Nevertheless, there are seven key takeaways from our 2017 Outlook:
• Improving growth: We expect global economic activity to accelerate
this year, with modestly higher GDP growth rates in the US, Eurozone,
Japan and many emerging market economies. We expect a small
slowdown in China.
• Low recession risk: Favorable monetary and fiscal policies substantially
reduce the probability of a recession in key developed and emerging
market countries.
• Still accommodative monetary policy: US monetary conditions will still
be relatively easy because of the slow and steady pace of tightening of
the federal funds rate by the Federal Reserve. At the same time, other
developed central banks are still expanding their balance sheets.
• Remain vigilant: Despite a favorable economic and policy backdrop, there
is no shortage of global risks, including rising populism in Europe, growing
geopolitical tensions, the spread of terrorism and the proliferation of
serious cyberattacks.
• China concerns: China is the biggest source of uncertainty given its
growing debt burden, accelerating capital outflows and potential for a
notable deterioration in the US-China relationship driven by changing US
trade and foreign policy toward China.
• Stay invested: The collective impact of these various risks is not yet sizable
enough to undermine our core view: that we are in a longer-than-normal
US recovery that supports equity returns, which are likely to exceed those
of cash and bonds. Thus, we recommend staying invested in US equities
with some tactical tilts to US high yield bonds and European equities.
• Modest returns: While we recommend clients remain invested, we
have modest return expectations. We expect that a moderate-risk welldiversified
taxable portfolio will have a return of about 3% in 2017.
Outlook
Investment Strategy Group
35
SECTION II
2017 Global
Economic Outlook:
Winds of Change
for most of the last eight years, global policy makers
have been buffeted by the gale force headwinds generated by
the financial crisis. In response, central banks around the world
have expanded their balance sheets by a staggering $12.5
trillion, 99 while fiscal austerity measures in the G-7 economies
have reduced the general government budget deficit from 10%
of GDP to just 3.6% today.
Although this mix of policies may have helped avoid a
second Great Depression, it has fallen short of fostering a
robust economic recovery. According to the IMF, the nominal
GDP of advanced economies has grown at just a 1.6%
annualized pace in US dollar terms since its 2009 trough,
making it among the slowest expansions on record. The
overt reliance on monetary policy has also had unintended
consequences. Persistently low interest rates have crippled
bank profitability and penalized savers. Moreover, the boost
that low rates provide to stock prices primarily benefited a
narrow segment of the income distribution, exacerbating
inequality concerns. Not surprisingly, populism has been on
the rise globally.
36 Goldman Sachs january 2017
Outlook
Investment Strategy Group
37
Last year witnessed a growing repudiation of
this status quo, evident in the surprise outcome
of the UK and Italian referenda, as well as US
presidential election. As we begin 2017, these
winds of change are gaining force. Central banks
are acknowledging the often counterproductive
impact of ultra-easy monetary policy and
shifting attention to the eventual withdrawal of
accommodation. At the same time, the recovery
in commodity prices and recent firming in global
growth is shifting the focus from deflation to
reflation. The same could be said of the increasing
focus on expansionary fiscal policy.
While this change brings hope, it also carries
risk. In the US, fiscal stimulus arrives eight years
into an economic expansion that is already near
full employment, increasing the danger of the
economy overheating. Although the Federal
Reserve could respond by hastening the pace
of rate hikes, it might overdo it. Similarly, an
overzealous negotiating stance on existing trade
relationships or imposition of protectionist policies
by the incoming US administration could staunch
the flow of trade—an outcome that would be
particularly damaging to emerging markets. And
in Europe, a victory of the far right in the French
presidential election could unleash fears about
France exiting the European Union and endanger
the survival of the euro.
Still, we do not yet accord a high enough
probability to these risks to alter our base case,
which assumes these winds of change fill the sails
of the ongoing global recovery, rather than capsize
it (see Exhibit 29).
Exhibit 30: Duration of Post-WWII Expansions
This expansion is already the fourth-longest since WWII.
Recovery Duration (Quarters)
45
40
35
30
25
20
15
10
5
0
40
35
31
30
Mar-91 Feb-61 Nov-82 Jun-09 Nov-01 Mar-75 May-54 Nov-70 Apr-58 Jul-80
Business Cycle Trough
Data as of December 2016.
Note: The recovery is measured from the business cycle trough.
Source: Investment Strategy Group, National Bureau of Economic Research.
United States: Age Is Just a Number
24
The US economic expansion is getting old by
historical standards. At nearly eight years, it is
already the fourth-longest in post-WWII history
and poised to be among the top three by the
middle of this year (see Exhibit 30). Concern that
the economy’s vigor is finally succumbing to its
advanced age was only bolstered by anemic 1.6%
real GDP growth in 2016, close to the weakest of
any year during the recovery.
But as we have argued in the past and as
Federal Reserve Chair Janet Yellen recently noted,
“it’s a myth that expansions die of old age.” 100
Instead, business cycles are typically derailed by
19
13
12
8
4
Exhibit 29: ISG Outlook for Developed Economies
United States Eurozone United Kingdom Japan
2016 2017 Forecast 2016 2017 Forecast 2016 2017 Forecast 2016 2017 Forecast
Real GDP Growth* Annual Average 1.60% 1.90–2.70% 1.60% 1.20–1.90% 2.10% 0.50–1.50% 1.00% 0.75–1.50%
Policy Rate** End of Year 0.75% 1.25–1.50% 0.00% (0.50)–(0.30)% 0.25% 0.00–0.50% -0.10% -0.10%
10-Year Bond Yield*** End of Year 2.44% 2.50–3.00% 0.21% 0.50–1.00% 1.24% 1.50–2.25% 0.05% 0.00%
Headline Inflation**** Annual Average 1.70% 1.80–2.60% 0.60% 0.80–1.60% 1.20% 2.00–3.00% 0.50% –
Core Inflation**** Annual Average 2.10% 1.80–2.60% 0.80% 0.90–1.40% 1.40% 1.50–2.00% -0.40% 0.25–1.0%
Data as of December 31, 2016.
Note: The above forecasts have been generated by ISG for informational purposes as of the date of this publication. They are based on ISG’s proprietary macroeconomic framework, and there can be
no assurance the forecasts will be achieved.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bloomberg.
* 2016 real GDP is based on Goldman Sachs Global Investment Research estimates of year-over-year growth for the full year.
** The US policy rate refers to the top of the Federal Reserve’s target range. The Japan policy rate refers to the BOJ deposit rate.
*** For Eurozone bond yield, we show the 10-year German bund yield.
**** For 2016 CPI readings, we show the latest year-over-year CPI inflation rate (November). Japan core inflation excludes fresh food, but includes energy.
38 Goldman Sachs january 2017
Exhibit 31: US Cyclical Spending
There is scope for business and consumer spending to
increase in the US economy.
Exhibit 32: US Inflation
Normalizing energy prices account for much of the inflation
increase we expect.
% of Potential GDP
32
30
US Cyclical Spending
Average
Recession
% YoY
4
3
Energy Contribution to Headline Inflation
Headline Inflation
Core Inflation*
Forecast
28
2
2.4
26
24
22
20
25.6
23.6
1
0
-1
18
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data through Q3 2016.
Note: 4-quarter average. Cyclical spending is business fixed investment plus consumer
durables spending.
Source: Investment Strategy Group, Datastream.
-2
2011 2012 2013 2014 2015 2016 2017
Data as of Q3 2016.
Note: ISG forecasts from Q4 2016. For informational purposes only. There can be no assurance
the forecasts will be achieved.
Source: Investment Strategy Group, Datastream.
* Core inflation excludes food and energy.
three culprits: economic imbalances, excessive
Federal Reserve tightening and/or exogenous
shocks (most commonly in the form of spiraling
oil prices).
As we survey these risks today, none are
particularly alarming. The depth of the financial
crisis and the lackluster pace of the recovery have
allowed the US to avoid the imbalances that would
typically be evident this far into an expansion (see
Section I of this year’s Outlook). If anything, there
is scope for spending in cyclical parts of the US
economy relative to overall GDP to move toward
its long-term average (see Exhibit 31).
There is also less risk of disruptive Federal
Reserve tightening, given how few signs we see
of economic overheating. Headline inflation
remains below the Federal Reserve’s 2.0% target,
and though we expect it to move higher this year,
normalizing energy prices are a key driver (see
Exhibit 32). Further, while the November 2016
unemployment rate of 4.6% suggests the economy
is near full employment, broader measures of labor
slack, as well as today’s depressed labor force
participation rate, argue that the central bank is
not “behind the curve” (see Exhibit 33). Lastly,
our expectation for continued modest gains for the
US dollar and a rebound in productivity growth
from generational lows (see Exhibit 34) provides a
natural offset to inflation pressures, even as wages
continue to rise.
Exhibit 33: US Unemployment Indicators
There are still signs of slack in the labor market.
%
14
Overall Employment Population Ratio (Right, Inverted)
Unemployment Rate
%
55
12
Natural Rate of Unemployment*
57
10
8
6
4
2
0
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
Data through November 2016.
Source: Investment Strategy Group, Federal Reserve Economic Data, Datastream.
* Long-term rate.
Of equal importance, the Federal Reserve is
acutely aware of the risks that tighter monetary
policy poses to the business cycle, which is
apparent in both its willingness to step back
from planned rate hikes last year as well as
Chair Yellen’s acknowledgment that an “abrupt
tightening would risk disrupting financial markets
and perhaps even inadvertently push the economy
into recession.” 101 With neutral real interest rates
59
61
63
65
67
Outlook
Investment Strategy Group
39
Exhibit 34: US GDP per Hour Worked
We expect a rebound in productivity growth from
generational lows.
% YoY
4
Exhibit 35: Goldman Sachs US Current
Activity Indicator
Economic activity accelerated in the second half of 2016.
Annualized % Change
3.0
3
2.5
2.5
2
2.0
1.5
1.6
2.1
1
0.6
1.0
0
0.5
-1
1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015
0.0
Average: January–May Average: June–November November Reading
Data through 2015.
Source: Investment Strategy Group, OECD.
Data as of November 2016.
Note: The current activity indicator is the first principal component of real-activity indicators,
expressed in GDP-equivalent units. This is the growth signal in the main high-frequency
indicators for the US economy.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research.
near zero and inflation expectations still below
levels compatible with its inflation target, the
Federal Reserve is likely to hike rates two or three
times in 2017, below the historical average pace.
On this point, it is worth remembering that the
Federal Reserve originally projected four hikes by
the end of 2016, yet enacted only one in December.
Thus, even if the Federal Reserve does raise rates
three times this year, it will have delivered those
four hikes over two years instead of just one.
Lastly, although a recession created by an
external shock is always a risk, the probability we
place on a hard landing in Europe and/or China
or a destabilizing increase in oil prices is not
currently high enough to alter our base-case view.
Indeed, even with the recent cut in oil production
coordinated between OPEC and non-OPEC
members, the size of today’s oil-supply glut and the
historical tendency for producers to exceed their
quotas greatly reduce the risk of a price spike (see
With none of the typical signs of
economic contractions flashing red,
we accord a 15% probability of a
recession in 2017.
Section III, Global Commodities). With none of
the typical signs of economic contractions flashing
red, we accord a 15% probability of a recession in
2017, roughly in line with historical average risk.
Against this backdrop, we expect US real GDP
growth to accelerate from last year’s moderate
1.6% pace, reaching 1.9–2.7% in 2017. There are
three key drivers to this story: fading headwinds,
a resilient US consumer and supportive policy. We
discuss each below.
Fading Headwinds
The combination of falling oil prices and a
rising dollar that began in mid-2014 has been a
meaningful drag on US growth, with energy-related
capital spending falling by more than 60% over
this period. In addition, exports have softened,
the S&P 500 has suffered almost two years of
contracting profits, and inventories throughout the
supply chain have ballooned as activity has slowed.
Such broad-based weakness has rarely
occurred outside a recession.
The silver lining to last year’s
slowdown, however, is that growth is
now poised to improve from depressed
levels. A modest recovery in oil prices
and stabilization of the dollar enabled
US economic activity to accelerate
notably in the second half of last year
(see Exhibit 35). This boost will be aided
40 Goldman Sachs january 2017
Exhibit 36: Contribution from Change in
Inventories to US GDP Growth
Inventories should support growth after five quarters of
subtracting from GDP.
Exhibit 37: National Association of Home Builders
US Housing Market Index
The post-crisis high in builder confidence bodes well for US
residential investment.
Percentage Points, 5-Quarter Moving Total
Contribution
Recession
Index Level
14
80
10
6
70
60
50
70
2
40
-2
-6
30
20
10
-10
1981 1986 1991 1996 2001 2006 2011 2016
0
2002 2004 2006 2008 2010 2012 2014 2016
Data through Q3 2016.
Source: Investment Strategy Group, Haver Analytics.
Data through December 2016.
Note: Based on a monthly survey of NAHB members who rate market conditions for the sale of
new homes, as well as the traffic of prospective buyers of new homes.
Source: Investment Strategy Group, Datastream.
Exhibit 38: US GDP Growth Impulse from
Goldman Sachs Financial Conditions Index
The persistent drag from tight financial conditions over the
last two years should reverse in 2017.
Percentage Points, 4-Quarter Moving Average
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
Forecast
-1.2
2012 2013 2014 2015 2016 2017 2018
Data as of Q3 2016.
Note: The financial conditions index is a weighted average of riskless interest rates, credit
spreads, equities and FX, based on effects on 1-year forward US GDP growth. Historical
estimates and forecasts by Goldman Sachs Global Investment Research. For informational
purposes only. There can be no assurance the forecasts will be achieved.
Source: Goldman Sachs Global Investment Research.
by inventory restocking, which looks ready to help
GDP growth again after five quarters of negative
contributions (see Exhibit 36). Similarly, residential
investment is set to contribute, reflected in the
National Association of Home Builders (NAHB)
housing market index reaching a post-crisis high in
December of last year (see Exhibit 37). Overall, we
expect this momentum to continue as the erstwhile
easing in financial conditions provides a growth
tailwind throughout 2017 (see Exhibit 38).
A Resilient US Consumer
The stars are aligned for US consumers in 2017,
as they enter the year with rising wages, higher
net worth from asset price gains, historically
low debt-servicing costs, ample savings and
confidence at a 12-year high. They also stand to
benefit directly from potentially lower tax rates
and indirectly from higher fiscal spending, a
topic we discuss in the next section. The abovementioned
factors should mitigate the headwind
from higher inflation. Overall, we expect private
consumption—a key driver of our GDP forecast—
to expand at a pace of approximately 2.5%.
Supportive Policy
While government policy is always a source of
uncertainty, it is even more so in 2017 given
potential changes to tax, trade and immigration
policies in the wake of last year’s presidential
election. Nonetheless, our base case is that policy
ultimately supports growth this year, with some
fiscal expansion and a measured pace of Federal
Reserve rate hikes. Although the final contours of
Outlook
Investment Strategy Group
41
Exhibit 39: CFO Optimism About the US Economy
Chief financial officers’ confidence is at its highest level
in a decade.
Exhibit 40: Eurozone Real GDP Growth
Economic activity has been surprisingly resilient and higher
than expected.
% YoY
%
90
% of CFOs More Optimistic Than Previous Quarter
Recession
2.5
Real GDP Growth
Consensus Estimate*
60
64.1
2.0
1.8
2.0
1.9
2.0
1.7 1.7 1.7
1.5
1.3
1.0
30
0.5
0
2004 2006 2008 2010 2012 2014 2016
0.0
4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16
Data through December 2016.
Note: The survey questionnaire is delivered online to senior financial executives and subscribers
of CFO Magazine from both private and public companies.
Source: Investment Strategy Group, Haver Analytics.
Data through Q3 2016.
Source: Investment Strategy Group, Bloomberg.
* One quarter prior to release.
the new administration’s policies remain uncertain,
a moderate-sized stimulus package of around
$200 billion per year seems likely. 102 While the
direct impact of such a package is estimated to
boost GDP growth by only 0.3 percentage point
in 2017, the positive indirect impact of tax cuts
and stronger anticipated GDP on household and
business confidence is arguably more important.
Indeed, both consumer and CFO confidence have
recently hit their highest readings in over a decade
(see Exhibit 39).
Our View on US Growth
As the expansion enters its eighth year, it is natural
to question its durability. But far from showing
its age, the US economy begins 2017 at an abovetrend
growth pace, with little evidence of cyclical
imbalances or other excesses that typically portend
the end of the business cycle. If anything, the slow
pace of this recovery has elongated its life span, a
dynamic that is likely to persist this year. Perhaps
in macroeconomics, as in life, age is just a number.
Eurozone: Weathering the Storm
The Eurozone has faced its share of challenges in
recent years. Not only did it relapse into recession
in 2011, but it also endured a domestic sovereign
bond and banking crisis at the same time. More
recently, it has been buffeted by a spate of tragic
terrorist attacks, an immigration crisis, the Brexit
vote, a failed Italian constitutional referendum
and renewed concerns about the solvency of its
banking system.
Yet despite this onslaught of headwinds, the
real economy has been remarkably stable in the
last two years. That fact is evident in Exhibit 40,
which shows real GDP growth has sustained an
above-trend pace over this period, an outcome
that clearly exceeded consensus forecasts. Business
sentiment has remained equally steadfast over this
period, suggesting that the rapidity of shocks may
have effectively inured confidence to bad news (see
Exhibit 41). Meanwhile, real household disposable
income grew by 2.3% over the past year—the
fastest pace since 2007.
We expect this stability to persist in 2017,
with our forecast calling for 1.2–1.9% real GDP
growth. Keep in mind that there is ample scope
for above-trend growth to continue, as the level
of Eurozone GDP still stands below its potential.
On this point, the OECD, IMF and European
Commission each currently estimate an output gap
of around 2%, indicating slack in the economy.
The Eurozone’s still elevated 9.8% unemployment
rate corroborates this point.
42 Goldman Sachs january 2017
Exhibit 41: European Commission Industrial
Confidence Survey
Eurozone business sentiment has remained steady despite
recent shocks, including Brexit.
Exhibit 42: Drivers of Eurozone 2-Year Capital
Spending Plans
Key factors that influence business investment stand at their
highest levels in years.
Index Level
10
0
-10
-1.1
-6.0
Z-Score
1.2
1.0
0.8
0.6
0.4
2013
2014
2015
2016
0.4
0.7
0.5
0.8
1.1
0.8
-20
0.2
-30
-40
Industrial Confidence
Average Since 1985
-50
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
0.0
-0.2
-0.4
-0.6
-0.8
-0.1
-0.1
-0.2
-0.2
-0.2
-0.6
Expected Demand Financial Conditions Technical Factors*
Data through November 2016.
Source: Investment Strategy Group, Datastream.
Data through 2016.
Note: Based on the European Commission investment survey.
Source: Investment Strategy Group, Datastream.
* Technical factors include technological developments, the availability of labor and government
incentives to invest.
As a result, Eurozone policy is likely to remain
accommodative, keeping financial conditions
supportive of growth. While we expect the
European Central Bank (ECB) to gradually shift
to a more neutral stance that is less punitive to
bank profitability and acknowledges the uptrend
in headline inflation, this shift does not imply the
removal of accommodation. Indeed, the ECB has
already announced an extension of quantitative
easing through December 2017. Meanwhile, the
European Commission has endorsed a moderate
fiscal easing of 0.5% of GDP for the Eurozone.
Given that fiscal policy is typically loosened ahead
of major elections, this guidance could soon be
embraced in France and Germany.
Of equal importance, both consumption and
business investment are well positioned as we enter
2017. On the former, continued improvement in
the labor market and ongoing GDP growth should
Ongoing uncertainty regarding Brexit,
the banking sector and upcoming
elections remains a potential
downside risk.
encourage consumers to spend a bit from their
precautionary savings, particularly given today’s
relatively high savings rate. At the same time, the
fundamental justifications for increased business
spending, such as higher demand and easy credit
conditions, stand at their best levels in years (see
Exhibit 42). Perhaps not surprisingly, a late 2016
survey of manufacturing firms revealed their
investment intentions stood at all-time highs. 103
Of course, ongoing uncertainty regarding
Brexit, the banking sector and upcoming elections
remains a potential downside risk, particularly
for an investment recovery. As a result, we
acknowledge a greater-than-normal range of
potential outcomes, both positive and negative. For
example, the victory of the far right in the French
presidential election could unleash fears about
France exiting the European Union and endanger
the survival of the euro, while the new government
in Italy could speed up the long-overdue
resolution of the banking sector’s
problems and change the electoral law to
reduce political uncertainties.
For now, our base case assumes
that Italy will avoid a populist party in
government and that a centrist candidate
will win the French presidential election.
Thus, we expect the Eurozone to again
weather the storm in 2017.
Outlook
Investment Strategy Group
43
Exhibit 43: Japan Consumer Prices
Core inflation and inflation expectations remain low.
% YoY
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Core Inflation*
Expectations of Average Inflation Over Following 10 Years**
BOJ Inflation Target
-1.0
2011 2012 2013 2014 2015 2016
Data through November 2016.
Source: Investment Strategy Group, Datastream, QUICK Bond Investors Survey.
* Core inflation excludes fresh food and VAT impact.
** Based on the QUICK Bond Investors Survey.
United Kingdom: A Fork in the Road
Much like the Eurozone, the UK economy is
notable for its resilience, evident in 15 consecutive
quarters of positive quarterly growth averaging
2.5% annualized. This streak is even more
impressive considering last year’s Brexit vote and
the resulting consensus view that the UK was
destined for recession. Although the 20% decline
in the trade-weighted sterling and rapid easing
by the Bank of England were no doubt pivotal in
avoiding that fate, the immediate impact of the
Brexit referendum has been far less destructive
than feared.
But as we begin 2017, the UK is rapidly
approaching a fork in the road. The government
must choose which path Brexit will take once it
triggers Article 50 of the Lisbon Treaty, which
formally sets the process of the UK exit in motion.
Here, the government’s current objectives—limiting
freedom of movement into the UK while retaining
full access to the European Union’s single market—
UK authorities will have little room
to cushion a downturn given today’s
large fiscal deficits and already highly
accommodative central bank.
2.0
0.9
-0.4
seem mutually exclusive and likely to engender a
politically charged negotiation process. This road
is made all the more dangerous by the fact that
UK authorities will have little room to cushion a
downturn given today’s large fiscal deficits and
already highly accommodative central bank.
Of course, a softer stance on the issues is also a
possible path, one that could elongate the effective
transitional period beyond two years and lead to a
far more benign outcome for the UK.
The uncertainty around the government’s
ultimate choices significantly increases the range of
GDP outcomes in the medium term. Our current
base case assumes GDP will expand by 0.5–1.5%
in 2017. This notable slowdown from last year’s
2% pace reflects the likelihood that both hiring
and investment activity will become more cautious
once the Brexit negotiations start. Even worse, this
slowdown arrives just as consumer price inflation
is accelerating from past sterling depreciation,
creating a lower growth/higher inflation backdrop
that is set to erode real income growth. For these
reasons, the risks to our central case are skewed to
the downside.
That said, the fate of the UK economy is not
preordained, even after the government chooses
its path. As with any other negotiation, the result
will ultimately reflect the reasonableness of the
parties, the concessions of both parties and how
the discussions evolve over time. Or in the words
of golf legend Arnold Palmer: “The road to success
is always under construction.” 104
Japan: Same Battle, Different Year
For Japan, the decades-long battle against deflation
never seems to end. Despite two years of abovetrend
GDP growth, including last year’s 1% gain,
core inflation remains negative, having fallen 0.4%
in 2016 (see Exhibit 43). This comes despite a tight
labor market and record profits that should have
encouraged companies to increase base
wages. These already muted inflationary
pressures were exacerbated by low
energy prices and the appreciation of
the yen, once again pushing the Bank
of Japan’s (BOJ’s) 2% inflation target
further into the future.
But far from waving the white flag,
Japan’s policymakers responded with
a range of bold measures, including a
44 Goldman Sachs january 2017
Exhibit 44: Emerging Market GDP Growth
We expect growth roughly in line with potential.
% YoY (PPP Weighted)
10
9
8
7
6
5
4
Actual GDP
Potential GDP
Forecast
4.6
These pro-growth policies, coupled with less
slack in the economy and a boost from higher
energy prices and past yen appreciation, should
enable core inflation (excluding fresh food) to
reach our expected range of 0.25–1.0%. While
Japan may have lost its battles against deflation
over the years, it has not yet lost the war.
Emerging Markets: Competing Forces
3
2
1
0
1993 1996 1999 2002 2005 2008 2011 2014 2017
Data as of 2016.
Note: ISG forecasts for 2016–17. For informational purposes only. There can be no assurance the
forecasts will be achieved.
Source: Investment Strategy Group, IMF.
large fiscal stimulus package last August and a
shift by the BOJ away from ever-higher purchases
of Japanese government bonds (JGBs). Instead,
the BOJ will now use a “yield-curve control”
framework, wherein it sets the short rate and
targets a yield of about 0% on 10-year JGBs. This
novel approach should afford the government
low real interest rates with which to finance its
fiscal expansion, while also providing Japanese
financial institutions with a sufficiently steep yield
curve to remain profitable. To augment these
deflation-fighting measures, the government also
implemented some modest structural reforms and
called for a substantial increase in the minimum
wage in order to support faster income growth.
Against this backdrop of supportive policies,
we expect that GDP will grow by 0.75–1.5%
in 2017. Our forecast is supported by three key
drivers. First, the fiscal stimulus announced in
August is poised to contribute 0.4 percentage point
to 2017 GDP growth, and the government has
indicated a willingness to do more if necessary.
Second, the BOJ remains very accommodative,
thereby providing easy financial conditions that
should foster an uptick in business investment.
While the central bank may consider a modest
rate increase in late 2017, we expect it to maintain
its negative interest rate policy (NIRP) for short
rates and a 0% target for 10-year JGB yields in the
interim. Lastly, the government is likely to push
for further wage increases during the spring wage
negotiations.
Emerging market economies failed to live up
to expectations once again in 2016, with GDP
expanding by an estimated 3.9% versus original
expectations closer to 5.0%. This marked the
second-slowest growth rate in 15 years; only the
2.6% expansion at the depth of the global financial
crisis in 2009 was slower. Yet this disappointing
headline belies the economic recovery that
unfolded over the course of 2016. Consider that
growth actually troughed during a challenging
first quarter, with economic activity gradually
improving thereafter on the back of recovering
commodity prices, the Federal Reserve’s willingness
to delay any further rate hikes and stable Chinese
growth. These tailwinds were bolstered into the
final quarter by early signs of recovery in Brazil
and Russia, both of which had suffered deep
recessions in 2015.
We expect this momentum to persist, with GDP
increasing by 4.3–4.8% (purchasing power parity
[PPP] weighted) this year, roughly in line with
potential (see Exhibit 44). The pickup we expect
is the product of two opposing forces. On the one
hand, growth should benefit from the ongoing
recoveries in Brazil and Russia, and somewhat
stronger activity in developed economies should
provide a small tailwind to emerging market
exports. On the other hand, the further moderation
in Chinese growth we expect is likely to weigh on
activity across emerging markets, particularly if the
US imposes tariffs.
Indeed, the policy agenda of the incoming US
administration remains a critical unknown for
emerging markets. Even if protectionist tariffs
were directed only at China and Mexico—which
account for 23% and 15% of US imports of
manufactured goods, respectively—they would still
negatively impact all emerging markets given the
sensitivity of these countries to Chinese growth and
fluctuations in the Chinese currency. This being the
case, countries with substantial trade exposure to
Outlook
Investment Strategy Group
45
Exhibit 45: China Economic Activity Measures
Actual growth is likely lower than official figures.
% YoY, 3-Month Moving Average
18
16
14
12
10
8
6
4
Real GDP Growth
2
Emerging Advisors Group China Activity Index
Goldman Sachs China Activity Indicator
0
2000 2002 2004 2006 2008 2010 2012 2014 2016
Data through Q3 2016.
Source: Investment Strategy Group, Emerging Advisors Group, Goldman Sachs Global
Investment Research.
both China and the US, such as Korea, Taiwan and
Malaysia, would be particularly vulnerable.
While the net effect of these competing forces
is positive in our base case, the risks are tilted to
the downside.
China
China continues to drive its economy with
one foot on the gas pedal and the other on the
brake. Consider that the government reached its
official GDP growth target of 6.5–7% last year
only by increasing public spending and allowing
rampant credit growth. But these measures also
exacerbated real estate bubble concerns and
hastened capital outflows, forcing the government
to apply the brakes through new restrictions within
the property market and more stringent capital
controls. This focus on dual-footed driving has also
come at the expense of much-needed structural
reforms. As a result, China continues to suffer from
considerable excess capacity in industrial sectors,
such as steel and coal, while its financial sector
risks have increased.
Even so, we expect this approach to continue
in 2017. Structural reforms are likely to stay
on the back burner because China’s leaders
will not risk slower growth ahead of important
leadership changes at the 19th Communist Party
of China National Congress in the fall. In turn,
the government is likely to use further fiscal easing
and rapid credit expansion to target growth of
around 6.5%. As a result, we expect official GDP
6.7
5.6
4.8
to expand by 6.0–6.75% in 2017, although actual
GDP growth will likely be lower (see Exhibit 45).
The risks to our outlook are skewed to the
downside for two reasons. First, the new direction
of US trade policy remains uncertain and could
have a sizable impact. For instance, a 15% tariff
would mechanically reduce China’s GDP by 0.9%.
China could respond by ramping up leverage,
letting its currency depreciate faster and injecting
more fiscal stimulus, but that could risk further
imbalances in the economy while also disrupting
global financial markets. Second, striking the right
balance between stimulative and contractionary
measures is a hazardous endeavor. On the road,
as in government policy, accelerating and braking
at the same time greatly increases the risk of
an accident.
India
India’s streak of strong growth continues. The
economy expanded by an estimated 6.5% in
2016, making it the fourth consecutive year of
GDP growth in excess of 6.0%, a rare feat that
India’s economy shares only with China’s. Growth
would likely have been even higher, were it not
for the “demonetization” scheme the government
introduced in November 2016. In a surprise
move, the government announced that largedenomination
bank notes, representing 86% of
cash in circulation, would no longer be accepted
as legal tender. The scheme—intended to root out
illegal income stored in cash—had the unfortunate
side effect of starving households of liquidity and
thereby thwarting consumption, the main engine of
growth. Although the severity of the consumption
shock remains uncertain, it should be temporary.
The silver lining for 2017 is that India will
probably benefit from a meaningful recovery in
household spending. Moreover, fiscal policy will
likely be eased ahead of the 15 state elections
occurring in 2017 and 2018, while investment
should receive a modest boost as the Reserve Bank
of India lowers borrowing costs. Accordingly, we
expect GDP growth of 6.5–7.5% in 2017.
46 Goldman Sachs january 2017
China continues to suffer from
considerable excess capacity in
industrial sectors, such as steel and
coal, while its financial sector risks
have increased.
Brazil
Brazil has had its share of hard times in recent
years. After being among the fastest-growing
economies in the world in 2010, it has more
recently suffered its worst recession in a
century, evident in seven consecutive quarters of
contraction. In turn, GDP fell an estimated 3.3%
last year, leaving it on par with 2010 levels. Even
worse, industrial production now stands where it
did in 2004.
Fortunately, there are already tentative signs
of a recovery. Inflation has peaked; the current
account deficit has shrunk; and confidence
indicators, while still weak, have stabilized. Of
equal importance, the financial markets have
welcomed a new government amid expectations
that it will finally tackle Brazil’s fiscal problems
and steer the economy out of recession.
But despite these promising green shoots,
our base case does not call for a robust recovery
in 2017. While the new administration is off to
a promising start, it is facing resistance to key
structural reforms while also navigating ongoing
corruption probes. Moreover, the recovery in
household consumption and business investment
is likely to be hamstrung by continuing high real
interest rates, a function of falling inflation and a
simultaneously easing central bank. Meanwhile,
fiscal policy will continue to tighten given a
new spending cap and proposed pension reform
measures. Finally, the modest commodity price
gains we expect are unlikely to foster a meaningful
rise in exports for Brazil. Accordingly, we expect
a tepid recovery, with GDP expanding just
0–1% in 2017.
Russia
Russia is also slowly recovering from a
deep recession. Although the economy
contracted for its second consecutive year
in 2016, headwinds are now receding
thanks to a recovery in real wages,
rising oil prices and a related increase in
oil production. The economy has also
received support from both fiscal and
monetary policy, with the central bank
cutting the policy rate by 100 basis points last
year as inflation moderated. Still, the economy has
likely suffered some permanent damage from the
combination of depressed oil prices and Western
sanctions, which have pushed down Russia’s longrun
growth potential.
While the cyclical recovery should continue in
2017, it is apt to be measured. The government is
planning to reduce the fiscal deficit by 1% of GDP
this year, which will limit fiscal support. That said,
elections in March 2018 could ultimately temper
such fiscal prudence. Meanwhile, the central bank
will likely deliver more rate cuts, but their size and
pace will depend on the path of inflation, which
could be stickier than anticipated.
Against this uncertain backdrop, we expect the
Russian economy to return to modest growth in
2017, expanding 0.5–1.5%. While not our base
case, growth could quicken if oil prices increase
more than we expect or if sanctions are lifted.
Outlook
Investment Strategy Group
47
SECTION III
2017 Financial Markets
Outlook: The Horns of
a Dilemma
investors have had an amazing bull run. Including last
year’s 12% total return, the S&P 500 is nearly 3.5 times as high
as its financial crisis trough. The advance has been equally longlasting,
second in length only to the almost-decade-long period
that preceded the technology bubble in 2000. These impressive
gains are not limited to just equities or US assets. US corporate
high yield has gained 177% over the same time span, while the
total return of the MSCI All Country World Index excluding
the United States has been higher only 5% of the time over
comparable eight-year periods since 1994.
But as we begin a new year, these gains have left investors
on the horns of a dilemma. Put simply, they must now choose
to either remain invested at high valuations and bear the
associated risk of loss or exit the market and forgo the potential
for upside surprises as well as returns that are attractive
compared to the alternatives.
48 Goldman Sachs january 2017
Outlook
Investment Strategy Group
49
To be sure, there are good reasons to be
cautious, as we discussed in Section I, The Risks to
Our Outlook. Even worse, investors are exposed to
these dangers at a time when most asset valuations
are expensive by historical standards, providing
them with a narrow margin of safety to absorb
such adverse developments. This is particularly
true in the US, where valuations have been cheaper
at least 90% of the time historically. 105 Even in
Europe, where valuations are more attractive, that
fact is counterbalanced by greater geopolitical risks
and deeper structural fault lines.
Still, as we highlighted in Section I of this
Outlook, there are three reasons why remaining
invested in risk assets is still warranted despite
what are likely to be uninspiring returns. First,
we see only a 15% probability of a US recession,
which has historically been the key driver of
losses in risk assets. Indeed, the S&P 500 has
generated positive annual total returns 86% of
the time during economic expansions in the post-
WWII period. Second, the comparable returns
of investment alternatives—such as cash and
bonds—are unappealing, particularly in the rising
interest rate environment that we expect. Third,
risk assets can surprise us to the upside, as last year
demonstrated. The potential for returns to exceed
our expectations is especially true in the US, given
the possibility of tax reforms, fiscal expansion
and deregulation. The same could be said for
our tactical positions across various asset classes,
which we discussed in Section I, Our Tactical Tilts.
While we have suggested that the dilemma
should be resolved in favor of remaining invested,
we are not Pollyannaish. Investors have ridden
this bull market for eight years, and while we
don’t expect the ride to end in 2017, we must stay
vigilant to avoid the horns.
Exhibit 47: US Equity Price Returns from Each
Valuation Decile
In the past, subsequent returns from high valuation levels
have been muted.
% Annualized
5-Year Annualized Price Return
%
14
13.0
% Observations With Positive Returns (Right) 100
90
12
11.2
80
10
9.5
70
8
8.3
7.0
6.6 6.6
7.1
60
50
6
4.5
40
4
30
2
0
1 2 3 4 5 6 7 8 9 10
Less Expensive
Valuation
Decile
More Expensive
Data as of December 31, 2016.
Note: Based on 5 valuation metrics for the S&P 500, beginning in September 1945: Price/Trend
Earnings, Price/Peak Earnings, Price/Trailing 12m Earnings, Shiller Cyclically Adjusted Price/
Earnings Ratio (CAPE) and Price/10-Year Average Earnings. These metrics are ranked from least
expensive to most expensive and divided into 10 valuation buckets (“deciles”). The subsequent
realized, annualized 5-year price return is then calculated for each observation and averaged
within each decile. Past performance is not indicative of future results.
Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.
US Equities: Life in the Fast Lane
US stocks have been driving in the fast lane since
2009. Over this nearly eight-year period, the S&P
500 has generated a stunning 16.5% annualized
price return, a pace exceeded only 3% of the time
since 1945. As a result, the 500 companies in the
index are collectively worth $20 trillion today,
about 3.5 times as high as they were at the trough
of the financial crisis. Needless to say, investors
have had a good ride.
Yet such a fast drive also raises the question of
whether US equities are now running on empty.
0.2
20
10
0
Exhibit 46: ISG Global Equity Forecasts—Year-End 2017
2016 YE
End 2017 Central Case
Target Range
Implied Upside from
Current Levels
Current Dividend
Yield Implied Total Return
S&P 500 (US) 2,239 2,225–2,300 -1–3% 2.1% 1–5%
Euro Stoxx 50 (Eurozone) 3,291 3,250–3,400 -1–3% 3.6% 2–7%
FTSE 100 (UK) 7,143 7,050–7,310 -1–2% 4.0% 3–6%
TOPIX (Japan) 1,519 1,530–1,590 1–5% 1.9% 3–7%
MSCI EM (Emerging Markets) 862 880–925 2–7% 2.6% 5–10%
Data as of December 31, 2016.
Note: Forecast for informational purposes only. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this Outlook.
Source: Investment Strategy Group, Datastream, Bloomberg.
50 Goldman Sachs january 2017
Exhibit 48: S&P 500 Price-to-Trend Earnings vs.
Subsequent Calendar-Year Price Return
Starting valuation multiples tell us little about equity returns
over the following year.
Exhibit 49: S&P 500 Valuation Multiples by
Inflation Environment
Periods of low and stable inflation have supported higher
equity multiples.
S&P 500 Returns 1 Year Forward (%)
50
40
30
20
10
0
-10
R 2 = 5.2%
Multiple (x)
30
25
20
15
16.7
Unconditional Average Over Entire Period
Average During Periods in Which Inflation Is 1–3% and Stable
22.5 22.6
18.6
16.6
19.5
-20
-30
10
-40
5
-50
0 5 10 15 20 25 30 35 40
Price-to-Trend Earnings Multiple
0
Shiller CAPE: 1881–2016 Shiller CAPE: 1945–2016 Price-to-Trend: 1945–2016
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.
This bull market is already quite old by historical
standards, second in length only to the almost 10-
year period that preceded the technology bubble
in 2000. Moreover, valuations now stand in their
10th decile, indicating they have been cheaper
at least 90% of the time historically. In the past,
starting from such a high base has led to muted
equity returns over the subsequent five years, with
only a third of those episodes generating a profit
(see Exhibit 47).
Even so, high valuations should not be
confused with certainty of loss, especially over
short periods. As seen in Exhibit 48, today’s
equity multiples tell us very little about potential
gains over the next year, explaining only 5% of
their variation historically. Moreover, history
teaches us that a strategy of selling equities based
solely on expensive valuations has been a losing
approach over time. As we noted in our 2014
Outlook, research conducted by three professors
at the London Business School concluded that
Investors have ridden this bull market
for eight years, and while we don’t
expect the ride to end in 2017, we
must stay vigilant to avoid the horns.
underweighting equities based exclusively on high
valuations underperformed a strategy of remaining
invested across every one of the 20 countries and
three country aggregates they examined. 106 In
short, valuations alone are a poor tactical timing
signal. Indeed, the S&P 500 has returned more
than 36% since first entering its 9th valuation
decile in November 2013, a time when many
were already suggesting that US equities were
in a bubble.
Valuations must also be considered in
the context of the prevailing macroeconomic
environment. Consider that periods of low and
stable inflation, such as we expect for the year
ahead, have supported higher valuations in the past
(see Exhibit 49). The same could be said for lower
taxes and deregulation—were they to materialize
later this year—as both would boost real returns
on invested capital and justify higher equity values.
Similarly, today’s structurally lower interest rates—
reflecting slower population and productivity
growth—reduce the rate at which
all future cash flows are discounted,
increasing their present value.
Here, it’s helpful to remember that the
S&P 500’s long-term average P/E ratio—
which many investors use to gauge
fair value—was forged over a period
when risk-free rates averaged 4.5%. In
contrast, the risk-free rate now is just
0.5–0.75% and the Federal Reserve
Outlook
Investment Strategy Group
51
Exhibit 51: ISM Manufacturing Index and S&P
500 Returns
Equity market performance is closely related to the
business cycle.
Index
65
% YoY
60
Exhibit 52: Estimated Incremental S&P 500
Earnings per Share by Tax Rate
Proposals for lower corporate tax rates could lead to
higher earnings.
Incremental EPS ($)
16
60
55
50
40
20
0
14
12
10
8
7
8
9
10
11
12
13
14
45
40
-20
6
4
3
5
6
35
ISM Manufacturing Index
S&P 500 Return (Right)
30
1995 2000 2005 2010 2015
-40
-60
2
0
30 29 28 27 26 25 24 23 22 21 20
US Effective Tax Rate (%)
Data through November 30, 2016.
Source: Investment Strategy Group, Bloomberg.
Data as of December 31, 2016.
Note: The current US effective tax rate for the S&P 500 companies is 33.3%.
Source: Investment Strategy Group, Standard & Poor’s.
estimates its new long-run equilibrium level has
fallen to 3%, a full 1.5 percentage points below
the historical average. 107 Of equal importance, the
Federal Reserve is not expected to reach that 3%
target for six years based on current market pricing
in Eurodollar futures.
A similar valuation tailwind emerges from the
market’s current sector composition. The combined
technology and health-care sectors constitute about
40% of S&P 500 earnings today, almost three
times as high as their 15% share in the late 1980s.
Because these faster-growing, higher-margin sectors
are generally accorded premium valuations, their
higher representation in the index today justifies a
higher S&P 500 P/E multiple.
Although current valuations may be
fundamentally justified, that does not mean
they are impervious to downward pressure. Our
central-case equity view for 2017 acknowledges
this, calling for some contraction in P/E multiples
given the uncertainty associated with a new
administration and continued Federal Reserve
interest rate hikes. Even so, that headwind will be
more than offset by the 6–10% earnings growth
we forecast, resulting in a 1–5% total return for US
equities this year (see Exhibit 50).
Investors might rightly ask whether it is worth
bearing equity risk for such meager returns. Our
read of the evidence suggests it is. The linchpin
of this view is our expectation of a continued
Exhibit 50: ISG S&P 500 Forecast—Year-End 2017
2017 Year-End Good Case (25%) Central Case (60%) Bad Case (15%)
End 2017 S&P 500 Earnings
Op. Earnings $140
Rep. Earnings $124
Trend Rep. Earnings $113
Op. Earnings $125–130
Rep. Earnings $113–117
Trend Rep. Earnings $113
Op. Earnings ≤ $102
Rep. Earnings ≤ $78
Trend Rep. Earnings ≤ $113
S&P 500 Price-to-Trend Reported Earnings 21–23x 18–21x 15–16x
End 2017 S&P 500 Fundamental Valuation Range 2,375–2,600 2,040–2,375 1,700–1,810
End 2017 S&P 500 Price Target (based on a combination of
trend and forward earnings estimate)
2,450 2,225–2,300 1,800
Data as of December 31, 2016.
Note: Forecasts and any numbers shown for informational purposes only and are estimates. There can be no assurance the forecasts will be achieved and they are subject to change. Please see
additional disclosures at the end of this Outlook.
Source: Investment Strategy Group.
52 Goldman Sachs january 2017
Exhibit 53: US Equity Performance Relative to
Fixed Income
Stocks have outperformed bonds following periods of muted
return differences.
Exhibit 54: US Equity and Bond Fund Flows
Equities could benefit from rebalancing out of bonds given
lopsided flows since 2009.
Total Return Difference Between
S&P 500 and 10-Year Treasury (%)
10
Cumulative Fund Flows ($ bn)
1,600
Bonds
Equities
1,400
1,467
8
6
7.8
6.8
1,200
1,000
800
4
2
2.0
600
400
200
0
Difference Over Last 20 Years
(19th Percentile Since 1945)
3 Years 5 Years
Median Return Difference Over Subsequent Time
Period When Starting from Bottom 20th Percentile
0
-200
-400
2009 2010 2011 2012 2013 2014 2015 2016
-177
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Leuthold Group.
Data through November 30, 2016.
Note: Beginning in March 2009.
Source: Investment Strategy Group, Bloomberg, ICI.
expansion in the US economy (see Section II,
United States). The state of the business cycle is a
key driver of market performance, evident in the
tight linkage between the S&P 500 and the ISM
Manufacturing Index (see Exhibit 51). Notably, the
S&P 500 has generated positive annual total returns
86% of the time during economic expansions in the
post-WWII period, while suffering annual declines
of greater than 10% just 4% of the time. During
the same postwar period, nearly three-fourths of the
bear markets—defined here as declines of 20% or
more—occurred during US recessions.
With few signs of an economic contraction
on the horizon, the high odds of positive returns
and low odds of large losses raise the hurdle
for underweighting equities significantly. This is
particularly true because the risks are not onesided:
markets often surprise to the upside, too,
even at high valuations. Last year was a case in
point: the S&P 500’s 12% return matched our
good-case scenario, although at the start of 2016
we had attached only 20% odds to it occurring.
As we consider the potential for similar upside
surprises in 2017, earnings growth tops the list for
three reasons. First, we expect the sizable profit
drag from energy earnings to reverse in 2017,
with scope for a greater than $4–5 contribution
to S&P 500 EPS if recently announced global oil
production cuts are realized. Keep in mind that this
contribution was closer to $15 prior to the collapse
in oil prices. Second, a shift to a 25% corporate tax
rate could add $9–10 to S&P 500 EPS in 2017 if
enacted retroactively (see Exhibit 52). Finally, a tax
holiday for the estimated $1 trillion of cash held
overseas could lead to an additional $1–2 of EPS
upside from repatriation-driven buybacks.
There are also other, less visible potential
catalysts for equities. Over the last 20 years, the
total return of stocks has exceeded that of 10-year
Treasury bonds by only 2 percentage points, well
below the historical average of 4.4 percentage
points and a result that ranks in the bottom 20%
of all post-WWII observations. But after similar
periods of underperformance, stocks generated
well above average relative returns over the
next three and five years (see Exhibit 53). Said
differently, history suggests stock returns will
outpace those of bonds, even if expected equity
returns are uninspiring.
A related source of upside stems from the
lopsided investor flows evident in Exhibit 54. Here,
even moderate rebalancing out of bonds by retail
investors—who represent 80% of mutual fund
owners—would represent a sizable tailwind to
equities. Historically, a shift in flows from bonds
into equities has been motivated by three factors:
confidence in the durability of the economic
recovery, unattractive prospects for bond returns
and higher equity prices (see Exhibit 55). Our
central case features all three factors, suggesting the
Outlook
Investment Strategy Group
53
Exhibit 55: US Equity Fund Flows and Change in
10-Year Treasury Yield
Bond returns can influence flows into equity funds.
Percentage Points, YoY
4
3
Change in 10-Year Yield
Equity Minus Bond Flows (Right)
% of Assets, 3-Month Moving Average
8
6
Exhibit 56: The AAII Bullish Investor Sentiment
Lack of investor euphoria is a contrarian positive for stocks.
% Bullish, 52-Week Average
60
55
2
1
0
-1
-2
-3
-4
-5
1984 1989 1994 1999 2004 2009 2014
4
2
0
-2
-4
-6
-8
50
45
40
35
30
25
20
1988 1993 1998 2003 2008 2013
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg, ICI.
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg, American Association of Individual Investors.
Exhibit 57: Non-Dealer US Equity Index Futures
Positioning
There is scope for increased US equity positions.
$ bn
140
120
100
80
60
40
20
0
-20
-40
-60
-80
2011 2012 2013 2014 2015 2016
Data through December 31, 2016.
Source: Investment Strategy Group, CFTC, Goldman Sachs Securities Division Equity
Strats Group.
incipient uptick in bond outflows seen in late 2016
may persist, especially with “risk-free” Treasuries
delivering a notable loss in the fourth quarter.
Today’s visible lack of market euphoria
represents another potential positive for stocks.
Exhibit 56 shows the proportion of investors
classifying themselves as “bullish” near its lowest
level in decades. Meanwhile, non-dealer positions
in US index futures stand well below the levels
seen in 2013–14, providing scope for upside (see
Exhibit 57). If bull markets “die on euphoria” as
Sir John Templeton observed, then these measures
argue we have not yet reached the apex.
A rare technical analysis signal corroborates
that view. As shown in Exhibit 58, the Coppock
curve—an intermediate-length momentum signal—
has generated only 17 buy signals over the past 71
years, but collectively they have provided attractive
low-risk entry points for long-term investors. If
we took the median path of S&P 500 prices after
past signals, it would imply the market gains 9%
this year with 88% odds of a positive outcome. Of
particular note, Coppock buy signals on the NYSE,
Russell 2000 and FTSE All-World Index were also
triggered in November, even before the post-election
rally. For all the reasons discussed above, we accord
a 25% probability to our good-case scenario of the
S&P 500 reaching 2,450 by year-end.
Of course, we are equally aware of the myriad
downside risks investors face, including growing
unease about a disorderly backup in bond yields.
But here, our work suggests that rates have scope
to increase further before becoming a headwind for
stocks, even if adjusted for today’s lower long-run
equilibrium nominal rate (see Exhibit 59). Keep
in mind that 88% of S&P 500 debt has a fixed
interest rate and only about 10% matures each
year. The impact of higher rates will be spread over
many years as a consequence.
54 Goldman Sachs january 2017
Exhibit 58: Coppock Curve S&P 500 Buy Signals
One of only 17 post-WWII buy signals was triggered in
July 2016.
Exhibit 59: Inflection Point for Negative
Correlation Between Bond Yields and Stock Prices
Typically stocks and interest rates move in the same
direction until yields reach levels far above those seen today.
S&P 500 Index (Log Scale)
10,000
US 10-Year Treasury Yield (%)
6
5
5.1
1,000
4
3
2
2.4
3.9
100
1
0
Current Historical Since 1962 Adjusted for Today’s
Lower Equilibrium Rate*
10
1945 1955 1965 1975 1985 1995 2005 2015
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
Yield at Which Stock Prices and
Bond Yields Become Negatively Correlated
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg, Federal Reserve.
* Adjusts for the reduction of 1.25 percentage points in the long-run equilibrium nominal rate, in
line with the shift in Federal Reserve projections since 2012.
Some have taken a less sanguine view, arguing
that the “taper tantrum” of 2013 suggests bond
yields have already reached a troublesome level for
stocks. However, the tantrum primarily reflected
concerns that by tightening policy prematurely, the
Federal Reserve was committing a mistake that
would undermine growth—a fact evident in the
episode’s widening credit spreads and declining
breakeven inflation rates. Despite a similarly
rapid increase in rates this time around, we have
seen the opposite market reaction, with credit
spreads tightening and breakeven inflation rates
moving higher alongside growth expectations.
This contrast reminds us that the reason rates are
increasing is as important as their resulting level.
Aside from rates, ongoing concern about a
hard landing in China and a banking or political
crisis in Europe remain top of mind (see Section
I, The Risks to Our Outlook). We also start the
year with less of a buffer to absorb such adverse
developments, given today’s high valuations. Even
worse, this narrower margin of safety arrives
at a time when policy uncertainty in the US is
particularly acute, given upcoming changes to
tax, trade and immigration policies under the new
administration. A destination tax, for example,
could be particularly damaging to S&P 500
margins given the growth of global supply chains
in the last decade, not to mention the sizable
Exhibit 60: US Dollar Index
Even if the dollar stays unchanged, it will still act as a drag
on US multinational earnings in early 2017.
YoY %
40
30
20
10
0
-10
US Dollar Index
US Dollar Index Assuming Constant from 12/31/16 Level
-20
2006 2008 2010 2012 2014 2016
Data through December 31, 2016, with illustrative projection through 2017.
Source: Investment Strategy Group, Bloomberg.
upward pressure it would place on the US dollar.
Even at current levels, the dollar will represent a
renewed drag on US multinational earnings in the
first quarter (see Exhibit 60).
That said, the collective impact of these various
risks is not yet sizable enough to undermine our
core view: we are in a longer-than-normal US
recovery that supports equity returns that are
14
26
11
Outlook
Investment Strategy Group
55
Exhibit 61: EAFE Price to 10-Year Average Cash
Flow Discount to the US
Today’s larger-than-average discount provides a margin of
safety to EAFE equities.
Exhibit 62: MSCI EMU Trailing 12-Month
Earnings per Share
Profits have been range-bound for almost four years.
Discount (%)
60
40
20
MSCI EAFE Discount to MSCI US
Average Since 1982
Average Since 1992
Trailing 12-Month EPS (€)
20
18
16
14
12
0
-20
-40
-19
-33
-40
10
8
6
4
2
Sideways
Since 2012
-60
1982 1987 1992 1997 2002 2007 2012
Data through December 31, 2016.
Source: Investment Strategy Group, MSCI, Datastream.
0
1969 1974 1979 1984 1989 1994 1999 2004 2009 2014
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
likely to exceed those of cash and bonds. In turn,
we recommend that clients maintain their strategic
weight in US equities, although we acknowledge
that risks have risen at the same time that returns
appear likely to be lower going forward. While US
equities are not yet running on fumes, we should
keep a close eye on the fuel gauge.
EAFE Equities: Priced for Imperfection
There is no shortage of concerns surrounding the
various countries that comprise Europe, Australasia
and the Far East (EAFE) equity markets. The
list is both long and valid, including persistently
low economic growth, a slow pace of structural
reforms and incessant political uncertainty, as well
as incremental, reactive and inconsistent policy
responses. Ongoing questions about the health of
the banking system only compound these worries.
But these concerns are also not new and are
consequently well understood by the market.
In turn, the key question facing investors is not
whether EAFE exposure subjects them to downside
risks. As the preceding list demonstrates, it clearly
does. The question instead is whether investors are
being fairly compensated to bear these risks.
One can never know precisely what equity
markets are discounting, but the above concerns
are almost certainly a key driver of EAFE
underperformance and the main reason behind
today’s larger-than-normal valuation discount to
US equities (see Exhibit 61). While this margin
of safety does not guarantee outperformance,
it may provide investors with a larger buffer to
absorb adverse developments and miscalculations
in their forecasts. In our view, the risk/return
profile of EAFE equities is more attractive than it
first appears.
As a result, we do not recommend that
investors underweight EAFE equities. In fact, there
are reasons to believe that EAFE equities will
outperform US equities in local currency terms
this year. In the sections that follow, we explore
these reasons by examining the three main EAFE
markets, beginning with the Eurozone.
Eurozone Equities: The Onus Is
on Earnings
Earnings have been going nowhere fast for
Eurozone equities. That’s apparent in Exhibit
62, which shows that profits have been rangebound—at
nearly half their 2007 peak level—for
almost four years. As a result, rising valuation
multiples have accounted for all of the 25% price
appreciation over this period.
This seeming contradiction between stagnant
earnings and rising multiples reflects the copious
liquidity provided by the ECB’s quantitative
easing. By depressing interest rates, ECB policy
56 Goldman Sachs january 2017
Exhibit 63: Relative Performance of ”Stable” and
“Volatile” EAFE Stocks
Investors have recently shifted toward firms more exposed
to the business cycle.
Exhibit 64: Spain 5-Year Credit Default Swap and
Relative Equity Performance
The dramatic reduction in Spanish default risks suggests
equity valuations have scope for upside.
Relative Return (%)
8
Stable
Volatile
6
Price Ratio (July 24, 2012 = 100)
150
140
Basis Points
0
100
4
130
200
2
0
-2
-4
120
110
100
300
400
500
600
-6
Last 3
Months
2016-to-Date 5 Years 10 Years 1987–2007 Since 1987
Annualized Returns
90
MSCI Spain vs. MSCI EMU (Sector-Adjusted)
Spanish CDS Spread (Right, Inverted)
80
2009 2010 2011 2012 2013 2014 2015 2016
700
800
Data as of October 31, 2016.
Note: Equally weighted USD-hedged returns relative to the developed markets (ex-US). Stable
and volatile stocks are drawn from the large-cap universe. Stability is measured using a model
based on return on equity, earnings growth, financial leverage and beta.
Source: Investment Strategy Group, Empirical Research Partners.
Data through December 31, 2016.
Source: Investment Strategy Group, MSCI, Datastream.
has both hobbled bank profits—which represent
a third of EuroStoxx 50 earnings—and boosted
equity valuations. But with ECB policy unlikely
to become any more accommodative, additional
valuation expansion can no longer be taken for
granted. Instead, the onus for Eurozone equity
upside now rests with earnings.
Here, the prospects are favorable for several
reasons. First, above-trend Eurozone GDP growth
is likely to lead to boosted domestic sales and
reduced economic slack, both of which have lifted
Eurozone earnings in the past. Second, the broader
pickup in global GDP growth we expect should
benefit the 45% of the EuroStoxx 50’s sales that
are generated outside Europe. Higher revenue
is particularly beneficial to these EuroStoxx
firms given their operating leverage, as small
improvements in sales spread over their sizable
fixed costs also push profit margins higher. Finally,
financial sector earnings stand to benefit from the
higher interest rates we foresee.
Against this backdrop, we expect earnings
to expand 5% in 2017. Meanwhile, valuation
multiples are likely to contract slightly as interest
rates normalize higher and investor focus shifts
toward eventual ECB tapering late this year.
Combining these elements with a 3.6% dividend
yield implies EuroStoxx 50 total returns of
3% in 2017.
The risks to our base case are skewed mildly
to the upside. After underperforming most equity
markets in 2016, Eurozone equities have room to
play catch-up. Moreover, the passing of long-feared
French and German elections could compress
today’s elevated equity risk premium, although
political uncertainty is likely to remain high in the
interim. Finally, investors’ recent shift toward firms
more exposed to the business cycle should benefit
Eurozone firms given their greater operating
leverage (see Exhibit 63).
Within the Eurozone, we are overweight
Spanish equities. Here, we are drawn to attractive
valuations (see Exhibit 64), domestic growth
momentum and embedded overweight to banks.
UK Equities: Scaling the Wall of Worry
While the Brexit vote was surprising, the
subsequent performance of the UK stock market
was even more so. Despite the tremendous
political and social uncertainty engendered by the
referendum’s outcome, UK equities generated one
of the strongest returns of any major equity market
last year in local currency terms.
Several factors at the root of this
outperformance should continue to work in favor
of UK equities in 2017. First, FTSE 100’s global
Outlook
Investment Strategy Group
57
Exhibit 65: FTSE 100 Price Level and British Pound
A weaker pound benefits FTSE 100 companies, which
generate 75% of sales outside the UK.
Exhibit 66: TOPIX Price Level
Japanese equities have traded in a large-butcontained
range.
Index Level
7,300
7,100
6,900
6,700
FTSE 100 Price Level
GBP/USD (Right, Inverted)
Brexit
Vote
Exchange Rate
1.15
1.20
1.25
1.30
Price Level
3,500
3,000
2,500
6,500
1.35
2,000
Flat
6,300
6,100
5,900
GBP
Depreciation
1.40
1.45
1.50
1,500
1,000
Fat
5,700
1.55
500
5,500
Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16
Data through December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
1.60
0
1980 1985 1990 1995 2000 2005 2010 2015
Data through December 31, 2016.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bloomberg.
footprint—75% of sales come from outside the
UK economy—should benefit from the accelerating
global GDP growth we expect this year, just
as this exposure profited from last year’s 16%
depreciation of the British pound (see Exhibit
65). Second, last year’s best-performing sectors—
commodities and financials—are well positioned
to extend their run. Financials—the largest UK
sector—stands to benefit from rising interest rates,
while the commodity sectors should get a boost
from higher oil prices. Notably, these two sectors
account for nearly half of FTSE 100 market
capitalization.
With these tailwinds in mind, we forecast UK
earnings growth of 11% this year, the highest of
our estimates across EAFE markets. That said,
continued uncertainty around the implications
of Brexit coupled with higher interest rates will
likely weigh on FTSE 100’s well-above-average
valuations. This view, combined with the UK equity
market’s hefty dividend yield of 4.0%, results in a
4% total return projection for the FTSE 100.
Although this return is attractive on its face,
We project UK earnings growth of
11% this year, the highest of our
estimates across EAFE markets.
we do not believe it offers investors a large enough
margin of safety to justify a tactical overweight.
Keep in mind that significant uncertainties remain
around the final contours of Brexit. Moreover,
a shift by the Bank of England toward raising
interest rates this year could reverse much of the
British pound’s depreciation, to the detriment of
UK earnings. Finally, FTSE 100’s global footprint
could magnify any disruption to global trade
volumes resulting from protectionist policies.
Japanese Equities: Scaling a Familiar Peak
Japanese equities have experienced their fair share
of booms and busts over the last 25 years. As seen
in Exhibit 66, this pattern of offsetting swings has
resulted in a “fat and flat” 108 trading range. With
the TOPIX price level again in the upper third of
its historical band, it is natural to ask whether
2017 will mark yet another market top in Japan.
The earnings outlook is pivotal to answering
this question. While our forecast for accelerating
global GDP growth points toward higher
earnings, near-peak profit margins are
a headwind (see Exhibit 67). Moreover,
with less central bank easing given the
BOJ’s already sizable balance sheet, yen
depreciation—a key driver of Japanese
revenue growth since 2012—is expected
to moderate this year. Even so, the
58 Goldman Sachs january 2017
Exhibit 67: Japanese Profit Margins
Near-peak profit margins could be a headwind for
Japanese equities.
Exhibit 68: Japanese Equity Valuations
Valuations are near the median level of Japan’s deflationary
period since 1999.
Trailing 12-Month Net Income (% of Sales)
6
5
Percentile
80
70
65
69
4
3
2
60
50
40
38
43
Average: 52%
47
1
30
0
20
-1
10
-2
1980 1985 1990 1995 2000 2005 2010 2015
0
Price to 10-Year
Average Earnings
Price-to-Peak
Earnings
Price-to-Book
Value
Price to 10-Year
Average Cash
Flow
Price-to-Peak
Cash Flow
Data through November 30, 2016.
Source: Investment Strategy Group, Datastream.
Data as of December 31, 2016.
Note: Based on data since 1999.
Source: Investment Strategy Group, Datastream, MSCI.
interplay of these inputs should still lead to positive
earnings growth of 6% in 2017.
The direction of valuation multiples is equally
important. As shown in Exhibit 68, Japanese
valuations are middling based on their history
since 1999, which we believe is the relevant
evaluation period given the deflationary headwinds
that emerged thereafter. For equity multiples
to move significantly higher from here would
require sustainable above-trend earnings growth
or a sizable increase in direct equity purchases
by the Japanese central bank. But with the BOJ
already holding a remarkable 60% of Japanese
ETF market assets 109 and profit margins near
their peak levels, neither of these upside catalysts
seems probable. In fact, P/E multiples are forecast
to contract in our base case, as the 6% earnings
growth we expect will likely disappoint current
market expectations of 12%.
Putting these pieces together, we expect neither
a boom nor a bust for Japanese equities. Instead,
the combination of mid-single-digit earnings
growth, slight compression in valuation multiples
and a 1.9% dividend yield should generate a
5% total return. While this return is attractive
from an absolute standpoint, it also comes with
significant downside risks given the country’s
poor demographics, declining labor force and
high government debt load. Consequently, we are
tactically neutral on Japanese equities currently.
Emerging Market Equities: Finally in Gear,
but Potholes Ahead
Emerging market equities as a whole finally moved
forward in 2016 after three years in reverse:
multiples expanded, earnings estimates improved
and currencies appreciated, generating a 12%
total return. Politics and commodity prices were
key performance differentiators among emerging
markets last year, leading Brazil and Russia to the
winners’ podium while leaving Turkey and Mexico
in last place.
We expect emerging market equities to remain
on track in 2017. Our central case calls for
earnings growth of 5% in US dollar terms, driven
by faster nominal GDP growth and the lagged
impact of easier financial conditions and higher
commodity prices. But with multiples already at
post-crisis highs in an environment of rising global
rates and heightened risks, we see little scope for
further expansion. Combining these two inputs
with a dividend yield of 2.6%, our forecast implies
a total return of about 7% this year.
However, the uncertainty around this forecast
is quite large, as emerging market equities face
several potential potholes on the road ahead.
Chief among these is the ultimate policy agenda
of the incoming US administration. On the one
hand, a policy mix that favors US growth over
trade restrictions would support emerging market
exports and boost profits and equity returns.
Outlook
Investment Strategy Group
59
Exhibit 69: EM Equity Valuations
Aggregate valuations are near neutral levels.
Normalized Composite Z-Score
1.0
0.8
0.6
0.4
0.2
0.0
0.0
-0.1
-0.2
-0.4
-0.3
-0.2 -0.2 -0.2 -0.2
Russia (4.5%)
Taiwan (12.2%)
Chile (1.2%)
Korea (14.4%)
Turkey (1.0%)
Malaysia (2.5%)
Thailand (2.3%)
0.1
EM
On the other hand, a harsher US stance on trade
and foreign policy would hurt emerging market
earnings, sentiment and valuation multiples.
China, Korea, Mexico and Taiwan—which
account for about 60% of MSCI emerging market
capitalization and earnings—seem particularly
vulnerable in the latter scenario. In comparison,
countries with less exposure to the US economy
and already strong domestic demand, such as India
and Indonesia, would likely fare better.
0.2
China (26.5%)
0.2 0.2
Data as of December 31, 2016.
Note: Based on monthly data since 1994 for Price/Forward Earnings, Price/Book Value, Price/
Cash Flow, Price/Sales, Price/Earnings-to-Growth Ratio, Dividend Yield and Return on Equity.
Numbers in parentheses denote the country’s weight in MSCI EM. Only showing countries with a
weight greater than 1%.
Source: Investment Strategy Group, Datastream, I/B/E/S, MSCI.
Mexico (3.5%)
Philippines (1.2%)
0.4
Poland (1.1%)
0.4
Indonesia (2.6%)
0.5
India (8.3%)
0.7
South Africa (7.1%)
0.9
Brazil (7.7%)
Against this uncertain backdrop and
considering today's uninspiring valuations (see
Exhibit 69), we remain tactically neutral on
emerging market equities. That said, we continue
to explore relative investment opportunities that
exploit the significant domestic activity, external
vulnerability and valuation differences among
individual emerging countries.
2017 Global Currency Outlook
In a notable departure from recent years, the
US dollar did not enjoy unequivocal dominance
in 2016 (see Exhibit 70). The yen, for example,
ended a four-year slide against the greenback as
the market questioned the BOJ’s commitment
to monetary easing. Certain emerging market
currencies—such as the Russian ruble and Brazilian
real—also outperformed the dollar on the back of
stronger commodity prices and favorable political
developments at home. And while the dollar did
make notable gains against the euro, pound and
Mexican peso in particular, these currencies enter
2017 with a more balanced risk/reward profile
as a result.
The upshot is that while tightening monetary
policy and potential fiscal expansion in the US
will continue to favor dollar strength, those
gains are likely to be more modest and reflected
in a narrower set of currencies as the dollar bull
market enters its fifth year. Our tactical positioning
Exhibit 70: 2016 Currency Moves (vs. US Dollar)
For the first time in several years, the US dollar did not appreciate against all major currencies.
2016 Spot Return (%)
G10 EM Asia EM EMEA EM Latin America
25
20
15
10
5
0
-5
-10
-15
-20
-16
USD
Appreciation
-7
-3
-2 -1
2 2 3 3
-6
-5 -4
-3 -3 -2
1
2 2
-17
-6
-3
-1
13
20
-17
2
6 6
22
UK
Sweden
Euro
Switzerland
Australia
New Zealand
Norway
Japan
Canada
China
Philippines
Malaysia
India
Korea
Singapore
Thailand
Taiwan
Indonesia
Turkey
Poland
Czech Republic
Hungary
South Africa
Russia
Mexico
Peru
Chile
Colombia
Brazil
Data as of December 31, 2016.
Source: Investment Strategy Group, Bloomberg.
60 Goldman Sachs january 2017
incorporates this view, as we are neutral on the
euro, yen and pound versus the US dollar, but
remain bearish on the Chinese renminbi.
We discuss our view on the broader US dollar,
as well as each of these currencies, next.
Exhibit 71: US Dollar Real Effective Exchange Rate
Dollar valuations are near their long-term average but below
levels reached in past bull cycles.
Z-Score
4
US Dollar
Following three consecutive years of dollar
outperformance, it would be reasonable to assume
the up-cycle is nearing an end. After all, dollar
valuation is now close to its historic average level
relative to the currencies of US trade partners, after
adjusting for inflation. Moreover, the length of this
dollar bull market is approaching that of the two
prior episodes shown in Exhibit 71 and shares a
similar underlying driver—tighter monetary policy
in the US relative to its global peer group.
But while we expect the pace of US dollar
appreciation to slow, there are many reasons
to believe the greenback’s outperformance can
continue this year. Dollar valuation remains
below the peaks reached in the 1985 and 2002
bull cycles, suggesting it is not yet prohibitively
expensive. The dollar should also benefit from
solid US macroeconomic fundamentals relative to
other developed economies. President-elect Trump
ran on a platform that includes fiscal expansion
and corporate tax reform. Although his economic
team’s spending plan is still forthcoming, the
package could represent an economic tailwind that
may justify tighter US monetary conditions at a
time when foreign central banks have committed
to easier policy. In turn, relatively higher US yields
may entice global investors to favor US dollar
assets over lower-yielding foreign-denominated
alternatives.
Furthermore, some elements of the new
administration’s desired corporate tax reform
could present material upside risk to the US dollar.
For example, the destination-based tax system
supported by several House Republicans disallows
deductions for any imported good or service—
Dollar gains are likely to be more
modest and reflected in a narrower
set of currencies as the dollar bull
market enters its fifth year.
3
2
1
0
-1
-2
6.3 Years 6.8 Years 5.4 Years
-3
1973 1978 1983 1988 1993 1998 2003 2008 2013
Data through November 30, 2016.
Note: Z-score is calculated on data since 1973 and represents the number of standard deviations
from the mean. Shaded areas highlight periods of dollar strength.
Source: Investment Strategy Group, Datastream.
effectively supporting US goods by making them
more competitive. Economic theory suggests that
free-floating currencies such as the US dollar
would need to adjust higher by the amount of
the tax to create equilibrium with similar goods
sourced across foreign borders. Taken at face
value, this implies a 20% destination tax would
require a simultaneous—and potentially very
disruptive—20% increase in the US dollar. A tax
holiday for cash held abroad could be similarly
dollar positive, in spirit if not in magnitude. While
it is true that a majority of the $2.6 trillion of US
corporate earnings trapped overseas are already
held in US dollar assets, the greenback would still
enjoy a tailwind if corporates elected to repatriate
some portion of the foreign currency balance.
That said, the risks to the US dollar are not
exclusively to the upside, as much of the good
news is embedded in current prices (see Exhibit
72). Consider that the bulk of last year’s dollar
advance occurred in the two weeks following the
US presidential election in November, as
the market quickly discounted a portion
of potential policy changes. Moreover,
Federal Reserve rate hike expectations
for 2017 have increased following
stronger US activity data during the
second half of 2016. Lastly, we expect
the BOJ and ECB to maintain their
highly accommodative policies again
this year. With these tailwinds already
0.6
Outlook
Investment Strategy Group
61
Exhibit 72: Trade-Weighted US Dollar Index
The recent dollar rally implies much of the good news has
already been priced in.
January 1997 = 100
140
Exhibit 73: Eurozone Net Portfolio Flows
Policy divergences could continue to drive portfolio
investment out of the Eurozone.
12-Month Rolling Sum, % of GDP
6
130
120
110
4
2
0
-2
Capital Into Eurozone
= Euro Appreciation
100
90
80
1995 2000 2005 2010 2015
Data through December 31, 2016.
Note: Shaded areas denote periods of US recession.
Source: Investment Strategy Group, Datastream.
-4
Capital Out of Eurozone
= Euro Depreciation
Net Equity
-6
Net Debt
Net Portfolio Flows
-8
2011 2012 2013 2014 2015 2016
Data through October 31, 2016.
Note: Q3 2016 data used to calculate Q4 2016 share of GDP.
Source: Investment Strategy Group, Haver Analytics.
partly reflected in current exchange rates, the US
dollar is vulnerable to both domestic and foreign
disappointments.
In sum, we expect the dollar to appreciate
further, but at a slower pace and with greater
volatility than in recent years.
Euro
The euro was on the losing side of the US
dollar’s strength again in 2016, marking the third
consecutive year of underperformance and the
longest stretch of annual declines since 2001. Last
year’s modest 3.2% decline actually masked a
much larger 10% drop from the euro’s intra-year
peak, half of which came in the weeks following
the US elections in November. Needless to say, the
combination of potentially expansionary fiscal
policy put in place by the new administration
coupled with tighter US monetary policy represents
a stiff headwind to the euro, particularly since
We should not lose sight of the fact
that after such persistent weakness
versus the US dollar, the euro is
undervalued and investors are now
positioned for further weakness.
the ECB just extended quantitative easing until
December 2017.
We expect these transatlantic policy divergences
to persist, driving European investors to continue
seeking higher-yielding, non-euro-denominated
assets abroad (see Exhibit 73). This preference
will likely be bolstered by uncertainty surrounding
upcoming national elections in Germany, France,
the Netherlands and possibly Italy and Spain.
While our central case assumes mainstream parties
prevail, any result that raises questions about the
long-term viability of the European Monetary
Union could push the euro even lower.
Still, we should not lose sight of the fact that
after such persistent weakness versus the US dollar,
the euro is undervalued and investors are now
positioned for further weakness. Additionally, the
above-trend Eurozone growth and normalizing
inflation we expect could justify the ECB shifting
toward a more neutral stance later this year.
Such a move would narrow the interest
rate differential between the US and
Eurozone, weakening a linchpin of the
weaker euro thesis.
Given this balance of risks, we
removed our tactical short positions in
the euro relative to the dollar following
the November US presidential election,
returning to a neutral view.
62 Goldman Sachs january 2017
Exhibit 74: Japanese Net Purchases of Foreign
Long-Term Debt by Investor Type
Additional buying of foreign assets by Japanese investors
could put further downward pressure on the yen.
12-Month Rolling Sum, % of GDP
-2
0
2
4
6
Banks
Pension Trusts
Insurers
All Other*
Capital Into Japan
= Yen Appreciation
Capital Out of Japan
= Yen Depreciation
2013 2014 2015 2016
Data through November 30, 2016.
Note: Q3 2016 data used to calculate Q4 2016 share of GDP.
Source: Investment Strategy Group, Haver Analytics.
* All Other defined as central banks, general government, financial instruments firms, investment
trust management companies and others.
Yen
For yen investors, last year was a reminder that
markets often take an escalator up but an elevator
down. After steadily appreciating almost 20%
against the US dollar over the first nine months
of 2016, the currency forfeited those gains in
just weeks after the surprising US presidential
election. Although the net effect was a small 2.8%
appreciation last year—breaking a four-year streak
of yen weakness—we do not believe further yen
strength is likely.
There are two reasons for this view. First, the
BOJ will likely keep rates negative or close to zero
this year by maintaining highly accommodative
monetary policy. In turn, Japanese investors will
continue to sell low-yielding domestic assets—
placing downward pressure on the yen—in order
to fund purchases of higher-yielding offshore assets
(see Exhibit 74). Japan’s Government Pension
Investment Fund (GPIF)—which manages the
world’s largest public pension—is a case in point,
as it will need to sell domestic fixed income assets
to reach its stated targets for foreign investments.
Similarly, Japanese life insurers may increase
their exposure to foreign currencies if interest
rate differentials between the US and Japan
remain wide.
Second, Japanese corporations are likely
to sell yen to invest in foreign operations with
better growth prospects, which will also place
downward pressure on the Japanese currency; such
announcements are already on the rise. 110
This is not to suggest that the prospects for the
yen are completely one-sided. The higher global
rates we expect may make it difficult for the BOJ
to maintain such low domestic yields, which would
alleviate some of the downward pressure on the
currency. Moreover, the many sources of global
uncertainty in the year ahead could lead investors
back into the yen as a liquid hedge, as we saw in
the first half of 2016. Finally, after four years of
weakness, the yen has reached undervalued levels.
Given this more balanced risk profile, we
currently have no tactical position in the yen.
British Pound
While broader financial markets were unperturbed
by the UK’s decision to leave the European Union,
the same cannot be said for currencies. Here,
the Brexit vote sent the pound tumbling to its
lowest level versus the US dollar since the 1985
Plaza Accord. 111 Although the pound has since
recovered some of those losses, its 16.3% decline
relative to the US dollar last year still ranks as the
worst performance among all developed market
currencies.
The trajectory of the pound will be largely
shaped by the evolution of Brexit negotiations.
Even though six months have passed since the
vote, there is no greater clarity on how the UK
will ultimately exit the European Union and on
what terms. Clearly a combative stance could see
the pound weaken further as the market discounts
lower potential growth in the UK. Alternatively, a
more conciliatory negotiating position could lead
to upside from today’s depressed levels.
Barring a hostile negotiating tack from the
UK government, the pound also has several other
factors working in its favor. First, foreigners
continue to buy pounds to invest in UK-domiciled
assets and firms, which is vital to funding the UK’s
sizable 5.2% of GDP current account deficit. In
fact, one of the largest cross-border acquisitions
last year was announced less than one month
following the EU referendum. 112 Importantly,