Global Equities: Outlook for the Second Half

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1 31 July 2014 Global Equities: Outlook for the Second Half Global growth still seems to be in an improving trend as the US job market expands and China maintains growth at 7.5% (p. 2). We expect a continued acceleration in global growth, offset by periods of volatility due to geopolitical developments. As a result, we expect most risk assets to grind higher for the remainder of the year (p. 3). In our Focus Piece, we discuss the outlook for global equity markets amid several signs that the market is slowly and steadily climbing back to normal (p. 4). If we have indeed returned to normal, we believe active management and stock selection will be critical for equity investors seeking aboveaverage returns. Among developed markets (DM), we believe 1) US equities could benefit from the strongest economic outlook; 2) Europe has the widest range of potential outcomes; and 3) Japanese equities could benefit from lower valuations and potential catalysts for improved sentiment. In emerging markets (EM), we favor companies exposed to stronger corporate investment in India and Chinese consumption. We are watching Brazil closely for signs of structural reform. While the macroeconomic environment is a key factor for equities, we think focusing solely on the macroeconomic outlook for a country or region creates the risk of missing micro opportunities to pick good companies. We see more potential for bouts of volatility given the escalation in conflicts in Ukraine and the Middle East, but so far markets have largely shrugged off geopolitical risk (p. 6).

2 Macro Trends and Views US The US labor market continues to show signs of improvement with job openings accelerating to a rate of 3.2% as of May from an average of 2.7% in Despite stronger job growth, wages remain relatively static with average hourly earnings growth of about 2% and few signs of acceleration. We think the improvements in the job market are a positive sign that will ultimately lead to stronger household formation and construction, but housing starts remain a weak spot in the economy for now. % Japan Japan s outlook continues to primarily depend on what happens to growth following the April tax hike. Although consumption and manufacturing activity remain relatively weak, surveys suggest that businesses and households are optimistic about a recovery. Considering the healthy momentum in advance of the tax hike, we are optimistic that the economic recovery will be sustained. Sales % yoy US job openings growing at the fastest rate since 2007 Japan consumption is still recovering from the sales tax hike Convenience Stores Supermarkets Department Stores Job Openings Rate 1.5 '04 '05 '06 '07 '08 '09 ' '11 '12 '13 '14-15 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Europe Recent economic data have shown some slowing in Eurozone growth momentum, particularly in France where the manufacturing purchasing managers index (PMI) has weakened for four consecutive months. Inflation remains low with the consumer price index rising just 0.5% year-over-year in June. We believe ongoing structural reform, a strong exchange rate, weak lending and a sizeable output gap will keep inflation subdued and eventually lead the European Central Bank (ECB) to further ease monetary policy. Index '08 '09 ' '11 '12 '13 '14 Source: Markit, Haver Analytics Growth Markets China s property market continues to slow. Developers have accelerated the completion of residential projects to boost stock for sale, similar to 2009 and China s GDP growth was 7.5% in the second quarter. The contribution from consumption fell to 4% versus 5.7% in the first quarter, while investment increased. We believe the slowdown in China s property market will slow the transition from investment to consumption. More stimulus may be needed to keep growth at 7.5%. % yoy Eurozone Manufacturing PMIs have softened, led by a decline in France Eurozone France Chinese property developers boosting stock for sale as prices deteriorate - Floor Space of Completed Residential -20 Buildings (3-month average) '09 ' '11 '12 '13 '14 Goldman Sachs Asset Management 2 July 2014

3 Market Trends and Asset Allocation Views We expect a continued acceleration in global growth, offset by some geopolitical risk. As a result, we expect most risk assets to grind higher for the remainder of the year. As growth improves, diverging central bank policy presents both opportunities and hazards for investors. In particular, market participants have turned to anticipating the first rate hike in the US and the UK, even as members of both monetary policy committees have remained dovish in their comments. Here employment data and wage growth, as indicators of labor market slack, will remain crucial going forward. In the US, we see some factors that could spur rates higher which are not yet priced into markets. In Europe, monetary policy will remain loose. The economic recovery remains broadly intact, though slower production figures and the return of credit fears led to some loss of investor confidence. The region is still quite leveraged, so growth volatility is to be expected and we believe the economic recovery is fundamentally intact. In Japan, inflation is firmly positive and importantly some of this is being seen in wages too. This should move domestic investors out of bond and cash positions and along the risk spectrum into equities. Signs of momentum in the 'third arrow' of reform are also encouraging with emphasis being placed on improved childcare facilities and greater investment. In Growth Markets, some of the nerves around Chinese leverage and housing growth have dissipated in the near term after recent GDP releases. We had previously written that we believe Q2 would see a recovery and continue to think a soft landing is the most likely growth scenario. Overall, our anticipation of re-accelerating economic growth, led by the US, has not changed yet this year. China s stabilization adds further momentum to this. Given our % yoy normalized Wage growth will be an important driver of central bank policy* Eurozone US UK Japan -2.5 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Source: Haver Analytics * Each country's yoy % wage growth is shown normalized relative to its own history since economic views, we remain overweight developed market equities. In particular, we hold positions in cyclical US equity sectors and areas of Europe with both value and a clear liquidity tailwind. We believe that Japanese equities offer reasonable value and implement our long position with a currency hedge. We stay overweight credit risk, duration-hedged due to our view that interest rates will rise. We monitor this closely, as we hold concerns about liquidity in the case of a sell off. However, we do not expect a surge in volatility or defaults in the near future. We have been rewarded recently for remaining overweight to emerging market risk in our portfolios, but tactically leave some hedges to this universe in place by being short vulnerable currencies and commodities geared to Chinese growth. We continue to be selective with our EM allocations and believe active management should be rewarded across this universe. We are still in a low volatility environment with easy financial conditions, though we position client portfolios to hedge a number of risks to our outlook. Such risks to investment views can be split along an axis of within, or exogenous to, the financial system. We do not perceive any immediate source of a large downturn coming from stresses in the financial system. However, a disorderly decompression in US rates could re-introduce volatility to markets. This could come from inflation, Fed messaging, or supply factors in the second half of the year. Recently, as we wrote last month, geopolitical risk has emerged as the largest source of concern for investors. With ongoing uncertainty across North Africa, the Middle East and Russia and Ukraine, spikes in volatility are likely to continue. The first line of defense is always robust diversification. We retain some exposure to high-quality government bonds, and recently introduced a short to Korea, a small open economy which is heavily exposed to global trade. Equity Fixed Income Real Assets Cash Asset allocation views on a 1-yr horizon* Less More Attractive Attractive Change US Equity - European Equity - Japanese Equity - Growth Markets Equity - EMD Local - Corporate Credit - High Yield - DM Sovereign Debt - Commodities - Cash - Source: GSAM Global Portfolio Solutions. As of July * Note that this does not account for liability-driven investment. Goldman Sachs Asset Management 3 July 2014

4 Focus Piece: Global Equity Outlook It has been a long time since we have experienced a normal investing environment, but we see several signs that the equity market is slowly and steadily climbing back to normal: Correlations and volatility have fallen from elevated levels during the financial and euro crises back to levels that are closer to average. Corporate earnings are expected to be up 8.7% in 2014, according to consensus, which we think should support roughly average historical equity returns of 8-%. Equity risk premiums are still elevated, suggesting that equities may look attractive compared to other assets, but have moved closer to their long-term average. If we have indeed returned to normal, we believe active management and stock selection will be critical for investors seeking above-average returns. Three main themes are driving our active management strategy in the current environment: Theme 1: EM vs. DM Matters Less Earlier this year, we saw more opportunity in developed economies but we now see more balance between emerging and developed equity markets. Valuations have moved higher for most developed markets, while economic and earnings growth are coming more slowly than consensus expectations. Meanwhile, prospects for some emerging markets have improved and many of their valuations remain slightly below those of developed markets. Theme 2: Countries and Regions Matter More While we think the distinction between emerging and developed economies probably matters less in the current environment, we see more reasons to distinguish among different countries and regions. In the following sections, we summarize our outlook across key country markets. US: Growth, at a price We believe US equities could benefit from the strongest macroeconomic outlook among the developed markets. The US equity market is also well-positioned to potentially benefit from the current strong M&A activity in the Information Technology (IT) and Healthcare sectors, which account for 30% of the S&P 500 Index, as well as our expectation of forthcoming capital expenditure (capex). We also continue to have a favorable view on companies and industries that are positively impacted by US shale development. Currently, we like US energy companies with predominantly domestic assets, which we believe could have an advantage over the more internationally-focused companies. We also favor companies that could benefit from the cheaper US feedstock, such as refiners and petrochemical producers. We are bullish on the IT sector globally, except in Japan, which has mostly hardware companies and we generally prefer software, IT services or companies related to secular trends like mobility and the cloud. We believe these companies are more likely to benefit from increased spending. US equity valuations are beginning to reflect strong economic and corporate growth prospects for the US. While we believe that this could mute upside potential for the US compared to other markets, we note that the equity risk premium is still well above pre-crisis levels. Europe: Widest range of outcomes We believe that the potential for upside, balanced against a number of risks, leads to a wider range of outcomes for Europe than other developed markets. The consensus expectation for Euro area economic growth in 2014 is a modest 1.1%, but it marks an important swing back into positive growth, following contractions in 2012 and If macroeconomic growth can support revenue growth, we believe that European companies have a lot of margin Average Correlation Exhibit 1: Correlations between stocks have fallen to more normal levels Stock Correlation 0.0 '05 '06 '07 '08 '09 ' '11 '12 '13 '14 Source: GS Global Investment Research Exhibit 2: Top areas where companies plan to accelerate IT spending in 2014 Business intelligence/analytics Security software / appliances Software-as-a-Service (SAAS) Public cloud computing Desktop virtualization Server hardware PC hardware Server virtualization Social/collaboration Wireless LAN # of responses Source: GS Global Investment Research Global Technology Spending Survey. Data as of December The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation. Goldman Sachs Asset Management 4 July 2014

5 Focus Piece: Cont d leverage to drive earnings higher, particularly with earnings still 35% below peak levels. European companies which collectively get 52% of their revenues from outside of Europe could also benefit from accelerating growth in other regions. Eurozone EPS Exhibit 3: Eurozone corporate earnings are still well below peak levels 6 MSCI Eurozone 12m Fwd EPS (EUR) 4 MSCI US 12m Fwd EPS (rhs) 2 '97 '98 '99 '01 '02 '04 '05 '06 '08 '09 '11 '12 '14 Source: JP Morgan US EPS Japan: Catalysts may be coming In our view, the ultimate driver of higher equity returns in Japan will have to come from successful structural reforms in terms of labor, inflation and corporate culture, which may take time. However, near- and medium-term catalysts may boost investor sentiment and equity prices. First, we think the Bank of Japan will likely take further steps to stimulate the economy in the coming months. Second, wage growth is taking hold and creating expectations for future wage growth and inflation, which is an important shift in the Japanese mind-set after years of deflation. Lastly, Japan is the developed market country most exposed to global growth, given its export-driven economy. Despite these prospects, Japan s equity market has lagged other developed market regions this year, leaving it a valuation advantage versus some other markets. India: Good days are coming Good days may indeed be coming to India, as promoted by the winning Bharatiya Janata Party (BJP) party s tagline. We believe the Modi government is likely to propose a business-friendly agenda with greater clarity in regulation and a renewed emphasis on reforms, all of which could lead to a pick-up in investment in the coming months. This outcome could have an outsized effect on the Indian economy, as business confidence improves from recent very low levels, and companies restart stalled or postponed projects. As a result, we are positioned in areas well-exposed to capex, such as commodity-related industries, industrial companies and the financials sector Valuations are near the historical average, which we believe looks attractive considering that India may be in the early stages of a multi-year earnings cycle. China: The growing shadow of local finances China is beginning to deal with excesses and unsustainable trends in the property market and financial markets. The process is likely to be slow, and there is a risk that it could be painful. The situation is already a drag on fixed investment growth, and could be the start of a multi-year deleveraging process. Therefore, we remain cautious on the macroeconomic environment in China until we have a better sense of policy and structural reforms the government might employ to diffuse the situation. We believe the mid-sized banks, which have relatively less liquid balance sheets, could be negatively impacted and we also have a cautious view on metals, mining and cement, which all suffer from overcapacity and are likely to be further hurt by reduced fixed asset investment. Chinese consumption, however, is still growing strongly and our positive view on the Chinese consumer is reflected through our positions in the consumer-related sectors as well as healthcare, technology and digital industries. Brazil: What will kick off growth? The end of the commodity boom has been a major contributor to Brazil s recent economic woes, particularly for the equity markets. But this is only part of the story. Like China, Brazil is also wrestling with some financial excesses, primarily an over-levered consumer. Similar to India, Brazil s economic growth dropped off sharply and has struggled to reignite it, in part due to high inflation which has kept interest rates high. However, Brazil also has an important election this year which could bring much needed structural reforms. Equity markets are already rising in response to increasing talk of change. We will be watching Brazil closely. Theme 3: Don t Miss the Micro for the Macro While the macroeconomic environment matters, we believe investors may overlook good companies by picking stocks based solely on a region s macroeconomic environment. We would rather attempt to appropriately discount the macroeconomic risk in the price we are willing to pay for an otherwise good investment opportunity. For example, we like bank stocks in some smaller, less covered markets like Colombia and Peru. These banks have massive market share and significant pricing power, which means they do not have to take nearly as much risk to earn the same return on equity (ROE) as a developed market bank that faces heavy competition. Goldman Sachs Asset Management 5 July 2014

6 Notes: Four Charts on Geopolitical Risk In the June Macro Insights, we noted that the S&P 500 had gone 45 days without a 1% move in either direction, the longest streak in almost 20 years. Tragically, that streak was broken on July 17 when Malaysia Airlines Flight MH17 crashed in Ukraine. Below, we show four charts illustrating the impact of geopolitical risks. Volatility Market volatility remains very low despite the increased geopolitical tensions in Ukraine after the downing of Flight MH17 and the conflict in Gaza. The VIX Index hit a post-crisis low on July 3 and has moved higher since then, but remains very low relative to history. Oil Prices Brent crude oil prices rose initially as the ISIS militant group took the Iraqi cities of Mosul and Tikrit, but prices have since stabilized. While violence has continued in Iraq, there has been no major disruption to oil production. Forward-looking expectations for Iraqi oil production have shifted downward. Index The VIX Index has risen only modestly after hitting a post-crisis low on July 3 VIX Index 30-Day Moving Avg Malaysia Airlines Crash in Ukraine $/barrel Crude oil prices have stabilized after rising on Iraq conflict Brent Crude Oil Price ISIS attacks on Iraqi cities 12 0 Jul-13 Oct-13 Jan-14 Apr-14 Jul Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Russia s Economy On July 16, the US government declared the first so-called sectoral sanctions against two Russian banks (Gazprombank and VEB) and two energy firms (Novatek and Rosneft). With the potential for further sanctions from both the US and European Union, expectations for Russia s economy have steadily declined. We have reduced our forecast for Russia s GDP in 2015 to 1.5%, consistent with the consensus forecast. % yoy Expectations for Russian GDP in 2015 have steadily declined Bloomberg Consensus 2015 GDP Forecast 0.0 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Emerging Market Debt Russia s sovereign debt spread has widened in the wake of the US sanctions and the downing of Flight MH17. However, Russian spreads have yet to reach levels hit when the country annexed Crimea earlier this year. Meanwhile, emerging market external sovereign debt spreads overall have been stable as investors appear to have rotated into other oil-producing emerging market countries such as Gabon and Kazakhstan. Basis points Emerging market sovereign spreads have been stable despite widening in Russia EM Sovereign Spread Russia Sovereign Spread 150 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Source: JP Morgan, EMBI Global Diversified Index Goldman Sachs Asset Management 6 July 2014

7 Appendix: GSAM Growth Forecasts and Asset Valuation GDP Growth Forecasts: GSAM vs Consensus GSAM Consensus* GSAM Consensus* US UK Euro area Japan Brazil China India Russia Mexico Korea Indonesia Turkey Advanced BRIC Growth Markets World *As of July Source: GSAM and Bloomberg Equity Valuation Across Advanced and Growth Markets Level CAPE* FY1 PE Price/Book Dividend Yield % time cheaper*** Level % time cheaper*** Level % time cheaper*** Level % time cheaper*** Earnings Momentum** % change in 1y fwd EPS Japan % % % % -1.6 US % % % % 0.0 Canada % % % % 3.1 India % % % % -1.7 Australia % % % % -0.8 Europe % % % % -2.5 Germany % % % % -2.7 France % % % % -2.9 Italy % % % % -2.6 UK % % % % -2.8 Spain % % % % -1.9 Portugal % % % % -5.8 China 11.7 % % 1.4 9% % -1.5 Brazil %.5 78% % % -4.7 Russia 5.7 9% % 0.7 9% 3.8 6% -0.8 * Cyclically-adjusted PE ratio (5-yr rolling window). ** % change in 1-yr fwd EPS over last 3 months. *** Current percentile relative to full history As of July All data based on MSCI country indices. Source: Datastream, GSAM calculations % US Equity Risk Premium 6.0 US ERP 200 day m.a '05 '06 '07 '08 '09 ' '11 '12 '13 '14 Source: GSAM calculations % Equity Risk Premium for the BRICs 12 Brazil China India Russia '07 '08 '09 ' '11 '12 '13 '14 Source: GSAM calculations Goldman Sachs Asset Management 7 July 2014

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