weathering change · weathering change fundamental equity team 1st quarter 2016 like seasonal...

Global Equity Outlook

Weathering Change

Fundamental Equity Team1st Quarter 2016

Like seasonal change, El Niño and unexpected storms, a mix of cyclical and other factors played out unevenly across equities in 2015. European and Japanese markets outperformed most major markets with solid gains in local currencies, but US and EM equity performance was disappointing. We once again expect positive, but below average, returns for global equities in 2016, in light of modest economic growth forecasts and rising valuations in some areas of the market. However, in our view, equities still look more attractive than other asset classes in a continued low-return environment. Importantly, we believe there are many ways to make hay even when the sun doesn’t shine. We discuss our outlook for 2016 in the following sections:

� Grey skies for global growth: economic forecasts are modest but could be enough to sustain corporate profitability and we believe central banks will remain accommodating.

� The commodity El Niño: low oil and commodity prices continue to depress many emerging market (EM) economies; oil supply has taken longer to correct than anticipated, which is having a more negative effect on the energy industry and US economy than originally forecasted.

� Change of seasons: late-cycle indicators are emerging in US credit and equities, while rates are finally going up. Low commodity prices could tip the balance into a default cycle, with an impact on EM. Changes in the credit and rate cycles have implications for financials stocks.

� Climate change: keeping up with the consumer requires looking at more granular data as well as accounting for changes in spending patterns that are both near-term, cyclical (weak currency and economic downturns) and long-term, secular (technology and demographics).

� Storm warnings: rising geopolitical tensions and political rhetoric across the world increase the possibility of unexpected events and financial market volatility.

� Developed markets (DM): staying close to home, we believe domestically-exposed companies in the US, Europe and Japan could benefit from increasing domestic consumption.

� US: the other 496 stocks did not participate in the extreme growth-at-any-price mentality that led to the narrowest trading breadth in 30 years for the S&P 500 Index and significant underperformance of value stocks. We think the US market is full of relative value opportunities.

� Europe: a little economic growth could go a long way toward helping European earnings and stocks catch up to the US, despite relatively high exposure to EM end-markets.

� Japan: changing corporate and consumer behavior could be the biggest drivers of Japanese equities, which are also among the least expensive in the developed markets.

� EM: minding the macro but not mired in it, we continue to believe that India has the best outlook, but mostly differentiate our portfolios through stock picking rather than country selection. We remain cautious on state-owned enterprises (SOEs) and believe many off-benchmark and small-cap stocks present more interesting opportunities.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.

2 | Goldman Sachs Asset Management

Global Equity Outlook 1Q2016: Weathering Change

While the macro outlook remains benign, particularly in Europe and Japan, US credit and equities appear to have advanced to late-cycle stages. In addition, some persistent risks, namely weak commodity prices and political/geopolitical uncertainty, continue to fuel a general sense of nervousness.

Forecasting returns for the global equity market is a bit like predicting the weather for the world. Like the change of seasons, economies and equity markets are at different stages of the economic, profit and interest rate cycles. The El Niño effect may cause droughts in Africa but floods in England, while low oil and commodity prices are wreaking havoc on many EM economies and the energy industry, yet benefitting India. Storms can still strike anywhere with little warning, while defaults and dividend cuts, central bank surprises and geopolitical disruptions can still shock equity markets.

Performance across global equity markets in 2015 reflects different stages of the economic, profit and interest rate cycles and the uneven impact of low commodity prices.

While the macro outlook remains benign, particularly in Europe and Japan, US credit and equities appear to have advanced to late-cycle stages. In addition, some persistent risks, namely weak commodity prices and political/geopolitical uncertainty, continue to fuel a general sense of nervousness. This “informed caution,” as the CEO of a global financial services company recently put it, may be impacting corporate, consumer and investor behavior alike.

Grey skies for growth

After dipping in 2015, we expect global economic growth to increase modestly in 2016, which we think will be enough to sustain corporate profitability and allow stock prices to move higher. However, this aggregate projection hides a number of regional divergences which are likely to have implications for companies and equity markets.

Overall global economic growth is still modest but varies widely between regions.

Source: MSCI, Datastream, as of December 31, 2015.

* 2016 World, DM and EM GDP growth forecasts are GS Global Investment Research forecasts.Source: GSAM, GS GIR as of January 11, 2016.


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In our view, working excess supply out of the oil market is taking longer and going deeper into economies than expected. Many other commodities are still in oversupply as China’s industrial economy slows.


In our view, central banks are likely to remain accommodative, in light of still fragile global economic growth, which we also see as helpful for equity markets. Even in the US, where Federal Reserve (Fed) policy has moved toward normalization, we do not expect to see much negative impact from gradual interest rate increases given continued strength in the housing and labor markets, though the strong dollar will likely remain a headwind for US multinationals. With inflation well below target in the Eurozone and Japan, we believe both the European Central Bank (ECB) and Bank of Japan (BoJ) could ease further in the second half of 2016. We believe the euro and yen will remain weak versus the US dollar, given the divergence in interest rates, which should help both countries’ large export sectors. Policy in China may be less predictable as policymakers juggle competing objectives of growth and reforms. We believe the People’s Bank of China (PBoC) is likely to further devalue the yuan, but are less certain about the trajectory and timing, given the surprise move this past summer.

The Commodity El Niño

Part of the reason global growth has struggled is the dampening effect of low commodity prices, oil in particular. Brent Crude and West Texas Intermediate (WTI) prices began the year at $57 and $53 per barrel, respectively, already well-below 2014 highs of over $100, and both ended 2015 still lower at $37 per barrel. The prolonged price decline has contributed to a deflationary effect worldwide, which makes nominal growth look lower.

Continued low oil and commodity prices are a bit like the current El Niño—part of the natural cycle but having a worse and more widespread impact than previous ones. We wrote about the oversupply in the oil market in our outlook a year ago and revisited the issue last quarter given the persistence and severity of the situation. In our view, working excess supply out of the oil market is taking longer and going deeper into economies than expected. Many other commodities are still in oversupply as China’s industrial economy slows. US dollar strength compounds the situation, as most commodities are priced in dollars putting further pressure on commodity prices.

Rainy days for commodity exportersCommodity-exporting economies, many of which are in the emerging markets, have already been suffering from the low price environment. While many economies are sturdy enough to weather a short-term shock from price declines, in a lower-for-longer environment, the negative impacts may become more widespread. Not only are major sources of government revenue reduced (since most natural resource companies in EM are at least partly state-owned), but currencies are weakened, adding to the issue of mounting deficits. Furthermore, EM banks are likely to experience rising non-performing loans (NPLs), which could lead to increased stress on the financial system. The weak economic environment ultimately flows to the consumer as well. One dramatic example is the virtual disappearance of Russian tourist spending in Europe.

Net positive or negative for the US?While low prices themselves present a number of issues, particularly as they hover below production cost levels, the prolonged period of depressed prices can bring on additional implications for many companies, financial markets and countries. We expected much of the US energy industry to be hit hard by production cuts to US shale, which had been a large contributor to the global supply glut as technological innovation kept increasing oil well efficiency. And while we also expected a negative impact to many US industrial companies with exposure to the energy industry, we believed it would be offset by consumers spending their gas savings. Consumer spending has indeed risen, particularly in areas typically associated with lower gas prices, such as autos and restaurants, but it does not yet appear to have fully offset the negative impact of low energy prices on corporate America. Further production cuts or companies going out of business could mean layoffs and induce an additional wave of negative effects in some regions of the US.



While weakness in energy stocks was widely expected, we believed that energy infrastructure investments would be somewhat more sheltered from the storm. However, low prices for longer than initially expected are negatively impacting production volumes, leading to financing concerns, dividend cuts at some large companies and technical headwinds as investors sell or short assets. As a result, we remain near-term cautious and believe that volatility will continue until prices begin to recover. Ultimately, we believe earnings could still grow, albeit at a slower pace, due to an eventual recovery in prices from reduced supply, lower break-even levels (which have declined more than 20%), long-term, take-or-pay contracts and the potential for exports. In the meantime, valuations are more attractive compared to historical averages.

Change of seasons: equity, credit and interest rate cycles move on

The commodity super cycle-credit cycle linkageThe epicenter of the next credit cycle will typically be in the most recent bubble. For the past few years, energy companies have taken advantage of relatively attractive financing in the high yield credit market. By the end of 2015, energy companies made up 18% of the high yield index par value.1 Current prices below cost of production are now raising concerns across global credit markets and the longer prices remain low, the more stress will accumulate. Many companies have hedges in place which have delayed the impact to earnings but our credit team thinks that cracks may show once the hedges roll off. While some level of increasing defaults in energy high yield bonds is widely expected, the actual severity and size of the defaults, as well as investor sentiment and market reaction, will be critical to assessing how far reaching the consequences might be.

The credit-equity-interest rate linkageThe credit cycle is a harbinger for equities. Currently, our colleagues in fixed income note several classic late-stage signs in the US, such as more shareholder-friendly actions, an increase in merger and acquisition (M&A) activity and a pick-up in leverage, all of which tend to coincide with an environment lacking topline growth. These observations are consistent with our views that growth has been increasingly scarce, particularly in the US, and challenges to growing the topline are likely to continue in 2016.

Historically, credit markets have led equity markets.

Currently, our colleagues in fixed income note several classic late-stage signs in the US, such as more shareholder-friendly actions, an increase in merger and acquisition (M&A) activity and a pick-up in leverage, all of which tend to coincide with an environment lacking topline growth.

1 Source: Bloomberg, as of December 31, 2015.This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.

Source: Bloombeg, Barclays as of December 31, 2015. US high yield is rolling 12-month excess return over Treasuries. S&P 500 is rolling 12-month total return. The time period is intended to include multiple cycles of a long-period.

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Many US companies have felt the headwind of the strong dollar, while low oil prices are likely to continue to negatively impact many companies and businesses related to the energy industry. Combined with a slightly slower pace of economic growth in 2016, the US could be at risk for a “profits recession” if revenue growth does not pick up. This scenario could put the Fed in a predicament as it seeks to normalize interest rates. Raising rates into a profit recession has not happened since 1967 and would be counterintuitive, but not raising them severely limits monetary policy options for boosting growth in the next economic downturn.

Higher equity valuations are also consistent with late-cycle indicators. In part due to years of ultra-low interest rates, the US equity market valuation has risen toward fair value, with some areas looking particularly vulnerable if companies cannot deliver growth. Europe, and particularly Japan, are less expensive, reflecting earlier stages of the economic and profit cycles. Emerging market valuations are reflecting weak earnings in many regions and industries, in part due to the challenging macroeconomic environment. However, we believe significant relative value opportunities abound across markets, which we discuss at length later in this outlook.

Equity valuations have risen, particularly in the US, in part due to low interest rates.

Europe, and particularly Japan, are less expensive, reflecting earlier stages of the economic and profit cycles.


Source: GSAM, Datastream, as of Decemer 31, 2015. Cyclically adjusted price-to-earnings ratio (CAPE) calculated using US inflationand a five-year rolling window to smooth earnings. All based on MSCI country indices. Totals calculated using MSCI World Index (for Total Developed Markets) and MSCI Emerging Markets Index (for Total Emerging Markets). All “% time cheaper” data is based on full sample history for each country. Start dates vary.

Credit defaults: nowhere to go but upCredit defaults are at cyclical lows in the US, meaning they are most likely to rise, as part of the process of getting back to normal. We share the current view of GSAM’s fixed income team that the credit environment in the developed markets could remain benign for some time, given relatively healthy corporate and consumer balance sheets, reasonable economic growth and employment and the likely gradual trajectory of rate increases in the US.

CAPE Sector Adj PE Sector Adj Price/Booklevel % time cheaper level % time cheaper level % time cheaper

US 20.7 65% 20.2 69% 2.6 49%Europe 15.7 47% 20.5 73% 1.7 40%UK 13.0 43% 17.2 77% 2.1 38%Japan 23.7 35% 19.7 52% 1.3 46%Australia 16.0 50% 19.8 61% 2.3 53%Brazil 5.1 2% 17.0 72% 1.6 25%China 9.9 19% 11.9 32% 1.4 26%India 17.7 43% 23.9 95% 3.2 73%Russia 3.2 2% 11.2 72% 1.3 77%Mexico 18.1 43% 20.9 72% 2.1 41%Korea 9.4 7% 12.7 51% 1.0 17%EM 9.7 3% 12.2 6% 1.2 1%DM 17.9 44% 19.0 64% 2.1 42%World 16.7 31% 18.0 62% 2.0 35%



Credit defaults appear to be at cyclical lows, but could stay there for some time.

We would view both a meaningful deterioration in consumer credit or tightening of lending standards as negative for the credit cycle. We are also monitoring commodity price weakness, which has the biggest potential to trigger rising defaults.

However, we will be closely watching for indications of a weakening credit market. We would view both a meaningful deterioration in consumer credit or tightening of lending standards as negative for the credit cycle. We are also monitoring commodity price weakness, which has the biggest potential to trigger rising defaults. While most energy exposure is in the high yield sector and spillover has so far been limited, we acknowledge that any deterioration in investor sentiment or loss of confidence can quickly dry up liquidity and drive up spreads and financing costs, all of which can impact financial markets broadly.

The situation in EM looks more worrisome. The rapid rise of credit in many emerging markets combined with more exposure to the decline in oil and commodity prices could result in negative consequences for a number of EM economies and banks. While private EM banks grew loan books faster, we believe they have been quicker to write down bad debts and have not been growing recently. We are more concerned about government-owned banks which we believe were more liberal with credit standards in an effort to boost economic growth, but are now experiencing rising bad debts, even if they have not yet posted them. In China, we believe the current reported NPL rate of roughly 1.5% is likely closer to 4-5%.2

Interesting times for financials stocksFinancials rank as one of the cheapest sectors worldwide on a variety of metrics, although this has not historically been a reliable indicator of financial stock performance. In fact, we believe investors need to be discerning in the sector as interest rate direction and credit trends may increasingly factor into financial stock performance in 2016.

In December 2015, the US Fed finally raised rates for the first time since October 2006. GSAM expects three additional interest rate increases in 2016 for a total of 75 bps. US bank stocks had been trading up and down with the likelihood of a rate hike, given their potential to benefit from an increase in net interest margins (NIMs), which have been at depressed levels in the near-zero interest rate environment. We believe US bank stocks will continue to fare well, in light of relatively strong balance sheets and what we expect to be a benign credit environment in the US. In addition, the majority of US bank stocks have relatively little exposure to the energy market and EM. In our view, bank earnings estimates are factoring in three interest rate increases in 2016, meaning that anything additional could be further upside for the group.

2 Source: China Banking Regulatory Commission, 2015.This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.

Source: World Bank via Factset, as of December 31, 2015. Time period reflects a full credit cycle.

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We remain positive on European and Japanese banks, for different reasons. Like US banks, European and Japanese banks have similarly suffered from low NIMs but improving fundamentals, such as loan growth, and reasonable valuations make them relatively attractive. Japanese banks are also significantly increasing dividends and unwinding cross shareholdings as a result of corporate governance improvements.

While historical evidence suggests that US real estate investment trusts (REITs) could be vulnerable to increasing interest rates in the US, we believe that a gradual increase is factored into most expectations and that only a greater or faster increase may cause the group to trade off significantly. However, an unexpectedly sharp turn in the credit cycle is a risk given the potential for a rapid widening of spreads to dampen investor sentiment and put new construction on hold.

Climate change: keeping up with the consumer

Once again, the consumer featured prominently in our quarterly meeting of senior investment professionals, given the far-reaching impact of consumption on economies and industries as well as the multifold challenges of investing in the global consumer. “The global consumer” is actually billions of people across the developed and emerging markets with a vast range of disposable income and spending patterns. Furthermore, consumption patterns are constantly evolving due to technological innovation and demographic change, among other factors. Lastly, investing in the consumer may not mean investing simply in traditional consumer-oriented industries in the Consumer Staples or Consumer Discretionary sectors. Technology, financial services and healthcare companies are also highly exposed to consumer trends.

US consumers are spending their gas savingsWe have spent considerable time over the last few quarters discussing US spending trends and the impact on the economy and stocks. One of our strong views from a year ago was the potential for the US consumer to significantly benefit from low gasoline and energy prices following the fall in oil prices. In our view, the US economy would also benefit because consumption accounts for 70% of US GDP and we believed there was a fair amount of pent-up demand from restrained spending in the years following the financial crisis. Furthermore, the labor and housing markets were both steadily improving.

Since that time, there has been a general—but misguided, in our view—sense of disappointment in US consumer spending. Americans have actually been spending much of their gas savings exactly where one might expect: on cars, going out to eat and home improvement. Restaurant sales rebounded quickly after the initial drop in oil and have remained robust, which is a pattern consistent with prior declines in gas prices. Auto sales actually hit a new record, posting over an 18 million SAAR, an annualized measure of vehicle sales, for three consecutive months.3 Continued strength in the housing market fueled strong sales of durables and other items related to home improvement. While stocks of restaurants and home improvement companies notably outperformed in 2015, auto stocks lagged, potentially in part due to investors anticipating some satiation of pent-up demand.

There has been a general—but misguided, in our view—sense of disappointment in US consumer spending. Americans have actually been spending much of their gas savings exactly where one might expect: on cars, going out to eat and home improvement.

3 Source: WardAuto, December 2015.This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.



Stocks of companies related to home improvement and restaurants dramatically outperformed apparel companies, reflecting sales trends.

This is the first expansion in 50 years in which the savings rate has trended higher.

Source: Datastream, as of December 31, 2015.

Source: Factset, as of December 31, 2015.

Strong spending in these industries contrasts sharply with sales at traditional retailers, which in previous rebounds would have also participated. Has something changed? While we think there are some cyclical factors at work, we also believe there are some secular trends emerging. From a more cyclical perspective, the savings rate continues to remain slightly elevated, which we believe could be attributed to the combination of the deep scars of the financial crisis, the more gradual recovery and exceptionally low interest rates. In fact, this is the first expansion in 50 years in which the savings rate has trended higher.4

The savings rate has remained high, contributing to weaker retail sales growth.

4 Federal Reserve Bank of St. Louis, December 2015.This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.

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In addition, increased spending on healthcare as a result of mandatory health insurance and associated out-of-pocket costs appears to be further diverting some funds from traditional retail spending. In fact, the additional spending on healthcare seems to almost offset savings from cheaper gas prices. Going forward, traditional retail may get a boost from some easier earnings comparisons. Overall, we continue to expect US consumption to remain strong, given the strength in the labor and housing markets, continued low oil prices and very gradual interest rate increases, allowing consumers the ability to spend. Exactly where they will spend may be another story.

Demographics and technological innovation are changing spending pattersThere are a number of secular changes underway, many of which are not unique to the US consumer and are playing out all over the world. Millennials sit right at the crossroads of demographic change and technological innovation, two of the biggest drivers of changing consumption patterns.

Weak trends at traditional US retailers are consistent with what millennials are buying and how they make their purchases. We find that this group highly values spending on travel and leisure. And when they do buy goods such as clothes, they tend to favor fast fashion brands. Millennials, as well as many other generations, are also doing much of their shopping online, and often through channels like Amazon, rather than going direct to a retailer’s website.

And like a growing number of people, Millennials do a lot more than shop online—they bank online, are active social networkers and are fluent users of technology in all aspects of their lives. We believe we are reaching tipping points for online ad spending and ecommerce penetration, which we expect to benefit a number of large cap internet companies but negatively impact other industries including TV, print and physical retailers. The tremendous outperformance in 2015 of Facebook, Amazon, Netflix and Google (now Alphabet), collectively nicknamed the FANGs, may actually be as much a reflection of confidence in the consumer as a commendation of technological innovation.

Millennials have also been quick to participate in the “shared economy,” using services like Airbnb in lieu of hotels and Uber rather than owning cars. Similarly, they tend to rent rather than buy homes. However, as the Millennial generation ages, there could be a bump up in household formation as their careers advance, incomes rise, student debts are paid off and they start families. Millennials could account for an even greater portion of consumer spending with additional spending on housing and home furnishings.

Tourism—follow the currencyLike Millenials, EM consumers also appear keen to travel. Tourism, particularly by Chinese, has been booming and is expected to grow significantly in the coming years. Currently only 4% of Chinese citizens have passports and significant amounts of infrastructure are still needed.5 Again, not only typical travel and leisure companies are exposed to this trend. Travel infrastructure companies like airport operators, online travel services companies and even education and property companies also benefit.

We believe we are reaching tipping points for online ad spending and ecommerce penetration, which we expect to benefit a number of large cap internet companies but negatively impact other industries including TV, print and physical retailers.

5 Source: Goldman Sachs Global Investment Research, “’The Chinese Tourist Boom”’, November 20, 2015.This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.



While we view increasing tourism as primarily a secular trend, near-term factors like currency can have a tremendous impact. Japan’s economy has significantly benefitted as the weak yen has attracted many Chinese and other Asian tourists. Similarly, the strong US dollar has become an increasing headwind to inbound tourists, and a number of retailers cite this as a contributing factor to recent weak sales. While the euro has remained relatively cheap, many EM currencies depreciated even further, which has negatively impacted European luxury goods retailers. While we expect weak currencies and economies will continue to weigh on EM consumer spending, we remain bullish on the secular trend of a growing EM middle class with more disposable income.

Storm warnings: Rising geopolitical tensions and political rhetoric

In contrast to the more cyclical nature of the equity and credit cycles, and even the unwinding of the commodity super-cycle, the many unresolved geopolitical issues and upcoming political decisions have potential to strike like a thunderstorm—unpredictable in terms of timing, intensity and aftermath. Syria has proven more difficult to resolve and contain than expected at the onset of war five years ago: terrorist groups have shown their ability to export terrorism to both failed states and the West, while an unprecedented migration from Syria has become a pressing domestic challenge for Europe. In the meantime, Europe is still figuring out how to fix Greece, Russia is proving a complicating force given its unpredictable actions in the Ukraine and Syria while North Korea is reasserting its potential nuclear capabilities.

Unsurprisingly, geopolitical tensions are heating up the political rhetoric across the world. The two largest powers in the Middle East, Saudi Arabia and Iran, have begun 2016 by breaking off diplomatic ties. Right wing and left wing parties in Europe had already been gaining traction due to economic dissatisfaction, but the migrant crisis has struck a sensitive chord and is providing further fuel for alternative and Eurosceptic parties. And while England was able to convince Scotland to remain in the UK, the current political climate has increased the risk that Great Britain could vote next year to leave the EU, which would have profound consequences for both economies. In the already polarized US political environment, presidential campaigns wasted no time jumping on a variety of issues from healthcare costs to border controls and foreign policy. Unexpected leaders in the polls are staking out positions far from the center and are adding an increased level of unpredictability to this US presidential election cycle. Whether politics is converted to policy in 2016 will be the key to any actual impact on economies and markets.

The strong US dollar has become an increasing headwind to inbound tourists, and a number of retailers cite this as a contributing factor to recent weak sales.

Chinese tourism is likely to keep up a rapid pace of growth.Number of outbound tourists


This has been prepared by Goldman Sachs Global Investment Research and is not a product of GSAM. The views and opinions expressed may differ from those of GSAM or other departments or divisions of Goldman Sachs and its affiliates. Please see additional disclosures.Source: GS GIR, November 20, 2015.

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Scarce growth scared investors into a growth-at-any-price mentality and the score at the end of the year was FANGs 75%, other 496 stocks -2%.6

Making hay while the sun doesn’t shine

Equities still look better than most other asset classes in another low return year. We believe investors need to look beyond the headlines, averages and aggregate numbers to find a more accurate picture of what is really driving markets. Despite the lackluster macro environment and expected lower returns, we see a number of ways individual stocks might outperform broader market averages. While we are neutral between the major regions of the world, we see many unique drivers of regional, industry and stock-specific returns.

Developed markets: staying close to homeOne common theme across the developed markets is that we currently believe domestically focused companies in the major regions could benefit from increasing domestic consumption while being more insulated from currency volatility. In the US, we expect that the strong dollar could continue to be a headwind for many globally-exposed companies, but believe the consumer remains healthy. We expect Japanese domestic consumption to continue to increase given the tight labor market which should increase wage growth. In Europe, we are interested in companies that can benefit from domestic recovery in Europe as well as those that are less exposed to relatively weak EM end-markets.

US: the other 496 stocksAs we have been writing for most of 2015, the relatively strong fundamentals in the US equity market have been largely reflected in higher equity valuations versus Europe and Japan. However, roughly flat 2015 performance of the S&P 500 obscures the drivers of returns, which have set up a number of opportunities for investors in 2016.

In 2015, US markets were bitten by the FANGs, the quartet of high-growth stocks whose outsized returns dominated the S&P 500 performance. Scarce growth scared investors into a growth-at-any-price mentality and the score at the end of the year was FANGs 75%, other 496 stocks -2%.6 This extreme dynamic resulted in several market conditions that could benefit savvy stock-pickers in 2016.

First, trading breadth for the S&P 500 hit a 30-year low, as a huge part of the market was left behind during the FANGs rally.7

US stock market breadth is near historical lows.Goldman Sachs Breadth Index

6 Source: Datastream, as of December 31, 2015. All performance is market-cap weighted average. “The other 496” technically refers to the S&P 500 Index ex the FANG stocks.7 GSAM calculations as of December 31, 2015, using GS GIR Breadth Index.


Source: Goldman Sachs Breadth Index from Goldman Sachs Global Investment Research, as of December 31, 2015.

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Secondly, in the hunt for growth many value stocks simply got cheaper. In fact, the same sectors within the Russell 1000 Value and Russell 1000 Growth indexes often performed dramatically differently. Across the developed markets, In our view, these conditions create many opportunities for active investors. We believe that many market participants are likely to refocus on valuations because of the risk of high-priced stocks and the relative attractiveness of those trading under the market multiple.

Value significantly underperformed Growth in the US in 2015.

We believe that many market participants are likely to refocus on valuations because of the risk of high-priced stocks and the relative attractiveness of those trading under the market multiple.

Source: Datastream, as of December 31, 2015.

The technology sector is a good example of intra-sector valuation dispersion. As often happens in the sector, investors are currently seeing the landscape in black and white, creating a huge valuation disparity between perceived secular winners and losers. For example, one of the major themes right now is the growth and acceptance of the public cloud. We believe that the leaders in both the applications and infrastructure layers of cloud technology will continue to benefit at the expense of some legacy tech vendors. We also believe some areas of traditional enterprise tech spending, particularly hardware and storage, will remain under pressure.

However, valuations for many of the traditional technology companies have narrowed to roughly 7-10x EPS8 as the market doesn’t appear to be appropriately differentiating between companies that have year-over-year revenue growth and those with declining sales growth. Any company that is perceived to be a loser in the public cloud transition has been sold indiscriminately and we see compelling opportunities in some traditional enterprise technology players that can grow through this transition. We also expect a boost from continued M&A in the sector through 2016, including semiconductor consolidation, which we believe has further to run.

Lastly, we are reminded of a phenomenon that occurred after the tech bubble burst. From March 2000 to March 2003, the average stock actually outperformed the S&P 500 Index. In fact, while the index lost almost half of its value, 58% of companies posted positive cumulative performance during that period because the heavy losses were so concentrated in the Technology, Media and Telecommunications sectors.9 We consider the possibility that 2016 could shape up to be a mirror image of 2015, in which the underperformance of a few highly valued stocks and areas of the market could be offset by gains in hundreds of other stocks.

8 Source: Factset, as of December 31, 2015.9 Source: GSAM calculations using Datastream.


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The European economic recovery is still in the early stages, meaning there is scope for medium-term normalization of trends that may benefit European companies.

Europe: a little growth could go a long way

European equities could benefit from earnings growth catch-up, which we think is achievable with modest improvements in economic growth, even factoring in the negative impact from weak EM end-markets. The European economic recovery is still in the early stages, meaning there is scope for medium-term normalization of trends that may benefit European companies. Capex as a share of GDP is still at a trough in the Euro area, though in the US it has already recovered to above long term average. The European consumer has just begun to come back, with car sales improving off depressed levels but overall retail sales significantly lagging the US. European balance sheets are in good shape to seize opportunities and M&A is still accelerating. Importantly, earnings and ROE are at historical lows compared to the US. Encouragingly, an index of European executive and consumer confidence unexpectedly rose in December to the highest level since April 2011.10

European earnings have catch-up potential.

Source: IBES, Datastream, as of December 31, 2015.

We acknowledge that high exposure to EM end markets and European politics are real risks. At the aggregate level, European companies derive over 30% of sales from EM.11 Germany has the highest exposure to EM and China, posing a challenge to Europe’s largest economy. These headwinds have already resulted in a disappointing Q315 European earnings season compared to recent history.

However, domestic European earnings positively surprised and we continue to look for companies more exposed to Europe’s domestic recovery and less exposed to EM end-markets, many of which are mid-cap stocks.

Valuations appear to have partially adjusted for these risks, as seen by a recent widening of Europe’s valuation discount to the US on a 12 month forward EV/EBITDA and P/E. While we believe valuations are generally reasonable, we expect earnings recovery to drive returns.

Japan: changing corporate and consumer behaviorWhile we remain optimistic on Japan’s ability to slowly grow its economy and inflation, we are more focused on the corporate earnings, profitability and reforms that are making many Japanese companies more attractive investments now than in recent decades.

Historically, Japanese companies have significantly lagged their developed market peers on both corporate profitability and corporate governance, while corporate debt levels were relatively high. All of this is changing. The earnings growth forecast for Japanese companies is now roughly in-line

10 Source: Bloomberg, January 7, 2016.11 Source: Morgan Stanley, as of May 2015.


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with Europe. Corporate profitability is already close to record levels, a result of the weak yen, as well as years of restructuring. In aggregate, companies are on track to hit double-digit ROEs for the first time in a decade,12 in part due to the creation of the JPX Nikkei 400, which has an ROE threshold as a listing requirement. Companies have also delevered and balance sheets are the healthiest in two decades. Importantly, we are also seeing significant evidence of improved corporate governance and shareholder orientation from many companies including more independent directors, fewer cross shareholdings, and a significant increase in share buybacks and dividends.

We also believe that equity market flows and investor behavior could push equities higher and encourage more long-term investors to enter the market. In recent decades, Japanese investors have not favored equities given low inflation and a lack of confidence in economic growth. The equity market followed a highly cyclical pattern of trading as market participants bought the cheapest stocks and traded out of them after they appreciated, regardless of the underlying fundamentals. We believe changes in investor behavior are already underway and have much farther to go. Japan’s GPIF, the largest pension fund in the world, has already increased its domestic equity allocation to 23% as of June 2015 (with a target allocation of 25%) from 17% in June 201413 and three other government pension funds have followed. We believe corporate pension plans may be next. In addition, households may opt to diversify assets, which are currently about 50% cash,14 into equities to offset low interest rates from Quantitative Easing (QE) and also due to increasing confidence in the equity market.

We believe a fundamentally-driven equity market, where investors have increased confidence in corporate profitability, governance and shareholder-friendliness, may attract more investors and benefit stock-pickers. Valuations also remain supportive, although we expect the strong earnings recovery to drive the majority of performance going forward. The TOPIX index continues to trade below the 10-year historical average and at a discount to the other major developed markets, whereas it has typically traded at a premium.

EM: minding the macro, but not mired in it

The MSCI EM Index is currently trading at a 30% discount to the MSCI World Index of developed markets, versus the historical average of 17%.15 While the overall valuation sounds intriguing, it must also be viewed in the context of higher DM valuations as well as the vast differences between EM economies, great diversity of companies and limitations of the indexes. As such, we continue to emphasize the importance of investing in companies, rather than markets or economies.

That said, we do acknowledge that EM investors should be aware of the macro environment and its implications. In our view, the EM macro is partially driven by external factors, but domestic factors tend to be dominant. The major external factors currently affecting EM are low oil prices and China’s industrial slowdown, which has also resulted in declining commodity prices. Oil price weakness is most negative for the Middle East. Non-oil commodity price weakness is worst for Latin America and South Africa, while China’s industrial slowdown is directly negatively impacting a number of countries in Asia, particularly Korean industrial companies.

In our view, the macro environment for India is better now than at any point in the last five years and the country offers the best outlook across EM. As a net importer, low oil and commodity prices are improving the current account deficit and allowing the central bank to reduce interest rates. Economic and earnings growth has not accelerated as quickly as expected but the government is functioning much better than in the recent past so we remain optimistic.

In our view, the macro environment for India is better now than at any point in the last five years and the country offers the best outlook across EM.

12 Source: DataStream, as of November 20, 2015.13 Source: GPIF, Ministry of HealthLabor and Welfare, Nikkei, Goldman Sachs Global Investment Research. As of November 3, 2014.14 Source: Bank of Japan, September 2015.15 Source: Factset, using 12 month forward P/E, as of December 31, 2015.




Given very few areas of clear macroeconomic strength outside of India, we continue to invest in many countries where we don’t have a favorable view of the economy but can find investment ideas that are compelling enough to offset the risk.

As we discussed at length in our outlook last quarter, China continues to transition from industrial to consumer-led growth and from a closed to a free-market economy. While the services sector had been growing well, toward the middle of the year it began to lag investment growth. At the same time, employment and consumption began to slow. In our view, the government remains highly focused on managing the impacts of slowing overall GDP growth, which could lead to an increase in rhetoric, some unpredictable policy action and volatility.

Given very few areas of clear macroeconomic strength outside of India, we continue to invest in many countries where we don’t have a favorable view of the economy but can find investment ideas that are compelling enough to offset the risk. For example, while we maintain a cautious outlook for most Latin American countries, we note that some banks in Colombia and Peru enjoy such enormous market share and pricing power in their small markets that they can potentially still thrive even as low commodity prices continue to negatively impact many Latin American economies. In Korea, some companies are benefitting from industry consolidation, even if the driver of consolidation is slower demand from China.

While we continue to remain positive on the Chinese and EM consumer as an important driver of growth, near-term trends look soft and are tempering our enthusiasm, particularly in China. Through 4Q2015, the majority of Chinese consumer companies we met with have been toning down guidance for the first quarter and 2016. However, pockets of consumer spending continue to do well, such as athletic wear and anything online-related, once again underscoring the need to focus on individual companies in the context of evolving trends and regional economies.

Lastly, we continue to be extremely cautious regarding SOEs in China and more broadly across EM. We continue to believe that despite cheaper valuations in some cases, as well as large weightings in local benchmarks, the companies themselves are less attractive investments because they often are not incented to run efficiently and typically have obligations other than maximizing shareholder interests. We see countless examples across regions and industries where we would prefer private companies. In China, we continue to have concerns about blatant government intervention in SOEs, while in Brazil the major state-owned energy company has been embroiled in a corruption scandal. In India, we believe that private banks are ahead of state-owned ones on writing off bad debts and will likely fare better going forward.

SOEs are 30% of the EM benchmark, and considerably more in some regions.

Source: Datastream, MSCI, UBS estimates as of November 2015.


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SOEs currently account for 30% of the MSCI EM Index,16 and even more in some country benchmarks. However, investors can build portfolios that look dramatically different from the indexes by choosing from hundreds of stocks not included in the benchmark, many of which are small cap stocks. We believe this truly active approach to investing in EM is particularly critical in the current cloudy macroeconomic environment. Furthermore, by remaining invested across EM, we believe that investors will be positioned for an eventual turn in EM equities, which typically happens before the macro environment improves.

In conclusion: observations from the top

At our most recent quarterly meeting in New York, CEOs of US-based companies across banking, diversified financial services, technology and real estate shared observations of their industries and the economy. Despite running vastly different businesses and organizations, they touched on a number of strikingly similar themes that we have discussed throughout this outlook.

All of the executives described a sense that the US economic cycle was advancing and bringing a vague sense of unease. The real estate CEO suggested that it feels like the end of a cycle, particularly noting the high M&A activity, currency wars and the unicorn phenomenon (early-stage technology companies with over $1 billion market capitalizations). The banking CEO also offered his view that we are at the very beginning of a credit cycle, and that while people were not afraid, they seemed nervous and increasingly cautious.

Yet, despite an uncertain economic climate, all of the CEOs remained focused on critical aspects of building great companies and brands, including innovation and customer service. Innovation, including technological innovation, extends well beyond Silicon Valley. A growing niche of financial technology companies will continue to adapt traditional banking to a growing millennial client base. Similarly, the CEO of the diversified financial services company described how his company is actively engaged with younger consumers by making use of mobile technology and partnerships with companies in the shared economy.

The CEOs all clearly realize they run consumer-oriented businesses. The technology CEO shared his view that the consumer experience is critical to driving a sustainable business. The banking CEO described the economic benefits of exceptionally high client retention, including the fact that referrals from clients tend to have even higher credit scores. The financial services CEO views customer service is a key differentiator and actually cited a well-known technology company as an example. The executives also reiterated the high importance they place on strong brands. In real estate, one store with a great brand can upgrade an entire mall. In financial services, brand may be more important than ever.

Like these CEOs, we are aware of the changes in the macroeconomic environment, as well as the different stages of cycles playing out across regions. The common theme through all of these environments is that we continue to look for innovative companies with differentiated offerings and strong brands, all of which we believe make competitive companies that can win over time.

Yet, despite an uncertain economic climate, all of the CEOs remained focused on critical aspects of building great companies and brands, including innovation and customer service.

16 Source: UBS, as of November 2015.




Disclosures

Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability.

International securities may be more volatile than investments in US securities and will be subject to a number of additional risks, including but not limited to currency fluctuations and political developments.

Equities are subject to market risk, which means that the value of the securities may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions.

Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity.

Energy infrastructure companies may be adversely affected by changes in worldwide energy prices, exploration, reduction spending, government regulation, and changes in exchange rates, depletion of natural resources and the risks that arise from extreme weather conditions.

This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice.

References to indices, benchmarks or other measures of relative market performance over a specified period of time are provided for your information only and do not imply that the portfolio will achieve similar results. The index composition may not reflect the manner in which a portfolio is constructed. While an adviser seeks to design a portfolio which reflects appropriate risk and return features, portfolio characteristics may deviate from those of the benchmark.

Index BenchmarksIndices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein.

The MSCI World Index is a capitalisation weighted index that monitors the performance of stocks from around the world. The “Standard & Poor’s S&P 500 Index” is an index based on the prices of the securities of 500 different companies, 400 of which are industrial, 40 of which are utility, 40 of which are financial and 20 of which are transportation companies.

The MSCI All Country World Index is a capitalisation weighted index comprised of 23 developed market countries and 23 emerging market countries.

The MSCI EM (emerging markets) Index is designed to measure the performance of the large and mid-cap segments of the market, covering approximately 85% of the EM equity universe.

The MSCI Europe Index captures large- and mid-cap representation across 15 developed markets in Europe. The index covers approximately 85% of the free float-adjusted market capitalisation across the developed European equity universe.

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Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.

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Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability. International securities may be more volatile than investments in U.S. securities and will be subject to a number of additional risks, including but not limited to currency fluctuations and political developments.

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