Climate of Change

<p>Candice Tse</p>

We hope that you, your family, and your community are mending from the disruption of COVID-19. Our thoughts continue to be with you during this period.

As we look into 2021 and beyond, it is increasingly evident to us that global policymaking, while important, will be less governed by the latest political victory than by the realities of massive sovereign deficits, shifting demographics, and environmental conditions. COVID-19 has only accelerated this climate of change and the need for prescriptive solutions and investment.

Furthermore, as we enter a hopefully long and sturdy global recovery, we should keep in mind a few important lessons from 2020, including: 1) the value of addressing tactical uncertainty with strategic discipline, risk management, and quality, 2) most investment horizons are much longer than election cycles, and 3) the opportunity set is becoming more idiosyncratic and global.

The remainder of this edition of the Market Know-How will focus on summarizing our macro expectations and providing a framework for positioning in 2021.

We emphasize:

Broadening global exposure that focuses on company-specific opportunities rather than geographic beta.
Moving down in cap to seek exposure to secular growth themes while reducing the concentration and regulatory risk of current mega-cap growth companies.
Complementing high quality core bonds with private credit for potentially attractive yield premiums and diversification benefits.
Investing sustainably through environmentally, socially, and economically aware strategies.

Macro & Market Views

Global Growth

We estimate that global real GDP will rise 6.1% in 2021. Barring major policy errors or health-related setbacks, this should keep growth far stronger than in previous recoveries. However, 2021 will likely be characterized by flatter growth as economies transition from the sharp rebound in Q3 2020, to a period of deceleration until we see the vaccine-contingent strength we expect in 2021. Moreover, we expect the fiscal bridge to be sizeable across advanced economies as many sectors struggle to normalize under physical distancing and occupancy limitations.

Source: Goldman Sachs Global Investment Research and GSAM.

Global Equity

The speed of the 2020 equity plunge and near instantaneous reversal was unparalleled. Lacking the early warning signs of some emergent cyclical or financial disequilibrium, markets were whipsawed between the medically-induced shuttering of global economies and the deluge of monetary and fiscal support. Notwithstanding full valuations, we believe global equities remain attractive, supported in 2021 by low real yields, contained inflation, easy financial conditions, peak earnings, and a substantial equity risk premium.

Source: Bloomberg and GSAM.

Top Section Notes: Goldman Sachs Global Investment Research and GSAM. As of November 30, 2020. ‘Real GDP’ refers to gross domestic product adjusted for inflation. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this document. Past performance does not guarantee future results, which may vary. Bottom Section Notes: Bloomberg and GSAM. As of November 30, 2020. Chart shows the MSCI ACWI Index levels from 1998 to 2020. For illustrative purposes only. ‘Peak-to-trough’ refers to the period from the market high to the subsequent market bottom. ‘Peak-to-recovery’ refers to the period from the market high to when prices fully recover to reach a new market high. ‘Easy financial conditions’ refers to an environment supportive of economic growth. The performance results are based on historical performance of the indices used. The results will vary based on market conditions. If any assumptions used do not prove to be true, results may vary substantially. Past performance does not guarantee future results, which may vary.

Unwanted attention

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Unwanted attention

Outsized exposure may come with some risk

A Narrowing Market Breadth

COVID-19 has helped some well-positioned companies generate extraordinarily high returns, while devastating others. The result has been a clear bifurcation between winners and losers. Consequently, the market capitalization of the top five companies has ballooned to roughly a fifth of the Russell 1000 Index today. Alongside their expansion, however, is a growing regulatory focus on big tech matters like data privacy, antitrust, and censorship. For investors heavily positioned in these mega-cap tech stocks, we believe the current market concentration may amplify idiosyncratic and regulatory risk.

Source: Bloomberg and GSAM.

The How

Below the radar

SMID growth may offer investment variety without sacrificing returns

Growth, Sales, and Diversification

Leaning into companies with smaller public profiles may be an option for reducing concentration risk while seeking exposure to “growth” characteristics. The five largest companies in US small and mid-cap (SMID) growth make up only 4% of the index, relative to US large cap at 18%. Yet historical performance between these indices has been similar given the sector composition—info tech, healthcare, and consumer discretionary make up ~60% of both indices. Additionally, more than half of SMID growth companies have sales growth above 8%. We think these features make SMID growth an attractive response to the risk of regulation and concentration.

Source: Bloomberg and GSAM.

Top Section Notes: As of November 30, 2020. Chart shows the US equity market concentration based on the market capitalization of the largest five companies in the Russell 1000 Index. Shading reflects US recessions. ‘Average’ refers to the long-run average from January 1995–November 2020. Bottom Section Notes: As of November 30, 2020. Chart shows characteristics of the Russell 1000 Index (US Large Cap Equities) and Russell 2500 Index Growth (SMID Growth) across market concentration, annualized return, and proportion of high sales growth companies. Diversification does not protect an investor from market risk and does not ensure a profit. ‘Market concentration’ refers to the market capitalization of the largest five companies for the Russell 1000 and Russell 2500 Growth indices, respectively. ‘Annualized return’ refers to the five-year gross total annualized return of the Russell 1000 and Russell 2500 Growth from December 2015–November 2020, inclusive. Companies with ‘high sales growth’ have annual sales growth of 8% or greater. For illustrative purposes only. Past performance does not guarantee future results, which may vary.

Precarious position

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Precarious position

Five companies have driven a majority of US equity returns

Top O’ the Market

The record degree of concentration in the US equity market has continued to rise as mega-cap tech companies have led the 2020 rally. The five largest US companies (Facebook, Apple, Amazon, Microsoft, and Google—or FAAMG) now comprise nearly a quarter of the S&P 500 Index market capitalization. The fundamental landscape today gives us reasons to be both constructive in the long-term growth trends supporting these names, but also cautious on their continued momentum. We think a good response to the potential risks of narrow market breadth may be geographically expanding the opportunity set.

Source: Bloomberg and GSAM.

The How

Going global

Investors may find outperformers by expanding their borders

Strength in Numbers

There are hundreds of companies around the world that outperform the basket of the FAAMG stocks from year to year, including 323 names in 2020 YTD. Many of these outperformers have been in the technology sector, but increasingly we believe the market’s willingness to pay a premium for innovation and earnings may extend to areas such as Med-tech, Fin-tech, Ed-tech, Green-tech, and Environmental, Social, and Governance (ESG) investments. These features are evident in some US companies, but are also prominently represented internationally. Investors who can identify high-quality companies with strong earnings potential may benefit from expanding their borders.

Source: Bloomberg and GSAM.

Top Section Notes: As of November 30, 2020. ‘YTD’ refers to year-to-date. Chart shows the year-to-date performance of the S&P 500 Index, the 5 largest companies in the S&P 500 on a market capitalization weighted basis (Facebook, Apple, Amazon, Microsoft, and Google), and the rest of the index. Any reference to a specific security does not constitute a recommendation to buy, sell, hold or directly invest in these securities. Bottom Section Notes: As of November 30, 2020. Chart shows the proportion of companies in the MSCI ACWI Index that outperformed the FAAMG basket on a calendar-year basis, grouped by company domicile. ‘Median’ refers to the 50th percentile. International securities entail special risks such as currency, political, economic, and market risks. The performance results are based on historical performance of the indices used. The results will vary based on market conditions. If any assumptions used do not prove to be true, results may vary substantially. Past performance does not guarantee future results, which may vary.

Navigating all markets

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Navigating all markets

Rising tides don’t float all boats

Annual Harvest

In years when the S&P 500 has had less than mid-single digit returns in the last decade, there have been plenty of opportunities to harvest losses in our view. On average more than 50% of stocks in the index had negative returns in those years. But even when the index was up more than 30%, some stocks in the S&P 500 have had negative returns, providing loss-harvesting opportunities as well. While limiting turnover may seem like a logical response in seeking to limit potentially taxable events, investors may strategically realize losses to offset capital gains and reduce annual 1099 shock.

Source: Bloomberg and GSAM.

The How

Tacking advantage

Tax-aware equity strategies may bolster after-tax returns

Potential Harvesting Opportunities

The after-tax experience of equity investors historically underwhelms headline index returns. We believe equity market volatility provides an opportunity to improve after-tax returns through tax-loss harvesting: offsetting capital gains with realized losses. When the S&P 500 has had mid-single digit returns, tax savings from loss harvesting has added 6.6 percentage points to after-tax returns on average. In an environment where investors are fighting for income across markets, keeping more in their pocket may be especially attractive.

Source: Bloomberg and GSAM.

Top Section Notes: As of November 30, 2020. The chart shows the proportion of companies in the S&P 500 Index that have experienced negative total returns by calendar year since 2010. ‘Loss-harvesting’ refers to the selling of securities at a loss to offset a capital gains tax liability. Bottom Section Notes: As of November 30, 2020. For illustrative purposes only. Chart shows bucketed returns of monthly rolling 3-year periods from November 30, 1945 to November 30, 2020. ‘Illustrative cumulative tax savings’ refers to the hypothetical capital gains saved by realizing monthly losses at the long-term capital gains tax rate of 23.8%. Index returns are used as a proxy for baskets of similar stocks. Analysis does not factor in wash sale rules. Actual results may vary. Goldman Sachs does not provide accounting, tax, or legal advice. For illustrative purposes only. Please see additional disclosures at the end of the document. Past performance does not guarantee future results, which may vary. The performance results are based on historical performance of the indices used. The results will vary based on market conditions. If any assumptions used do not prove to be true, results may vary substantially.

When defense mechanisms kick in

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When defense mechanisms kick in

Municipalities can deploy countercyclical measures to manage economic stress

Pillars of Strength

Elevated economic stress has historically driven corporate default volumes higher. But for municipalities, there are a number of countercyclical levers available to help support credit quality. Munis benefit from having 1) access to federal funding, 2) budgetary discipline, 3) diversified revenue streams, all while 4) maintaining rainy day reserves to buffer against deep economic downturns. These multiple defensive features have historically allowed state and local governments to sustain remarkably low default rates through a variety of economic conditions. As is true of football, in munis the best offense is a great defense.

Source: GSAM.

The How

Rolling with the punches

Municipal debt has proven resilient to shifting policy

Policy Pendulum

Cycle after cycle, municipals are consistently impacted by elections. However, the impact is rarely binary. To be sure, some scenarios would herald outcomes that are larger (or smaller) in consequence, but as a general rule most legislative shifts have historically incurred a one-time, short-lived technical moment for the municipal market. Not surprisingly, we believe the composition from recent US elections is likely to have limited impact on the municipal market in 2021.

Source: GSAM.

Top Section Notes: As of November 30, 2020. Chart shows the countercyclical fiscal measures available to US municipalities to help minimize economic stress throughout different phases of a business cycle. ‘UI’ refers to unemployment insurance. Bottom Section Notes: As of November 30, 2020. Chart shows the impact of potential policy on the US municipal bond market. ‘State and local tax (SALT) deductions’ refers to the 2017 Tax Cut and Jobs Act that instituted a $10,000 cap on the amount of local taxes that may be deductible on federal taxes. For illustrative purposes only. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this presentation.

Yielding and expanding

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Yielding and expanding

Private credit has rapidly gone from niche to mainstream

Rapid AUM Growth Post-Global Financial Crisis

Private credit has grown three-fold over the past decade, and is now the third-largest private asset class following private equity and real estate. Private credit has attracted investors globally, and continues to show healthy supply and demand dynamics in our view. Additionally, as companies increasingly decide to stay private for longer, private credit demand has expanded as the asset class benefits from positive spillovers from private equity. Supply has simultaneously been on the rise: as of April 2020, there were 457 private credit funds in the market, up from 261 in 2015. As investors familiarize themselves with the asset class, its role in client portfolios is set to grow accordingly in our view.

Source: Preqin, Goldman Sachs Global Investment Research, and GSAM.

The How

Historically higher yield

Liquidity premiums make private credit a desirable source of yield

Wide Yield Differential in Different Types of Credit

Propelled by investors’ search for yield, direct lending has grown to represent over a third of the private credit universe by AUM. Its yield has remained higher than that of both high yield credit and leveraged loans. While part of the gap can be attributed to differences in firm size and default rates, investors are increasingly attracted to the asset class for its liquidity premiums. Private credit offers potential compensation for illiquidity over time, while its public counterparts may not retain their liquidity all the time—for example, under stressed market conditions. We believe a long-term focus allows investors to better capitalize on liquidity premiums.

Source: Bloomberg, Cliffwater, and GSAM.

Top Section Notes: As of June 30, 2020, latest available data. ‘Dry powder’ refers to committed, but unallocated capital. ‘Global financial crisis’ refers to the financial crisis from 2007-2008. An investment in private equities is not suitable for all investors. Investors should carefully review and consider their potential investments, risks, charges and expenses before investing. Bottom Section Notes: As of June 30, 2020, latest available data. Yields are measured by yield to maturity. ‘AUM’ refers to assets under management. ‘Liquidity’ refers to an asset’s ability to be bought and sold easily and quickly. ‘Liquidity premium’ refers to the increase in the price of an illiquid asset required by investors in return for holding an investment that cannot easily be sold. The performance results are based on historical performance of the indices used. The results will vary based on market conditions. If any assumptions used do not prove to be true, results may vary substantially. Past performance does not guarantee future results, which may vary. Investments in fixed income securities are subject to credit, liquidity, and interest rate risk. High yield bonds are corporate or municipal bonds with a higher level of default risk relative to their investment grade counterparts. Given the riskier credit profile of high yield bonds, investors are generally compensated with higher yields. Leveraged loans are floating rate loans with below investment grade rating made by banks to companies. Leveraged loans typically fall higher in the capital structure relative to high yield bonds. Historically, leveraged loans have offered higher recovery rates in the case of a default. Direct lending is a form of corporate debt provision in which lenders other than banks make loans to companies. The borrowers are usually small and medium enterprises while the lenders may be wealthy individuals or asset management firms. Direct lending debt is typically structured as floating rate loans with below investment grade credit rating. Floating rate debt reacts to interest rate changes in a similar manner to fixed rate debt, although typically to a lesser degree. Typical features of this asset include strong loan collateral and reasonable leverage, but can also be less liquid than public fixed income instruments. There is limited ability to trade these loans on the public market due to the fact that issuers are generally small and consequently not well-known. Credit and default risk is higher for direct lending strategies compared to traditional broad market fixed income strategies given that the focus in direct lending strategies is on below-investment-grade issuers. Investors are typically compensated through credit risk and illiquidity premiums.

Investing sustainably

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Investing sustainably

COVID-19 has amplified the importance of environmentally, socially, and economically aware portfolios

Why Invest Sustainably?

Investors in 2020 were reminded of the investment importance of environmental, social, and governance (ESG) factors. The Coronavirus pandemic has made social issues—such as the health and safety of employees, customer support, and production decisions—key operational factors, and has elevated their significance in investors’ due diligence. During the stress of COVID-19, ESG industry leaders outperformed their peers during drawdown and recovery. We believe that ESG investing is a lasting trend supported by demographic shifts, the Great Wealth Transfer, and the potential to generate sustainable returns and manage risk.

Source: JUST Capital, Factset, Cerulli Associates, Goldman Sachs Global Investment Research, and GSAM.

The How

Portfolios with purpose

We believe ESG is here to stay as a fundamental process of portfolio construction

Integrating ESG in Portfolios

ESG is not a separate asset class or a carve out in a portfolio. Rather, it is a part of integrated asset allocation. Investors can invest sustainably across a variety of investment options and asset classes from traditional equity to fixed income to private equity. Sustainable investing is not a singular act, but one that may continue to enhance portfolio durability in any macro climate. In our view, ESG and Impact investing will be increasingly relevant for years to come.

Source: GSAM.

Top section Notes: As of September 30, 2020, latest available data. ‘Drawdown’ refers to a market decline. ‘The Great Wealth Transfer’ refers to intergenerational wealth passed from the Baby Boomer generation to beneficiaries. Past performance does not guarantee future results, which may vary. Bottom Section Notes: As of November 30, 2020. For illustrative purposes only. ‘MLP’ refers to master limited partnership.

See Glossary for definition of terms used in reference to Products