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MARKET KNOW-HOW
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Q3 2017

MARKET KNOW-HOW

The Synchronized Expansion

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The Synchronized Expansion


The economic expansion has deepened and synchronized around the globe, with the participation of more than 98%1 of world economies. The inputs are broad, including improving labor markets, accommodative monetary policy, supportive financial conditions, favorable sentiment, and the potential for fiscal impulses. Taken together, these inputs suggest the global expansion should persist.

Even so, markets remain vulnerable to shocks of volatility, and late-cycle dynamics reinforce the need for realistic expectations. We expect meaningfully lower annualized returns from risk assets due to market and policy realities such as full valuations, legislative bottlenecks, and diminishing excess economic capacity. Each of these factors serves to heighten our commitment to strategic portfolio design.

Our key views:

  • Elevated US equity valuations create a rationale for moving beyond beta and beyond borders
  • Political risk continues to loom over markets, even as events in Europe have retreated from the headlines
  • Greater equity market return dispersion creates a target-rich environment for skilled active managers

1. Source: GSAM

Overview


Market


Growth

Global growth has both broadened and deepened in the most synchronized recovery since 2010. Manufacturing and US labor appear particularly strong.

Inflation

Inflationary impulses have paused, particularly in Europe. Diminishing excess capacity has supported prices in the US, while Sterling weakness has buttressed UK prices.

Monetary Policy

Divergent policy remains a global theme. The Federal Reserve’s efforts to neutralize its policy stance contrasts with more expansive commitment in Europe and Japan.

Politics

The possibility of pro-cyclical US policy has continued to intrigue markets, but the news cycle of near-constant controversy and legislative bottlenecks are blocking meaningful initiatives.

Risk

Politics remains dominant, followed by the pace of US rate hikes, Brexit turbulence, stability of Chinese currency and growth, lofty valuations, and structurally diminished market liquidity.

The Trend Is Your Friend


Source: Haver, Markit, and GSAM. Analysis as of May 2017. Table shows headline readings for Composite (weighted aggregation of manufacturing and services sectors) Purchasing Managers Indices. PMI surveys based on questionnaire responses from panels of senior purchasing executives (or similar). Respondents are asked to state whether business conditions for a number of variables have improved, deteriorated or stayed the same compared with the previous month, as well as to provide reasons for any changes. A reading of over 50 indicates expansion; a reading of less than 50 indicates contraction. 12m Δ represents the change since the reading 12 months prior to this document, i.e. May 2016. Developed Markets and Emerging Markets refer to GDP-weighted categories for regional PMIs as categorized by Haver. BRIC is an acronym that refers to Brazil, Russia, India and China, which are all grouped in a similar stage of economic development. 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.

Key Takeaway


We see increasing evidence of economic synchronization across both advanced and emerging markets. Global growth data suggests the expansion could continue for another couple of years.

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Overview


Market


Equities

We continue to favor equities, but with modest return potential on account of valuations. Earnings growth is likely to be the primary driver of returns, favoring ex-US equity markets.

Rates

We expect the trend of higher rates to resume, driven by monetary policy evolution, global growth, and reduced excess capacity. Government debt may be a less effective hedge.

Credit

Tight spreads and higher leverage reflect late-cycle conditions, leaving us wary of investment-grade and high-yield beta, but confident in security selection.

Currency

Despite recent weakness, Dollar risk may be to the upside given central bank divergence. Sterling is likely tethered to UK politics. Global growth could drive emerging market currencies.

Volatility

Low volatility reflects the strong macro backdrop, but cannot insulate investors from exogenous shocks, especially any potential fallout from political risk in Washington and Europe.

It's Been A Good Run (If Uneven)


Source: Barclays Live, Bloomberg, and GSAM. Analysis from January 1, 2009 to May 31, 2017. Chart shows total cumulative returns for asset classes. US Equities represent the
S&P 500 Index, European High Yield Bonds represents the Bloomberg Barclays Pan-Euro High Yield Index, Global Equities represents the MSCI World Index, European Equities
represents the Stoxx Europe 600 Index, US High Yield Bonds represents the Bloomberg Barclays High Yield Corporate Bond Index, Japan Equities represents the TOPIX Index,
Emerging Market Equities represent the MSCI Emerging Markets Index, German Bunds represents the German subset of the Bloomberg Barclays Aggregate Government Index,
US Inv. Grade Bonds represents the Bloomberg Barclays US Corporate Bond Index, US Treasury Bonds represents the Bloomberg Barclays US Aggregate Treasury Index, Gold is
represented by the Gold Spot Price $/oz, European Inv. Grade Bonds represents the Bloomberg Barclays Investment Grade European Corporate Bond Index, and Japan Government
Bonds represents the Bloomberg Barclays Japan Aggregate Government Bond Index. Past performance does not guarantee future results, which may vary.

Key Takeaway


We believe the macro backdrop remains supportive of risk assets, although full valuation and politics may limit near-term upside and intensify tail risk. We favor equities over credit, credit over sovereign debt, and emerging markets over developed markets.

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The Know
High valuations, modest historical returns

We think investors should temper their US equity return expectations.

Rich equity valuations such as today’s have often presaged returns of less than 10%.

Following periods of top-quartile valuations, the S&P 500 Index has delivered single-digit or negative returns 99% of the time. In nearly a fifth of instances (17%), returns were negative. High valuations have often persisted for years at a time, elongating the timeframe for modest equity returns.


Source: Bloomberg, Robert Shiller, and GSAM.


The How
Know your alternatives

In periods of lower equity returns, alternative strategies’ performance has been attractive.

Historically, alternative strategies have been similar to equities in periods of muted returns, with less than half the volatility (standard deviation).

We believe we are entering a favorable environment for alternative strategies. During periods when equity market returns registered in single-digit or negative territory, these strategies outperformed the S&P 500 on a risk-adjusted basis. In light of high equity valuations and the potential for lower returns, we see the case for a fresh look at alternative strategies.


Source: Bloomberg and GSAM.

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The Know
The recovery is global

Growth has gained momentum internationally, broadening out the US-led recovery.

The current macroeconomic backdrop is supportive of continued positive international momentum.

Developed economies have seen improvement in a number of economic indicators, led by manufacturing. We believe this trend, alongside the steady expansion in the consumer and labor sectors, suggests a robust global developed investing environment.


Source: GSAM.


The How
Watch the bottom line

Historically, earnings outside the US have improved more rapidly when growth rates have risen.

For every dollar in sales growth, the benefit to earnings has been greater outside the US.

In Europe and Japan, fixed costs tend to be a higher share of total costs than in other markets. This has caused Europe and Japan to historically see more earnings upside when sales have strengthened but also more earnings weakness when sales have weakened. Given our expectations for improving global growth, Europe and Japan seem particularly well positioned.


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

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The Know
Many investors overlook international small cap equities

We see a pronounced underweight in many client portfolios.

Our analysis of thousands of professional investors’ portfolios through GSAM PRISM™ reveals a missed opportunity.

Investors are overweight US large caps by an average of 14 percentage points relative to our 70:30% PRISM™ strategic asset allocation. We see a case for greater diversification through international small caps, particularly at a time of lofty US equity valuations.


Source: GSAM PRISM™.


The How
Think globally, act locally

International small caps may be well positioned to benefit from the global economic expansion.

We see these stocks’ exposure to domestic economies as a differentiator.

International small caps’ exposure is 70% cyclical by sector and includes a relatively high degree (55%) of domestic revenue drivers. These domestically-oriented companies in the past have also been better positioned than international large caps during periods when broad international equity markets have outperformed the US.


Source: FactSet, Bloomberg, and GSAM.

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The Know
Emerging market flows have picked up

In the past, EM inflows have been supportive of both equity and debt performance.

We believe the improving macro backdrop has been supportive of emerging market flows and returns.

The recent uptick in emerging markets equity (EME) and debt (EMD) inflows follows an extended period of easier financial conditions and improved corporate earnings. In the past, such periods of strong inflows have helped drive performance. EME and EMD returns rose an average of 3.0% and 0.9%, respectively, during months with inflows greater than $5 billion.


Source: Bloomberg, the Institute of International Finance (IIF), and GSAM.


The How
Potential for growth and income

We think EM earnings and yields warrant attention in today’s market environment.

EM equity and debt investments stack up favorably vs. other major regions when measured by yield and earnings growth expectations.

For equities, we expect the recent positive emerging markets earnings growth trends to continue driving performance, and is reflected in forward-looking expectations. In a low-rate environment, dollar-denominated EMD yields stand out versus US investment grade bonds, US aggregate bonds, and global bonds.


Source: Bloomberg, Goldman Sachs Global Investment Research (GIR), and GSAM.

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The Know
Taxing policy

Municipal bond investors are focused on US tax policy outcomes.

Municipal tax equivalent yields may remain higher than US government or corporate debt, even assuming a tax cut to 35%.

Often underutilized by investors, the breadth of the municipal market potentially provides compelling opportunities to enhance tax equivalent yields (TEY) through the diversification of term structure and credit.


Source: Barclays Live, Bloomberg, Moody’s, US Department of Treasury, and GSAM.


The How
Give munis some credit

Adding credit and term structure diversification to a muni portfolio may improve outcomes.

Muni diversification has the potential to provide improvement to yield, volatility, and interest rate risk.

In the table to the left, we introduce high quality short duration muni bonds and high yield muni bonds to match key metrics of a static municipal benchmark. We find that simple adjustments to a core muni bond portfolio can potentially generate a meaningful increase in income, a reduction in interest rate sensitivity, or both.


Source: Bloomberg, Barclays Live, and GSAM.

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The Know
A deep bench matters

We believe a deep bench of funds for a given asset class can help investors ensure they have backup options.

Reinvestment risk and tax-loss harvesting are two of the reasons we think investors should look for a deep bench of substitutable funds.

One method we use to test product depth is the “80, 2” screen. A category may fail this screen if 80% or more of exchange-traded fund (ETF) assets under management are concentrated in two or fewer ETFs. National municipal bonds and emerging market debt are two areas that provide limited fallback options.


Source: GSAM Strategic Advisory Solutions/Portfolio Strategy and Morningstar.


The How
Think mutual fund and ETF

We think investors should be open to a range of fund types; no fund structure can serve every purpose.

Portfolio diversification and due diligence require a broad and deep product set.

Applying our fallback rules as well as historical performance, we see a case for building portfolios with ETFs where the product offerings are extensive, such as in large cap US equities. We also see a case for mutual funds where ETF coverage is less extensive and where mutual fund managers historically have outperformed, such as in foreign large cap stocks and high yield bonds.


Source: GSAM Strategic Advisory Solutions/Portfolio Strategy and Morningstar.

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