goldman - july 25

July 25, 2014

GOAL: Global Opportunity

Asset Locator

Portfolio Strategy Research

Preparing for higher yields: Downgrading equities and credit

Macro outlook: Sustained growth and higher bond yields

Growth has improved substantially. Most of the acceleration we had

expected is now behind us, but we expect growth to be sustained at

current or slightly higher levels, with the US growing at around 3% through

2017. We think the likelihood of a rise in government bond yields has

increased and see this as a key aspect of the near-term macro outlook.

Our recommend allocation and investment themes

Equities: We downgrade to neutral over 3 months as a sell-off in bonds

could lead to a temporary sell-off in equities. This makes the near-term risk/

reward less attractive despite our strong conviction that equities are the

best positioned asset class over 12 months, where we remain overweight.

Commodities: We expect dispersion within commodities due to different

supply situations together with backwardation to drive returns and see

opportunities in nickel, zinc palladium and aluminum. However our return

forecast for the asset class as a whole is low and we remain neutral.

Corporate credit: We downgrade to underweight over both 3 and 12

months. We think spreads will narrow slightly, but given already tight

levels, rising government bond yields are likely to dominate the returns,

especially for US IG credit where spreads are the lowest.

Government bonds: We stay underweight. We expect yields to rise due

to sustained high US growth and accelerating inflation, a decline of

deflation concerns in Europe and an improving inflation outlook in Japan.

Investment themes: We seek to benefit from sustained growth at current

higher levels and the return of cash to shareholders. See page 4.

Expected returns and recommended asset allocation

Source: Goldman Sachs Global Investment Research.

Anders Nielsen +44(20)7552-3000 [email protected] Goldman Sachs International

Peter Oppenheimer +44(20)7552-5782 [email protected] Goldman Sachs International

Jeffrey Currie (212) 357-6801 [email protected] Goldman, Sachs & Co.

Francesco Garzarelli +44(20)7774-5078 [email protected] Goldman Sachs International

Charles P. Himmelberg (917) 343-3218 [email protected] Goldman, Sachs & Co.

David J. Kostin (212) 902-6781 [email protected] Goldman, Sachs & Co.

Fiona Lake +852-2978-6088 [email protected] Goldman Sachs (Asia) L.L.C.

Kathy Matsui +81(3)6437-9950 [email protected] Goldman Sachs Japan Co., Ltd.

Timothy Moe, CFA +852-2978-1328 [email protected] Goldman Sachs (Asia) L.L.C.

Aleksandar Timcenko (212) 357-7628 [email protected] Goldman, Sachs & Co.

Dominic Wilson (212) 902-5924 [email protected] Goldman, Sachs & Co.

Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investorsshould be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investorsshould consider this report as only a single factor in making their investment decision. For Reg AC certification and otherimportant disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed bynon-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.

The Goldman Sachs Group, Inc. Global Investment Research

Asset Class Return* Weight Asset Class Return* Weight

Cash 0.1 % OW Equities 10.5 % OW

Equities 1.8 N Cash 0.5 N

Commodities ‐0.5 N 5 yr. Corporate Bonds ‐0.6 N

5 yr. Corporate Bonds ‐0.3 UW Commodities 0.1 N

10 yr. Gov. Bonds ‐1.6 UW 10 yr. Gov. Bonds ‐4.7 UW

* Return forecasts assume full currency hedging

12‐Month Horizon3‐Month Horizon

New Recommendation

July 25, 2014 Global

Goldman Sachs Global Investment Research 2

What’s new?

Since our last GOAL report the likelihood of a rise in bond yields with knock-on implications for other assets has increased. To prepare, we downgrade corporate credit to underweight over both 3 and 12 months and downgrade equities to neutral over 3 months. For a 12-month horizon and beyond we still see the best strategy as being overweight equities and underweight government bonds to capture the equity risk premium which remains very high.

The biggest news on growth since our last GOAL report has been the continued

improvements in China with support from easy policy on both the fiscal, monetary and

administrative side. We now expect to see some moderations in policy support, but the

overall stance is likely to remain loose. We expect qoq growth to accelerate further in 3Q14

to 8.4% reflecting the strong momentum coming into the quarter before falling back a bit in

4Q14 to 8.0%. In Europe on the other hand our current activity indicator (CAI) has

weakened marginally in June to 1.2%. German and French data have disappointed while

we have revised our forecasts for Spain higher. Our annual growth forecast for the Euro

area is unchanged and we expect growth of 1.6%-1.7% in the second half in line with the

level of our CAI in April. The 1.2pt improvement in the July Euro area flash PMI is

encouraging in this respect.

In the US, growth has been steady over the last month as we expected, with the most

interesting data point being the continued decline in unemployment. Given the improved

labor market, upside surprises to inflation and very easy financial conditions our US

economists have shifted their forecast for the first rate hike to 3Q15 instead of 1Q16. This

forecast of near-zero rates for another year reflects that broader measures of the labor

market remains weaker than unemployment alone would suggest, our expectation of a

slow normalization of inflation as wage growth remains low and the risk/reward favoring

policy makers erring on the side of being a bit late rather than a bit early.

At the same time 10-year yields have declined further and are now around their lowest

levels post the sell-off over the summer last year (Exhibit 1). In the case of Germany we

have even surpassed the lows from before the sell-off. We expect bond yields to be pushed

higher by sustained high US growth and accelerating inflation, a decline of deflationary

concerns in Europe and an improving inflation outlook in Japan. The conclusion of Fed

bond purchases in October could also be a catalyst for a reassessment of the speed and

size of the hiking cycle as well as the neutral rate. As time has passed while yields have

stayed low, the time window over which we would expect this sell-off in bonds has

shortened from one side. At the same time, the data has shortened it from the other by

moving forward our expectation for the first rate hike. We now see the likelihood of a sell-

off in bonds as large enough that we adjust our allocation to both equities and credit as a

preparation for a rise in yields. We balance these changes with an upgrade of cash to

overweight over 3 months.

We downgrade corporate credit to underweight over both 3 and 12 months. We continue to

have a benign outlook for spreads and expect a slight further tightening over the coming

year as monetary policy remains very accommodative and inflation and macro risks remain

relatively low leading to a strong search for yield. However, spreads are now so tight that

carry and further spread compression offer a relatively low offset against the rise we

expect in the underlying government bond yield, especially for US investment grade

credits. This tension between total return and spread return expectations have existed for a

while, but the latest developments have shifted the balance between these two forces far

enough for us to prefer a credit underweight, given that our credit portfolio puts 60%

weight on US investment grade.

In summary

On growth

An earlier hike…

Yields to rise

Downgrading credit



Exhibit 1: Government Bond yields back at very low

levels

Exhibit 2: US data surprises close to high 3-month linearly weighted data surprises vs. consensus for

the US and Euro area, as measured by our MAP indexes

Source: Datastream, Goldman Sachs Global Investment Research.

Source: Haver Analytics, Goldman Sachs Global Investment Research.

We also downgrade equities to neutral over 3 months. We are concerned that a sell-off in

government bonds will lead to a temporary sell-off in equities in line with what we saw last

summer, though the magnitude is likely to be smaller as the need for bond yields to correct

is lower than it was back then. At the same time, on our forecasts the acceleration of

economic growth is now largely behind us, with any further expansion being very small

compared to what we have seen. We see an environment where growth is sustained

around current levels as being positive for equities over the longer term, but would expect

the pace of returns to slow down relative to the strong performance we have seen over the

last couple of years. This suggests that the forgone return by lowering the equity exposure

temporarily if equities continue their grind higher is likely to be lower than it has been. This

is particularly true in the US where earnings and valuations are at high levels, and where

data surprises are already very positive. Our MAP index of data surprises here is close to

its highest levels over the last couple of years (Exhibit 2). Over the longer term we still see

equities as the best positioned asset class, and remain overweight over 12 months. We

would see any sell-off over the next few months as an opportunity to increase exposure

again also on a short-term basis.

Geopolitical risks remain high, but in the case of both Iraq and Ukraine our expectation is

that the likelihood of a broader market impact is low. Still, both conflicts remain very

volatile and have the potential to have broad impact if they escalate beyond our

expectations and this risk provides additional support for our equity downgrade. The risks

to our growth outlook on the other hand have diminished as we now see the risks to our

Chinese growth forecast as being broadly balanced rather than skewed to the downside.

We see a move in bond yields as the most likely cause of market volatility in coming

months and think our new allocation lowers the risks to the portfolio from this.

In our last GOAL report, we maintained our equity overweight and government bond

underweight over both 3 and 12 months. Since then equities have returned 1.4%

outperforming the 1.0% return on government bonds.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jul-12 Mar-13 Nov-13 Jul-14 Mar-15

%

US 10-Year UK 10-YearGermany 10-Year Japan 10-Year

'Taper tantrum' sell-off

-2

-1

0

1

2

Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14

Euro Area

US

Downgrading equities

An update on risks

Performance



Investing in our themes

To benefit from the stronger growth environment, we would position in stocks with high

operational gearing, exposure to developed markets or both. We have active

recommendations to leverage this view across the four regions that we look at. We see the

reflation story in Japan as another angle on this theme. In government bond markets we

are long Euro area inflation and short 3 year US Treasuries.

Exhibit 3: Our recommendations position for a cyclical recovery…


As risk aversion moderates we expect companies to put cash to work. Given regional

differences in return policies, we have developed different strategies for the different

regions to capture this, but we like the theme in both the US, Europe and Japan.

Exhibit 4: ...and companies using cash for shareholder returns


We are long the US dollar vs. the Canadian dollar.

Exhibit 5: Other trade recommendations


Cyclical recovery

US companies with high operational leverage (GSTHOPHI) vs. US companies with low operational leverage (GSTHO

US stocks we expect to benefit from higher rates (GSTHUSTY) vs. S&P 500

US companies with high weak balancesheets (GSTHWBAL) vs. US companies with strong balance sheets (GSTHSBAL

DAX vs. Stoxx 600

Operationally geared DM exposed European companies (GSSTDMGR) vs. Stoxx 600

European financially levered companies (GSSTFNLV) vs. Stoxx 600

FTSE 250 vs. FTSE 100

Asian global cyclicals (GSSZMSGC) vs. defensives (GSSZMSDF)

Asia ex‐Japan margin expanders vs. margin contractors (see June 30 3Q views: Harder‐earned returns)

Japanese capex growth beneficiaries (GSJPCPEX)

Wavefront US Consumer Growth basket (GSWBCOGA)

Large cap banks in the US, Europe and Japan, with Equal weights in BKX, SX7E and TPNBNK

Long Euro area 3 year inflation swap rates 2‐year forward

Short 3 year US Treasuries

Equity

Gov

Bonds

Shareholder return

US companies with high trailing buy‐back yield relative to their sector (GSTHREPO) vs. S&P 500.

European companies with high dividend yields and growth (GSSTHIDY) vs. Stoxx Europe 600

Japanese total shareholder yield stocks

Equity

Other trades

S&P 500 Dec 14 Future funded out of short AUD/USD Dec 14 future

Japanese womenomics winner basket (GSJPWMN2)

Shanghai‐Hong Kong stock connect beneficiaries (see June 30 3Q views: Harder‐earned returns)

FX Long USDCAD

Equity

X‐

asset

Cyclical recovery

Shareholder return

Other strategies



Our forecasts

Exhibit 6: Our forecasts across asset classes


Exhibit 7: US GDP growth vs. our CAI

Exhibit 8: Euro area GDP growth vs. our CAI



Exhibit 9: Our forecasts for global economic growth vs. consensus

Source: Consensus Economics, Goldman Sachs Global Investment Research.

Return in % over last Current Forecasts

12 m 3 m 1 m Level 3 m 6 m 12 m Unit

Equities

S&P 500 ($) 20.4 6.4 2.1 1988 2000 2050 2075 Index

Stoxx Europe 600 (€) 18.2 3.8 ‐0.2 344 360 370 385 Index

MSCI Asia‐Pacific Ex‐Japan ($) 17.1 7.1 4.5 509 500 520 535 Index

Topix (¥) 6.2 9.2 0.2 1270 1250 1300 1450 Index

10 Year Government Bond Yields

US 3.6 2.1 0.6 2.50 2.75 3.00 3.25 %

Germany 6.3 3.3 1.0 1.18 1.40 1.60 1.92 %

UK 1.5 0.9 1.0 2.71 2.81 3.00 3.13 %

Japan 3.5 1.1 0.5 0.56 0.73 0.75 0.88 %

5 year credit spreads*

iBoxx USD 6.8 1.8 0.4 78 75 73 70 Bp

BAML HY Master Index II 8.7 1.6 ‐0.5 348 339 332 320 Bp

iBoxx EUR 6.7 2.2 0.4 109 102 99 95 Bp

Commodities

WTI 1.7 2.1 ‐3.2 102 96.00 95.00 90.00 $/bbl

Brent 7.0 ‐0.9 ‐5.6 107 105.00 105.00 100.00 $/bbl

Nymex Nat. Gas ‐5.5 ‐18.0 ‐13.5 3.85 4.50 4.25 4.25 $/mmBtu

Copper 2.1 6.3 4.0 7170 6600 6600 6200 $/mt

Aluminium 0.6 7.0 6.6 2026 2000 2050 2100 $/mt

Gold ‐2.3 0.1 ‐2.2 1291 1195 1135 1050 $/troy oz

Wheat ‐23.4 ‐25.0 ‐9.0 529 610 560 575 Cent/bu

Soybeans 8.4 ‐10.7 ‐11.4 1085 1400 1050 1050 Cent/bu

Corn ‐23.5 ‐23.6 ‐14.7 362 450 400 400 Cent/bu

FX

EUR/USD 1.8 ‐2.6 ‐0.9 1.35 1.35 1.34 1.30

USD/JPY 1.6 ‐0.5 ‐0.3 102 103 107 110

* We show performance for credit in total return terms, but current level and forecasts are for spreads

-3

-2

-1

0

1

2

3

4

5

6

Dec-10 Dec-11 Dec-12 Dec-13 Dec-14

%

Annualised QoQ GDP Growth

GS Forecast

CAI

Q2‐14 Q3 ‐14 Q4‐14 Q1‐15 Q2‐15 Q3‐15 Q4‐15 Q1‐16

3.2 3.3 3.3 3.0 3.0 3.0 3.0 3.0

QoQ GDP Growth Forecasts (% Annualised)

-3

-2

-1

0

1

2

3

4

5

6

Dec-10 Dec-11 Dec-12 Dec-13 Dec-14

%Annualised QoQ GDP Growth

GS Forecast

CAI

Q2‐14 Q3 ‐14 Q4‐14 Q1‐15 Q2‐15 Q3‐15 Q4‐15 Q1‐16

0.8 1.7 1.6 1.4 1.6 1.5 1.6 1.8

QoQ GDP Growth Forecasts (% Annualised)

2014E 2015E 2016E 2017E

GS Consensus* GS GS GS

USA 2.8 1.9 1.6 1.6 3.1 3.0 3.0

Japan 1.4 1.5 1.5 1.5 1.2 1.6 1.5

Euro Area -0.6 -0.4 1.0 1.1 1.5 1.7 1.6

China 7.7 7.7 7.3 7.3 7.6 7.6 7.4

BRICs 5.9 5.9 5.5 5.6 6.3 6.6 6.7

Advanced Economies

1.4 1.3 1.8 1.8 2.5 2.5 2.5

World 3.1 2.9 3.1 3.0 3.8 4.1 4.1

* Consensus Economics July 2014

2013% yoy 2012



Equities: Downgrade to neutral over 3 months

We downgrade equities to neutral over 3 months but remain overweight over 12. The longer-term case for equities

is still strong: we expect sustained economic growth around current levels to drive earnings growth and

performance, while the potential for equity risk premia to compress from still very high levels leaves room for

equities to perform over the longer term despite a rise in bond yields. However in the short term we worry that a

rise in bond yields will drive equities lower, and we also expect the general pace of returns to slow compared to

what we have seen in the last couple of years. We maintain our regional allocation with an underweight in the US

over both 3 and 12 months balanced by an overweight in Europe over 3 months and Europe and Japan over 12

months.

We downgrade equities to neutral over 3 months as we are

concerned about the potential impact of rising rates. We

also think the acceleration in economic growth is largely

behind us and geopolitical risks are elevated. While these

issues weaken the risk/reward from equities in the near

term, they do not change our view that equities are the

most attractive asset class on a 12-month horizon by a wide

margin and we remain overweight.

Many investors are concerned about current valuation

levels, but in our central economic scenario we expect

these levels to be sustained. For us the main concern

related to valuation is that current levels create downside

risks if the economic environment was to disappoint.

Whereas absolute valuations are on the high side, relative

valuations remain attractive. The gap between dividend

yields and bond yields shown on Exhibit 10 is still high and

our estimates of equity risk premia ranges from 5.2% in the

US to 8.5% in Asia ex-Japan. We expect continued

compression of these high premia to offset the rise in bond

yields over the longer term and therefore think valuations

should be relatively steady even as bond yields rise.

This leaves earnings as the key driver of returns in our view.

Whereas earnings were revised down across all markets

except Japan at the beginning of the year, they have now

stabilised in all regions except Europe, where the

downward revisions have continued. This stabilization is

supportive of our forecasts for earnings growth which are

roughly in line with consensus in all regions except for

Japan where we are more optimistic. We are concerned

about the continued downward revisions in Europe and see

this as a key risk to our overweight here. But, we expect

both a slight improvement in European economic growth

for the rest of the year as well as the currency depreciation

to lead to a stabilisation of earnings. Though it is early, the

2Q14 earnings season in Europe has so far been positive,

which is encouraging.

We continue to see the return of cash to shareholders as a key theme across the US, Europe and Japan and recommend strategies to capture this in all these regions. We also recommend a number of strategies geared towards capturing the stronger environment for economic growth that we have now shifted into (see page 4 for a list of these trades).

Exhibit 10: Dividend yields are high vs. real bond yields Dividend yields minus 10-year real government bond yields.

We use five-year average inflation as a proxy for inflation

expectations. The distribution uses data from 1990 except for

Asia ex-Japan where it is from 1995

Exhibit 11: Earnings revisions have stabilized except in

Europe Percent change in consensus expectations for the level of

2014 EPS vs. expectations at the beginning of the year.

Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research.

Source: Datastream, Goldman Sachs Global Investment Research.

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

Europe US Asia Ex-Japan Japan

+/- stdev

current

Average

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

Dec-13 Jan-14 Mar-14 Mar-14 Apr-14 May-14 Jun-14

Europe (STOXX 600)US (S&P 500)Japan (TOPIX)Asia ex Japan (MSCI Asia ex Japan)



Our sector weightings also reflect the stronger economic

environment, with overweights in many of the financial

sectors, technology and parts of the industrial space,

whereas we underweight more defensive sectors including

the more defensive parts of the consumer space. (See

Exhibit 17 for sector details).

Our pro-cyclical thematic trades and sector

recommendations could suffer under a temporary

drawdown. But we have kept these recommendations, due

to our constructive longer-term outlook.

We keep our regional allocation unchanged, with an

underweight in the US over both 3 and 12 months balanced

by an overweight in Europe over 3 months and Europe and

Japan over 12 months.

Exhibit 12: Global indices price targets and earnings growth All data is in local currency except data for the MSCI Asia Pacific ex-Japan index which is in US$

Source: Bloomberg, I/B/E/S, Goldman Sachs Global Investment Research.

Exhibit 13: Earnings sentiment by region Upgrades less downgrades, as percentage of changes in estimates (last four weeks)

Source: FactSet, I/B/E/S, Goldman Sachs Global Investment Research.

Exhibit 14: Global valuation metrics P/E is NTM on consensus earnings, net income margins is consensus 2013, all other data is 2013 or last twelve months

Source: Worldscope, I/B/E/S, Datastream, FactSet, Goldman Sachs Global Investment Research.

Current Earnings GrowthPrice GS Target Upside to target (%) GS top-down Consensus bottom-up

Index 24-Jul-2014 3-m 6-m 12-m 3-m 6-m 12-m 2014E 2015E 2014E 2015E

Stoxx Europe 600 344 360 370 385 4.6 7 12 6 12 5 13

MXAPJ 509 500 520 535 -1.7 2 5 9 13 10 10

S&P 500 1,988 2,000 2,050 2,075 0.6 3 4 8 8 10 12

TOPIX 1,270 1,250 1,300 1,450 -1.6 2 14 16 14 7 11

Note : TOPIX EPS is based on fiscal, not calendar, years (i.e 2014 represents the fiscal year ending in March 2015).

-80%

-60%

-40%

-20%

0%

20%

40%

60%

Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14

Pan-Europe US

-80%

-60%

-40%

-20%

0%

20%

40%

60%

Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14

Asia ex-Japan Japan

P/E EV / EBITDA FCF Yield Div Yield P/B Net Income ROE Implied(X) (X) (%) (%) (X) Margin (%) (%) ERP (%)

S&P 500 15.9 9.8 4.6 2.0 2.8 8.9 14.7 5.2Stoxx Europe 600 14.3 8.3 3.9 3.1 1.8 6.4 9.3 7.2

MSCI Asia Pacific ex-Japan 12.4 8.7 2.3 2.9 1.7 8.8 12.1 8.5Topix 13.7 7.6 5.2 1.9 1.3 7.1 8.7 6.4

Note : TOPIX EPS is based on fiscal, not calendar, years (i.e 2013 represents the fiscal year ending in March 2014)



Exhibit 15: Regional valuation relative to historical distribution (using data from 2001)

Source: Worldscope, I/B/E/S, Goldman Sachs Global Investment Research.

We remain constructive on Japan over the longer term,

where we expect performance to be supported by further

profit expansion and implementation of additional reforms.

We see the government’s new growth strategy released in

June as supportive of this view with its focus on an

eventual reduction in the corporate tax rate to below 30%,

a new corporate governance code in 2015, neutralization of

the tax code to encourage more married women to work,

and an aim to boost foreign workers. Despite this we stay

neutral over 3 months, as we think it is a little late to

upgrade tactically after the strong performance over the

last couple of months.

We believe that Europe has solid return potential going

forward. This year earnings have been disappointing, but

earnings growth has turned positive on a trailing basis and

we expect it to accelerate as margins recover from

cyclically depressed levels. We also see room for strong

earnings growth for the financial sector where earnings

are depressed.

We expect reasonable returns for the US on an absolute

basis over the coming year, but relative to other markets,

the longer-term recovery potential is smaller given already

high margins and strong performance so far.

Asia ex-Japan has been supported by the improvement in

Chinese and US economic growth, but most of the

acceleration is now behind us. Longer term, there is still

significant uncertainty about the Chinese growth outlook

and we also worry that pressure on EM assets as a

consequence of higher DM yields could have a knock-on

impact for Asia ex-Japan even though we see it as much

less vulnerable than the rest of EM. We therefore stay

neutral despite the current economic improvements.

Exhibit 16: Our recommended weighting within equities Total return forecasts for each region (in local currency and in USD) and the allocation we would currently make relative to

benchmark on both a 3- and 12-month horizon


0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

0

5

10

15

20

25

30

35

40

Europe US Asiaex-Japan

Japan Europe US Asiaex-Japan

Japan

(x) "+/- 1 Stdev"

Average

Current

High/low

12‐month forward PE (LHS) Trailing P/B (RHS)

Recommended Recommended

Local Cur. In USD Allocation Local Cur. In USD Allocation

Stoxx Europe 600 5 6 Overweight Topix 16 8 Overweight

Topix ‐1 ‐2 Neutral Stoxx Europe 600 15 11 Overweight

MXAPJ ‐1 ‐1 Neutral MXAPJ 8 8 Neutral

S&P 500 1 1 Underweight S&P 500 6 6 Underweight

3-Months 12-Months

IndexReturn ForecastsReturn Forecasts

Index



Exhibit 17: Recommended sector weightings by region


Analyst Contributors

Peter Oppenheimer

+44(20)7552-5782

[email protected]

Goldman Sachs International

David J. Kostin

(212) 902-6781

[email protected]

Goldman, Sachs & Co..

Kathy Matsui

+81(3)6437-9950

[email protected]

Goldman Sachs Japan Co., Ltd.

Timothy Moe, CFA

+852-2978-1328

[email protected]

Goldman Sachs (Asia) L.L.C.

Anders Nielsen

+44(20)7552-3000

[email protected]


Matthieu Walterspiler

+44(20)7552-3403

[email protected]


Overweight Neutral UnderweightUS

Information Technology Financials Consumer StaplesConsumer Discretionary Health Care Utilities

Industrials Energy Telecom ServicesMaterials

EuropeBanks Oil & Gas Chemicals

Autos & Parts Media Basic ResourcesInsurance Telecoms Retail

Technology Real Estate Food & BeverageHealthcare Constructruction & Materials

Financial ServicesUtilities

Travel & LeisurePersonal & Household GoodsIndustrial Goods & Services

Europe SubsectorsIntegrated Oil & Gas* Oil Services*

Luxury Goods* Food Products*Staffing

UK HomebuildersCivil Aerospace

JapanSteel & Nonferrous Chemicals Retail

Industrial Electronics Elec components & Precisions Household ProductsBanks Trading Securities & Other Financials

IT Services Telecom Software & Internet ServicesMedia Transportation Consumer Electronics

Machinery Automobiles & Parts UtilitiesConstruction Food & Beverage

InsuranceReal Estate & Housing

PharmaceuticalsEnergy

Building Products

Asia ex-JapanSoftware & Services Banks Real Estate

Energy Metals & Mining UtilitiesCapital Goods Autos & Components Consumer Staples

Tech Hardware & Semis Transportation Telecom ServicesInsurance & Other Financials Health Care

Chemicals & Other MaterialsConsumer Retail & Services

*denotes long/short trade.



Commodities: Muted reactions to geopolitical risks; supply

dynamics to remain key to return differentiation

As the long anticipated macroeconomic acceleration shows tentative signs, not all commodity markets are likely

to benefit due to significant supply differentiation. While we maintain our neutral recommendation with 12-

month expected GSCI S&P returns of 0.1%, we see opportunity in Nickel, Zinc, Palladium and Aluminum markets

should the acceleration continue as expected.

Despite a very modest rise and subsequent decline in oil

prices during late June, the broader commodity prices as

measured by the S&P GSCI are almost back to the same

place they started the year (and 2011/2012 for that matter).

In addition, volatility across nearly all the sectors continues

to grind lower despite extremely high geopolitical risk.

With events in Ukraine, Iraq and Israel occurring all at the

same time, the price reaction from both commodity and

financial markets has been extremely muted as the

likelihood of a supply disruption remains very low and the

ability of other regions to respond, particularly the US

energy sector, remains high (see: Top of Mind: Geopolitics

and Oil – What’s Changed?, July 22, 2014). Instead, market

focus has been on the long awaited tentative signs of a

macroeconomic acceleration in both the US and China.

However, while financial markets have reacted favorably to

these signs, with equities reaching new highs, commodity

indices have remained mostly flat.

However, this relatively benign description of commodity

prices misses two important themes: 1) an extremely high

level of dispersion across commodity markets that has

come to characterize 2014, and 2) commodity returns as

measured by the enhanced S&P GSCI are up 2.2% year-to-

date as the positive carry in key markets has continued to

generate returns. While we maintain our neutral

recommendation and a flat 12-month return forecast for

the S&P GSCI, we believe that these themes will continue

to characterize commodity markets in 2014.

Commodity dispersion is driven by supply differentiation

This lack of reaction by broader commodity indices does

not suggest that all commodity market have not reacted to

the macroeconomic recovery. Some key energy and metal

markets have reacted to the cyclical upswing, while other

commodity prices remain unchanged – increasing the

already high level of dispersion since the start of 2014,

initially due to weather events. Driving this recent

dispersion is a high level of supply differentiation between

those commodity markets which are now firmly in the

Exploitation phase versus those which either remain in the

Investment phase or are suffering from negative supply

shocks.

While cyclical recovery will see rising commodity demand,

returns will largely be determined by more structural

supply factors. Accordingly, not all boats are expected to

rise with the tide created by continued improvement in

global macroeconomic data. Due to weaker supply growth

we see upside in Nickel, Zinc, Palladium and Aluminum

prices as macroeconomic acceleration gets further

underway (see: Bulks, Base, Bullion: Mining commodities

riding the exploitation phase, July 23, 2014).

Backwardation surging in WTI as it fades in Brent

The second theme that has generated returns this year,

despite relatively weak price action and low volatility, is

backwardation in key commodity markets. This

backwardation provides a positive carry in the form of a

‘roll’ yield on the S&P GSCI. As well as increasing

structurally during the Exploitation phase of the

commodity cycle (which we have been in since early 2011),

the roll yield typically increases with cyclical strength in

economic growth. As we move further into the Recovery

phase, and eventually the Expansion phase, we see further

reinforcement of both supply differentiation and positive

roll yields drivers.

Exhibit 18: S&P GSCI® Enhanced Commodity Index and strategies’ total returns forecasts

Source: S&P, Goldman Sachs Global Investment Research.

Current 12-MonthWeight Forward

(%) 2012 2013 2014 YTD¹ 12-mo Forecast

S&P GSCI Enhanced Commodity Index 100.0 -0.1 -0.8 2.2 0.1Energy 72.4 -1.5 5.6 1.3 1.5Industrial Metals 7.0 1.3 -13.0 4.6 0.0Precious Metals 2.8 6.2 -29.7 8.5 -15.0Agriculture 11.3 5.4 -18.0 -6.0 -2.0Livestock 6.5 -2.8 -2.8 29.5 -5.0

¹ YTD returns through July 22, 2014



Energy

We expect 1.5% returns on the S&P GSCI® Enhanced

Energy index on a 12-month horizon.

Petroleum: Brent price risks remained skewed to the downside amid heightened geopolitical risks

During the last quarter, Brent prices have fluctuated

between $105-$115, with pressure on the upside strongest

by mid-June due to Iraqi supply disruption fears. As those

fears subsided and news arrived about some Libyan

exports becoming available in the near term, prices came

back down, fluctuating during the last week at around $107.

Geopolitical tensions, however, are once again rising on

stronger US sanctions on Russia, and rising violence in

Israel. Amid this backdrop of elevated geopolitical risks,

crude oil volatility has remained close to record low levels,

despite global oil inventories remaining low by historical

standards. In our view, this relatively stable market

environment both in terms of Brent prices and low

volatility is a sign of a balanced underlying crude oil

market in which the US shale revolution has resulted in a

much flatter oil supply curve, increasing supply flexibility

with the effect of limiting price volatility. Importantly, we

believe three key shifts that occurred in 2H13 will continue

to shape the 2014 global crude oil market: (1) demand

rotation with stronger DM demand offsetting weaker EM

demand, (2) supply normalization with non-OPEC

production outside North America continuing to grow, and

(3) OPEC supply disruptions with Libyan supply

uncertainty remaining elevated. Taken together, our

supply and demand outlook for 2014 continues to suggest

a modest weakening of the global oil balance and as a

result points to a modest decline in prices, leading us to

leave our year-end Brent price forecast unchanged at

$105/bbl.

In the US, WTI has fluctuated as well on geopolitical

tensions, but in a tighter range ($101 - $107). The WTI-

Brent differential has continued to narrow, and it sits

currently at -$4.9/bbl, the highest level since April, up from

-$12/bbl at the beginning of the year. WTI timespreads

remain well supported, with strong backwardation. Driving

this strength in WTI prices and the level of backwardation

was the continuous outflow of crude from Cushing to the

Gulf Coast via the new MarketLink pipeline. Going forward,

we believe that there exists only very little room for light

crude import displacement and that exports to Canada will

play a role in the adjustment process during the rest of

2014. Importantly, we estimate this still happens at a WTI-

Brent spread between -$7.00/bbl and -$10.00/bbl. However,

within that range, we believe that the adjustment will be

far from a continuous sequential process, but rather

characterized by volatility as the ability for US refineries to

process the excess crude oil remains a key driver.

US natural gas

US natural gas prices have traded down 14% since the

beginning of the month, closing at $3.85/mmBtu as of July

25. Despite coming out of last winter with the lowest gas

inventories since 2003, in the last 10 weeks the market has

been rebuilding storage at record rates. While the market

was relatively comfortable with large builds in May-June

on the back of the impressive supply growth viewed as

necessary to balance the market next winter, pricing has

reacted negatively to continued strong builds in July.

Bearish pricing has been a function of significantly weaker-

than-normal power demand in July, driven in turn by 10%

milder-than-normal temperatures in the US. In our view,

the current bearish pricing environment is driven by the

need for the market to encourage price-induced coal-to-

gas switching to compensate for lower overall power

generation demand in this period of mild weather.

However, we currently maintain our view that under

normal weather conditions into August, the market will not

need to incentivize significant coal-to-gas switching until

significant supply growth comes online in November,

driven by pipeline debottlenecking out of the Marcellus

and Utica shale plays. Accordingly, we maintain our 2014

and 2015 forecasts of $4.50/mmBtu and $4.25/mmBtu,

respectively. However, emphasize that risks to our 2014

forecast are no longer skewed to the upside, and we would

view continued mild weather into August as a downside

risk to pricing through the rest of 2014.

European natural gas

Despite a brief rally in European gas prices last week on

the back of US and EU sanctions against Russia and

escalating geopolitical tensions in Ukraine, northwest

European gas prices have largely continued on their strong

downward trajectory, which started last December. Indeed,

on July 15, NBP closed at 36.7 p/th, more than 50% off its

December peak. The northwest European market has

struggled to adjust to the oversupply it was left with at the

end of the mild winter, and for the first time in more than

two years, we now estimate that prices have fallen to

levels that incentivize coal-to-gas switching in UK power

markets. In our view, coal-to-gas switching demand will

continue to be needed throughout the summer to balance

northwest European gas markets, requiring prices to trade

on average at 34.2 p/th through 3Q2014. From winter 2014,

however, we believe that European gas markets will

tighten again, on a return to demand growth and as the

effects of the Dutch production cut from the Groningen

field will require imports from Russia at levels close to

2013. As a result, we forecast that NBP will trade at a

relatively tight average annual discount of 5.8 p/th to our

estimate of the oil-linked contract price through 2015.

Accordingly, we change our 2015 average price forecast

for NBP to 57.2 p/th. We continue to view the risk of

significant disruptions to Russian imports to northwest



Europe as limited (even given the recent expansion of

sanctions), as the EU still finds the costs of gas exports

sanctions on Russia unacceptable for its own economies.

Indeed, we note that no sanctions have been placed on

Gazprom, the monopoly Russian supplier of pipeline gas

to Europe. We continue to expect that disruptions to

European imports of Russian gas would only be employed

as a last resort.

Industrial metals

We expect 0.0% returns on the S&P GSCI® Enhanced

Industrial Metals index on a 12-month horizon.

Over the year to date, the LME copper price has fallen by

3%, a substantially weaker outturn than the 15% rally in

LME zinc, c.23% increase in all-in aluminium prices

(including a 15% increase in the LME price), and 35%

increase in LME nickel. Looking ahead, we expect further

base metals price differentiation over the next 12 months,

with copper set to continue to underperform relative to

nickel, aluminium and zinc, in line with the medium-term

outlook we presented in our July 2014, Base, Bulks and

Bullion report.

The copper price declines over the year to date come

despite recent bullish macroeconomic (improving China

sentiment and US demand) and copper specific

developments (such as Indonesia export disruptions and

Chinas Reserve Bureau copper purchases). In our view the

outright price declines and copper’s underperformance

reflect structural factors that are unlikely to ease over the

next 12-18 months. We believe that sluggish copper

demand growth – particularly from China’s construction

sector to which copper is heavily exposed – combined with

a once in 20 year supply boom will push prices down to

6600 on a 3 to 6-month horizon and to 6200 on a 12-month

horizon. We also see limited upside risks to Chinese

demand growth owing to highly leveraged Chinese

corporate balance sheets and anticipated weakness in

copper-intensive construction completions, and downside

risks to our price forecasts in the case of a rapid unwind in

Chinese Copper Financing Deals (not our base case), or a

larger-than-expected slowdown in the Chinese property

market.

By contrast, low supply growth following years of

underinvestment in new capacity outside of China, in

combination with a cyclical upswing in demand have seen

zinc and aluminium prices rise strongly in 1H14.

Meanwhile nickel is being boosted by the attempts of a

large producer (Indonesia) to encourage value-add

capacity domestically. We see these themes continuing to

support base metals prices ex-copper over the next 12

months and see 15% upside in nickel prices (to $22,000/t),

6% further upside in zinc (to $2,500/t) and 5% further

upside in aluminium (to $2,100/t) over this period.

Precious metals

We expect -15.0% returns on the S&P GSCI® Enhanced

Precious Metals index on a 12-month horizon.

Higher inflation prints over recent months coupled with

disappointing US 1Q GDP growth have provided support

for gold prices around $1,300/toz. More recently, hawkish

comments by Fed Chair Yellen and signs of a pickup in US

2Q GDP growth (as evidenced by our US Current Activity

Indicator running at c.3.5% annualized and strong labor

market stats over 2Q) have seen gold lose just over $40

from July 11 to 15. However, following recent events in

Ukraine and escalation of violence in the Middle East,

geopolitical risk sentiment has deteriorated sending gold

back to just over $1,300/toz.

We expect continued sequential acceleration in US

economic data over 2014H2 and for nominal 10Y yields to

rise to 3.0% by end-year. At the same time, we believe that

US inflation has now returned to a more moderate upward

trajectory (following unexpectedly high prints in April and

May). As such we continue to see real interest rates

grinding gradually higher and gold prices gradually lower.

That said, ongoing political uncertainties in the Ukraine

and the Middle East remain, posing continued upside risks

to our forecasts.

Agriculture

We expect -2.0% returns on the S&P GSCI® Enhanced

Agricultural index on a 12-month horizon, and -5.0%

returns in the Enhanced Livestock index.

Agriculture prices rallied sharply to the end of May this

year (+20%ytd), but have since reversed and are now down

8%ytd. The key drivers of this moderation have been signs

of more moderate demand for the old crop (increasing

ending stocks in 13/14), no disruptions to Black Sea

exports despite the ongoing tensions in Ukraine and

favorable weather conditions for the new crop as: 1)

drought conditions have eased in southern US states; 2)

weather has remained cool and dry in the US corn belt; 3)

rains have returned to Brazil. Global corn, soybeans, wheat

and cotton inventories also remain elevated. Soft

commodities have seen prices trade sideways, but remain

volatile, as the full effect of the previous drought in Brazil

and the potential for an El Nino later this year (which

would shift most soft commodity markets into deficit in

2014) remains uncertain. That said, with lower seas surface

temperatures in the Pacific (and better progress of the

Indian monsoon), there are tentative signs that an El Nino

may now be less likely. In livestock, with the continued



outbreak of the PED virus reducing hog numbers, and little

sign of increased breeding, we see hog prices remain

elevated for the next couple of months before moderating

on seasonal effects later in the year.


Jeffrey Currie

(212) 357-6801

[email protected]

Goldman, Sachs & Co.

Damien Courvalin

(212)902-3307

[email protected]


Samantha Dart

+44(20)7552-9350

[email protected]


Max Layton

+44(20)7774-1105

[email protected]


Christian Lelong

+61(2)93218635

[email protected]


Roger Yuan

+852-2978-6128

[email protected]


Michael Hinds

(212) 357-7528

[email protected]


Anamaria Pieschacon

(917) 343-9076

[email protected]


Daniel Quigley

+44(20)7774-3470

[email protected]


Amber Cai

+65 6654-5264

[email protected]

Goldman Sachs (Singapore) Pte



Credit: Downgrade to UW on lower spread cushion vs. higher rates

Corporate bond spreads continued to tighten in 2Q14. Investment grade bond spreads are now at their 42nd

percentile since 1985, while HY bonds are even tighter - near their 23rd percentile. Although risks are obviously

becoming increasingly one-sided, we expect volatility to remain low, and for spreads to trade flat-to-tighter from

here, driven by a pick-up in economic growth and continued monetary accommodation.

We continue to think that spreads will grind incrementally tighter as bond yields rise. Despite of this, we

downgrade to underweight over both 3 and 12 months, because there is now less carry and scope for additional

spread tightening to offset the expected rise in government bond yields. Within corporate credit, we continue to

suggest that investors find relative value in IG financials, shorter-duration bonds in HY, levered loans, cyclical

sectors, and illiquids. Tactically we expect EUR bonds to outperform USD, despite our continued concern over

the lingering tail risk of systemic shocks in European financials.

We continue to think that credit markets remain “carry

friendly.” We remain directionally constructive on the top-

down demand for credit spread, with stable growth (good

but not great) amid low yields and low expected returns

across most asset classes being the primary drivers.

Mainly for this reason, we expect spreads to continue their

slow grind tighter over the next year, in both IG and HY, in

both the United States and Europe.

Better growth, weak inflation, and thus accommodative

monetary policy should continue to support credit risk

appetite. Our constructive credit view is underpinned by

our macro outlooks for the United States and Europe,

where we expect modestly improving economic growth

against a backdrop of persistent “slack” and hence,

continued low to moderate inflation.

We think the sea change in financial regulation (including a

new “macroprudential” regulatory philosophy) has

materially curtailed the growth in leverage that has

historically accompanied economic expansions. In turn, we

think this muzzling of the “financial accelerator” (i.e., the

feedback loop between economic growth and credit

growth) has likely reduced the magnitude of both growth

and financial market volatility. A sustained period of low

volatility is a “carry friendly” environment for credit.

We also think this low-volatility environment implies that

the risks to growth and inflation remain skewed to the

downside (more so in Europe than in the US, despite the

determined efforts of central banks in both regions to push

inflation higher). We therefore believe that as growth data

continue to improve, as we expect, monetary policy will

continue to follow a relatively dovish “reaction function.”

We expect overnight policy rates in the United States to

remain at zero until the second half of 2015, and well

beyond that date for Europe.

We maintain our forecast for a continued grind tighter.

We think IG 5-year spreads will continue their grind tighter,

with USD spreads reaching 73 bp by year-end, and EUR

spreads reaching 99 bp. In HY we project that OAS on the

BAML USD HY index will reach 332 bp by year-end and

320 bp by the end of 2Q15.

Exhibit 19: We forecast a slow grind tighter in both IG,

HY IG 5y spreads to Treasury, and HY OAS by rating.

Exhibit 20: IG spreads are at their 42nd percentile

Current vs historical distribution of OAS since 1985

Source: Yieldbook, iBoxx, Goldman Sachs Global Investment Research.

Source: BAML, Goldman Sachs Global Investment Research.



Exhibit 21: HY spreads are forecast to grind tighter

OAS spreads on broad index and by broad rating index.

Source: Yieldbook, Goldman Sachs Global Investment Research.

A “US inflation surprise” is our top risk to credit

We now rank a “US inflation surprise” as our top risk to

credit. To be clear, our baseline view remains relatively

sanguine about the probability of meaningful upside

surprises in US inflation data (and the unexpectedly early

withdrawal of monetary accommodation this could imply).

But this risk scenario is one of the more painful we can

envision for credit spreads, so it warrants close scrutiny,

despite its low probability.

Surprisingly high inflation and the resulting removal of

monetary accommodation would obviously provoke a

painful risk-off event for rates and equities, but we think it

could be even more painful for credit, for the following

reasons:

First, we do not think markets for risk or rates are

priced or well-positioned for such a surprise.

Second, a “monetary shock” driven by inflation rather

than growth would reverse the usual negative

correlation between rates and credit spreads, causing a

“double whammy” of rising rates and wider spreads

for corporate bond yields (our baseline scenario, driven

mainly by better growth, envisions tight spreads amid

a benign normalization of rates).

Third, such a sharp rise in bond yields might spark

further selling by mutual fund investors, thus

generating additional spread widening on temporary

market imbalances.

We recently noted the many reasons why inflation will

most likely remain well-contained: core PCE is tracking at

just 1.5%; unemployment still remains high by historical

standards; global growth and inflation are low, while the

dollar should strengthen, keeping downward pressure on

inflation (growing domestic energy production in the US

should help too); wage inflation is still dormant; and the

logic of the Greater Moderation implies upside for demand

growth, and hence inflation pressure, is limited (see A US

inflation surprise: An unlikely but painful risk scenario

(especially for credit), Global Markets Daily, July 22, 2014).

Our US economic forecast.

We expect 4Q/4Q headline and core inflation to end the

year at 2.3% and 2.1%, respectively, and core PCE (the Fed’s

preferred inflation measure) to register just 1.7% 4Q/4Q for

2014 (from its current level of 1.7%), still well below the

Fed's target level of 2%. So under our forecasts, the

concerns raised here are simply risk scenarios.

That said, we cannot completely discount the risk from

inflation due to the potential magnitude of the impact. Nor

is it easy to discount that a wide range of inflation

indicators appeared to move higher in March, reversing the

prior-year trend during which year-on-year core PCE

inflation averaged less than 1.2%, and appeared to be

headed even lower in January and February.

Balance sheet re-leveraging also warrants a wary eye

Re-leveraging risk also remains high on our risks to credit.

To be clear, we remain skeptical of the popular view that

corporate leverage will inevitably rise due to low corporate

bond yields. We think the 2005-07 period provides a

counter example because corporate leverage actually fell

during the midst of what was clearly a period of easy

access to credit.

And to further avoid being misunderstood, when we worry

about re-leveraging, we are more concerned about weak

earnings than about financial engineering. Our bottom-up

analysis suggests that a sizeable portion of the increased

leverage since 2011 reflects weakness in the growth of

revenues and earnings. As US GDP growth is expected to

firm in the second-half, the resulting strength of earnings

growth should help stabilize aggregate debt-to-EBITDA

metrics.

That said, we continue to worry that low yields, tight

spreads, and the lack of financial leverage available to

investors all create clear incentives to seek leverage instead

through company capital structures. While company

managements have for the most part resisted the

temptation to abandon their still-conservative capital

structures, we are concerned that high stock market

valuations and future slowing of the M&A boom will

increase pressure for higher payouts via higher leverage if

future growth is not forthcoming.

For now, we view re-leveraging risk as less systematic than

idiosyncratic, especially for companies that have

underperformed their peers.



And of course, rising rates are not a risk but our baseline

Following the first six months of the year during which

most credit investors benefitted quite unexpectedly from

the rally in rates, we have argued that it now makes sense

to seek refuge in shorter durations (see Searching for carry

in a duration-risky world, The Credit Line, March 26, 2014).

In IG, the modest spread tightening that we envision at the

five-year point, for example, would be overwhelmed by the

60 bp increase in 5-year Treasury rates that we foresee by

year-end. Thus, we expect negative total returns over the

rest of the year. In HY, higher carry provides enough return

to offset the rate increase, but we still see room for only

modest incremental returns from here.

We do not worry that a rate rise will cause retail investors

to flee fixed income and push up spreads. And to the extent

we are wrong on flows, we expect such spread widening to

be met by yield-seekers, as long as higher rates are driven

by growth and not inflation (see Why our fund flow view

passed the taper tantrum test, The Credit Line, March 6,

2014).

Relative value: We still like IG financials, shorter-duration bonds in HY, cyclicals, and illiquids

Although much progress has been made since the financial

crisis, US IG financial credits still trade wide compared to

non-financials. We think these financial credits look

attractive for three reasons. First, higher carry will boost

returns, consistent with our top themes for 2014 (see A

carry-friendly world, Global Credit Outlook, November 22,

2013). Second, financial yields tend to move less than non-

financials in response to Treasury rate moves, insulating

financials from the risks around a rate increase. And third,

we expect the spread between financials and non-financials

will invert by year-end.

Within high-yield, investors who are concerned about the

rate increase in our forecast should either shorten duration

or move down in the rating spectrum. The former makes

more sense to us, but we also think B-rated bonds are now

in the sweet spot of the tradeoff between carry and

duration, as they feature a relatively high loss-adjusted

carry with lower duration than longer-dated credits.

We also recently reconfirmed our view that cyclical sectors

should outperform in the second half as the economy

accelerates (see Growth is back in favor in IG, still ignored

in HY, The Credit Line, July 11, 2014), and we also continue

to think liquidity premia offer opportunities for spread

enhancement.

Finally, we have a tactical preference for EUR over USD

bonds given their wider spreads and hence great appeal to

yield searchers. However, we still see elevated tail risks in

the Euro area, hence we continue to prefer US credit over

Europe’s on a fundamental basis.

Exhibit 22: For spreads, a slow grind tighter in USD…

Historical vs forecast 5-year spreads to US Treasuries.

Exhibit 23: …and in EUR

Historical vs forecast 5-year spreads to German Bunds.

Source: Compustat, Goldman Sachs Global Investment Research.

Source: Compustat, Goldman Sachs Global Investment Research.


Charles Himmelberg

(917) 343-3218

[email protected]


Lotfi Karoui

(917) 343-1548

[email protected]


Kenneth Ho

852-2978-7468

[email protected]




Government Bonds: The bond bearish case

We continue to recommend an underweight on government bonds over both a 3- and 12-month horizon.

Forward bond yields are below our forecasts and we expect them to increase on the back of: (i) strong growth

and an acceleration of inflation in the US; (ii) our expectation that, as the Fed concludes bond purchases in

October 2014 and the macro outlook strengthens, the market will become more hawkish relative to the timing,

speed and size of the Fed tightening cycle, also revising upward its assessment of the neutral rate; and (iii) a

rebuild of the global term premium as Euro area inflation stabilizes and the ‘tail risk’ of deflation in the currency

union fades.

Over most of the first quarter we held a neutral duration

stance and focused mostly on cross-country opportunities.

Our views of a divergence in economic outlook and the

direction of monetary policy stance between the US and

the Euro area, crystallized with our Top Trade

recommendation to receive 5-year EONIA against going

short 5-year US Treasuries, played out. Entering the

second quarter, we advocated outright bearish exposures

to longer-dated bonds both at the 3-and 12-month horizon.

But, since then, bond markets across the developed world

have continued to rally with 10-year yields in the US and,

most notably, in Japan and Germany now at their

minimum levels since the beginning of the year (and in the

case of German Bunds, the lowest in their history). Year-to

date total returns at the 7-10 year sector (using EFFAS

indices) are 2.3% in the JGB market (with low volatility),

4.2% in Gilts, 5.5% in US Treasuries, and 7.8% in German

Bunds. The reasons behind this global fixed income rally

are manifold, but we have argued that the following ones

stand out:

Policy easing from the ECB: Expectations of policy

easing have been building during the year on the back

of continued downward surprises in Euro area CPI

inflation. Since October 2013 and today, our own

forecasts for 2014 and 2015 inflation have come down

by 50bp, from 1.1% to 0.6% and from 1.6% to 1.1%,

respectively. Facing this challenging macroeconomic

outlook, at the June 5 policy meeting, the ECB brought

the rate at which excess liquidity deposited with the

central bank is remunerated to minus 10bp.

Additionally, the Governing Council announced further

injections of liquidity and the scheme for banks to lock

in funding at a fixed rate of 25bp for a minimum of 2

years, with the possibility of extending the funding for

two more years provided certain net credit creation

targets are met. As a result, the whole money market

curve out to three years has flattened, with the

forwards discounting no reversal of this policy until

the end of 2016. In our assessment, we find similarities

between the potential effects that the set of policies

announced by the ECB could have on euro are longer-

dated yields with the impact of the Fed’s ‘calendar

guidance’ (in place from mid-2011 to end 2012) on US

Treasuries.

Duration risk absorption by the BoJ: Long-dated

JGBs are ‘expensive’ relative to their macro

underpinnings as the BoJ continues to absorb around

two thirds of their gross monthly issuance and has in

its portfolio around 15% of the total stock of

government bonds outstanding. On top of the

depressing effect that the removal of duration by the

central bank has on yields, expectations of further

easing are on the rise. Our Japanese economics team

expects that the BoJ will expand its Quantitative and

Qualitative programme (QQE) sometime in 2H14 in

order to boost inflation further.

Cyclical weakness in 1Q14 in the US economy and a dovish Fed: The remarkable, and completely

unexpected, contraction in real GDP in the US during

the first quarter of this year (minus 2.9%), has lent

support to the view that the economic recovery will be

tepid. Adding to this, Chair Yellen’s tone has been

mainly tilted to the dovish side, in particular given her

considerations about the amount of slack in the labour

market and the importance she assigns to closing this

gap before contemplating a lift to policy rates.

Exhibit 24: ECB policy rates floored until end 2016 as

excess liquidity increases Euro area excess liquidity and EONIA forwards

Source: Haver Analytics, Bloomberg, Goldman Sachs Global Investment Research.

-0.25

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

0

100

200

300

400

500

600

700

800

900

09 10 11 12 13 14 15 16 17

%EURbnRange exc. reserves(lhs)Excess reserves (lhs)

1m EONIA (rhs)

MRO rate

Deposit rate

forecasts



Exhibit 25: Lower Euro area yields have pulled the global

term premium down Cumulative rate bullish 'shocks' in German Bunds outweigh

rate bearish 'shocks' in USTs

* Footnote: Shocks here are cumulated errors from a structural

VAR, See Who’s in the Driving Seat? Fixed Income Monthly, Feb

12, 2013

Source: Bloomberg, Goldman Sachs Global Investment Research.

‘Marking to market’ our forecasts

Against this background, and recognizing the possibility

that the ECB engages in purchases of credit assets, thus

lifting inflation expectations, may come later than we had

expected (the timeframe we now have in mind is between

the fall and next spring), earlier this month we lowered our

bond forecasts a touch for the US and Japan, while we

lowered our forecasts for German Bunds more

substantially. In the case of the former two bond markets,

we simply shaved 25bp off from our 10-year yield

forecasts until 2017 recognizing that the global bond

premium has fallen year to date. Instead, we now see

German Bunds yields ending the year at 1.6% (2.25%

previously) and increasing to 2.25% (3% previously) by

end-2015. This forecast, however, stills reflect our more

bearish stance relative to the market, as we are still above

the current forwards by about 40bp and 75bp, respectively.

The case for a bearish stance on intermediate maturities

Even accounting for our lower bond yield forecasts, we

still expect negative returns on holdings of intermediate-

maturity government bonds. We envisage that the

following forces will drive yields higher:

1. We expect a material pick-up in US economic activity

relative to 1Q14, with real growth rates slightly above

3% until end-2017, supported by easing financial

conditions and an acceleration of inflation towards the

2% PCE inflation objective of the Fed.

2. As the Fed concludes bond purchases in October 2014

and the macro outlook strengthens, the market will

become more hawkish relative to the timing, speed

and size of the tightening cycle, also revising upward

its assessment of the neutral rate.

3. A rebuild of the global term premium as the ‘tail risk’

of deflation in the Euro area declines. Moreover, we

think that the implementation of the Banking Union

will contribute to the reduction in the fragmentation of

European financial markets. This, together with the

targeted LTROs and purchases of ABS by the ECB

should support the expansion of corporate credit and,

consequently, aggregate demand. We forecast a

sequential slow improvement in Euro area growth and

a stabilization of Euro area inflation in the coming

months, with a slow increase in 4Q14 and further rises

during 2015 until approaching 2% by the end of 2017.

Exhibit 26: US services inflation accelerates Estimates of trend inflation of services component following

Stock-Watson (2007) methodology

Exhibit 27: The decrease in bond premium in 1H14 should

reverse in coming months Latent common factor in regression of G-4 10-year

government bond yields against macro variables

Source: Haver Analytics, Goldman Sachs Global Investment Research

Source: Goldman Sachs Global Investment Research

-8

-6

-4

-2

0

2

4

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14

US Germany

UK Japan

Cumulativestandard errors

0

1

2

3

4

5

92 94 96 98 00 02 04 06 08 10 12 14

Service Inflation (yoy)

Trend

16%-tile

84%-tile

%

-16

-12

-8

-4

0

00 02 04 06 08 10 12 14

Global Bond Premium(US,UK, Germany and Japan)

Jan-14

level



In terms of strategy, in this macro scenario we see scope

for:

1. The term structure of US yields to move upward and

flatten by more than what is discounted by the

forwards, as the risk of an earlier and faster tightening

cycle increases. We point out the inconsistency of

having a negative term premium at the front end in an

environment in which the uncertainty about the

amount of slack left in the jobs market is very elevated;

2. The intermediate part of the Euro area nominal rate

curve should ‘bear-steepen’, led by a combination of

healthier credit dynamics in the second half of the year,

a reduction in the negative inflation risk premium

priced in the Euro curve as tail deflationary risks

dissipate, and in sympathy with the sell-off in US

rates; and,

3. A further pick-up in Japanese underlying inflation, led

by demand-pull factors and underpinned by further

BoJ easing, that ultimately should translate into higher

nominal longer-term yields, and the possibility that

Japanese pension funds and insurance companies’

portfolios should be rebalanced in favour of equities at

the expense of bond holdings.

Reflecting these views, we are currently recommending to:

(i) be short 3-year US Treasuries, opened at 93 bp on June

16, 2014, with a target of 150 bp (35 bp above 3-month

forwards) and a stop on a close below 70 bp, currently at

98 bp, and (ii) be long Euro area 3-year inflation swap rates

2-years forward, opened at 1.46% on May 30, 2014, with a

target of 1.70% and a stop on a close below 1.35%,

currently at 1.54%.

Exhibit 28: Goldman Sachs forecasts for 10-year government bond yields

End of year forecasts (%)


Year USA Germany Japan UK

2014 3.00 1.60 0.75 3.00

2015 3.50 2.25 1.00 3.25

2016 3.75 2.50 1.25 3.50

2017 4.00 3.00 1.50 3.75


Francesco U. Garzarelli

+44(20)7774-5078

[email protected]

Goldman Sachs

International

Silvia Ardagna

+44(20)7051-0584

[email protected]


Mariano Cena

+44(20)7774-1173

[email protected]




Major FX views: Still Dollar Bullish

We provide up-to-date views on the major FX rates. We continue to expect the USD to strengthen against the

major crosses. We refreshed our Euro view after the ECB easing in June and expect the currency to trade at 1.34 by

year end and 1.30 in 12 months. We continue to expect USD/JPY higher in the near- and mid-term in anticipation

of further BoJ easing including clarification on what the BoJ intends to do with its QQE program in 2015 and

beyond. We have refreshed our GBP views and expect Sterling to continue to appreciate against the Euro.

We argued in the spring edition of the FX Quarterly that

there were three major drivers of USD strength against the

major currencies – interest rate differentials, shifts in the

oil balance in the US and ‘safe-haven’ demand. We still

believe in those arguments even though it has been a

frustrating time for dollar bulls. The USD on a TWI basis

has been broadly flat against the G10. However, this TWI

performance goes against interest rate differentials which

are becoming more supportive of Dollar strength. Indeed,

the 2-year rate differential of the US versus the trade-

weighted G10 has risen to its most Dollar supportive level

since 2009 (Exhibit 29), as underscored by our US

economics team bringing forward their assumed date for

the first rate hike to 3Q15.

The ECB has eased, pushing the Euro weaker. The Euro

has weakened from 1.40 to 1.34 in expectation of and

subsequent delivery of ECB easing at its June meeting. As

a result, we have changed our 3-month EUR/USD forecast

to 1.35 from 1.38. Our 6- and 12-month forecasts are

unchanged at 1.34 and 1.30. Our continued expectation of

Euro weakness rests on relative growth and monetary

policy dynamics vs. the US. A regular client push back to

this view is the Euro area’s solid current account surplus

and strong portfolio inflows. However, foreign buying of

European equity and fixed income is already very strong

and in line with historical trends (Exhibit 30). Therefore we

expect ECB easing to trump the solid Euro area external

surplus and cause the Euro to weaken over the next 12

months.

The USD/JPY has been stuck between 101.5 and 102.5

since early April. However, relative monetary policy

dynamics are likely to change in October, when the Fed

ends its tapering process and the BoJ eases policy further

as inflation softens into year end, thus providing a kicker

for USD/JPY higher – we expect Japanese CPI to soften to

0.8% yoy (ex VAT) by year end, below the BoJ’s forecast.

BoJ easing is likely to take the form of doubling the

purchase amount of ETFs to JPY2 tn, and the BoJ needs to

clarify what it intends to do with QQE into 2015. Our

forecast is 110 in 12 months' time.

BoE has been more hawkish pointing to a lower EUR/GBP.

EUR/GBP has lagged the sharp move in rate differentials,

so that – even though front-end rates in the UK have

moved quickly to reflect the change in rhetoric from the

BoE – there is plenty of room for the move lower in

EUR/GBP to extend further (Exhibit 31). This is the reason

that we recently upgraded our GBP forecasts, where we

now foresee 5.8% appreciation on a trade-weighted basis

over the next 12 months, the bulk of which against the

Euro. Our new EUR/GBP path is 0.78, 0.77 and 0.75 in 3, 6

and 12 months.

Exhibit 29: Two-year interest differentials supportive of

USD TWI appreciation

Exhibit 30: Foreign buying of Euro area assets has

already been very strong

Source: Bloomberg, Goldman Sachs Global Investment Research.

Source: Haver Analytics, Goldman Sachs Global Investment Research.

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

60

70

80

90

100

110

120

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

US Dollar TWIagainst majors

2-year swap ratedifferential, in %



Index

-800

-600

-400

-200

0

200

400

600

800

1000

01 03 05 07 09 11 13

EURbn Portfolio Investment:Assets Portfolio Investment:Liabilities

Draghi "Do what it takes"

Rolling 12-mth cummulative total



Exhibit 31: EUR/GBP has plenty of room to catch up with

rate differentials, which put this cross much lower.


To be short the AUD in anticipation that the currency will

weaken and therefore reflect its underlying fundamentals

has been a frustrating trade so far this year. One argument

for the AUD’s resilience is strong foreign buying of

Australian assets and reserve diversification into the AUD.

Certainly Japanese buying of Australian assets has picked

up since March and with total Japanese bond outflows

remaining firm, it is likely that Japanese buying of

Australian assets has remained strong. The 1Q14 IMF data

on FX reserves did reveal an increase in central bank

allocation to AUD. While these flows are supportive of the

AUD, they need to be put into context of a deteriorating

trade and current account balance and therefore Australia’s

external balance is likely less healthy than generally

perceived. A further hamper to a weaker AUD is the fact

that a short AUD trade has negative carry. This is likely

unpalatable given tough market conditions and that a low

volatility environment favours carry trades. Consequently

the RBA easing we expect in September may well be the

kicker to cause the AUD to ‘catch-down’ to its deteriorating

fundamentals.

In the past month or so, the CNY fix has become more

volatile, in particular showing notable strength around the

release of the bumper May trade surplus and more recently

ahead of the US-China strategic economic dialogue.

Interestingly the volatility has tended to follow the volatility

of the DXY since the band widening in mid-March. Given

the Chinese authorities desire to curb speculative inflows

into the CNY, a more volatile fix is an ideal policy tool,

particularly given that the ongoing solid trade surplus limits

the scope of further CNY weakness. However, implied

volatility at the 3-month tenor is currently at the bottom of

its range since early February, suggesting that the market is

not yet pricing a more volatile fix.

Exhibit 32: Our FX forecasts


0.60

0.65

0.70

0.75

0.80

0.85

0.90

0.95

1.00

06 07 08 09 10 11 12 13 14

EUR/GBP

Fitted using 2-year differential

Fitted using 5-year differential

Forecasts Forecasts

Current 3 months 6 months 12 months Current 3 months 6 months 12 months

EUR/$ 1.35 1.35 1.34 1.30 A$/$ 0.94 0.90 0.88 0.86

$/JPY 101.84 103.00 107.00 110.00 $/C$ 1.07 1.10 1.12 1.14

£/$ 1.70 1.73 1.74 1.73 $/KRW 1030 1030 1050 1070

EUR/£ 0.79 0.78 0.77 0.75 $/BRL 2.22 2.30 2.40 2.55

EUR/CHF 1.22 1.25 1.28 1.28 $/MXN 12.96 13.00 13.00 13.00



Exhibit 33: US BBoP vs. Current Account

Exhibit 34: Euro area BBoP vs. Current Account

Source: National sources, Goldman Sachs Global Investment Research.

Source: National sources, Goldman Sachs Global Investment Research.

Exhibit 35: €/$ spot vs. GSDEER

Exhibit 36: US real trade weighted index



-8

-6

-4

-2

0

2

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% of GDP4qtr avg

Current Account BBoP

-5

-4

-3

-2

-1

0

1

2

3

4

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% GDP12-mth ma

BBoP Current Account

0.8

0.9

1

1.1

1.2

1.3

1.4

1.5

1.6

1.7

90 92 94 96 98 00 02 04 06 08 10 12 14

GSDEER EUR/USD Spot

70

80

90

100

110

120

130

140

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

real USD TWI

TWI Appreciation


Fiona Lake

+852 2978-6088

[email protected]


Robin Brooks

(212) 902-8763

[email protected]

Goldman Sachs & Co



How we construct our asset classes

Exhibit 37: Goldman Sachs 3- and 12-month return forecasts by asset class


Exhibit 38: Performance of our asset classes since the last GOAL report

Source: Datastream, Bloomberg, Goldman Sachs Global Investment Research.

Local currency In USD Local currency In USD

Equities 1.8 1.8 10.5 8.4

S&P 500 40 1.1 1.1 6.4 6.4

Stoxx 30 5.4 5.7 15.3 11.3

MXAPJ (in USD) 20 ‐0.9 ‐0.9 8.4 8.4

Topix 10 ‐1.1 ‐2.2 16.2 7.6

10 yr. Government Bonds ‐1.6 ‐1.5 ‐4.7 ‐6.3

US 50 ‐1.5 ‐1.5 ‐4.0 ‐4.0

Germany 50 ‐1.7 ‐1.5 ‐5.4 ‐8.7

5 yr. Corporate Bonds ‐0.3 ‐0.3 ‐0.6 ‐1.2

US: iBoxx USD Dom. Corporates 60 ‐0.5 ‐0.5 ‐1.0 ‐1.0

BAML HY Master Index II 20 0.0 0.0 0.7 0.7

Europe: iBoxx EUR Corporates 20 ‐0.1 0.2 ‐0.4 ‐3.8

Commodities (GSCI Enhanced) ‐0.5 ‐0.5 0.1 0.1

Cash 0.1 0.2 0.5 ‐1.2

US 50 0.1 0.1 0.6 0.6

Germany 50 0.1 0.3 0.5 ‐3.0

FX3 month

target

Return vs

USD

12 month

target

Return vs

USD

EUR/$ 1.35 0.3 1.30 ‐3.4

$/YEN 103 ‐1.1 110 ‐7.4

12‐month Total ReturnAsset Class

Benchmark

Weight3‐month Total Return

97

98

99

100

101

102

103

104

105

23-Jun 30-Jun 07-Jul 14-Jul 21-Jul

Equities S&P 500

Topix MXAPJ

Stoxx Europe 600

94

95

96

97

98

99

100

101


Commodities

99

99.5

100

100.5

101

101.5

102


Government bonds

US 10 year Gov. bonds

German 10 year Gov. bonds

99

99.5

100

100.5

101

101.5

102


Credit

US IG Credit

European IG Credit

US HY Credit



Equity basket disclosure

The Securities Division of the firm may have been consulted as to the various components of the baskets of securities discussed in this report prior to

their launch; however, none of this research, the conclusions expressed herein, nor the timing of this report was shared with the Securities Division.

Note: The ability to trade these baskets will depend upon market conditions, including liquidity and borrow constraints at the time of trade.



Disclosure Appendix

Reg AC

We, Anders Nielsen, Peter Oppenheimer, Charles P. Himmelberg, David J. Kostin, Kathy Matsui and Timothy Moe, CFA, hereby certify that all of the

views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also

certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this

report.

We, Jeffrey Currie, Francesco Garzarelli, Fiona Lake, Aleksandar Timcenko and Dominic Wilson, hereby certify that all of the views expressed in this

report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships.

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As of July 1, 2014, Goldman Sachs Global Investment Research had investment ratings on 3,697 equity securities. Goldman Sachs assigns stocks as

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