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Dominic Wilson
(212) 902-5924 dominic.wilson@gs.com Goldman, Sachs & Co.
Kamakshya Trivedi
+44(20)7051-4005 kamakshya.trivedi@gs.com Goldman Sachs International
Jose Ursua
(212) 357-2234 jose.ursua@gs.com Goldman, Sachs & Co.
George Cole
+44(20)7552-3779 george.cole@gs.com Goldman Sachs International
Julian Richers
(212) 855-0684 julian.richers@gs.com Goldman, Sachs & Co.
Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.
Goldman Sachs
2011 1.8 -0.7 1.5 3.1 1.7 0.6 0.4 0.9 9.3 7.5 2.7 4.3 1.6 7.0 3.8
2012 2.2 1.7 -0.4 1.0 0.2 -2.0 -1.3 -0.1 7.6 5.4 1.5 3.7 1.3 5.5 3.0
2013 1.9 0.3 -0.2 0.8 0.0 -0.8 -1.7 1.4 8.1 6.5 3.8 3.8 1.2 6.1 3.3
2014 2.9 1.1 0.9 1.9 0.6 0.6 -0.2 2.0 8.4 7.2 4.3 4.8 2.1 6.6 4.1
2015 3.2 0.4 1.3 2.1 1.2 0.9 1.0 2.3 8.3 7.2 4.0 4.3 2.3 6.5 4.2
2016 3.0 0.9 1.5 2.2 1.5 1.2 1.8 2.6 8.2 7.5 4.0 3.1 2.4 6.4 4.3
1 See Global Economics Paper 208 : The BRICs 10 Years on: Halfway Through the Great Transformation, December 7, 2011
The oil supply constraint on global growth appears to be loosening. For most of the past decade, the slow growth of global oil production capacity has imposed a speed limit on the global economy. A pick-up in growth quickly resulted in downward pressure on spare capacity in the energy market, upward pressure on energy prices, increases in headline inflation, and adverse effects on real incomes in commodity-importing economies such as the US, the Euro area and most of Asia. However, the structural growth rate of global oil production capacity has risen significantly, and this is already loosening the oil constraint.
Perhaps the most visible change in our new set of forecasts is that we have lengthened our horizon through the end of 2016, an extra two years relative to our previous update schedule. The main reason for this shift is that some central banksespecially the Federal Reservehave adopted forward guidance for short-term interest rates several years into the future as a key instrument of monetary policy. It is difficult to have an informed discussion of whether the mid-2015 guidance for the first hike in the federal funds rate is sensible without a fully specified forecast for how the economy will be doing at that point. Other central banks have not embraced forward guidance quite as enthusiastically as the Fed, but expectations for the first rate hike from the current near-zero level have also moved several years into the future in many places.
OECD Financial Balance Private Sector Financial Balance Public Sector Financial Balance
10 8 6 4 2
2007
2008
2009
2010
2011
2012
Exhibit 2 illustrates the interplay. It shows the financial balancesthe differences between income and spendingof the private and public sector for all DM economies taken together. It is not a coincidence that these balances are near-perfect mirror images of one another. As a matter of double-entry bookkeeping, the private- and public-sector balance must always sum to zero because one persons spending is always another persons income.2 But on an ex ante basis, the private- and public-sector balance need not sum to zero. It is quite possible for different sectors to pursue spending plans that are mutually inconsistent with one another. We believe that such inconsistencies often hold the key to the ups and downs of the business cycle. For example, if an asset price boom induces households and firms to reduce their financial balancei.e., increase their spending relative to their income and finance the difference by increased borrowingand this move is not offset by public-sector restraint, there is an ex ante excess of spending over income and the economy will tend to grow above trend. The strength in economic activity results in stronger output and employment growth, which continues until total income in the economy has caught up with total spending and the accounting identities hold on an ex post basis. Conversely, if concerns about fiscal sustainability induce governments to cut their budget deficits on a cyclically-adjusted basis, and this move is not offset by private-sector expansion, there is an ex ante shortfall of spending versus income and the economy will tend to grow below trend. The weakness in economic activity continues until income has fallen to the level of spending in the economy as a whole. Where is the great race between the private and public sectors likely to take us in the years ahead? We believe that the private-sector side is likely to look increasingly supportive, especially in economies such as the US that have made significant strides in private-sector balance sheet adjustment and where monetary policy is geared strongly towards an easing of financial conditions. In our past work, we have found that the ex ante private-sector balance largely depends on financial conditions, household balance sheet measures such as debt and net worth, and real economic excesses such as the overhang of vacant homes for sale.3 These measures are all improving in the DM economies, albeit at different speeds. Financial conditions have eased substantially in the past year, as long-term interest rates have fallen, equity valuations have recovered and European financial stress has diminished (see Exhibit 3, which shows a GDP-weighted average of our Goldman Sachs Financial Conditions Index (GSFCI) across the DM economies). Likewise, the quality of householdsector balance sheets has improved in recent years, partly as a result of the easing in financial conditions (see Exhibit 4). Since 2009, the household net worth/disposable income ratio has recovered nearly half the prior decline. These ongoing improvements should result in continued gradual declines in the ex ante private-sector financial balance. If the private-sector adjustment were the only impulse, we would likely be forecasting GDP growth significantly above the long-term trend in DM economiesespecially where the balance sheet adjustment is already advanced and monetary policy is strongly geared towards economic recovery. But it is not the only impulse, as the restraint from government budget consolidationan ex ante increase in the public-sector financial balance in terms of Exhibit 2acts as an offsetting drag on growth.
This statement is only strictly true for the world as a whole, but it is not too far from the truth for the OECD as a whole, where the aggregate external balance is typically small. 3 See Jan Hatzius and Sven Jari Stehn, Private Boost, Public Restraint, US Economics Analyst 11/25, June 24, 2011. Goldman Sachs Global Economics, Commodities and Strategy Research 4
As a simple proxy for the size of this drag, Exhibit 5 shows the fiscal impulse measured as (the inverse of) the change in the cyclically adjusted primary budget balance in the two largest DM economies: the US and the Euro area (represented by Germany, France, Italy and Spain). While our figures are rough, they are quite revealing. Since 2010, there has been a turn towards larger and larger negative fiscal impulses. In the US, these have essentially offset the healing in the private sector and kept headline growth at about a trend pace. In the Euro area, they have overwhelmed themore halting and limited healing in the private sector; together with the tightening in financial conditions over the course of 2011, this has pushed the Euro area economy back into recession. The extent of the fiscal drag is close to a peak in both the US and the Euro area. In the US, we estimate that it will increase from 1% of GDP in 2011-2012 to 1% of GDP in 2013. These numbers assume expiration of both the payroll tax cut and the upper-income Bush tax cuts at the end of 2012, as well as smaller sources of restraint such as the new healthcare taxes, the phase-down of emergency unemployment benefits, discretionary spending cuts agreed in the 2011 budget agreement and the wind-down of the 2009 fiscal stimulus package. The added restraint is likely to lead to a further slowdown in the US economy to around 1% in the first quarter of 2013; the slowdown would be greater were it not for the -1 percentage point boost caused by the bounce back from the disruptions associated with Hurricane Sandy, as well as from the 2012 droughts. If resolution of the fiscal cliff remains elusive and/or the size of the fiscal tightening ultimately agreed is even larger than we have assumed, a new recession could result. In the Euro area, the extent and timing of the fiscal drag is harder to estimate with confidence than in the case of the US, largely because of the greater decentralisation of fiscal policy decisions. At the country level, there are some clear shifts, with a reduction in fiscal drag in Italy but a step-up in France. But at the Euro area level, we expect the negative GDP impulse to remain at 1% of GDP in both 2012 and 2013. So the degree of fiscal retrenchment looks similar to the US, although with much greater differences across countries and also with the crucial difference that the private-sector adjustment in the Euro area is less advanced. This is one factor likely to keep the Euro area in recession in early 2013.
1.0 0.0 -1.0 -2.0 2008 2009 2010 2011 2012 2013 2014 2015
But Exhibit 5 also shows that the picture is likely to brighten gradually thereafter. In the US, we are reasonably confident that early 2013 will mark the peak of the fiscal drag, and that the pace of fiscal restraint will slow to %-1% of GDP per year thereafter. If so, and if the boost from changes in the ex ante private-sector balance is no smaller than in prior years, the US economy should gradually accelerate to a trend or above-trend pace. In the Euro area, we also expect a gradual reduction in the pace of fiscal restraint to below 1% of GDP per year, although we are less optimistic about the size of the boost from the private sector and therefore do not expect above-trend growth in Europe for several years to come.
0.80
0.85
0.95
1.00 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan 2010 2011 2012 2013
7 6
GS forecast
5 4 3
Forecast 2 1 0 07 08 09 10 11 12 13 14 15 16
Despite the progress, serious risks remain. While the ECBs measures have contained the virulence of the Euro area crisis and reduced the risk of large spillovers to the rest of the world, they have not resolved the Euro areas underlying structural problems: large competitiveness differentials, poor fiscal positions, large external debt loads in the periphery, weak bank balance sheets and segmented financial markets. Peripheral economies remain deeply depressed and are highly unlikely to achieve the fiscal targets to which they have committed themselves, disappointing policymakers in the core countries. Meanwhile, the combination of economic weakness and fiscal austerity is proving increasingly unpopular in the periphery. This could result in the election of more openly Euro-sceptical governments, willing to defy the wishes of the policy community in the core countries. If so, worries about a failure of the European project could come back onto the agenda. From a more near-term perspective, the biggest risk is that the OMT framework is still untested. Markets have been looking for the Spanish government to apply for an adjustment package under the European Stability Mechanism (ESM)a precondition for OMT purchases of Spanish government bondsfor several months, but so far in vain. Until this application is submitted and approved, and the ECB has started to provide an explicit rather than just implicit backstop, doubts about the central banks commitment will likely continue to linger.
Exhibit 10: Increased ability to bring on oil supply near current prices
120 100 80 60 40 20 0 5,000 10,000 15,000 20,000 25,000 30,000 Oil prices $/bbl
Exhibit 8 also illustrates that the output gap in the developed markets, which we estimate to be around 4.4% of GDP, dominates the picture. The challenges of measuring the output gap (and both the growth and level of potential output) are compounded by the rolling crises across the developed world. But in the US at least, the evidence from the labour market continues to point solidly to the notion that most of the unemployment we see is cyclical rather than structural. And in all of the G4, the evidence suggests that output gaps remain substantial. Despite very easy monetary policy, we continue to see this environment of still ample spare capacity as one that keeps the inflation picture in the major DM economies benign (our forecasts are for relatively stable core inflation in the US, Euro area, UK and Japan). Helping this story of ample spare capacity over the medium term is the shift in US energy production and the way in which that is changing the global oil price outlook. Exhibit 10 shows how our oil equity analysts estimates of the oil supply that can be brought on at current prices has increased sharply over time, as new projects have come on line. After a decade of rising long-term oil prices and structural tightness across commodity markets, we now believe we are in a transition to a new, more stable environment. With increasing capacity to bring significant amounts of oil onto the market at prices not far from current levels, the global supply curve for energy is effectively flattening out and the constraint that oil prices have played on global growth in the last 5-10 years is loosening. Global growth above 4% will still put cyclical pressure on oil prices. But if global demand growth can recover, the prospects of the global economy hitting a hard constraint from energy supplyas it did in 2008would diminish. Further out, we may even see a positive supply shock that lowers long-term prices. With high unemployment and benign inflation, the developed world outlook continues to be one in which monetary policy is likely to stay easy for a very substantial period of time. As Exhibit 9 shows, we envisage that the world of zero G4 rates will last until at least mid2015. Unconventional monetary policies are also set to continue. In the US our forecasts imply that the open-ended QE programme will last until early 2015, with the first hike not coming until 2016. We expect a shiftprobably quite soonto more explicit forward guidance from the Fed in terms of economic outcomes rather than dates. But on our forecasts, that kind of guidance is likely to reinforce the notion of a commitment to zero rates that lasts beyond the Feds current time commitment. Elsewhere, the prospects of more aggressive action from the BoJ are rising as a new governmentand a new head of the BoJraise the prospects of a more aggressive approach to inflation targeting and QE
Goldman Sachs Global Economics, Commodities and Strategy Research 8
there. In the Euro area, the policy options remain more complicated given the segmentation of markets, but we think the bias towards further easing will remain there too, as it will in the UK.
*Close November 27, 2012 ** Investment grade credit spreads to UST and bunds Source: GS Global ECS Research.
The combination of spare capacity, benign inflation and continued QE means that we expect bond yields to remain at relatively low levels in the major developed markets for an extended period. However, as the growth recovery solidifies in the US and beyond, and we slowly approach the monetary policy exit, we forecast a gradual but steady rise in bond yields, as reflected in our Sudoku model outputs, which we expect to be reflected in the real rate profile. With the US 10-year bond yield moving to 3.75%, our forecasts lie above the forwards but leave real yields well below pre-crisis levels even at that horizon. Although the forecasts imply a gradual shift in the term premium from ultra-depressed levels, they still imply that central bank balance sheet expansion is weighing on the term premium even by late 2016. Our currency forecasts point to a modest USD trade-weighted depreciation in the next two years, driven by the Feds more aggressive easing posture and the ongoing US financing requirement. In our modal case, EUR/$ appreciates moderately, helped by a mild decline in sovereign risks and a more proactive easing stance from the Fed. Of course, the tail risks that we described, particularly earlier in the year, would see downside here if they occur. In $/JPY, our central case is that BoJ easingwhile more aggressivewill be sufficient to stop JPY appreciation but not enough to compensate for an easy Fed or to push the JPY weaker. In EM, we expect appreciation in the BRICs and much of Asia in 2013, with some
Goldman Sachs Global Economics, Commodities and Strategy Research 10
depreciation elsewhere (Turkey, most notably). As we move through 2015-2016, we have built in assumptions of a gradual return to GSDEER fair value. With the market starting to anticipate a Fed exit, alongside USD undervaluation, we envisage some USD strengthening at that stage, with EUR/$ falling back and $/JPY finally moving higher. Our commodity views reflect the combination of cyclical tightness and structural stability described above. We expect curves to remain backwardated in oil and several other commodities, reflecting that cyclical strength. We see support for oil prices (we expect Brent to average $110/bbl in 2013 and end the year at $105/bbl) but not the kind of sharp upside that we have forecast at times in the past. And while it is hard to be certain about the timing of the relaxation of the global energy supply constraint, our longer-term forecasts envisage a gradual decline in oil prices. In metals, Chinas construction cycle plays an important rolehelping to drive copper higher in the short term, but lower beyond that; and putting further downward pressure on iron ore. Reflecting the changing commodity price picture, our forecasts for the commodity currencies (AUD in particular) are lower than in past years. The combination of unusually low real bond yields, a move towards a more stable recovery path and supportive monetary policy underpins a benign environment for equities. We are forecasting double-digit price returns from the major equity markets next year. Valuation is a key driver here and the comparison of dividend yields to bond yields continues to make stocks look relatively attractive. Within that, our Portfolio Strategy teams expect investors to reward growth across a broad range of geographies. While our forecasts for EM returns are higher than in DM, the differential is not so large that it clearly compensates for higher risk or volatility. But our forecasts do imply higher returns in Asia (including Japan) than elsewhere. The key challenges for stocks are the same as those for the broader macro picture: a period of weak growth in the US and globally early in 2013 as fiscal restraint bites, and fresh tail risks from Europe. In that sense, the notion of getting over the hump applies strongly here too. If markets can become comfortable that some of the risks in early 2013 are temporary, they should be able to look to a steadier and stronger growth path beyond.
The outlook presented here represents the work of the entire ECS team globally. Our Portfolio Strategy and Commodities teams provided the equity index targets and commodities forecasts, and our Global Macro and Markets team provided the FX, Bond Yield and Credit forecasts.
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Source: Goldman Sachs Global ECS Research. For India we use WPI not CPI. For a list of the members within groups, please refer to ERWIN. For our latest Bond, Currency and GSDEER forecasts, please refer to the Goldman Sachs 360 website: (https://360.gs.com/gs/portal/research/econ/econmarkets/).
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See Global Economics Weekly 12/18 for methodology Source: OECD, Goldman Sachs Global ECS Research.
* Includes OECD countries plus BRICs, Indonesia and South Africa See Global Economics Paper 199 for methodology Source: OECD, Goldman Sachs Global ECS Research.
GLI swirlogram
0.15% 0.10% Jul-12 0.05%
GLI Acceleration
Recovery
110
Index
Dec-11
100
0.00%
Jun-12
Jan-12
90
-0.20% -0.4% -0.3% -0.2% -0.1% 0.0% 0.1% 0.2% 0.3% 0.4%
GLI Growth
Contraction
Slowdown
70 Jan-11
May-11
Sep-11
Jan-12
May-12
Sep-12
See Global Economics Paper 214 for methodology Source: OECD, Goldman Sachs Global ECS Research.
See Global Economics Weekly 12/15 for methodology Source: Goldman Sachs Global ECS Research.
See Global Economics Weekly 02/35 for methodology Source: Goldman Sachs Global ECS Research.
See Global Economics Weekly 03/25 for methodology Source: Goldman Sachs Global ECS Research.
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Disclosure Appendix
Reg AC
We, Jan Hatzius, Dominic Wilson, Kamakshya Trivedi, Jose Ursua, George Cole and Julian Richers, 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.
Disclosures
Global product; distributing entities
The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs Australia Pty Ltd (ABN 21 006 797 897); in Brazil by Goldman Sachs do Brasil Corretora de Ttulos e Valores Mobilirios S.A.; in Canada by Goldman, Sachs & Co. regarding Canadian equities and by Goldman, Sachs & Co. (all other research); in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs (India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs New Zealand Limited; in Russia by OOO Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman, Sachs & Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union.
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