November 28, 2012

Issue No: 12/39

Global Economics Weekly

Economics Research

Moving over the hump

On the surface, our global economic forecasts for 2013 look quite similar to 2012. We expect real GDP to grow 3.3%, slightly above the 3.0% we now estimate for 2012 but well below our 4.2% estimate of potential growth. The ample amount of spare capacity, especially in the developed market economies, is likely to keep inflation very subdued and monetary policy very accommodative. But our view differs in importantand generally encouragingways from a year ago. First, the time profile of growth both in the US and the Euro area looks better. Assuming the world can muddle through the weakness we expect early in the year as a consequence of even greater fiscal contraction, growth should pick up in the second half of the year. Further gradual acceleration is likely in subsequent years, as shown in our now-expanded global economic forecasts for 2014-2016. Second, the recent progress in containing the Euro area crisis marks an important difference compared with last year. ECB President Draghi has made it clearer than before that the ECB will not tolerate a significant convertibility premium in peripheral European bond yields. This has reduced the risk of financial spillovers from Europe to other regions, including the US and Asia. Third, the oil supply constraint on global growth appears to be loosening. For most of the past decade, constraints on oil production capacity have 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. However, both the structural growth rate of global oil supply and its elasticity to higher prices have risen significantly in the wake of the shale revolution. These economic forecasts translate into relatively benign asset market views. In our modal case, we expect equity prices to rise by 10%-15%, bond yields to edge up slightly more than the forwards, the Dollar to depreciate modestly, and commodities to trade sideways. That said, the risks to our modal forecasts for the economy and for asset markets are tilted to the downside over the next few months, at least until the US fiscal cliff is safely behind us.
Jan Hatzius
(212) 902-0394 jan.hatzius@gs.com Goldman, Sachs & Co.

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.

The Goldman Sachs Group, Inc.

Goldman Sachs

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Global Economics Weekly

Moving over the hump

On the surface, our global economic forecasts for 2013 look quite similar to 2012. We expect global GDP to grow 3.3% in real terms, slightly above the 3.0% we now estimate for 2012 but well below our estimate of global potential GDP growth of around 4.2%1 (see Exhibit 1). The still-sluggish growth pace reflects many of the same factors as in prior years, namely the restrictive stance of fiscal policy and the continued financial tensions in the Euro area. Ample spare capacity, especially in the developed market (DM) economies, is likely to keep inflation very subdued and monetary policy very accommodative. But our view differs in importantand generally more encouragingways from last year: The time profile of growth both in the US and the Euro area looks quite different. We worry about economic weakness in the early part of the year, when the impulse from fiscal policy will be at its most negative. Indeed, we have downgraded our forecasts for the Euro area further and now expect the contraction to last through mid-year 2013. But if the world manages to muddle through the first half of the yearour baseline assumptiongrowth should pick up in the second half, especially in the US. A further gradual acceleration is likely in 2014-2015, when the drag from fiscal policy is likely to diminish, while monetary policy looks set to remain highly accommodative. The recent progress in containing the Euro area crisis and its spillovers to the rest of the world marks an important difference compared with last year. President of the European Central Bank Draghi has made it clearer than before that the ECB will not tolerate significant convertibility risk in peripheral European bond yields. The Outright Monetary Transactions (OMT) framework that is supposed to govern ECB interventions at the front end of peripheral government bond markets is still untested, many questions of implementation remain and the economic outlook for the periphery remains poor. But we are cautiously optimistic that Mr. Draghis pledge has reduced the tail risk of near-term financial instability, and thus also the risk of greater spillovers to other regions, including the US and Asia.

Exhibit 1: Global GDP growth forecasts 2012-2016

% yoy USA Japan Euro Area Germany France Italy Spain UK China India Brazil Russia Developed Markets Emerging Markets World
Source: GS Global ECS Research.

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

Goldman Sachs Global Economics, Commodities and Strategy Research

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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.

The great race between the private and public sector

The post-crisis world economy remains caught between a gradual growth boost resulting from the progress in financial adjustment in the private sector and an increasing growth drag from public-sector retrenchment. At the global level, these two forces have kept GDP growth slightly below trend. At the regional level, however, they have at times been quite unbalanced, leading to episodes of strong recovery and deep recession.

Exhibit 2: Private healing, public restraint

10 8 6 4 2 0 -2 -4 -6 -8 Financial Balance = Income less spending -10 1970 1976 1982 1988 1994 2000
Source: OECD; GS Global ECS Research.
% of GDP

Exhibit 3: DM financial conditions have eased

% of GDP

OECD Financial Balance Private Sector Financial Balance Public Sector Financial Balance

10 8 6 4 2

102.0 101.5 101.0 100.5 100.0 99.5 99.0 98.5 98.0

Goldman Sachs Financial Conditions Index, Developed Markets

0 -2 -4 -6 -8 -10 2006 2012 Forecast

Easier Financial Conditions

2007

2008

2009

2010

2011

2012

Source: GS Global ECS Research.

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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

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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.

Exhibit 4: Some recovery in household net worth

730 710 690 670 650 630 610 590 570 550
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Exhibit 5: An increase in fiscal drag, then relief

4.0 % of GDP

Household net worth as % of disposable income, G7 aggregate 3.0 2.0

Fiscal Impulse US Euro-4 (Germany, France, Italy, Spain) Forecasts

1.0 0.0 -1.0 -2.0 2008 2009 2010 2011 2012 2013 2014 2015

Source: OECD, 2011/2012 are forecasts.

Source: IMF; GS Global ECS Research.

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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.

Less risk of spillovers from Europe

A year ago, most investors put dissolution of the Euro area at the top of their list of concerns about the global economy. Their key worry was the feedback loop between rising peripheral bond spreads, stress on bank balance sheets, reductions in bank lending, weakness in economic activity, deteriorating fiscal positions and rising doubts about the ability of peripheral countries to service their debts, illustrated in Exhibit 6. Markets were unconvinced of the willingness and/or ability of policymakersfirst and foremost the ECBto break this feedback loop. As a result, peripheral bond spreads and other measures of European financial stress surged to levels implying a clear risk of a Euro break-up. The intensifying crisis quickly spilled over to other parts of the world economy, primarily via a tightening in financial conditions. Exhibit 7 plots our summary measure of European financial stressmeasured as the first principal component of European bank stock prices, European bank CDS, European sovereign CDS and the EUR/USD cross-currency basis spreadagainst our US GSFCI. Since the middle of 2011, the two measures have moved almost in lockstep with one another. We interpret this close correlation mainly as a spillover from the European crisis into broader global financial and economic conditions. But Exhibit 7 also shows that European developments have more recently triggered a significant easing in financial conditions in other parts of the world, including the US. The main reason is that the ECB under President Draghi has made a much more determined effort to assert the irreversibility of the Euro, providing a framework for backstopping both private banks (via the long-term refinancing operations) and peripheral governments (via the still-nascent Outright Monetary Transactions programme). Moreover, this has happened with the support of the German government, a prerequisite for any successful stabilisation scheme. Exhibit 6: The European feedback loop
Fiscal Crisis Lower Tax Receipts Expected Bailout Costs Fiscal Austerity

Exhibit 7: European stress relief helps FCI easing

100.6 100.4 Index Index Worse 0.75

Bank Solvency Concerns

100.2 100.0 99.8 99.6

0.80

0.85

0.90 GSFCI (left) Euro Risk (right, inverted)

Loan Losses Banking Crisis Reduced Loan Supply Economic Crisis

99.4 99.2 99.0

0.95

1.00 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan 2010 2011 2012 2013

Source: GS Global ECS Research.

Source: GS Global ECS Research.

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Exhibit 8: Room to grow, but still mostly in DM

Estimated Output gaps as % of GDP, forecasts after 2012
5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% -5.0% -6.0% 04 05 06 07 08 09 10 11 12 13 14 15 16 % GDP EM DM World

Exhibit 9: A long period of low rates still ahead

7 6
GS forecast

Policy rates (%)

USA Euro area Japan UK

5 4 3

Forecast 2 1 0 07 08 09 10 11 12 13 14 15 16

Source: GS Global ECS Research.

Source: GS Global ECS Research.

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.

Still a lot of room to grow

If these near-term risks can be navigated, the prospects beyond that look significantly brighter. In part, this is because the global economy still has plenty of room to grow before running into the kinds of constraints on capacity that normally generate tightening, and ultimately the end of expansion periods. Exhibit 8 shows that the flipside of the relative weakness of growth in the past year or two is that the global output gap our best guess of spare capacitystill stands at around 2.5% of GDP.

Goldman Sachs Global Economics, Commodities and Strategy Research

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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

Top 230 2009

Top 280 2010

Top 330 2011 Top 360 current

Cumulative Peak Crude Oil Production (kbls/d)

Source: Goldman Sachs Oil & Gas Equity Research.

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
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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.

EM still has limited room for above-trend growth

Compared with the abundant slack in the developed economies, Exhibit 8 also shows that most of the emerging world has less spare capacity. But after a period of sub-trend growth here, the substantial positive output gap across emerging markets (EM) that developed from the sharp early recovery in 2009 and 2010 has been eroded. The challenges of estimating output gaps are even greater here (in practice, we rely on a couple of different methods and compare them). Our best guess is that the EM world too shows a roughly zero output gap. But this still means that for the first time in several years, there may be room for trend growth here too, albeit with significant variation across countries. We expect this room to be exploited. Easier financial conditions in many EM economies over the last 6-12 months create the backdrop for a rebound in domestic demand. And although in absolute terms our growth forecasts for EM (at 6.1% for 2013 and 6.6% for 2014) are well below pre-crisis levels, and indeed below the 2010 and 2011 rates, we do envisage that 2013 and 2014 will show some acceleration in EM GDP growth. In the last five years, that has only happened once (in 2010). The reason not to expect a return to stronger growth than this isat its most basicthat spare capacity is still quite limited and underlying inflation pressures are, as a result, less dormant in many EM economies. As a result, while a more positive global impulse is more likely to translate into better observed growth in the DM world, it is more likely to lead to inflationary pressure in the EM world. Lingering concerns about the pace of credit creation or housing imbalances in some countries (China and to a degree Brazil) or current account deficits in others (India, Turkey) may also mean that policymakers will be more reluctant to tolerate a significant acceleration in growth than at times in the past. We do not expect those pressures to build immediatelyand they vary greatly by country. But we do envisage a pick-up in inflation across many EM countries as we move towards the later part of 2013. We also foresee tightening in a number of economies as the year progressesthrough both monetary policy and greater tolerance of FX appreciation. And we think that a number of economiesincluding Brazil and Turkeywill rely in part on alternative measures to policy rates and currencies to curb liquidity or credit. The outlook for China still dominates the EM outlook in many areas, and here we expect a modest improvement in the growth picture (to a little above 8% in 2013 and a little higher than that in the years beyond). But the story is more one of stabilising growth than of a sharp reacceleration, and these growth outcomes represent a meaningful downshift in growth from the average rates of the last decade. Moreover, while we expect policy to be generally supportive of growth, we think that even with the completion of the transition to the new leadership group, policymakers will remain more cautious about the pace of growth that they are targeting given the importance of other goals.

Goldman Sachs Global Economics, Commodities and Strategy Research

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Higher bond yields, weaker Dollar, stronger equities

We discuss the top market themes for 2013 that stem from this macro picture in a separate publication. But we summarise the key market forecasts, set out in Exhibit 11, briefly here. We are also extending these forecasts to 2016, alongside the economic path. Exhibit 11: Key market forecasts, 2012-2016
Current* Equities TOPIX MXAPJ Stoxx Europe 600 S&P 500 10 Year Bond Yields (%) Germany Japan UK US FX EUR/$ EUR/GBP AUD/$ $/JPY $/CNY $/BRL $/INR $/RUB USD TWI Credit IG (spreads, bp)** US Europe Commodities Brent ($/bbl) Soybean (Cent/bu) Corn (Cent/bu) 114 1,200 525 105 1,200 525 105 1,200 525 100 1,200 525 85 1,200 525 135 179 104 156 102 127 100 115 99 114 1.29 0.81 1.04 82.2 6.29 2.09 55.5 31.1 89.5 1.40 0.85 0.98 80.0 6.10 2.00 52.0 29.0 86.2 1.40 0.85 0.95 80.0 6.05 2.07 50.0 28.7 86.1 1.35 0.85 0.89 85.0 6.27 2.16 51.0 30.4 88.8 1.25 0.85 0.84 90.0 6.37 2.26 52.0 32.4 92.7 1.39 0.72 1.79 1.62 1.90 1.00 2.25 2.20 2.00 1.25 2.50 2.75 2.50 1.30 2.75 3.25 3.00 1.75 3.50 3.75 782 447 273 1,399 930 520 310 1,575 End-2013 End-2014 End-2015 End-2016

*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 $/JPY, our central case is that BoJ easingwhile more aggressivewill be sufficient to stop JPY appreciation but not enough to compensate for an easy Fed or to push the JPY weaker. In EM, we expect appreciation in the BRICs and much of Asia in 2013, with some
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depreciation elsewhere (Turkey, most notably). As we move through 2015-2016, we have built in assumptions of a gradual return to GSDEER fair value. With the market starting to anticipate a Fed exit, alongside USD undervaluation, we envisage some USD strengthening at that stage, with EUR/$ 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.

Jan Hatzius and Dominic Wilson

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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Global economic forecasts

Real GDP, %ch yoy
2013 G3 USA Euro area Japan Advanced Economies Australia Canada France Germany Italy New Zealand Norway Spain Sweden Switzerland UK Asia China Hong Kong India Indonesia Malaysia Philippines Singapore South Korea Taiwan Thailand CEEMEA Czech Republic Hungary Poland Russia South Africa Turkey Latin America Argentina Brazil Chile Mexico Venezuela Regional Aggregates BRICS G7 EU27 G20 Asia ex Japan Central and Eastern Europe Latin America Emerging Markets Advanced Economies World 1.9 -0.2 0.3 2.7 2.2 0.0 0.8 -0.8 2.5 1.6 -1.7 1.7 1.0 1.4 8.1 3.7 6.5 6.4 5.3 5.5 3.0 3.4 3.5 4.8 0.2 0.0 1.7 3.8 2.6 5.5 3.8 3.8 4.9 3.6 3.0 6.8 1.2 0.2 3.3 6.9 1.1 4.0 6.1 1.2 3.3 2014 2.9 0.9 1.1 2.9 2.5 0.6 1.9 0.6 2.3 2.3 -0.2 3.0 1.3 2.0 8.4 4.5 7.2 6.5 5.5 5.5 4.0 4.0 4.2 5.0 1.8 1.2 3.0 4.7 3.4 4.2 3.1 4.3 4.8 3.8 2.8 7.4 2.2 1.2 4.1 7.3 2.4 4.1 6.6 2.1 4.1 2015 3.2 1.3 0.4 2.5 2.5 1.2 2.1 0.9 1.7 1.9 1.0 3.0 1.4 2.3 8.3 4.3 7.2 6.7 5.6 5.6 4.2 3.8 4.0 5.2 2.4 1.5 3.4 4.3 3.8 4.5 2.6 4.0 4.6 3.6 2.6 7.3 2.3 1.6 4.2 7.3 2.9 3.8 6.5 2.3 4.2 2016 3.0 1.5 0.9 3.6 2.5 1.5 2.2 1.2 2.6 1.9 1.8 2.9 1.5 2.6 8.2 4.1 7.5 6.7 5.6 5.8 4.5 3.8 4.0 5.5 2.5 1.7 3.5 3.1 3.2 3.0 2.6 4.0 4.6 3.6 1.0 7.2 2.4 1.9 4.3 7.3 3.0 3.8 6.4 2.4 4.3

Consumer Prices, %ch yoy

2013 G3 USA Euro area Japan Advanced Economies Australia Canada France Germany Italy New Zealand Norway Spain Sweden Switzerland UK Asia China Hong Kong India Indonesia Malaysia Philippines Singapore South Korea Taiwan Thailand CEEMEA Czech Republic Hungary Poland Russia South Africa Turkey Latin America Argentina Brazil Chile Mexico Venezuela Regional Aggregates BRICS G7 EU27 G20 Asia ex Japan Central and Eastern Europe Latin America Emerging Markets Advanced Economies World 2.0 2.0 0.1 3.0 1.7 1.7 2.0 2.0 1.6 2.2 2.6 0.6 0.6 2.6 3.0 3.6 7.2 5.7 2.6 4.2 4.1 2.7 2.0 4.1 1.9 4.7 2.3 6.6 5.6 7.4 10.8 5.3 2.7 3.7 25.0 4.5 1.7 2.1 3.1 4.0 2.6 6.2 5.0 1.9 3.2 2014 1.7 1.7 1.9 2.7 2.0 1.8 2.2 1.6 2.0 2.2 1.7 2.9 0.8 1.9 3.6 3.5 6.0 5.3 2.5 3.8 3.6 3.0 2.0 3.8 1.7 3.5 2.1 5.6 4.5 6.7 12.7 5.3 2.8 3.6 23.1 4.5 1.8 1.8 3.1 4.0 2.2 6.3 4.9 1.9 3.2 2015 2.0 1.7 1.2 2.7 2.0 1.8 2.5 1.7 2.0 2.6 1.4 2.8 1.1 1.8 3.7 3.5 5.3 5.5 2.8 3.5 3.5 2.9 2.1 3.6 1.9 3.3 2.3 5.3 6.0 6.6 12.4 5.3 3.1 3.0 20.8 4.3 1.9 1.8 3.1 4.0 2.4 5.9 4.7 1.9 3.2 2016 2.0 1.9 1.5 2.6 2.0 1.9 2.9 1.9 1.9 2.5 1.3 2.6 1.6 1.7 3.3 3.1 4.7 5.5 2.8 3.5 3.2 2.8 1.9 3.5 1.7 3.2 2.6 4.6 5.4 6.9 12.0 4.9 3.0 3.0 20.0 3.9 2.0 1.9 3.0 3.6 2.5 5.6 4.3 2.0 3.1

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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Global macro and markets charts

PMI-implied global growth
8 6 4 2 0 -2 -4 -6 -8 03 04 Global PMI Model-Implied Growth Global Actual Sequential Growth GS Forecast 05 06 07 08 09 10 11 12 13 % qoq annl

GLI momentum vs. global industrial production*

2 %mom 1 0 -1 -2 -3 -4 GLI Momentum Global Industrial Production*, 3mma 00 01 02 03 04 05 06 07 08 09 10 11 12 13

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

China, Europe and US risk factors

Nov-11 Aug-12 Sep-12 Oct-12 Nov-12 May-12 Feb-12 Apr-12 Mar-12
80
Expansion

110

Index

Europe Risk China Risk US Risk

Dec-11
100

0.00%

Jun-12

Jan-12

-0.05% -0.10% -0.15%

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.

US equity risk premium

6.5 6.1 5.7 5.3 4.9 4.5 4.1 3.7 3.3 2.9 2.5 2.1 1.7 04 05 06 07 08 09 10 11 12 13 % US ERP, calculated daily US ERP, 200 Day Moving Average

US equity credit premium

5 4 3 2 1 0 -1 -2 -3 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 2 standard deviations band 1985-1998 average Credit relatively expensive %

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
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