29 OCTOBER 2013

Credit Cycles and Sustainability in Growth and Emerging Markets

Developed Markets (DM) data disappointed in October pointing to some loss
of momentum. Despite the set-back, we continue to expect stronger growth across DM, lead by the US as well as Euro area, with peripheral countries coming out of recession by the end of 2013.

Growth and Emerging Markets (Growth and EM) continued printing mixed
data throughout October, but overall growth momentum turned more positive on balance.

With the Feds liquidity provision in place for longer, we expect risk assets,
particularly equities, to benefit the most into the year end. In our tactical portfolios, we are overweight DM equities and underweight DM rates.

The re-emphasis on monetary accommodation should also continue to

provide relief for broad Growth and EM assets, though we still expect to see differentiation along the axis of the domestic growth story and external vulnerabilities which need to correct further.

In our Focus Piece we look at private sector credit across Growth and EM
and scan for signs of potential vulnerabilities in terms of the impact on growth cycles and sustainability. For now, the key indicators of credit across these countries reveal a relatively benign picture overall.

After a period of sharp slowdown, some countries, such as Mexico, are

showing signs of credit acceleration which should bode better for their shorter-term growth prospects. And while the pace of credit accumulation in some countries, particularly Turkey and Thailand, could point to potential overheating, their credit-to-GDP ratios are less concerning.

From a shorter-term perspective, we see more risks around further credit

slowdown, rather than overheating. Higher rates globally and intensifying inflationary pressures domestically could constrain credit expansion over the next few months.

In the longer term, the challenge of managing risks from a universally rapid
post-crisis credit expansion remains, particularly in countries where debt levels are already high. China is probably the best example of this challenge today, particularly given its systemic importance in the global economy.

GSAM Macro Insights

Macro Trends and Views

US We believe the US government shutdown had a relatively
small economic impact, probably detracting less than 0.5pp from Q4 GDP growth.

Euro Area Euro area data was mixed in October. Some national
surveys of consumer and business confidence have pointed to a continuing recovery in sentiment.

US data pointed to some loss of momentum in October,

particularly in the housing sector. However, distortions in the labour market indicators complicate interpretations and forward-looking components of latest activity surveys were still encouraging.

However, the latest Flash PMIs for the core economies

disappointed, both on the headline and components, as well as across sectors. We will be watching the final PMIs for October to see if this trend is confirmed in the core as well as in the periphery.

The nomination of Janet Yellen as the next Fed chair, in

line with expectations, suggests that US monetary policy will likely remain very accommodative for longer.
000's 300 250 200 150 100 50 Jan-12 A broader range of labour market indicators suggest the improving trend is still intact
Sep '13 estimate

Despite some data weakness, we continue to expect a

gradual recovery in Euro area growth, with peripheral countries coming out of recession by the end of 2013.
Index 55 54 53 52 51 50 49 October Flash PMIs point to a slower pace of Euro area recovery Previous Flash >50 implies expansion

Labor market tracker (3m average)* Actual payrolls growth (3m average) Jul-12 Jan-13 Jul-13

48 47 France Mfg France Germany Germany Euro area Euro area Svs Mfg Svs Mfg Svs

* First principal component of key US labor market indicators; scaled to NFPs Source: GS Global ECS Research

Source: Bloomberg

Japan Our current activity indicator for Japan has fallen sharply
recently as data improvements have stalled. This points to a weaker Q3 growth relative to H1 of this year.

Growth Markets Chinas Q3 GDP was in line with expectations at 7.8%

yoy, with investment contributing over half to this headline. We expect momentum to subside in Q4 as the boost from the mini-stimulus package subsides.

Inflation continues to move higher. The latest headline

release for September came in above expectations at 1.1% and core is now above 0.0%. The April consumption tax hike to 8% from 5% has been confirmed, together with a fiscal package that is intended to soften its impact. We will be watching the upcoming Autumn Diet for developments surrounding Abes third arrow.
% 15 10 5 0 -5 -10 -15 -20 02 03 04 05 06 07 08 09 10 11 12 13
Source: Haver Analytics and GSAM
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Other Growth Markets continued printing mixed data

throughout October, but overall growth momentum turned more positive on balance. Koreas GDP positively surprised with a 3.3%yoy print for Q3.

Growth Markets have seen a general uptick in inflation

over the past few months. In our Focus Piece we point out that this could pose downside risks to credit growth.
%yoy 9 8 7 6 5 4 3 2 1 0
Indonesia Turkey

Recent data suggests economic activity in Japan has softened GSAM activity indicator GDP %qoq annualised

Inflationary pressures are building up across Growth Markets Current (30/9/2013) Central bank target (official or otherwise)

China

Brazil

India

Source: Haver Analytics and GSAM

October 2013

South Korea

Russia

Mexico

GSAM Macro Insights

Market Trends and Asset Allocation Views

Despite a weak start to the month, global equities performed strongly in October, gaining over 5.0% from their lows for the month. Europes peripheral markets outperformed, with Greek equities posting gains of over 13.0% month to date. Growth and EM equities also had a strong month on average. India, Turkey and Indonesia have led the field while Mexico and China lagged. Rates rallied globally throughout October as investors expectations of the Feds taper date got pushed back by the political stalemate in Washington. This fed through to broad USD weakness, with AUD and several EM currencies strengthening significantly against USD, while JPY remained range-bound. The commodities spectrum was broadly unchanged for the month. Once again, events in the US continue to be the key market drivers. The resolution of the fiscal stand-off in Washington has re-focused market attention on monetary policy. The agreement reached has provided spending authority until 15 January 2014, while the debt limit was suspended until 7 February 2014. This short-term fix has raised concerns about uncertainty acting as a drag on growth as well as a slightly larger fiscal drag. Coupled with some loss of momentum in October as evidenced by recent data, consensus now expects tapering to begin in the first quarter of next year. In addition, given Yellens well documented dovish monetary policy stance, the case for the continuation of the very loose monetary policy is now even stronger. This accommodative environment seems to have positioned the market in a very similar place to the start of this year, before the first tapering suggestions in May. As the exhibit below shows, the US financial conditions are now back roughly in line with the levels seen in January. However, we
Index 100.3 100.2 100.1 100.0 99.9
Fixed Income

believe that the US recovery has not been derailed by recent events. The private sector remains strong and the fiscal drag is ultimately set to abate as we head into the new year. Also, with the bar now set so low, there is even a chance that the US government could positively surprise in the coming months. Therefore, we believe the downside for rates is limited from here, and the recent bout of USD weakness is set to reverse. Nevertheless, with the Feds liquidity provision in place for longer, we expect risk assets, particularly equities, to benefit the most into the year end. Looking further out we believe stronger growth should provide some cushion to equities when the Fed ultimately takes the decision to slow the pace of its asset purchases. In digesting this, however, markets are unlikely to escape completely unscathed. The re-emphasis on monetary accommodation should also continue to provide relief for broad Growth and EM assets, though we still expect to see differentiation along the axis of the domestic growth story and external vulnerabilities which need to correct further. In our Focus Piece we point out that credit growth will be one area to watch to get an idea of the shorter-term growth dynamics. Our views over the 12-month horizon remain unchanged, as shown in the table below. In our tactical portfolios, we are overweight DM equities and underweight DM rates and are looking to add to this short rates stance in the near term. In our view, the theme of equity versus debt outperformance is likely to occur within the EM asset complex too. And while our outlook on Growth and EM assets remains neutral, we have exposure to the pockets of value that we see as most attractive.

US financial conditions are back to their pre-summer levels US Financial Conditions Index

Asset allocation views on a 1-year horizon*

Less More Attractive Attractive
US Equity

Change -

Equity

Easing

European Equity Japanese Equity Growth Markets Equity EMD Local Corporate Credit High Yield DM Sovereign Debt

99.8 99.7 99.6 99.5 99.4 Jan-12 May-12 Sep-12 Jan-13 Jun-13 Oct-13

Real Cash Assets

Commodities Cash

Source: GS Global ECS Research

* Note that this does not account for liability-driven investment. Source: GSAM Global Portfolio Solutions. As of Sep 2013.

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October 2013

GSAM Macro Insights

Focus Piece: Credit Cycles and Sustainability in Growth and Emerging Markets
Growth and EM countries rebounded strongly after the global financial crisis. While weak DM demand undoubtedly weighed on their export-oriented growth models, private sector credit provided a significant offsetting growth driver in many places. As Exhibit 1 illustrates, real private sector credit growth across Growth and EM accelerated rapidly in the aftermath of the crisis, even though growth rates generally remained below pre-crisis levels.1 Having peaked at the end of 2011, private sector credit growth has been on a downward trend, falling especially sharply in the second half of last year. Reasons for this deceleration varied across countries. Some central banks had to hike rates due to capacity constraints and inflationary pressures. More recently, capital outflows from Growth and EM driven by expectations of lower global liquidity reduced the availability of financing. Disappointing GDP growth across this universe over the past couple of years has partly been a consequence of this slower credit expansion. Nonetheless, amidst the slowdown in credit flows, the stock of credit has continued rising as Exhibit 2 shows. While credit growth is generally good for boosting domestic demand and overall growth, especially from a shorter-term perspective, a fast pace of accumulation and/or high credit stock can be signs of dangerous financial imbalances that could result in a crisis.2 We look at the main credit metrics across the Growth and EM universe to identify places which are well positioned to benefit from current credit expansion cyclically. We also look at those which could see downside growth risks from slowing credit and scan for signs of potential vulnerabilities where credit expansion might prove unsustainable.3
%yoy 25 20 15 10 5 0 -5 03 04 05 06 07 08 09 10 11 12 13
Source: Haver Analytics and GSAM. *GDP weighted averages
1

Is credit growth sustainable?

As Exhibit 3 illustrates, the majority of countries continue to see strong positive growth in private sector credit in real terms. While the pace is below the post-crisis peaks on average, current annual growth rates are higher in a number of countries, particularly in Turkey, Thailand, Mexico and Russia. At the same time, credit growth in Central European economies, Nigeria and Brazil is significantly lower relative to their respective post-crisis averages. To pick up the shorter-term dynamic, we look at credit acceleration, or rather a proxy for this measure; the difference between the current quarter-on-quarter annualised growth and year-on-year growth, standardized relative to each countrys history. This allows for more consistent cross country comparison, eliminating individual country level biases. As Exhibit 4 shows, there is a significant divergence in credit momentum across EM countries, with primarily LatAm countries (Peru, Chile, Mexico) showing meaningful acceleration relative to their history, potentially pointing to better growth prospects in the near term. Conversely, Turkey, China, Brazil, and Indonesia are showing signs of sequential credit deceleration, suggesting near-term risks around their growth trajectories. While the slow credit expansion (or, in some cases, contraction) is clearly worrying from a future growth perspective, countries with high credit growth could face a different issuethat of sustainability. Extensive literature exploring the link between credit growth and financial crises often uses the deviation of real credit from its trend to assess potential risks of a credit boom.4 While there are no clearly defined thresholds, a cyclical component that is
% GDP 100% 90% Growth and EM* 80% 70% 60% 50% 40% 02 03 04 05 06 07 08 09 10 11 12 13
Source: Haver Analytics and GSAM. *GDP weighted averages

Exhibit 1- Private sector credit growth decelerated in H2 2012 but has since stabilised Growth and EM* Growth and EM ex-China*

Exhibit 2 - Growth and EM credit stock continues to accumulate Private sector credit as a share of GDP

Growth and EM ex-China*

Due to data availability, all data in this piece refers to bank credit to the private sector, omitting other sources of credit such as bond markets, nonfinancial intermediaries, trade credit, shadow and informal finance etc. On the relationship between credit growth and domestic demand, see Phoenix ups and downs: How domestic demand responds to credit in EMs, GS GIRs EM Macro Daily, 26 March 2013. See Rapid Credit Growth: Boon or Boom-Bust?, Selim Elekdag and Yiqun Wu, IMF Working Paper, October 2011; Policies for Macrofinancial Stablity: How to Deal with Credit Booms, IMF Staff Discussion Note, 7 June 2012; various editions of IMF World Economic Outlook. For example, see Are credit booms in Emerging Markets a concern?, IMF WEO Chapter IV, April 2004. 4 October 2013

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GSAM Macro Insights

Focus Piece: Contd

%yoy 25 20 15 10 5 0 -5 -10
Turkey China Peru Colombia Russia Indonesia Thailand Philippines Chile Brazil Mexico Malaysia Taiwan India South Africa Nigeria Poland Korea Hungary Romania

Standard Exhibit 3 - Private sector credit growth deviations looks broadly sustainable Real private sector credit growth (LHS) 4 Std. dev. of credit stock from trend 3 1.75 std. dev. (benchmark for overheating) 2 1 0 -1 -2

Score 1.6 1.2 0.8 0.4 0.0 -0.4 -0.8 -1.2

Exhibit 4 - Credit in LatAm is accelerating, while momentum in parts of Asia and EMEA is falling Private sector credit impulse (measured as the standardised 'z score' of the difference between %qoq and %yoy growth)

Source: Haver Analytics and GSAM calculations

Source: Haver Analytics and GSAM calculations

greater than or equal to roughly 1.75 standard deviations is commonly used in the literature to point to credit overheating. As Exhibit 3 suggests, Thailand, Turkey and Peru are at or above this threshold. While the pace of credit accumulation is important for gauging shorter-term credit and growth dynamics, the stock of credit is the ultimate measure of longer-term sustainability. Comparing credit-to-GDP ratios across countries needs to take into account important country differences, such as the stage of development. In theory, a more developed country with solid institutions should be able to support a structurally higher debt burden. Using income per capita as a proxy for development, we can identify countries where levels of credit stock might be concerning. As Exhibit 5 shows, China and Malaysia both stand out as having particularly high credit-to-GDP ratios relative to their incomes per capita. Compared with DMs, these countries debt ratios are higher than those of France, Germany and Japan and only slightly lower relative to the UK. On the other hand, the stock of credit in LatAm, particularly Mexico, Turkey and Russia appears to be at reasonable levels, despite the high pace of credit accumulation.
Debt/ GDP, % 160 140 120 100 80 60 40 20 0 0 Chile Brazil Hungary India Turkey Peru Colombia Poland Russia Romania Indonesia South Africa Philippines GDP/capita (US$) Mexico 5,000 10,000 15,000 20,000 25,000 Thailand Exhibit 5 - China and Malysia have large stocks of debt relative to their incomes per capita R = 0.3142 China Malaysia Korea Taiwan

Managing private sector credit risks

Looking at the key indicators of credit across Growth and EM reveals a relatively benign picture overall. It is encouraging that after a period of sharp slowdown, some countries are now showing signs of credit acceleration which should bode better for their growth prospects to year end and into 2014. Mexico stands out in this regard. And while the pace of credit accumulation in some countries, particularly Turkey and Thailand, could point to potential short-term overheating, their credit-to-GDP ratios are less concerning. Even in China, where the credit-to-GDP ratio is a clear outlier, the recent slowdown in the pace of credit growth is a welcome development. As we move into the next year, the credit story is an important one to watch. From a shorter-term perspective, we would be more concerned about further credit slowdown, rather than overheating. While DM rates have dropped recently, we believe they will start moving higher before long, pushing up the cost of financing in Growth and EM to levels better aligned with their fundamentals. This would place a constraint on credit expansion. In addition, intensifying inflationary pressures in places like Brazil, Turkey and Indonesia could lead to further rate hikes, tightening financial conditions. That said, those places where a cyclical pick-up is stronger will be better placed to withstand the effects of slower credit. From a longer-term perspective, the challenge of managing risks from a universally rapid post-crisis credit expansion remains, particularly in countries where debt levels are already high. China is probably the best example of this challenge today, particularly given its systemic importance in the global economy. We are carefully watching risks around Chinas financial system which we plan to explore in this publication in due course.

Source: Haver Analytics and GSAM

Goldman Sachs Asset Management 5 October 2013

Peru Chile Mexico Malaysia Thailand India Nigeria Korea Russia Romania Philippines Turkey China Brazil Colombia Hungary Poland Taiwan South Africa Indonesia

GSAM Macro Insights

Appendix: GSAM Growth Forecasts and Asset Valuation

GDP Growth Forecasts: GSAM vs Consensus
2011 US UK Canada Euroland Japan Brazil China India Russia Mexico Korea Indonesia Turkey Advanced BRICs Growth Markets World 1.8 0.9 2.6 1.4 -0.6 2.7 9.3 7.9 4.3 3.9 3.6 6.5 8.5 1.5 7.7 7.2 3.9 2012 2.2 0.3 2.0 -0.5 2.0 0.9 7.8 3.9 3.6 3.9 2.0 6.2 2.2 1.2 5.8 5.3 3.0 2013 GSAM 1.8 1.3 2.0 -0.5 2.0 2.0 7.5 4.5 2.5 2.0 3.0 6.0 4.2 1.1 5.7 5.3 3.0 Consensus* 1.6 1.4 1.7 -0.4 1.9 2.4 7.6 4.6 2.0 1.6 2.7 5.6 3.5 1.0 5.8 5.3 2.9 GSAM 2.8 2.0 2.5 1.2 1.8 3.5 7.5 6.0 4.5 4.3 4.0 6.3 5.0 2.1 6.5 6.1 4.0 2014 Consensus* 2.6 2.2 2.3 1.0 1.7 2.6 7.4 5.7 2.6 3.6 3.5 5.5 3.9 1.9 6.1 5.7 3.6

*As of October 2013. Source: GSAM and Consensus Economics

Equity Valuation Across Advanced and Growth Markets

CAPE* Level % time cheaper*** Level FY1 PE % time cheaper*** Price/Book Level % time cheaper*** Dividend Yield Level % time cheaper*** Earnings Momentum** % change in 1y fwd EPS

Japan 31.6 44% 14.3 14% 1.3 11% 1.7 38% 1.5 US 21.0 67% 14.4 50% 2.5 60% 2.1 69% -0.6 Mexico 22.0 74% 17.3 98% 2.8 77% 1.4 82% -2.3 Indonesia 14.5 29% 13.5 64% 3.3 63% 2.7 37% -4.7 India 14.6 18% 14.0 57% 2.5 20% 1.5 52% -1.3 Germany 15.5 52% 11.7 26% 1.6 38% 3.2 57% -2.4 France 14.5 40% 12.5 48% 1.4 36% 3.3 61% -2.4 UK 13.0 45% 12.2 41% 1.9 48% 3.6 66% -3.4 Korea 13.8 20% 8.7 25% 1.1 28% 1.0 93% -2.6 China 12.5 25% 9.0 14% 1.5 26% 3.3 15% -0.4 Turkey 10.1 18% 10.0 71% 1.7 7% 2.4 57% -2.2 Brazil 9.4 11% 10.5 86% 1.4 50% 4.2 29% -4.9 Italy 9.6 21% 11.4 26% 0.9 16% 3.7 25% -3.6 Spain 9.3 8% 12.6 55% 1.3 37% 4.8 37% -3.2 Russia 6.3 5% 5.0 20% 0.8 10% 3.6 8% 0.7 * Cyclically-adjusted PE ratio (5-yr rolling window). ** % change in 1-yr fwd EPS over last 3 months. *** Current percentile relative to full history As of October 2013. All data based on MSCI country indices. Source: Datastream, GSAM calculations

% 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 05 06 07

US Equity Risk Premium US ERP 200 day m.a.

% 12 10 8 6 4 2 0 -2

Equity Risk Premium for the BRICs Brazil China India Russia

08

09

10

11

12

13

07

08

09

10

11

12

13

Source: GSAM calculations

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Source: GSAM calculations

October 2013

GSAM Macro Insights

Appendix: Key Macro and Markets Indicators

Index 35 30 25 20 15 10 5 0 -5 -10 -15 05 06 07 08 09 10 11 12 13
Source: Institute for Supply Management, Haver Analytics

US ISM: New Orders Inventories ISM Manufacturing: [New Orders - Inventories]

Index 65 60 55 50 45 40 35 30 05 06 07 08

Global PMI Global PMI: Manufacturing Output Global PMI: Services Business Activity

09

10

11

12

13

Source: JP Morgan, Haver Analytics

ISM is a key industrial US survey. The new orders less inventories component is one of the main leading indicators for the US and the global industrial cycle.
China Lead Indicator Index 1996=100 106 CEMAC-GS Leading Indicator 105 104 103 102 101 100 99 98 97 96 97 99 01 03 05 07 09
Source: GS Global ECS Research

The Global Purchasing Managers Index (PMI) is a PPPweighted average of different countries PMI headlines. The PMI headline gives a snapshot of economic activity.
%yoy 50 40 30 20 10 0 -10 -20 -30 Korean Exports %yoy change in exports (USD, 3mma)

11

13

03

04

05

06

07

08

09

10

11

12

13

Source: Haver Analytics

The CEMAS-GS Leading indicator was designed to provide a more accurate and timely view on Chinas growth momentum than official data.
Index Jan06=100 104 103 102 101 100 99 98 06 07 08 09 10 11 12 13
Source: GS Global ECS Research, Haver Analytics, GSAM calculations Easier Conditions

Korean exports are a key leading indicator for world trade and the global industrial cycle. This is the first trade statistic to be published at the beginning of every month.
% GDP 5 4 3 2 1 0 02 03 04 05 06 07 08 09 10 11 12 13
Source: GS Global ECS Research

G3 Financial Conditions USA Euro area Japan

China Total Social Financing New TSF as share of GDP, 3mma

GS FCIs measure effects of monetary policy on growth by combining real short- and long-end interest rates, tradeweighted exchange rate and equity market cap/GDP.
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China TSF is a broad measure of liquidity and credit supply which includes both bank loans and non-bank loan credit to non-financial entities.
October 2013

GSAM Macro Insights

Anna Stupnytska +44(20)7774-5061 anna.stupnytska@gs.com

James Wrisdale +44(20)7774-5282 james.wrisdale@gs.com

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October 2013