Investment Management Division

The Federal Reserve: Dont Let It Be Misunderstood June 26, 2013

Investment Strategy Group

This material represents the views of the Investment Strategy Group (ISG) in the Investment Management Division of Goldman Sachs. It is not a product of Goldman Sachs Asset Management (GSAM) or Goldman Sachs Global Investment Research. The views and opinions expressed herein may differ from those expressed by other groups of Goldman Sachs.

Todays Call

Investment Management Division

Recent Financial Markets Performance Interpreting the Federal Reserves Commentary Implications for Financial Markets

China: A Confluence of Events Fueling the Fire

Key Takeaways

Great Market MomentumUntil Recently

1. Asset Class Returns: Dec. 31, 2012 S&P 500 Peak Close (May 21, 2013)
20% 18.0%

Investment Management Division

2. Asset Class Returns: S&P 500 Peak Close (May 21, 2013) June 25, 2013
0% -2% -1.0%

15% 10.0%

10%

-4%
-4.7%

-4.8%
-6.7%

5.4% 5% 3.9% 3.4% 2.1%

0% -1.2% -5%

-6%

1.2%

-8% -8.3% -10% -12% -9.5%

-9.7% -11.6%

-10%

-14% -16% -15.3%

-15%

-20%

-17.8% S&P 500 Euro US Corp HY Muni HY Bank Stoxx 50 High Yield Loans EM Equities EMLD Chinese Equities Gold

-18%
HY Bank S&P 500 US Corp Loans High Yield Gold HY Muni Euro Stoxx 50 EMLD EM Equities Chinese Equities

Source: Investment Strategy Group, Datastream (1) Indices used: Barclays US Corporate High Yield for US Corp High Yield, Barclays High Yield Munis for HY Muni, Barclays US High Yield Loans for HY Bank Loans, MSCI Indices for EM and Chinese equities, JP Morgan GBI-EM Global Diversified Index for EMLD and Gold Bullion LBM for Gold.

Key Driver of Markets Recently: Taper Timetable

US 10-Year Treasury Yields Around Major Events in 2013 (Through June 25, 2013)
2.6

Investment Management Division

2.55 2.5 2.4

2.3 2.2

2.1 2.0
1.9 1.8

FOMC Statement and Bernanke Press Conference (June 19) FOMC Meeting Minutes Released and Congressional Testimony "Taper" (May 22)

1.7 1.6 Jan-13

April Employment Report (May 3) Feb-13 Mar-13 Apr-13 May-13 Jun-13

Recent FOMC commentary introducing the possibility of tapering later this year pushed yields above their YTD range. The 10-year Treasury is now down 5.5% YTD on a total return basis, down 3.2% since June 19 and a total drawdown of 7.6% since early May.
Source: Investment Strategy Group, Datastream

Federal Reserve Commentary Reverberations

1. Forward Implied Short Rate Curve (3 Month Rate)
4.5% As of May 21st (Day Prior to FOMC Minutes and Testimony) 4.0%
As of Jun 25th
5.5

Investment Management Division

2. US 5-Year Treasury Yield 5 Years Forward1 (Through June 25, 2013)

6.0

3.5%
5.0

3.0%
Percentage Points
4.5

2.5% 2.0%
1.5% 1.0% 0.5%

4.14 4.0

3.5

+126 bps
2.88

3.0

2.5

0.0% 13 14 15 16 17 18

2.0 2010

2011

2012

2013

The market now expects the FOMC to raise interest rates earlier. Moreover, 5-year interest rates are expected to normalize faster than previously thought.

(1) This is a proxy measure for the 5-year Treasury yield based on the swap market. Source: Investment Strategy Group, Datastream

US Equity Volatility has not Matched the Increase in Rates

Investment Management Division

VIX (S&P 500 Implied Volatility) Through June 25, 2013

90

VIX

Average

50-Day Moving Average

200-Day Moving Average

80

70

60

50

40

30 24.7 20 18.5 15.0 15.0

10

0 2008

2009

2010

2011

2012

2013

Source: Investment Strategy Group, Federal Reserve.

Interpreting the Federal Reserves Commentary: Congressional Testimony and FOMC Minutes (May 22)

Investment Management Division

Chairman Ben Bernanke's Testimony

Dovish1
A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further. To this point our sense is that major asset prices like stock prices and corporate bond prices are not inconsistent with the fundamentals.

Hawkish1

If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases.

Minutes from April/May FOMC Meeting

Dovish1

Hawkish1

continued progress, more confidence in the outlook, or However, economic data releases over diminished downside risks would be the intermeeting period were mixed, required before slowing the pace of raising some concern that the recovery purchases would become appropriate. might be slowing after a solid start A number of participants expressed earlier this year, thereby repeating the willingness to adjust the flow of pattern observed in recent years. purchases downward as early as the June meeting

(1) Represents the views of the Investment Strategy Group. Source: Investment Strategy Group, Reuters, Federal Reserve, C-SPAN.

Interpreting the Federal Reserves Commentary: Chairman Bernankes Press Conference (June 19)

Investment Management Division

Chairman Ben Bernanke

Dovish1
The Committee expects a considerable interval of time to pass between when the Committee will cease adding accommodation through asset purchases and the time when the Committee will begin to reduce accommodation by moving the federal funds rate target toward more normal levels.

Hawkish1

If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.

However, any need to consider applying the brakes by raising shortterm rates is still far in the future.

And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.

When asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent.

(1)

Represents the views of the Investment Strategy Group.

Source: Investment Strategy Group, Federal Reserve, C-SPAN.

Commentary From Other Fed Officials (June 24)

Investment Management Division

Richard Fisher (President of the Federal Reserve Bank of Dallas, Non-Voting Member of the FOMC)1 Dovish3 Hawkish3

Narayana Kocherlakota (President of the Federal Reserve Bank of Minneapolis, Non-Voting Member of the FOMC)2 Dovish3 Hawkish3

I'm not in favour of going from Wild Turkey to cold turkey over night

It would be appropriate for us to dial back the monetary stimulus.

The Committee should continue to buy "The Committee may choose to stop assets at least until the unemployment using this tool [QE] before the economy rate has fallen below 7 percent has fully normalized."

Even if we reach a situation this year where we dial back (stimulus), we will still be running an accommodative policy.

The housing market is very robust. The question is when do you get market forces to take that on. For me the answer is now.

"It may be appropriate for the Committee to buy additional assets even after the unemployment rate falls below 7 percent." "The Committee should keep its target range for the fed funds rate at its current extraordinarily low level at least until the unemployment rate has fallen below 5.5 percent"

An exit is still way out in the future.

I agree fully with the chairman that we should dial back on the stimulus.

On Thursday, June 27, New York Fed President and FOMC Vice-Chairman Bill Dudley is scheduled to give a speech in which he may comment on monetary policy.
Source: Investment Strategy Group, Bloomberg, The Wall Street Journal, The Financial Times, Global Post, Federal Reserve Bank of Minneapolis. (1) (2) Excerpts from his speech at a conference at the Official Monetary and Financial Institutions Forum on June 24, 2013. Excerpts from Statement: Recent FOMC Communications as a Part of Appropriate Monetary Policy, published by the Minneapolis Fed June 24, 2013.

(3)

Represents the views of the Investment Strategy Group..

The FOMC Has Upgraded Their Outlook

1. FOMC & GIR Unemployment Rate Projections (As of June 25, 2013)
10.0
9.5 Unemployment Rate Dec. 12 FOMC Projection June GS Projection June 13 FOMC Projection

Investment Management Division

2. FOMC & GIR Core PCE Inflation Projections (As of June 25, 2013)
3.0
Core PCE Inflation (YoY) Dec. 12 FOMC Projection June GS Projection June 13 FOMC Projection

2.5
9.0

8.5
YoY - Percent

2.0
1.8 1.8

Percentage

8.0
7.5

1.8 1.8
1.7

1.9 1.9 1.9

7.6

7.6 7.5 7.3

7.1 6.9

1.5
1.3 1.0 1.1

7.0 6.5
6.0

6.7 6.3 6.3

6.0

0.5

5.5 5.0
10 11 12 13 14 15

0.0 10 11 12 Years 13 14 15 Years

The FOMC has revised its unemployment rate projections down since the end of 2012. In contrast, projections for core inflation have been also revised lower. The FOMC appears to have focused on changes in the labor market outlook more than on changes in the inflation outlook.
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Source: Investment Strategy Group, Datastream, Federal Reserve, GIR.

Slight Shift in Communication Seems Inconsistent with Data

1. US Real GDP Growth Through Q1 2013
8% 6% 4%
2%

Investment Management Division

2. Non-Farm Payroll Growth Through May 2013

Real GDP

Real GDP Ex. Government Consumption and Investment QE2 (3.3%)

600 500

QE3 3.5% 1.8%

400

300
0%
%QoQ Ann.
Thousands

QE2: 49 QE3: 135 155 7 171 -3

-2%
-4%

200
100

-6% -8%

0 -100

-10%

QE1 -12% -14%

06 07 08 09 10 11 12 13

-200 -300 Jan-10

Jul-10

Jan-11

Jul-11

Jan-12
Construction

Jul-12
Public sector

Jan-13

Years

Private ex Construction

The economy has been growing at a moderate pace, and private demand had been resilient in spite of higher taxes and sequestration.
Employment has continued to grow at a moderate but steady pace. Nonfarm payroll growth has averaged 155 thousand in the last 3 months as compared to 221 thousand in the prior 5 months.
Source: Investment Strategy Group, Datastream

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US GDP Growth is Expected to Accelerate

1. GS GIR US Real GDP Growth Forecasts (QoQ Ann. %) As of June 25, 2013
4.0
Forecast

Investment Management Division

2. GS US Financial Conditions Index Through June 25, 2013

100.6

3.5 3.0

3.5

3.5

3.5
100.4 Financial Conditions Tighter

3.0 2.4 2.0 1.8 2.5

100.2

2.5

US Financial Conditions Index

QoQ Ann. %

100.0

2.0

99.8

1.5

99.6

QE2

1.0

99.4

QE3

0.5

99.2

0.0
Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

99.0
10 11 12 13

Source: Investment Strategy Group, Goldman Sachs Global Investment Research

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Is a Repeat of 1994 Likely?

1. Path of US 10-Year Treasury Yields
4.5% 8.5%

Investment Management Division

2. Drawdowns and Annual Returns Across Fixed Income and S&P 500 in 1994

4% 2%

5/1/13 Left Axis

1%

4.0%

1/28/94 Right Axis

8.0%
0%

3.5%

7.5%

-2% -4%

-1%

-3%
-4%

3.0%

7.0%

-6% -8%

-6%

-5% -7%

-5%

-8% -8%
-10%

2.5%

6.5%
-10% -12%

-8%
Drawdown During 1994 Total Return in 1994 Current Drawdown

2.0%

6.0%
-14%

-12%

-13%
-16%

0 7 14 21 28 35 42 49 56 63 70 77 84 91 98 105 112 119 126 133 140 147 154 161 168 175 182 189 196 203 210 217 224

1.5%

5.5%

-16% -18%

Number of Days Since 10-Year Yield Trough

30-Year Treasury 10-Year Treasury

S&P 500

Barclays US US Corp High Yield Aggregate Index

The rise in interest rates since early May has drawn comparisons to1994: 10-year Treasury yields have risen by a similar magnitude to the initial increase in 1994. This increase in rates has also been accompanied by declines in both bond and equity prices.

Source: Investment Strategy Group, Datastream

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Keeping 2013 Returns in Perspective

Year-to-Date Asset Class Total Returns1 (Through June 25, 2013)
15% 10%
5%

Investment Management Division

12.5%

2.4% 0.3%

0% -0.4%
-5%

-4.8% -8.6%
-9.7%

-10% -15%

-16.3% -20% -25%

-30% -23.3%

S&P 500 HY Bank US Corp Euro HY Muni Loans High Yield Stoxx 50

EMLD

EM Equities

Chinese Equities

Gold

Source: Investment Strategy Group, Datastream (1) Indices used: Barclays US Corporate High Yield for US Corp High Yield, Barclays High Yield Munis for HY Muni, Barclays US High Yield Loans for HY Bank Loans, MSCI EM for EM equities and JP Morgan GBI-EM Global Diversified Index for EMLD.

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China: A Confluence of Events

Investment Management Division

1. China: Real GDP Growth Bloomberg Consensus Expectations (%YoY)

8.6%

2. China: 7-Day Shanghai Interbank Offered Rate (%)

12%

2013

2014

11.0

China Consensus Real GDP Growth (%YoY)

8.4%

10%

8.2%

8%

7-Day SHIBOR

7.2

8.0%

6%

7.8% 7.70 7.65

4%

7.6%

2%

7.4% Jun-12

Aug-12

Oct-12

Dec-12

Feb-13

Apr-13

Jun-13

0% Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13

Chinas growth expectations have fallen as new leadership has signaled a desire for quality growth at the expense of faster growth. Interbank rates spiked last week, with the overnight repo rate reaching an intraday high of >30%. This raised concerns about a banking crisis in response to central bank efforts to slow rising off balance sheet lending. The Peoples Bank of China has asked larger banks to play an active role in stabilizing the market. It also provided liquidity to some financial institutions this week.
Source: Investment Strategy Group, Bloomberg, Datastream

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Key Takeaways

Investment Management Division

Clients should use the recent downdraft to build toward their strategic allocation to equities. While we think that interest rates will gradually rise over the next several years and lead to low Investment Grade Fixed Income returns, a repeat of 1994 is highly unlikely. We recommend tactically underweighting Investment Grade Fixed Income in favor of the following areas where the risk-return opportunities are much more attractive: High Yield Bonds US Bank loans Emerging Market Local Debt Euro Stoxx 50 (currency hedged) US Bank Equities

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Important Information

Investment Management Division

Investment Strategy Group. The Investment Strategy Group (ISG) is focused on asset allocation strategy formation and market analysis for Private Wealth Management. Any information that references ISG, including their model portfolios, represents the views of ISG, is not research and is not a product of Global Investment Research or Goldman Sachs Asset Management, L.P (GSAM). The views and opinions expressed may differ from those expressed by other groups of Goldman Sachs. If shown, ISG Model Portfolios are provided for illustrative purposes only. Your asset allocation, tactical tilts and portfolio performance may look significantly different based on your particular circumstances and risk tolerance. Your actual asset allocation, tactical tilts and portfolio performance may look significantly different based on your particular circumstances and risk tolerance. The model performance calculation assumes that (1) each asset class was owned in accordance with the recommended weight; (2) all tactical tilts were implemented at the time the recommendation was made; and (3) the portfolio was rebalanced every time a tactical tilt change was made and at the end of every quarter (unless a tactical tilt was made within a month of quarter-end). Performance is calculated using the daily returns (actual or interpolated) of indices that ISG believes are representative of the asset classes included in the model. Results shown reflect the total return but generally do not take into account any investment management fees, commissions or other transaction expenses, which would reduce returns. The results shown reflect the reinvestment of dividends and other earnings. All returns are pre-tax and are not adjusted for inflation. 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Important Information

Investment Management Division

Indices. Any references to indices, benchmarks or other measure of relative market performance over a specified period of time are provided for your information only. Certain Investments / Strategies. Alternative Investments. Private investment funds and hedge funds are subject to less regulation than other types of pooled vehicles. Alternative investments may involve a substantial degree of risk, including the risk of total loss of an investors capital and the use of leverage, and therefore may not be appropriate for all investors. Please keep in mind that liquidity may be limited. Investors should review the Offering Memorandum, the Subscription Agreement and any other applicable disclosures for risks and potential conflicts of interest. Commodities. Commodity investments may be less liquid and more volatile than other investments. The risk of loss in trading commodities can be substantial due, but not limited to, volatile political, market and economic conditions. An investors returns may change radically at any time since commodities are subject, by nat ure, to abrupt changes in price. Commodity prices are volatile because they respond to many unpredictable factors including weather, labor strikes, inflation, foreign exchange rates, etc. In an individual account, because your position is leveraged, a small move against your position may result in a large loss. Losses may be larger than your initial deposit. Investors should carefully consider the inherent risk of such an investment in light of their experience, objectives, financial resources and other circumstances. No representation is made regarding the suitability of commodity investments. Emerging Markets Securities. Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability. Tactical Tilts. Tactical tilts may involve a high degree of risk. No assurance can be made that profits will be achieved or that substantial losses will not be incurred. Distributing Entities. This material has been approved for issue in the United Kingdom solely for the purposes of Section 21 of the Financial Services and Markets Act 2000 by GSI, Peterborough Court, 133 Fleet Street, London EC4A 2BB; by Goldman Sachs Canada, in connection with its distribution in Canada; in the United States by Goldman, Sachs & Co.; in Hong Kong by Goldman Sachs (Asia) L.L.C.; in Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in Japan by Goldman Sachs (Japan) Ltd; in Australia by Goldman Sachs Australia Pty Limited (ACN 092 589 770); in Singapore by Goldman Sachs (Singapore) Pte (Company Registration Number: 198602165W); and in Brazil by Goldman Sachs do Brasil Banco Mltiplo S.A. Tax Information. Goldman Sachs does not provide legal, tax or accounting advice. Any statement contained in this presentation concerning U.S. tax matters is not intended or written to be used and cannot be used for the purpose of avoiding penalties imposed on the relevant taxpayer. You should obtain your own independent tax advice based on your particular circumstances. Tax results may differ depending on a clients individual positions, elections or other circumstances. This material is inte nded for educational purposes only. While it is based on information believed to be reliable, no representation or warranty is given as to its accuracy or completeness and it should not be relied upon as such. Information related to amounts and rates set forth under U.S. tax laws are drawn from current public sources, including the Internal Revenue Code of 1986, as amended, as well as regulations and other public pronouncements of the U.S. Treasury Department and Internal Revenue Service. Such information may be subject to change without notice. In some cases, rates may be estimated and may vary based on your particular circumstances.

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