Questions for the Second Half

27 June 214 Questions for the Second Half Economic data suggest global growth is improving, led by a broad recovery in the US after the weak first quarter (p. 2). Macro risks appear to have declined, with growth stabilizing in China (p. 6) and the European Central Bank introducing new easing measures. With growth improving and downside risks abating, market volatility has fallen to low levels. In our Focus Piece, we examine five questions related to the low volatility environment and whether it can continue in the second half of the year (p. 4). We think volatility can remain low in the near term on a combination of improving growth, reduced macro risk and continued central bank accommodation. However, we think the market is too complacent about Fed policy risk as the US economy improves, and we see a risk of a sell-off in US rates that could lead to a broader pick-up in market volatility (p. 4). In our asset allocation views (p. 3), we are positive on growthsensitive assets such as equities based on our economic outlook......and we are favorable on select inflation-linked securities and commodities, where prices could rise on higher inflation and increased geopolitical risk. We are negative on US government bonds on the view that rates are likely to rise if growth and/or inflation pick up as we expect and the Fed begins to signal rate hikes.

Macro Trends and Views US US non-farm payrolls added 217, jobs in May and the national manufacturing PMI was the strongest in the past three months, rising to 56.4 from 55.4 in April. Auto sales data also surprised to the upside, up 11% on the month, amounting to the strongest sales in roughly nine years. The rebound in a broad range of economic data including auto sales, jobless claims, and manufacturing activity leads us to believe the US is growing at a rate well above 3% in the second quarter. Millions of units 2 18 16 14 12 1 8 Auto sales indicate improved momentum in the US economy US Auto Sales Seasonally Adjusted Annual Rate 6 '6 '7 '8 '9 '1 '11 '12 '13 '14 Europe The European Central Bank cut rates by 1bps, becoming the first major central bank to move the deposit rate into negative territory, along with additional liquidity measures targeted at stimulating lending. Low inflation is becoming entrenched in the Eurozone with low inflation across countries and across many components of the consumer price index. The pace of UK job growth has exceeded expectations, leading the Bank of England (BOE) to suggest that rate hikes could come earlier than the market had anticipated. Thousands 4 3 2 1-1 -2 Growth in UK employment at an all-time high UK 3-Month Employment Change -3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 Japan Japan s economy is in the midst of the slump that was widely expected to follow the April consumption tax hike, with a broad range of indicators down sharply. Core consumer prices jumped 3.2% in April from a year earlier, the largest rise in more than 2 years, as the consumption tax hike raised prices across the board. Sustainable inflation will depend on wage growth. Although unemployment is just 3.6% and Japan is close to full employment, base wage growth remains sluggish. YoY (%) 4 3 2 1-1 -2 Japan's consumption tax drove a broad increase in inflation Japan CPI ex-fresh food -3 '9 '92 '94 '96 '98 ' '2 '4 '6 '8 '1 '12 '14 Growth Markets China s manufacturing purchasing managers index (PMI) has stabilized after slowing earlier this year, providing support to the broader emerging market manufacturing sector. A slowdown in China s housing market has weighed on the overall economy, with the number of cities reporting a rising price trend down sharply in recent months. However, the slowdown in China s property market has been offset to some extent by infrastructure investment and overall growth appears to be relatively stable. China's manufacturing sector has stabilized, Index 55 supporting overall EM manufacturing activity Manufacturing Purchasing Managers Index 54 53 Emerging Markets China 52 51 5 49 48 47 212 213 214 Goldman Sachs Asset Management 2 June 214

Market Trends and Asset Allocation Views A rebound in developed market growth in an environment of plentiful liquidity and low macroeconomic volatility has underpinned our asset allocation views throughout 214. We have broadly been overweight risk assets and underweight US government bonds, a view shared by many market participants. However, as we transition from this naturally low-volatility regime towards an increasingly interesting macroeconomic and geopolitical setting, we anticipate greater dispersion in both asset performance as well as market positioning. As a result, we may see a shift in the potential returns from market exposures versus active views one that may reward a more selective and less broad -brush approach to portfolio positioning in the years to come. Despite underwhelming Q1 US GDP growth, market data and behavior have been consistent with our growth rebound thesis. Economic data in the US and UK continue to exceed rising expectations, unemployment across developed markets continues to fall, leading indicators in the US and Europe continue to point to sustained growth, and global financial conditions continue to ease. At the same time risk premia have compressed, with developed market equities achieving all-time highs, credit spreads tightening to cycle lows, and demand for market protection as expressed by equity implied volatility reaching levels not seen since 25. Looking forward, the next six months brings us closer to resolution on many of our macro calls. We should achieve better clarity on labor slack and its impact on the US inflation outlook, on US housing formation and the Chinese housing slowdown, and on liquidity injection by the ECB and the Bank of Japan (BOJ) as well as liquidity withdrawal by the BOE and the Fed. Given our economic outlook, we continue to favor developed-market risk assets, have a neutral view on growth markets, and are underweight US government bonds. Across equities, we favor pro-cyclical exposure in the US, peripheral positions in Europe, and are overweight US economic activity looks much stronger % than GDP suggests 1 US Current Activity Indicator 8 US GDP 6 4 2-2 -4-6 -8-1 ' '1 '2 '3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 Source: GSAM, Bloomberg. The Current Activity Indicator is a composite measure calculated by GSAM based on 14 US economic indicators. Japan. After the performance reversal in early 214, many foreign investors abandoned Japanese equities. In the near term, we believe proposed reforms to the corporate tax code, potential purchases by local investors including the Japanese Government Pension Investment Fund, and the orderly absorption of the April tax hike will continue to support the market and attract renewed flows from global investors. In terms of our Fixed Income views, we have moved towards quality in our high yield overweight. While we see a supportive default environment, we observe that as rates rise and the business cycle matures, asset allocators may begin to unwind the credit carry trade and shift positioning towards equities. A rapid unwind would increase volatility but also present potential tactical buying opportunity for quality assets. We are underweight US government bonds because we believe the current rate environment offers investors insufficient compensation for bearing Fed policy and inflation risks. Geopolitics has recently emerged as the principal risk in investors assessment of the financial markets, overshadowing global growth concerns and a possible Chinese housing crisis. There are a number of geopolitical risks that have come into the frame concurrently, as exhibited across Europe, the Middle East and the South China Sea, bringing increased uncertainty and potential tailrisk for investors worldwide. More presently, destabilization in the Ukraine and Middle East increases the potential for energy supply shocks that could particularly impact the economic recovery in Europe as well as in Growth Markets. We note that such an energy shock may be exceptionally damaging for oil-importing growth market economies that retain large current account deficits (e.g., Turkey, South Africa, India). The unpredictable nature of geopolitical tailrisks underscores the value of a strategic and systematic approach to the diversification of equity and nominal-bond centric portfolios. Equity Fixed Income Real Assets Cash Asset allocation views on a 1-yr horizon* Less Attractive More Attractive Change US Equity - European Equity - Japanese Equity - Growth Markets Equity - EMD Local - Corporate Credit - High Yield - DM Sovereign Debt - Commodities - Cash - Source: GSAM Global Portfolio Solutions. As of June 214. * Note that this does not account for liability-driven investment. Goldman Sachs Asset Management 3 June 214

Focus Piece: 5 Questions for the 2nd Half The dominant theme across asset classes is the lack of volatility. One statistic often cited in our recent market discussions is the fact that, as of June 2, the S&P 5 had gone 45 days without a 1% move in either direction (Exhibit 1). That is the longest stretch without a 1% move since 1995 almost 2 years! And with indicators of implied volatility near multi-year lows across equities, rates and currency markets, investors seem to anticipate a continuation of low volatility for at least the next few months. In this month s Focus Piece, we look at five questions related to the low volatility environment, why it can continue in the near-term and the potential risks on the horizon. Why is volatility so low? We see three main reasons for the low level of volatility: The economic cycle. The US appears to be rebounding after a weak first quarter and we believe the economy is finally transitioning into a sustainable expansion. Historically, expansions tend to be associated with low volatility and modest-but-positive returns on equities and credit. This leads to lower realized and implied volatility. Low macro volatility. Stabilizing global economies and a marked reduction in tail risk relative to the 28-211 period naturally reduces volatility. In the US, the economy appears to be expanding but questions about the amount of slack in the economy and the potential for inflation remain unresolved. Expectations of future US inflation have settled into a very narrow range (Exhibit 2), reflecting the lack of volatility in actual inflation over the last few years. Data over the next 3-6 months will give an indication as to who is right on the level of slack in the labor market, but until then, markets are in a waiting game. Central banks liquidity and transparency. The major central banks have been providing a backstop on asset prices, better clarity on monetary policies and a commitment to continued plentiful liquidity ( lower-forlonger policy rates), all of which reduce policy uncertainty and suppress volatility. Days 1 8 6 4 2 94 Exhibit 1: Number of trading days without a move of 1% or more in the S&P 5 '95 '97 '99 '1 '3 '5 '7 '9 '11 '13, GSAM 38 45 % 3. 2.5 2. 1.5 Exhibit 2: Market-implied inflation expectations are very stable Breakeven inflation on 1-year US TIPS 1. '1 '11 '12 '13 '14 Are markets too complacent? We think markets are being fairly rational with regard to geopolitical conflict but are probably too complacent about the risk of rising interest rates and an unexpected shift in the outlook for Fed policy. Geopolitical Risk: Iraq is the latest focus with the rise of a militant group ( ISIS ) that has taken control of large areas of the country, bringing talk of US intervention. However, market reaction to renewed sectarian violence in Iraq has been confined to a relatively modest move in oil and gasoline markets. We think this is consistent with the near-term risk, as fighting appears unlikely to reach the southern areas where most of Iraq s oil is produced. If anything, we think the market may be too complacent about the longer-term risks. Iraq and the US are the main sources of potential growth in oil output. With this latest conflict, the investment needed to grow Iraq s oil output seems less likely to occur. But we see that as a developing trend, not a source of near-term event risk. Ukraine has moved to the back burner as the conflict has become more localized. We think the situation in Ukraine is likely to remain a simmering concern, but not a reason to price in additional risk premium across markets. Rate Risk: Exhibit 3 shows the path of the Fed s policy rate implied by market rates versus the path implied by Fed forecasts, based on the median forecast from the dot plot ( the dots ) showing % Exhibit 3: Market Expectations for the Fed 4. Policy Rate are Below the Fed's Median 3.5 3. Fed Median Market 2.5 2. 1.5 1..5. 214 215 216 217 218 219, GSAM, Federal Reserve Goldman Sachs Asset Management 4 June 214

Focus Piece: Cont d the forecasts of individual members of the Federal Open Market Committee. As the chart shows, by this measure at least, the market is below the Fed in terms of rate hikes. Why would the market be more dovish than the Fed? We think there are two main reasons. First, market pricing suggests very little uncertainty in the outlook for inflation. Second, Fed Chair Janet Yellen and others have cited continued headwinds from the financial crisis as reasons to expect policy may remain more accommodative than the median of the Fed s forecasts suggests. Even if one expects growth and inflation to remain relatively subdued, we think the rate market should be providing more compensation for the risk that incoming data runs counter to these views over the next few months. Has the Fed s long-term neutral rate fallen? One of the more popular debates in the rate market this year is whether the long-term neutral rate in the US has fallen. The neutral rate is essentially the rate level at which growth and inflation are balanced, and the general idea is that if US long-term growth potential is lower, the neutral rate should also be lower. Our view is that US growth potential and the long-term neutral rate have probably declined, but only by a bit. Essentially, US labor force and productivity growth are likely to be somewhat weaker going forward due to demographic trends, reduced immigration and a lack of business investment in recent years. We think 3.75% (the median of the Fed s longer-run forecasts) is a reasonable estimate of the long-term nominal neutral rate. Even if the neutral rate is somewhat lower, we would note several important caveats before assigning too much significance to this trend as an explanation for the decline in long-term US rates so far this year. The Fed tends to overshoot when tightening. The Fed s terminal rate the rate at which the central bank stops raising rates has generally been higher than the neutral rate. The neutral rate is variable and uncertain. The neutral rate is difficult to estimate, has a wide margin of error, and can vary significantly over time. Other factors could explain lower US rates. If the neutral rate has fallen, the trends driving that decline are long-term and slow-moving. We think the decline in US rates in 214 is probably due to more immediate factors, including foreign central bank buying, falling rates in Germany and weak first-quarter growth. In sum, we think the focus on the neutral rate is largely a case where an intriguing theory fits the price action and the market seizes on the theory as explanation. Will macro volatility increase? We think volatility can remain low in the near-term, but is likely to increase later this year. In the US, core inflation is rising and economic growth has rebounded from the first-quarter weakness. The Fed has been more upbeat in its statements and its rate forecasts for the next few years have moved higher. In the UK, policymakers recently suggested that rate hikes could come sooner than the market anticipated. These developments suggest that we are nearing the start of a cycle of rate hikes, against a backdrop of: 1) High government debt stocks 2) Elevated asset prices 3) Low volatility that has turbocharged the search for yield 4) Theories as to why this time is different 5) Significant divergence in growth and policy globally 6) Uncertainty around the exit from unprecedented monetary policy easing. We think the Fed will use the September 214 meeting to begin preparing the market for rate hikes, and the Bank of England could start raising rates this year. Historically, the early stages of a hiking cycle tend to be most negative for rate risk. Equities and credit can still deliver positive returns, and volatility in risk assets can remain relatively low for extended periods. Eventually, higher rates lead to a turn in the credit cycle, causing defaults, higher volatility and the potential for negative returns across risk asset sectors. When will the credit cycle turn? Credit cycles turn when growth can no longer support the amount of debt in the economy and weaker or over-levered borrowers begin to default. In our view, we are not close to this type of environment and we do not expect a broad increase in defaults until 217 or later. Idiosyncratic risk in the credit markets has increased with the rise in M&A activity, but many of these transactions have been specific to the US technology and pharmaceutical sectors. These are two sectors with substantial cash, much of it trapped overseas due to tax reasons. Transactions have been driven by the motivation to re-domicile for tax purposes and funded with cash or equity rather than debt. As a result, the rise in M&A has not translated into a significant increase in leverage. Investors are increasingly pushing corporate management to use cash for M&A and investment rather than stock buybacks given the increase in earnings multiples. Lending terms in the corporate bond market have also gotten easier. These trends could become more destructive for bond investors over time. However, we see little catalyst for a near-term increase in defaults and little reason to believe the credit markets are likely to be a significant source of broad market volatility. Goldman Sachs Asset Management 5 June 214

Notes: Observations From Our Recent Travels in China Several members of GSAM s Global Fixed Income team have conducted research trips in China over the last few months. Below, we summarize some of the key observations from the team s travels and meetings. Property vs Infrastructure Investment The property market is slowing but infrastructure investment, and the amount of property development that needs to be completed, should help to prevent a sharp slowdown in growth. Exhibit 1: China infrastructure investment RMB, Bn 3 28 offsetting slowdown in real estate Fixed Asset Investment 3-month avg, year-over-year 26 Infrastructure 24 22 2 18 16 14 12 Infrastructure Real Estate Real Estate 1 213 214 Source: Capital Economics The slowdown in the property sector is causing a meaningful drag on upstream heavy industry, though infrastructure demand has partially offset this. % 15 1 5 Exhibit 2: Property weakness has weighed on heavy industry Industrial Output 3-month avg, year-over-year Crude Steel Cement 213 214 Excess inventory is evident in the real estate market and this is contributing to tightening in credit availability. Real estate oversupply tends to be concentrated in cities that rely more on land sales as a primary source of revenue. Larger cities appear to have a better balance of supply and demand. We think the consensus view is that excess property supply will be absorbed but views on how long it will take to absorb inventories have been extended. Stimulus vs Reform Key players, including state-owned enterprises, local governments and heavy industry, appear to be taking a wait and see approach to talk of further stimulus, as opposed to the aggressive pre-empting that has occurred in the past. The focus on improving discipline/reducing corruption within the Party is the key area of reform and is not likely to abate. This has significantly dented high end retail spending, which is damaging activity in luxury brands, retail property and high-end residential property. Many high-end multinational retailers and other multinational corporations are now describing China as a long-term play that requires patience, with a pay that is five to 15 years away. % yoy 8 6 4 2 Exhibit 3: Reforms are contributing to a slowdown in high-end retail sales -2 Gold and Jewelry Furniture -4 '1 '11 '12 '13 '14 Credit continues to tighten, with a shift toward more transparent forms such as bank loans and corporate bonds and away from trust loans and other shadow forms of credit. CNY Bn 7 6 5 4 3 2 1 Exhibit 4: A shift toward more transparent forms of credit Corporate Bonds Trust and Entrusted Loans -1 '1 '11 '12 '13 '14 Goldman Sachs Asset Management 6 June 214

Appendix: GSAM Growth Forecasts and Asset Valuation GDP Growth Forecasts: GSAM vs Consensus 211 212 213 214 215 GSAM Consensus* GSAM Consensus* US 1.8 2.8 1.9 2.3 2.2 3.6 3. UK 1.1.3 1.7 3. 3. 2.7 2.5 Euro area 1.5 -.7 -.4 1.1 1.1 1. 1.5 Japan -.6 1.4 1.7 1.4 1.5 1.3 1.2 Brazil 2.7 1. 2.3 1.5 1.4 2.2 1.8 China 9.3 7.7 7.7 7.2 7.4 7. 7.2 India 6.3 3.2 4.4 5.2 4.7 6. 5.4 Russia 4.3 3.4 1.5.8.5 2.5 1.8 Mexico 4. 3.7 1.2 3.5 2.9 3.8 3.8 Korea 3.7 2. 2.8 3.7 3.6 4. 3.8 Indonesia 6.5 6.2 5.3 5. 5.3 6. 5.8 Turkey 8.8 2.2 3.8 2. 3. 4. 3.6 Advanced 1.4 1.3 1.1 1.8 1.8 2.4 2.2 BRIC 7.3 5.5 5.8 5.5 5.5 5.8 5.7 Growth Markets 6.9 5.1 5.2 5.1 5.1 5.5 5.4 World 3.8 3. 3. 3.4 3.3 3.9 3.7 *As of June 214. Source: GSAM and Bloomberg Equity Valuation Across Advanced and Growth Markets Level CAPE* FY1 PE Price/Book Dividend Yield % time cheaper*** Level % time cheaper*** Level % time cheaper*** Level % time cheaper*** Earnings Momentum** % change in 1y fwd EPS Japan 3.8 47% 13.2 8% 1.2 11% 2. 26% -1.3 Mexico 22.9 78% 18.1 1% 2.8 78% 1.5 66% -3.7 US 22.7 72% 15.7 69% 2.7 69% 2. 71% -.2 India 18.4 49% 15.8 74% 3. 57% 1.4 57% -2.1 Germany 17.2 59% 13.2 43% 1.8 57% 2.6 72% -2.7 France 16.9 54% 14.2 6% 1.5 51% 3.2 67% -3.6 Indonesia 16. 38% 14.4 75% 3.5 72% 2.3 56%.6 Italy 14.4 36% 13.8 45% 1.1 37% 2.8 53% -4. UK 14.3 55% 13.7 66% 2. 6% 3.5 71% -4.1 Korea 13.4 26% 9.3 34% 1.1 27% 1.1 91% -4.5 Spain 12.7 33% 15.4 82% 1.6 64% 4.9 36% -3.9 China 11.7 24% 8. 5% 1.4 26% 3.4 12% -2.5 Turkey 1.6 31% 1.6 82% 1.7 2% 2. 75% -3.7 Brazil 9.3 21% 1. 76% 1.3 48% 4.6 2% -2.6 Russia 5.5 5% 4.6 12%.7 1% 4. 1%.4 * 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 May 214. All data based on MSCI country indices. Source: Datastream, GSAM calculations % US Equity Risk Premium 6. US ERP 2 day m.a. 5. 4. 3. 2. 1. 5 6 7 8 9 1 11 12 13 14 Source: GSAM calculations % Equity Risk Premium for the BRICs 12 Brazil China India Russia 1 8 6 4 2-2 -4-6 7 8 9 1 11 12 13 14 Source: GSAM calculations Goldman Sachs Asset Management 7 June 214

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