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return expectations, given all the economic policy and geopolitical uncertainty mentioned earlier. We believe there are three compelling arguments. First, there is potential for upside surprises in 2017: * Saudi Arabia and the rest of the oil producers may stick to the announced oil production cuts, thereby boosting energy sector earnings. ¢ A Trump administration fiscal stimulus could boost growth by more than we expect. Corporate tax cuts could increase corporate sector profitability. A possible tax holiday could encourage US multinational corporations to repatriate some of their earnings and deploy them for stock buybacks. We assign a 25% probability of such upside surprises relative to a 60% probability of our base case scenario and a 15% downside probability. (Please see Section III, 2017 Financial Markets Outlook, for a more detailed discussion.) Second, we recommend staying invested because we believe that the probability of a recession in the US is about 15% over the next year. There is an 85% chance that the economy will grow at a rate of about 2% or higher. Absent a recession, equities are more likely to generate positive returns. Obviously, the probability of a recession is substantially higher over the next five years, and our five-year annualized expected returns incorporate a 70-80% probability of a recession. Third, and most importantly, we do not see better investment alternatives. Cash will provide negligible returns with no upside, and we expect investment grade bonds to have equally negligible returns with little upside, if any. We also expect hedge funds, in aggregate, to lag equities on an after-tax basis. We expect similarly modest returns from our tactical tilts. As equities, high yield and the dollar have rallied over the course of the year, we have continued to reduce the overall risk level of our tactical tilts. Our Tactical Tilts As equities, high yield and the dollar have rallied over the course of the year, we have continued to reduce the overall risk level of our tactical tilts. At the beginning of 2016, we had already reduced our exposures by 50% relative to peak levels in 2015, as measured by value at risk. By the end of 2016, we had reduced exposures further, based on our investment discipline of averaging in and out of our tactical tilts. Underweight Fixed Income: We continue to recommend underweighting US fixed income assets as the Federal Reserve slowly but steadily raises the federal funds rate. We expect the 10-year Treasury bond yield to range between 2.5% and 3.0%. As a result, we forecast a 1% return across short- and intermediate-maturity fixed income assets and a near zero return for the 10-year Treasury. Longer maturities are expected to have negative returns. We also recommend underweighting fixed income assets to fund tactical tilts given their higher expected returns. Overweight to High Yield: While we reduced our tactical allocation to high yield assets by half throughout 2016, we continue to recommend an allocation to general high yield bonds, high yield energy bonds and high yield bank loans. The incremental yield in such securities, adjusted for defaults, is still compelling, with expected returns of about 4% for high yield bonds and high yield energy bonds and about 5% for bank loans. We forecast that crude oil prices will stay in the $45-65 range, partly owing to some production discipline by Saudi Arabia as the largest swing producer. Our bank loan tilt is further supported by a rising rate environment; the coupon rate on bank loans will be reset higher as LIBOR rises. Modest Overweight to US Banks: We maintain a modest overweight to US banks despite their 31% return in 2016. Banks will benefit from rising rates, especially if the increase is greater in the short end of the yield curve. About 60% of changes in the net interest margin of banks is typically driven by changes in short rates since they are used for setting the banks’ prime lending rate. Banks will also likely benefit from a more favorable regulatory environment under a Trump administration. We forecast a return of about 7%. 24 | Goldman Sachs | JANUARY 2017 HOUSE_OVERSIGHT_014557