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Exhibit 61: EAFE Price to 10-Year Average Cash Flow Discount to the US Today's larger-than-average discount provides a margin of safety to EAFE equities. Discount (%)} 60 5 MSCI EAFE Discount to MSCI US — ——-— Average Since 1982 Average Since 1992 40 4 20 + 20 = eS = Se See = SS = aS jah AR -60 - 1982 1987 1992 1997 2002 2007 2012 Data through December 31, 2016. Source: Investment Strategy Group, MSCI, Datastream. Exhibit 62: MSCI EMU Trailing 12-Month Earnings per Share Profits have been range-bound for almost four years. railing 12-Month EPS (€) 20 4 84 6 4 Sideways Since 2012 o 1969 1974 1979 «1984 1969 1994 1999 2004 2009 2014 Data through December 31, 2016. Source: Investment Strategy Group, Bloomberg. likely to exceed those of cash and bonds. In turn, we recommend that clients maintain their strategic weight in US equities, although we acknowledge that risks have risen at the same time that returns appear likely to be lower going forward. While US equities are not yet running on fumes, we should keep a close eye on the fuel gauge. EAFE Equities: Priced for Imperfection There is no shortage of concerns surrounding the various countries that comprise Europe, Australasia and the Far East (EAFE) equity markets. The list is both long and valid, including persistently low economic growth, a slow pace of structural reforms and incessant political uncertainty, as well as incremental, reactive and inconsistent policy responses. Ongoing questions about the health of the banking system only compound these worries. But these concerns are also not new and are consequently well understood by the market. In turn, the key question facing investors is not whether EAFE exposure subjects them to downside risks. As the preceding list demonstrates, it clearly does. The question instead is whether investors are being fairly compensated to bear these risks. One can never know precisely what equity markets are discounting, but the above concerns are almost certainly a key driver of EAFE underperformance and the main reason behind today’s larger-than-normal valuation discount to US equities (see Exhibit 61). While this margin of safety does not guarantee outperformance, it may provide investors with a larger buffer to absorb adverse developments and miscalculations in their forecasts. In our view, the risk/return profile of EAFE equities is more attractive than it first appears. As a result, we do not recommend that investors underweight EAFE equities. In fact, there are reasons to believe that EAFE equities will outperform US equities in local currency terms this year. In the sections that follow, we explore these reasons by examining the three main EAFE markets, beginning with the Eurozone. Eurozone Equities: The Onus Is on Earnings Earnings have been going nowhere fast for Eurozone equities. That’s apparent in Exhibit 62, which shows that profits have been range- bound—at nearly half their 2007 peak level—for almost four years. As a result, rising valuation multiples have accounted for all of the 25% price appreciation over this period. This seeming contradiction between stagnant earnings and rising multiples reflects the copious liquidity provided by the ECB’s quantitative easing. By depressing interest rates, ECB policy 56 | Goldman Sachs | JANUARY 2017 HOUSE_OVERSIGHT_014589