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by remaining overweight US corporate high yield credit versus investment grade fixed income and by funding various tactical tilts from their high-quality bond allocation. While most investment grade bonds may have uninspiring tactical prospects, we emphasize that investors should not completely abandon their bond allocation in search of higher yields. As the last several years have reminded us, investment grade fixed income serves a vital strategic role in the portfolio, due to its ability to hedge against deflation, reduce portfolio volatility and generate income. In the sections that follow, we review the specifics of each fixed income market. US Treasuries While 2016 began as a bumper year for US Treasuries, it ended in a rout. The yield on 10-year Treasury bonds, for example, reached an all-time low of just 1.36% by the middle of last year before jolting higher by more than one percentage point by year-end. As a result, investors’ nearly double- digit gains devolved into a small loss. Even worse, the bulk of the rate increase occurred in just the last three months of 2016, generating a 7% loss for the quarter that has been exceeded less than 1% of the time historically since 1981. We expect rates to continue to increase, albeit at a slower pace in 2017, as many of the forces that have restrained yields are slowly fading. Inflation, in particular, has been a persistent drag, reflecting a toxic combination of excess labor slack that depressed wages, a strong dollar that lowered import prices and a significant decline in oil prices that weighed on breakeven inflation rates. But as we begin the eighth year of the US expansion, labor slack has been largely absorbed, evident in today’s firming wages. Moreover, the impact of the dollar is diminishing as its pace of ascent slows, while the recovery in oil is boosting breakeven inflation rates. Other headwinds are also receding. The fiscal austerity among the advanced economies that has dampened economic growth and decreased sovereign bond issuance—both of which depress interest rates—is now reversing (see Exhibit 78). Indeed, US fiscal spending is expected to add 0.3-0.5 percentage points to GDP growth in each of the next two years.!4 At the same time, there is reduced demand for risk-free assets, like US Treasuries, given the unexpectedly sanguine reaction to negative Exhibit 78: Fiscal Stance of Advanced Economies Fiscal austerity in developed markets has reversed in recent years. Number of Countries Loosened 35 5 mTightened m Remained Neutral 30 + 8 9 25 4 a 20 + 2011 2012 2013 2014 2015 2016 Data as of December 31, 2016. Source: Investment Strategy Group, IMF. geopolitical events—such as the UK and Italian referenda—and the results of the US election. Finally, the deleterious impact of depressed interest rates on banking sector profitability has raised the hurdle for global central banks to cut interest rates further and/or increase the scale of QE programs. In turn, market focus has shifted toward the eventual tapering of BOJ, ECB and BOE accommodation, which has helped lift bond term premiums and boosted long-term yields (see Exhibit 79). In light of these waning headwinds, the Federal Reserve is likely to hike two or three times in 2017, with upside risks from a larger-than-anticipated fiscal expansion. Combined with some further normalization in the term premium, we expect 10- year rates to increase to 2.50-3.00% by year-end. Given the balance of risks, we remain comfortable funding tactical tilts out of investment grade fixed income. Treasury Inflation-Protected Securities (TIPS) TIPS fared better than nominal bonds in 2016, delivering a positive mid-single-digit return. Their outperformance was driven by the recovery in breakeven inflation rates, which began the year at very depressed levels consistent with only 1.5% annual inflation over the next 10 years—well below long-run forecasts (see Exhibit 80). In fact, our work suggests that breakeven inflation rates were reflecting high odds of a deep recession over the course of 2016, well above the risk suggested by our recession models. 66 | Goldman Sachs | JANUARY 2017 HOUSE_OVERSIGHT_014599