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further rate cuts and lowered the deposit rate to -0.40%. Second, it increased the size of its asset purchase program from €60 billion to €80 billion per month, effectively buying more Eurozone bonds each year than are actually issued (see Exhibit 90). Finally, it continued to limit its buying to bonds with yields above the deposit rate, which concentrated its purchases toward long- maturity bonds. These measures created an extreme scarcity effect in long-term German bunds, as investors scrambled to buy today for fear of even lower interest rates tomorrow. In response, German 10-year rates fell to an all-time low of -18 basis points in July of 2016. During these same summer months, all German government bonds with less than a 15-year maturity offered negative yields. However, monetary policy does not operate in a vacuum. With negative interest rates impairing the profitability of the European banking system, the ECB has already begun to alter its policy mix. At its December 2016 meeting, the ECB reversed the increase in asset purchases mentioned above, targeting €60 billion per month for the upcoming March—December 2017 period. Moreover, it lifted the restriction on purchasing bonds with yields below the deposit rate, alleviating the scarcity premium attached to long-maturity bonds meeting this criterion. While these adjustments are well short of QE “tapering,” they have shifted the market focus toward the eventual end of asset purchases and the timing of the first ECB rate hike—currently priced for late 2018. With less ECB policy pressure on long-maturity bonds, coupled with continued above-trend Eurozone growth and some further normalization in global term premiums, we expect 10-year bund yields to increase to 0.5-1.0% by the end of 2017. While overall peripheral bond spreads should be mostly range-bound in 2017, political woes in Italy and France pose upside risks to the spreads of those countries. In the UK, we expect gilt yields to reach 1.5- 2.25%. Here, persistently high headline inflation induced by the depreciation of sterling and a less-than-feared economic drag from Brexit thus far could encourage the BOE to unwind a portion of the preemptive easing it deployed in response to the surprise referendum outcome. Given this outlook and today’s still depressed bond yields, we remain underweight UK and Eurozone government bonds for European Exhibit 90: European Government Bond Issuance and ECB Purchases ECB buying is outpacing net issuance of Eurozone bonds. €bn 400 Net Issuance MECB Purchases Net Issuance Including ECB Purchases 200 ° -200 5 -600 -800 2016 2017 Data as of December 31, 2016. Source: Investment Strategy Group, JP Morgan. investors. After all, just a 2 basis point increase in German 10-year bund yields generates a capital loss sufficient to offset an entire year of income. That said, we should not confuse an underweight with a zero weighting, as European clients should retain some exposure to German bunds and other high-quality Eurozone bonds in the “sleep-well” portion of their portfolios. These high-quality bonds would provide an attractive hedge in the event of a Eurozone recession or the return of deflationary concerns. Emerging Market Local Debt Last year’s 10% return for emerging market local debt (EMLD) provided some solace to those who have suffered through nearly three years of losses totaling more than 30%. But investors had to endure considerable volatility to realize this gain, as returns fluctuated between -4% and +18% in 2016. In fact, the asset class lost roughly 5% in just the last two months of the year. This last point is important, since many of the tailwinds that drove EMLD’s strong returns in the first half of 2016 reversed toward year-end and are likely to impact the asset class again in 2017. Here, we refer specifically to the resumption of Federal Reserve rate hikes, renewed US dollar appreciation and a resumption of Chinese renminbi depreciation against the dollar. Just as falling global interest rates helped the asset class for the first part of 2016, so too should the rising rates we expect 72, | Goldman Sachs | JANUARY 2017 HOUSE_OVERSIGHT_014605