2008 Secular Forum: An Annual Strategic Review
Investment Outlook and Strategy

Paul O’Connell
Director of Investment Research

Secular Forum Process
In November and December of each year, we devote our weekly Investment Committee meetings to our Secular Forum, an annual strategic review.  During this Forum, we update our economic and investment outlook and identify major long-term trends that we expect will impact future investment returns.  Since markets are often driven by psychology and irrational behavior in the short-term, we focus on the secular outlook for the next several years, rather than attempting to predict the direction of the markets over the next few quarters.

We also carefully review the analyses and forecasts of some of the most thoughtful and insightful market strategists and investment managers.  We synthesize this information to identify the opportunities and risks in the various asset classes.  While it is impossible to accurately predict investment returns, understanding the many possible outcomes and estimating their likelihood of occurring serves as an important basis for developing investment strategies for our client portfolios.

Finally, we revise our model portfolios by adjusting asset-class allocations and selecting an appropriate mix of mutual funds and other investments.  Our Investment Committee, guided by the Investment Research Department, manages three model portfolios that reflect our strategies and guide our decisions in client portfolios.

Review of 2007 Investment Strategy
In 2007, we made six asset allocation decisions that affected the results in our model portfolios.  
These five decisions improved model portfolio performance in 2007:

• The decision to reduce exposure to high yield or “junk” bonds and U.S real estate stocks based on risk and valuation concerns as these categories underperformed in 2007.  
• The allocation to smaller company stocks was reduced in favor of larger company stocks which outperformed in 2007.
• The significant allocation to foreign stocks (both developed and emerging markets) in 2007 improved performance as many foreign markets outperformed the U.S. market.  
• The allocation to foreign stock and bond funds that were denominated in foreign currencies and a direct investment in foreign currencies improved performance in 2007 as the value of the U.S. dollar continued its long-term decline relative to many foreign currencies.  
• The allocation to natural resources also improved performance as global demand for commodities remained strong and the natural resources category finished 2007 as a top performer.
  

One asset allocation decision detracted from model portfolio performance in 2007:

• The decision to reduce the allocation to bonds and invest in money market funds (U.S. Treasury or municipal), given our view of the increased risks in the credit (bond) markets, detracted from performance as money market funds lagged the performance of many bond funds.
  

2008 Investment Outlook
Risks remain elevated for investors both in the U.S. and abroad.
We continue to believe that we are in a transition period in which the prices of a wide range of assets are adjusting to reflect a wide-spread mispricing of risk.  Over the last five years, low interest rates, excess global liquidity (excess cash) and investor demand for higher yields and returns fueled demand for riskier investments.  In some cases, this pushed the prices of some categories of stocks and bonds well above what could be justified by fundamentals and therefore increased the risks to investors.  Increased market volatility is likely to continue during this extended period of price adjustment. 

 
This environment of elevated risks is best illustrated by the strong performance in recent years of investments that have historically been considered to be among the most risky such as high yield or “junk” bonds.  This is the type of investment that we have been avoiding based on valuation concerns but may reconsider as valuations become more compelling and the disruptions in the global credit markets are resolved.

Geopolitical risks appear to remain elevated as we begin 2008 with the heightened tensions between the U.S and Iran over its nuclear program and the potential for armed conflict and the possible disruption of oil supplies from the Persian Gulf.  There is also the continuing risk that the Iraq war will devolve into a full-blown civil war between Sunni and Shiite Muslims and spread to neighboring countries.  There are growing concerns regarding the safety of the nuclear arsenal in Pakistan given the recent political upheaval and the escalation of attacks by al-Qaeda and Taliban insurgents.  There has also been a resurgence of the Taliban in Afghanistan and an escalation in attacks which necessitated a request from NATO for more U.S. military support.  The potential for protectionist actions and legislation are also likely higher given the change of control in the U.S. Congress in 2006 and the run-up to the presidential elections in November.  

Global credit market conditions are likely to remain challenging.  
The collapse of the U.S. subprime mortgage market that began in June of 2007 has triggered a crisis in global credit markets.  Low interest rates and lowered lending standards over the preceding five years fueled a residential housing bubble in many U.S. regional housing markets.  Many lenders didn’t keep the loans on their books.  They securitized the mortgages into bond issues, and sold the bonds to individual and institutional investors in the U.S. and abroad.  Many of these bond issues were rated investment grade by the bond rating agencies.  When the default rates began to rise on the underlying subprime mortgages, prices of the bonds fell precipitously and the ability of bondholders to value and sell these issues also fell dramatically.  The value of derivative instruments tied to these mortgages also fell sharply.  With the benefit of hindsight, it is now clear that bond rating agencies were overly optimistic in assessing the risks and assigned investment grade ratings to many of these subprime-related bonds that were inappropriate.   

 
The subprime mortgage induced crisis in the global credit markets has resulted in more than $130 billion of losses and markdowns on subprime mortgage-related debt held by securities firms and banks around the world.  The full extent of the eventual losses is unknown, but current estimates range from $300 billion to $500 billion. As losses have mounted, the ability of bond insurers to cover potential claims has also been called into question.  Many financial institutions have responded to the crisis by tightening lending standards and curtailing lending activities.  These actions have further impaired the availability of credit and the normal functioning of the credit markets.  The deterioration in global credit market conditions should gradually begin to improve as financial institutions write-off hundreds of billions of dollars in subprime mortgage-related debts, but the process will likely occur over an extended period of time.

Central banks have responded to the credit crisis through coordinated actions to add liquidity (cash) to the credit markets and by acting independently and cutting key short-term interest rates.  Additional central bank actions are expected as part of a continuing effort to avoid a recession.  Complicating the efforts to facilitate a recovery of the global credit markets is the increasing role of non-traditional financial entities that are participating in the global credit and financial markets but operate outside of the traditional banking systems, i.e., hedge funds, sovereign wealth funds, off-balance sheet entities such as structured investment vehicles (SIVs), etc.  The extraordinary growth of derivative instruments, the complex nature of some derivative structures, the lack of disclosure and transparency of their use and the difficulties in assessing the value of derivatives could also prove to be challenging in the months ahead.

Economic growth in the U.S. and abroad is expected to slow.  
In its most recent World Economic Outlook Update, The International Monetary Fund (IMF) forecasted that the world economy will grow 4.1% in 2008, down from an estimated 4.9% in 2007.  According to the report, the largest contributors to global growth in 2008 are expected to be the emerging markets which the IMF estimates will grow 6.9% in 2008, down from an estimated 7.8% in 2007.  Advanced economies are expected to grow at a more modest 1.8% in 2008, down from an estimated 2.6% in 2007.  The U.S. economy is expected to grow 1.5% in 2008, down from an estimated 2.2% in 2007.

The ongoing correction in the U.S. housing markets will likely deepen and persist for an additional 12-18 months or longer as home sales remain weak and mortgage defaults and foreclosures continue to climb. The ongoing housing correction has the potential to further slow U.S. economic growth and to restrain consumer spending which accounts for nearly 70% of U.S. economic activity.  The consumer was a key driver of the U.S. economy during the recovery from the economic slowdown and market correction that occurred between 2000 and 2002.  The appreciation in home values provided consumers with additional cash through refinancing activities and helped to fuel consumer demand and the economy over the previous five years.  

A deeper and prolonged correction in the regional U.S. housing markets also has the potential to further pressure economic growth and corporate profits abroad.  According to the IMF, the U.S. economy currently represents approximately 21% of the global economy.  Given Americans’ appetite for foreign goods as reflected in the $700 billion annual trade deficit (2007 estimate), it appears likely that a significant slowdown in U.S. consumer spending would cause additional downward pressure on the economic growth and corporate profits of our global trading partners.

A key question that remains unanswered is whether emerging market economies have sufficiently decoupled from the U.S. economy to enable the global expansion to continue unabated if U.S. economic growth continues to slow.  There is no broad consensus among strategists.  We continue to believe that the key determinant of economic decoupling is the extent to which the internal consumer markets in developing countries have evolved and are able to fill a spending gap created by a decline in U.S. consumer demand.  It remains unlikely that the developing countries have attained the critical mass in their internal consumer markets needed to offset a prolonged and deeper contraction in U.S. consumer demand.  Consequently, a protracted and more extreme slowdown in U.S. consumer demand could have a significant impact on the global economy and foreign markets.

 
Investment opportunities outside of the U.S. are expanding and remain attractive.   
The world economy is being altered by the forces of globalization, and the economic influence of the U.S. and European industrialized nations no longer dominates to the extent it once did.  The economic power  of the emerging market countries is rising at a rapid rate.  China will likely be the third largest economy in the world in the next 2-3 years, behind the U.S. and Japan.  India and South Korea will likely join the top ten within a decade.  Developing nations now account for approximately 50% of world economic output, up from 39% in 1990.  According to the International Monetary Fund, China, India and Russia accounted for half of the global growth over the last year.

As a result of powerful global economic trends and the strong performance of foreign stock markets over the last six years, approximately 64% of all stock investments (by market capitalization) in the world now reside outside of the U.S. (Standard & Poor’s Fact Book 2007).  Although the valuations of foreign investments currently appear to be generally comparable to those in the U.S., foreign investments remain attractive because their use in portfolios expands the opportunity set of investments, enhances diversification and offers the potential for additional returns when they are denominated in foreign currencies that are expected to strengthen against the U.S. dollar.

2008 Investment Strategies
While developing our investment strategies for 2008, we considered the mix of asset classes and strategies that would be appropriate given the outlook and valuation level for U.S. equities, foreign equities, emerging markets investments, U.S. bonds, foreign bonds, real estate and alternative strategies.  Based on our outlook, we believe that a moderately defensive strategy is appropriate at this time.  The strategies highlighted below will guide our decisions in client portfolios in 2008.

Allocating the majority of U.S. and foreign stock investments to larger companies.  When economic growth and corporate profit growth are slowing, larger-cap stocks have historically provided investors with better opportunities than smaller-cap stocks.  Large-cap stocks are also better positioned to benefit from a further decline in the value of the U.S. dollar because a larger portion of their revenue and profits are derived from sales in overseas markets. There is also a larger company valuation advantage compared to smaller companies.

Maintaining the investment in a passive strategy within the U.S. large-cap stock allocation. Our research indicates that passive index strategies can add value when selectively used to supplement core positions in actively managed mutual funds that seek to outperform their benchmark index.  In addition, passive index strategies offer the added benefit of hedging against the risk of multiple active managers experiencing underperformance at the same time.  As part of our passive investing strategy, we are shifting from the S&P 500 to the S&P 100 in order to increase exposure to the largest U.S. companies.

Increasing the allocation to foreign and emerging markets stocks. In view of higher economic growth rates overseas, continued U.S. dollar weakness and expanding investment opportunities abroad, we are increasing the allocation to foreign stocks in both developed and emerging markets.  

Maintaining the increased allocation to alternative investments. Alternative investments have become a key part of our asset allocation strategy.  Alternatives provide access to investment opportunities such as commodities, international real estate, currencies, absolute return and long/short strategies.  Alternative investments enhance portfolio diversification and enable access to non-traditional investment opportunities.

Reducing the allocation to bonds and investing proceeds in cash (money market funds). Given the ongoing turmoil in the credit markets and the more difficult environment for bond investors going forward, we continue to broadly diversify into cash, high-quality bonds, multi-sector bonds and foreign bonds.  Cash at a 3% to 4% yield looks attractive compared to current bond yields with the added benefits of stability of principal and full liquidity.

Conclusion  
As we begin 2008, we are cautious about the investment outlook:

• Investors face an environment of increased geopolitical, economic and market risks.
• Economic growth in the U.S. and abroad is expected to slow, but risks can be mitigated through broad diversification and by selectively reducing exposure to investments that appear overvalued.
• Global credit market conditions are likely to remain challenging, but we believe a strategy of diversifying income-oriented investments among high-quality U.S. bond funds, foreign bond funds, multi-sector bond funds and cash (money market funds) will help to mitigate the risks and enhance returns.
• Foreign investment opportunities are expanding and remain attractive, and we are positioned to benefit from evolving global trends.
• Alternative investments have become a key part of our strategy and provide access to non-traditional investment opportunities such as commodities, international real estate, currencies, absolute return and long/short strategies.

We continue to review a broad universe of investment opportunities on an ongoing basis with a research process focused on asset class valuation, manager due diligence and risk management.

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