The bull market that began in 2003 was supported by solid fundamentals including robust global economic growth, soaring corporate earnings, and a strong appetite for risk. Capital was readily available for investments in all corners of the world as cash-rich investors sought attractive returns. Money could be borrowed cheaply, often under favorable terms, encouraging excessive risk-taking. These conditions created an environment that produced stellar returns for global equities, commodities, real estate, and many types of alternative investment vehicles.
We think the investment landscape is changing to a much more challenging environment. Credit market stress and commodity price inflation threaten global economic expansion and the bull market. The collapse of the housing and credit market bubble has reduced the appetite for risk-taking and sparked fears of a credit crunch. Risk is being re-priced upwards, causing declines in asset values, and the equity markets are enduring a correction.
This change in the market environment calls for a cautious approach to investing in 2008, at least in the early part of the year. We expect high quality, large capitalization stocks in both domestic and foreign markets to outperform. Relatively defensive sectors such as energy, health care, and consumer staples are favored over cyclical stocks, financials, and consumer discretionary.
2008 Market Outlook
Our 2008 market outlook calls for a difficult trading environment into the second quarter, followed by a bottoming process and market recovery in the second half of the year. Market action is likely to be volatile, continuing a trend of higher volatility that began in 2007. Looking one year ahead, we expect stocks to finish at higher levels and outperform bonds.
During the first few months of the year, we expect the markets to focus on the economic slowdown and continued turmoil in the credit markets. Recent economic data, including leading indicators, employment, and manufacturing activity suggest the U.S.is on the brink of a recession. We should also expect banks to report additional asset write-downs tied to the mortgage crisis as the housing market continues to deteriorate, intensifying concerns of a credit crunch. Finally, the market will be vulnerable to earnings disappointments as the slowdown filters through corporate America. Volatility is likely to remain elevated until current uncertainties ease, including the extent of losses in the financial system, the depth of the economic slowdown, and the impact on economies overseas. This process will take some time to sort out.
The Federal Reserve, as well as central banks around the world, will face increasing pressure to ease monetary policy to stimulate the economy. In addition, President Bush will make an attempt to provide fiscal stimulus through tax cuts. The Fed has been reluctant to cut interest rates due to soaring commodity prices and the threat of accelerating inflation, yet inflation is likely to moderate with the economy brushing with recession.
Assuming the Fed comes to the rescue and aggressively cuts interest rates, equity markets should begin to rally around mid-year as the economy responds to global central bank stimulus. Attractive equity valuations and prospects for accelerating growth should allow stock prices to recover nicely, while bond yields rise significantly.
