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Continuing Volatility and Maybe New Market Leaders

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The rising volatility that U.S. and global markets have experienced of late is expected to “continue, increase, and spread” in 2008, said Richard Bernstein, Merrill Lynch chief investment strategist at the sixth annual Dow Jones Indexes/STOXX Ltd. 2008 Global Economic Outlook, held January 22 at Dow Jones’ lower Manhattan headquarters. It’s “not simply a U.S. subprime problem,” he says, but worldwide. “U.S. subprime is a symptom of a bigger issue–tightening of global credit markets.” The mood in the room was expectant on a morning in which plunges in overseas markets on January 21 and 22 perhaps helped propel the Federal Reserve to take the unusual step of slashing the federal funds and discount rates–before the U.S. markets opened, and in between scheduled Federal Open Market Committee (FOMC) meetings–by 75 basis points to 3 1/2 % and 4% respectively. The next scheduled FOMC meeting is slated for January 30 and 31.

The new market leadership sectors that come out of the current volatility will not be the leadership sectors investors saw in the last five years, Bernstein says, “Volatility always signals a change in leadership in the financial markets,” with special emphasis on “always.” One big change is that sectors that were leading the markets in the last five years, were “extremely capital-intensive”–and with credit harder to come by Bernstein expects to see leadership change from “small cap, energy, commodities, emerging markets, and low quality bonds,” all of which “had easy access to cheap capital,” Bernstein explains, to new leadership in “high-quality bonds,” “large-cap U.S. stocks,” “smaller-cap stocks outside of the U.S.,” “defensive sectors in the U.S.,” such as “healthcare, utilities, and consumer staples,” and he favors “developed markets over emerging” markets, and “very-high-quality dividend oriented strategies–not high dividend yield” because, he asserts, high dividend yields may end up getting cut in his market scenario. Bernstein suggests that for clients that have been invested in emerging markets “it’s not unrealistic that emerging markets possibly might have tripled in the last five years–a 5% allocation” might have grown to be a 15% allocation now; perhaps trim that extra 10% in the emerging markets allocation and use that cash to “look to new leadership of the market.”

All of the economists on the panel (David Bryson, PhD, global economist at Wachovia Corporation; David Powell, currency strategist at IDEAglobal; and Brad Setser, PhD, a fellow for geoeconomics at the Council on Foreign Relations) expect to see volatility continue. Bryson expects “3.5% to 4% global GDP growth in 2008,” and forecasts, for ’08, the “slowest year of global GDP growth since ’02.” But he doesn’t forecast a global recession: rather, he sees a “global slowdown but not global recession because of the strength” of the fundamentals in most non-U.S. economies.

While he notes that a “U.S. recession seems extremely likely,” Setser says one thing that could affect the breadth and depth of a U.S. recession is the price of oil. “Each $10 increase in the price of oil is a net drain of $50 billion from consumers,” so oil at $90 a barrel versus oil at $70 is a difference of $100 billion in consumers’ hands.

Powell, a currency expert, expects the U.S. dollar to continue to decline in the first half of ’08 but not forever–”it’s not eternal,” so perhaps there’s more stability in the second half for the dollar.


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