Genworth Financial Asset Management, Inc.035 (02/08)

GFAM 2008 MArket OutlOOk

The investor anxiety and economic concerns that dominated the markets at the end of 2007 accelerated at the beginning of 2008. While anticipating the timing of market reactions is, at best, problematic, we feel that our 2007 Outlook identified many of the trends and opportunities that have impacted the markets in recent months. In particular, we believed that the deflation of the housing bubble would be more severe than many anticipated. On the positive side, we also saw the potential opportunities that arose from the weak U.S. dollar and falling Treasury yields.

At this juncture, the questions are: will we see a recession in the U.S. economy in 2008? What are the unique drivers (if any) to the current slowdown? Clearly, no forecast is ever certain, but we believe that some potential outcomes are far more likely to materialize than others.

R e c e s s i o n P o s s i b i l i t i e s ?

Some Wall Street observers believe that the recession began in late 2007. On the other hand, the consensus view still calls for “slow economic growth, but no actual recession.” But before you take solace in the consensus, similar views have been expressed in the past, even after recessions had already begun. It is our belief that yes, a recession is likely for 2008.

We believe that the drivers behind the recent volatility have not fully played themselves out. Rather than the typical economic cycle of contraction following

expansion, the current volatility has been sparked by an asset bubble tied to debt, debt that must be repaid or written off as asset prices shrink. The asset, in this case, is housing prices and how it directly impacts the consumer sector of the U.S. economy.

Of course, opportunities frequently present themselves well before an economic downturn has run its course. The stock market, in effect, tries to predict future worth and may begin to price in a recovery before it shows up in the economic indicators. Our Active Asset Allocation approach will be an essential component of our response to any market turnaround.

In the meantime, let’s take a closer look at the potential consequences of the current credit crunch.

t h e e f f e c t s o f a c R e d i t

c R u n c h

The problems are not simply mortgage defaults. The problem has been an American consumer that has seen sluggish wage growth since the start of the decade and felt more inclined to take on debt in order to fund discretionary purchases.

Now, delinquencies in broad categories of consumer debt are rising noticeably, as well as in commercial real estate and other business loans. Banks are taking losses on credit cards and car loans, and as some credit card companies report consumers are now both cutting back on spending and paying their bills late.

A ballpark figure for credit and mortgage losses (not including potential losses in the corporate sectors) is $250 billion. Certainly the U.S. Gross Domestic product, currently around $12 trillion, can absorb that potential loss. The larger concern, however, is that losses accruing to bank balance sheets become multiplied in terms of curtailed lending.

Banks are generally required to hold on their balance sheets capital equal to about one-tenth of the loans they write. Thus, assuming that half of this debt resides on bank balance sheets (the remaining debt having been securitized and sold to investors) that equals losses of $125 billion. That, in turn, equals perhaps $1.25 trillion in loans that banks cannot make. While this can severely hamper mortgage lending, the primary risk is that capital may not be available for small business expansion. Keep in mind that small businesses are the largest employer of Americans.

c o n s u m e R b a l a n c e s h e e t s

While banks may be increasingly unable or unwilling to make loans, consumers are also reluctant to take on new debt as well. Consumer outlays to non-discretionary spending (such as food, fuel, medical and debt services) are greater than at any time in recent memory. Falling property values and higher gasoline and food prices further discourage consumers from extending themselves.

With some economists suggesting housing prices may decline anywhere from 10% to 30% over the next few years, the reduction to household wealth could range from $2 trillion to $7 trillion. One rule of thumb suggests that households cut spending by six cents for every dollar lost in household wealth. That translates into consumer spending cuts as much as $300 billion over the next few years.

Source = BEA, Federal Reserve

NonDiscretionary Outlays*as % Wages

*Food + Energy (30.3%) + Medical (26.5%) + Debt Service (23.0%)=79.8%

64.0

65.5

67.0

68.5

70.0

71.5

73.0

74.5

76.0

77.5

79.0

80.5

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Commercial Real Estate Delinquencies$ Million

4Q Average

8000

13000

18000

23000

28000

33000

38000

43000

1992 1994 1996 1998 2000 2002 2004 2006 2008

Source = Federal Reserve

Credit Card Delinquencies$ Million

4Q Average

5200

6030

6860

7690

8520

9350

10180

11010

11840

12670

13500

1992 1994 1996 1998 2000 2002 2004 2006 2008

Source = Federal Reserve

Commercial Real Estate Delinquencies$ Million

4Q Average

8000

13000

18000

23000

28000

33000

38000

43000

1992 1994 1996 1998 2000 2002 2004 2006 2008

Source = Federal Reserve

Credit Card Delinquencies$ Million

4Q Average

5200

6030

6860

7690

8520

9350

10180

11010

11840

12670

13500

1992 1994 1996 1998 2000 2002 2004 2006 2008

Source = Federal Reserve

Taken over two years, this would represent a 2% hit to consumer spending per year. With savings rates near zero, consumers may choose to save instead of spend in order to shore up their personal balance sheets. Any increase in savings, by definition, must come from spending, reducing GDP in the process.

Of course, increased savings rates would be a positive for the economy in the long-term. At some point, increased savings deposits would make more capital available for business expansion through bank loans, helping alleviate the credit crunch.

o f f s e t s t o c o n s u m e R

s P e n d i n g d e c l i n e s ?

In addition to increased savings, are there other sources of economic strength to offset the decline in consumer spending we outlined in the last section?

One argument is that with employment strong, consumers will continue to spend. We believe that logic, however, is flawed. The simple cause-and-effect equation is that recessions cause job losses; job losses do not cause recessions. Most often, the job losses mount well after the recession is underway, and may even continue even after the economy is deemed to have been in a “recovery.”

Another argument put forth by many market-watchers is that strong corporate balance sheets and ample cash reserves will lead to strong capital expenditures by businesses, a segment that represents about 16% of the economy. While it might be true that corporations have the capacity to increase spending, their willingness to invest during a downturn is highly questionable. Recent surveys of CEOs have indicated confidence levels similar to that achieved during past recessions, which does not suggest an appetite for increased spending.

Finally, others suggest that exports, at 12% of U.S. GDP, will compensate for any declines in the consumer sector, which represents 71% of U.S. GDP. While it is true that a weaker U.S. dollar has increased exports, the segment may not be large enough to compensate for U.S. consumer-led weakness. Moreover, any downturn in the U.S. will, at some point, likely affect the global economy, simply given the sheer size of U.S. GDP at 20% of the global economy.

g l o b a l e c o n o m i c h e a lt h

This leads us to consider the health of the global economy, where we find the theme of slowing economies being played out across most of the developed world. The emerging world, on the other hand, continues to steam ahead, fueling demand for crude goods of all types.

This growing demand for commodities of all types by the emerging world presents another opportunity. Of course, in the near term, emerging economies may suffer from a slowdown in the developed and (especially) U.S. economies. While emerging markets are developing consumer societies, they still depend on exports of both finished and crude goods to the developed world. Despite this short-term risk, we remain long term bullish on emerging economies.

There are, however, opportunities to capitalize on the strengths of overseas markets that are now developing consumer societies, especially when coupled with a weak U.S. dollar. One asset category prominent in a number of our strategies is “Domestic Export,” which invests in U.S. based companies that derive a significant amount of their revenue and profits from overseas markets. This asset class may be poised to capitalize on overseas consumers and businesses around the globe that are becoming increasingly prosperous as a weak U.S. dollar makes U.S. goods and services more competitive overseas.

c u R R e n c i e s a n d f i x e d i n c o m e

The dollar has weakened since 2002 against our major trading partners, but lately the weakness has accelerated as lower short term interest rates relative to other economies and weaker growth prospects make the dollar less attractive versus investments in other countries.

While this has presented opportunities for investing abroad or investing in companies that export abroad, it presents a worry for financing U.S. debt. Foreign capital has flowed into the U.S. providing both a floor for the dollar and a ceiling on U.S. interest rates on the longer end of the yield curve. Now that there is a risk that the capital inflows will continue to be reduced, concerns mount that the dollar will fall further.

We think it likely that global investors will continue to favor non-U.S. dollar assets.

While we see weakness in Europe and the potential for rate cuts in that region keeping the Euro from appreciating further against the dollar, we see Asian and emerging markets currencies appreciating further versus the dollar. This, of course, will make their exports to the US more expensive (and our exports to them cheaper), thus narrowing our trade deficit but crimping their economies in the process.

Fortunately, the U.S. is seen as a “safe haven” for assets worldwide, and assets fleeing to “quality” may mitigate the currency decline.

P o s i t i o n i n g f o R 2 0 0 8

In the U.S., we remain focused on defensive strategies early in the New Year, favoring quality, large cap over smaller caps, and favoring growth over value.

However, the U.S. economy is flexible and nimble despite its size. No economic downturn lasts forever. The stock market can turn at a moments notice, creating significant opportunities – opportunities unique to the nature and character of forces driving the recovery.

In a fast-changing environment, it is critical to be active and forward-looking. Our active asset allocation approach, with access to dozens of potential asset classes, leaves us poised to benefit quickly when the turnaround finally materializes.

We look forward to investing in 2008 to highlight the ever-changing market and economic outlook and we thank you for your continued business.

Genworth Financial Asset Management, Inc.

16501 Ventura Blvd., Suite 201

Encino, CA 91436Tel: 800 691.6680 www.gfaminc.com

©2008 Genworth Financial, Inc. All rights reserved. Genworth, Genworth

Financial and the Genworth logo are service marks of

Genworth Financial, Inc. Advisory services provided

by Genworth Financial Asset Management, Inc.

(“GFAM”), an investment adviser registered with the

U.S. Securities and Exchange Commission, and a wholly

owned subsidiary of Genworth Financial, Inc. All charts supplied by MacroMavens, LLC.