Genworth Financial Asset Management035 (02/08)

GFAM 2009 MArket OutlOOk

We believe that the recession that began in December 2007 will likely persist through much of 2009, followed by a tepid recovery at best. Given this timing, we expect the capital markets to remain challenged, making defensive positioning and bargain hunting the major focus for our asset allocation decisions this year.

Before we can develop that forecast further, we need to ask deeper questions: Are we in a “typical” cyclical recession or is the slowdown phase of a deeper structural change? Has the bursting of the credit bubble coincided with a new paradigm of savings instead of consumption? Finally, what will be the impact of government stimulus and the debt it entails?

G o v e r n m e n t s t i m u l u s p l a n s

Government spending through fiscal stimulus plans is often an effective counter-cyclical means of dealing with recessions. The government does not directly affect consumer spending, a key component of the current slowdown, but it can create spending programs that may be effective if the multiplier effect (the ripples created in the broader economy) is sufficient.

Currently, investors worldwide have funded the US government’s efforts by snapping up Treasurys at almost any yield for the safety of principal. At some point, however, foreign investors may see a greater need for using their funds for their own domestic stimulus,

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Chart 1. Fed Balance sheet

or they may seek better yields elsewhere. The likely effect would be some combination of a falling dollar and rising interest rates.

Meanwhile, the Federal Reserve has been injecting new cash into the banking system and buying debt in the financial markets, including commercial paper and mortgage related securities. This has increased the money supply and Fed balance sheet dramatically. (As seen Chart 1.) But when the economy begins to turn around and consumers and businesses are no longer hoarding cash, the extra cash in the system may be inflationary, sending interest rates higher. If the Fed can extract the excess cash from the system, inflation can likely be avoided. The potential for higher interest rates and higher inflation, however, must be considered in our investment decisions.

Currently, however, the excess supply of capital and capacity versus the demand for finished products and services puts the focus on deflation. Deflation can cause consumers and business to postpone spending, furthering the economic slow down. As demand returns, however, the Fed must remove the excess liquidity to prevent inflation. In simple terms, supply must be balanced with demand, and that is a tricky prospect in an economy as large and complex as that of the U.S.

The timing of these shifts is difficult to forecast. However, while there is a strong possibility that government bond yields may head higher, there are two important reasons why Treasury yields might not rise. One is the traditional role of the U.S. Treasury market as a safe haven investment for investors around the globe. Recently, investors have even accepted negative yields on short term Treasury bills. Second, the Fed is expanding its balance sheet to pump money into the system, and may seek to lower interest rates on longer term bonds by buying US Treasurys.

The likely scenario is that investors will eventually begin to migrate from safe-haven instruments into those with higher yields and credit risk. (We have already seen late in 2008 that foreign demand for longer dated US government and agency bonds has waned, with net selling by foreign holders.) At that point, the Fed may want to remove some of this money and sell securities from its balance sheet to accomplish that task.

Meanwhile, the Treasury will likely continue to issue securities for a fiscal stimulus plan that will take at least two years to accomplish its objectives, also putting more bond supply on the market. (The infrastructure and other projects floated by the Obama administration will take some time to plan, let alone implement.) This balancing act likely will be resolved with credit spreads contracting as Treasury yields rise to a price that will clear the market, the dollar falling, and corporate bond yields remaining flat or even declining a little if investors once again are comfortable investing in corporate debt.

C o n s u m e r s t u r n F r o m C o n s u m p t i o n t o s av i n G s

There is an added nuance to address in our 2009 Outlook. Consumers have begun to save more and pay down debt. Every dollar a consumer saves is a dollar that is not spent, and that unspent dollar has a multiplier effect in the real economy. Therefore, increased savings may keep a lid on economic growth – but it may help keep a lid on interest rates as some of the savings are invested in fixed income instruments.

The shock of the dot com bubble bursting, followed by that of the housing bubble bursting, has perhaps left an indelible mark in the psyche of American consumers. Now, with assets having fallen in value and access to credit scarce or unaffordable, future consumption is much less likely to be supported by increasing debt or drawing on inflated asset values. (See Chart 2) Add in a generational shift as baby-boomers retire and leave their peak consumption years behind, and the shift from consumption to savings may become more pronounced.

What does this mean for the investor? Money formerly put toward discretionary spending may be redirected to savings, which in turn may lower the cost of capital for corporations seeking to fund investments in property, plants or equipment. However, as the American consumer scales back on consumption (as seen in Chart 3), profit and sales growth may recede to a rate closer to that of nominal GDP (with adjustments for things like foreign trade). Corporate profits per share will likely be lower, with future returns to equity investors more in line with nominal GDP growth. This is in contrast to

the higher returns seen during the 1980’s and 1990’s, a period of strong growth, falling interest rates, and healthy P/E multiples.

A vulnerable corporate profit outlook and heightened equity volatility point to alternatives such as investment grade bonds that offer attractive yields relative to Treasurys. Care must be taken, however, to monitor signs of excess money supply and the resultant inflation that could erode fixed income returns.

t h e G l o B a l i m pa C t: C a s h F l o w s

The recession is not confined to the U.S.; Europe and Japan are also in a significant and serious recession, with demand for exports waning and manufacturers cutting production. The ripple effects are then seen in emerging markets that supply the commodities or export finished goods to developed markets. Even China is proposing a fiscal stimulus plan to help employ the people migrating into the cities by building out infrastructure (which it certainly needs). This internal focus around the globe means a few things for trade and international capital flows.

Countries import less due to weaker local demand. Other countries respond by devaluing their currency to make their exports more attractive, which inspires more aggressive responses as countries seek to promote their trade and defend against imports. If this is carried to the extreme, trade wars may develop and protectionism may result. Protectionism is a highly dangerous element that can subvert economic growth globally.

Slower global trade, whether from weak demand or government policy, also affects cross border capital flows. As we buy Chinese goods, they send the dollars back to buy US Treasurys. This has helped fund our budget deficit, but now that we are importing less, they are sending fewer dollars back to buy our government debt. Given a backdrop of massive issuance of US Treasurys to finance not only the existing trillion-dollar-plus deficit but also the stimulus plan, we must hope that we have enough buyers.

On a different front, a devaluing of the dollar may present a mixed blessing for the US economy. On one hand, it will make imports more expensive and decrease our purchasing power abroad, ultimately leading to an increase in inflation. On the flip side, it will generally make US companies more competitive overseas, boosting exports. These forces working in tandem would continue to narrow the U.S. trade deficit. The price of oil, difficult to forecast because of many variables including geopolitical risk, is an important wildcard in the trade deficit equation.

Another effect of a falling dollar is that it will enhance the profitability of investments made abroad when repatriated into US dollars. Should US investors become concerned about the potential for rising US Treasury interest rates later in 2009, investing in fixed income instruments overseas may be appealing, especially when factoring in the currency gains from a falling dollar. While overseas equity markets will likely face similar challenges as those of the US, at some point entry to those markets may be compelling. In the US alone a mountain of cash is sitting on the sidelines that may be deployed in any number of instruments as the investing climate shifts from risk aversion to risk taking.

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Chart 2. household Borrowing Chart 3. Discretionary spending Growth

l o o k i n G a h e a D

When will a shift in risk attitude happen? The capital markets typically begin recovering four to eight months before the real economy, and we do believe that we are perhaps halfway through the current market difficulties. But we also believe that there are several preconditions before the economy recovers, including:

Credit must flow smoothly through the •economy, so that homebuyers can get a mortgage or a business can invest in a new plant or equipment.

Housing prices can therefore stabilize, •even if prices do not rebound for several years.

That will in turn renew consumer •confidence in the economy and markets, sparking consumer spending…

... which will in turn bring about rising •employment. This is not a precondition for the markets to recover, but it is still very important nonetheless.

We do not see these conditions being met until 2010, which suggests a potential for market recovery in mid-2009. The rebound off the November low may ultimately be seen as a bear market rally spurred by optimistic hopes regarding federal fiscal stimulus spending. Tax cuts are temporary, however, and are likely to be saved rather than spent. Also, investments in infrastructure require considerable planning and overcoming logistical hurdles before any money is actually dispersed. It might be 2010 before a significant amount of the stimulus actually reaches the economy.

While we believe opportunities may present themselves at various points during 2009 we are positioned realistically for what we believe to be another challenging year. We favor companies with strong balance sheets, demonstrable earnings, and stable cash flow – in a word, “quality”.

We are also attracted to securities that rank higher up on the corporate structure, such as investment grade corporate bonds, which we may favor over the equity of the same issuer. Yields are compelling in our view. The chart (Chart 4) shown here isolates the additional yield for Baa-rated corporate debt over Treasurys, demonstrating a widening spread in favor of corporate debt in recent months. And, as debt ranks higher than equity on corporate balance sheets, investment grade bonds may offer an additional measure of safety and potentially less volatility relative to equities.

We are beginning to see potential opportunities in emerging economies with developing consumer societies less dependent on exports to a weakened industrialized world. In addition to, or instead of, investing directly in emerging markets, we may invest client assets in companies that export to them, such as the Domestic Export mandate. We may also revisit commodities as a way to play the infrastructure stimulus sometime in 2009 (This will require careful consideration as the tangible effects of building programs on commodities may be offset by continued global economic weakness.) We also may place greater emphasis on convertible bonds, which can offer equity upside in addition to the income characteristics of bonds.

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Yields on corporate debt very attractive compared to Treasurys

Chart 4. Baa Bond Yield minus t-Bill Yield

F l e x i B l e r e s p o n s e t o o p p o r t u n i t Y, r i s k

Across our Unified Managed Account solutions and in our Preservation Strategy, we have access to dozens of asset classes and risk mitigation tools. The 2009 Outlook detailed here will provide the framework for our responses, but we retain the flexibility within most of our strategies (particularly in Opportunistic sleeves) to respond as opportunities and risk arise. It must be noted that not all of the responses described here are available in every strategy. Decisions made for specific accounts, including risk levels, equity focus and other considerations, may limit our ability to use some of the tools in our asset class toolbox.

Nevertheless, there are opportunities in adversity, but one must be both creative and prudent, particularly during periods of great financial distress and uncertainty. We believe that 2009 will be a volatile year with opportunities for selective risk taking and incremental position building, all against a very challenging economic backdrop.

Source: All charts supplied courtesy of MacroMavens, LLC. Charts 1 and 2 from the Federal Reserve Flow of Funds and Chart 3 from data from the Commerce Department.

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