Author: Eric Uhlfelder

2008 March 1, Monthly Strategist Commentary
By Eric Uhlfelder, Guest Author

Reality Bites For the first time since we started reporting in 2005, foreign shares aren’t providing shelter against the current market downturn. Most troublesome: no one is using the term “correction” in describing the pullback.

The broad stock picture over the past quarter has been dismal. During that time, no market was up in U.S. dollar or local currency terms, with double-digit losses prevalent across most of the developed world.

In comparative terms, however, the U.S.’ standing is improving. Two thirds of the world’s 21 developed markets underperformed the U.S. over the past quarter and trailing 12 months through February 12 in local currency terms. All but two foreign markets trailed the states over the last quarter when measured in dollar terms, revealing the effects of a stabilizing greenback. And over the past year, one-third of these markets are now underperforming the U.S.. These numbers reflect the slowing of the global economy. The latest 2008 consensus growth estimates have been reduced from the last quarter for every market, save for oilrich Norway. Most disturbing, the largest decliners were the core economies of the U.S., Japan, Britain and Canada. This indicates that some nasty news has made its way into these projections.

Even if the prime cause of today’s market turmoil is the collapsing U.S. housing market, the problem has metastasized into other consumer markets and across the oceans to institutions holding significant amounts of sub-prime-related securities. This has resulted in billions in losses across Europe and as far east as Australia that may eventually total $400 billion worldwide.

But we are facing more than a banking crisis. The seizing up of credit and reduction of risk exposure is slowing growth around much of the world. Steady expansion will not likely return until financial institutions write down the vast majority of their losses, recapitalize balance sheets, fortify reserves, boost capital ratios and convey confidence that they alas now know what they are doing.

A reduction in interest rates and the steepening of the yield curve, pushing up lending margins, will also be necessary to restart debt markets and rekindle lenders’ appetite for risk. However, uncertainty over when all this will play out also weighs heavily on markets and investor sentiment.

I. Macroeconmic Trends

While to some it may be a misleading technical point, according to The Economist consensus estimates, no economy is forecast to fall into recession in 2008. GDP growth in the U.S., the eurozone and Japan are all projected to come in under 2%, well below expectations made just late last year. The only developed economies expected to see growth over 2% include most of Scandinavia, Austria, Spain, Greece and Australia, with the folks Down Under projected to enjoy a 3.5% rate of expansion.

As mentioned above, the most disturbing trend is the rapid deceleration of the U.S., Japanese, British and Canadian economies, which represent about half of the world’s GDP. Fear that expansion of these core markets will slow by 25% to an average GDP growth rate of just 1.6% will reverberate across markets—whether or not it comes to pass. And it will challenge the belief that there is indeed a disconnect between the world’s major markets.

Latest trends in industrial production and employment versus last quarter are also negative, with two-thirds of the developed economies having suffered a decline in both measures.

Observation: Investors are hoping that the Fed’s aggressive loosening of monetary policy will restart our economy before claims that we are already in recession are borne out. However, with consumer prices rising above 4%, the Fed may also be unleashing inflation. Japan is facing the same problem. And while the eurozone expanded by a healthy rate of 2.7% in 3Q07, estimates that its expansion will slow by one-third this year as inflation breaches 3% will soon put the ECB in the same position as the Fed. Despite largely accommodative interest rates, economies are slowing across the globe. The health of economies going forward are likely geared to financial institutions restarting their engines. Unfortunately, this doesn’t seem likely to happen for at least several quarters.

II. Stock Markets

The modest declines that were registering across half the bourses last quarter have now enveloped all developed markets. Through February 12, every exchange was down over the past three months in local currency terms, and double-digit losses were seen in three quarters of these markets. The worst hit were the peripheral continental markets of Norway, Portugal and Spain, and the Asian-Pacific markets of Japan, Singapore and Australia, all suffering nearly twice the losses of the U.S. when measured in local currency terms.

In most western markets, dollar stability has at least temporarily eliminated the boost the falling greenback had been giving investors. In some cases, such as Britain, a rebounding dollar has increased local losses of 7.75% over the last quarter to 12.05% in dollar terms. While the dollar continued to devalue against Asian-Pacific currencies, helping to mitigate recent U.S. investor losses, the weak dollar trend is clearly not as pronounced as it once was.

The clearest indicator of how widespread the market malaise has reached is the performance of EAFE ex Japan. Perennially having registered huge gains in dollar terms, the index fell nearly 13% over the last quarter and was up a paltry 1.12% over the last year.

Observation: This is clearly the most challenging environment we have seen in foreign markets since we started tracking them. Investors should expect volatility to continue for at least the next several quarters, as credit and liquidity issues will likely contribute to further growth contraction. Fear that this may push markets into recession is adding to investor uncertainty. While buying opportunities are evolving, we suggest waiting until the flow of bad news slows before establishing new positions.

Performance in dollar terms of the four markets we recommended in the last review have collectively outperformed EAFE over the past quarter by 563 basis points, but trailed the states by 58 bps. Chilean shares held up the best, falling just 1%, followed by Canadian stocks, which gave back 2.23%. Worst hit were Singapore and Australian shares, which lost 13.20% and 14.43%, respectively. Long term, we still favor these markets, supported by sound economies and policies, along with currencies that continue to rise against the dollar. But these shares will remain volatile while markets are unsettled.

III. Debt Markets

The dollar’s fall over the past year against most major currencies has helped generate high rates of returns on most develop market sovereigns through February 11, according to the JP Morgan Sovereign Debt Index. European sovereigns gained 17% on average, boosted by a 12% gain from currency. The exception: a weakening pound limited UK sovereign gains to 6.76%, despite cuts in interest rates. The top-performing debt markets continue to be the resource- rich economies of Canada [+24.7%] and Australia [+20.62%], driven by very large currency gains. The biggest surprise was Japanese sovereigns. They benefited from an 11.5% gain from the yen, which helped push up returns 17.5%. Observation: Investors who have ignored our past reticence towards foreign debt have done very well in most sovereign markets. Still, we continue to believe that returns will be under pressure from a strengthening dollar. This loss could be offset by foreign rate cuts—which may happen if local economies significantly slow. We feel more confident, however, in U.S. government debt, whose trailing 12-month gain doubled since the last quarter alone. It now stands at 12.27%. With expectations that the Fed will cut rates further to get both banks and the economy restarted, we believe there are still more gains to be harvested from U.S. exposure.

IV. Forgeign Exchange

For last five years, the brunt of the dollar’s devaluation has been largely absorbed by western European currencies. But over the last quarter, as exchange rates in the region have stabilized, dollar weakness has shifted over to eastern Asia. As we surmised, the 4Q07 run against the dollar in Europe came to a halt. Over the last quarter, the greenback gained 3.74% versus sterling, limiting the currency’s full-year gain against the dollar to just 1 percent. Since hitting a low of $1.49 against the euro in late November and then again in January, the dollar appears to be building a base, standing at $1.457 as of mid-February.

In contrast, the yen has appreciated 8.6% over the last three months, pushing the currency’s full-year gain against the dollar to 11.5%.

Observation: As major economies cycle into and out of recession, their currencies tend to rally. This may prove so with the dollar. It remains significantly undervalued versus most major currencies based on purchasing power metrics. The U.S. economy is slowing down in front of other major markets, which we suspect will also slow. This should mean that the U.S. would be the first to start raising rates as it powers up toward the end of the year. If this plays out, the dollar should strengthen, which would cut into U.S. investor returns abroad.

The information is sent to you for informative purposes only and in no event should be construed as a recommendation by us or as an offer to sell, or solicitation of an offer to buy any securities. The information given herein is taken from sources that we believe to be reliable, but is not guaranteed by us as to accuracy or completeness. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within.


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