2008 Investment Outlook
The headlines from the past two months would suggest that 2007 has not been a good year for equity investors, and that 2008 could be even worse. It seems like every time we pick up the business section of a newspaper, we read stories about mounting sub-prime mortgages losses, $100 oil, the plunging dollar, waning consumer confidence and the increased likelihood of a recession. Although there are numerous pressures facing the stock market and the United States economy, the economic outlook may not be as bleak as some headlines suggest.
Despite more than $50 billion in sub-prime write downs, $90 oil, and a U.S. dollar on par with the Canadian dollar for the first time since 1976, the S&P 500, including dividends, has generated returns just north of four percent this year. Some of the trends that helped the S&P 500 stay in the black in 2007 should continue to help equity performance in 2008, including reasonable valuations, strong corporate balance sheets and a flexible Federal Reserve.
In our 2007 Outlook, we noted that equities, as an asset class, were selling at more attractive valuations than bonds. This remains true heading into 2008, with the 12-month forward P/E ratio of the S&P 500 significantly below the historical average for periods of comparable inflation. The relatively low valuation on equities translates into an earnings yield that exceeds six percent versus a 10-year Treasury yield of 4.25%. Historically, the market tends to do much better when earnings yields are high relative to Treasury yields.
In addition to having attractive valuations, many companies currently have very strong balance sheets. The non-financial companies in the S&P 500 boast collective cash balances of $800 billion, which is double the historical average. These strong financial positions allow companies to invest in capital expansion, recruit new employees, make strategic acquisitions, increase dividends, and repurchase shares.
The Federal Reserve has stated that it will be flexible and vigilant in its attempt to ameliorate the current lending and housing market crisis. The Fed cut the federal funds rate by one quarter of a point last week, and also cut the discount rate for the fourth time since August. The Fed is implementing policy measures such as freezing rates on certain sub-prime mortgages and offering banks special funding at below market rates to encourage lending. Although we do not believe that the Federal Reserve can solve all of the problems facing the credit and housing markets, its flexibility and responsiveness should help lead to a softer landing.
In our opinion, the major risks to positive equity returns in 2008 are inflation, geopolitical events and a slowdown in consumer spending.
Inflation, which has been relatively benign for the past several years, is one of the biggest risks facing the stock market. Overall consumer prices rose by a seasonally adjusted .8% in November, which was the largest monthly gain in two years. If consumer prices continue to increase at a faster than anticipated rate, it could force the Fed to implement a more contractionary monetary policy, which would negatively impact the stock market.
While less likely than an acceleration in inflation, geopolitical risks and the potential repercussions from such events will continue to threaten equity returns. Political tensions in many parts of the world, including the Middle East, pose a threat to investor confidence, and have historically caused volatility in the stock market.
Although inflation could cause a downturn in the stock market, a slowdown in consumer spending would certainly curtail economic growth. With oil prices widely expected to stay above $60 a barrel in 2008, combined with high health care and education costs, the U.S. consumer could see a decrease in disposable income. Consumption currently accounts for more than two thirds of gross domestic product (GDP), and a significant pull back in consumption would limit economic growth in 2008.
For 2008, we see economic growth slowing to around one percent, and predict equity returns in the mid to high single digits. With the slowing U.S. economy, we favor large-cap companies with strong balance sheets and a track record of profitable growth. Diversification across both sectors and geographic areas is of paramount importance, as returns could differ widely for different segments of the economy, and different regions of the world.
Special thanks to our Investment Committee members from Trust Company of Vermont for drafting this outlook piece.
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