Numerous Reasons Behind Economic Slowdown

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OCEAN CITY – In assessing the current state of the U.S. economy, the mood has turned decidedly somber. And though many economists are convinced that today’s troubles are merely part of the normal economic cycle, Merrill Lynch strategists caution that this time it may be different.

A deliberate approach to investing – along with a keen eye for overlooked opportunities – is what’s required now. That’s the consensus view of a group of Merrill Lynch’s top economists and strategists who recently gathered to take stock of the first half of 2008 and to talk about what may lie ahead for investors. To these experienced market watchers, making well-informed investment choices depends more than ever on understanding unfolding global changes.

The experts include Richard Bernstein, Merrill Lynch’s Chief Investment Strategist; David Rosenberg, Chief North American Economist; Martin Mauro, Fixed Income Strategist; Brian Belski, U.S. Sector Strategist; and Felipe Illanes, Latin American Economist.

Although it is still the world’s leading economic force, these experts concur that the U.S. has been losing influence, and recent events appear to have accelerated that decline. Over the past several years, Europe’s unified currency has raced past the dollar, while such emerging nations as China and Brazil have gained in financial power. American consumers borrowed heavily for years so they could experience or enjoy imported goods, propping up the global economy all that while. Now they are finding their free-spending days at an end. “Consumer balance sheets in the U.S. will continue to deteriorate,” says Rosenberg, who foresees reduced outlays for restaurant meals, vacations and other non-necessities.

Much of the U.S. debt problem started with overextended homebuyers who defaulted on their mortgages in record numbers. Hit hard by credit losses, banks and other lenders, including automakers and credit card companies, have cut back on lending, and with home sales as weak as they’ve ever been, prices have been sinking at a 15% annual rate. Rising food and energy costs have further squeezed consumers, and weakening sales are boosting unemployment. Against this backdrop, Merrill Lynch expects the U.S. gross domestic product (GDP) to expand just 1.1% this year, half the 2007 rate of 2.2%. And 2009 could be worse, with projected growth of only 0.5%.

In the past, a U.S. slowdown would have put the brakes on a number of foreign economies as well. But this time, much of the rest of the world is proving resilient. Latin America’s GDP, buoyed by booming sales of agricultural products and natural resources, should grow 4.6% this year and 4% in 2009. Similarly, long-running booms in India, China and Asia’s other emerging economies should slip only slightly, with GDP growth declining from 9.4% in 2007 to 8.8% this year. And although expansion in Europe is decidedly slower — down from 2.6% in 2007 to a predicted 1.8% this year and 1.9% in 2009 — rising exports to Eastern Europe are helping stimulate employment in many of the countries linked to the euro.

In response to these realignments, most U.S. investors should consider limiting risk, perhaps adding to holdings in high-quality fixed income.

“If global growth rates slow, stocks could be disappointing, and bonds may provide a safe haven,” says Bernstein.

Rate cutting by the Federal Reserve has benefited both Treasuries and top-rated municipal bonds, even though higher demand for Treasuries has pushed down their yields. In fact, tax-free munis may now provide higher after-tax returns for many investors.

While many corporate bonds are also attractive, high-yield, below-investment-grade issues are likely to suffer, says Mauro. “Default rates will climb as more companies face problems in the slowing economy,” he adds.

Bernstein suggests that equity investors focus on blue chips, particularly in the technology sector.

To take advantage of rapid growth in emerging markets, consider investing in Brazilian stocks, says Illanes. Brazil’s GDP is forecast to expand at a 4.5% rate this year, and the biggest winners may be infrastructure builders and consumer-goods companies serving the domestic economy. Blue-chip stocks in Hong Kong, where the economy is projected to grow 6% this year, could open the door to Asia’s continuing expansion. With several major projects about to launch, property development is a particularly attractive sector.

Eventually, of course, the U.S. economy will recover, and when that happens, the balance of global power could shift back toward its longtime leader. But progress in developing countries is likely to continue, launching millions of middle-class consumers into the global economy and adding a new variation to venerable economic themes. In shaping our experts’ collective insights into an overall investment strategy for current markets, it seems that an internationally balanced portfolio, fine-tuned to take into account ongoing shifts in the global economic balance of power, may well be the smartest approach.

(The writer is a Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)

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