Most economists think the U.S. and, thus, the global economy will slow only moderately this year and accelerate again in 2008. That means single-digit earnings growth and equity returns this year, but less buoyancy than in 2006.

But there are dissenters. Three of the 12 global money managers and strategists interviewed for Investment Executive’s annual Outlook report think the odds of a recession are high. Only one — Lloyd Atkinson, a financial and economic consultant in Toronto — sees a clear horizon.

These four have maintained their respective views for a number of years, with the evidence so far supporting Atkinson. Everyone, including the pessimists, has been surprised by the resiliency of the U.S. economy. But the pessimists could still be right.

It’s common wisdom, but nonetheless true, that it all depends on American consumers. If U.S. consumers can find the will and the money to keep spending, the U.S. economy should keep chugging along, especially given the stimulus of continued strong business capital spending and export growth.

The problem is no one knows how tight consumer budgets are or how far consumers are prepared to extend themselves. We know they have borrowed heavily in recent years, treating the increased value of their homes as an ATM. But we also know that new jobs are being created every day in the U.S. and wages are increasing.

Of the three pessimists, Ross Healy, president of Toronto-based Strategic Analysis Corp. , is the most convinced that a recession is around the corner. Consumers borrowed US$630 billion last year to finance their purchases, he says, and so would have to borrow another US$630 billion simply to keep their outlays at 2006 levels — and borrow even more to increase their consumption. He doubts whether consumers can keep adding to their debt loads this way — and he’s sure they won’t if housing prices start dropping, as he expects. “The average person is struggling,” he says. “If the value of his or her house drops, it’s the end of the story.”

Nandu Narayanan, chief investment officer at Trident Investment Management LLC in New York and manager of several funds for Toronto-based CI Investments Ltd. , and Clement Gignac, chief economist and strategist at National Bank Financial Ltd. in Montreal, are less adamant. But they are worried, putting the odds of a U.S. recession at 50% and 40%, respectively. Both feel falling house prices could trigger a downturn.

What’s ominous is both Healy and Narayanan think that if we do have a recession, it will be nasty. They think inflationary pressure, combined with downward pressure on the U.S. dollar, will prevent the U.S. Federal Reserve Board from lowering rates to get the economy moving again quickly. Indeed, they think the Fed will be forced to raise rates, thereby exacerbating the pain. Both see oil prices heading higher, although perhaps with a near-term pullback, and expect inflationary pressure from wage gains.

Gignac’s scenario is more benign. He doesn’t see inflationary pressure or a US$ crisis, so he believes the Fed will be able to lower interest rates quickly if needed. If a recession materializes, he expects a 300-basis-point drop in rates, which would accelerate the economy in 2008. In his base case, there’s no recession and rates drop only 100 bps, but growth is sluggish through to 2008.

Atkinson’s view on the outlook is entirely different. He thinks the American consumer is in good shape. Unemployment is low, jobs are being created, wage gains are strong and personal wealth has grown as a result of both house price increases and equity markets gains. Although there will probably be a pause in the U.S. housing market, he expects another burst of strong productivity growth to fuel continued increases in wages and corporate profits.

Nor does Atkinson expect inflationary pressure or downward pressure on the US$. He expects strong growth in productivity and an easing in commodity prices will keep inflation low. He expects oil prices to average US$57 a barrel this year and US$52 in 2008, with base metal prices easing in tandem. As far as the US$ is concerned, he doesn’t see any drop in Asian central bank purchases of U.S. Treasury bonds. And he expects plenty of interest in U.S. equities, which, he believes, will outperform European and Japanese equities.

@page_break@The other global managers and strategists expect more of a slowdown than Atkinson does. But continued strong growth in emerging markets, particularly China, and/or accelerating growth in Europe and Japan should keep a recession at bay.

Most money managers and strategists consider Chinese domestic demand strong enough to insulate that country from a shallow and short U.S. recession. Narayanan, for example, puts the odds of global recession at only 20%, assuming the U.S. doesn’t go into a severe downturn.

Leo de Bever, from his new perch as chief investment officer at Victorian Funds Management Corp. in Australia, thinks China could keep growing for a while if the U.S. slipped into a recession. But, he says, if the U.S. downturn lasted a year or two, China would be affected and there would be a global recession.

Neither Europe nor Japan are fast-growing regions, mainly because their populations are not growing or are declining. Nevertheless, they are big economies and even a little acceleration in their growth can be a help. Bill Sterling, chief investment officer at Trilogy Global Advisors LLC in New York, which manages a number of CI funds, believes accelerating growth in Europe and Japan will save the day — allowing the U.S. to slow severely to 1.5%-2% this year without triggering a global recession.

At Richardson Partners Financial Ltd. , both Craig Basinger, private client strategist in Toronto, and Clancy Ethans, chief investment officer in Winnipeg, see similar growth acceleration in Europe and Japan but more moderate slowing in the U.S. — and, thus, the global economy — than Sterling expects. Indeed, the two Richardson Partners analysts think U.S. and global growth will pick up speed in the second half of 2007.

A critical point in making asset-allocation decisions this year is the very low or even non-existent risk premium on emerging markets investments, says Peter O’Reilly, global money manager at I.G. Investment Management Ltd. in Dublin. That means you are buying the earnings power and potential growth of companies in these markets without being compensated for political risk. Despite this, O’Reilly has emerging markets exposure — mainly in Asia.

Jean-Guy Desjardins, president of Fiera YMG Capital Inc. in Montreal, is disturbed by the lack of risk premiums in many markets. Indeed, he says: “A significant concern for investors should be the very low premium for risky assets across the board — high-yield debt and emerging country debt and equity.” He expects risk premiums to rise this year and is underweighting emerging markets’ equities as a result.

Basinger and Ethans put the lack of risk premium down to investors’ “irrational complacency.” They think a wake-up call is probable as investors recognize the reality of the slowing U.S. and global economies and start reacting to negative economic news. This, they note, will provide opportunities for patient investors. The pair have advised clients to reduce their equity exposure to 55% from 65%, and to keep half of their proceeds in cash to take advantage of such opportunities.

Currencies could be an important factor in returns this year. Most money managers and strategists expect the US$ to go down 5%-10% against the euro and yen.

The downward trend of the US$ is almost universally accepted, although there are dissenters. Given his views on the attractiveness of U.S. investments for both central banks and investors, Atkinson doesn’t foresee downward pressure on the greenback.

But most analysts think the US$ has to decline to make U.S. companies more competitive globally and at home so they can sell more. That would bring the huge U.S. trade deficit down to manageable proportions.

For most global managers and strategists, the biggest risk is a US$ crisis caused by concerns that the U.S. is going into a recession or by foreign central banks, particularly in Asia, moving to diversify their foreign-exchange reserves.

Both Healy and Narayanan believe such a crisis is likely, occasioning the need to raise U.S. interest rates to stem the greenback’s plunge. And that would exacerbate the pain of the coming recession.

Others think a crisis is improbable because it is in no one’s interest to spark one. The biggest support for the US$ comes from Asian central banks and they, in particular, don’t want to see the US$ fall against their currencies. Should the greenback go into free fall, the pressure on Asian countries to appreciate their currencies would be immense.

Even without a US$ crisis, there is pressure on China to push up the value of the renminbi. If that fails to materialize, the U.S. may take protectionist measures to curtail Chinese imports, on the basis China is artificially holding down its currency. And once protectionism gets started, it’s hard to stop. The World Trade Authority can’t be counted on to stop it, given that the current Doha round of world trade talks is now at a standstill and appears unlikely to restart.

Another risk is a major stock market correction. De Bever expects equities to decline 20%-25% and other markets, including housing, to drop in many countries in the next three to five years. In his view, valuations are far out of line and have to come down. But he sees things going on as they are for the next 12 to 18 months. He admits that earnings have been unusually good but, he argues, they can’t keep growing at such a frenetic pace.

Given a moderate U.S. and global slowdown, many money managers and strategists suggest underweighting the U.S. and overweighting Europe, emerging markets and, perhaps, Japan. They are generally underweighted in resources and overweighted in financials, technology and sectors benefiting from the growth of consumer spending in emerging markets.

But the biggest message this year is to be selective whenever investments are made. Price/earnings ratios are generally considered reasonable but not cheap, averaging about 14 to 14.5 times forward earnings globally, with Europe at 13 to 14 times, the U.S. at 15 to 16 times, and Japan at 17 times. IE



Catherine Harris is Investment Executive’s economics editor and the editor of this report.