The big question for 2008 is not whether the U.S. economy will go into a slump, but how prolonged and deep the slowdown will be.

Many global money managers are optimistic. They see very slow growth in the first half, and some expect a technical recession — that is, two quarters in a row with drops in real gross domestic product. But they expect the U.S. economy to strengthen in the second half of 2008 and steam ahead in 2009.

If this happens, the impact of the U.S. slowdown on the rest of the world will be mild; domestic demand will keep growth chugging along. And that suggests that equity markets overall will probably move sideways this year, with some increasing, and will generally move upward in 2009.

But there is a growing group of pessimists who see an extended slowdown, if not a recession, lasting a couple of years that will drag the rest of the world down with it. This group acknowledges that there could be a delay before the full impact of this slowdown is felt. That’s because 2008 is a U.S. presidential election year and both President George W. Bush and the U.S. Federal Reserve Board will do all they can to ensure that the economy is growing, however slowly, when the election occurs in November. But that would be only a delay.

This pessimistic outlook is based on the view that there are so many negatives in the U.S. — most obviously, the public and private debt loads — that an extended slowdown is needed to get the country’s finances in shape.

This pessimistic group argues that on the consumer side, the substantial decline in house prices will cause heavily leveraged U.S. consumers to curtail expenditures drastically in order to remain solvent. Consumers don’t have savings to draw upon, and the widespread refinancing of homes during the past few years leaves them with no option of increasing their mortgage debt.

Cash-strapped American consumers aren’t the only dark cloud. The U.S. federal government has both a substantial deficit and long-term debt load. It’s also facing increasing health-care and social security costs as its population ages.

Then there’s the U.S. trade deficit, which hasn’t come down despite the substantial drop in the greenback, which has made U.S. goods and services more competitive in other countries as well as giving domestic producers a leg up against increasingly expensive imports. One problem: soaring oil prices are keeping the trade deficit high, even though volumes of other imports are falling and exports are rising. As a result, even more of a drop in imports is needed, bringing the pain back to consumers, the biggest buyers of imports. Only corporations seem relatively free of the debt boondoggle: balance sheets of non-financial corporations are generally in very good shape.

This pessimistic view is not new. Some of these doomsayers have been with us for years even though the U.S. economy has continued to grow. The problem is that U.S. debt has also climbed during the good times. It may be that the U.S. is reaching or, indeed, has reached a crisis point, given the current global credit crunch and the large charges that some U.S. and European financial institutions have been forced to take as a result.

Ross Healy, president of Strategic Analysis Corp. in Toronto, says the U.S. is in a “second-order insolvency,” which he defines as debt that’s 3.5 times larger than annual GDP. When this occurs, the entity in question has to sell assets to meet its obligations, which is what Healy sees state and local governments doing as they sell assets such as toll roads to foreigners.

Healy foresees a major recession, either this year or next. For now, he advises inves-tors to have 25%-50% of their portfolios in cash or short-term instruments and the rest in solid Canadian stocks such as Shoppers Drug Mart Corp., Canadian Tire Corp. Ltd., both of Toronto, and the cheaper oil companies. Calgary-based Petro-Canada is trading at two times book value, for instance, while Imperial Oil Ltd., also of Calgary, is trading at five times book value. Healy also suggests buying a gold exchange-traded fund or gold shares; his preference is Toronto’s Barrick Gold Corp., which is trading at slightly more than two times book value; or Yamana Gold Inc. of Toronto, trading at about 2.5 times.

@page_break@If it becomes clear that the U.S. is going into recession, then Healy suggests going 100% cash.

Nandu Narayanan, chief investment officer at Trident Investment Management LLC in New York and manager of several funds for Toronto-based CI Investments Inc. , believes a U.S. recession, accompanied by further drops in the U.S. dollar, is almost certain. He also expects China’s growth to slow to around 6% — which is close to recessionary conditions in that fast-industrializing country — as a result of efforts to quell rising inflation, particularly for food, which is a big part of China’s consumer price index.

That’s the best outcome, as Narayanan sees it. The worst would be a deflationary spiral if the credit crunch intensifies. Narayanan warns that even if the credit crunch does not worsen, inflation will probably rise as a result of all the money central banks are printing in order to inject liquidity into the system. That will create a major problem, with central banks torn between fighting inflation and supporting economic growth.

Narayanan suggests overweighting fixed-income that is invested in government bonds other than those of the U.S. He also advises staying away from U.S. equities, except for selective multinationals that have overseas sales providing a hedge against a further decline in the US$. He favours Japanese equities, particularly banks, because Japan is the one country that will benefit from rising inflation. He also likes precious metals and other resources such as aluminum. He expects a correction in oil stocks and suggests buying them when the correction occurs. He notes that even now there are some very inexpensive oil stocks and even cheaper natural gas companies.

Clément Gignac, chief economist at National Bank Financial Ltd. in Montreal, puts the odds of a U.S. recession at 50%. He also expects the U.S. economy to be weak through to 2009. In his view, the slowdown will turn into a recession if there is a further 10% drop in average national U.S. home prices, which he thinks is quite possible; home prices have already dropped 6%. Gignac suggests an asset allocation of 40% equities, 45% fixed-income and 15% cash.

Jean-Guy Desjardins, president of Fiera YMG Capital Inc. in Montreal, also believes a U.S. recession is likely this year and he expects slow growth in 2009. This thanks mainly to the global credit crunch, which, in his opinion, is “far from being resolved.” Desjardins expects “a lot of bad news and surprises coming in the next six months, resulting in significant volatility in markets.” With the hits that banks will have to take, they will have to rebuild their balance sheets, and that will result in tighter credit conditions that will dampen growth in 2009.

Like Narayanan, Desjardins is concerned about the possibility of rising inflation, pointing out that productivity growth decelerates with slow growth while wages may keep rising. He puts this risk at 35% and says it could result in a deeper and much longer recession than most expect.

Desjardins recommends staying on the sidelines, with a very conservative asset allocation of about 25% equities. “This is not the time to take risks,” he says, “because we don’t know if it will be a big storm or a small one.”

He sees upside potential of about 12% on equities but a downside potential of 35%. There will be opportunities to buy equities at good prices in the next six to 18 months, he adds.

Peter O’Reilly, global money manager for I.G. Investment Management Ltd. in Dublin, is concerned that the credit crunch could produce a deep recession. He feels the central banks didn’t act quickly enough and that’s there is a risk of a drop in confidence if consumers and businesses can’t get loans.

O’Reilly, though, is assuming this won’t happen. U.S. employment numbers are healthy outside of financial services and housing-related sectors, while corporations have strong balance sheets and are still in “labour hoarding mode,” given relatively robust domestic demand and good international demand.

The most optimistic of those interviewed is Lloyd Atkinson, an independent financial and economic consultant in Toronto. He believes the U.S. is still the world’s most flexible and dynamic economy and thinks we are on the cusp of revolution in technology that will spur U.S. productivity gains. He foresees a strong US$ and is not concerned about the credit crunch, which, he believes, will be resolved in the coming months.

Atkinson would overweight the U.S., which he considers the best game in town. In his view, Europe is being “increasingly eaten alive by social programs” and Japan is a “demographic nightmare,” given its aging population, low birth rate and lack of immigration.

There are other analysts and global money managers who share Atkinson’s views that the U.S. will sneak through without going into recession, although, they admit, there is significant risk of a downturn. They also believe the credit crunch will be resolved over the next six months.

The liquidity that central banks are injecting should be enough to avoid recession, say Clancy Ethans, Richardson Partners Financial Ltd. ’s chief investment officer in Winnipeg, and Andy MacLean, RPFL’s director of private investing in Toronto. They, like O’Reilly, don’t think the central banks are acting as aggressively as they should, which adds to the risk of recession.

Ethans and MacLean also express some concerns about rising inflation, but think the central banks are right to be focused on preventing deflation, which would be much more damaging than a pickup in inflation.

Bill Sterling, chief investment officer at Trilogy Advisors LLC in New York, is more upbeat, saying that when we look back at this credit crunch, it will be judged a “garden-variety financial crisis.” Although he expects sluggish U.S. growth next year, which will feel like a recession, he doesn’t expect an actual downturn. “The recession odds are receding with the cuts in interest rates,” he says.

Sterling expects inflation to moderate in the industrialized world due to the expected U.S. and global slowdown, although he notes that there is a lot of inflationary pressure in emerging countries and also in resources-producing regions of countries such as Canada.

On the other hand, John Arnold, managing director and chief investment officer with AGF International Advisor Co. Ltd. in Dublin and manager of several funds sponsored by AGF Funds Inc. of Toronto, says the fight against inflation has already been lost. He thinks it will rise to 3% in both the U.S. and Europe this year. As a result, he expects an abrupt turn in monetary policy at mid-year, with interest rates going up instead of down.

Arnold is not expecting recession and believes the worst of the credit crunch is over: “We are in the echo rather than the eye of the credit storm; no one has securitized anything since early August.”

He adds that he’d now be a happy buyer of Citibank, a division of Citigroup Inc., or Bank of America Corp., both of New York.

Assuming the U.S. stays out of recession, most analysts think the rest of the world will continue to grow albeit more slowly than in 2007, resulting in global growth at around 4% vs 5%. This is based on a reconfiguration of world growth drivers, with the U.S. no longer the dominant engine of global growth. That role is now being shared by emerging markets, in which rising consumer incomes are fuelling domestic demand.

Nevertheless, Ethans and MacLean suggest keeping an eye on the BRIC countries — Brazil, Russia, India and China. If demand falters in those countries, there will be serious implications for global growth generally and the Canadian market in particular, given our heavy weighting in resources. Sterling notes that domestic consumption in BRIC has been a major driver of global growth in the past 12 months.

Atkinson is virtually alone in recommending overweighting the U.S., although O’Reilly says his next move will be to sell European and Asian equities and buy oversold U.S. and Japanese stocks. And a number of global money managers are beginning to rethink their underweighted positions in the U.S. As Sterling explains: “Many other markets have so outperformed the U.S. in the past few years that U.S. valuations are now looking much more attractive.”

That said, most managers say 2008 is a year when returns will depend more on stock-picking than on geographical or sector asset allocations. For example, Fred Sturm, chief investment officer with Mackenzie Financial Corp. in Toronto, suggests a diversified portfolio of leading global players that don’t have a lot of debt.

Others agree it’s important to look at debt loads. Healy advises looking at debt ratios using assets, excluding goodwill, to get a true picture of the financial condition of companies. Goodwill is an intangible rather than a financial or hard asset.

Both Healy and Gignac advise against looking at price/earnings ratios in this environment, saying that they are based on optimistic earnings expectations that might not be met. Certainly, the forecast of a 16% average rise in earnings for the S&P 500 companies seems very high in a year in which most forecasters expect U.S. growth to be only about 2%. (See page B14.)

The more optimistic global money managers are generally overweighting equities because of the lacklustre returns expected for fixed-income. As Sturm puts it: “I have no desire to lock in 4% 10-year government bond yields.”

Only if an investor does not have a five- to 10-year time horizon and needs to draw down assets in the next year would he suggest tucking money away in fixed-income.

A number of global money managers also like European and emerging-markets equities, and some are enthused about Japan. Although there are those, like Atkinson, who view Europe as a region with poor prospects because of stagnant population growth and rigid labour market regulations, others see lots of restructuring, including outsourcing to Eastern Europe, increased demand from Eastern Europe and other emerging markets and attractive valuations.

O’Reilly notes a general change in attitude and approach among Continental European firms. They are less dependent on the U.S. and are both “more proactive and less willing to pander to trade unions and farmers.” Nevertheless, he has some concerns, noting that consumer demand isn’t particularly robust in the big economies of Germany and Italy. He also notes the aging population, although Europe, unlike Japan, has reasonably liberal immigration policies.

The debate about emerging markets centres on valuations, not on growth prospects. Some markets, particularly China, are experiencing a speculative bubble, which the Chinese authorities are defusing by allowing Chinese investors to buy stocks listed on other exchanges, starting with Hong Kong.

There’s also an issue about whether global stock prices sufficiently reflect the risks, given the convergence of P/E ratios in emerging markets with those of industrialized countries. Emerging countries are vulnerable to political upheaval, so investors expect to pay relatively less for their stocks to make up for the risk being taken.

One way to avoid exposure to country risk is to invest in industrialized global companies that are benefiting from the fast growth and industrialization of emerging economies. That includes natural resources companies; firms making machinery and equipment or otherwise participating in infrastructure spending in that part of the world; and shippers. O’Reilly is in this camp, pointing to General Electric Co. of Fairfield, Conn., and Munich-based Siemens AG.

Another concern is whether Asian companies will get the capital they need to continue to grow, given the global credit crunch.

Japan is the biggest question mark. It’s a market money managers love or hate — depending on whether they believe the economy is on a self-sustaining growth path. There still isn’t strong evidence of a revival in consumer spending, but property values are rising, Japanese banks have cleaned up their act and the country is exporting to booming China.

Sterling notes that Japan looks particularly attractive because of the country’s low bond yield. But he wonders if there is a catalyst that will push earnings higher.

Like Atkinson, O’Reilly isn’t enthusiastic about Japan, characterizing it as caught in “interminable decline as a result of political paralysis.” Nevertheless, O’Reilly plans to take some of his profits from European investments to buy oversold Japanese stocks.

Arnold, on the other hand, has just 4% in Japan.

One factor that should be considered in determining geographical asset allocation is possible currency moves, particularly with respect to the US$. Most analysts expect the US$ to continue its decline, but mostly against Asian currencies. If the Canadian dollar stays steady, it too will go down against Asian currencies, which will enhance returns from investments in that region when translated into C$.

Unfortunately, economists are divided on what will happen to the C$ vs the US$. (See page B6.) If the loonie goes up, returns on investments in the U.S. and possibly other regions will be negatively affected. One option is buying currency-hedged investments. There are a number of mutual funds that either hedge or offer hedged versions of their investments.

Most global money managers are underweighting energy and base metals because they expect a decline in prices as a result of the U.S. and global slowdowns, although a few remain bullish. (See page B12.) The general view is that oil prices will move back to US$70-US$80 a barrel this year. Most base metals will follow suit, although there are a few exceptions, such as iron ore, for which a few companies control most of the production. Also, a number of money managers think the prices of copper and aluminum will remain reasonably high.

On the other hand, many money managers are overweighting gold, which is expected to rise in the wake of continued downward pressure on the US$. Some money managers also think agriculture-related stocks could do well, given increased demand for higher-quality food in emerging economies and the demand for biofuels.

In terms of other sectors, money managers tend to be underweighting financials because of the big charges that some banks have had to take and the fear that they will have to take more. Some, however, view this as an opportunity to pick up financials at bargain prices. This is a very strong theme among managers of European funds. (See page B8.)

O’Reilly says it’s hard to find sectors that are really defensive, noting that pharmaceutical companies are being hit by patent expirations. Also, with deregulation, utilities in many countries are no longer a bond proxy but more of an energy proxy. Interestingly, one of the sectors he considers reasonably defensive in the current environment is energy, as well as some food companies. He also finds that tobacco and alcohol remain pretty attractive and he notes that technology growth companies are coming back into vogue. IE

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