In 2008, our research suggests that a strong global economic environment could help prevent the U.S. economy from tipping into recession, brightening the prospect for equity and bond markets.

During the second half of 2007, market volatility intensified as many major indexes sought direction. In the end, amid subprime mortgage defaults, record oil prices and a weak dollar, non-U.S. equities continued to outperform U.S. issues, and growth outpaced value. Meanwhile, bond prices spiked as yields collapsed in the face of U.S. Federal Reserve easing. In the pages that follow, OpCap's lead investment professionals weigh in on the markets' prospects for 2008, the global economy and more.

Given the issues facing the U.S. economy and global market environment, how are we positioning client portfolios?

Jeff (JP): This may come as no surprise from a growth investor, but the two sectors we're most excited about for our growth portfolios are health care and technology. The health care sector is less cyclical and not really influenced by a slowing economy. Health care and technology companies both have underperformed and the valuations look extremely attractive. Although there are some cyclical aspects of technology, companies have to spend on technology regardless of the economy, as it's a productivity enhancer and keeps them competitive. Conversely, we're underweight consumer, where I want to see what shakes out with housing and employment - two massive headwinds - before we consider venturing back in.

Colin (CG): From an intrinsic value perspective, financials look good on a long-term basis because the valuations have come down. We've seen a lot of things that typically happen at the bottom: The weaker mortgage companies have gone out of business, stressed companies have issued equity, and equity capital has become more readily available. On the other hand, materials are likely to underperform. I don't think the implications of a U.S. and potentially a global economic slowdown are being fully appreciated by the market. For example, if economic growth in China falls from 11% to 7%, the demand for steel could fall rather than just decelerate.

Elisa (EM): In international equities, we like consumer staple companies as they stand to benefit from food inflation. There's a misconception that food inflation is bad for consumer staple companies, when in fact it's good for them since they can pass those price increases onto the consumer. In the near-term, we're avoiding most large-cap pharmaceutical companies, due to major patent expirations, limited new-product pipelines and the upcoming U.S. elections, and also commercial- and capital market-related financials.

Miles (MW): In addition to consumer staples, we also like the high-end consumer, which should prove largely immune to an economic slowdown. Similar to Colin, we're avoiding economically sensitive materials, but we do like some deepwater drilling and specialty steel companies, which have substantially de-rated. These materials companies selling steel into exploration or utility capital expenditures should not be substantially affected by a slowing economy.

Jerry (JT): In fixed income, we were emphasizing pure quality, U.S. Treasuries for most of 2007, anticipating the pressures that were building in the economy. One of those pressures we were monitoring closely was mortgage resets. Spring 2008 should be the peak in pressure from ARM resets. (See chart below.) As the market begins to price in the settling of these resets, some sizable mortgage opportunities should begin to appear in the first quarter. We also believe that credit, in particular financial credit spreads, which we were very negative about in 2007, will likely become increasingly attractive. This could prompt a portfolio shift from Treasuries.

What are the most likely surprises to consensus thinking for 2008?

CG: I believe housing will find a bottom in pricing and housing starts will find a bottom in terms of construction sooner than most people think. The U.S. economic slowdown will happen relatively soon, and will be sharper than many people think, and I believe it will more seriously affect global growth than expected. The slowdown in China will also result in part due to the U.S. slowdown, and may also affect commodities.

EM: I think the dollar will be stronger than expected, emerging markets will be weaker than expected, and Chinese economic growth will slow meaningfully. I also anticipate a rebound in Japanese inflation and economic growth.

JP: Despite the economic headwinds, I think 2008 could be a much better year for the U.S. stock market than most are anticipating. Market pessimism is extremely high, but I think domestic stock returns could be above historical norms. The market may continue to be volatile at times, but I think it will turn in a big gain. Valuations are inexpensive, and remember, when the Fed cuts rates, markets tend to do well.

What is hurting the U.S. economy most right now?

CG: There are three primary factors. First, oil prices reached $90 per barrel and stayed there. This is a fundamental difference from $60 oil. Second, credit availability has tightened due to the subprime mortgage crisis. Many people who previously got mortgages are no longer qualified and cannot buy homes. This has magnified the housing downturn, which in turn increases the possibility that housing problems will drag down the overall economy. Lastly, interest rate spreads among Treasuries and private sector borrowing and weak credits have widened sharply. Although the Fed has eased, very few borrowers, whether individuals or companies, have seen their cost of funds fall.

JP: The complete collapse of confidence in the credit markets has caused them to shut down from a liquidity standpoint. In addition, the employment picture continues to darken, and that's scary. The housing situation, in terms of new home sales and prices, continues to worsen as well. Now, I still think global growth may be strong enough to keep the U.S. economy from sliding into recession, but the odds aren't improving. Amazingly enough, higher oil prices have not yet materially hurt U.S. consumer spending, but they have to at some point, and that's part of the reason why we're underweight consumer discretionary stocks in the growth portfolios.

JT: The real story, in my view, is a corporate profit recession. Operating earnings, which are the feeding bowl for everything else including employment, fell 8.5% year-over-year during the third quarter. And reported earnings looked even worse.

Can the U.S. Federal Reserve do anything at this point to prevent a recession?

JT: The only tool the Fed has is to pump in as much liquidity as possible. If you look at the monetary aggregates such as MZM (Money Zero Maturity), liquidity is being pumped in at a rapid rate. However, if you look at the monetary base, it appears to be evaporating even quicker. The Fed has found itself in another conundrum it helped create. It recently started an auction rate process (TAF) to add liquidity in a new way. This is really designed to help reduce LIBOR rates. The amount of securities tied to LIBOR is tremendous: 60% of Alt-A mortgages (in between prime and subprime), and near 100% of subprime mortgages are LIBOR resets, the bulk of which are scheduled to reset in early 2008. The effect will take investors some time to get used to because transparency was built on the Fed targeting a specified rate. In all likelihood, if successful, the business of raising or lowering a target Fed Funds rate will be gone. Along with it will be some lost transparency, likely keeping volatility quite high.

CG: The Fed can't do anything to prevent a recession in 2008 (assuming that we are on track to have one) because there are too many lags in the system. The only thing the Fed can try to do at this point is affect how deep the slowdown is and how long it may last. But the Fed's actions in the next quarter will not have a tangible effect until late '08 or early '09. What's more important are the underlying data, which show a lack of systemic inflation despite oil prices doubling and then doubling again. Although prices are increasing, wages are not accelerating, and that's encouraging.

MW: Although the Fed has been trimming short-term interest rates, I'm not sure that aggressively lower rates are even the answer. The Fed has a dilemma: It is trying to address both economic risks and the possibility of inflation. Inflationary pressures in food and energy might be mitigated if the U.S. economy were to weaken dramatically, but these pressures are still high and might become a real problem if rates are cut substantially.

Is $120 oil next?

JP: Make no mistake about it - oil is going to stay at a high level even if it doesn't reach $120. Global demand is strong and there is very little new production. The world consumes about 85 million barrels of oil a day. Producers can meet this demand, but there's not much left over. As the U.S. continues to slow, the rest of the world will slow as well, albeit not to a recession, and with that, oil demand and prices should fall to some degree. (See chart below.) But I have a hard time believing we will ever see $50 oil again. More likely, prices should stay fairly consistently north of $70.

JT: I'm sure oil will one day reach $120. After all, there hasn't been a large oil discovery in 40 years and demand is increasing. However, look in the business section of your local book store and count the number of publications predicting the end of oil, and higher oil prices. It should lead you to conclude that these concerns are already priced in. The greater risk for markets is that if oil falls, the petrodollars that are keeping real estate alive, retail alive, tourism alive, could dissipate along with it. The amount of leverage tied to the need for oil prices to move higher leaves me worried more about risk and economies if oil prices fall.

Is the strong decline of the dollar likely to continue in 2008?

EM: The multitude of pressures on the dollar from large deficits and lower interest rates to potentially large dollar-holding sales from foreign owners of U.S. debt is unlikely to abate materially next year. However, it could be that the dollar has adjusted already, and now it's time for other currencies to adjust to their own domestic economic issues.

JP: The dollar is in secular decline and lower interest rates certainly aren't going to stop that trend. But a weak dollar is not all bad. Many of our growth portfolio companies sell overseas and bring back those profits, so there are some distinct advantages in a weak U.S. currency.

JT: I'm surprised that people prefer to own the British pound in a country that actually suffered a modern-day bank run with citizens lined up outside of one of the U.K.'s largest financial institutions. I'm also surprised by the demand for the euro. The European Central Bank has acted with eminence, front-pumping nearly $1 trillion in liquidity since August but remaining tough on inflation. Considering these factors, I don't think the dollar will decline dramatically from here, and almost certainly not at the rate it did in 2007.

What will the effect of a weak dollar be on overseas demand for U.S. products?

EM: In many areas around the world, there are structural growth drivers for U.S. products that are not dependent on the course of the dollar. Russia is allocating significant ($150+ billion) sums to rebuild its aging infrastructure. The Chinese are spending heavily on power, rail, roads and other infrastructure. Europe's power infrastructure needs to be rebuilt. High oil prices are creating demand for fuel-efficient airplanes. Many of these planes are being manufactured in the U.S. Additionally, a weaker U.S. dollar underpins external demand as prices are very competitive.

Are you concerned about the Chinese stock market falling off a cliff in '08? How could that impact global markets?

CG: I think the Chinese market could slip another 30% to 40%. However, I don't believe China's market falling off a cliff would interrupt global markets. It didn't make much difference to global markets when the Chinese market tripled. It's fundamentally a very closed market - not many people participate in it. If it falls 50%, it's not going to have very many direct or indirect implications for anyone else. What happens to the Chinese economy is much more important, because a lot of the incremental growth for U.S. and European companies is derived from doing business in China. (See chart above.)

EM: Many Chinese shares are off 30% from their peaks and could continue to fall due to inflated valuations. The market has been driven by excessive liquidity and momentum, led in part by a strong IPO market. Inflation is running at 7% in China, yet bank deposits pay about half of that. Little exists in the way of alternatives outside of equities or real estate, which have offered very attractive returns. Of greater concern to us are recent efforts to constrain credit growth, which could cause economic growth to moderate below its high levels. Global market performance has been geared into continued strength in China, so I do believe that sustainable weakness in Chinese GDP growth could jeopardize gains made elsewhere around the world.

JP: I'm concerned about the outlook for the Chinese economy and its near-term impact on Chinese stocks. You have to be cognizant of the huge run-up that they've had in the growth of their economy, as well as the infrastructure build-out ahead of the '08 Olympics. In addition, their stock market looks like it's gotten ahead of itself. But at the same time, looking out at the next 10 years, there's no other global economy that presents more opportunity than China. If you have a much longer time horizon, you have to consider investing in China.

Are China's prospects pegged to the success of the 2008 Summer Olympics?

MW: No, that's the most overblown story I have seen in many, many years. Most economic statistics show that the contribution to GDP of an Olympic event like that, particularly for China, is less than 1%. (See chart below.) One reason why equity markets in China domestically have been so strong are negative real interest rates and the lack of yield you get on your deposit account, and secondly, the tremendous wealth that is being generated. So, no, I don't think this is an Olympic bubble. It's a valuation bubble for other reasons.

CG: Despite the widespread headlines, economic growth in China is unrelated to the Olympics in our view. China's unique mix of moderated totalitarianism and managed capitalism is succeeding beyond any other historic example. The accelerated application of technology and capital has created a real great leap forward that has now run for 15 years! But at this point there are a lot of imbalances. There's clear evidence to me that the Chinese economy, within the context of a very high-growth economy, is becoming overheated. They see it too. The government has been responding, but incrementally and too slowly. The Olympics may have influenced their reluctance to act.

Are strong stock market returns in other emerging markets sustainable?

EM: The strength and uniformity of performance is unlikely to continue at the levels seen in recent years. The multi-year period of interest-rate declines has ended and rates will likely climb in many markets, making 2008 more challenging. There's a consensus view that global markets move in lockstep when equities appreciate, and then decouple and move separately when equities fall. This has been the bull case for emerging markets, that they can return 1.4x what developed markets return on the way up, but stand on their own and sustain their strength when developed markets fall. Emerging market valuations are at all-time highs. Earnings growth is at an all-time high and is likely to fall or, at the very least, moderate. So if global economic growth is to slow and - at least temporarily - pressure equity markets, we believe emerging markets could be impacted.

Is Japan's prolonged underperformance due to sentiment or fundamentals? What will be the catalyst behind the Japanese market?

MW: It's a combination of the two. Fundamentally, the Japanese economy is not as strong as a year ago. But, in terms of sentiment, the market panics when the yen moves a couple of percentage points. Japan is around its lowest P/E in 33 years. Corporate returns on equity are solid, now over 10%, and we're seeing more share buyback activity than we've seen in the past. And the weaker U.S. and European outlooks make it less likely that the Bank of Japan will make a mistake and hike interest rates too high. One potential catalyst is M&A. It's unlikely, but all it would take is one or two deals for investors to realize how undervalued many of the assets in Japan are. About 40% of listed stocks are trading at a discount to book value. The market is cheap but assets are not clearing.

EM: Japan's change in government has not been particularly well-received. Prime Minister Koizumi led the market through real changes which have gone backwards under his two recent successors. A move backwards in corporate governance with protectionism rising again has been poorly received by the market participants, still primarily foreigners. There are still many areas of the domestic economy that need to consolidate and rationalize, which are now hampered by uneconomic processes.

However, Japan is looking very underpriced, certainly relative to any point in history, and this further exemplifies why it's more of a sentiment issue. The majority of company dividend yields trade over the bond rate. Historically, that's only happened three times, and they've been very interesting points to buy into the market. Dividend payouts went from being among the lowest globally to market-oriented payouts of 30% to 40% of earnings. Finally, senior members of the Japanese business community are making comments about the prolonged underperformance. That's a hopeful sign.

From a style perspective, which is poised to outperform in 2008, growth or value?

CG: Neither. Reliable growth stocks should outperform cyclical value stocks, yes. But the stabilization of the financial system will give a huge boost to deeply oversold financial stocks - the biggest sector in the value benchmarks - over all other sectors. And technology - a big part of the growth benchmarks - could be more adversely affected by a cyclical slowdown than anticipated.

EM: Growth stocks that offer predictable, reliable earnings streams will get rewarded in this uncertain economic environment. Additionally, in non-U.S. markets, large-cap stocks are poised to outperform after nearly seven years of underperformance.

JP: Growth. Most importantly, the U.S. economy is slowing and the Fed is cutting interest rates, trends that are likely to continue. You can't have two better catalysts for growth stocks outperforming.