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As 2008 comes into view it’s time to see which way the investment winds are blowing and gauge what assets will bring the biggest bang for your buck. Russ Mould casts a considered eye toward 2008 to see what the future holds

It has been a wild year for investors. It all started so well, as merger and acquisition activity, strong economic growth and rising commodity prices created a wave of liquidity which sloshed around the world, driving up asset prices across the board. Yet by the end of the year the picture looked very different.

Major equity markets such as the US and the UK failed to regain their poise after a stumble caused by the US sub-prime mortgage credit crisis. This had a contagious effect on debt markets worldwide and sucked away vital liquidity. Central bankers began to fear an economic slowdown and, as confidence wobbled, so too did prices in the art, bloodstock and property markets.

But despite this renewed volatility, shrewd investors were still able to make terrific gains if they picked the right stocks, currencies or assets. Equity markets in Brazil, India and Russia racked up new all-time highs in December. Gold reached a 28-year high of $845 in the autumn and soybeans a 34-year high of $11.64 a bushel in December. Currency speculators had a profitable year by simply staying short of the US dollar, which at one point hit an all-time low against the euro at $1.48 and a 21-year low against the yen at Y107.

Shares has therefore peered into its crystal ball to help investors identify what will be the key investment themes for 2008 and how best to turn the big picture into big profits.

GLOBAL ECONOMY

Any assessment of what asset classes to buy, hold or sell in 2008 has to begin with a look at the global economy. Recent interest rate cuts in the US, UK and Canada suggest the outlook is a lot less rosy than it was six months ago, before the world’s banks began to suffer dreadful losses on their exposure to the US sub-prime debt markets.

‘I think the big threat is recession and so does the market,’ says Andrew Garthwaite, global equity strategist at bulge-bracket investment bank Credit Suisse. ‘All the talk is of stagflation but the real issue is deflation.’

Garthwaite believes three key issues will determine the fate of the global economy in 2008 .

‘Firstly, if oil goes to say $130 a barrel, this would be bad for global markets, inflation and policy response [to threat of recession]. Secondly, how quickly central bankers respond. And thirdly, when LIBOR normalises and what causes it to normalise,’ he says.

The London Interbank Offered Rate (LIBOR) is the interest rate at which banks lend to each other. Despite central bank action, LIBOR has remained stubbornly high, with one month money costing 6.54%, compared to the 5.50% UK base rate. Banks’ newfound reluctance to lend stems from a desire to preserve cash and avoid taking further debt market hits.

If cheap credit did so much to fuel the 2003-07 economic upturn – US interest rates troughed at 1% and UK rates at 3.5% in 2004 – it seems logical to expect dearer debt will slow consumer spending, corporate investment and merger-and-acquisition activity going forward.

December’s concerted action by central banks in the US, UK, Canada and Switzerland to provide over $60 billion of liquidity to banks met with a lukewarm response and interbank rates and credit spreads barely twitched. There remains a suspicion individual banks will need to provide greater transparency on their possible debt market losses before trust can be rebuilt and credit starts to flow freely again.

Announcements from UBS, Bank of America and Wachovia of an extra $14 billion of credit losses between them in December alone suggest this needed transparency may not develop too quickly. Marcel Roehner, chief executive of Swiss megabank UBS, called the ultimate value of sub-prime debt holdings ‘unknowable’, because the value of the underlying properties continue to fall.

Some deceleration in US and UK growth therefore seems inevitable. A recession – which is officially termed as two consecutive quarters of economic shrinkage – looks unlikely in the USA, as the weaker US dollar should help the world’s largest economy correct its trade and current account deficits.

But the UK is now exhibiting many of the sickly symptoms which caused 2007’s US debt crisis.

‘We still fear that, of all the economies we look at, the UK has the highest chance of a hard landing,’ argues Credit Suisse’s Garthwaite. ‘The consumer and the banks are both much more leveraged than the US, housing is more overvalued, 45% of GDP growth has come from housing and finance and fiscal policy is being tightened.’

Europe is starting to catch a chill too. Such usually reliable leading economic indicators as the Belgian Courbe Synthetique and the German IFO figures are pointing to a slowdown.

At least Chinese GDP is still expected to grow at a double-digit clip in 2008. Strong prices for commodities such as copper, soybeans and wheat, driven by demand from China, should help Latin America’s economies, where domestic expansion is also underpinned by the first signs of credit growth in countries such as Brazil and Mexico.

EQUITIES

If global GDP growth does slow in 2008 (see Table 2), equity investors’ best profit opportunities in 2008 should come from stocks and sectors which have long term secular growth prospects and limited exposure to the economic cycle.

‘Defensive, non-traded services, like utilities, are likely to outperform “making things” as the Atlantic, if not global, economy slows in 2008,’ argues Nick Stevenson of equity strategy think tank Mirabaud Securities.

Shrewd market watchers will have already noted a move up the sector performance tables from such stable and able areas as Tobacco, Food Producers and Utilities in the UK and US toward the end of 2007.

All are classically defensive sectors and investors should perhaps take the hint, especially as the areas which did so much to lead the markets up after the 2003 bottom – construction, industrials, financials and real estate – have fallen swiftly from favour in what looks like a classic change of market leadership (see Table 1).

The Federal Reserve and Bank of England are both doing their best to stimulate growth but it could take several more cuts before the global economy is back on track.

‘It takes three to 18 months for rate cuts to take effect,’ explains Kully Samra of US brokerage firm Charles Schwab (SCHW:NDQ).

Samra therefore highlights technology, where firms such as Apple (AAPL:NDQ) and Cisco (CSCO:NDQ) should ride new product cycles to generate secular organic profits growth, and healthcare as areas likely to generate solid returns for shareholders, whatever the weather.

Just as defensives have already begun to outstrip cyclicals, so ‘growth’ stocks have begun to outperform ‘value’ stocks, at least in the UK (see Charts). Cyclical firms which look cheap now could prove to be ‘value traps’, if a decelerating economy leads to earnings forecasts downgrades in 2008 from what turn out to be ‘peak’ earnings levels in 2007.

In addition, big caps have massively outperformed small caps since the summer, and this trend looks set to continue. Big caps tend to be better funded and more cash rich than smaller ones, so the more expensive debt and less accommodating equity markets are less of a problem. Large caps are also more liquid and easier for investors to trade, should cash have to be pulled out of the markets in a hurry or applied quickly if confidence returns.

This swing toward defensive, growth, large cap stocks rings alarm bells for some.

‘We reckon European and US equities are already in the grip of a bear market,’ says Mirabaud Securities’ Stevenson. ‘Assorted technical indicators, top-down evidence, defensive sector rotation and demanding valuations lead us to this conclusion. We estimate European index downside of 10-20% over 12-18 months.’

Trevor Greetham, who runs the Multi Asset Strategic Fund for money management giant Fidelity, is also wary. ‘If you believe current earnings forecasts, then valuations are fine, but that’s the rub. We see earnings disappointment and markets grinding lower,’ he admits, before adding: ‘But markets are not very overvalued and there should not be a sell off like those of 2001 or 1987.’

Greetham says he is underweight in both the UK and Japan, and has a particularly downbeat view of the latter. ‘We have a disappointing economy, bumping along even when the Asia Pacific region is booming. Exports are doing well, but the economy is still tepid and the Bank of Japan could even be raising interest rates,’ he says.

Farther afield, Latin America’s newfound political and financial stability yielded rich returns for stock market punters in 2007 and could so again in 2008. Foreign & Colonial’s Urban Larson highlighted a preference here for stocks with exposure to rising domestic consumer spending, construction activity and infrastructure investment in a well-attended presentation last autumn.

‘Mexico stopped lending altogether between 1995-2004 and we can now see Brazil’s first bank mortgage lending since the 1980s,’ he argued. ‘Credit as a percentage of GDP is very low, as there has not even been prime, let alone sub-prime lending.’

However, even the bullish Larson admitted there are risks, particularly ‘if China blows out, global growth slows markedly or there is a sharp reduction in global risk appetite’.

It therefore seems unwise to overdo the story of decoupling – namely that emerging economies and equity markets can power ahead regardless of how the US economy fares.

‘I don’t believe in decoupling on an absolute basis, but a relative basis,’ opines Credit Suisse’s Andrew Garthwaite. ‘Domestic demand is accelerating across the Asia Pacific and Brazil has a very good monetary and fiscal position, with a record current account surplus, so it can do what it wants [in terms of policy response to any slowdown].’

Malaysia, Singapore and Brazil look to have the best chance of ‘decoupling’ their economic performance from the rest of the world in 2008. Investors with an appetite for risk could seek out investment trusts or direct equity exposure to those markets, but Eastern Europe looks a much dodgier proposition.

‘Hungary, for example, is looking like the Tiger economies of 1997, with a huge current account deficit and a lot of local mortgages locked into the Swiss franc or the euro,’ says Fidelity’s Greetham. Ian Harnett of independent boutique Absolute Strategy Research agrees.

‘Eastern Europe has sucked up more foreign exchange capital inflows than emerging Asia, at some $800 billion, and a quarter of that has come from Austrian banks, which look like the major faultline,’ comments Harnett. ‘It’s 1997 all over again.’

Experienced investors will remember similarly huge overseas debts finally crippled the economies of Thailand, Indonesia, Malaysia and Korea in 1997, eventually forcing them into recession and causing their currencies to collapse in 1998.

Yet for all the short-term caution, in the long term the picture still looks rosy, according to Credit Suisse’s Garthwaite. He particularly picks out the ongoing industrial revolution in markets such as China and India, a phenomenon which took over 150 years to play out in the UK.

‘There is an ongoing industrialisation in emerging markets, corporations are underinvested and in developed markets, labour has little price power, so there is not really an inflation issue,’ he argues.

Fidelity’s Greetham agrees any gloom must not be overdone. ‘It is worth reminding people equities offer the best long-term returns. They can be volatile but really you should not sell when volatility picks up as long term this is usually one of the better times to be buying,’ he says, before adding: ‘Investors should diversify and not try to be too clever. Momentum players have been killed chasing rallies and investors should look at a portfolio, across bonds, commodities and international markets.'

BONDS

Bonds may sound dull. After all, the yields on ten year notes vary from 4.75% in the UK, 4.25% in euro bunds and in the USA, down to a meagre 1.50% in Japan.

But equity investors would do well to remember that holding ten year US T-Bills since 2000 would have generated a better total profit than US equities, mainly because the Dow Jones collapsed between 2000-2003, while treasury yields kept on trickling money into their holder’s pension pots.

More dramatically, bond yields have plunged – and therefore bond prices have risen sharply – as traders have responded to this year’s interest rate cuts in the US and UK, and begun to anticipate more.

‘Bond investors are gobsmacked by the equity markets’ complacency,’ admits Fidelity’s Trevor Greetham. ‘Just like financial stocks, they are telling you the markets are in trouble.’

Further rate cuts have been priced in by the US and UK bond markets, with a cut in the US to 4% seen as a certainty in January. Bond investors therefore need to be careful, warns Greetham who confirms: ‘Bonds have rallied a lot and are pricing in a lot already.’

If the world’s bankers decide inflation is the killer problem and not growth, and start holding or even raising interest rates, bond players could be in for a shock.

There are some warning signs here. November saw consumer price inflation (CPI) reach a two-year high of 4.3% in the USA and a six-year high of 3.1% in the EU, while producer price inflation (PPI, or factory gate prices) rise to a 16-year high of 4.5% in the UK.

But for now, it does seem as if more rate cuts are coming, so bonds still look to offer good short-term profit potential.

‘The stage is not quite yet set to be underweight bonds,’ argues Credit Suisse’s Andrew Garthwaite, before adding: ‘I would also look at short-term interest rate futures, as LIBOR simply has to fall, and the Bank of England simply has to target debt supply.’

COMMODITIES

One feature of the carry trade was the strength of commodity-backed currencies such as the Australian dollar, as booming metals prices drove economic growth down under and drove interest rates higher, to yield levels which proved irresistible.

Oil, gas, metal and mining stocks have been at the spearhead of the 2003-2007 bull run in equities and continued strength in commodity prices looks set to be a feature again in 2008. But this year may see more action in so-called ‘softs’, such as soybeans, wheat and rice, rather than metals.

Booming demand from Brazil, Russia, India and China (the so-called BRIC countries) has underpinned soaring metal prices for much of the past five years. Yet despite continued economic growth in these countries, metal prices sagged in the fourth quarter of 2007. Lead prices fell 28%, zinc 22% and nickel 18%. Most damningly, copper, which is widely seen as an excellent barometer of global economic growth, saw a near 20% fall.

Metal traders, and buyers, appear to be taking a more cautious view on economic growth in 2008, perhaps not surprisingly after autumn’s profit warning from cemented carbide cutting tool expert Sandvik. The Swedish firm admitted demand had disappointed and it would therefore not need as much nickel as planned.

This is not to say global economic growth is going to collapse or metals demand disappear, as Asia undergoes its very own industrial revolution. But the story of emerging markets growth and metals prices is well known and baked into many metals’ stocks valuations now.

BHP Billiton’s (BLT) attempt to buy rival Rio Tinto (RIO) using shares rather than cash is very reminiscent of tech firms using high-valued paper to buy their rivals just before the tech bubble burst in 2000. It suggests chief executive Marius Kloppers feels either his shares are richly valued, or at least a cash bid for Rio is hard to justify economically, despite the strategic positives. Either way, UK stock market watchers appear to have taken the hint. Even though it headed the annual performance tables for 2007, the Mining sector underperformed in each of July, August, October and December, and the bull run here may at last be running out of steam.

Oil has been a rollercoaster in 2007 too. Shares’ August prediction that the black stuff would rally from $70 to near the $100 per barrel level proved uncannily prescient, although Brent and West Texas Intermediate crude have both since pulled back to around the $90 mark.

Perversely, a fall in the oil price would ease some of the inflationary pressure which has central bankers worried about whether they are able to cut interest rates as fast as the markets want them to. If global growth does wane demand for oil could slip a little too and see oil prices easing in 2008, a prospect which Ian Harnett of Absolute Strategy Research thinks could lead to an interesting switch opportunity for equity investors.

‘As global growth declines, there is a risk to the oil price and there could be then a trade in banks over oils,’ he says. ‘Banks outperform [in a slowdown] when everything else has been trashed as the benefit from the steepening yield curve. Lloyds TSB (LLOY) might be an interesting one at some stage in 2008.’

US equity investors may also need to be on their toes if the eventual Democrat candidate for November’s presidential election should win. All of the leaders in the race have discussed imposing fresh punitive taxes on oil majors such as ExxonMobil (XOM:NYSE).

But for commodities speculators the greatest action this year should come from cereals. We have already noted the worrying inflation numbers from the US, UK and Europe for the month of November. Food price increases have been a key component of this, reaching 4.3% in the EU, 4.8% in the US and 5.1% in the UK.

Investors do not have to get involved in the physical markets, offered by the Chicago Board of Trade (CBOT) and can use contracts for difference (CFDs) or spread betting to play crops such as wheat, corn, soymeal, soybeans and even cotton.

Equity investors can also get their slice of farming action. Credit Suisse’s Andrew Garthwaite unveiled a list of 20 global agriculture stocks to watch last summer and remains convinced there are more profits to be made in this area.

‘Demand [for food] is growing at 3.5% a year and the supply of land is rising by just 1%,’ he asserts. ‘Crop demand is being driven by a rising global population, biofuel demand and changes in diet. As consumers [in emerging economies] eat more meat and dairy, livestock also takes up more land than grain.’

The EU’s famous food mountains have long since gone, and supply is clearly constrained. Investors should therefore look at firms which sell fertilisers, seed or equipment which improve the yield of farmer’s existing assets. Syngenta (SYT:NYSE), Monsanto (MON:NYSE) and the UK’s Genus (GNS:AIM) all fit the bill.

If food price inflation continues to run rampant, food producers such as Northern Foods (NFDS) or Associated British Foods (ABF) could see profits squeezed by rising input prices. Food retailers such as Tesco (TSCO) and Sainsbury (SBRY) should be able to pass at least some price increases to drive their top line, as consumers will after all have to eat, regardless of what the economy does this year. Firms with strong brands and market positions such as Unilever (ULVR) should be able to pass on price increases to cover the cost of their raw material price increases too, although a further hedge against inflation is of course gold.

The shiny yellow stuff’s price peaked at $840 in the autumn, a 27-year high. Investors might like to use the recent pullback to around the $800 level to get involved in high-quality gold mining stocks such as Randgold Resources (RRS) or America’s Newmont (NEM:NYSE). Alternatively, those with a high appetite for risk can get involved with the physical asset itself, though spread betting, CFDs or futures contracts.

PROPERTY

Everyone has exposure to the property market, through the mortgage or rent paid for the house they live in, or investments designed to boost their incomes, either through capital gains or rental yield.

Since 2003, housing prices have gone ballistic in regions as diverse as Eastern Europe, Australia, Ireland, America, Spain and the Baltic states and the UK, helped by the availability of cheap credit and fuelled by the expectation of rising prices and rents. A glut of overbuilding began to smother the Irish and Spanish markets early in 2007 and America hit a similar problem later in the year. Some think the UK could be next

A Nationwide survey of UK housing prices revealed a 0.8% drop for the month of November, the first since February 2007 and the biggest monthly slippage for 12 years. Amazingly, the US had not suffered any falls in property prices since 1945, but the influential Case-Shiller index of property across 20 cities shows that trend has now been broken.

Certain commercial markets look sickly, too. According to the Investment Property Databank (IPD), UK commercial property prices fell 4.1% in November, the steepest monthly drop since records began in December 1986. This could be just the beginning.

Absolute Strategy Research’s Ian Harnett flags data from the Bank of England which shows commercial property lending is now 9% of total UK lending, higher than at the peak of the last boom in 1989-90. Worse, over six million square feet of commercial property is already under construction in the UK and will have come on to an already glutted market by 2009.

No wonder investors in property funds have begun to get twitchy, so much so that several funds, including ones run by UBS, Deutsche Bank and Morley, have moved to stop client redemptions for up to 12 months.

Brazil and Mexico look set to embark upon a housing boom, too, so selective markets still have potential.

Fidelity’s Trevor Greetham says he is ‘overweight commodities, overweight cash and underweight property’ as part of what he terms ‘a classic stagflation trade’, fears there could be worse news yet to come from more developed property markets now a long bull trend has snapped.

‘You have made money in [UK commercial] property for every month since 1992, yet we have now had two consecutive monthly price declines [according to IPD data],’ he says, before adding of 2007’s credit market woes: ‘The root cause is falling property prices, not sub-prime debt. Falling prices will affect the consumer whose equity is starting to evaporate and the banks who can’t get their money back.’

At least Brazil and Mexico look set to embark upon a housing boom as lending begins again, so selective markets still have potential.

CURRENCIES

Trends in inflation and interest rates are usually key determinants of a currency’s short term value, as traders will switch between currencies in order to get the best returns, or yield, on offer.

One of the biggest trends in the foreign exchange market in 2006 and 2007 was the so-called ‘carry trade’. Here, forex players would sell a low yielding currency, such as the Swiss franc or Japanese yen, and put the cash into a currency where local interest rates were much higher, such as the Australian, New Zealand or US dollars.

But the ‘carry trade’ began to fall apart in the second half of last year as the US credit crisis broke, US interest rates began to fall and confidence in the US dollar sagged. Traders began to take losses on the dollar which offset the yield gains they were making, forcing many to dump their US dollars and buy back the yen they had sold short.

As a result the yen whipsawed against the dollar, soaring from Y123.8 in June to Y107.5 in November before settling around Y113 at the year end.

‘The carry trade will become less of a theme in 2008,’ says City Index’s Richard Cunningham. ‘The big bets were on the dollar to fall in the last half year and our trend analysis shows trends tend to culminate in a big final move. We now don’t see cable [the sterling-dollar cross rate) moving to a new high, past $2.15.’

Cunningham cites the Bank of England’s move to an accomodative monetary policy with December’s 25-basis point interest rate cut to 5.5%.

‘The US dollar sank on trade and budget deficits and a move to an accomodative interest rate policy, and a weak dollar will now help those deficits,’ he argues. ‘Conversely, the UK is now in a similar position, with trade and budget deficits, and we see a slowdown in consumer spending and construction.’

This suggests Mervyn King may have to cut harder and faster to try and prop up the economy at the expense of sterling, just as America’s Ben Bernanke was tacitly happy to let the dollar slide as he began to cut in the autumn of 2007.

Aggressive US rate cuts are expected, but similar action in the UK less so and this could make the downtrodden dollar a good play against the pound, especially as sentiment is so negative on the greenback already.

‘We think to bet on a dollar decline after the first quarter of next year is wrong,’ says City Index’s Cunningham. ‘If the pound rebounds to $2.10 against the dollar, we would be looking to sell [sterling].’

The euro has so far been a beneficiary of central bank governor Jean-Claude Trichet’s hardline stance on inflation. But even he could be forced to cut in 2008 if the economy decelerates, in a move which could really catch markets by surprise and again benefit contrarian buyers of the dollar.

City Index’s Richard Cunningham believes this scenario could happen. ‘If the dollar were to rebound to $1.51-1.52 against the euro, we would sell the euro and buy dollars. Although if you sell sterling, you have to buy something and the euro is probably the lesser of the evils on offer, as it has nothing serious against it.

‘There is a very important support level at 0.725 [euro against sterling] and if that breaks, we could see it going to 0.75, for a 4-5% move,’ he continues.

FEELING GLOOMY?

There are clearly grounds for approaching 2008 with some degree of caution, as the credit crunch grinds on, economic growth slows and long-running bull markets in equities and property face their most serious challenges for some time.

Yet it rarely pays to be overly gloomy for too long. Statistics clearly show equities yield solid returns over time and even in the individual years where they fail to deliver, other asset classes, such as bonds or commodities, can still yield rich returns for the savvy investor.

Despite the prospect of an economic slowdown in the US and UK, global GDP growth is still expected to be 4.3% in 2008 and 4.1% in 2009 – hardly a shabby performance.

Moreover, falling asset prices in some areas have already yielded what some sharp operators think are value opportunities. Megabank Morgan Stanley (MS:NYSE) snapped up an 80% stake in 11,000 home sites from US house builder Lennar (LEN:NYSE) for $525 million in December. A number of downtrodden UK small and mid caps, including NSB Retail (NSB), Kiln (KIN), Inspicio (INP) and Northgate Information Solutions (NIS) have been bid for following sharp share price corrections.

Every asset has its price, and even if 2008 proves to be as challenging a year as 2007, there is still every chance opportunities for juicy profits will be created.