As you can see from the Equity Composite Performance box below, 2007 was another successful year as we ended up the year with a 10.8% equity composite return which is 5.7% above the S&P 500 return of only 5.1% (including dividends). Several factors accounted for our good performance last year; namely,

• At the end of 2006 we sold all U.S. real estate investments and direct investments in the finance sector ahead of the housing and mortgage meltdown.
• We sold a majority of our U.S. small cap exposure and overweighted U.S. mid-cap growth and U.S. large cap growth equities.
• We overweighted our investments in direct energy investments within our commodities managers.
• We continued to overweight developed and emerging market equities aboard.W

SWIFT WEALTH MANAGEMENT: EQUITY COMPOSITE PERFORMANCE

T WEALTH(3.2%)                5.1%

The U.S. Economy and Market Outlook

Although the U.S. and Global stock markets have started off poorly in January, we believe there is cause for guarded optimism in the U.S; although there will be a slow down in Europe, U.K, Japan, and India, the prospects abroad outside  these countries remain strong.

Of course pessimism has taken hold of the markets thus far with worries about a continued slowdown in corporate profits, with $100 oil, tighter credit conditions, continued housing deflation, and rising defaults among investor’s top concerns.  Our thesis for cautious optimism for stocks here in the U.S. revolves around the following ideas:

• Easing Monetary Conditions – The Fed has reduced its Federal Funds Rate three times since late last year with continued reductions forecasted prospectively. Historically these reductions do not show up in increased economic activity for between six to nine months after the initial easing. Accordingly, the full effect of these rate reductions should start to show up in the economic data in the late first quarter and second quarter.
• Brisk Global Growth – Economic output especially among the emerging economies has driven world output in the past five years. We see continued strong growth among many emerging and developed foreign economies for the upcoming year.
• Weak U.S. Dollar – The weak U.S. dollar has started to have the intended affect of increasing our exports abroad as the market adjusts the exchange rate to combat the twin fiscal and current account deficits in the U.S. (see section on the “Consequences of a Falling U.S. Dollar”)
• Good Investment Spending.- We see decent growth in corporate investment spending tempered by CEO fiscal restraint because of the possibility of a U.S. recession.
• Robust Governmental Outlays – We see robust governmental fiscal outlays in this election year.
• Labor Market & Balance Sheets – The recent jobs report is a cause for some concern, but we don’t see significant slack in the labor market or weak balance sheets in the aggregate that would normally be associated with the prospective on set of a recession.
• Governmental Intervention into Mortgage and Housing Markets -  We saw this late last year with the government’s brokering of a interest rate freeze on some sub-prime mortgages.
• Modest Stock Valuation – at only a 15.6 price-to-earnings ratio the market is well below the historical average of 18.6 during periods of similar economic growth and inflation rates.

Taken together we believe that the U.S. will narrowly avoid a recession, but it won’t feel that way to consumers who are leading the economic slow down. There will be continued calls that we are in a recession from the popular press and news shows which will be over blown. The U.S. household net worth increased $18.5B during the past five years with only $4.4B  of that figure from increased home equity values. Don’t discount the American consumer; the richest 20% of Americans drive 40% of consumer spending. Rich Americans (and that’s you if you’re reading this missive) are certainly aware of high gasoline prices, but that has not stopped them from driving their cars. They have less of their personal net worth tied up in the homes and have high credit quality and are not as affected by increasing mortgage rates.

The bottom line in the U.S. is that the ride won’t be smooth and the direction won’t always be clear, but don’t be at all surprised when the U.S. stock market is up in the high single or low double digits for 2008. Our equity strategy is to continue to overweight large cap growth stocks around the world especially those tied to emerging market growth.

U.S. Stocks vs. U.S. Bonds

The earnings yield on U.S. equities is now above 6%, which makes them comparatively cheap compared with the yield on the 10 year U.S. Treasury Bond yield of around 3.8%. We are looking toward a very slack year among US Treasury Bonds and have overweighted corporate bonds and developed foreign government bonds.

We’ve done very well with our Treasury Inflation Protected Bonds in the past year, but with a benign inflation outlook (see next section), and a very rich valuation that has pushed the TIPS real yield down to just 1.8%, we have been taking our gains and redeploying the capital in other fixed income asset classes mentioned above.

U.S. Inflation Outlook

We are forecasting continued benign levels of U.S. inflation as the housing deflation keeps consumer spending in check. $100 oil and high food costs certainly hurt, but we use 80% less oil per dollar of gross domestic product compared with the last time we saw $100 oil (on an inflation adjusted basis) in the early 1980s. We have forecast inflation at 2.2% for the year.

Sector Outlook

Financials will continue to be weak because credit tightening will hurt merger and private equity activity. We see additional discounting as earnings fall another 5%-10% from already depressed levels. But as the Fed rate reductions become fully incorporated into the economy, and the yield curve becomes steeper, look for financials and value stocks in general to have a good second half of the year. Finally, the financial sector has suffered consecutive bad years only once in the last forty years (1973-1974).

World technology, especially in wireless transmission in data, voice, and video, will be strong in 2008. There has been a tremendous amount of infrastructure investment especially among the emerging economies (read: China). Now they need to make those buildings and work places more efficient. Additionally, the tech sector has little or no exposure to housing, but is tempered somewhat by a slowdown in the tech spending among financial firms.

Globalization and the Changing Nature of International Investing

Globalization, which has had a remarkable effect on the world’s economies, has also changed the international investing landscape. In countries around the world, political and economic reforms, open markets, burgeoning international trade, and increased property rights have attracted foreign investment and allowed capitalism to take root and thrive. In addition, many governments have successfully leveraged new infusions of capital and taken reforms to the next level, improving: infrastructure, banking systems, financial market, and education systems. These changes have helped lay the groundwork for developing nations to compete on the world stage.

We believe that many of the changes brought about by globalization are secular in nature. The dynamic, far-reaching effects of these shifts would be difficult to reverse; they create fundamental reasons for the strength and viability of many developing nations.

During the past ten years, global GDP has grown by 90%. During that time, the rest of the world has grown faster than the United States:

Source: CIA World FactBook, 2007, Data as of March  each year.

For investors, global growth and the integration of financial markets has expanded opportunities. To take full advantage of the world’s publicly traded companies, investors will need to look beyond core asset segments. Developed and emerging market equities, international small and mid caps, and international real estate have continued their improving fundamentals. While real risks remain, the paradigm shift in international markets makes them attractive options for global investors today.

Emerging market economies today account for 30% of world output, but only 11% of global market capitalization. Emerging markets comprise 45% of all exports, 50% of world energy consumption, 80% of energy demand growth over the past five years, and hold 75% of the world’s foreign currency reserves. Together they run a current account surplus and have dramatically reduced their foreign debts since the last emerging market decline in the late 1990s. They are now net creditors to the world. In short, these are not your father’s emerging markets.

To be sure, the market has noticed, with more than 400% increase in the Morgan Stanley Capital International merging Market Index over the past five years, compared with only a 70% increase in the S&P 500 index over that same span.

Of course, the emerging markets are not homogeneous and we see huge problems in India created by their large current account deficit and rampant inflation. Turkey and Hungary are also suffering the same ills and should be avoided. Countries with large current account deficits are vulnerable to the outflow of capital if foreign investors become adverse and pull their investment capital. India also suffers from skyrocketing credit growth and huge budget deficits that leave them no room to ease monetary or fiscal policy in the likely event of a slowdown. We look to a bursting of the India bubble as one of the top economic headlines of 2008.

China is much less risky with a very small (official) budget deficit (most think it’s actually a surplus) and a huge surplus in both their foreign reserves and current account balance. Additionally, the Chinese central bankers will not do anything that adversely affects their economy, such as revaluing the yuan, ahead of this summer’s Olympics in Beijing. We look for at least one more strong year in the Chinese market, as well as the much smaller Thai and Malaysian markets.

Emerging Market History: The Boom Before the Fall?

An  economic boom similar to what is happening currently among the emerging markets occurred in the early 1990’s only to end with what became known as the “Asian Contagion” that ultimately wiped out 60% of the market capitalization of  emerging markets. Actually the problems started with a Mexican foreign debt default in 1994 followed by similar defaults in East Asia in 1997, Russia in 1998, Brazil in 1999 and Turkey in 2000. Argentina and Venezuela then defaulted in 2002.

But there are significant differences today. First, you would normally see weakness in earnings ahead of a bursting valuation bubble. We saw this among US technology companies in 1999 and in East Asia in 1997. But today earnings growth remains healthy in most of greater Asia, sans India, and quite strong in Brazil and Russia.

Of course, too much investor interest can lead to problems down the road. Vast capital inflows not only inflate asset bubbles, but also increase that country’s exchange rate, which hurts these export - based economies. Most of emerging Eastern Europe has suffered from loose monetary standards, leading to persistent and damaging inflation rates in these economies.

Finally, investors from around the world worry that a US recession will lead to a global economic slowdown and the demise of the Chinese economy. In 1999 the US accounted for 34% of Chinese exports, but today we only account for less than 24%. There is no doubt that a US recession would have repercussions around the world, but there has been a significant decoupling of the U.S. economy with the rest of the world, brought on by globalization, the global pain resultant from a US recession would be much less acute than in the past.

The Consequences of a Falling U.S. Dollar

Behind the problems of the dollar lies the huge and growing US trade deficit, and the large Federal budget deficit that has and will continue to hit Asian countries particularly hard whose governments hold huge foreign currency reserves in dollars.

For many years financial markets have worried about the growing size of the US trade deficit - the difference between the amount the US imports from the rest of the world, and the amount it can sell to the rest of the world. That deficit is now above $800bn for 2007, or 7% of the US economy, and shows no signs of diminishing. At the same time, tax cuts and the war in Iraq have led to a US budget deficit of several hundred billion dollars despite the strong economy.

Asian giants

Much of the trade gap relates to US commerce with East Asian countries such as China, Japan, and Korea, that sell much more to America than they buy. Together, the East Asian countries have accumulated foreign currency surpluses of nearly $1T , much of it held in US Treasury bonds denominated in dollars. Accordingly, they are funding both the budget gap and the trade gap.

The classic economic view of how to correct such changes is to adjust the exchange rate in order to make US goods cheaper and Asian goods more expensive. But many Asian currencies - especially the Chinese yuan - do not float freely on international currency markets, and the US has long been pressuring China to revalue its currency. The markets have taken matters into their own hands, by forcing the US dollar down. In the long run, the fall in the dollar will lead to a cut in the trade deficit and a boost to US exports. But this process often takes a long time, and, in the meantime, is fraught with dangers.

Run on the dollar

In the first place, a rapid fall in the dollar, if it accelerates, could cause short-term problems for the US economy. The higher price of imported goods could lead to a hike in domestic inflation, and it could take several years before consumers switch back to buying more US goods. But the fears of inflation are also likely to affect the interest rates on long-term bonds, which determine mortgage rates. The rising mortgage rates will also give a further boost to inflationary pressures.

International exporters hit

Meanwhile, foreign companies who have derived an increasing proportion of their sales and profits from the US market could also be hit by falling demand for their exports. The sharp falls in non-US stock markets, especially in Asia, are a response to this fear, with electronics and car companies like Toyota and Sony especially vulnerable. And that, in turn, could affect the growth rate of countries like China, who derive much of the growth in their economies from exports. But the Asian exporters also have another reason to feel vulnerable.

As the value of the dollar falls, their reserves of the currency also reduce in value, as do the yields on the US Treasury bonds held by many of their central banks. In buying such bonds these governments are, in effect, underwriting the large US Federal budget deficit as well. This deficit is set to increase as the baby boomer generation faces retirement. The Asian governments and investors may be tempted to sell many of their dollar holdings in order to protect themselves - but this would have the effect of weakening the dollar further. And it would force the Fed to raise interest rates even more to protect the dollar.

Countries like China are reluctant to massively revalue their currency; it would make investing in China much more expensive and could deter valuable foreign investment.

Managed float

This problem with the dollar has happened before, in the 1980s, when it was Japan rather than China that was seen as the main threat. At that time, the main industrialized countries worked together for a managed currency float in an agreement called the Plaza Accord. The coordinated approach led to a managed decline in the value of the dollar, which then stabilized at a more sustainable level, supported by central banks. Current US administration, however, does not favor such an approach, believing that the markets should be left to their own devices. And given the vast size of foreign currency markets today, it is doubtful that central banks could make such an effective intervention again.

The downside for the US in the 1980s was that it was forced to enter into an international agreement with other governments that reduced its freedom to set its own domestic policy. But in the absence of such an agreement, it looks like the markets themselves are finally deciding that the US 'twin deficits' are no longer sustainable. And when the world's largest economy begins to look shaky, it is not surprising that confidence among financial markets is weakened around the world.

Municipal bond market

If something positive has come from the sub-prime market fallout and resulting credit market crunch it is that municipal bond investors are being afforded unusually high yields. In fact, today you can purchase a 10-year AAA municipal bond at a yield about equal to the yield on a 10-year Treasury bond.

Municipal bonds have an attractive feature of being exempt from federal income taxation and many states exempt the interest from in-state municipal bonds. Because of that, the yields are normally lower than on taxable securities, such as U.S. Treasury Bonds. Historically, the 10-year AAA Municipal Bond has yielded approximately 80% of the 10-year Treasury.

Two factors are responsible for driving these yields to unprecedented levels relative to Treasury Bonds. First, investors have been selling anything not issued directly by the federal government. It doesn’t matter that the issuer’s credit-worthiness is sound; investors have been in a “flight to quality” and don’t seem to care about the fundamentals of these municipal credits. Second, the municipal bond market has been spooked by concerns about the financial health of companies that insure municipal bond issuers against defaulting on their interest payments. These insurers in some cases also guaranteed bonds backed by low-quality mortgages and are under pressure to back up those guarantees or face ratings downgrades. We find the prospect of such downgrades unlikely. Moody Investors Service completed a study of default rates on high-rated municipal bonds and found that just 0.1% failed to make good on interest payments- a far lower rate as compared with corporate bonds. As long-term investors we can ride out any short-term turbulence caused by irrational investors selling good credits, and we will benefit from the historically rich yields on the highly-rated municipal bonds that we hold.

Equity & Fixed Income Asset Allocations

(c) Swift Wealth Management

www.swiftwealthmanagement.com