Fixed Income Year Ahead-Hwang Peter

Research :

Fixed Income Year Ahead- Martin Mauro

Investment Themes for 2008
Emphasize high-quality alternatives to Treasuries.

Investors with a 12-month horizon or longer should focus on instruments that offer an
appropriate yield pickup over Treasuries. The flight to quality that drove the
out performance of Treasuries in 2007 also pushed their yields down substantially.
Our favorite alternatives are preferreds and munis. CDs also fit the bill.
Minimize cash holdings.
We think that the Fed will cut the federal funds rate by 0.75 percentage point in 2008 and even further in 2009. If we are right,
rates on money market instruments will decline. We are comfortable with the
safety of money funds and auction market securities, but we doubt that investors
will be able to maintain the current income stream on these instruments.
Make selective forays into Closed End Funds (CEFs).
We think that selected preferred and muni CEFs offer good value. At present, we are not
recommending senior loan fund CEFs, as a weakening economy should hurt the
performance of low-quality instruments. Many CEFs are selling at unusually large
discounts, a far cry from a year ago.
TIPS as an inexpensive inflation hedge.
TIPS were the best performer in the bond world during 2007, thanks to a fairly high inflation rate, and
a decline in real rates helped along by Fed rate cuts. But the breakeven inflation
rate for 10-year maturities remains low at 2.3%. If inflation is higher than that over
the next 10 years, TIPS will do better than nominal Treasuries.
Distinguish “good mortgages” from “bad mortgages.
” A clear lesson from 2007 is that not all mortgage debt is the same. The mortgage-backed
passthroughs and CMOs from Fannie Mae and Freddie Mac did well, as did the
straight debt from these companies. We think they will do well in 2008 also.
Look abroad.
Foreign bonds have done well for U.S. investors in recent years largely because of the dollar’s depreciation.
We think that the dollar may benear a bottom, so coupon income and price appreciation may be the keys for
2008. We recommend the Eurozone for U.S. investors.

Emerging Markets
2007 Winners and Losers- Michael Hartnett

2007 equity market winners and losers
The winners were emerging market equities (37%), global materials (36%) and
global energy (31% - see Table 1). The losers were developed markets (7%), UK,
US, Japan and global financials (-8%). Note the degree by which EM
outperformed DM was the largest since 1993 and 1999.
2007 equity market winners and losers in EM
EM winners were: "commodity plays" e.g. energy, materials, BRIC markets (56%);
“domestic-demand plays” e.g. telecom (50%), industrials (66%), and “highyield/
lower inflation plays” e.g. Turkey (70%). See Table 2, page 2.
EM losers were "US-plays" Taiwan (5%), Mexico (9%), Asian tech (flat) and
“consumer-plays” e.g. discretionary and “high-yield/rising inflation plays”
e.g. South Africa.
Energy dominated emerging markets in Q4’07
EM was up 3.4% but excluding energy EM equities were down 0.3%. Note
cyclical sectors (materials, industrials, consumer discretionary and technology)
were all down. See Table 3, page 2.
Directionally long EM in Q1
We would be directionally long EM equities: investors very bearish according to
Fund Manager Survey; fund outflows total $3.7bn in past two weeks.
Temptingly contrarian “losers” such Taiwan, Asia tech, Mexico need a trough in
US growth expectations and/or sustained decline in oil prices to work. We think
it’s too early. For the moment we would stick with BRIC + Gulf “winners”.


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