May 2008 Economic Update

Successful investing requires us to make sense of situations that are often characterized by rapid change, information overload, and time pressure to make high stakes decisions. Even passive investors face this challenge, to the extent that they need to identify and limit their exposure to substantially overvalued asset classes, with their attendant potential for large losses. In our conception of this challenge, sensemaking is a circular process, characterized by multiple feedback loops, that is comprised of three stages:

1. Allocating our limited attention to obtaining certain types of information;
2. Identifying the most likely causes of the current situation; and,
3. Based on that understanding, forecasting the most likely ways the situation could evolve in the future, and deciding what action to take.

The circularity and complexity of this process manifests itself in many ways. Consider the first stage - the allocation of our scarce attention. To a great extent, this takes place outside of our conscious control, guided by our existing mental model (developed in stage 2) about the way the world works - the key variables to which we must pay attention, their normal range of values, and how they interact with each other to produce outcomes of interest (e.g., returns on our portfolio). We also have a natural tendency (which was no doubt useful eons ago when our ancestors lived on the East African plain) to attend to variables characterized by fast and/or large changes. To the extent that we are conscious of decisions regarding how we allocate our scarce attention, we are most often trying to check on how our previous forecasts matched up with actual results, rather than how well the indicators we used actually correlated with the eventual outcomes we were trying to forecast. However, when the gap between our forecasted outcomes and the actual result grows too wide, it can trigger a reexamination of our basic mental model of the situation. We also have a well-documented tendency to pay attention to information that others are also focusing on, regardless of its reliability and diagnostic value (i.e., its ability to help us determine which explanation or forecast is most likely to be accurate). To a greater extent than most of us acknowledge, the allocation of our scarce attention is socially driven.

In the second stage of this process, we try to construct a mental model to understand the situation we observe. Following the principle that humans always try to conserve the use of their scarce cognitive resources, we can think of this stage of the sensemaking process as follows. Our initial attempt at understanding a new situation is largely unconscious, and based on the recall of mental models that we used in similar situations, or, at a more conscious level, situations that seem analogous to the one we face. Our ability to use these approaches is fundamentally dependent on the range of our experience and knowledge of history. If these are inadequate, and fail to provide a satisfactory understanding of the situation at hand, we typically proceed to a conscious attempt to recall and evaluate known theories that could explain what we observe. If this approach fails, we are forced to take the approach that requires the most mental energy: deliberate analysis of a truly novel situation on its merits, and the use of induction to create new generalized theories on the basis of the apparent causes and effects we observe. Human nature makes accurate induction particularly challenging when causes and effects are widely separated in time, and/or asymmetric and/or non-linear. It therefore comes as no surprise that humans tend to cling to their existing mental models until the evidence that they are outmodes becomes overwhelming, in order to avoid the heavy mental effort required to change them.

In the third stage, of the sensemaking process, we use our current mental model to deduce (forecast) how the situation is likely to evolve. In some cases, this includes an assessment of how any actions we could take would affect this evolution. To close the circle, implicit in the forecasts we make are judgments about where we should direct our scarce attention in the next stage of the cycle.

Clearly, sensemaking is not an easy task. Moreover, when the number of elements being forecast grows large (as is usually the case with active investment management) the cognitive challenges grow exponentially more difficult (which no doubt accounts for some of the attractiveness of quantitative - model driven - active strategies, that remove human beings from the sensemaking loop, except when a modification of the model is required).

This description of sensemaking suggests that a broad perspective on economic and financial history, as well as familiarity with advances in investment theory should play important roles in investors' sensemaking process. Unfortunately, too often they don't - and investors are likely much poorer as a result. A number of recent papers help to illustrate why this is so.

Let's start with economic and financial history. In "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises", Reinhart and Rogoff find the data show that "serial default is a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies. Major default episodes are typically spaced some years (or decades) apart, creating an illusion that 'this time is different' among policymakers and investors." They also provide fascinating and important evidence that "each lull has invariably been followed by a new wave of defaults" and "crises have frequently emanated from financial centers with transmission through interest rate shocks and commodity price collapses." In particular, "over the period 1800 to 2006, peaks and troughs in commodity price cycles appear to be leading indicators of peaks and troughs in the capital flow cycle, with troughs typically resulting in multiple defaults." The authors also show how "historically, significant waves of increased capital mobility are often followed by a string of domestic banking crises" and that "other crises, including inflation and exchange rate crashes" often accompany debt default. As they note, "the recent US sub-prime financial crisis is hardly unique."

The second outstanding history paper is "Macroeconomic Crises Since 1870" by Barro and Urusa. Barro, as readers may recall, is the author of another famous paper ("Rare Events and the Equity Premium") on the impact of rare but deep crises on investors' required returns on real return bonds (it makes them lower) and equities (it makes them higher). The authors find, across 22 countries, 148 crises (defined as a peak to trough decline of 10% or more in GDP), "implying disaster probabilities of around 3.6% per year. The disaster size has a mean of 21% (decline in GDP) and an average duration of 3.5 years."

The third history paper is published by the Bank for International Settlements. In "Growth Dynamics: The Myth of Economic Recovery", Cerra and Saxena note that "crises, shocks and changes in policies can be ignored only if their output consequences are transitory." Based on their study of data for a large number of countries, they critically find that "economic contractions are not followed by offsetting recoveries. Trend output lost is not regained, on average. Wars, crises and other negative shocks lead to absolute divergence and lower long-run growth."

In sum, the main message of these three recent papers is clear: crises occur with depressing regularity, tend to follow common patterns, and have lasting negative effects. Keep that in mind the next time someone tells you, "this time is different." Let us now move on to a short review of some of the excellent theoretical papers published recently, that can expand the approaches an investor can use to understand a situation and forecast how it is likely to evolve.

The best of these, which we strongly recommend all our subscribers read, is "The Virtues and Vices of Equilibrium and the Future of Financial Economics" by Doyne Farmer and John Geanakopolos. The paper presents an extended review of the equilibrium and rational expectations models that underlie many of the most popular theories used in financial economics. The authors then provide an extended critique of the equilibrium approach, and the additional insights that come from the use of agent based and other behavioral models that assume that while markets may be attracted to equilibrium and rational pricing, they are seldom in this state. No summary can do this paper justice; it is worth your while to read it.

Three other new papers explore the implications of the risk of rare but serious disasters, as evidenced by the historical studies noted above. In "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macrofinance", Xavier Gabaix, the author theorizes that, building on Barro's work, "during a disaster, an asset's fundamental value falls by a time varying amount, which in turn generates time varying risk premia and volatile asset prices." He concludes that if his assumption of an "intensity of disaster" that varies over time is correct, it ties together and explains a range of apparent anomalies, including the relatively high equity risk premia, excess equity return volatility and low real interest rates we observe in historical data. Importantly, Gabaix notes that "the model is presented as fully rational, but [also] could be interpreted as a behavioral model. The changing [investor] beliefs about the intensity of possible [future] disasters are very close to what the behavioral finance literature calls "animal spirits" and the recent rational expectations literature calls "time varying risk aversion. The theory's structure gives a consistent way to think about the impact of changing sentiment on prices." More recently, Gabaix and Emmanuel Farhi have teamed up to write "Rare Disasters and Exchange Rates", which offers a theory to explain the so-called "forward premium puzzle" where countries with relatively higher interest rates often see their currencies appreciate rather than depreciate as the uncovered interest parity (UIP) theory predicts. The authors also link exchange, interest rate and equity market conditions together: "high domestic interest rates imply high currency risk premia - an expected appreciation of the currency - and low equity risk premia." The authors note, however, that "time varying disasters are inherently difficult to assess. As such, they might be especially vulnerable to expectations errors."

This is a point Martin Weitzman analyzes in depth in his paper, "Subjective Expectations and Asset Return Puzzles." His starting point is the "big three" of financial anomalies: given the relatively low historical variability of consumption, historical equity risk premiums and volatility seem too high, and real interest rates too low. Weitzman's key (and common sense) assumption is that the average investor does not accurately understand the structure of the underlying process generating changes in future consumption. Uncertainty about the true likelihood of bad events (e.g., a sharp decrease in consumption) changes the perceived distribution of future consumption growth from a normal distribution to a so-called "T-distribution" that has fatter tails - i.e., to a distribution in which substantial downside events have a higher probability than assumed in standard finance theories derived only from observing historical data (note that this is changing, as more historical research like the papers cited above is published). Weitzman concludes that "aversion to structural uncertainty increases both the equity risk premium [i.e., required returns on equity] and equity volatility, while simultaneously decreasing the risk free real interest rate" (for a practical application of this view to climate change, see Weitzman's paper "The Role of Uncertainty in the Economics of Catastrophic Climate Change").

Finally, another recent paper highlights the centrality of the credit cycle to patterns of equity returns over time. In "Asset Pricing and The Credit Market", Longstaff and Wang begin by noting that the credit market facilitates borrowing by less risk averse investors from those who are more risk averse. When this process is constrained, the market impact of the former group declines relative to the latter. This causes an increase in the average required return on equity, and a consequent decline in equity prices.

In sum, the recent papers noted above provide investors with a wealth of historical patters and theories that can help us to better understand the causes of the economic and market changes underway today, to make educated forecasts of where they could lead, and to understand the consequences of these scenarios. With that in mind, we will briefly review our basic economic scenarios and the critical uncertainties that underlie them, and then turn to the IMF's most recent analysis of the global economic outlook.

The first branch of our scenario tree is between a mild global economic slowdown, and one that is deeper and more protracted. The resolution of two critical uncertainties will determine which of these develops over the next few months. The first question is whether the lagged impact of interest rate and tax cuts, the depreciation of the dollar versus the Euro, and the Federal Reserve's efforts to limit the contraction of market liquidity will be sufficient to prevent the development of a recession in the United States. The forces militating against the success of these moves are substantial. House price declines have been significant in many markets, and appear to be accelerating. Since, at more than 6% of GDP, the contribution of residential investment to demand growth was at an all time high in the United States, and since, at 70% of GDP, consumption spending was also near an all time high (with a considerable amount of this financed by loans secured against housing equity), the impact of falling house prices on U.S. demand is sure to be large. At the same time, U.S. businesses and consumers are facing substantially higher energy and food prices than a year ago, which is feeding into higher inflation which further contributes to the sense of economic uncertainty in the United States. It is also not at all clear that the "deleveraging" of the U.S. economy has come anywhere close to its logical conclusion. Moreover, due to higher oil import costs, and perhaps a scarcity of export capacity in certain industries (e.g., capital goods, where a lot of capacity has moved offshore over the past decade), the significant decline in the U.S. dollar versus the Euro and other currencies (but not, notably, against the Chinese renminbi) has had a relatively weak impact on the nation's net trade balance. As a result, the U.S. continues to be heavily dependent on foreign central banks for the financing of its still very large current account deficit (foreign private investors are no longer significant buyers of U.S. dollar denominated assets). Overall, the combined impact of all these negative factors on the psychology of American consumers cannot help but be significant. We have serious doubts that the monetary and fiscal stimulus now working its way through the U.S. economy will be sufficient to overcome these negative forces. The second major uncertainty is whether China will choose to make significant policy changes to further stimulate domestic demand growth in its economy, to pick up the slack left by consumer retrenchment in the United States and declining exports to that market. To some extent, this trend is already underway, with domestic demand growing at an increasing rate. However, there is still the perception (e.g., evidenced by the reluctance of the Chinese government to allow its exchange rate versus the dollar to further appreciate) that this process is not taking place fast enough to offset the global impact of a slowing U.S. economy.

The most commonly proposed policy change is substantial reform of China's healthcare, education and retirement income security systems, which would (assuming Chinese consumers trust the long term viability of these new programs) reduce the need for savings and release funds for increased consumption spending.

Thus far, however, policy change in China has been slow, and more focused on reducing inflation which (due to rising commodity costs and growing skilled labor shortages) has recently passed 8%. This is a top priority issue for the Chinese government, because in the past high inflation has been associated with rising levels of social unrest (e.g., 1989). Given continued strong exports, any attempt to further stimulate domestic demand would only further aggravate this inflation problem. On the other hand, there remains a serious risk that, absent substantial policy changes to further stimulate domestic demand growth, the fall in exports caused by the slowing of the U.S. economy could set off a very dangerous process in China, as export oriented firms facing overcapacity default on loans (reducing confidence in the banking system where most consumer savings are held), layoff workers, and/or try to keep up capacity utilization by sharply cutting prices and trying to sell those goods in either the domestic market or in export markets. This latter move could set in motions deflationary forces that could further worsen already weak credit market conditions. To some extent, this process is already underway, as evidenced by the sharp drop in the domestic Shanghai exchange index this year, which must have dented consumer confidence (equally disturbing is a new paper, "Just How Capitalist is China?", by Yansheng Huang of M.I.T., who concludes that, beneath the surface, the country has been losing dynamism since the mid 1990s, when more state oriented urban interests gained the upper hand over more entrepreneurial rural interests). Given the reluctance of the Chinese government to take more aggressive policy measures, we cannot help but believe that they are waiting to see if U.S. stimulus measures will be sufficient and allow the current system to continue a bit longer, despite its increasing fragility. If this bet proves wrong, however, their delay in taking the policy steps needed to boost domestic demand may result in a sharp decline in the Chinese economy.

There is also an argument that the Chinese government may view a prolonged world recession as being in their best long term interests, provided that its domestic consequences can be managed. As we noted in February, "a prolonged recession would further weaken the United States, and could strengthen China's relative position in the world. Moreover, a prolonged crisis in the capitalist economies of North America and Europe might also strengthen the Chinese regime's popular legitimacy at home, and help defuse some of the current political tensions caused by high levels of inequality and corruption. Last but not least, as a means of moderating the sharp rise in domestic inflation caused by the pegging of its currency to the U.S. dollar, a slowdown in growth (as would be caused by falling exports to the U.S., offset to some extent by increased domestic consumption) might be preferable to a sharp appreciation of the renminbi, which would trigger immediate, very large, and quite possibly politically costly losses on China's foreign exchange reserves. In sum, while we clearly see how an appreciation of the renminibi versus the U.S. dollar and increased Chinese domestic consumption could benefit the rest of the OECD, we cannot say the same for the benefits to the Chinese leadership in the short and medium term, unless they decide a global downturn would place the survival of the current government at an unacceptable level of risk." Regarding the latter issue, the recent display of Chinese nationalism in the face of protests along the Olympic Flame route certainly cause one to wonder whether this powerful force might be harnessed (e.g., via a raising of tension with Taiwan) to support the survival of the Chinese government through a prolonged global economic downturn. And we also have to remember that the U.S. current account deficit today is being financed not by private investors, but by central banks - of which the Chinese People's Bank of China/State Administration for Foreign Exchange is by far the most important player. To be blunt, if the Chinese government wants to trigger a dollar crisis and global recession, it is well within its power to do so.

This brings us to the next branch in our scenario tree. Assuming the world enters a recession (based on how our U.S. and Chinese growth and political uncertainties turn out), we have two further scenarios about what will transpire next: either a deep and prolonged recession characterized by high levels of conflict and uncertainty, or one where heightened global cooperation limits its severity and duration. More specifically, we have pointed to the future actions of three different groups as central to whether the conflict or cooperative scenarios is likely to develop. The first is Chinese peasants, who seem to hold the key to domestic stability in China. If their resentments continue to build (e.g., over rising inflation and falling standards of living, corruption, widening income gaps, continued land seizures, and poor health care, education and old age income security), and if they become better organized (e.g., through better use of technology, or by organizations like Falun Gong or disaffected former People's Liberation Army members), then the chances of serious instability in China and disruption to its (and, by extension, the world's) economy sharply increase. In this context, it will be interesting to see how the outrage provoked by the recent earthquakes in China plays out, particularly the grief and anger of so many families who lost their only children in the collapse of multiple poorly built schools. In the medium term, either improving conditions or diversion of the people's growing anger (e.g., into rising nationalism and international tensions) could be used to keep this powderkeg from exploding, as it has many times in China's past.

The second key group is Iranian youth. Two third's of that country's population is under thirty years old, and unemployment, by unofficial estimates, now stands at roughly 25 percent, while inflation approaches 20 percent. Political stability rests on government subsidies (e.g., for energy and imported food), which are financed with oil export earnings. On the positive side, the National Intelligence Estimate released last December by the United States seems to have reduced the tensions somewhat between Iran and the United States. Moreover, in recent parliamentary elections, reformists (despite the disqualification of many of their candidates) and so-called "pragmatic conservatives" did very well, and President Ahmadinejad's supporters suffered a significant setback. This seems to bode well for a reduction in the belligerent rhetoric that has characterized the Ahmadinejad regime. At this point, with Ahamdinejad the subject of growing criticism for his mismanagement of the economy (which has been amplified by the impact of international sanctions), a sharp fall in the price of oil, particularly if it was not matched with a fall in the price of imported food, could lead to significant unrest and perhaps a change to a more moderate government. Alternatively, rising unrest among young Iranians could cause President Ahmadinejad to force a confrontation with the West, in an attempt to harness Iranian nationalism to retain his political control.

The third group whose actions are central to the evolution of a cooperative or conflict driven scenario is the American middle class, and increasingly their peers in other Anglo Saxon countries. All of them have been coming under increasing economic pressure, made worse by the ever widening gap between stagnant real wages for the middle class and significant increases for those at the top of the income and wealth distribution. This situation is only being made more difficult by falling house values and rising energy and food prices. The consequences of these unprecedented (at least for most Americans) pressures are currently on full display in the U.S. presidential primaries. As Douglas Schoen noted in the Washington Post, "Voters today aren't just fed up with the status quo; they're furious." The consequences of this rising anger are as yet unknown, and will undoubtedly depend on the quality of these nations' political leadership. On the upside, it could, in the presence of effective leadership, lead to the reestablishment of the political center and substantial progress towards resolving America's underlying economic tensions.

On the downside, significantly higher taxes on upper income taxpayers (with no accompanying changes in spending) and/or increased protectionism (even of the "cut your nose off to spite your face" variety) cannot be ruled out. Regarding the latter possibility, it is well to keep in mind one of the key conclusions in the 2007 Report of the Congressionally chartered U.S. - China Economic and Security Review Commission (www.uscc.gov): "China's mercantilist policies are taking a huge toll on small and medium sized manufacturing facilities and their workers in the United States. While U.S. - based multinationals can transfer and have transferred much of their production to China, small and medium sized manufacturers in the United States are not as mobile. They face the full brunt of China's unfair trade practices, including currency manipulation and illegal subsidies for Chinese exports. This is significant because small and medium enterprises represent sixty percent of the manufacturing jobs in America." With the middle class under increasing pressure and America in the throes of a presidential election year, the outlook is volatile indeed.

Finally, our basic framework for understanding the world economy and financial markets also includes two "wildcards" whose impacts, while impossible to predict, could easily be very substantial. The first is the continuing evolution of the H5N1 influenza virus. While the "pandemic flu" headline long ago disappeared from the world's headlines, the virus itself has continued to steadily evolve. Most recently, the World Health Organization warned in early May that the risk of a pandemic developing had grown, as the virus became entrenched in poultry populations around the world. On the positive side, we have not seen any sharp increase in rates of human to human transmission, even in Egypt and Indonesia, the two countries where H5N1 seems to be most widespread and fastest evolving. On the other hand, H5N1 continues to be unusually lethal in those humans who become infected. If the past is any guide, then as evolution makes H5N1 easier to pass between humans, it should also become less lethal. If that doesn't happen, we are likely in for a very nasty stretch that could substantially reduce global growth rates.

The second wildcard is a major environmental incident that causes very substantial economic damage and/or widespread loss of life. In our view, most human beings have a innate desire for transcendent experience. Traditionally, this has been satisfied by the world's religions. However, in an increasingly secular world, their "market share", so to speak, has been falling, particularly in the West. What often seems to be taking the place of religion is a growing concern for the environment that at times borders on nature worship (i.e., animism), and is finding increasing expression in the political arena (e.g., the recent decision to name the polar bear as an endangered species, which seems likely to trigger a great burst of CO2 related litigation). Given these trends, it seems likely, in our view, that an extreme environmental event could trigger a rapid acceleration in efforts to limit CO2 and other emissions, which in turn would create new investment opportunities (e.g., in the so-called "cleantech" space) but also possibly slow down economic growth (at least in the short term) as taxes are imposed on CO2 emissions. If this environmental shock came in the middle of a global recession, its affect could be quite beneficial, in that it could trigger a wave of new investment; however, if it came in the middle of a period of strong economic growth, it might have a negative effect.

The following table sums up our three scenarios, including the indicators we watch to see if they are developing, as well as our assessment of their implications for different asset classes:

	Short Shallow Recession	Prolonged Shallow Recession	Prolonged, Deep Recession
Key Indicators:	End of house price declines in U.S.; moderate declines in U.K. Narrowing credit spreads and improving liquidity Expansion of domestic demand in China Commodity prices stay high; inflation remains above targets Foreign central banks continue to finance U.S. current account deficit – sharp fall in dollar’s value avoided	Continued falls in house values in multiple countries Credit spreads remain wide and liquidity tight Reduced consumption spending in U.S. and Europe Falling exports in China with no offsetting rise in domestic demand No sharp fall in U.S. dollar Moderate fall in commodity prices; inflation at target levels No major domestic unrest in China; new U.S. President able to build effective domestic and international coalitions; Ahmadinejad bypassed or replaced and move toward moderation of Iranian foreign policy	Sharp falls in commodity prices Credit market conditions worsen and liquidity becomes more scarce Sharp fall in inflation; possible appearance of deflation Rising tensions between U.S. and China and/or Iran Rising domestic unrest within China
Implications for Asset Classes:
Real Return Bonds	Could lead to an increase in real rates, and negative return on RRBs	Further increases in risk aversion and falling investment cause real rates to fall further; positive returns on RRBs	Further increases in risk aversion and falling investment cause real rates to fall further; positive returns on RRBs
Nominal Return Government Bonds	Yields could rise as economy recovers and/or due to inflation, producing negative returns	Flight to quality should bid prices up and yields down; returns will be positive	Falling inflation or deflation would produce strong returns
Exchange Rates and Gold	Commodity exporters (AUD, CAD) remain strong/gradually appreciating; CNY (China) appreciates; gold benefits from continued inflation concerns	Little change from current levels; perhaps some appreciation of USD as part of flight to quality	Sharp increase in U.S. dollar (could be temporarily offset by China selling US Govt bonds); sharp increase in gold (flight to quality)
Commercial Property	Could see rising returns as confidence grows that deep recession has been avoided; may also benefit from being a perceived inflation hedge	Continuing weakness and negative returns	Significant price falls and negative short term returns (which, looking further ahead, set the stage for substantial positive returns when the economy eventually recovers)
Commodities	Possibly high returns driven by combination of true scarcity in some cases, and growing speculative bubble in others	Falling returns	Sharply negative returns
Timber	Positive returns as investors look for inflation hedge	Flat to negative returns as falling construction causes downward price pressure	Positive returns as investors hedge deflation risk
Equity	Flat to positive returns, depending on degree of investor belief that deep recession has been avoided	Negative returns	Very negative returns
Uncorrelated Alpha Strategies	Moderate positive returns	Negative returns for leverage based strategies	Very negative returns for leverage based strategies
Equity Market Volatility	Moderate positive return	Strong positive returns	A long deep recession could reduce volatility and returns.

Obviously, the key question is which of these scenarios is most likely to develop. In this regard, it is worth quoting at length from the most recent (April 2008) World Economic Outlook published by The International Monetary Fund.

"The global expansion is losing speed in the face of a major financial crisis. The slowdown has been greatest in the advanced economies, particularly in the United States, where the housing market correction continues to exacerbate financial stress. Among the other advanced economies, growth in western Europe has also decelerated, although activity in Japan has been more resilient. The emerging and developing economies have so far been less affected by financial market developments and have continued to grow at a rapid pace, led by China and India, although activity is beginning to slow in some countries. At the same time, headline inflation has increased around the world, boosted by the continuing buoyancy of food and energy prices. In the advanced economies, core inflation has edged upward in recent months despite slowing growth. In the emerging markets, headline inflation has risen more markedly, reflecting both strong demand growth and the greater weight of energy and particularly food in consumption baskets. Commodity markets have continued to boom despite slowing global activity. Strong demand from emerging economies, which has accounted for much of the increase in commodity consumption in recent years, has been a driving force in the price run-up, while biofuel-related demand has boosted prices of major food crops. At the same time, supply adjustments to higher prices have lagged, notably for oil, and inventory levels in many markets have declined to medium- to long-term lows. The recent run-up in commodity prices also seems to have been at least partly due to financial factors, as commodities have increasingly emerged as an alternative asset class."

"The financial shock that erupted in August 2007, as the U.S. subprime mortgage market was derailed by the reversal of the housing boom, has spread quickly and unpredictably to inflict extensive damage on markets and institutions at the core of the financial system...One of the most dramatic aspects of this crisis has been an unprecedented loss of liquidity...The persistence of liquidity problems has been due in large part to increasing concerns about credit risks...The global economy is now facing a widespread deleveraging as mechanisms for credit creation have been damaged in both the banking system and the securities markets - that is, both of the financial system's twin engines are faltering at the same time...Liquidity remains seriously impaired despite aggressive responses by major central banks...evidence is gathering of a broad credit squeeze - although not yet a full-blown credit crunch...The pressures on household finances in the United States are likely to be augmented by the correction in equity prices in early 2008, and by deteriorating labor market conditions...A protracted weakening of growth in the advanced economies would have negative effects on the growth prospects of emerging and developing economies. Significantly weaker global growth would likely slow their exports and trigger a decline in commodity prices, with knock-on effects on domestic demand and especially investment."

"The overall balance of risks to the short-term global growth outlook remains tilted to the downside...Large global current account imbalances also remain a worrisome downside risk for the global economy...The disproportionate pattern of adjustment in exchange rates since the summer of 2007 means that certain emerging economy currencies remain overvalued and that new misalignments may be emerging. At the same time, there is a concern that financial market dislocations have reduced confidence in liquidity and risk-management characteristics of U.S. assets and institutions. Coming on top of prolonged weak returns in U.S. markets relative to those elsewhere, investors and fund managers (including of international reserves and sovereign wealth funds) may increasingly seek to diversify their portfolios. This would make it more difficult to obtain the flows needed to finance the U.S. current account deficits and may even trigger a disorderly adjustment. There are also concerns about increasing protectionist sentiment in the advanced economies, particularly in the context of deteriorating labor market conditions."

"To further explore the downside risks to the global economy, the IMF staff has constructed an alternative scenario based on a combination of negative shocks, using a new multicountry general equilibrium model. Assessing the impact of multiple shocks is difficult because of significant interactions between sectors within an economy, across economies, and over time. These interactions generate positive and negative feedback, leading to nonlinear reactions. A model-based approach allows a more systematic examination of these interactions and of the potential effects of alternative policy responses, although of course no single model can possibly capture all aspects of a situation. The downside scenario is based on a combination of three related shocks. First, it includes a temporary shock to consumption and investment from a further tightening of credit conditions while the financial system goes through a protracted rehabilitation period during which capital and credibility are repaired after extended financial turmoil. Equity and real estate prices would be reduced relative to baseline (by 30 percent and 20 percent, respectively). The economic impact of this shock is felt most directly in the United States and western Europe, but it also affects parts of the world that have heavily relied on borrowing. Second, the scenario builds in a permanent downward shift in expectations for long-term productivity growth in the United States, which would tend to raise the U.S. saving rate as households and businesses adjust their expectations for capital gains and lower investment. Third, the scenario incorporates a shift in investor preferences away from U.S. assets, raising their risk premiums and reflecting investors' diminished confidence in the U.S. financial system and their downscaled expectations for U.S. potential growth. Under this scenario, the U.S. economy would experience a deeper and more extended recession as negative effects from lower asset prices and lower longer-term growth expectations continued to depress aggregate demand, even with a gradual improvement of credit availability and with substantial support from monetary easing and fiscal stabilizers. Slower domestic demand growth, together with exchange rate depreciation, would contribute to an improvement in the U.S. current account. The euro area would undergo an extended period of weakness, as the economy faces the negative financial shock and upward pressure does not build in the longer-term adverse shift included for the United States. The rest of the world would also experience a slowdown in the aggregate, albeit less intense. Although the global model does not explicitly model housing markets or commodity prices and includes only limited country detail, the negative effects appear most intense in countries with particularly large exposure to house price and commodity cycles. Thus, countries in western Europe that have experienced rapid house price appreciation in recent years - such as Spain and the United Kingdom - as well as some emerging economies with booming housing markets - would be vulnerable to sustained housing corrections that would amplify their business cycles. Commodity prices would also be expected to weaken in the context of a global downturn that slowed growth in the large Asian emerging economies that have accounted for the bulk of the increase in demand for commodities in recent years. Such a shift would have consequences for exporters of food and metals in Africa and Latin America, as well as for oil exporters in the Middle East and elsewhere. This scenario is intended to be illustrative, but it underlines two key points. First, a downturn would be expected to have global consequences, leading to more moderate rates of growth in emerging and developing economies and exposing some of them to greater external financing strains. Second, a downturn could be followed by a slow rather than rapid recovery, as financial system constraints take time to dissipate and as negative wealth effects continue to dampen activity."

In sum, we continue to be pessimistic about what lies ahead for the world economy. That said, there remains substantial uncertainty about how events will unfold, and their eventual impact on different asset classes. We continue to believe that investors should ensure that they have adequate cash reserves (which can be increased, if necessary, by selling down overvalued asset classes) and have rebalanced their portfolios to overweight asset classes that appear undervalued today, and to underweight those that appear to be overvalued. We emphasize that, given the incentive structure under which many investment managers operate, not to mention the difficulty of estimating fundamental asset values in rapidly changing environments, we believe there is a greater structural tendency towards herding and prolonged overvaluation in financial markets today than there was in the past. The fragility and risk this creates are only magnified when large amounts of leverage are added to the mix as they have been in recent years. As we have seen in the credit markets, this can cause savage falls in asset prices when liquidity contracts. Under these conditions, prudent investors need to redouble their efforts to identify and take steps to limit their exposure to substantial overvaluations. We recognize that this involves making judgments on the basis of imperfect foresight, and occasionally feeling pangs of regret when it appears one has sold too soon (i.e., when an asset class an investor believes to be substantially overvalued keeps rising after he or she has reduced his or her exposure to it). Recognizing the powerful influence these emotions can have on our decisions, we remain more committed than ever to the discipline of grounding one's decisions in the outputs from a consistent set of valuation models. When one's emotions are in conflict with a model's results (as they may be today), an investor can then ask what valuation assumptions would make the two consistent with each other. More often than not, the end result of such an exercise is not favorable to an overly emotional approach to investing.

Here then, is our view of different asset class valuations at the end of April 2008, in light of our outlook for the global economy:

Probably Overvalued	Commodities, Corporate Bonds/Credit Risk, Equity Markets in Canada, Japan, the U.S. and India
Likely Overvalued	Commercial Property except Australia
Possibly Overvalued	India, U.S., Canada and Eurozone Govt Bonds
Possibly Undervalued	Australian Dollar and UK Pound Govt Bonds; Australia Commercial Property; Non-U.S. Dollar Bonds
Likely Undervalued	Australian Dollar Real Return Bonds; U.K. Equity; Equity Volatility; Timber (in long run, if not short run given downward pricing pressure)
Probably Undervalued

| 2007-2008 Benchmark Portfolios - All Currencies | This Month's Issue: Key Points | Product and Strategy Notes: Interesting New Research; New ETF Products - RWO, GRI, FFR, CYB, ICN, UHN and DYY/DEE; Canadian Asset Allocation ETFs; Vanguard & Russell Retirement Products; and New Research Investing After Retirement | May 2008 Economic Update | This Month's Letters to the Editor: Nominal vs Real Calculations, Canadian Oil Trusts - Claymore's ENY and Omega Function in Optimization | Global Asset Class Returns | Asset Class Valuation Update |