Genworth Financial Asset Management, Inc.MARKET_OUTLOOK (01/07)

2007 Market outlookjANUARY 2007

As we begin the New Year, we see a number

of positive factors affecting the markets, which

during the latter half of 2006 drove many markets

to new highs, but we also see significant risks to

the downside. In the face of 2006’s decelerating

economy, a number of areas of the economy

have shown remarkable resilience, among them,

consumer spending.

Going forward, issues such as whether the

bursting of the housing bubble will be contained

among the industries most directly affected (such

as construction, real estate sales, mortgage

lending, home improvements and furniture) or

whether it will spread to the economy as a whole

have us concerned.

On balance, however, moderating inflation and

resultant low longer-term interest rates and strong

corporate profits leave many securities reasonably

valued. Some, however, are priced for perfection,

with significant risks to the downside should an

optimistic scenario not unfold.

Going through possible scenarios and how they

may unfold, we can picture several that range from

materially disadvantageous to benign. There are

uncertainties on how different “elephants in the

room” will act and how the markets will react. The

economic drivers to which we are paying particular

attention include, among others:

The possible contagion of the chill in the

housing sector to the broader economy, and

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most importantly, its impact on consumer

spending and capital markets

The huge trade deficit financed by the equally

enormous budget deficit and this impact on

the U.S. dollar

Labor markets: global labor force competition

balanced against a tight domestic job market

and the impact on corporate profits, inflation

and consumer spending

Growing long term demand for commodities

of many varieties derived from growing

emerging market prosperity and global

demographic trends

The scenario we believe as more probable begins

with the housing bubble deflating much more

rapidly and severely than many would like to

believe, especially those closest to the situation,

such as the National Association of Realtors.

Consumer spending, which comprises 70% of

U.S. GDP, has been tied over the past ten years or

so to the “wealth effect” of consumers spending

money based on the gains they have seen, first in

the stock market during the 1990’s and then in the

housing market during the 2000’s. More recently,

we have seen consumers using their homes as

a “piggy bank,” with significant equity extraction

from their homes, which has been used for a

variety of purposes, included paying off debts,

making other investments, or simply for spending

on cars, vacations, or clothes. More importantly,

however, is the psychology behind this spending:

As consumers feel wealthier, they spend more. A

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reversal in this psychology is more important than

the actual amount of spending money they have

extracted from their homes.

As consumers have significantly increased their

debt, both mortgage and credit card, it makes

continuing this trend difficult at best. As rising

interest rates and plateauing, if not declining, home

values have limited homeowners from extracting

equity from their homes, equity extraction has

shrunk markedly. After reaching a peak of $869

billion in the third quarter of 2005, representing

nearly 10% of U.S. personal disposable income,

home equity extraction plunged to $380 billion in

the third quarter 2006. By contrast, home equity

extraction was only $71 billion ten years prior,

in the third quarter 1995, representing a much-

smaller 1.3% of personal disposable income .

Not all of this was spent, of course, but certainly

much of this money created demand for consumer

goods of all types. Many have argued that cash

out refinancings have allowed consumers to pay

down debt from higher-interest credit cards, but

that argument is flawed. In fact, consumer credit

outstanding (exclusive of mortgages) increased

by $1.3 trillion since the beginning of 1995, an

increase of 115% . Meanwhile, personal disposable

income increased by a much smaller amount, 79%,

during this period. As a result, total U.S. consumer

debt now exceeds U.S. GDP, when only eight years

previous, that figure was only 64% of GDP.

Not surprisingly, many people are falling behind

in their mortgage payments and defaults and

foreclosures are increasing markedly, especially

in the sub-prime market. Two sub-prime lenders,

Sebring and Ownit, recently filed for bankruptcy,

as foreclosures doubled from a year ago, according

to UBS. According to the Federal Reserve, nearly

13% of sub-prime mortgages are currently 60

days or greater past due, a 20% increase from just

a year ago. As a result, investors fear that some

mortgage-backed securities (MBS) that consist

of sub-prime mortgages may face losses from

defaults.

Rising debt and prospects for default are certainly

concerning to many people. Consumer spending

gains in the past decade were financed first

by gains in the stock market, then by gains in

the housing market, and now by increases in

credit card debt and reductions in savings. The

savings rate has been in the negative range since

2005; never has the savings rate as a percent of

disposable personal income been negative for this

long nor by this amount since data were published

in the 1950’s. The U.S. savings rate, now -1.0%

as of November 2006, started the 1980’s at 9.5%

of personal disposable income and had not fallen

below 5% until the beginning of 1994. Eventually,

consumer spending must either decline or be

supported by higher disposable income.

Of course, a tight labor market makes wage gains

entirely plausible, but wage gains mean either

higher inflation or lower corporate profits, unless

it is accompanied by increased productivity.

Productivity, however, has decelerated over the

past year and stalled in the third quarter, with no

gains in hourly output per employee. Corporate

profits make up a much larger slice of GDP than

they had even five years ago, rising to 12% of

GDP from 7.7% of GDP in 2001, while wages as a

component of GDP fell in tandem. A reversion to

the mean could reduce corporate profits and crimp

stock market returns. If corporations have the

pricing power to shift any higher employment costs

to consumers, higher inflation would result, hurting

both stock and bond market performance.

However, one important factor cannot be ignored,

and that is the now-global competition in the

labor market. As companies find it relatively easy

and cost-effective to employ labor for both goods

and services abroad (factories in China and call

centers in India are two prominent images in

many Americans’ minds), it is difficult for many

Americans to demand higher wages. This is

skewing the income distribution to those at the

very top and those towards the bottom, squeezing

out the middle class in the process. Those jobs that

can command higher wages are those in industries

such as healthcare, education and finance, while

those that are seeing job growth are those in

various services industries, where wages may be

helped by the proposed increase in the minimum

wage. (As an aside, Wal-Mart, with approximately

one million employees in the U.S., could see a

significant impact on earnings from a 40% increase

in the minimum wage.) Jobs that have been the

staple of the middle class, such as manufacturing,

are disappearing.

While it is hard to determine in the aggregate

at this point whether the tight labor market

(outside of manufacturing and construction) will

indeed command higher wages, the scenario of a

consumer-driven slowdown in the U.S. will most

likely result in an easing of the labor market and

resultant wage and inflation pressures. However,

this scenario would also result in weaker corporate

profits as a percentage of GDP, returning in a

reversion to longer-term average distributions of

wages versus corporate profits as slices of the

national economic pie.

Meanwhile, against this backdrop of potentially

weaker U.S. corporate profit growth is the weaker

dollar. Foreign holders of U.S. dollars, often central

banks holding the dollar as a reserve currency,

already have indicated that they intend to shift

their allocations towards a more evenly balanced

currency mixture that better reflects the economic

landscape. This means that China, which holds

$1 trillion in currency reserves, much of it in U.S.

Treasurys, may allocate more to the euro, yen,

and other currencies. As the insatiable appetite

for foreign goods by U.S. consumers continues,

we need to finance our huge trade deficit with

our equally huge budget deficit. This economic

imbalance cannot be sustained, and the most

likely outcome is that foreign investors will no

longer desire to hold U.S. dollars as U.S. economic

growth wanes. Better investment prospects in

other currencies means foreigners will sell U.S.

dollar denominated assets, sending the U.S. dollar

lower, interest rates higher to attract capital, and

foreign goods more expensive in the process.

The economic mechanics at some point will make

domestic goods more attractive in terms of price,

and hopefully will stabilize the dollar and correct

the trade deficit, but likely after the dollar has

fallen significantly, perhaps by 50% over the

intermediate term.

As a result, we are favoring investments that

benefit from a differential in faster-growing

economies overseas versus the U.S. and a falling

U.S. dollar, either by investing in certain overseas

markets or in those companies that benefit by

exporting to them, including many U.S.-based

multinationals. It is important to note that our

investments in companies that export significantly

abroad are not a hedge for a falling dollar, but

hopefully will benefit as the profits of quality

growth multinationals increase when repatriating

higher-valued currencies back into dollars and

participating in higher growth markets outside of

the U.S.

While the long term mechanics of a falling U.S.

dollar can push interest rates up, over the short

term we see opportunities in the long bond given

a slowing economy. The yield curve is already

inverted, indicating that the bond market expects

the Fed to lower interest rates at some point

next year and that the slowing economy will ease

inflationary expectations over the near term.

Of course, over a longer term, as emerging market

prosperity continues to propel demand for products

ranging from toasters to televisions to tractors,

the inputs for these products will become more

valuable. Commodities are, of course, of a finite

supply, and demand can only increase over the

long term as populations grow and become more

prosperous. We see a long-term bull market in

commodities, but note that short-term gyrations

in the market and the entrance of speculators can

make commodities as an asset class overpriced

at times. We plan to eventually invest again in

this asset class, but for now, we see shorter term

overbought conditions that do not fully factor in a

slowing U.S. economy and the resultant temporary

reduction in demand for commodities.

Overall, there are always opportunities, even if

a recession should occur in the U.S. during the

latter half of 2007. These opportunities are not

necessarily the most obvious, and that makes

active asset allocation especially important. In

Opportunistic strategies, we have the ability to

choose from 49 asset categories, including those

that profit from weakness, such as inverse high

yield and inverse OTC, among others. This enables

GFAM to actively manage our clients’ accounts

to manage risk exposures, while increasing the

ability to engage in return-seeking investments

outside of the usual categories. It is a different

world, but we recognize where risks lie in an

uncertain environment, and believe that profitable

investment prospects are ever-present. Seeking

opportunities while understanding the challenges is

how we strive to add value.

Genworth Financial Asset Management, Inc.

16501 Ventura Blvd., Suite 201

Encino, CA 91436Tel: 800 691.6680 www.gfaminc.com

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