Positioning Your Portfolio

Outlook 2007

Even if a portfolio review wasn’t on your list of New Year’s resolutions, it isn’t too late to benefit from one.

In many ways, 2007 is likely to be a year in which the U.S. economy lags in the global economy, so it’s important to adjust your investments accordingly. Now would be a good time to rethink your allocations for domestic and international investments and upgrade the quality of your holdings.

Prepare for a U.S. Slowdown
After three years of robust expansion, the United States is expected to post a lumbering growth rate of less than 2% in 2007—the aftereffect of a 450- basis-point interest rate hike and falling real estate prices.

As a result, watch for domestic uncertainty in the next 12 to 24 months. As always, U.S. consumers will be the wild card. They spent freely during the recent expansion—not because of rising wages or real income, but because of the “wealth effect” created by soaring home prices. No one can say for sure how they will react to deflation in residential real estate.

Over the next several years, there is a good chance that baby boomers will discover they can’t sell their homes for as much as they thought, and they may turn to risk-averse, income-producing securities, such as high-quality preferred stocks and high-quality income-producing stocks. The key to benefiting from the trend is taking a position in these securities before boomers realize they have under-saved.

Therefore, this year should be an opportune time to prune high-risk, stocks and bonds and replace them with high-quality holdings. Where should you look? Strong sector plays include top-drawer technology companies, defense, discount retail companies and certain media stocks. High-quality bonds could also perform well this year if inflation expectations come down or if lower-quality bond spreads widen.

Invest Overseas
The outlook, however, isn’t all about retrenchment. Overseas markets will still provide growth opportunities. Europe’s economy, for example, is entering 2007 with far greater momentum than expected. Although this year’s growth rates are unlikely to match those of 2006, a sharp loss of momentum seems just as unlikely. Among the reasons: a robust, selfsustaining. European consumer with bright job prospects.

The 2007 outlook for Japan is riskier, but equally optimistic. 2007 might finally be the year during which the Japanese consumer beings to spend again. Domestically based customer-oriented companies stand to benefit.

Of course, a slowdown in the U.S economy, which represents 30 percent of the global gross domestic product, does pose some risks to overseas investments. Therefore, you might want to take a look at high-quality, dividend-paying foreign stocks or domestic companies with a strong international presence. Dividend income—when it comes in euros or another currency—can be a great way to gain international diversification and can, like gold, afford some protection against a falling dollar.

Wade Into Emerging Markets
If you have a long investment time horizon and an appetite for calculated risks, allocating some of your portfolio to emerging markets could prove prescient.

High expectations from this group of countries stem from their traditionally high savings rate. Emerging market consumers could be beginning to emerge. The total market capitalization of consumer stocks in emerging markets is about $30 billion, just 0.4 percent of the more than $7.5 trillion in developed markets. This disparity suggests that investing in the “emerging market consumer” could prove profitable over the intermediate to longer term.

Additionally, many of these countries are spending heavily on infrastructure. China is a case in point, with a rising consumer class born after 1978 that is 314 million strong and heavily influenced by Western culture. This commanding demographic will power internal growth along with heavy spending on roads, subways, airports and other projects in advance of and beyond the 2008 Olympics. Both trends could help insulate China and the global economy from the U.S. slowdown.

Heavy infrastructure growth in China will create demand for commodities, and many Emerging Market funds are filled with commodity investments. That is good news for investors in such funds who believe in the commodities super cycle. However, commodities can be volatile and may take a breather in 2007, so it’s important to take a measured approach.

Stay Diversified
No matter how the global economy trends this year, the foundation of any sound investment plan is appropriate asset allocation. If you don’t already have target allocations for your stock, bond and cash holdings, it is crucial to establish them with a Financial Advisor who understands your financial goals, investing time horizon and appetite for risk.

If you already have target allocations, this isn’t the year for major changes. By making small adjustments such as rebalancing toward foreign and higherquality investments, you can help ensure that your portfolio is ready for 2007.

Asset Allocation and Diversification do not assure a profit or protect against a loss in declining markets.

Richard Bernstein is the Chief Investment Strategist at Merrill Lynch.