S&P: Ease Up on International Equities

Its Investment Policy Committee also raised its recommended portfolio allocation for cash

On September 13, the S&P Investment Policy Committee (IPC) decided to reduce its exposure to international equities to 20% from 25% and increased its recommended cash allocation to 15% from 10%.

Given that our benchmark holds only a 15% international equity weighting, our new 20% international allocation continues to represent an overweight to foreign equities, reflecting our continued faith in the asset class.

In light of our continued positive outlook on emerging markets and European equities, the 5% reduction in the foreign equities allocation is focused on Japan. While international equities continue to outperform the U.S. year-to-date, this is largely the result of double-digit gains in emerging markets and solid European returns. Japan has lagged badly, falling 4.5% year-to-date through Sept. 12. As a result, we eliminated our 3% allocation to Japan based on weakening economic growth and high valuations. We're also concerned about earnings, since recent yen appreciation threatens to derail exports.

In addition, we modestly reduced our recommended allocation to developed international equities (as represented by the MSCI EAFE index, which includes Europe, Britain, Japan, Australia, New Zealand, Singapore, and Hong Kong) to 15% from 17%.

While developed international equities continue to perform well, the extent of their U.S. equity outperformance has fallen to only 120 basis points through Sept. 12.

We made no change to our 5% diversified emerging markets equity weighting. Superior long-term GDP and earnings growth, coupled with low relative valuations, gives us confidence that the recent outperformance will continue.

As for the U.S., S&P's Chief Economist David Wyss cut his U.S. GDP forecast for 2008 to 2% from 2.7%, and has raised his recession risk forecast for the next 12 months to 40% from 33%.

"We were surprised by the payroll numbers, which were much weaker than expected," Wyss says. "It wasn't just the August numbers, but also downward revisions for several other months. These unemployment stats have us concerned. We expect the unemployment rate to tick up to 5% by the summer of 2008."

Though the risk of recession has risen, it's important to note that there is still a 60% chance it will be avoided, says Sam Stovall, S&P's chief investment strategist.

"Because we think no recession is more likely, those investors who gravitated toward Treasuries in an attempted flight to safety - thereby depressing the yield on the 10-year note - should begin to lighten up on their heavy safe-haven exposure once the threat of recession abates."

Stovall adds the IPC believes that the short-term gains to be had in bonds have been realized, and if yields rise, prices could fall. With yields currently very low and further capital appreciation unlikely, we believe cash is currently a more attractive option.

We took the 5% from foreign equities and put it all into cash. We remain underweight fixed income at 25% vs. our benchmark's 30% fixed income allocation. Our exposure to U.S. equities remains at 40%.

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