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The American Economy
…many, many challenges
The critical question to be addressed in coming months is whether or not the U.S. economy will dip into recession.  We suggest about a 35% chance of recession during the next 12 months, with a stronger expectation that a “growth recession” or sluggish growth is more likely. 

Real (inflation adjusted) economic growth could slow to a 0.5%-2.0% annual growth pace during the next six months, versus the already sluggish 2.2% real annual growth pace during 2007’s first half.  Housing weakness and credit market anxiety, combined with a constantly negative view from the national media, could make it “feel” like a recession.   

The Federal Budget
…tax revenues climb
A budget deficit near $150 billion (the smallest in six years) seems on tap for fiscal year 2007, which ended on September 30.  Powerful gains in individual and corporate tax revenue, tied to income and investment tax cuts of recent years, are today’s reality.  When you cut tax rates, you typically generate more tax revenue.  Of concern?  Budget challenges become more daunting in coming years.

Employment
…rising jobless rate?
The nation’s unemployment rate averaged 4.6% over the past 20 months, below the averages of the ’70s, the ’80s, and the ’90s.  Economic weakness could see the rate approach 5.0% in coming months.  The longer-term issue of tighter labor availability—especially for skilled workers—will challenge businesses of all shapes and sizes. 

Inflation
…staying under control
Most forecasts still see consumer inflation this year near 2.5%-2.8%, with slightly lower inflation pressures in 2008.  By comparison, the Consumer Price Index rose 2.5% last year, 3.4% in 2005, and 3.3% in 2004.  Powerful competition in nearly all industries helps keep inflation low. 

The Federal Reserve
…to the rescue
The Fed reduced its most important interest rate—the federal funds rate—on September 18 from 5.25% to 4.75%, the first change in nearly 15 months and the first reduction in four years.  Many on Wall Street were expecting only a 0.25% cut.

If the economy stabilizes, further rate cuts will be limited.  If the recession forecasters are correct, a federal funds rate approaching 4.00% could be on tap by Summer 2008.

Long-Term Interest Rates
…global pressures
Traditional 30-year fixed-rate mortgages approached the 6.25% level in early October.  Anxiety in the jumbo mortgage market has led such rates higher than before in many communities, while getting a subprime mortgage is very difficult.  In the event that a full-blown U.S. recession emerges in coming months, traditional 30-year fixed-rate mortgages would likely fall below 6.00% again.

Home Prices
…real estate pain
Surging home prices on both coasts and in the Southwest during 2002 to 2006 gave way to a buyers’ market during the past year.  The simple reason?  The average U.S. home value rose 50.76% between June 30, 2002 and June 30, 2007.  Florida?…up 95.30%.  Arizona?…up 90.78%.  California?…up 90.15%.  Nevada?…up 89.47% (source: OFHEO).  Homeowners and “investors” simply became too greedy, requiring the current painful downward adjustment in many markets.  We expect greater home price strength in the nation’s interior as relative values (compared to the coasts) are attractive.

The Global Economy
…rising global anxiety
Strong global growth continues, following impressive growth during the prior four years.  Global credit market anxiety regarding risk, combined with markets that have “frozen up” at times, does suggest some slowing is likely (see below).

The highly emotional issue regarding the quality and safety of goods “Made in China” will be center stage in the U.S. for years to come, with many American consumers simply refusing to buy.  Powerful Chinese economic growth has led to further steps by political leaders to slow the economy. 

Japan has returned to modest economic growth during the past few years after a decade of economic stagnation.  A vacuum in regard to strong political leadership has developed at the time when such leadership is most critical.  Strong Indian economic growth remains on track, led by solid domestic demand for goods and services.  The disparity between the “haves” and “have nots” seems to be widening. 

European economic growth has strengthened during the past two years.  The global credit crisis is a hot topic across the Continent, with the European Central Bank (ECB) the most aggressive of the world’s central banks in providing liquidity to financial markets.  Long-delayed labor reforms bode well for greater European competitiveness in coming years, particularly in Germany.   

By various measures, Russia has now surpassed Saudi Arabia as the world’s largest oil producer.  President Putin’s recent selection of a largely unknown old crony to be Prime Minister has heightened the buzz about Putin’s influence after he is supposed to step down in 2008. 

Various South American countries struggle with high taxes and stifling regulatory burdens.  Brazilian economic growth is solid, while Venezuela remains a political powder keg.  Canadian economic growth has slowed, although the energy-rich Western provinces are booming.  The Mexican economy is growing at a reasonable pace, with the immigration issue highly charged on both sides of the Rio Grande.

The Bottom Line?
U.S. economic performance will slow in coming months, with mild recession a possibility.  In addition, we expect:  a declining budget deficit…tighter long-term labor availability…modest inflation pressures…declining short-term interest rates…soft coastal housing markets, with more solid interior performance…and an anxious but impressive global economy.

Hot Potatoes

Private equity houses…megafunds…leveraged buyouts…equity bridges…collateralized mortgage obligations…subprime mortgages…complex credit derivatives…widening risk spreads…PIK toggles…dividend recaps…CDOs…CMOs…IPOs…LBOs…

…welcome to the exotic, complex, and at times scary world of 21st Century finance.

One recently failed Bear Stearns hedge fund’s name is a great example of 21st Century excesses…the High-Grade Structured Credit Strategies Enhanced Leverage Fund. Aggressive investors who had money in this hedge fund have essentially lost it. The reason? More traditional investor terms still apply today, including fear…flight to safety…investor anxiety…greed…guilt by association…and shoot first, ask questions later.

Domestic and global financial market developments since late July have sharply raised anxiety levels about the use of aggressive debt financing, the use of private equity to “do deals,” and the use of extremely complex credit derivative products to “spread the risk” around. Such anxiety is likely to remain high as additional news of weakened or failed hedge funds and postponed financing deals is released. Though a possibility, we do not see these issues leading to U.S. recession.

At the same time, dozens of mortgage companies that “specialized” in providing subprime mortgage loans to American home buyers have failed. Mortgage delinquencies and foreclosures are up sharply. To this caldron of anxiety, one can also add in the reality that oil prices have now reached the $80 per barrel level.

Financial markets of all types are prone to excess…and prone to greed. Stratospheric price levels reached by many technology stocks 7-8 years ago are a good example. Rising U.S. home prices and “flipper” greed during 2005 and 2006 is a more recent example…

…unfortunately, excessive greed is many times followed by excessive fear.

Bridge Lenders
Many Wall Street and global commercial banks and investment banks are currently sitting on billions of dollars of “loans” they never had an intention to keep on their books. Such firms act as the bridge lender between a private equity firm in getting a new deal financed and the ultimate purchaser of the loans, such as hedge funds, retirement funds, wealthy individuals, insurance companies, etc. Many of these ultimate debt buyers are currently telling major banks, “Thanks but no thanks…we don’t want any more.” Nobody wants the hot potato.

Every 10 Years
Shocks to U.S. and global financial markets are historically common occurrences, with 10-year cycles at play more recently. Twenty years ago saw financial markets and investors trying to survive the Crash of ’87, where the Dow fell more than 22% in one day. Ten years ago saw the Asian financial crisis of 1997, followed quickly by the collapse of high profile Long-Term Capital Management in 1998.

Market extremes tend to be self correcting. Two examples come to mind. The sharp rise in bond prices in recent months saw long-term interest rates fall sharply. The 10-Year U.S. Treasury Note yield reached a five-year high of 5.31% in mid-June, with related 30-year fixed-rate mortgages approaching 7.00%. The Treasury yield fell to around 4.60% by early October, with 30-year mortgages around 6.25%. Such a decline helps housing demand.

The second development is the reality that the Federal Reserve will provide more assistance if market psychology gets progressively worse. The Fed has a history of injecting new money in the economy when “crisis” is underway. They would do so again.

For example, the Fed came to the rescue in 1998 when Long-Term Capital Management failed, pushing anxiety sky-high. This firm’s management included some of Wall Street’s most glamorous names. The team even included two Nobel Prize-winning economists.

Economists? Well there’s the pr

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