Nearly half way through the year, the markets appear very different to most observers than they did at year end:
- Private Equity (PE) acquisitions are achieving new records
- Foreign central banks and wealth coffers are refocusing their US investments
- Domestic housing and subprime mortgage woes have worsened
- Inflation concerns are more tangible
None-the-less, our outlook for relatively strong US and emerging markets remains on track.
Year to date, U.S. private equity deals have trebled to $281 billion from the same period in 2006, and globally, PE deals have more than doubled to $447 billion year to date. PE accounts for 35% of current US merger-and-acquisition (M&A) deals and a fifth of all global deals. Total M&A volume so far this year is $2.2 trillion, 77 percent ahead of last year at this time. In the U.S., volume is at $800 billion, up 54%. In Europe, volume is up 129%, at $1 trillion. Even in a higher interest rate environment, because PE funds remain awash in cash, expect deal making to remain strong.
Asian exporters and global oil producers – that have accumulated trillions of U.S. dollars in their central bank reserves and corporate coffers over the last several years – are diversifying their investments away from US Treasury debt (which has kept our interest rates low) to equities and other currencies. For example, this month, China purchased a $3 billion investment in Blackstone Group. In addition, new money is on the horizon. The Chinese government is broadening the exchange rate band and will soon allow its citizens to buy international stocks through their local banks. Repatriated dollars should support U.S. equities because many foreign investors are most interested in diversifying into solid, stable companies that will be around in 20 years, and will return better than U.S. Treasuries.
Domestic housing and subprime mortgage woes have worsened. Existing home sales fell in April to its lowest level in four years, new homes prices have slid 10%, some builders are facing 40% cancellation rates, permits for new building activity are down 70% from a year ago, and the affordability index for first time buyers is well below its ten year average. In addition, late payments and foreclosure rates are at levels not seen since last decade’s recession. As a result, banks are tightening lending standards and some major Wall Street firms and hedge funds are fire-selling mortgage backed securities that have lost value. As interest rates increase and adjustable rate mortgages reset upwards, expect housing woes to worsen and negatively affect home furnishing and consumer goods retailers.
In addition to credit problems, the US consumer is feeling inflationary pressures as imports become increasingly expensive for a weakening dollar, commodities and heavy manufactured items continue to be globally backlogged, and consumer food prices creep up. Interestingly, the Fed’s usual inflation control mechanism, interest rates, often has little effect on sectors such as food because food is not directly interest rate sensitive. If Bernanke increases borrowing costs, he will depress aggregate demand but food prices could continue to rise.
Michael Ashley Schulman, CFA
Hollencrest Capital Management