High and rising energy costs are compounding a deceleration in the global industrialized economy which has already been weakened by the subprime mortgage fallout. The energy crunch has further stoked inflation concerns, which have added to selling pressure in the global bond market (since inflation erodes the value of bonds). The U.S. economy is in a morass, dragged down by a housing bust and subsequent credit crisis. Although not abysmal, employment is weak and consumers are retrenching; home, auto, boat and consumer sales have been crushed. Retail stores are closing and shopping centers are losing their tenants. The Federal tax credit boost caused a short-lived positive aberration but won’t turn the tide. The sole positive note is that the weak dollar has helped domestic exporters, thus the overall manufacturing sector is only in a mild slowdown phase. None-the-less, risks remain on the downside until the consumer retrenchment is further advanced and/or some relief from soaring commodity prices arrives.

Although still under 1%, corporate default rates have recently escalated and will keep rising into 2009. Thus, expect fixed income to bear additional spread-widening (i.e., negative) events as well as occasional spikes in credit spreads. Leveraged closed-end funds (CEFs) usually offer a hefty yield relative to the underlying sectors in which they invest, however CEF prices recently rallied ahead of underlying net asset values (NAVs), thereby causing yield premiums to shrink. Therefore, we may decrease our leverage across these funds. In addition, we may see the dividend impact of rising default rates which will lead to wider discounts to NAV and further price return deterioration.

Rising energy cost have reached a choking point: a further rise in prices may send the G7 [Canada, France, Germany, Italy, Japan, United Kingdom, and USA] economies into a renewed slump. An extended period of consolidation or price correction in the oil market, however, would allow growth to regain traction. Unfortunately, the oil market is in a mania and there is little reliable way to predict near term price moves. None-the-less, the odds of a correction or consolidation are higher than the probability of a continued surge; and when the correction occurs, oil prices could move very quickly as a myriad of speculators exit simultaneously. Meanwhile, the dollar will extend its “bottom-making process” in the third quarter and the euro will remain vulnerable.

Unfortunately, borrowing rates for businesses and consumers have actually gone up, while the Fed Funds rate has plummeted. Moreover, the continued drop in the residential market has been the worst in postwar history and there is little sign of it ending. As long as real estate prices keep falling, the banking sector will remain vulnerable. Note that the Savings and Loan (S&L) debacle in the early 1990s wiped out a large chunk (approx. 2,000) of regional banks and thrifts. It is unlikely that we will see the same number of bank failures that occurred in the early 1990s. Nevertheless, a sharp rise in failures in the coming months should not come as a surprise.

Michael Ashley Schulman, CFA
Hollencrest Capital Management