Shutdown, bankrupt or no longer operating independently, the subprime tsunami has swallowed sixty-seven (67) US mortgage lenders since late 2006. The tempest has hit home builders too; Toll-Brothers, Lennar, and Shea are stepping up promotions and discounts in the face of lower sales and a high numbers of customers walking away from their commitments. Banks are also feeling some losses from their subprime portfolios, but are not in trouble as they were during the Savings & Loan crisis of the 80s; the major US banks and financial firms remain sound. A more meaningful metric to watch is credit card delinquencies because consumers are more likely to default on their plastic before their mortgages.

The Fed will maintain rates at 5.25% for a while longer; however, speculation about possible Fed actions is at a true crossroads for the first time in years. The market is reasonably split between whether Bernanke takes rates higher, lower, or keeps them the same.

  • Decrease? Rates would decline if the economy risked collapsing, but it doesn’t. Business is strong and consumers are still spending. In addition, Bernanke may also fear the “irrational exuberance” that lower interest rates may create
  • Increase? A weak dollar is playing a dual role of, a) propping our GDP engine by making our exports cheap for the rest of the world, and b) heightening the chance of inflation by making our imports more expensive.
  • Stay the same? The Fed is correct in its assessment that inflation is the primary risk, but with shaky consumer credit restraining consumer spending, near-term inflation risk is minimal. However, expect food (agricultural) prices to rise, especially dairy, grains, and meat because of growing foreign demand and alternative uses. [Interestingly, over the past seven years, global growth in milk consumption has outpaced oil.]

The Fed may eventually lower rates to prop consumer finance/spending, but with a healthy domestic economy and minimal inflation, rates should be stable into the fourth quarter.

Domestically, capital market flows have undergone swift change. U.S. companies raised more money last year through private placements deals than IPO’s and recently, private equity deals have reduced the number of U.S. stocks faster than initial public offerings have replaced them. Private equity pools still have over $500 billion to invest. The positive effect on US stocks has been noticeable: the S&P 500 index is up 21.7% since the end of ’05 and up 5.1% since the end of ’06. Expect more corporate takeovers and higher stock markets.

Much of the current excitement is overseas. France has a new right-wing President, Nicolas Sarkozy, who has boldly named a socialist foreign minister and seven women (in order to improve the gender imbalance in French politics) to his slim cabinet. The lean cabinet, with half the positions of the previous cabinet, headed by Prime Minister (PM) Fillon, is part of Mr. Sarkozy’s plan to cut expenditures and make government more efficient. Across the channel, Tony Blair, has announced he will stand down as Britain’s PM and Labour party’s Gordon Brown has strong backing to succeed him. In Russia, President Vladmir Putin is also preparing to step down next year. Elsewhere, emerging markets continue to find favor as risk concerns diminish. The swing of capital towards international markets continues unabated.

Michael Ashley Schulman, CFA
Hollencrest Capital Management