Where are we at now? We are enjoying unprecedented global economic growth and the world is still flush with liquidity. There is a lot of cash out there looking for a home and enormous assets are being traded like baseball cards in 4th grade homeroom. The liquidity has been fueled primarily by low interest rates. Low interest rates have kept a lot of money on the sidelines ready to be invested and have also enabled powerful tools of leverage used to acquire huge assets. Quite a rosy picture but as economic history has taught us all good things come to an end, at least for a while.

Buyout firms such as KKR, Blackstone, and Cerberus have seized upon this great opportunity to make mountains of cash. Initially, these private equity groups had a lot of sound long term reasoning behind their acquisitions. Prices were not as high as they are now and by taking companies private they could create added value by decreasing bureaucratic and regulatory inefficiencies as well as creating huge tax savings by being able to write off the company’s debt interest payments. How long can this arbitrage be viable? I do not have the exact answer to that but I don’t think the end is far off. The irony that Blackstone is now taking itself public seems to be a pretty strong signal that things have shifted. While momentum is still on the side of the buyout firms, I believe most of the acquisitions being made now are simply to feed the beast and not for the original sound principles. A lot of speculation has helped move the entire stock market higher because so many companies are now considered potential takeover candidates. That could be one of the reasons why there still seems to be some value in the larger cap stocks that would be the most difficult to acquire.

If the momentum is on the side of buyout firms, what could cause this ride to come to a screeching halt? One answer is interest rates. Higher interest rates will make it harder to finance large acquisitions and stock buyback programs. In addition, it will give the pension fund investors, which have been large contributors to the capital in these deals, a reason to keep their money in bonds.

The US Treasury has been one of the primary benchmarks for the world’s coupons. Foreign central banks, desperately trying to keep their currencies low against the dollar in order to keep exports flowing have gorged themselves of this asset, particularly the US 10 year. Part of the “problem” is that it is the easiest option. To buy certain large US companies foreign entities have jump through hoops and often fail because of the political roadblocks that they face. No one likes to lose money, not even communist countries. The interest rate on the 10 year has finally started trending upward while the dollar has depreciated significantly against major currencies and commodities. You can bet this has a lot of politicians in China (and many other countries) thinking about other ways they could use the money they have in US treasuries, especially since the US congress seems dead set on imposing import restrictions if China doesn’t allow the RMB to appreciate more rapidly. There has been a clear shift already of nations removing or significantly changing their pegs against the dollar and allowing them to float against a wider range of currencies, particularly the Euro. I believe this trend away from the dollar will continue and could accelerate.

Another reason for the historically low global interest rates has been the perception that single-currency interest rate derivatives have eliminated exchange rate and interest rate risk. The explosive growth of this segment in the derivatives market is a testament to how much people believe in it. According to the Bank for International Settlements, in 1995 the notional amount of contracts outstanding in dollars was close to $18trillion. By June 2006, this number had grown to $291trillion (almost 5 times global GDP). While these types of derivatives have withstood some major stress tests such as the 98 Asian currency crisis, the market back then was much smaller also more nimble. Some argue that if something like that were to happen today the major trading houses might not be able to logistically handle the volume of transactions that would take place.

Another more obvious threat to the health of the credit markets is the state of the US housing market. Many investors/traders feel that the risk has already been priced in and that it is old news but I would caution them that things are going to get much worse. Even the sub prime debacle, which a majority feel has hit bottom, has significant future headwinds in the form of many interest rate resets on loans that were made at the peak of the market. Also, many of the bad loans that lenders sold to investors had buyback provisions and if they are forced to exercise them, the cash available in banks coffers for all types of loans will dry up. Downward price pressure of homes in most markets is accelerating. Most investors would say that the problem is “contained” but I do not think they appreciate how long these things take to play out. Housing prices may have been declining for over a year (a short time considering a bull market of about 15 years) but its impact on employment, GDP, and sentiment has only just begun. Could the US enter a recession? Most likely. Does that mean the end of the world? For some people it obviously does because they would never admit something like that. To me it is simply an opportunity if positioned correctly. Timing these things correctly all the time is impossible but an investor needs to maintain independent judgment and not simply run with the herd.

The most common argument I hear against a recession is that there is so much liquidity in the market. I would argue that liquidity would simply make the change more rapid, not prevent it from happening. If there was some catalyzing event or combination of events, liquidity in the form of cash would quickly flee to other parts of the world that are enjoying much stronger growth rates and don’t have severe twin deficits. Liquidity resulting from a generous financing environment could also disappear overnight from a number of scenarios. Was there not a lot of liquidity for sub prime mortgages only a year ago?

Another argument against a recession is that strong global growth will keep the US afloat. This, I believe is a much stronger argument because there are many US companies with a strong presence abroad and will thrive in a strong global economy. Companies such as Procter & Gamble, Johnson & Johnson, and McDonalds should outperform. However, continued expansion in emerging markets could pose some challenges for the US. Faster growth in emerging markets will lead to higher labor costs as well as increased demand for commodities, which will contribute to global inflationary pressures. Should the US Dollar devalue further, the effect of this inflation will be amplified in the US. This will put the US Federal Reserve in between a rock and a hard place not giving it freedom to lower rates and possibly forcing it to raise rates in order to combat inflation.

While some of the things I am predicting may seem dire. It really just depends on your perspective. It might be a good thing should the US stop resting on its laurels as a consumption machine and start producing more. A weaker dollar and higher interest rates probably won’t cure our sins alone but it will certainly sober us up quite a bit. The transition would not be without pain but it would make us better off. After all, we have an obligation to take care of our aging population. We need to start paying off the nation’s giant credit card or we won’t be able to borrow when we need it most. This is certainly not a new argument but freshness has nothing to do with the truth.