Global Economy Faces Harsh Headwinds

Bullish participants contend that the economic strength in the Indian, Chinese and other emerging markets has been achieved without the typical inflationary result. This couldn't be further from the truth, as seen in a multiyear high in the CRB RIND Index (an index of spot raw-materials prices) and in the high price of energy products and food (all stemming in part from the voracious appetite of Chinese and Asian consumers).

Speaking of the rising cost of food, Costco's(COST Quote) management last week cited food price inflation in cheese (+25%), coffee (+12% to +15%), butter (up high single digits), chicken (+12% to +15%), blueberries (+20%), etc.

And speaking of China, that country's inexorable move toward a revalued yuan will not only bring China toward ever higher inflation but will reduce that country's ability to export deflation into the U.S. Stated simply, the elevated real rate of inflation manifested in the widening relationship between U.S. headline and core inflation comes at an inopportune time.

The rising structure of interest rates coupled with demand-pull inflation in the BRIC countries will have multiple effects.

• Sales growth will slow. By the second half of 2007, an interest rate rise will have hit the developed and more mature economies, producing a sharp deceleration in top-line sales growth for U.S. companies.
• Housing's smackdown is worsening. Higher interest rates will be especially hard felt in the U.S. homebuilding industry, which is already burdened by record-high inventories of unsold homes, a contraction in the availability of subprime loans that are integral to first-time homebuyers, rising regulatory clampdowns on creative financing and still stretched affordability issues. (Since only mid-May, 30-year fixed-rate mortgage rates have risen by 30 basis points, to over 6.60%.)

  Lost in the housing and economic polemic is the adverse effect of over $1 trillion of "exploding" adjustable mortgage rate loans that are to be reset over the next five years, many of which will immediately carry double-digit interest rates upon reset. (Adjustable ARMs are typically repriced at 500 to 600 points above the London interbank offered rate, producing an 11%-plus mortgage rate today!)

  Most believe that housing has already bottomed (or will bottom shortly) and that a recovery will set in early in 2008. From my perch, it now looks unlikely that housing will bottom until late 2008 and more likely that the residential market will struggle at low levels of activity until a more meaningful recovery occurs in 2010. The multiplier effect of a longer-than-expected and prolonged housing downturn on the U.S. economy will be dramatic and unexpected, and so will the growing population of "upside down" loans (i.e., loans that have little or no equity in their homes) as the housing bubble continues to unravel in the face of lower home values and mortgage resets.