Global Economy Faces Harsh Headwinds

• Corporate profit margins will shrink. Slowing U.S. sales growth and continued cost pressures (particularly of a commodity-kind) combined with the ebbing of the enormous productivity gains over the last several years will likely cause U.S. corporate profit margins to begin to suffer in late 2007 and revert back to more normalized and historical levels.
  Profitability could be pressured further should wage benefits rise as the tug of war between labor and owners stabilizes or reverses under the political pressures exerted by the Democratic Party in the face of the widening gaps between economic classes. A Democratic win in 2008 would clearly favor labor (a rise in the minimum wage and more cost pressures) and disfavor corporations (windfall oil profit taxes and a higher corporate profit tax), further exacerbating the shrinkage in profit growth.
• Stretched equity valuations will be challenged by higher risk-free rates of return. Not only are theoretical equity values (dividend discount models) lowered by rising interest rates, the higher risk-free rates of return are beginning to provide reasonable competition to stocks. (For example, an eight-year municipal bond yielding 4.10% produces a pretax equivalent return of 6.30%.)

Associated Risks

The likely risks emanating from these developments are several-fold, mostly as an outgrowth of the Brave New World of Levered Finance.

• The downside of the hedge funds' community dominance will soon surface in the capital markets. Today's dominant investors (hedge funds) and, as importantly, their investors (especially of a Swiss kind) are more leveraged than any influential money management class in history.

  Leveraged carry trades rule the hedge fund landscape, and the explosive growth in derivatives remains unchecked and unregulated. Should a trend in lower stock prices accelerate after earnings disappointments and rising interest rates, too many will be searching for the exit at the same time.