Global Economy Faces Harsh Headwinds

• Financial flows are changing. The "kindness of strangers" in buying U.S. bonds has been estimated to have reduced our bond rates by between 50 and 75 basis points, serving to keep the U.S. consumer alive. However, at the margin, the already announced diversification by petrodollar recyclers and central banks away from the U.S. fixed-income market treasuries (e.g., China's $3 billion investment in Blackstone) is symptomatic of a trend that will likely lift interest rates by reducing the aforementioned "subsidy" of bond rates.
• Private equity's impact will peak as interest rates rise. Terminal asset values of private-equity targets (i.e., the straw that stirs the drink of today's worldwide markets) will be reduced in an environment of higher interest rates and slowing growth.

  Should credit spreads widen, private-equity return expectations could quickly be undercut, as will the massive institutional inflows into that asset class. If credit markets seize up (even somewhat), the outcome will be less deal leverage, and the syndicate market, which provides an important exit strategy for private equity, will grow less accommodative.

• Financial innovation has its downside. The fantasy -- namely, credit market conditions of ready credit (e.g., subprime and syndicated private-equity loans), loose standards and limited corporate and consumer loan losses -- in the mortgage and private-equity markets will soon become a relic of the past, receding quickly back to historical conditions.

  Importantly, the disproportionate role of housing in the U.S. and the sector's multiplier effect coupled with the adverse impact of the aforementioned exploding adjustable-rate mortgages will further exacerbate the domestic economy's downturn, made ever more difficult by the debt-laden U.S. consumer.

For some time, I have been looking for a period of blahflation (i.e., blah economic growth and stubbornly high inflation). However, conditions are now changing, and a U.S. recession in 2008 to 2009 appears increasingly likely. The orgy of cheap money is now over, and Goldilocks is dead as the world's economies turn cyclical and growth becomes less consistent.