This column was originally published on Street Insight on June 11 at 7:59 a.m. EDT. It's being republished as a bonus for TheStreet.com and RealMoney.com readers.

It's shaping up to be a perfect storm for the global economy.

The salutary impact of an increasingly levered hedge fund industry, globalization, financial innovation, recycling of financial flows, lower taxes, free trade and loose monetary policy -- which Pimco's Bill Gross recently described as leading to a "stable disequilibrium" and others have termed leading to Goldilocks -- appears to be waning.

At the same time that these factors are changing, it is particularly worrisome that risk spreads are at near historic lows, global equity markets seem priced nearly for perfection, the world's investor base has never been more leveraged with margin debt and carry trades, and the U.S. consumer has never had so much debt, nor has he been so dependent on cheap money and the appreciation of stocks and homes.

Today, a synchronized worldwide economic expansion is morphing into a simultaneous tightening by the world's major central banks. The world's debt markets are making lows in price and highs in yields (e.g., the yield on the 10-year U.S. note increased by 20 basis points last week and by 50 basis points over the last four to five weeks).

The implications will be felt in the economies and equity markets around the world. Slowing earnings growth, climbing interest rates and lower profit margins will be the outgrowth of the aforementioned tightening monetary policy. In the U.S., the

Fed's

hands will be tied, as it will be next to impossible to ease anytime in the near future, or else the U.S. dollar would suffer materially.

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) - Get Report

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.
  • 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.
  • 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.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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