Posted on July 13, 2007 by David Laidlaw
During April and May, stocks advanced strongly as a number of reports suggested that the economy was growing again rather than slowing as feared earlier in the year. However, interest rates rose leading to slight market declines in June. The yield on the 10-year US Treasury Note has increased from about 4.6% to more than 5% over the past month as bond buyers anticipated more inflation. Finally, sub-prime mortgages continued to lose value as borrowers defaulted on their obligations and Bear Stearns arranged $3.2 billion in financing to bail out one of its failing hedge funds filled with low quality debt.
Persistent problems in the sub-prime space have caused increased anxiety and market losses because our financial system is so interrelated. Low quality mortgages are held in a number of highly leveraged hedge funds so that their borrowings remain high, but their collateral is much less valuable. Defaults in these highly leveraged funds cause anxiety since almost every major bank is impacted. For instance, Bear Stearns’s hedge fund borrowed money from almost all of the major Wall Street firms including Merrill Lynch, Citibank, Barclays and Deutsche Bank.
Stock values are also negatively impacted since cheap borrowing fuels takeovers and private equity deals. Other than the largest public companies such as ExxonMobil and GE, almost every stock sells for a premium based on the chance that that particular company will be purchased by someone else. For example, a Barron’s report that FedEx represented an attractive private equity takeover candidate caused the stock to rise over 5% on July 9th, the first day of trading after the article appeared. These takeovers are being financed with low cost (and in many cases low quality) debt. As the market assesses greater credit risk to this debt, lenders require higher interest rates. Therefore, takeover deals that were attractive with cheap financing become much more expensive and are less likely to occur.
Even though the above threats are real, we do not believe that the sky is falling. Both the service and manufacturing bases in the domestic economy are expanding nicely. Global growth is also strong which is a boon to US-based multinational companies and allows them to book higher profits. Also, stock prices are not expensive relative to their earnings, cash flows and sales.