Market Overview

Economic uncertainty continues to rule the day, with the continuing market volatility and last weeks sell-off dropping major indices to five-year lows. The markets are expected to continue to fall, due to ongoing credit concerns and the anxiety surrounding the auto industry and broader economy. 

As major indices have dropped to lows not seen since the last downturn, other economic indicators have hit levels not seen since the ’40s and ’50s. According to the Labor Department, consumer prices fell by 1% in October, the biggest one-month decline on records dating back to February 1947. The drop was twice as large as the 0.5% decline analysts expected. Part of the big drop in inflation reflected a huge fall in gasoline and other energy costs, as oil prices slipped further last week, dipping below $54 on fears of global economic weakness. These fears have sent crude down more than 60% in four months, approaching the psychologically significant $50 mark. Widespread declines in other areas also contributed to drops in consumer prices, as core consumer prices, excluding food and energy, fell by 0.1% last month, the first drop in core prices in more than a quarter-century. In addition, the Commerce Department reported that construction of new homes and apartments fell by 4.5% in October to an annual rate of 791,000 units. That was the slowest construction pace on records going back to 1959.

Minutes from the Federal Reserve’s meeting last week signaled that an additional rate cut may be forthcoming, as the Fed sharply lowered its projections for economic activity this year and next, and predicted unemployment will move higher.  Under its new economic forecast, the Fed now believes gross domestic product could be flat or grow by just 0.3% this year. GDP could actually shrink by 0.2% or expand by 1.1% next year. Both sets of projections are lower than the Fed's forecasts delivered to Congress in July. The prospects for weaker economic activity will push up unemployment. The Fed projected that the national unemployment rate will rise to between 6.3% and 6.5% this year. Next year, the Fed expects the jobless rate to climb to between 7.1% and 7.6%.

Deal Overview

The ongoing credit constraints and uncertainty about 2009 have conspired to severely curtail the current deal environment. With loans trading on the secondary market providing a much more attractive risk/reward profile than newly issued offerings, the credit market for buyout activity has dried up significantly. In addition, uncertainty about 2009 economic conditions has put many buyers in a “wait and see” holding pattern, with either existing deals being cancelled or new deal activity being put on hold.

For example, WebMD Corp. has been party to two cancelled transactions in the last several weeks, with the recent cancellation of its $50 million buyout of QualityHealth.com coming on the heels of the October cancellation of a $2.31 billion cash-and-stock merger deal with its parent company HLTH Corp. Cliffs Natural Resources also recently announced that its proposed $2.7 billion takeover of coal producer Alpha Natural Resources has been called off, due to the faltering U.S. economy, uncertainty in the steel industry, and other factors, according to a news release.

However, deals continue in some industry sectors, as the ongoing challenges in the financial industry have led to significant consolidation. In addition, the oil industry is expected to see consolidation in the short term, as oil companies are sitting on large cash balances generating during the record setting quarters over the past years. The cleantech space, although faced with significant funding challenges, is also expected to drive investment activity. German solar energy company SolarWorld AG recently announced an unsolicited bid of $1.3 billion for GM subsidiary Adam Opel GmbH. SolarWorld said it would develop a new generation of energy efficient and reduced-emissions automobiles alongside successful models that Opel currently produces - an ambitious effort in a challenging automotive market environment that has already seen one electric car company, Tesla Motors, apply for funds under the proposed auto bailout package.

The Exhibit above illustrates the degree to which banks have tightened (and relaxed) lending standards for commercial and industrial loans over time.  The chart overlays periods of recession with the Federal Reserve's survey of US banks.  As shown by the shaded areas, the past two periods of recession have followed a period of tightened lending standards throughout the banking system.  As banks became aware of the economic downturn in late 2007 and throughout 2008 in the form of weak earnings, slowing GDP growth and expectations of loan defaults, they responded by narrowing their focus, first by eliminating “second lien” debt, then curtailing cash flow loans and “stretch” financing.  In the most recent survey, the percentage of banks responding that they have increased lending standards jumped to 83.6%.  This number compares to 57.6% in the July survey and 19.2% in the October, 2007 survey.  This rapid tightening is unprecedented though not surprising given the current climate, and if history is any guide, it suggests that the U.S. economy is in for a recession that is both longer and deeper than the recessions of 1991 and 2001.