"The foundations of our economy are strong" - Retail sales fell in March as soaring job losses and tighter credit conditions forced consumers to cut back sharply on discretionary spending. Nearly every sector saw declines including electronics, restaurants, furniture, sporting goods and building materials. Auto sales continued their historic nosedive despite aggressive promotions on new vehicles and $13 billion of aid from the federal government.
The crash in housing, which began in July 2006, accelerated on the downside in March, falling 19 percent year-over-year, signaling more pain ahead. Mortgage defaults are rising and foreclosures in 2009 are estimated to be in the 2.1 million range, an uptick of 400,000 from 2008. Consumer spending is down, housing is in a shambles, and industrial output dropped at an annual rate of 20 percent, the largest quarterly decrease since VE Day. The systemwide contraction continues unabated with with no sign of letting up.
Conditions in the broader economy are now vastly different than those on Wall Street, where the S&P 500 and the Dow Jones Industrials have rallied for 5 weeks straight regaining more than 25 percent of earlier losses. Fed chief Ben Bernanke's $13 trillion in monetary stimulus has triggered a rebound in the stock market while Main Street continues to languish on life-support waiting for Obama's $787 billion fiscal stimulus to kick in and compensate for falling demand and rising unemployment. The rally on Wall Street indicates that Bernanke's flood of liquidity is creating a bubble in stocks since present values do not reflect underlying conditions in the economy. The fundamentals haven't been this bad since the 1930s.
The financial media is abuzz with talk of a recovery as equities inch their way higher every week. CNBC's Jim Cramer, the hyperventilating ringleader of "Fast Money", announced last week, "I am pronouncing the depression is over." Cramer and his clatter of media cheerleaders ignore the fact that every sector of the financial system is now propped up with Fed loans and T-Bills without which the fictive free market would collapse in a heap. For 19 months, Bernanke has kept a steady stream of liquidity flowing from the vault at the US Treasury to the NYSE in downtown Manhattan. The Fed has recapitalized financial institutions via its low interest rates, its multi-trillion dollar lending facilities, and its direct purchase of US sovereign debt and Fannie Mae mortgage-backed securities. (Monetization) The Fed's balance sheet has become a dumping ground for all manner of toxic waste and putrid debt-instruments for which there is no active market. When foreign central banks and investors realize that US currency is backed by dodgy subprime collateral; there will be a run on the dollar followed by a stampede out of US equities. Even so, Bernanke assures his critics that "the foundations of our economy are strong".
As for the recovery, market analyst Edward Harrison sums it up like this:
"This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks' inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless." (Edward Harrison, "The Fake Recovery", Credit Writedowns)
The rally in the stock market will not fix the banking system, slow the crash in housing, patch-together tattered household balance sheets, repair failing industries or reverse the precipitous decline in consumer confidence. The rising stock market merely indicates that profit-driven speculators are back in business taking advantage of the Fed's lavish capital injections which are propelling equities into the stratosphere. Meanwhile, the unemployment lines continue to swell, the food banks continue to run dry and the homeless shelters continue to burst at the seams. So far, $12 trillion has been pumped into the financial system while less than $450 billion fiscal stimulus has gone to the "real" economy where workers are struggling just to keep food on the table. The Fed's priorities are directed at the investor class not the average working Joe. Bernanke is trying to keep Wall Street happy by goosing asset values with cheap capital, but the increases to the money supply are putting more downward pressure on the dollar. The Fed chief has also begun purchasing US Treasuries, which is the equivalent of writing a check to oneself to cover an overdraft in one's own account. This is the kind of gibberish that passes as sound economic policy. The Fed is incapable if fixing the problem because the Fed is the problem.
Last week, the market shot up on news that Wells Fargo's first quarter net income rose 50 percent to $3 billion pushing the stock up 30 percent in one session. The financial media celebrated the triumph in typical manner by congratulating everyone on set and announcing that a market "bottom" had been reached . The news on Wells Fargo was repeated ad nauseam for two days even though everyone knows that the big banks are holding hundreds of billions in mortgage-backed assets which are marked way above their true value and that gigantic losses are forthcoming. Naturally, the skeptics were kept off-camera or lambasted by toothy anchors as doomsayers and Cassandras. Regretably, creative accounting and media spin can only work for so long. Eventually the banks will have to write down their losses and raise more capital. Wells Fargo slipped the noose this time, but next time might not be so lucky. Here's how Bloomberg sums up wells situation:
"Wells Fargo & Co., the second biggest U.S. home lender, may need $50 billion to pay back the federal government and cover loan losses as the economic slump deepens, according to KBW Inc.’s Frederick Cannon.
KBW expects $120 billion of “stress” losses at Wells Fargo, assuming the recession continues through the first quarter of 2010 and unemployment reaches 12 percent, Cannon wrote today in a report. The San Francisco-based bank may need to raise $25 billion on top of the $25 billion it owes the U.S. Treasury for the industry bailout plan, he wrote.
“Details were scarce and we believe that much of the positive news in the preliminary results had to do with merger accounting, revised accounting standards and mortgage default moratoriums, rather than underlying trends,” wrote Cannon, who downgraded the shares to “underperform” from “market perform.” “We expect earnings and capital to be under pressure due to continued economic weakness.”
What happened to all those nonperforming loans and garbage MBS? Did they simply vanish into the New York ether? Could Wells sudden good fortune have something to do with the recent FASB changes to accounting guidelines on "mark to market" which allow banks greater flexibility in assigning a value to their assets? Also, Judging by the charts on the Internet, Wells appears to have the smallest "ratio of loan loss reserves" of the four biggest banks. That's hardly reassuring.
Paul Krugman takes an equally skeptical view of the Wells report:
"About those great numbers from Wells Fargo....remember, reported profits aren’t a hard number; they involve a lot of assumptions. And at least some analysts are saying that the Wells assumptions about loan losses look, um, odd. Maybe, maybe not; but you do have to say that it would be awfully convenient for banks to sound the all clear right now, just when the question of how tough the Obama administration will really get is hanging in the balance."
The banks are all playing the same game of hide-n-seek, trying to hoodwink the public into thinking they are in a stronger capital position than they really are. It's just more Wall Street chicanery papered over with vapid media propaganda. The giant brokerage houses and the financial media are two spokes on the same wheel gliding along in perfect harmony. Unfortunately, media fanfare and massaging the numbers won't pull the economy out of its downward spiral or bring about a long-term recovery. That will take fiscal policy, jobs programs, debt relief, mortgage writedowns and a progressive plan to rebuild the nation's economy on a solid foundation of productivity and regular wage increases. So far, the Obama administration has focused all its attention and resources on the financial system rather than working people. That won't fix the problem.
Deflation has latched on to the economy like a pitbull on a porkchop. Food and fuel prices fell in March by 0.1 percent while unemployment continued its slide towards 10 percent. Wholesale prices fell by the most in the last 12 months since 1950. According to MarketWatch, "Industrial production is down 13.3% since the recession began in December 2007, the largest percentage decline since the end of World War II"....The capacity utilization rate for total industry fell further to 69.3 percent, a historical low for this series, which begins in 1967." (Federal Reserve) The persistent fall in housing prices (30 percent) and losses in home equity only add to deflationary pressures. The wind is exiting the humongous credit bubble in one great gust.
Obama's $787 billion stimulus is too small to take up the slack in a $14 trillion per year economy where manufacturing and industrial capacity have slipped to record lows and unemployment is rising at 650,000 per month. High unemployment is lethal to an economy where consumer spending is 72 percent of GDP. Without debt relief and mortgage cram-downs, consumption will sputter and corporate profits will continue to shrink. S&P 500 companies have already seen a 37 percent drop in corporate profits. Unless the underlying issues of debt relief and wages are dealt with, the present trends will persist. Growth is impossible when workers are broke and can't afford to buy the things the make.
The stimulus must be increased to a size where it can do boost economic activity and create enough jobs to get over the hump. Yale economics professor Robert Schiller makes the case for more stimulus in his Bloomberg commentary on Tuesday:
"In the Great Depression ... the U.S. government had a great deal of trouble maintaining its commitment to economic stimulus. 'Pump- priming' was talked about and tried, but not consistently. The Depression could have been mostly prevented, but wasn’t.... In the face of a similar Depression-era psychology today, we are in need of massive pump-priming again.
It would be a shame if we are so overwhelmed by anger at the unfairness of it all that we do not take the positive measures needed to restore us to full employment. That would not just be unfair to the U.S. taxpayer. That would be unfair to those who are living in Hoovervilles...; it would be unfair to those who are being evicted from their homes, and can’t find new ones because they can’t find jobs. That would be unfair to those who have to drop out of school because they, or their parents, can’t find jobs.
It is time to face up to what needs to be done. The sticker shock involved will be large, but the costs in terms of lost output of not meeting either the credit target or the aggregate demand target will be yet larger." (Robert Schiller, Depression Lurks unless there's more Stimulus, Bloomberg)
A Year of Cockeyed Optimism
"We are starting to see glimmers of hope across the economy." President Barack Obama, April press conference
Even though industrial production, manufacturing, retail and housing are in freefall, the talk on Wall Street still focuses on the elusive recovery. The S&P 500 touched bottom at 666 on March 6 and has since retraced its steps to 852. Clearly, Bernanke's market-distorting capital injections have played a major role in the turnabout. Former Secretary of Labor under Bill Clinton and economics professor at University of Cal. Berekley, Robert Reich, explains it like this on his blog-site:
"All of these pieces of upbeat news are connected by one fact: the flood of money the Fed has been releasing into the economy. ... So much money is sloshing around the economy that its price is bound to drop. And cheap money is bound to induce some borrowing. The real question is whether this means an economic turnaround. The answer is it doesn't.
Cheap money, you may remember, got us into this mess. Six years ago, the Fed (Alan Greenspan et al) lowered interest rates to 1 percent.... The large lenders did exactly what they could be expected to do with free money -- get as much of it as possible and then lent it out to anyone who could stand up straight (and many who couldn't). With no regulators looking over their shoulders, they got away with the financial equivalent of murder.
The only economic fundamental that's changed since then is that so many people got so badly burned that the trust necessary for consumers, investors, and businesses to repeat what they did then has vanished.... yes, some consumers will refinance and use the extra money they extract from their homes to spend again. But most will use the extra money to pay off debt and start saving again, as they did years ago....
I admire cockeyed optimism, and I understand why Wall Street and its spokespeople want to see a return of the bull market. Hell, everyone with a stock portfolio wants to see it grow again. But wishing for something is different from getting it. And cockeyed optimism can wreak enormous damage on an economy. Haven't we already learned this? (Robert Reich's Blog, "Why We're Not at the Beginning of the End, and Probably Not Even At the End of the Beginning")
If the purpose of Bernanke's grand economics experiment was to create uneven inflation in the equities markets and, thus, widen the chasm between the financials and the real economy; he seems to have succeeded. But for how long? How long will it be before foreign banks and investors realize that the Fed's innocuous-sounding "lending facilities" have released a wave of low interest speculative liquidity into the capital markets? How else does one explain soaring stocks when industrial capacity, manufacturing, exports, corporate profits, retail and every other sector have been pounded into rubble? Liquidity is never inert. It navigates the financial system like mercury in water darting elusively to the area which offers the greatest opportunity for profit. That's why the surge popped up first in the stock market. (so far) When it spills into commodities--and oil and food prices rise--Bernanke will realize his plan has backfired..
Bernanke's financial rescue plan is a disaster. He should have spent a little less time with Milton Friedman and a little more with Karl Marx. It was Marx who uncovered the root of all financial crises. He summed it up like this:
"The ultimate reason for all real crises always remains the poverty and restricted consumption of the masses as opposed to the drive of capitalist production to develop the productive forces as though only the absolute consuming power of society constituted their limit." (Karl Marx, Capital, vol. 3, New York International publishers, 1967; Thanks to Monthly review, John Bellamy Foster)
Bingo. Message to Bernanke: Workers need debt-relief and a raise in pay not bigger bailouts for chiseling fatcat banksters.
Source: Mike Whitney
Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.
Showing posts with label economic recovery. Show all posts
Showing posts with label economic recovery. Show all posts
Friday, 17 April 2009
Thursday, 16 April 2009
Alistair Darling poised to slash spending and raise taxes in Budget
Alistair Darling is considering fierce public spending curbs and deferred tax rises to convince the markets that Britain will emerge eventually from its massive debt.
The Chancellor is likely to predict in next Wednesday’s Budget that the economic recovery will start around the turn of the year. But he will have to decide within days how far to go in highlighting deferred spending economies and tax rises after 2011 and how much to save up for the Pre-Budget Report in November.
The Government’s borrowing isexpected to balloon to almost £175 billion a year in each of the next two years as the recession triggers a surge in public spending and a slump in tax payments.
The scale of the Treasury’s slide into the red, expected to be confirmed by the Budget, is set to push the deficit to as much as 12 per cent of GDP — a level not seen since the Second World War and far above an 8 per cent peak reached after the 1990s recession under the Conservatives
The latest Treasury survey of City economists’ forecasts, released yesterday, shows an average prediction that public borrowing will hit £160 billion in 2009-10 (compared with the Chancellor’s £118 billion projection last autumn) and rise to £167 billion in 2010-11.
Mr Darling is expected also to focus on environmental measures as part of the recovery. Today, as the Cabinet meets in Glasgow, ministers will say that discounts as high as £5,000 could be made available to help buyers of electric cars. Gordon Brown has said that there should be a roadside network of charging points for cars and incentives for carmakers.
Treasury insiders say that while the Chancellor is determined to show that his “direction of travel” is towards balancing the books over several years, he will not want to do anything to jeopardise the recovery. Most economists believe that the public finances cannot be restored to health without big spending cuts, tax rises or both.
One Treasury insider said: “There are two fiscal events each year with the Budget and Pre-Budget Report \ and we can use each to make adjustments. There has to be clawback — we know that. The key judgment is when to announce it.”
The extent of these — on top of those already announced, such as the new top rate of income tax of 45 per cent for people earning more than £150,000 — will be determined in discussions between Mr Darling and Mr Brown.
Most of the focus after the last PBR was on future tax rises. But Mr Darling slashed the growth in spending after 2012 from an already painful 1.8 per cent to 1.2 per cent. He could go even farther to show his seriousness about setting the finances straight once the shocks to the world economic system have calmed. That will mean cuts of billions from planned programmes.
Mr Darling will make a drastic revision of his growth and borrowing forecasts from the PBR, arguing that the downturn has been far worse than experts expected. He will admit that his hopes last November that growth might resume by the middle of this year have been dashed and he is likely to say that the economy will contract overall by about 3 per cent this year, the worst performance since the Second World War.
The City forecasts that the economy will shrink by 3.7 per cent this year and grow by just 0.3 per cent in 2010.
Source: The Times
The Chancellor is likely to predict in next Wednesday’s Budget that the economic recovery will start around the turn of the year. But he will have to decide within days how far to go in highlighting deferred spending economies and tax rises after 2011 and how much to save up for the Pre-Budget Report in November.
The Government’s borrowing isexpected to balloon to almost £175 billion a year in each of the next two years as the recession triggers a surge in public spending and a slump in tax payments.
The scale of the Treasury’s slide into the red, expected to be confirmed by the Budget, is set to push the deficit to as much as 12 per cent of GDP — a level not seen since the Second World War and far above an 8 per cent peak reached after the 1990s recession under the Conservatives
The latest Treasury survey of City economists’ forecasts, released yesterday, shows an average prediction that public borrowing will hit £160 billion in 2009-10 (compared with the Chancellor’s £118 billion projection last autumn) and rise to £167 billion in 2010-11.
Mr Darling is expected also to focus on environmental measures as part of the recovery. Today, as the Cabinet meets in Glasgow, ministers will say that discounts as high as £5,000 could be made available to help buyers of electric cars. Gordon Brown has said that there should be a roadside network of charging points for cars and incentives for carmakers.
Treasury insiders say that while the Chancellor is determined to show that his “direction of travel” is towards balancing the books over several years, he will not want to do anything to jeopardise the recovery. Most economists believe that the public finances cannot be restored to health without big spending cuts, tax rises or both.
One Treasury insider said: “There are two fiscal events each year with the Budget and Pre-Budget Report \ and we can use each to make adjustments. There has to be clawback — we know that. The key judgment is when to announce it.”
The extent of these — on top of those already announced, such as the new top rate of income tax of 45 per cent for people earning more than £150,000 — will be determined in discussions between Mr Darling and Mr Brown.
Most of the focus after the last PBR was on future tax rises. But Mr Darling slashed the growth in spending after 2012 from an already painful 1.8 per cent to 1.2 per cent. He could go even farther to show his seriousness about setting the finances straight once the shocks to the world economic system have calmed. That will mean cuts of billions from planned programmes.
Mr Darling will make a drastic revision of his growth and borrowing forecasts from the PBR, arguing that the downturn has been far worse than experts expected. He will admit that his hopes last November that growth might resume by the middle of this year have been dashed and he is likely to say that the economy will contract overall by about 3 per cent this year, the worst performance since the Second World War.
The City forecasts that the economy will shrink by 3.7 per cent this year and grow by just 0.3 per cent in 2010.
Source: The Times
Tuesday, 14 April 2009
The Fake Recovery
Submitted by Edward Harrison of the site Credit Writedowns
I last posted on "Credt Writedowns" on Thursday before the Easter Holidays in two posts very much at odds with one another. The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009. Meanwhile, the later re-post pointed out the continued fragility of the U.S. economy and banking system and focused on liquidity and solvency as unresolved issues. I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.
Why 'Fake'? This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks' inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.
The real situation
In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system. Witness a recent post by Nouriel Roubini:
Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.
These constraints, some artificial and others very real, leave the Administration with limited options.
Engineer recovery
With the preceding constraints in mind, we should remember that the first priority of elected officials in Washington is not necessarily to make the best long-term choices for the American people, but rather to get re-elected in order to have the opportunity to make those choices. It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time - irrespective of whether it is sustainable.
How to engineer recovery is another question altogether. Here again there are a set of political constraints which make things more challenging. First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates. Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.
As a result, the Obama Administration has crafted a plan to circumvent these obstacles.
The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other 'stimulus' has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government's claims of wanting to increase transparency ring hollow (see my post on Bloomberg's suit against the Fed as an example of what is really happening).
I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line.
Other positive economic factors
There are a number of so-called green shoots (a phrase coined by Norman Lamont) of note.
•Jobless claims have plateaued and comparisons to last year are actually declining (see post).
•The U.S. trade deficit is declining significantly as U.S. import demand has fallen off a cliff.
•Inventory liquidation will put U.S. manufacturers in a better position by Q4 and help make quarterly and yearly comparisons favourable.
I linked to the first two bullets of these other factors. And I wanted to spend a little time on factor number three because I think it is important.
Turning my attention to the global economy, after a rather muted beginning, manufacturers around the world have now begun to react aggressively to the economic downturn and inventories are falling aggressively. Chart 5 below depicts US manufacturing inventories as published recently by the Census Bureau. Inventory changes can have a meaningful impact on GDP. There is one example from the 1981-82 recession where the inventory correction subtracted 5% (annualised) from GDP in just one quarter. The current inventory correction is very negative for GDP in Q1 and possibly also in Q2, but it is very difficult to quantify the effect it is going to have. We will have to wait and see.
However, as we must remind ourselves, the stock market is not trading on what is going to happen in Q1 and Q2 of this year. Projecting at least 6-9 months ahead, the stock market is probably already looking ahead to Q4 and possibly even Q1 of next year. And the inventory adjustment currently underway is very bullish for GDP growth later this year and into next. The reason is simple. Manufacturers always overreact. Come Q3 or Q4, they will suddenly sit up and realise that inventories have fallen too much and that they need to produce more. There is no reason to believe that this recession will be any different.
Obviously, this means that U.S. Q1 and perhaps even Q2 GDP will be very low due to the subtraction of inventories now being purged. However, when we get to Q3 and Q4, this effect will be gone and quarterly and yearly comparisons will look favourable. So the inventory purge may mean a huge upside surprise to GDP in the second half of the year and early 2010 - potentially enough to see positive GDP numbers.
A brief reminder of what lurks beneath
Despite the positives from the previous section, there are significant headwinds which may even preclude a positive GDP number. They include:
•Rising joblessness
•Increased savings as households rebuild balance sheets
•Spending cuts by local and state governments
•Decreased capital spending by companies
•A calamitous GM bankruptcy
Moreover, credit availability --and hence GDP will be constrained by numerous factors including the following:
•Declining home values
•Increasing foreclosures
•Commercial property writedowns
•Credit card-related writeoffs
•Junk bond defaults
All of this means that a cyclical rebound is not a foregone conclusion at all.
Tying the threads together
You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the 'green shoots' because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.
Nevertheless, banks are going to earn a lot of money and that is bullish for their shares - at least in the medium-term. Yes, the stock market is overbought right now. However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.
Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well. It is still too early to tell how this will play out over the longer-term. For now, I am much more positive on financials, and somewhat positive on the broader market as well.
I last posted on "Credt Writedowns" on Thursday before the Easter Holidays in two posts very much at odds with one another. The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009. Meanwhile, the later re-post pointed out the continued fragility of the U.S. economy and banking system and focused on liquidity and solvency as unresolved issues. I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.
Why 'Fake'? This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks' inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.
The real situation
In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system. Witness a recent post by Nouriel Roubini:
The RGE Monitor new estimate in January 2009 of peak credit losses (available in
a paper for our RGE clients) suggested that total losses on loans made by U.S.
financial firms and the fall in the market value of the assets they are holding
would be at their peak about $3.6 trillion ($1.6 trillion for loans and $2
trillion for securities). The U.S. banks and broker dealers are exposed to half
of this figure, or $1.8 trillion; the rest is borne by other financial
institutions in the US and abroad. The capital backing the banks’ assets was
last fall only $1.4 trillion, leaving the U.S. banking system some $400 billion
in the hole, or close to zero even after the government and private sector
recapitalization of such banks and after banks’ provisioning for losses. Thus,
another $1.4 trillion would be needed to bring back the capital of banks to the
level they had before the crisis; and such massive additional recapitalization
is needed to resolve the credit crunch and restore lending to the private
sector.
Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.
These constraints, some artificial and others very real, leave the Administration with limited options.
Engineer recovery
With the preceding constraints in mind, we should remember that the first priority of elected officials in Washington is not necessarily to make the best long-term choices for the American people, but rather to get re-elected in order to have the opportunity to make those choices. It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time - irrespective of whether it is sustainable.
How to engineer recovery is another question altogether. Here again there are a set of political constraints which make things more challenging. First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates. Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.
As a result, the Obama Administration has crafted a plan to circumvent these obstacles.
1.Moderate fiscal stimulus. The Obama Administration decided not to seek massive stimulus earlier this year because they deemed it non-viable politically.This clears the first obstacle: deficit hawks. Most economists understand that the output gap that has opened up in the American economy is $2 trillion or more whereas the Obama stimulus package was only $800 billion. That leaves a massive hole in output in the U.S. Moreover, the immediate effective stimulus is less. Much of this 'stimulus' will be saved or will not come into play until months from now. Obviously, this is not going to meet the grade (See my comments on this from February).
2.Quasi-fiscal role for the Fed. Having partially assuaged deficit hawks, Obama still needed to close the output gap. Enter the Federal Reserve. You will have noticed that the Federal Reserve has added legacy assets as eligible for the TALF program. In effect, this allows banks to slip tens or even hundreds of billions of dollars in so-called toxic assets off their balance sheets. Mind you, these are assets already on the books impairing banks' ability to loan money. Under normal circumstances, one would expect the Federal Government to take these assets out of the system (bad bank, good bank, nationalization) after being given legislative approval to do so. However, as I have previously stated this approval is not going to be forthcoming. This is why the Federal Reserve is taking these assets on. In so doing, the Federal Reserve is taking on a quasi-fiscal role that re-capitalizes the banking system in order to stimulate the economy by increasing credit availability.
3.Quasi-fiscal role for the FDIC. The new PPIP is a similar end-run around Congress. After all, the role of the FDIC is that it "maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships." Meanwhile, the PPIP has the FDIC guaranteeing dodgy assets in a massive transfer of wealth from taxpayers to banks and select investors. (See my previous comments on this issue).
4.End of mark-to-market as we knew it. You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not. This is one reason that large international institutions which participate in the securitisation markets have taken the lion's share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets. But, this should end because of new guidelines in marked-to-market accounting. However, the new guidelines do have two major implications. First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses. Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses. In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment. If much of the impairment is real, as I believe it is, we are storing up problems for later.
5.Interest rate reductions. One reason often given for a large increase in writedowns at financial institutions had been the coming reset of Alt-A adjustable-rate mortgages in 2009. With the subprime writedowns mostly accounted for, a souring of the much larger pool of Alt-A and Prime residential mortgage loans is the real Armageddon scenario. Well, part of this problem has been temporarily relieved because the Federal Reserve has reduced short-term interest rates to near zero and has begun trying to manipulate long-term interest rates lower by buying long-dated treasury securities.
6.Bank margin increases. Key to the whole program is banks' ability to earn massive amounts of money and re-capitalize themselves through retained earnings as opposed to shedding assets or receiving additional paid-in capital (see post from last April on these three methods of recapitalizing). The market for bank assets is distressed and few banks can get enough capital from private sources or investors. Therefore, Obama's plan hinges on the ability to allow these banks to earn shed loads of money as quickly as possible. If the banks cannot do this, we are going to have a big problem very quickly (Of course, I think the can).
The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other 'stimulus' has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government's claims of wanting to increase transparency ring hollow (see my post on Bloomberg's suit against the Fed as an example of what is really happening).
I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line.
Other positive economic factors
There are a number of so-called green shoots (a phrase coined by Norman Lamont) of note.
•Jobless claims have plateaued and comparisons to last year are actually declining (see post).
•The U.S. trade deficit is declining significantly as U.S. import demand has fallen off a cliff.
•Inventory liquidation will put U.S. manufacturers in a better position by Q4 and help make quarterly and yearly comparisons favourable.
I linked to the first two bullets of these other factors. And I wanted to spend a little time on factor number three because I think it is important.
Turning my attention to the global economy, after a rather muted beginning, manufacturers around the world have now begun to react aggressively to the economic downturn and inventories are falling aggressively. Chart 5 below depicts US manufacturing inventories as published recently by the Census Bureau. Inventory changes can have a meaningful impact on GDP. There is one example from the 1981-82 recession where the inventory correction subtracted 5% (annualised) from GDP in just one quarter. The current inventory correction is very negative for GDP in Q1 and possibly also in Q2, but it is very difficult to quantify the effect it is going to have. We will have to wait and see.
However, as we must remind ourselves, the stock market is not trading on what is going to happen in Q1 and Q2 of this year. Projecting at least 6-9 months ahead, the stock market is probably already looking ahead to Q4 and possibly even Q1 of next year. And the inventory adjustment currently underway is very bullish for GDP growth later this year and into next. The reason is simple. Manufacturers always overreact. Come Q3 or Q4, they will suddenly sit up and realise that inventories have fallen too much and that they need to produce more. There is no reason to believe that this recession will be any different.
Obviously, this means that U.S. Q1 and perhaps even Q2 GDP will be very low due to the subtraction of inventories now being purged. However, when we get to Q3 and Q4, this effect will be gone and quarterly and yearly comparisons will look favourable. So the inventory purge may mean a huge upside surprise to GDP in the second half of the year and early 2010 - potentially enough to see positive GDP numbers.
A brief reminder of what lurks beneath
Despite the positives from the previous section, there are significant headwinds which may even preclude a positive GDP number. They include:
•Rising joblessness
•Increased savings as households rebuild balance sheets
•Spending cuts by local and state governments
•Decreased capital spending by companies
•A calamitous GM bankruptcy
Moreover, credit availability --and hence GDP will be constrained by numerous factors including the following:
•Declining home values
•Increasing foreclosures
•Commercial property writedowns
•Credit card-related writeoffs
•Junk bond defaults
All of this means that a cyclical rebound is not a foregone conclusion at all.
Tying the threads together
You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the 'green shoots' because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.
Nevertheless, banks are going to earn a lot of money and that is bullish for their shares - at least in the medium-term. Yes, the stock market is overbought right now. However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.
Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well. It is still too early to tell how this will play out over the longer-term. For now, I am much more positive on financials, and somewhat positive on the broader market as well.
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