Nouriel Roubini: The Dismal Outlook for the US and Global Economy and the Financial Markets

Here is a below brief summary of many of the points that I have made for the last few months on the outlook for the U.S. and global economy and for financial markets:

• The U.S. will experience its most severe recession since WWII, much worse and longer and deeper than even the 1974-75 and 1980-82 recessions. The recession will continue until at least the end of 2009 for a cumulative GDP drop of over 4%; the unemployment rate will likely reach 9%. The US consumer is shopped out saving less and debt burdened and now faltering: this will be the worst consumer recession in decades.
• The prospect of a short and shallow 6-8 months V-shaped recession is out of the window; a U-shaped 18-24 months recession is now a certainty and the probability of a worse multi-year L-shaped recession (as in Japan in the 1990s) is still small but rising. Even if the economy were to exit a recession by the end of 2009 the recovery could be so weak because of the impairment of the financial system and of the credit mechanism (i.e. a growth rate of 1-1.5% for a while well below the potential of 2.5-2.75%) that it may feel like a recession even if the economy is technically out of the recession.
• Obama will inherit and economic and financial mess worse than anything the U.S. has faced in decades: the most severe recession in 50 years; the worst financial and banking crisis since the Great Depression; a ballooning fiscal deficit that may be as high as a trillion dollar in 2009 and 2010; a huge current account deficit; a financial system that is in a severe crisis and where deleveraging is still occurring at a very rapid pace, thus causing a worsening of the credit crunch; a household sector where millions of households are insolvent, into negative equity territory and on the verge of losing their homes; a serious risk of deflation as the slack in goods, labor and commodity markets becomes deeper; the risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed Funds rate; the risk of a severe debt deflation as the real value of nominal liabilities will rise given price deflation while the value of financial assets is still plunging.
• The world economy will experience a severe recession: output will sharply contract in the Eurozone, UK and the rest of Europe, in Canada, Japan, and Australia/New Zealand; there is also a risk of a hard landing in emerging market economies. Expect global growth – at market prices – to be close to zero in Q3 and negative by Q4. Leaving aside the effects of the fiscal stimulus China could face a hard landing growth rate of 6% in 2009. The global recession will continue through most of 2009.
• The advanced economies will face stag-deflation (stagnation/recession and deflation) rather than stagflation as slack in goods markets, slack in labor markets and slack in commodity markets will lead advanced economies inflation rates to become below 1% by 2009.
• Expect a few advanced economies (certainly US and Japan and possibly others) to reach the zero-bound constraint for policy rates by early 2009. With deflation on the horizon a zero-bound on interest rates implies the risk of a liquidity trap where money and bonds become perfectly substitutable, where real interest rates become high and rising thus further pushing down aggregate demand, and where money market funds returns cannot even cover their management costs. Deflation also implies a debt deflation where the real value of nominal debts is rising thus increasing the real burden of such debts. Monetary policy easing will become more aggressive in other advanced economies – even if the ECB will cut too little too late - but monetary policy easing will be little effective as it will be pushing on a string given the glut of global aggregate supply relative to demand and given a very severe credit crunch.
• For 2009 the consensus estimates for earnings are delusional: current consensus estimates are that S&P 500 earnings per share (EPS) will be $90 in 2009 up 15% from 2008. Such estimates are outright silly and delusional. If EPS fall – as most likely – to a level of $60 then with a multiple (P/E ratio) of 12 the S&P500 index could fall to 720, i.e. about 20% below current levels; if the P/E falls to 10 – as possible in a severe recession, the S&P could be down to 600 or 35% below current levels. And in a very severe recession one cannot exclude that the EPS could fall as low as $50 in 2009 dragging the S&P500 index to as low as 500. So, even based on fundamentals and valuations, there are significant downside risks to U.S. equities (20% to 40%). Similar arguments can be made for global equities: a severe global recession implies further downside risks to global equities of the order of 20-30%.Thus, the recent rally in US and global equities was only a bear market sucker’s rally that is already fizzling out buried under a mountain of awful worse than expected macro, earnings and financial news.
• Credit losses will be well above $1 trillion and closer to $2 trillion as such losses will spread from sub-prime to near prime and prime mortgages and home equity loans (and the related securitized products); to commercial real estate, to credit cards, auto loans and student loans; to leveraged loans and LBOs, to muni bonds, corporate bonds, industrial and commercial loans and CDS. These credit losses will lead to a severe credit crunch absent a rapid and aggressive recapitalization of financial institutions.
• Almost all of the $700 billion in the TARP program will be used to recapitalized US financial institutions (banks, broker dealers, insurance companies, finance companies, etc.) as rising credit losses (close to $2 trillion) will imply that the initial $250 billion allocated to recap these institutions will not be enough; sooner rather than later a TARP 2 will become necessary as the recapitalization needs of US financial institutions will likely be well above $1 trillion.
• Current spreads on speculative grade bonds may widen further as a tsunami of defaults will hit the corporate sector; investment grade bond spreads have widened excessively relative to financial fundamentals but further spread widening is possible driven by market dynamics, deleveraging and the fact that many AAA-rated firms (say GE) are not really AAA and should be downgraded by the rating agencies.
• Expect a US fiscal deficit of almost $1 trillion in 2009 and 2010. The outlook for the US current account deficit is mixed: the recession, a rise in private savings and a fall in investment, and a further fall in commodity prices will tend to shrink it but a stronger dollar, global demand weakness and a larger US fiscal deficit will tend to worsen it. On net we will observe still large US twin fiscal and current account deficits and less willingness and ability of the rest of the world to finance it unless the interest rate on such debt rises.
• In this economic and financial environment it is wise to stay away from most risky assets for the next 12 months: they are downside risks to US and global equities; credit spreads – especially for speculative grade – may widen further; commodity prices will fall another 20% from current level; gold will also fall as deflation sets in; the US dollar may weaken further in the next 6 to 12 months as the factors behind the recent rally weather off while medium term bearish fundamentals for the dollar set in again; government bond yields in US and advanced economies may fall further as recession and deflation emerge but, over time, the surge in fiscal deficits in the US and globally will reduce the supply of global savings and lead to higher long term interest rates unless the fall in global real investment outpaces the fall in global savings. Expect further downside risks to emerging markets assets (in particular equities and local and foreign currency debt) especially in economies with significant macro, policy and financial vulnerabilities. Cash and cash like instruments (short-term dated government bonds and inflation-indexed bonds that do well both in inflation and deflation times) will dominate most risky assets.
• So serious risks and vulnerabilities remain and the downside risks to financial markets (worse than expected macro news, earnings news and developments in systemically important parts of the global financial system) will dominate over the next few months the positive news (G7 policies to avoid a systemic meltdown, and other policies that – in due time – may reduce interbank spreads and credit spreads). So beware of those who tell you that we reached a bottom for risky financial assets. The same optimists told you that we reached a bottom and the worst was behind us after the rescue of the creditors of Bear Stearns in March, after the announcement of the possible bailout of Fannie and Freddie in July, after the actual bailout of Fannie and Freddie in September, after the bailout of AIG in mid September, after the TARP legislation was presented, after the latest G7 and EU action. In each case the optimists argued that the latest crisis and rescue policy response was “THE CATHARTIC” event that signaled the bottom of the crisis and the recovery of markets. They were wrong literally at least six times in a row as the crisis - as I consistently predicted here over the last year – became worse and worse. So enough of the excessive optimism that has been proven wrong at least six times in the last eight months alone.
• A reality check is needed to assess the proper risks and take the appropriate actions. And reality tells us that we barely literally avoided only a week ago a total systemic financial meltdown; that the policy actions are now finally more aggressive and systematic and more appropriate; that it will take a long while for interbank markets and credit markets to mend; that further important policy actions are needed to avoid the meltdown and an even more severe recession; that central banks instead of being the lenders of last resort will be for now the lenders of first and only resort; that even if we avoid a meltdown we will experience a severe US, advanced economy and most likely global recession, the worst in decades; that we are in the middle of a severe global financial and banking crisis, the worst since the Great Depression; and that the flow of macro, earnings and financial news will significantly surprise (as during the last few weeks) on the downside with significant further risks to financial markets.