• Recession. When GDP numbers are released mid next week, it should become evident that the US economy was still mired deep in the recession in Q1 2009. We expect real GDP to have shrunk by 4½% annualized, following the -6.3% in Q4 2008.

  • Destocking. Alongside investment, the rapid inventory rundown was the main drag on growth. We expect real inventories to decline at an annual rate of USD 95 bn or 5½%. That would be the strongest inventory correction in 60 years. But as paradoxical as it may sound: That is good news for the coming quarters (pages 4-6).

  • Turning point. Historically, such a strong decline has marked not only the lower turning point of the inventory cycle but also the end of each US recession! And leading indicators such as new orders also suggest the rapid economic slowdown will end soon (cf. chart below). For the current quarter we still expect a mild contraction of economic activity. But we anticipate a positive reading for the second half of the year.

  • Muted. However, there is no solid foundation of a sustained economic recovery. The base is too narrow for that. What is missing is the traction of personal consumption, which so far has always pulled the US strongly out of recession. The erosion of wealth, combined with a still miserable labor market, suggests that 2010 will bring only meager growth well below potential.

  • Further topics:

    – Weekly Comment: Stressing test (page 2).

    – US: Healthcare reform as the next disputed issue (page 7).

    – France: First in its class, but until when (page 10)?

    – Data outlook: Sentiment indicators to spread hope around the globe; disinflation trend not yet halted (page 12).

    – Market outlook: Waiting for the stress test results (page 22).


Stressing test

Stress-testing turned into a stressing test for policymakers and markets, as well as the nineteen major financial institutions being tested – and it is now coming to the crunch, with the Treasury expected to unveil the results in early May. The challenge is to persuade investors that the problems in the financial sector are manageable, in other words that most of the nineteen institutions can weather the recession and cleanse their balance sheets by raising a moderate amount of additional capital from either private or public sources. The risk is that of ending up in another Catch-22, where a reassuring verdict would lack credibility but a harsher one would plunge the financial sector into a renewed bout of paralysis. Markets seem excessively sanguine in the run-up to the disclosure of the test results, and might over-react once the announcement comes, with a significant risk of a sudden surge in risk aversion and volatility. In particular, while the Treasury has indicated that banks would be given six months to bolster capitalization levels deemed insufficient, markets might give them less than six hours if a verdict of insufficient capitalization is rendered before the banks in question have had a chance to secure a source of new capital. On the other hand, a very benign result might undermine the credibility of the test, especially as the IMF has just increased again its estimates of total financial losses, and the macro assumptions underlying the test look closer and closer to a baseline rather than a worst case. This will be an extremely delicate balancing act for the Treasury, and one which could be crucial in determining progress towards normalization of the financial system not only in the US, but in Europe as well.

With impeccably awkward timing, the IMF published this week its new Global Financial Stability Report, where it has again doubled its estimate of total losses in the global financial sector to over USD 4 tn. To be precise, the IMF has raised its estimate of losses on US-originated assets to USD 2.7 tn from its January estimate of USD 2.2 tn, and has this time provided an estimate of losses on assets originated in Europe and Japan, set at about USD 1.3 tn. This gives a headline-grabbing figure of USD 4 tn, which dwarfs the USD 1.3tn of write-downs to date. The IMF argues that US and European banks would need to raise close to USD 900bn in additional capital to bring the ratio of tangible common equity to tangible assets back to the 4% level prevailing before the crisis. As nearly 70% of write-downs to date have been taken by US financial institutions, the new IMF estimate suggests that the likelihood of uncovering further holes in the balance sheets of these same institutions is not insignificant. Of course we should not expect that the full USD 2.7 tn of remaining losses (taking as accurate the new USD 4.0 tn IMF estimate and subtracting the 1.3 tn recorded so far) will eventually come to light, as some might remain hidden in the books of sovereign wealth funds or other institutions. MoreMoreover, the USD 1.3 tn of losses corresponding to assets originated outside the US might arguably be less likely to show up in US banks. And finally, the fact that about 70% of writedowns so far have shown up in US institutions could reflect a faster recognition of losses in the US than elsewhere rather than simply a greater exposure of US institutions. Having said all this, markets will reasonably expect US financial institutions to announce further write-downs, especially after the release of these new IMF estimates.

The upward revision of global financial losses by the IMF marks a worrying contrast to the sudden deceleration in the pace of write-downs, which after averaging about USD 250bn per quarter between Q4-07 and Q4-08 have collapsed to a mere USD 40bn in the first quarter of this year. This sudden halt to the stream of write-downs has coincided with robust results announced by several major banks, which have contributed to shoring up investor confidence in equity markets.

This sudden halt to the stream of write-downs is especially concerning when seen in conjunction with the recent decision by the Financial Accounting Standards Board (FASB) which relaxed mark-to-market rules. The concern that marking to market makes little sense when some markets have all but disappeared and might in fact contribute to a spiral of financial losses and market dislocations is a valid one. However, an even more important concern in my view is the lack of transparency and confidence which still plagues financial markets nearly two years since inception of the crisis. Weakening mark-to-market rules gives banks more leeway, but inevitably undermines transparency and could therefore hinder the return of confidence in the markets. This, moreover, stands in direct contradiction to the Treasury’s efforts to create more transparency via the Public-Private Investment Program (PPIP).

The macroeconomic assumptions underlying the stress test might also engender some skepticism in the exercise. The worst case scenario (see table for the quarterly path) assumes that real GDP would contract by 3.3% this year and expand by a meager 0.5% in 2010, with unemployment reaching 8.9% this year and 10.3% in 2010, and house prices falling 22% this year and another 7% next year. These figures certainly do not paint a tail-event scenario. On unemployment, the worst case already looks more like a best case, as the rate has already climbed to 8½%. On real GDP growth, a contraction of about 3% is unfortunately quite plausible (the April Consensus Forecasts sees GDP at -2.7%), and a +0.5% for next year certainly does not look overly pessimistic. House prices were down 7.4% in the first quarter, based on the Case-Shiller index; here though another decline of about 15% this year followed by a further meaningful drop next year does sound more like a worst-case.

Macro Assumptions

It would of course be counter-productive to force banks to raise additional capital as cushion against a very lowprobability pessimistic scenario; on the other hand, however, there is a clear risk that the macro assumptions adopted in the stress-test will soon be regarded too sanguine to generate a sufficient buffer.

The main underlying concern is what will happen once (if) the stress test indicates that some financial institutions need to raise additional capital. The Treasury has indicated that banks would be given six months to bolster capitalization levels deemed insufficient. The markets however might give them at best six hours if a verdict of insufficient capitalization is rendered before the banks in question have had a chance to secure a source of new capital. An alternative solution could come from the conversion of existing government preferred equity stakes into common equity, as indicated this week by US Treasury Geithner to Congress. Beyond the concerns of de facto nationalization, there is of course the risk that this might not be enough. Additional capital could be injected by the government, but there is very little money left: the Treasury indicated that it can still count on about USD 135bn of TARP funds, assuming however some repayment of funds already disbursed. Additional funds would need to be authorized by Congress, which appears far from well disposed, and might either refuse authorization or impose further draconian restrictions on financial institutions receiving capital injections.

It is a very difficult circle to square, and markets are probably too sanguine in these last few days leading up to the verdict. To help restore confidence, the verdict should ideally be sufficiently harsh to show whether some institutions are indeed in serious trouble, possibly suggesting the unwinding of one or more bank, and it should clearly indicate contingency sources of public capital for those institutions which will need recapitalization. If the verdict is perceived as too positive, the stress test might lack credibility, weakening investor confidence and fuelling fears of a Japan-style scenario of zombie banks undermining growth in the coming years.

Europe meanwhile looks on with ill-concealed anxiety: the results of the stress test and the reception of the markets will be key to determining the progress towards normalization of the US financial sector. And just as Europe is hoping for a recovery of global growth and trade to pull its real economy along, so it should hope that a normalization of US financial markets can spill over into an easing of financial tensions on this side of the Atlantic.