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Economic Stabilization Does Not Indicate Recovery


Hope exists despite poor economic indicators.

Mixed Metaphors

Botanical commentators are finding "green shoots." The astronomically minded have seen "glimmers." The meteorologically minded have spoken about the storms "abating." Strong rallies in equity and debt markets have confirmed the recovery for the "true believers." The Global Financial Crisis (GFC) is over! (See also: Key Lessons From the Financial Crisis.)

It's useful to remember Winston Churchill's observation after the British expeditionary force's escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory." There may be confusion between "stabilization" and "recovery."

The "green shoots" theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates, and large fiscal stimulus packages. The recovery of emerging markets and a renewed belief in Decoupling (Release 2.0) also underpin hopes of a swift return to growth.

Shooting Messengers

The puzzling thing is that real economy indicators continue to be poor. Growth forecasts for 2009 have steadily deteriorated with world growth expected to be negative 2.00-3.00% with especially poor prospects for Japan and the Euro Zone. Industrial output, employment, consumption, investment, and global trade continue to be weak. Even China, expected to grow between 6% and 8% in 2009, experienced a fall in exports of over 20% over the last year.

The "wealth effects" of the GFC on economic activity are unclear. In the US alone, $30 trillion of value has been destroyed. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be ready to fully flow through into consumption.

The financial system has stabilized but not returned to the "rude good health" that current executive compensation demands within banks would suggest.

Good results for Goldman Sachs (GS) and JPMorgan (JPM) are offset by less impressive performances by Bank of America (BAC), Citigroup (C), Morgan Stanley (MS), and Deutsche Bank (DB). The problems at CIT Group (CIT) also highlight the problems for the financial system and the threat to availability of credit to small- and medium-sized businesses.

Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raising by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.

Bank risk levels have increased, too, and in some cases, beyond pre-crisis levels. Goldman Sachs' second-quarter earnings showed an increase in risk levels as measured by Value-at-Risk (VAR). The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It's probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk-taking reflect increasing comfort in central bank support of financial institutions' liquidity and their ability and willingness to intervene to limit price risks.
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