Comments from Nouriel Roubini

Below is Nouriel Roubini's latest. He was among the few who foresaw the recent turmoil in the markets. He is likely right in economic terms however the real question is has the market already discounted the slowdown ahead. My intuition tells me that we will likely see a good start to the year as there is a large amount of money on the sidelines and people coming into the markets after tax loss selling. However I suspect the markets will fade after that and the S&P could see an new low as investors come to terms with the depth of the cycle ahead. I have played the January bounce correctly however I suspect I will get out of the trade sooner rather than later as I believe the markets are poised to head lower.

Jan. 1 (Bloomberg) -- The global financial system in 2008
experienced its worst crisis since the Great Depression of the
1930s. Major financial institutions went bust. Others were bought
up on the cheap or survived only after major bailouts. Global
stock markets fell by more than 50 percent from their 2007 peaks.
Interest-rate spreads spiked. A severe liquidity and credit
crunch appeared. Many emerging-market economies on the verge of a
crisis had to ask for help from the International Monetary Fund.
The global financial system literally went into a cardiac
arrest after the Lehman Brothers Holdings Inc. collapse and a
meltdown was barely avoided through very aggressive policy
responses. So what lies ahead in 2009? Is the worst behind us or
ahead of us?
Unfortunately, the worst is ahead of us. The entire global
economy will contract in a severe and protracted U-shaped global
recession that started a year ago. The U.S. will certainly
experience its worst recession in decades, a deep and protracted
contraction lasting at least through the end of 2009. Even in
2010 the economic recovery may be so weak -- 1 percent growth or
so -- that it will feel terrible even if the recession is
technically over.

Recession Spreads

There also will be recessions in the euro zone, the U.K.,
continental Europe, Canada, Japan and the other advanced
economies.
A hard landing for emerging-market economies may also be at
hand. Among the so-called BRICs, Russia will be in an outright
recession in 2009. Growth in China will slow to 5 percent or
less, representing a hard landing for a country that needs
expansion of close to 10 percent to move 10 million to 15 million
poor rural farmers into the urban industrial sector every year.
Brazil will barely grow in 2009. Even India will experience a
sharp slowdown.
Most other emerging market economies will suffer a similar
hard landing. This severe global recession will morph into a
stag-deflation, a deadly combination of economic
stagnation/recession and deflation. In the advanced economies,
with aggregate demand falling below growing aggregate supply,
slack in goods markets will lead to deflationary pressures as
companies’ pricing power is restrained.
Likewise, rising unemployment will constrain labor costs and
wage growth. These factors, combined with sharply falling
commodity prices, will cause inflation in advanced economies to
ease toward negative territory, raising concerns about deflation.

Danger of Deflation

Deflation is dangerous as it leads to a liquidity trap:
nominal policy rates can’t fall below zero, so monetary policy
becomes ineffective and even quantitative easing may not work.
Falling prices mean that the real cost of capital is high
and the real value of nominal debts rise. This leads to further
declines in consumption and investment, thus setting in motion a
vicious circle in which incomes and jobs are squeezed,
aggravating the fall in demand and prices.
As traditional monetary policy becomes ineffective, other
unorthodox policies will continue to be used: policies to bail
out investors, financial institutions, and borrowers; massive
provision of liquidity to banks in order to ease the credit
crunch; and even more radical actions to reduce long-term
interest rates on government bonds and narrow the spread between
market rates and government bonds.

Triggering Event

Today’s global crisis was triggered by the collapse of the
U.S. housing bubble, but it wasn’t caused only by it. America’s
credit excesses were in residential mortgages, commercial
mortgages, credit cards, auto loans and student loans.
There were also massive excesses in the securitized products
that converted these debts into toxic financial derivatives; in
borrowing by local governments; in financing for leveraged
buyouts that should never have occurred; in corporate bonds that
will suffer massive losses as defaults surge; in the dangerous
and unregulated credit default swap market.
Moreover, these pathologies weren’t confined to the U.S.
There were housing bubbles in many other countries, fueled by
excessive and cheap lending that didn’t reflect underlying risks.
There was a commodities bubble and private-equity and hedge-funds
bubbles.

Shadow Banks

We now are seeing the demise of the shadow banking system,
the complex of non-bank financial institutions that looked like
banks as they borrowed short term and in liquid ways, leveraged a
lot, and invested in longer term and illiquid ways. As a result,
the biggest asset and credit bubble in financial history is going
bust, with overall credit losses likely to be more than $2
trillion.
Unless governments rapidly recapitalize financial
institutions, the credit crunch will become even more severe as
losses mount faster than recapitalization and banks are forced to
constrain credit and lending. Equity prices and other risky
assets have plunged from their peaks of late 2007, but there are
still significant risks for more declines.
An emerging consensus argues that the prices of many risky
assets -- including equities -- have fallen so much that we are
at the bottom and a rapid recovery will occur. But in the next
few months the macroeconomic news, the earnings and profits
reports, and the financial sector news from around the world will
be worse than expected. This will put more pressure on prices of
risky assets, with a chance of a 20 percent fall in global equity
prices.

Meltdown Averted

While the odds of a systemic financial meltdown have been
reduced by the actions of the Group of Seven and other economies,
severe vulnerabilities remain.
The credit crunch will persist and spread beyond mortgages.
Deleveraging will continue, as thousands of hedge funds -- many
of which will go bust -- and other leveraged players are forced
to sell assets into illiquid and distressed markets, thus causing
price declines and driving more insolvent financial institutions
out of business. Credit losses will mount as the recession
deepens. And a few emerging-market economies will certainly enter
a full-blown financial crisis.
So 2009 will be a painful year of global recession and
further financial stresses, losses and bankruptcies. Currently,
the probability of an L-shaped, stag-deflation is now rising to a
third, while the probability of a severe U-shaped recession is
two-thirds. Only aggressive, coordinated and effective policy
actions by advanced and emerging-market countries can ensure that
the global economy starts to recover -- however slowly --in 2010,
rather than entering a more protracted period of economic
stagnation.