Outide View: As the US economy has a hard landing, earnings still have far to fall

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The Independent Online

I am giving a party for the survivors this weekend. That's the kind of week we've had in the markets. Many bankers I spoke to on Friday said they had never had a week with so much excitement ... and so little sleep. The dramatic falls of the first few days were matched by equally extreme movements as the week came to a close, with the biggest rate cut from the Fed in a quarter-century proving the turning point.

Let me remind you what this is all about. The current financial crisis had its origins in the US housing market. For some years, US banks became more relaxed in their lending, particularly to those with limited or non-existent credit histories. In consequence, there was a significant price surge, based on these shaky foundations.

Worse, the situation was even more fragile than it appeared. The initial lending banks had often passed loan risks on to others, packaged in a series of complex instruments such as CDOs (collateralised debt obligations). The people who bought them, often understood little if anything of what they were buying. Wrapped up in arcane formulae and complex diagrams, there was underneath simply a passing of the risk buck. As the US housing market slowed, so default levels rose, way beyond initial optimistic expectations.

The unsavoury nature of this situation was made crystal clear last year, when several banks, led by IKB in Germany, began to confess to unforeseen, and often significant, loan risk. This, for me, was a signal to sell. As fear crept into the financial system, credit markets unwound. A terrifying liquidity squeeze began, which essentially put money markets in the freezer. Indeed, as we approached Christmas, it started to look as if confidence in the entire financial system was at stake. By this stage, it was apparent to me that we were heading for the shredder.

Financial confidence remains fragile. Central bank support has now eased inter-bank tensions, but the liquidity injections are not feeding through to the economy, as banks focus on strengthening their balance sheets. The private financial sphere, the huge source of liquidity that has powered financial markets in recent years, is shrinking fast. This has real economic implications.

It is now crystal clear that the US economy is having a hard landing. The housing market continues to deteriorate, with the latest figure on existing home sales down 20 per cent (year on year). Prices are down 3.3 per cent. This is feeding through to a reduction in consumer confidence, and concern in manufacturing industry. Overall, US 4th quarter GDP growth, which will be reported on 30 January, will likely show a marked slowdown from 4.9 to 1.2 per cent.

It is true that this hard landing is already partly discounted by markets. In addition, some support for embattled financials and real-estate stocks has come from the activity of the Sovereign Wealth Funds. But, in general terms, earnings expectations still have far to fall, and we must expect downgrades – implying further medium-term downside risk to markets.

George Soros added to our heartburn on Wednesday, helpfully commenting that this was the worst financial crisis in 60 years. I'm not sure I'd go that far, but when high street banks won't lend to each other, you know something is wrong.