This post is a guest contribution by Richard Berner of Morgan Stanley.

Hopes are strong that a combination of timely fiscal stimulus and a fix for the financial system will end the US and global recession and promote recovery. Eventually, we think they will, but there are three major hurdles.

First, only 20% of the $819 billion fiscal stimulus package moving through the Congress will occur in FY2009, much of the spending and tax cut thrust will be deferred into 2010 and 2011, and it would be difficult to accelerate the spending.

Second, any plan to clean up lenders’ balance sheets, mitigate mortgage foreclosures and recapitalize lenders will also take time. Encouragingly, the Fed’s January Survey of Bank Lending Practices suggests that banks stopped tightening their lending standards last month. But credit is still tight. For example, “only” 47.5% of respondents (on a weighted-average basis) reported tightening their mortgage lending standards last month versus 79% in July, and an index of willingness to lend to consumers bounced to -16% from -47.2% in October. But both readings still indicate a bigger credit crunch than any in the survey’s history, and the cumulative impact of past tightening is still working its way through the economy with a lag.

Finally, and reflecting that lag, declining output, prices, and profits are connected in a vicious circle that is unlikely to abate soon. Pricing power is dwindling and margins are shrinking, in turn weakening corporate credit quality, access to credit, and capital spending. Although GDP declined by a less-than-expected 3.8% in the fourth quarter of 2008, the upshot is that we expect the economy to weaken further through the first half of 2009.

One more macro risk keeps us awake at night: Recessions always raise the threat of protectionism, and the threat of barriers to trade and capital flows this time may be especially high. Globalization has knit economies closer in the past two decades, bringing benefits for consumers but pressure on companies and workers in developed markets. Efforts to protect old jobs rather than create new ones would prolong the global recession, hobble productivity and raise the specter of stagflation. Signs of incipient protectionism and trade tensions are rising: Some EM countries have raised employment barriers. Officials in various countries have discussed directing credit from institutions that receive government assistance to domestic borrowers only. The US stimulus package contains Buy American clauses. And US officials are revisiting the question of whether China is manipulating its currency. None of these creates a favorable backdrop for financial markets.

Source: Morgan Stanley, February 5, 2009.

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