By Nouriel Roubini
I was this morning on CNBC’s Squawk Box being interviewed – in part - by the legendary Mohamed El-Erian (co-CEO of Pimco) who is the lead guest for the show this morning. Mohamed is a friend/colleague and one of the most thoughtful and deep thinkers about financial markets and the global economy combining analytical academic rigor, senior policy experience (a decade long at the IMF) and the deepest and most sophisticated knowledge of financial markets. His latest book on global investing is a must read for all.

Let me elaborate the point I made in the interview and some additional points on the economy and financial markets…

In the interview I discussed my bearish outlook for the US and global economy with about a dozen major economies now at risk of a recessionary hard landing, the risks of global stagflation, the unraveling of Bretton Woods 2 regime, the deadly combination for the global economy of asset bubbles going bust with stagflationary shocks, the more sharply bearish outlook for US and global equities and my trillion dollar plus estimates for credit losses from the current financial crisis.

Those credit losses are now mounting and spreading from subprime to near prime to prime mortgages, to commercial real estate, unsecured consumer credit (credit cards, auto loans, student loans), leveraged loans financing reckless LBOs, muni bonds as many insolvent local government will go bankrupt, industrial and commercial loans, corporate bonds (as a tsunami of corporate defaults are ahead of us) and CDS.

As I argued in writings last February such credit losses would be at least $1 trillion and could be as high as $2 trillion, well above the $300 billion of subprime writedowns that have been recognized so far. At that time the $1 trillion estimate was considered as lunatic but by now the IMF estimates these losses at $945 billion, George Magnus of UBS estimated them at $1 trillion; Goldman Sachs put them at $1.1 trillion, the legendary hedge fund manager John Paulson (who made last year $3.5 billion of income on shorting subprime) put them at $1.3 trillion; and a couple of days ago Bridgewater Associates estimated such losses at $1.6 trillion. Thus, as I argued then $1 trillion would be floor, not a ceiling, to such credit losses.

Of course such losses have been in part transferred from US banks to capital market investors and to foreign investors via securitization. But with the entire capital of the US financial system at $1.3 trillion such staggering losses will lead to a systemic banking crisis and systemic financial crisis.

No wonder that Bernanke is now telling non-bank primary brokers that the Fed exceptional liquidity support (TAF, TSLF and especially PDCF) will be extended into 2009. And no wonder that Geithner, Paulson and Bernanke have now all three spoken of the need to find orderly ways to let even large and systemically important institutions go bankrupt if they are insolvent.

So brace yourself for a severe recession in the US and other advanced economies, a serious global growth slowdown and a systemic financial crisis. The worst is ahead of us rather than behind us and the financial and equity markets complacency and sucker’s rally that – in April and May - followed the Bears Stearns creditors rescue and the Fed bailout of non-bank broker dealers (the PDCF lender of last resort support extended to primary dealers) was gone by June with stock markets now back to bearish 20% plus downward adjustment.

The same pattern occurred in 2001. The economy entered into a recession in March 2001 but then 95% of professional forecasters predicted no recession as there was the delusion that the aggressive Fed easing – that had started in January 2001 – would prevent the recession and lead to a H2 growth recovery. Forecasters got it wrong; the Fed got it wrong (as it mispredicted the effects of the tech bust on the economy) and the stock market got it wrong too: in April and May 2001 the S&P500 had its sucker’s rally going up 18% on expectations that the Fed would rescue the economy from the recession.

It was only in June when markets realized that, in spite of a very aggressive Fed easing, the economy was spinning into a deeper recession, that stock prices resumed their free fall. The same pattern of complacency and delusional hope that the Fed could bail out investors and markets occurred this year: a sucker’s rally in April and May and a fall back to reality in June.
Expect a much sharper fall in equity prices in the US, advanced economies and emerging markets from current levels in the rest of 2008 as a severe US recession and global slowdown and a severe financial crisis and credit/liquidity crunch takes a more severe toll on earning of non-financial firms. In a typical US recession the S&P500 falls – from peak to through – by 28%; and this is not your typical run of the mill mild recession.

So the worst is ahead of us for the real economy and financial markets. From time to time markets will rally again reacting to mild and deceptively positive economic news. For example the temporary drug of a $160 billion fiscal package including $100 billion of tax rebates will boost Q2 growth into positive territory (1% to 1.5% growth in Q2). But that boost is deceptive as it is entirely driven by such temporary tax rebates.

The effects of those rebates on consumption are temporary while a half a dozen more persistent shock will lead to a consumption reduction – by late summer –once the effect of the rebates fizzle out. Persistent headwinds hitting consumers on a more protracted basis are: falling home prices, falling home equity withdrawal, falling stock prices, rising oil and food prices, rising debt servicing ratios, falling consumer confidence, falling employment and income generation.

The US economy indeed entered a recession in February of 2008: Q1 GDP is misleading as monthly GDP figures – from MacroAdvisers – show falling GDP between February and April 2008; also falling employment now for six months in a row, falling durable and non-durable consumption, falling demand and supply in housing, financial sector, auto sector, consumer discretionary sector, etc. are consistent with an economic recession that started in Q1.

When it looks and walks and quacks and ducks like a recession duck it is a recession. Of course the cheerleading bulls will rejoice to the news of a Q2 positive growth and argue that we will avoid a recession. The trouble is that we are already in a recession and the Q2 – and possibly Q3 – marginally positive headline GDP growth – will confirm what this author and others –Goldman Sachs, Merrill Lynch and a few others – have argued all along: a protracted U-shaped recession (rather than the short and shallow V-shaped recession of the consensus) may turn into a W-shaped recession if the tax rebate temporary drug boost GDP growth into marginally positive territory in Q2 and possibly Q3.

By Q4 the negative headwinds hitting US consumers will dominate the effect of a disappearing tax rebate and the severity of the economic contraction will become clear again. And indeed in the last few weeks equity markets, credit markets and now even oil and commodity markets are starting to price the scenario of a protracted US recession and a sharp global economic slowdown.

So fasten your seat belts as it will be a bumpy ride for the US and the global economy and for financial market. The most wise and savvy Mohamed El-Erian agrees on that.