There are still more nasty surprises to come from banks

Banks are headed for more trouble as the economy heads downhill. And things will be particularly tough in Britain, says John Stepek. With the public finances in a mess, we face a long hard slog before we're anywhere near recovery. So what should investors do?

The recent uptick in optimism is gradually being replaced by a creeping realisation that the banking sector and the wider economy is still in a terrible mess.

For all the capital raising, and government intervention, and bail-out mania, the world's banks are still very weak.

How weak? Well, one prominent US analyst reckons that loan losses at US banks, as a percentage of loans, "will likely pass the level of the Great Depression."

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No wonder the markets broke their winning streak yesterday...

We can expect more nasty surprises from the banks

US analyst Mike Mayo said yesterday that banks are heading for more trouble. He reckons that "mortgage losses may be halfway to the peak." But "card and consumer losses may only be about one-third of the way and industrial and commercial real estate problems (except construction) seem in the early stages."

In other words, the banks have still to feel the worst impact of consumers and companies going bust. On top of this, in the longer run, they'll face "lower revenues (less loans and fees)" and "higher expenses (more oversight costs)". That's not to mention that they're likely to have to maintain "permanently higher capital and reserve levels" in the future, meaning they'll be less profitable.

And the US government's latest attempts to help the banking sector by taking toxic assets off their hands "might not help as much as expected." That's because the banks haven't actually written down some of their toxic assets quite as heavily as they should have. "Loans have been marked down to only 98 cents on the dollar, on average." In other words, banks will still be reluctant to offload their bad assets to bargain-hunting, government-backed vulture investors, because it'll almost certainly mean taking a hit on the price, which would then have an impact on their balance sheets.

As the market rally petered out, hit by fear in the banking sector, the rally in copper is starting to fizzle out too, as my colleague David Stevenson discussed on Friday: Why the base metal rally won't last. With demand sliding, commodity prices are still under pressure - Macquarie Group reckons that copper usage will fall by 9.2% this year, reports Bloomberg, as weak home and car sales "reduce demand for wire and pipe made from the metal."

Oil prices faltered too, as the Qatari oil minister Abdullah bin Hamad al-Attiyah said that he doesn't think prices will hit $70 a barrel this year - "fifty dollars a barrel is reasonable for the world economy now". That sounds like a man who's just grateful that the oil price isn't at $25. Although I can't see the oil price moving much higher for now, there is a stock you can buy to profit from current conditions in the oil market we look at it in this week's issue of MoneyWeek, out on Friday (subscribe to MoneyWeek magazine).

Britain will have a long, uncomfortable slog to recovery

None of this bad news is a surprise. Anyone who stops to think for a moment will realise that with job losses and corporate bankruptcies rising, banks must be in the firing line to experience more pain, while it's hard to see how commodity prices can sustain a rally when global demand remains so weak. But no market, bull or bear, moves in a straight line. And while investors may have felt that the worst was behind us last week, they're now remembering that even if that's true, what's left is a long, uncomfortable and uncertain slog back to recovery.

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And that slog will be particularly uncomfortable in Britain. The latest study from the Institute of Fiscal Studies suggests that the Government "may have to find an additional £39bn a year in tax rises and spending cuts to plug the black hole in the public finances," reports The Telegraph. If all of that was raised from tax, says the paper, it would cost £1,250 per British family per year, between now and 2016. That's a crude measure, but it gives you an idea of the scale of the problem.

And "these projections are, if anything, optimistic," reckons the FT. If the economy deteriorates even further, or the government's cost of borrowing goes up, the bill could be much higher.

Clearly, the temptation is just to get the Bank of England to buy government debt to fund this black hole in other words, for the government to simply write itself a cheque for all the extra money it needs to spend.

That's not a big step away from what the Bank's already doing with quantitative easing. Of course, that way lies Weimar Germany or Zimbabwe. But it's also the politically tempting route for a government on its last legs. After all, as the FT puts it, "who wants to tell the voters that they will pay more money for worse services in the year before a general election?"

This year's budget will be grimmer than ever

What it all means is that this April's Budget will be one of the most important in recent history. The government has to convince the markets that it does have some plan to curb all this borrowing and spending. And meanwhile, the Budget will no doubt be loaded with more stealth taxes than ever to claw as much as possible from the electorate.

As to what it means for investors well, I'd definitely keep out of the gilts market, which is now too heavily manipulated for any sensible investor to want to take a punt on. As for stocks, we'll be looking at some potentially solid individual companies in the next issue of MoneyWeek, but as I said yesterday, I still wouldn't be keen to snap up a tracker yet.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.