British banks’ profits should rise strongly over 2010-12 as impairment charges fall, suggesting that tax-payers will gain from their stakes in Lloyds Banking Group, the Royal Bank of Scotland (RBS), Northern Rock and Bradford & Bingley lending.

British banks in aggregate lost £2 billion in 2009, according to recently-released annual results. Underlying net income rose to a record £51 billion – the prior peak was £42 billion in 2007 – but was outweighed by impairment charges of £53 billion*.

Impairments, however, fell by 19% between the first and second halves and should continue to decline steadily – assuming no “double-dip” recession. Guidance about their trajectory is provided by bad debt experience in the early 1980s and early 1990s, associated with the 1979-81 and 1990-91 recessions. Impairments totalled 4.7% of “assets at risk” over the five years 1982-86 and 7.1% over 1989-1993.  The first chart shows projections based on losses over 2008-2012 falling within this range – low real interest rates suggest that higher numbers are unlikely. From £53 billion in 2009, impairments are forecast to fall to £30-40 billion in 2010, £15-32 billion in 2011 and £8-25 billion in 2012.

On the conservative assumption of no further increase in underlying net income from its 2009 level of £51 billion, this would imply a recovery in profits after charges to £11-22 billion in 2010, £19-36 billion in 2011 and £26-43 billion in 2012. In other words, profits could surpass their 2007 peak of £31 billion as early as 2011 – second chart.

Lloyds and RBS lost a combined £13 billion last year, with underlying net income of £27 billion offset by £40 billion of impairments. If charges fall in line with the industry average, and the underlying surplus is stable, the two banks could earn profits of £8-21 billion in 2012. Taking the mid-range figure of £14.5 billion and applying a corporation tax rate of 28% and a price/earnings ratio of 10, the equity of the two banks could be valued at about £104 billion in 2012, up from £65 billion at Friday's close. (The P/E of UK banks averaged 10.8 between 1965 and 2009, according to Thomson Datastream.) Assuming no change in equity outstanding, this would be consistent with share prices of 96 pence for Lloyds and 71 pence for RBS versus 60p and 44p respectively on Friday, implying a paper profit on tax-payers' stakes of about £25 billion. (The National Audit Office has estimated average in-prices of 50p for RBS and 74p for Lloyds, with each 10 pence increase boosting the value of the stakes by £9 billion and £3 billion respectively.)

* These numbers cover the main high-street banking groups: Santander UK, Barclays, Bradford & Bingley lending, HSBC Bank (the UK subsidiary of HSBC), Lloyds Banking Group, Northern Rock and RBS.

The Federal Reserve this week reiterated its assessment that "economic conditions ... are likely to warrant exceptionally low levels of the federal funds rate for an extended period". While official rates will stay low, however, the Fed has already begun to withdraw liquidity from the banking system.

The monetary base – currency plus bank reserves at the Fed – has fallen for three consecutive weeks, by a cumulative 4.7%. This mainly reflects the impact of the "supplementary financing programme" (SFP) under which the Treasury issues bills and deposits the proceeds at the Fed – this has more than offset a further liquidity injection from central bank purchases of mortgage-backed securities (MBS).

Monetary base movements have recently led equity market fluctuations – see Andy Kessler's Wall Street Journal article and the chart below.

The Fed will complete its $1.25 trillion of MBS purchases by the end of the month but carried $1.066 trillion on its balance sheet as of Wednesday, suggesting a further substantial liquidity injection. The SFP, however, is scheduled to rise from $75 billion to $200 billion. The net impact of these and other changes on the monetary base is uncertain; a further decline would be another warning signal for markets.

The Dow Jones industrial average fell by 54% from peak to trough in the bear market between October 2007 and March 2009. The Dow has declined by 45% or more on seven prior occasions since 1900 – see table. Six of these declines were in the 45-55% range, the exception being the depression bear market of 1929-32, when prices dropped by 89%.

The Dow reached its low on 9 March 2009 and had risen by 61% by 9 March 2010. This is in the middle of the 42-85% range of first-year recoveries after the six prior big bear markets, excluding the 1929-32 decline. The mean rise across these recoveries was 59%.

The Dow's performance was mixed in the second year after the troughs of these prior cycles. The change in prices ranged from a fall of 8% to a rise of 22%, with a mean increase of 7%. In one case – the recovery after the 1973-74 bear – a strong second-year gain followed a below-average rise in the first year.

Historical evidence, therefore, suggests that equity markets are entering a less dynamic period, although any downside risk should be modest against the background of a continuing economic recovery. This conclusion is consistent with evidence of less favourable global liquidity conditions discussed in yesterday's post.

The liquidity "jaws" are closing. Annual growth in Group of Seven (G7) real narrow money, M1, was only marginally higher than industrial output expansion in January – see first chart. The series are likely to have crossed in February, with the annual output gain boosted by a large monthly decline in February 2009 falling out of the calculation.

Since 1970, global equities on average have underperfomed cash by 5% per annum when annual real M1 growth has fallen short of output expansion while outperforming by 11% pa at other times – see previous post. These averages, of course, conceal significant variation but the ex ante return / risk profile of holding equities has deteriorated.

Slower real money growth than output expansion implies that the economy is draining liquidity from markets. Historically, cross-overs have also signalled higher short-term interest rates. On average, G7 short rates have risen by 0.7 percentage points per annum during real money / output growth shortfalls while falling by 0.9 points pa at other times – second chart.

G7 plus E7 industrial output continues to rise solidly and is now only 4% below its pre-recession peak – see prior post – while the recovery is broadening to labour markets. Central bank policies adopted during the financial emergency – suppressing official interest rates below inflation and flooding banking systems with reserves – are increasingly misaligned with economic developments.

The Federal Reserve last night repeated its commitment to low interest rates for an "extended" period but this does not preclude an early withdrawal of liquidity. A rise in Chinese official rates is overdue while the UK "MPC-ometer" is close to signalling a need for policy restriction. Earlier-than-expected monetary tightening could be the trigger for a set-back in equity markets.

Prior posts have argued that weak broad money trends in the US and Europe are not an obstacle to a continuing economic recovery because corporate liquidity is rising solidly, supporting prospects for business investment and hiring. Firms have been able to raise cash levels because of a fall in the demand to hold money by households and financial institutions, mainly reflecting negative real interest rates.

This hypothesis received further support from US fourth-quarter flow of funds accounts data released last week. A broad money measure comprising currency, banking system deposits, money market mutual funds, repurchase agreements and foreign deposits was unchanged in the year to end-December but this stability concealed a rise of 8.5% in business holdings offset by falls of 1.9% and 3.0% respectively in household and financial money – see first chart. Business liquidity grew at a 15.0% annualised rate during the second half.

The decline in household and financial money implies that there is less “sideline cash” available to flow into markets and push up prices. Expressed as a proportion of financial assets, however, money holdings are still at a “normal” level by recent historical standards – second chart. Investors may wish to rebalance their portfolios further away from cash in response to the negative real interest rate “tax” imposed by central banks.

Combined industrial output in the Group of Seven (G7) major economies and seven large emerging economies (the "E7", defined here to include Brazil, China, India, Russia, Korea, Taiwan and Mexico) rose by a further 0.8% in January to stand 10.9% above its trough reached in February 2009. Following a 13.6% drop during the recession, output is now only 4.2% below the peak reached in February 2008.

The recovery has been led by the E7 – output has risen by 19.1% from a low in January last year and is 8.8% above its pre-recession peak. G7 production, by contrast, has recovered by 8.3% from a March 2009 trough and is still 12.9% below peak. Relative performance improved in January, however, with a 1.4% gain versus flat E7 output, reflecting a sharp fall in Russia.

The recession and recovery in G7 plus E7 output continues to track closely G7 performance during and after the mid 1970s first oil shock downturn. This template suggests a sustained economic upswing but with momentum slowing during the second half of 2010 and into 2011 – see first chart.

The interpretation here is that recent monetary developments are consistent with this template. G7 real broad money is contracting on an annual basis but this is unlikely to signal insufficient liquidity to support an ongoing economic recovery because of a fall in household and institutional money demand due to negative real interest rates. Corporate liquidity – a key driver of the business cycle – continues to improve while narrow money M1 is rising solidly. Real M1 expansion, however, has moderated, suggesting slower economic growth later in 2010 – second chart.