Recovery: A long bearish road ahead

NEW YORK (Fortune) -- Back in 2007, David Rosenberg was one of the first economists to warn investors of the Great Recession. Looking ahead, his outlook has not improved much.

Despite a brighter corporate outlook and what looks like a bottom in home prices, he says the U.S. is in a "very low quality recovery" fueled by short-term, quick fixes like Cash for Clunkers and housing tax credits.

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David Rosenberg, chief economist at Gluskin Sheff

Rosenberg, who left an eight-year career at Merrill Lynch to become chief economist at Gluskin Sheff last May, is one of Wall Street's best-regarded financial experts. His on-the-ball predictions have landed him on Institutional Investors' list of All-Star researchers for years.

In a recent interview with Fortune that ranged from Greece's debt crisis to the Obama administration's plan for heavier bank regulation, he offered this bearish conclusion: Expect more contraction ahead for real estate, credit markets, and stocks.

Below are edited excerpts from the conversation.

Jobs seem to be stabilizing and companies are posting great earnings. Why are you still worried about the economy?

Analysts tend to superimpose the most recent economic experience onto the future. People thought 2009 would be a replay of 2008, but it wasn't. People are now imposing the rallies of 2009 onto 2010. But 2009 was a very special year of unprecedented policy reflation around the globe. These policies overwhelmed the deleveraging of the private sector. The $1 trillion in debt deleveraging that happened last year was dwarfed by the rapid expansion of public sector balance sheets.

So here we are: zero percent interest rates, a $2.2 trillion Federal Reserve balance sheet, and a Federal deficit to GDP ratio at 10.5%, more than double what Franklin Roosevelt dared to run in the 1930s. The big story for 2009 wasn't that the stock market jumped 70% in some dramatic technical rally. It was that despite everything the government threw at the situation we still lost 5 million jobs. What do you do for an encore?

You're also concerned about Wall Street. Why?

Problems for banks and for the economy started in the housing market, where there are still problems. It's the risk no one talks about anymore, but home prices could go down another 10% to 15% because of excess supply.

What does that decline mean for future write-downs at banks? Analysts are optimistic because they use stable home prices and 3% to 4% GDP growth in their models and see a profit turnaround in the banking sector. But if you asked most bank analysts to put a big home price decline in their models, universally they would no longer be bullish.

The question becomes, have banks reserved enough against more bad losses?

But home prices seem to have bottomed. How do you calculate such a big price decline?

First, that bottom has happened because of a government moratorium on foreclosures and the dramatic Fed incursion into the mortgage market. With about $1 trillion in mortgage securities on its balance sheet, the Fed owns more mortgages than Treasury securities, and it has been a vital source of support for the housing market over the course of the last year.

But Fed intervention and short-term fixes like homeowner tax credits are not enough to fight the supply problem.

We have almost two years of residential real estate supply. If you total the number of newly built homes that are vacant, the number of existing homes that are occupied and for sale, and the number of homes that are vacant for sale that have been held off the market for unspecified reasons, that's over 7 million units in the homeownership sector that are either potential or actual inventory. That's over a 6% vacancy rate.

I've got news for you. The laws of supply and demand are such that this number will exert ongoing downward pressure on home prices over the next several months and quarters.

There is also such a thin layer of equity in homes that if home prices tumbled 10% or 15%, the number of people upside down in their mortgage would go from 15 million to 30 million -- that's half the mortgage population with negative equity. When you run models on delinquencies, defaults and foreclosures, whether or not someone has skin in the game is a critical point.

You've also been vocal about the problems in, as you call it, the European periphery -- Greece, Spain, Portugal, Italy, and Ireland. Can you help readers make sense of what is happening there?

More than two years after the peak of the crisis we're still experiencing a post-bubble credit collapse. For years, the riskiest of borrowers -- whether households or governments -- were able to borrow money in abundance. Greece is the current poster boy for the fact that we're still cleaning up this problem.

In Greece -- and Spain and Portugal and Ireland -- bloated deficit and debt burdens have made it very hard for these countries to make payments on its debt. It's not a whole lot different from what's happening in California.

But we have learned one thing from the Lehman Brothers bankruptcy. We can't tolerate another massive collapse. So the question for countries like Greece is not whether it will be rescued, but the extent and speed with which it can follow through on fiscal reform.

If we can't tolerate a big collapse, what effect do troubles overseas or even in states like California have on the economy if they are going to be rescued?

No matter how you slice it, the road towards fiscal probity means intense restraint and slower growth. The PIIGS -- Portugal, Italy, Ireland, Greece, and Spain -- represent 37% of the Euroland economy. They'll be putting on a fiscal tourniquet over the next several years, at a time when China and India are tightening credit policy and Ben Bernanke is in the process of at least toying with the idea of some exit strategy in the U.S. This makes the global economic outlook very murky.

If you look at U.S. state and local governments, in terms of their share of the economy, they are more than 50% larger than the federal government. Local government has a huge impact on the overall economy. Since state governments can't run operational deficits, we'll see tremendous fiscal tightening, and that restraint -- whether it's tax increases or civil servants being furloughed or services being cut -- will slow growth. It will also significantly offset the policy stimulus measures coming out of Washington.

You worked at Merrill. Not only was it among Wall Street's biggest firms, it collapsed under the weight of credit problems and was sold to Bank of America (BAC, Fortune 500). What do you think of White House proposals to reign in the sorts of activities the big banks can engage in?

I am a proponent of the Volcker Plan. I believe that the banks should be de-risked and be more heavily regulated. This will impact growth, but we won't have as much volatility as we've had in the past. After living through what we just did, we found that bigger is not always better. The benefits outweigh the costs of reducing the complexity of the financial system.

The crisis came about because of excessive leverage, a misunderstanding of credit quality as linked to securitized products, and a general lack of appreciation for risk. Thanks to years of deregulation, the government created a wild west and never established a strong sheriff. The head of the Fed was a libertarian who believed that all economic problems would always be solved in the private sector and that the private sector would always adequately price risk. The degree of supervision never matched the extent of the regulation.

Do you have advice for investors?

I think it's time to be cautious on risk assets. The technical run up of 2009 is over. China and India have pulled back on stimulus, clouding the near term outlook for commodities. Policy re-flation in the U.S. is largely behind us, and I see no reason that we'll see organic private sector growth over the next few quarters. The contraction in bank balance sheets is ongoing, and housing is still searching for the elusive bottom.

I favor bonds over stocks. Corporate balance sheets are in reasonably good shape, so credit will be a good place to be in, relatively speaking. In stocks, more defensive and yield oriented sectors will probably outperform. The ones that were out of favor last year and that are under-owned right now in institutional portfolios -- I'm talking utilities, health care, consumer staples -- will be the areas to scale into in 2010.

For commodities, I think we're halfway through a secular bull market, but it will take a breather in 2010 and there will be a pullback.

We had an 18-year bull market in equities from 1982-2000, but that didn't mean that you wanted to be long every single year. There were periods when it was fine to take profits off the table, and that's what I'd do with commodities with the view of getting back in at cheaper prices in the future.