The tide turns

By Craig Alexander, Senior Vice President and Deputy Chief Economist, TD Bank Financial Group

Man in store shopping for leather jacket.

Improved consumer and business confidence should also be reflected in a greater willingness to spend and invest.

What a difference a year makes. In September 2008, the global financial system came under extreme stress in the wake of the collapse of Lehman Brothers and the bailout of AIG. Fear dominated financial markets as well as the minds of individuals and businesses. This was far from surprising, given the vast number of comparisons at the time being drawn to the terrible depression of the 1930s.

Over the subsequent months, the transmission mechanism between the financial system and real economy proved almost instantaneous, bringing deep economic contractions in late 2008 and early 2009. The extreme interconnectivity of the global economy also became evident as the most synchronous world recession since the 1930s unfolded.

The response

Significant economic damage was done, but the worst fears were not realized. Policymakers responded with deep interest rate cuts, massive coordinated fiscal stimulus and creative actions to help stabilize the global financial system.

Although it was a rocky road, these actions paid off. By March 2009, a psychological shift had taken place. Fear evolved into the view that “just” a severe downturn was taking place. Talk went from Great Depression II to references to the 2009 Great Recession.

Another change occurred in the middle of the year. Signs were materializing that the worst of the contraction had passed. The bad economic news was becoming less negative and the financial system was looking a lot healthier.

Green shoots

By the time data on the second quarter became available, it was evident that Asia had rebounded strongly and the tide was turning in other regions as well. Indeed, the economies of Germany and France stopped contracting in the April-June period.

The data for North America were also looking better. The rate of contraction diminished and everything started to point to economic growth in the U.S. and Canada resuming in the third quarter. The terribly synchronous global downturn was rapidly changing to a wonderfully synchronous global recovery. Acceptance of recession shifted to optimism about a better future.

We’re watching the recovery closely

The focus is now on the shape of the recovery. The economic outlook has a very glass-half-full perspective to it; we believe that the recovery is for real and that worries about a double dip will likely prove unfounded.

In much of the world, inventories were run down to remarkably low levels during the recession, implying that even modest improvements in demand will lead to significant gains in production. Real estate markets, which were the epicentre for the financial problems in the U.S. and the U.K., are stabilizing — and, given the low levels reached, even a modest improvement could bring a significant boost to economic growth.

The previously announced fiscal stimulus programs will continue to be a contributor to economic growth in the coming quarters, while the impact of record low interest rates should keep pushing on the economic accelerator.

Unemployment rates are likely to continue to rise in the near term, but this is traditional for this lagging indicator. Some of the rise will reflect workers re-entering the labour market, which is actually a positive. Improved consumer and business confidence should also be reflected in a greater willingness to spend and invest. This is how economies have climbed out of recessions before, and this scenario is expected to play out again.

Recovery will be slow

However, the pace of economic recovery is likely to prove to be quite gradual compared to the past. In the U.S., the financial system is being repaired, but this will take considerable time. Loan losses are not over, as foreclosure rates are expected to rise further, while additional declines in real estate prices (of about 5%) will push more homes into negative-equity position. In commercial real estate, further weakness is anticipated.

A systemic shock to the financial system is highly unlikely, but the wounds from the credit crunch and the economic downturn will be slow to heal. The de-leveraging of the global financial system is also not complete and the ability to securitize loans will not return to its prior level. Credit growth should improve, but gradually.

Households have experienced a significant loss of wealth, and this is likely to induce a tendency towards increased savings and a slower trend rate of consumer spending growth during the recovery. The gradual nature of the economic recovery also implies that unemployment rates will be slow to decline and personal income growth will remain modest — suggesting that a consumer-led spending spree fuelled by pent-up demand is nowhere on the horizon.

What’s expected in the U.S.

The bottom line is that the U.S. economy is likely to experience a rebound to 4% annualized growth in the third quarter of 2009, but more moderate growth thereafter, with an average of 2.4% in 2010 strengthening to 3.3% in 2011. This pales in comparison to the sharp rebounds that followed the early 1970s and early 1980s recessions.

The moderate economic growth combined with only gradual improvement in credit flows means that inflation should not be a problem in the coming year, giving the Federal Reserve the flexibility to leave rates on hold until early 2011. On the fiscal front, large deficits and mounting debt pose a significant challenge.

However, these cannot be addressed while the U.S. economy is fragile. And all of the above points to a further weakening of the U.S. dollar.

Asia and Europe

Outside of the U.S., the rebound of economic growth in Asia looks to have considerable momentum, but it should start to give way to more moderate gains after the first quarter of next year.

In Europe, economic growth is expected to broaden around the region, but our bet is that it will be in the 2.2% to 2.5% range over 2010 and 2011.

On the home front

The Canadian economy went along for the ride during the global downturn. Now it will ride the recovery wave, with real GDP growth of 2.5% in 2010 and 3.1% in 2011. The domestic side of the economy will strengthen, but while exports will be on the mend, the sector will remain challenged by a further appreciation in the Canadian dollar, which is expected to touch parity before pulling back.

In the near term, a further reduction in inventories will also be a headwind for growth. The moderate pace of economic expansion implies that the output gap will be slow to close and the national unemployment rate will decline slowly.

These trends, combined with the lagged nature of core inflation, point to the Bank of Canada being able to remain on hold until the final quarter of 2010 and then only gradually tightening monetary policy over the course of 2011.

Our main conclusion is that the tide has turned. However, the waters will recede only gradually.

Highlights

TD Economics revises its global growth forecast for 2010 up by one full percentage point to 3.8%.
A potent combination of inventory rebuilding, alongside ongoing monetary and fiscal stimulus, is driving the U.S. towards its strongest post-recession recovery since the 1980s.
This recovery is still weak given the depth of the worst contraction since the Great Depression.
U.S. real GDP is expected to post a 3.5% gain in 2010.
Real GDP growth for Canada in 2010 is expected to reach 2.5%.
Canadian domestic demand will outperform its U.S. counterpart, since the domestic economy faces fewer constraints related to depleted wealth and hampered credit flow.