Economic recovery to take root in 2010

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

A shipping employee checks boxes on an assembly line.

A pickup in production has already returned many economies to positive growth.

The global economy has turned the corner. The recession in Asia drew to a close in the second quarter of 2009, as did the economic contraction in the two largest economies in Continental Europe, Germany and France. Economic growth in the U.S. and Canada resumed in the third quarter of 2009.

This has led to two questions. First, will the recovery be sustained? Second, how strong will the recovery prove to be?

In the opinion of TD Economics, the odds hugely favour continuing economic growth in 2010 and beyond. However, the pace of economic recovery in North America will be gradual, with the U.S. and Canada experiencing economic growth in the 2% to 3% range for 2010.

A positive backdrop

Let’s start with the really good news. A pickup in production has already returned many economies to positive growth. While global “synchronicity” (shorthand for the interdependence of economies worldwide) meant a collective decline on the way down, this is also leading to a positive cycle on the way up.

Significant credit for the recovery is due to policy makers. Governments around the world introduced policies to boost their economies while central banks slashed interest rates and took actions to bolster their financial institutions. These rapid and coordinated actions put a floor under what could have spiraled into a much worse economic outcome.

Gradual recovery in the U.S.

We believe that the U.S. recovery is sustainable. Admittedly, it is being underpinned by a terrific boost of fiscal stimulus, and government transfers to households remain the major source of income growth. For a sustainable recovery, the baton must be passed successfully to private sources of demand. Re-hiring and private sector wage growth must eventually re-emerge. We believe this should occur in the coming months, but it is likely to be gradual.

As the recovery unfolds, U.S. monetary policy must walk a careful tightrope. Hiking rates too early would risk a “double dip” into a renewed contraction of output; moving too late could mean accelerating inflation.

We expect the U.S. recovery to proceed steadily, as both household balance sheets and financial institutions are still working their way back to health. These factors will constrain consumer spending, which represents about 70% of the economy.

This suggests that the U.S. Federal Reserve (the “Fed”) may not increase rates until early 2011. Although short-term rates will remain anchored by Fed policy, bond yields should head modestly higher in 2010, as investors anticipate stronger economic conditions and speculate about the future tightening of monetary policy. The combination of low interest rates and heavy government borrowing suggests that the U.S. dollar may continue weakening in the near term.

Solid fundamentals in Canada

For Canada, we expect the Canadian dollar to breach parity in early 2010. The soaring loonie will act as a major obstacle to the recovery of Canadian exports.

To a greater degree than in the past, Canada’s economic recovery will rely on growth in domestic demand. The silver lining is that Canada emerged from the credit crunch with a well-functioning banking system that continues to advance credit strongly to households. In addition, the cost of borrowing for business is highly favourable. Overall, the Canadian economy is likely to experience moderate economic growth in 2010.

The Bank of Canada has committed to holding interest rates at their present levels at least until June 2010, and, given the relatively slow uptake in economic slack, we forecast that it will not hike rates until the final quarter of 2010. Bond yields in Canada will largely track those stateside, but Canadian debt will carry modestly lower yields than its American counterpart. This will be a reflection of the better Canadian fiscal position.

Rebound in corporate profits

Globally, corporate profits will rebound in the coming quarters. Equity markets have already largely anticipated this, which is why markets have rallied strongly since the spring of 2009. Investors will be looking for confirmation that corporate earnings are rising on a sustained basis. Based on the economic outlook, TD Economics forecasts corporate profits in the U.S. and Canada to rise at a high single-digit pace in 2010.

So the economic outlook for 2010 is for a gradual recovery. From an investor’s perspective, this suggests that the yield on cash products is likely to be almost negligible. Bond yields are projected to rise modestly, but are expected to be in the 3% to 4% range. The Canadian dollar is likely to remain strong and corporate profits should post a solid gain.