For whom the bell tolls

By Beata Caranci, Director of Economic Forecasting, TD Bank Financial Group

A "House for Sale" sign stands in front of a two-storey suburban home.

Housing price movements impact household spending and consumer confidence.

As a result of significant broadening of economic weakness across the global stage, TD Economics has marked down economic forecasts. We believe the global economy will suffer a 1.6% contraction in 2009. This would mark the first global contraction on post-war record; with no country left unscathed, the bell tolls for thee.

In particular, the capitulation of the U.S. consumer at the end of 2008 has been sharper than anticipated. This has been a key catalyst for causing the year-over-year decline in global trade to double and distribute the economic shock around the world. This sharp change in such a short period of time has accelerated the ongoing retrenchment in global production levels, foreshadowing an increased level of global bankruptcies, alongside losses in jobs and corporate profits — particularly for Japan and the Asian emerging markets so intricately intertwined into global supply chains. The recession in the U.S. economy is now expected to extend to the third quarter, resulting in a contraction of 3.1% for 2009 as a whole. Canada, as an unfortunate bystander, will see real GDP growth contract by 2.4%.

We expect a budding U.S. recovery to materialize at the very end of 2009, but the risks to the forecast in recent months indicate that the recovery for 2010 will be shallower than originally expected. There are five key pillars that form our current view. If all five come to fruition quickly and strongly, then the pace of economic recovery will be considerably stronger than we are currently predicting. However, if some of the five steps are not substantially realized in the next three to six months, we will consider downgrading the outlook further.

Five pillars to recovery

1. The U.S. real estate market must stabilize in the next three to six months. What does this mean? So much market and media attention has been placed on the rate of decline in U.S. home prices. The Case-Shiller home price index (HPI) for December showed that prices were declining at a breakneck pace of 18.5% year-over-year. We believe existing home prices will fall a further 10% by the first half of 2010, for a peak-to-trough contraction of close to 35%.

There is obvious importance attached to price movements, especially when it comes to the psychological impact they can have on household spending and confidence alongside the direct influence on household wealth, mortgage financing and default activity. In particular, resumption in price growth would trigger the completion of housing-related write-offs, helping to restore the health of the financial industry.

However, waiting for prices to return to the black will not tell you when the housing market has bottomed. Turning points in prices lag those of sales and inventories by as much as three to 12 months, although home prices do tend to lead new construction. Right now, we’re encouraged to see that inventories in the existing-home sales market are already down from their peak in November and that sales activity in the heartland of the housing woes — the West — firmed up in December and January.

However, it’s too early to say definitely whether these developments will improve further or stagnate. There is still acute downward pressure on the new-home market, and downside risk remains due to the impact of record foreclosures on inventories and prices and the possibility of a vicious cycle.

2. Credit conditions must continue to improve. Although the U.S. is making slower-than-expected progress on restoring its financial health, there is some good news. Short-term financing rates have receded dramatically in recent months and 30-year mortgage rates have fallen to an all-time low. However, monetary policy filters through the economy with lags of six to 12 months, and in this environment of credit upheaval and economic uncertainty, the lags could be more exaggerated. Most of the improvement in financial markets just started to show up in the economy in early 2009, so it will take time to stoke GDP growth.

Furthermore, there has been little progress made on medium-term financing rates, which remain extremely high. The spread of five-year U.S. bank debt over its Treasury counterpart is close to 400 basis points. Over time, this spread should decline to around 150 basis points. Progress on this front is tied to government policy, which must still address the core problem of toxic assets on the balance sheets of financial institutions. Attempts thus far have not met our expectations.

For instance, when the Trouble Asset Relief Program (TARP) was first created last year, it appeared to be targeted at the underlying bad asset issue. However, the objective and implementation of the TARP program have been redefined many times over and about $100 billion of the funds have yet to be deployed — now past the sixth month since inception. President Obama’s 2009 budget sought additional aid for the financial industry, but it remains to be seen how effective the U.S. Treasury will be in deploying new funds and removing the troubled assets that have plagued the financial system for well over a year. To add to the confusion and uncertainty that is already undermining the financial system, there is an ongoing ideological debate raging as to whether the government should nationalize some of the banks.

The improvement thus far in shorter-term financing costs and mortgage rates, though welcomed, is not sufficient to set the stage for a broad-based solid recovery in the second half of this year. There are still too many loose ends on the financial front, which is why our forecasts reflect a longer recession in 2009 and a shallower recovery in 2010.

3. Related to this is the increased prevalence of systemic risk in the global financial system, which must diminish for our forecast to materialize. The accelerated deterioration of the global economy has aggravated some underlying financial fragilities. A substantial amount of loans from Western European banks to Eastern European borrowers has quickly soured, exacerbated by the sharp depreciations in many East European economies. This will be a drag on borrower and lender economies alike, thereby slowing the pace of economic recovery. We are presuming that attempts to stabilize the financial systems and economies of Central and Eastern Europe will avoid the worst case scenario of total meltdown, which would have dire effects on creditors in Western Europe and even North America.

4. Restructuring of the auto sector must continue to make progress. If the Big 3 North American auto assemblers were allowed to fail outright, the economy would certainly be worse than currently projected. This view does not preclude these firms from seeking bankruptcy protection and restructuring, but does assume their operations continue in some, albeit diminished, form.

5. The U.S. fiscal stimulus package must be implemented swiftly and the economic boost needs to be in the ballpark of our current expectations. The fiscal stimulus is projected to lift the level of U.S. real GDP by 2.3% by the end of 2010. Our assumption is relatively conservative, as it rests in the middle of the Congressional Budget Office’s range of potential outcomes.

Conclusion

The upside and downside risks are evenly balanced around this economic forecast, such that if some of the ambiguity lifts and progress is made on any one of these elements over the next three to six months, there is upside potential to the outlook, particularly for 2010. Given the excruciatingly slow economic recovery expected on both sides of the border next year, a substantial output gap will remain in both Canada and the U.S. for years to come. This should mitigate the risk that inflation will become problematic once some of the global and domestic risks abate, allowing central banks time to pull liquidity out of the financial system as the recovery takes hold.