Global Markets: Stepping Back from the Brink

HIGHLIGHTS

• There has been a somewhat more positive (or at least less negative) tone in the recent spate of economic data, and there is further evidence that the banking sector is working through its troubles.
• The recent decisions by a number of G20 central banks have followed the Fedl's lead as rates have trended lower and in some cases quantitative easing measures have fallen into place.
• But with so much stimulus in the global pipeline, the next hurdle is to come up with a good exit strategy. The concern about inflation down the road is not without merit. Ultimately, we do not think that runaway inflation is in the cards, however.
• The publication also includes quarterly interest rate and exchange rate forecasts for the U.S., Canada, Australia, and New Zealand, and also offers additional exchange rate forecasts for the Japanese yen, the euro, the U.K. pound, and the Swiss franc.

Spring has brought with it not only the usual blossoms, but also slight signs of revival in the global economy. In particular, the U.S. economy has shown some encouraging signs of stabilization which has underpinned a guardedly optimistic view for the outlook. And as for the rest of the globe, other economies that just recently appeared on the brink of disaster have also started to show small improvements in what was previously a plethora of abysmal data.

In addition to a somewhat more positive (or at least less negative) tone in the recent spate of economic data, there is further evidence that the banking sector is working through its troubles. The raft of provisions delivered by the various global monetary authorities and fiscal bodies seems to be getting some traction. In turn, this has helped underpin an improvement in risk appetite, as a result of improved credit spreads and overall optimism. Moreover, worries about swine flu and its impact on the global economy seem to have receded as quickly as they emerged. That said, global flu pandemics do tend to have a sneaky element of surprise and for that reason a return of a stronger more virulent form of the flu should not be ruled out entirely.

But despite the slow improvement in the economy and credit markets, there is still much more downside than upside risk. Moreover, it is important to put these so called “green shoots” into context. They are, in many cases, simply a slowing in the pace of decline in the major macro economic indicators, though in other cases some outright positive readings for the various global economies have been recorded.

So in light of some improvements in the global economic data, plus the fact that there have been unprecedented monetary and fiscal responses by the various global authorities, there seems to be a groundswell of cautious optimism. Certainly, the slow improvement in economic activity and sentiment has been acknowledged by the global equity markets. All the major bourses have been rallying since the beginning of March. Even in Japan, where conditions have been the slowest to respond, there has been a bull run in the Nikkei. Perhaps the worst really is in the rear view mirror. The question then becomes when can we expect a recovery to get some traction? And the answer to that might be a bit disappointing.

Global Central Banks Put Up a Good Fight

Through the course of this synchronized global recession, the monetary policy response has been impressive. Across the G7, official central bank rates have been slashed to historical lows. The Federal Reserve led the way and the fed funds rate has been at 0.00%-0.25% for five months now. The recent rhetoric, however, acknowledges that the “economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions.” But even so, the Fed conceded that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

It seems as though the Fed is looking for further signs that the “green shoots” turn into some blossoms before they admit any significant changes to the economic outlook. That is not an uncommon theme among global central bankers.

The recent decisions by the Bank of Canada, Swedish Riksbank, Bank of England, European Central Bank, Reserve Bank of Australia and the Reserve Bank of New Zealand, among others, have followed the Fedl's lead as rates have trended lower and in some cases quantitative easing measures have fallen into place.

The Bank of Canada ended its easing cycle with one last 25bps rate cut to leave the overnight rate at 0.25%. And in a wholly unexpected move, they committed to keeping rates steady until June 2010, but also they did not pursue a quantitative easing path with any vigour. In a similar fashion to the Bank of Canada, Swedenl's Riksbank cut its repo rate to 0.5% recently and explicitly noted that “the repo rate is expected to remain at a low level until the beginning of 2011”. This of course, assumes the Riskbankl's forecasts for growth are correct, but nonetheless offers an astonishing amount of transparency.

The Bank of England has been equally, if not more aggressive (though it recently kept its base rate at 0.50% at the May meeting), committing to increasing its quantitative easing program by £50 billion to buy back assets across a spectrum of classes.

The Antipodeans have been cutting as well. The RBNZ cut its cash rate to a record low of 2.5% and left the door open for further easing, plus suggested the low cash rate will persist until the end of 2010. The RBA recently kept its cash rate at 3.00% and has taken a slightly more optimistic tone in its statement, citing the notable turning point in Chinese economic growth and the contraction in credit spreads. But the level of the cash rate is already sharply lower than it was just a year ago. It would appear that the massive 4 trillion yuan stimulus package that Chinal's government recently implemented is getting some traction.

At 1.00%, the ECBl's refi rate is also plumbing the depths. Moreover, the fact that the ECB has floated the idea of offering banks longer term loans to tackle the crisis is in keeping with the popularity of alternative policy tools to reflate economies. In the ECBl's most recent statement, the ECBl's governing council administered some alternative medicine, extending refi operation maturities to 12 months. The ECB also decided in principle to purchase as much as €60bn in covered bonds, both of which will only take place in June after the next policy meeting.

While the major developed economies are doing their best to combat the recessionary forces, it will still take time for the global economic slack to be fully absorbed. In our view that will not happen until 2010 at the earliest, when we still expect G7 GDP to post just a 0.7% rate of growth. Global growth in 2010 is expected to post a 2.2% rate of growth, but this is still below the historical average.

Draining the Pipeline When Necessary

But with so much stimulus in the global pipeline now, and a confluence of nascent signs of a stabilization in the global economy, the next hurdle is to come up with a good exit strategy. The concern about inflation down the road is not without merit. Basic economic theory tells us when too much money chases too few goods, it can spark inflation.

Perhaps the most pertinent case study will be the U.S., as the Fedl's balance sheet has exploded recently. But we are not particularly concerned about runaway inflation for the main reason that the link between the monetary base and the actual money supply, which depends on the flow of credit, has broken down as a result of the credit crunch. Further, there is another disconnect between the money supply and inflation. As such, there has been a massive deterioration in both the velocity of money (the number of times a dollar is turned over) and the money multiplier.

Moreover, inflation expectations as measured by survey data and the bond market suggest inflation is still not on the radar. Certainly, consumer and business behaviour has underpinned this trend. Consumers have been actively seeking out bargains and have scaled back their purchases, suggesting robust demand will no longer push prices higher.

Lastly, although a withdrawal of the stimulus has never really been done before on this scale, the potential to unwind it quickly is there. Just as the Fed is printing money and then using it to buy treasuries, MBS and agency debt, it could then simply sell them to shrink the money supply. Similar arguments can be made for the BoE and other countries that have been active in their respective markets.

Manufacturing a Turnaround

Aside from the encouraging amount of monetary stimulus put in place, some of the recent G7 data point to modest signs of stabilization in some of the business confidence surveys, and manufacturing data. This is indeed a light at the end of the tunnel.

Perhaps the best spate of upside surprises has come from the Fedl's regional PMI surveys. Specifically, the Philadelphia Fed, Empire Manufacturing and Chicago PMI all posted larger than expected gains in their April PMIs. This translated into the ISM manufacturing survey posting its highest level since September 2008. However, at 40.1, the ISMl's manufacturing index is still below the 50-threshold denoting expansion and contraction. Still, it is a move in the right direction.

Even China, the workhorse of the global economy, has shown signs of stabilization in its manufacturing industry. Its manufacturing PMI has staged its fourth consecutive monthly increase to 53.5 in April, after hitting a low in November 2008. Not only is it encouraging that the headline index exceeded the 50-expansion/contraction threshold, but it is equally encouraging that the new orders component of the index, which is a precursor to future growth, also posted an above-50 reading.

The laggard has been Europe, though it has produced some improvements but at a much slower pace than elsewhere. Factory orders in Germany rose 3.3% M/M in March, in the first positive print since last October. And the pace of decline in Europel's manufacturing industries is easing. The composite Euro-zone PMI is starting to rebound from its trough in February, and in April was at 36.8. This is good news only insofar as it suggests that Euro zone manufacturing has turned a corner. There is still a long way back before the economy is firing on all cylinders.

About the only disappointment in the collection of developed countriesl' manufacturing data has been Australia. Its PMI touched a low of 30.1 in April, though that could have more to do with its exposure to Asian markets and the relative lack of demand from its largest trading partners, notwithstanding the gains in China.

Thus, there are signs that manufacturing across the major economies has at least stabilized, and in some cases turned a corner. What matters going forward is the liquidation of inventories as well as a sustained improvement in the new orders component of these various PMIs. Until such time, there is little hope for the global economic recovery to get traction.

Less Bad Still Isnl't Good

Talk of these 'green shootsl' has become common and with good reason. The global economic data is posting some promising results. But one should not get too excited about these signs of life. The prevailing theme in the data is that it has become “less bad.” That is not the same as good. As such, what has become obvious is that a bottoming process has been put in place.

That said, in the near term there are still a number of risk factors that suggest that the next few months contain more downside risk than upside risk. Included in that litany of possible risks is another financial market “event” such as a struggling bank, which would certainly undo the gains seen thus far.

Moreover, the deleveraging process is far from over and the negative feedback loop from the lack of access to credit to the real economy could still play a role. Recent survey data from senior loan officers suggests that there has been only a second derivate improvement in the extension of credit. Credit is still overall quite tight.

Lastly, a resurgence of swine flu could easily test the fortitude of the global economy. Economic conditions, while encouraging, are still sufficiently fragile enough that a global flu pandemic could easily prompt a reversal in any gains made recently. The likelihood of this, in our view, is still relatively remote, as the flu fears have recently been relegated to the back burner.

With signs of improvement popping up, but still measurable risks around those green shoots, the outlook for the currency and bond markets has changed a bit. To the degree that some central banks, like the RBA and the RBNZ are still ostensibly cutting rates, while others like the Fed, BoE and perhaps the ECB are engaged in forms of credit and/or quantitative easing, this still argues that bond yields could have some further distance left to drop in the near term before the much discussed green shoots take over.

In the currency market, it seems that a gradual unwind in the risk aversion trade could continue. As the USD loses its lustre as a safe haven and investors slowly embrace risk once again, there is scope for the Euro, Canadian dollar and Australian dollar to benefit in the near term. All in all, there are pieces in place for a turnaround. It is unlikely to be quick, but we hold to our view that by the second half of 2009, we still start to see these 'green shootsl' take root. Global output gaps, however, are unlikely to fully close until much later in 2010 or early 2011. The lesson of this recession then, is that slow and steady wins the race.

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TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.