Mixed news getting better

Ever since the U.S. National Bureau of Economic Research first proclaimed America was in a recession, investors and consumers alike have been desperate to get a handle on just what lies ahead. Unfortunately the news has been mixed.

In March, there were reported sightings of “green shoots” of a recovery south of the border. In late April, the previously upbeat governor of the Bank of Canada declared that the recession would be longer than initially anticipated, with Canada not staging a recovery until 2010.

And then there are the television economists, who have used far too much of the alphabet to describe the shape of the recession. The traditional U and V descriptions — the former being a gradual decline and recovery, the latter being a sharp drop and rebound — have been joined by the W — decline, recovery, decline, permanent recovery — and the L, which indicates, essentially, the end of the economy as we know it.

“People have been so mesmerized by the financial stuff, and ridiculous talk of this becoming the Great Depression or Great Recession,” says Glen Hodgson, chief economist, Conference Board of Canada. “I think this is a recession like many other recessions… recessions are all bad.”

He points out there’s no law forcing a recovery to follow the same pattern as the decline, suggesting the steep downward side of the V, which came to pass in Q4 2008 and Q1 2009, is likely to be followed by the gradual upward slope of a U.

“We think it’s going to claw its way back up to normal, but it’s going to take 18 months to two years,” he says. The Conference Board’s economics team has forecasted a full-year contraction of 7% in Canada and 5.5% in the U.S. for 2009.

News getting balanced

“Increasingly, the news is getting balanced; you’re getting good news and bad news mixed,” Hodgson says. “The single most important factor is whether people can get access to credit again.”

While the Bank of Canada’s data suggests credit availability has improved, Hodgson points out this is true only among the Canadian banks; foreign-based banks have pretty much sold out of their positions and gone home.

“Canadian firms have lost their access to foreign capital markets and foreign institutions operating here,” he says. “I hear from the guys on Bay Street that it was up to 25 to 30% of all business financing in Canada, so that’s a big hole that has to be filled in.”

He says American banks are on a healing path, but that it will take an entire year for them to shore up their reserves to the point where they can be considered to be operating “normally”.

“There’s still a bit of a black hole when it comes to the credit default swap market, but the longer we go without a second or third shock [the better], those things are time-dated, so they expire.”

He points out the biggest black hole in this market, AIG, has not needed any additional capital from the government in about two months. The next big problem may arise in Europe, where eastern Europeans borrowed in euros, and tried to repay in their local currency.

“Currency depreciation has been a big shock there. You have meltdown in gold conditions and then you get this financial shock on top of it.

Worst case avoided

Patricia Croft chief economist at RBC Global Asset Management, RBC Asset Management, agrees the economy is on the mend.

“I do think we’ve reached an inflection point, a critical one, in that we are probably now past the worst of the recession,” she says. “While the news is still going to be bad, it’s not going to be as bad. That’s part of the reason the stock market has been able to rally, because the fundamental outlook is slowly starting to improve.

“The worst case scenario, of the world going into depression, that’s now off the table, so we can all breathe a sigh of relief in that regard. But there are enormous challenges to the world economy, and I think the key one is the negative wealth affect – trillions of dollars in wealth have basically gone up in smoke and we’re starting to see the implications of that sink in with the U.S. consumer.”

She suggests Hodgson’s V-U hybrid outlook may be too optimistic. There is plenty of room, she says, for an economic sucker’s rally.

“The contours of the recovery remain very uncertain and the outlook is murky. There is going to be this debate: is it going to be a U, a V, an L, or whatever you’re going to call it. I think its going to indeed be a W,” she says. “Many people are saying this is going to be a U, but historically, there has never been a U. You usually get a V shaped recovery or a W. There has never been a U. That’s not to say we can’t have one.”

She expects a moderate recovery to take shape in the U.S. economy in the third and fourth quarter. When that happens, American consumers and businesses may face higher taxes, as the government starts tackling the debt it amassed in staving off the recovery.

“You’re going to slap income taxes, dividend taxes, capital gains taxes, carbon taxes, etc. I think that may actually create the W, whereby the recovery is quickly snuffed out,” she says. “We’re going to see the intergenerational transfer of taxes – forget about transferring wealth, the next generation is going to have to pay for it.”

That will slow the potential growth rate for the U.S. considerably. Consumers, who together make up 70% of the U.S. economy, will continue to spend, but real growth in spending will fall from 3.5% to 2%.

While the U.S. struggles under its massive debt-load, she expects China will lead the global recovery, but it won’t be easy. The U.S. consumer sector alone accounts for 16% of the global economy. To put that in context, the impact of the American consumers is eight times larger than the entire Canadian economy, and twice that of China’s economy.

“If the [U.S.] consumer has gone into hibernation, what’s going to fill that gap? Some argue China isn’t quite big enough; I’m not so sure of that,” she says. “When China slowed, you saw the impact very quickly on Taiwan, Korea and Japan. Any sign of China improving will see the reverse.”

She says her balanced funds are sitting slightly overweight in equities right now, as valuations are “extremely compelling,” while government bonds appear overpriced. But she warns it’s probably too early for investors to significantly overweight their allocation to stocks, as there remains a great deal of uncertainty.

Hodgson, on the other hand, is already back in the market.

“Equity markets are usually about six months ahead of the economy in recovery,” he says. “I personally have shifted into equities. Any client who says they lost money and they regret it, was in the wrong investments. If you take a long enough view, this is actually a growth opportunity.

(05/01/09)

Steven Lamb