April 2009
What's left to be done?
The global financial mess has turned out to be much more messy than most originally thought. While it may have started with U.S. subprime mortgages, it has spread to a devastating slide in worldwide asset values and wealth, and has shaken the foundations of the financial system, particularly in the U.S. and Europe. Virtually no region of the global economy has been left unscathed, and the magnitude of this shock, in terms of wealth declines and the initial slide in global industrial output, looks to be the worst since the Great Depression.
While this crisis therefore deserves all of the superlatives assigned to it, so too does the policy response. Never before have we seen such dramatic cuts in worldwide interest rates. And in the U.S. at least, the coming wave of fiscal stimulus is equally unprecedented in term of a peace-time boost from government spending, equivalent to 5.5 per cent of U.S. GDP. Unleashing these measures has been an important step toward a resumption of growth and the avoidance of another depression. But to bring growth in North America to the kind of pace that will let unemployment fall and earnings soar, there’s still some work to be done.
Japan’s experience in the 1990s demonstrated the need for a healthy banking system that can finance growth once it gets going. The U.S. Treasury plan to clean up the detritus on Wall Street by buying “legacy” loans and assets will only work if bidders are prepared to pay up more than the banks now value these assets. Given all of the uncertainties surrounding their performance, including the potential for judges to rewrite the terms of the underlying mortgages, even a bidding system fuelled with cheap non-recourse leverage, through which taxpayers take on most of the downside risk, might not be enough to do the trick. We could end up needing a more direct approach to recapitalizing the banking system in the U.S., and Europe looks to have a similar job ahead.
Fiscal and monetary stimulus outside the U.S. still looks too tame to do the job. In Canada, Finance Minister Flaherty’s budget delivered about a one per cent boost to GDP growth in each of the next two years. He promised to do more if necessary, and that’s likely what we will have to see in a 2010 budget that will be set against the backdrop of a jobless rate in the nine per cent range at that time. Bank of Canada Governor Carney is studying approaches to quantitative or credit easing to extend cuts in overnight rates to other terms and credits, and will likely have to take that plunge as well. There’s an even greater gap between the policy need and the response to date in the eurozone, in everything from fiscal stimulus, to monetary ease, to banking support. Printing money worldwide to promote a reflation that shrinks the real value of the global debt mountain may ultimately be the only road to salvation.
So equities are likely to see only start and stop moves towards recouping the past year’s losses for the next quarter or two. At least until autumn, there will be frequent reminders of economic gloom, as employment keeps plunging, housing prices fall (with Canada not exempt) and TSX earnings tumble to a 25 per cent yearly decline. That said, we expect policy makers to deliver on the remaining steps towards the road to recovery, leaving room for Canadian equities to rebound sharply by the end of 2010.
March 25, 2009
By Avery Shenfeld, managing director and chief economist, CIBC
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