Recovery from the Great Recession is Heading Back on Course

January 2011

After hitting turbulence shortly after takeoff, the global economy appears to be headed towards a more normal flight path.

Time to unbuckle your seat belt and move about the cabin?

“We think so,” says Jim McDonald, chief investment strategist for Northern Trust. “There will be bumps along the way, but world growth is expanding nicely, and that’s good news for stocks.”

It’s also a switch from just a few months ago, when talk of a “double-dip” recession dominated the conversation.

But those fears have largely vanished, thanks to a spate of encouraging economic data, more fiscal stimulus and relentless efforts by the Federal Reserve to boost growth.

Lending support
Federal Reserve Chairman Ben Bernanke lit the fuse for the latest boost to the global bull market in stocks.

Speaking last August to an annual gathering of global central bankers, Bernanke indicated that the Fed was ready to embark on another round of Treasury bond buying — known as quantitative easing, or QE2 — to hold down interest rates and push up inflation.

Of course, anyone who lived through the inflation-wracked 1970s might find such an objective unfathomable.

But with core inflation running perilously close to zero and enormous slack remaining in the domestic labor market, Bernanke is more worried about Japanese-style deflation taking hold in the United States than about inflation getting out of hand.

“It’s a different world now,” McDonald notes. “For at least the next year, deflation should remain the greater risk, despite the Fed’s efforts to boost inflationary expectations and consumer prices.”

Though there is some evidence that inflationary expectations are rising, McDonald expects the Fed to keep short-term interest rates near zero for all of 2011.

Picking up speed
The unnerving deceleration in economic activity during the first half of 2010 shouldn’t have come as a total surprise. So-called mid-cycle slowdowns are part of an economy’s normal rhythm, and lingering problems caused by the credit bubble added to the problem.

“The global economy went through a soft patch last summer as inventory rebuilding and government stimulus started to wane,” McDonald recalled. “But growth regained momentum in the fall and early winter as corporate and consumer spending picked up.”

There’s still plenty of room for improvement.

Sectors of the economy that typically drive growth — consumer durables, real estate investment and business spending — took unusually large hits during the recession.

“Those key areas are showing signs of life,” McDonald says, “so we anticipate that the pace of the global recovery will accelerate as the year unfolds.”

Wealth effect
The Fed’s QE2 program seems to be boosting U.S. economic growth, but not necessarily in the way it was intended.

Yields on 10-year Treasury bonds actually began climbing before the central bank’s latest bond-buying binge started in November, pushing mortgage rates higher as well. It turns out that the economy had gathered steam — and inflationary expectations rose — between when the Fed formally indicated at a September policy meeting that the program was imminent and when it was implemented two months later.

But two positive factors have more than offset the negative impact of higher borrowing costs on longer-term loans.

Historically, there’s been a high correlation between stock prices and consumer spending. Stocks soared after QE2 set sail, climbing by about 20% during the last four months of 2010.

“When people see the value of their portfolios rise, they feel better about the future and are more willing to spend,” McDonald says. “And since the consumer accounts for more than two-thirds of economic activity, strong retail sales sets in motion a virtuous circle of more hiring and more spending.”

The recent pickup in mergers and acquisitions activity also is a bullish sign, as are attempts by the Obama administration to repair frayed relations with the business community.

“It’s all about confidence, both on the business and household levels,” says McDonald.

Job security
Besides feeling richer, there’s another reason why consumers may have loosened their purse strings of late: The labor market has stopped getting worse for those who still have jobs.

“Unemployment has been unusually slow to decline in this recovery, but at least the 90% of Americans who have jobs are feeling more secure that their work won’t disappear,” McDonald says. “That’s a critical change in psychology.”

Assuming global growth continues on its present upward path, look for the Fed to complete its $600 billion of Treasury purchases as scheduled in June, then take to the sidelines.

“We don’t anticipate that there will be a QE3,” McDonald says.

Some investors worry that when the Fed stops printing money, bond yields will shoot up, stopping the expansion in its tracks.

But McDonald doubts that rates will jump by enough to do meaningful damage. He notes that inflationary pressures remain benign and considers it unlikely that growth will be robust enough to remove slack from the job market any time soon.

“The Fed leaders want marginally higher inflation and they’ll probably get it,” he says. “But with unemployment having risen so much, the conditions for significantly higher inflation are not there.”

Notably, many economists don’t foresee a return to full employment for three to five years. That implies little upward pressure on labor costs, and thus scant cause for businesses to pass along higher costs to consumers.

Coming home
Meanwhile, individual investors are dipping their toes back into the equity market, after giving stocks the brush-off since the first signs of the looming financial crisis appeared in 2007.1 In recent years, investor dollars have flowed out of equity funds and into bond funds, exerting strong downward pressure on bond yields but functioning as a headwind on stock prices.

Look for those headwinds to abate, McDonald says.

“Over the next few years we should see a more balanced flow of money between the stock and bond markets,” he says. “With economic growth accelerating and fixed-income prices no longer going only in one direction — up — equity funds could see sizeable inflows of investor dollars.”

Increased demand for equities could mean higher stock prices, especially in areas that benefit from accelerating world economic growth, like the energy, technology and industrial sectors.

Pain from Spain
But while global economic choppiness appears to be lessening, there could still be some rough air ahead.

Heading the list of troublesome issues are the ongoing sovereign debt concerns in Europe. Bailouts last year kept fiscal and banking woes in Greece and Ireland reasonably contained, but liquidity and solvency issues could resurface again in 2011 and beyond.

Portugal, Italy, Belgium and Spain all could face funding shortfalls in coming years. Investors seem especially skittish about Spain, since that country’s economy is bigger than Greece and Ireland combined.

McDonald thinks the eurozone will muddle through and keep its single currency intact, but that the process won’t be quick or pretty.

“European Union leaders have to focus on this issue,” he said. “There should be progress this year towards creating funding vehicles that would support countries that get into fiscal distress. But we don’t expect a final resolution by the end of 2011.”

That’s not necessarily a bad thing, however, because when worries over Europe recede, investors could turn their collective angst to seemingly intractable fiscal problems in the United States.

Yet those same investors may actually be the catalyst to finally bringing America’s simmering debt problem under control.

“I doubt that Congress has the political will to make the kinds of fiscal adjustments that would bring the deficit down to a manageable level,” McDonald says. “The bond market will do it for them, in the form of higher interest rates. But that’s a ways off.”

Chinese inflation
Besides easing the high public debt burdens afflicting Europe and the United States, the other main risk to the global expansion is China, where money growth and inflation each are rising too fast.

“Chinese authorities are working to restrain credit expansion by just enough to take the edge off inflation” McDonald notes. “But if they go too far, it would take a big piece out of global growth.”

Commodities, which have boomed in recent years thanks in large part to unrelenting demand from China, also would be vulnerable if China suffered a hard landing.

Still, McDonald says a severe slowdown in China is unlikely. In fact, he sees continued strong growth in developing nations as powering much of the global expansion.

Unlike the 1990s, when plunging currencies made emerging markets vulnerable to a series of financial crises, most of those countries now have their economic houses in sound working order. If anything, emerging markets are fighting to keep their currencies from appreciating, which would undermine their competitiveness.

“They learned their lessons well,” McDonald says. “Emerging markets are in a much stronger financial position now, with lower debt loads and plenty of foreign currency reserves.”

That financial muscle is underwriting a major, long-term shift in the global economy — with huge implications for investors.

Rather than being completely dependent on consumer spending in developed countries, the global economic plane now is being powered by both rich and developing countries.

And with the U.S. economic engine finally gaining thrust, the world economy is regaining its wings.

“We’re not quite there yet,” says McDonald, “but the growth outlook is much brighter.”

And the ride much smoother.

Past performance is no guarantee of future results.

Mutual fund investing involves risk, including loss of principal.

1 Financial Times. December 29, 2010. Page 17.

2 Bank for International Settlements, Annual Report 2009-10;

3 The Economist. December 11, 2010. Page 13.

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