October 10, 2008

• Global equity rout
• Policy makers around the world react, but financial markets fail to respond
• Canada not immune to global slump and credit crunch

Global financial markets this week gave a stunning performance as King Lear: standing naked, gripped with madness, screaming in rage into the storm but to no avail. Betrayed by evil daughters Fear and Panic, and failing to listen in the past to the calming voice of good daughter Rationality, equity markets retreated despite ardent efforts by governments and central banks to stem the rout.

Governments ride to the rescue

Indeed, this week was dominated by national policy makers scrambling to address the global financial distress. For those trying to keep track, here is a quick recap of the latest initiatives. The U.K. government raised the public guarantees on bank deposits and introduced a bank rescue plan that included the government purchase of preferred shares in eight banks and substantial loan guarantees to stimulate interbank lending. Meanwhile, the Bank of England (BoE) doubled the amount of short-term lending available to 200 billion pounds. Ireland and Greece announced a firm guarantee of all bank deposits; while Austria, Germany, Iceland and Portugal made implicit commitments to do the same. Although a coordinated European plan failed to materialize, the heads of government in Europe agreed to a set of principles for bank rescues. Meanwhile, the German government approved a 50 billion euro bailout package for Munich-based Hypo Real Estate Holding AG. The European Central Bank (ECB) announced changes to their liquidity measures, including moving from periodic auctions to unlimited access and lowering the premium charged on emergency loans. The U.S. Federal Reserve announced the creation of a new facility that will buy 3-month commercial paper from eligible issuers to provide addition liquidity. The Government of Canada announced that it would buy $25-billion in insured mortgages from financial institutions to provide additional funds at a time that bank financing costs have climbed sharply.

Take a breath, because there’s more. Central bankers around the world also came together and delivered a surprise coordinated half percentage point rate cut last Tuesday. The Fed, Bank of Canada (BoC), ECB, BoE, Sweden’s Riksbank and Swiss National Bank all cut rates – while the Bank of Japan (BoJ) left rates unchanged but provided a statement supporting the decision of the other monetary authorities. In explaining their actions, the central banks were clear: inflation is no longer a concern and the greatest risk is weakness in the global economy. Investors embraced this assessment, as markets went from speculating about whether or not there would be a global recession to contemplating how long and how deep.

Global economic slump in the cards

TD Economics has long been of the pessimistic side of economic forecasters and in our last Quarterly Economic Forecast (QEF) we outlined the case that the global economy would experience at least a mild recession. Earlier in the year, markets and central bankers were worried about inflation, but we argued that the slowing world demand and a correction in commodity prices would resolve any price pressures. We also stressed that expectations of a global ‘decoupling’ from the U.S. would prove a fallacy.

What TD Economics failed to anticipate was the degree of financial turmoil, which clearly poses a downside risk to the economic outlook the longer it persists. And, history tells us that every financial crisis must induce investor capitulation before the tide can turn. No one can call the bottom of the market accurately, but the deep correction in recent days certainly has that capitulation feel to it.

The problem is that stock markets are the single best leading economic indicator available, and equities traditionally only turn about two quarters before the economy starts to recover. We’re really only in the early stages of the economic slump and before the economic recovery can take hold there must be a significant decline in the cost of funds between financial institutions. Despite all of the policy actions taken, the interbank lending rate has continued to climb. The inference is that investors should be braced for continued volatility until there are clear signs that the distress in the global financial system is finally subsiding.

To this end, further policy announcements are likely, including central bank rate cuts. TD Economics expects that the Bank of Canada will cut the overnight rate by a further half point to 2.00% on October 21, while the Fed should lower the fed funds rate from 1.50% to 1.00% on October 29. We also anticipate that the ECB has 125 basis points to easing and the BoE has 150 basis points of easing in the months ahead.

Canada hit by two-fold external shock

One of the most frequent questions received this week was about the impact on Main Street. Notwithstanding the latest economic numbers showing solid economic growth in July and the creation of 107,000 net new jobs in September, there is no question that the Canadian economy will be deeply affected by the global recession. Canada is a major exporting nation and the correction in commodity prices combined with weakening demand in the major trading partners will be a blow to the economy. The decline in exports will dampen domestic economic conditions. The credit crunch will also constrain the domestic economy, as evidenced by the Bank of Canada senior loan officer survey released on Friday that showed a tightening in lending conditions. However, it is important to stress that the Canadian economy is fundamentally sound. Canada’s fiscal situation is solid and the Canadian financial system is weathering the recent turmoil far better than its G-7 counterparts due to its better balance sheets and comparatively prudent lending practices in the past. This was also reflected by news this week that the World Economic Forum ranked Canada as having the strongest banking system in the world. The reality is that Canada is being impacted by two external shocks – a global economic downturn and a global increase in financing costs. Due to these factors the Canadian economy will experience little or no growth over the next several quarters and that will impact Canadian households, but the economy will recover when the external problems subside.

Craig Alexander
VP & Deputy Chief Economist
416-982-8064

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