>>The Worst Is Behind Us. Now What? (WELLS FARGO)

The global economy plunged into its deepest recession in decades last autumn as financial markets seized up in the wake of Lehman Brothers’ failure. By early this year industrial production in the 30 countries that comprise the Organisation for Economic Cooperation and Development was down more than 15 percent from year-earlier levels (Figure 1).

It could have been far worse, however. The governments of the world’s major countries averted catastrophe last year by taking steps to prevent a wholesale collapse of their financial systems via recapitalization, loan guarantees and increased deposit insurance. In addition, governments responded to the crisis with stimulative economic policies. Major central banks slashed policy rates to unprecedented levels, and governments in most major countries opened the fiscal taps.

There are signs that the medicine is having its desired effects and that growth is returning to most economies. The global recovery is being led by Asia where growth turned positive again earlier this year. The financial systems of most Asian economies were not nearly as levered as their western counterparts, so banks in the region were able to ramp up lending again. In addition, most Asian governments responded to the crisis with expansionary fiscal policy. The year-over-year GDP growth rate in China rebounded to a strong 9 percent in the third quarter of 2009, but the expansion is not confined to only China. Many other countries in the region, including the large economies of Japan, Korea and Taiwan, are posting positive growth rates again.

On a purchasing power parity basis, we forecast global GDP will decline about one percent in 2009. Although our projection may not sound “bad,” global GDP has never contracted, at least not since the International Monetary Fund began calculating the series in 1970. We project that the global economy will grow close to its long-run average of 3.6 percent in 2010 before accelerating to roughly 4 percent in 2011. Relative to 2004-2007, however, when global GDP grew nearly 5 percent per annum, the global recovery that we project over the next few years may seem a bit sluggish. Indeed, we project that growth in the United States and in some western European economies will be held back by slow growth in consumer spending as individuals attempt to delever and repair battered balance sheets.

Inflation rates in most countries shot higher in the first half of 2008 and commodity prices went through the roof. On a global basis, CPI inflation rose to 6 percent in 2008, the highest rate in about 10 years. However, the global downturn caused commodity prices to collapse, and global inflation has receded significantly this year. Despite unprecedented amounts of monetary stimulus, inflation should not really be an issue until the global economy truly strengthens. Due to the slow recovery that we project, we believe that inflation in most countries will largely remain benign over the next few years.

The Dollar Should Appreciate Modestly versus Major Currencies
The dollar strengthened significantly last autumn as risk aversion spiked. U.S. Treasury securities are considered to be the safest assets in the world, and massive buying of U.S. government bonds by foreign investors contributed to the dollar’s strength. However, the greenback has given up most of its gains over the past few months as investors have turned less risk averse. With stock markets rising in most countries and corporate bonds rallying, the safety of low-yielding U.S. Treasury securities is not as compelling as it was only a few months ago when worst-case scenarios did not seem farfetched.

Looking ahead, the currency strategy team of Wells Fargo projects that the dollar will trend modestly higher against most major currencies. Investors expect that most major central banks, including the Federal Reserve, the European Central Bank and the Bank of England, will be on hold until well into next year. Therefore, expected changes in short-term interest rates will not have as much of an influence on exchange rates as in the past. As the U.S. recovery gathers steam, foreign investment flows into long-term securities (e.g., corporate bonds and equities) and direct investment inflows should resume, helping to lift the greenback. In addition, the decline in the U.S. current account deficit will exert less headwinds on the greenback than it did earlier this decade when the dollar was trending lower.

However, most “commodity” and emerging market currencies should continue to trend higher versus the greenback in the quarters ahead. The global recovery should cause most commodity prices to drift higher, which should help to support “commodity” currencies (e.g., the Aussie dollar). In addition, rising levels of risk tolerance should cause capital to flow to “risky” developing countries, which should put upward pressure on many of those currencies.

WORLD
■ The global economy fell into its deepest recession in decades as capital markets locked up in the wake of the Lehman Brothers bankruptcy. Fortunately, the central banks and governments of the major economies of the world averted disaster by slashing interest rates, undertaking fiscal stimulus and taking steps to support the global financial system.

■ There are clear indications that the global economy is starting to recover, although levels of activity remain well below year-earlier levels in many countries. Commodity prices are off their cyclical lows and the rise in the Baltic Dry index, which measures international shipping prices of dry bulk cargoes, suggests that global trade is starting to pick up again. Moreover, “hard” data show that industrial production is beginning to expand in most economies.

■ Asia, which did not have overly leveraged financial systems heading into the crisis, is leading the world out of recession. However, both the United States and the euro area appear to be turning the corner as well.

UNITED STATES
■ The United States recently endured its deepest recession in decades. Between Q2 2008 and Q2 2009, the economy contracted about 4 percent. However, real GDP rebounded in the third quarter, rising at an annualized rate of 3.5 percent.

■ Some of the lift in the third quarter reflects the temporary effects of government stimulus. “Cash for Clunkers” contributed to the 22 percent jump in durable goods purchases, and home building was stimulated by the first-time home buyer tax credit. However, growth in other areas of private spending, such as consumer purchases of non-durable goods and services and business spending on machinery and software, shows there was more to overall GDP growth in the third quarter than simply government stimulus.

■ Despite the rise in real GDP in the third quarter, a self-sustaining recovery has not yet truly taken hold. Unemployment has shot up to the highest rate since the early 1980s, and it will likely climb a bit further in the months ahead.

EURO-ZONE
■ Since peaking in the first quarter of 2008, real GDP in the Euro-zone has contracted more than 5 percent, making the current downturn the worst in decades. Not only did exports take a sizable hit, but domestic demand weakened as well as credit markets ground to a halt in the wake of the Lehman Brothers bankruptcy.

■ Official GDP data have not been released yet, but there are indications that growth turned positive again in the third quarter. The purchasing managers’ indices for the manufacturing and service sectors moved into expansion territory during the quarter, and “hard” data show that industrial production grew at a solid rate in the first two months of the third quarter.

■ Although the worst may be over, we believe that the recovery in the Euro-zone will prove to be frustratingly slow. There are a few important economies in which consumers became highly geared. In our view, sluggish growth in consumer spending in these economies will restrain the overall GDP growth rate in the Euro area. In addition, economic weakness in eastern Europe should constrain growth in exports from the Euro-zone.

JAPAN
■ Japan’s economy started growing again in the second quarter, and growth continued into the third quarter. The most visible sign of expansion is the rebound in Japan’s industrial production. Industrial production rose another 1.4 percent month-over-month in September, extending the rebound to seven consecutive months. Japan’s industrial production has already retraced about half of the amount that was lost over the prior five months. September inventories were the lowest in five years, suggesting that production gains are sustainable.

■ The strong yen may be denting Japan’s export performance, however. Japan’s export growth has struggled to advance at the same pace as its Asian neighbors such as China, South Korea, and Taiwan. On a seasonally adjusted basis, Japan’s exports have slipped for three consecutive months, back down to April levels.

■ Deflation is still firmly entrenched in Japan. The national core CPI edged up 0.1 percent in September relative to the previous month, but the overall CPI is down -2.3 percent from a year ago.

UNITED KINGDOM
■ Real GDP in the United Kingdom has declined for six consecutive quarters. Since peaking in the first quarter of 2008 British real GDP has plunged 6 percent, making the current slump as deep as the horrendous downturn in the late 1970s/early 1980s. N0t only have exports tanked, but domestic demand has taken a sizable hit as well.

■ There are some signs that the worst may be over. The purchasing managers’ indices for the manufacturing and service sectors have moved into expansion territory, although “hard” data on industrial production have yet to confirm the upturn in manufacturing activity. Most indices of house prices have risen from their lows of earlier this year.

■ As with their counterparts in the United States, British consumers have built up their leverage over the past decade or so, and it seems likely that a period of consumer retrenchment is in store. Therefore, we project that the upturn will prove to be very slow due, at least in part, to sluggish growth in consumer spending.

AUSTRALIA
■ Despite a global recession, Australia managed to avert a deep contraction in its economy. After a mild decline in real GDP of 2.2 percent in Q4 2008 , growth returned to positive territory in the first and second quarters.

■ The Royal Bank of Australia (RBA) is among the first foreign central banks to begin tightening monetary policy in this cycle. It lifted the cash rate by 25 bps to 3.25 percent in October, and then another 25 bps to 3.50 percent in November. In the RBA’s accompanying statement, it noted that the “considerable downside risks” present when the bank decided to take the cash rate from 7.25 percent to 3.00 percent had abated and that the Australian economy now seems well on the way to recovery.

■ Whether or not the RBA will continue to hike rates will depend on the inflation outlook and the pace of economic growth in Australia. Since the run-up in oil and other commodity prices in the summer of 2008, CPI inflation has come down in Australia, giving the RBA cover to continue to tighten if the bank sees fit.

To read the full report: GLOBAL CHARTBOOK