>Will the Global Economy Expand in 2010? (WELLS FARGO LIMITED)

The seizing of financial markets that followed Lehman Brothers’ failure caused the global economy to fall into its deepest recession in decades. By the spring of 2009 industrial production in the 30 countries that comprise the Organisation for Economic Cooperation and Development (OECD) had plunged more than 15 percent from year-earlier levels (Figure 1).

Incredibly, it could have been far worse. The governments of the world’s major countries averted catastrophe at the height of the crisis by taking steps to prevent a wholesale collapse of their financial systems via recapitalization, loan guarantees and increased deposit insurance. In addition, major central banks slashed policy rates to unprecedented levels, and many implemented programs of “quantitative easing” to provide further stimulus. 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. Industrial production in the OECD nations rose 5 percent from its nadir in March 2009 to September, although it remains 13 percent below its February 2008 peak.

The global recovery is being led by Asia where growth turned positive again last 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.

Major economies appear to be stabilizing as well. The U.S. economy expanded at an annualized rate of 2.2 percent in the third quarter, and monthly indicators point to growth in excess of 4 percent in the fourth quarter. The temporary effects of fiscal stimulus certainly played a role in the positive outturn in the third quarter, but recent increases in core measures of retail sales and capital spending indicate that there is more to the story than simply fiscal stimulus. Both the Euro-zone and Japan registered modest increases in real GDP in the third quarter, and growth likely remained positive in the fourth quarter.

Will the global economy slip back into recession again? Probably not. Production was slashed much faster than final demand in most economies, which led to sharp declines in inventories. The unprecedented liquidation of inventories appears to be coming to an end, and producers should continue to boost production to bring output back into alignment with final sales. In that regard, stimulus measures enacted late in 2008 and in 2009 are helping to boost activity. Most western economies should post positive growth rates over the next few quarters. That said, the modest global upturn that appears to be underway remains fragile, and self-sustaining recoveries, especially in the most advanced economies, have not yet been firmly established.

The Dollar Should Appreciate Modestly versus Major Currencies
The dollar strengthened significantly in late 2008/early 2009 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 gave up most of its gains over the balance of 2009 as investors 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 in early 2009 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 suspect that most major central banks, including the Federal Reserve, the European Central Bank and the Bank of England, will be on hold until the second half of 2010. 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 fewer headwinds on the greenback than it did earlier this decade when the dollar was trending lower. The dollar has already bounced back a bit since early December as U.S. economic data have been stronger than expected on balance.

However, most “commodity” and emerging market currencies should continue to trend higher versus the greenback in the quarters ahead. The global recovery will likely 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 will clear the way for capital to flow to “risky” developing countries, which should put upward pressure on many of those currencies.

WORLD
■ The global economy is starting to bounce back from its deepest recession in decades, although industrial production in the OECD nations remains well below the peak that was reached in early 2008. That said, purchasing manager indices generally remained in expansion territory in the fourth quarter, suggesting that the expansion remains intact. Most regions of the world are starting to grow again with Asia clearly in the vanguard.

■ The major governments of the world averted catastrophe in the fall of 2008 by taking steps to prevent the global financial system from collapsing. In addition, most major governments enacted fiscal stimulus programs to shore up economic activity.

■ Not only have interest rates been reduced to unprecedented lows, but major central banks have enacted “quantitative easing” programs via unconventional purchases of private sector assets. Central banks in some countries (e.g., Australia and Norway) have started to hike rates again, but the Fed, the ECB and the Bank of Japan remain firmly on hold.

■ The deep global recession and the collapse in commodity prices caused inflationary pressures to recede significantly. Commodity prices have risen off their lows, but elevated unemployment rates have kept a lid on wage inflation. Although we forecast that CPI inflation rates will trend higher this year, we do not project a return to runaway global inflation à la the 1970s.

To read the full report: GLOBAL ECONOMY