The global economy’s long climb back to the new normal

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There is perhaps no more potent symbol of the post-Lehman Brothers global collapse than what happened in Detroit.

A bankrupt city. A crippled auto industry. Workers with no future.

Fast forward five years. Last week, Ford Motor Co. repatriated much of the production of the Fusion – a popular sedan previously made only in Mexico – to a plant in Flat Rock, Mich., 40 kilometres outside Motor City. The company added 1,400 jobs to staff the new line.

As the U.S. auto industry rebounds, Americans are buying and borrowing again. Factories are hiring and revving up. Workers are buying homes.

They're signs of a U.S. renaissance, and the first steps back to normal for the global economy.

Global momentum is shifting back toward the United States, the world's largest economy, which was rocked by the Lehman collapse in mid-September, 2008, and spent years afterward limping along. There are also indications of a nascent recovery in Europe, where the economies of most countries are picking up after years of recession and financial crisis. In Japan, stuck in low-growth mode for a generation, Abenomics is beginning to bear fruit.

"The future is suddenly looking brighter for the global economy," said Ed Yardeni, chief investment strategist at Yardeni Research Inc.

Analysts say this new normal will feature a number of important shifts: a stronger U.S. dollar, downward pressure on commodity prices, faster global growth, and, eventually, an easing of painful government cutbacks.

"The U.S. is the absolute linchpin to global growth," said Drummond Brodeur, senior vice-president and global strategist at Toronto-based money manager Signature Global Advisors.

While there are hints of economic improvement elsewhere in the world, it is what happens in the U.S., and to a lesser degree China, that will matter most over the next few years, he said. "The U.S. is poised for a sustainable, multiyear growth trajectory," he said.

To be sure, the recovery in Canada and elsewhere is fragile, highly dependent on rising U.S. demand, and threatened by the prospect of vanishing cheap credit.

And there are challenges for emerging economies, which have seen a gusher of investment since the Great Recession, beneficiaries of the U.S. Federal Reserve's easy money policies. Now as the Fed prepares a return to more normal monetary conditions, money is returning to the U.S. and other advanced economies. "Momentum in advanced economies has moved up, but that has been happening at the same time as momentum in some of the emerging economies has weakened," explained Jorgen Elmeskov, deputy chief economist at the Organization for Economic Co-operation and Development in Paris. "In a sense, this is a reversal of what has been the pattern over recent years."

Over all, though, a brighter picture is emerging. Peter Hall, chief economist at Export Development Canada, is optimistic about prospects and says most of the advanced economies in the OECD are seeing an "economic renaissance."

"Growth is going to look much more normal than anyone's expecting," Mr. Hall said.

GEOPOLITICS

Geopolitical concerns, particularly Syria's civil war, overshadowed other topics at this week's G20 meeting.

Unrest – including a possible U.S.-led military strike in Syria along with political instability in Egypt – has already translated into higher oil prices, sending West Texas intermediate crude oil to a two-year high last week and fuelling demand for currencies linked to commodities, such as the Canadian dollar.

Central bankers are keeping a close eye on the impact of Middle East tension. "Geopolitical stresses [are] putting some upward pressure on global oil prices," the Bank of Canada noted this week.

Instability has a multitude of spillovers, from increasing market volatility to stunting economic growth.

The Middle East isn't the only uncertainty for financial markets. Germany is holding elections this fall and Brazil next year, while the Federal Reserve is poised to select a new chairman in the coming weeks.

Taken together, it suggests the wild ride for investors isn't likely to quiet any time soon.

THE CONSUMER

The return of Ford, alone among its U.S. peers in not filing for bankruptcy protection and not taking a government bailout, and the other U.S. auto makers is just one clue that consumers are spending again in the world's largest market.

And that bodes well for Canada and the rest of the world, where consumer confidence remains softer.

U.S. real consumption grew at an annual rate of 2 per cent in the first half of the year, in spite of tax hikes on higher-income earners imposed by Congress.

Americans are feeling better because the value of their homes is rising, their stock portfolios are generally up and more of them are working. Unemployment is now at a post-recession low of 7.3 per cent.

New vehicle sales reached their highest level since the recession in August at an annual pace of more than 16 million.

Home prices were up 12.1 per cent across the U.S. in June compared to a year earlier, according to the Standard & Poor's/Case-Shiller index for the nation's 20 largest cities. Price gains in some cities hardest hit by the housing crash are up more than 20 per cent, including San Francisco and Las Vegas.

More impressive is the improving debt situation of Americans. Household debt was at a decade low in the second quarter, at 90 per cent of disposable income.

THE FISCAL DRAG

A common global response to the Great Recession was to boost government spending. From Ottawa to Beijing, governments pumped up the stalled economy with a surge of fiscal stimulus.

Faced with swollen budget deficits, governments have been cutting ever since.

But there are hints that the worst of the so-called fiscal drag is now easing.

The U.S. budget deficit has shrunk dramatically after peaking at 10 per cent of GDP in 2009. It's on a course to fall to less than 4 per cent of GDP next year.

The U.S. Congress must still reach a deal by mid-October with the White House to raise the government debt ceiling. But the consensus is that the worst of the U.S. austerity will be in 2013 and the hit to economic growth will diminish in 2014 and beyond.

The IMF warned this week that too much austerity could jeopardize the nascent recovery. "Although policy makers continue to show resolve to keep the global economy away from the precipice, the greatest worry may well be a prolonged period of sluggish global growth," the IMF said in a briefing paper for leaders at the G20 summit.

In Japan, the government of Shinzo Abe is also due to decide next month whether to push ahead with a plan to raise the national value-added tax to 8 per cent from 5 per cent, a move that risks squelching already weak consumer demand.

And in Europe, the debate between austerity and growth continues as a decision looms this month whether to give Greece more debt relief.

COMMODITIES

Commodity prices have been mostly weak over the past two years, plagued by sluggish global growth and over supply.

That's shifted of late. Gold is climbing, while U.S. crude recently hit a two-year high, fuelled by the prospect of better growth in the U.S., Europe and China and amid concerns over oil supply disruptions in the Middle East.

A strike on Syria could add about $15 a barrel to the price of Brent crude, Bank of America estimated last month. Barclays analysts expect geopolitical tension will likely nudge oil prices higher in the coming months.

Higher oil prices have a mixed impact on Canada, but as a general rule of thumb for developed nations, every $10 increase in oil prices tends to add half a point to consumer prices (after two years time) and shave a quarter point off GDP, according to Mr. Elmeskov.

Gold and oil aren't the only climbers of late. The Thomson Reuters-CRB index, which tracks 19 commodities, rose 2.5 per cent last month, although it's still down about 20 per cent from levels of 21/2 years ago.

"While it's too early to say that commodity prices have bottomed, the correction since April, 2011... could be largely over later this year," said Bank of Nova Scotia analyst Patricia Mohr, who sees higher prices for nickel, zinc and WTI crude in the coming year.

Lumber also looks promising, thanks to a U.S. housing market revival – good news for Canada's long-beleaguered forestry sector.

INFLATION

Inflation fizzled in the recession and has remained, largely, low ever since.

Consumer prices among developed nations are up 1.9 per cent from a year ago, according to the OECD and have been below 2 per cent throughout the year. Energy and food prices are heating up, but the general picture remains one of subdued price pressure.

That spells relief for consumers, many of whom are grappling with stagnant incomes or reduced work hours. In Europe, for example, "real incomes have benefited recently from generally lower inflation," the European Central Bank noted this week.

While inflation in Japan made headlines recently – with consumer prices running at the strongest pace since 2008 – prices excluding fresh food are still up a muted 0.7 per cent from a year ago.

Canada's inflation rate is 1.3 per cent, with consumer prices running below the 2-per-cent mark for the past 15 months. "Inflation in Canada remains subdued," the central bank said this week, adding that it will return to the 2-per-cent mark "slowly" as activity picks up.

It's not a uniform picture, of course. In India, consumer price increases are running at almost 10 per cent. But much of the world has been spared from the misery of runaway price hikes.

Spare capacity and slow growth mean central banks in Europe and North America don't see inflation flaring up any time soon.

Given still high unemployment and weak inflationary pressures, "considerable" monetary policy support should remain in place, the OECD said this week.

EMERGING ECONOMIES

Emerging markets were the beacon of hope in the post-recession years, the driver of global growth as most advanced economies flailed.

That's flipped. The BRICs are slumping. Business and consumer confidence in Brazil is faltering, exports and weaker consumption is denting Russia's economy, India's currency has buckled and China's growth has clearly decelerated from the blistering pace of prior years.

Blame America, in part. Investor capital is flowing out of emerging markets, as the prospect of higher rates make U.S. assets more attractive. That outflow has triggered a slump in emerging-market currencies, boosting market volatility and driving the rupee, Indonesia's rupiah and Brazil's real lower. It has also sparked talk of the possibility of a financial crisis in some countries.

The International Monetary Fund this week warned that emerging markets are now slowing more than expected, saying some risks have grown to the downside. Some economists have cut their global growth forecasts of late – citing a slowdown in markets such as China and Brazil as a chief reason.

Even with slowing growth in many markets, their economic clout remains. Emerging markets' share of global output has grown to more than 30 per cent from 20 per cent in the early 1990s, led by growth in Asia.

CIBC World Markets economist Peter Buchanan said the flood of easy money opened a yawning and unnaturally large gap in growth between emerging economies and developed economies post-Great Recession. "Now we're looking at a more normal gap," he said.

CURRENCIES

The flip side of the surging U.S. dollar is the rout of emerging-market currencies.

They have become the first casualties of the looming end to easy money in the U.S.

Currencies from the Indian rupee to the Brazilian real have lost 12 to 20 per cent of their value against the U.S. dollar this year – a reversal that has already erased billions of dollars of stock market value.

Commodity-reliant currencies, such as the Canadian dollar, have also been pushed lower by the U.S. dollar strength.

Since the Great Recession, credit has been flowing from the U.S. into Brazil, India, Malaysia, South Africa, Turkey and many others, inflating stock prices and currencies.

That all stopped abruptly when the Federal Reserve signalled that it was preparing to begin phasing out years of easy money policies.

"Emerging markets have had a bonanza of capital inflows over the past couple of years," said Mr. Brodeur of Signature Global Advisors. "Those flows have now begun to unwind. The era of free and cheap credit is over."

Worried about capital flight, the BRIC countries (Brazil, Russia, India and China) recently announced the creation of a $100-billion reserve pool to shield their weakening currencies. They said they wanted to guard against "unintended negative spillovers."

But the fund represents a tiny fraction of the trillions of capital now gravitating back to the U.S.

ECONOMIC GROWTH

It's a measure of Europe's nascent recovery that the hot topic at this week's G20 meeting in St Petersburg, Russia, wasn't the euro crisis.

"I want to tell you, at this G20, we were no longer the focus of attention," a relieved European Commission President Jose Manuel Barroso told reporters.

Indeed, the economic news for most advanced economies is finally looking up after five years of recession and stagnation.

Most of Europe is growing again, albeit tentatively. Japan's economy is enjoying a good year and is expected to grow as much as 1.7 per cent this. And China's slowdown appears to be less severe than initially thought.

Gross domestic product growth is Canada remains below potential (up an annualized 1.7 per cent in the second quarter), held back by weakening consumer spending and falling exports.

And, of course, the U.S. is expanding again, buoyed by a comeback in manufacturing and housing.

Mr. Yardeni points to factory activity surveys, such as the JP Morgan Global Manufacturing PMI, as evidence of the improving global outlook. The index rose for a 10th consecutive month in August and now sits at its highest level since January.

But experts caution that the recovery in many advanced economies remains extremely fragile, particularly in Europe and Japan.

Mr. Brodeur of Signature Global Advisors is doubtful that Japan can continue to grow in 2014 and beyond without major structural reforms. And Europe could bump along at near-zero GDP growth for several years, he said.

"Europe is the new Japan," he remarked. "They are four years into a 10-year adjustment process."

JOBS

Scars from the recession linger in the labour market, with unemployment elevated, long-term joblessness prevalent and scores of young people idle.

Still, there are encouraging signs. The jobless rates in the U.S. and Japan are falling (with Japan's a scant 3.8 per cent) and Australia, Canada, New Zealand and South Korea have replaced a good part or all of the jobs lost in the downturn.

Across the OECD, more people are working than last year, although employment levels are still lower than before the financial crisis.

The wounds are stark in Europe. The region's jobless rate remains at 12.1 per cent, a record high, with more than one in four people in Spain and Greece out of work. Even there though, the job losses appear to have plateaued.

It will take years for the region's labour market to repair. Nonetheless, "the welcome thing is that unemployment seems to have stopped getting worse," said the OECD's Mr. Elmeskov. "These days, you become grateful for a little."

Canada's labour market has been healthier than many others, although the jobless rate has stayed at 7 per cent or higher since December, 2008. Young people are still struggling in the labour market, while older workers are faring better.

Joblessness and what to do about it remains a pressing political issue. The OECD this week urged governments to establish training policies and introduce targeted measures for young jobless people, while leaders in the G20 this week said economic growth and job creation are their top priority. "We are united in the resolve to achieve better-quality and more productive jobs," they said. They too, singled out the young as a particular focus.

Global unemployment is expected to near 208 million by 2015, up from 200 million today, according to the International Labour Organization, which is particularly concerned about the dearth of high-paying, permanent jobs.

MONETARY POLICY

Calling the beginning of the end of easy money "tapering" makes it all sound so simple.

It isn't. The U.S. Federal Reserve is headed into uncharted territory as it prepares to start unwinding five years of unprecedented monetary easing in the coming months.

It will be slow, complicated and sometimes wrenching business.

Higher interest rates could suck the air out of everything from home purchases and car buying to business investment – not just in the U.S., but around the world. Stock markets will take a hit as bonds and other fixed-income investments become more attractive.

The tremors of the U.S. tapering will be felt throughout the global economy.

Consider the sheer scale of what must be done. We are talking about trillions of dollars. The Fed amassed a portfolio of more than $2-trillion (U.S.) in U.S. government bonds and another $1.5-trillion in mortgage-backed securities and other assets as it scrambled to save the U.S. banking system and revive the stalled economy. The total value of its portfolio is expected to top out next year at nearly $3.8-trillion.

Step one is to wind down those purchases, now running at $85-billion a month. That process could last most of next year. The Fed has said it won't stop the purchases completely until the jobless rate falls to 7 per cent, down from 7.3 per cent now.

Once the jobless rate sinks to 6.5 per cent – perhaps in mid-2015 – the Fed could begin to raise its benchmark rate, stuck near zero since late 2008, to a more normal level. But what's normal, and how far and fast will the Fed go?

Société Générale's chief U.S. economist Aneta Markowska figures the Fed may have to hike its key rate by more than five percentage points in just two years, starting some time in 2015. That could mean a Fed rate of nearly 6 per cent by 2017.

The final challenge for the Fed will be to then shrink its swollen portfolio, a process that analysts say could take more than five years. Fed chairman Ben Bernanke is expected to reveal details of how that might work Sept. 18.

In the end, many of these decisions won't be Mr. Bernanke's to make. He is expected to leave in January, and his successor – likely Fed vice-chair Janet Yellen or former U.S. Treasury secretary Lawrence Summers – will be in the driver's seat.

An emerging challenge for central banks in Europe and elsewhere, where growth is not as strong, is to keep its own interest rates from getting swept up in the up-draft of U.S. tapering.