Equity markets will likely recover eventually, but it could take a long time, and markets will probably remain quite volatile in the short term, says TD Economics in a special report.

TD reports that global equity markets have suffered a severe correction, down 34% on the Canadian S&P/TSX and 40% on the U.S. S&P 500 for the 52-week period ended November 12. “This dramatic decline in valuations amid concerns about a global recession has led to speculation about the ability of stocks to recover. Investors worry about a repeat of Japan in the 1990s and early 2000s, when a protracted period of economic stagnation and bouts of deflation led to extended weakness in equities,” it observes.

“While there are some disturbing similarities between Japan’s economic and financial crisis of the last decade and the problems today, there are also key differences that suggest global equities could avoid replicating the Japanese experience,” it says. The main difference being how governments and central banks are responding to the current financial crisis, having learned from what happened in Japan.

Even so, while the authorities may be doing the right things, the policy response could take many months to be fully implemented and cannot prevent the weakening in the global economy, TD says. If the policy actions have their desired impact, and TD Economics believes they ultimately should, the near-term economic recessions and weak inflation environment should pass in late 2009 or 2010. “Although the recovery could prove drawn out, as credit conditions might improve only gradually, the outcome would be positive for equities,” it adds.

“The Japanese experience shows what could happen if the government and central bank policy actions fail to diminish the problems in the financial system – the outcome would be economic stagnation and deflation that would likely prevent a recovery in stocks. However, the Swedish experience highlights that an eventual economic recovery and a rebound in equities should occur if the balance sheets of financial institutions are repaired in a relatively timely fashion,” TD says.

“With respect to these two potential scenarios, we believe there is likely to be a global recession and the possibility of a short period of deflation, but the government policy actions should eventually help to restore the global financial system,” it concludes, thanks to capital injections into bank balance sheets, increased liquidity facilities and additional fiscal stimulus packages and easier monetary policy.

“All of this is ultimately good news for equities, although the Swedish experience highlights that the recovery could take an extended period of time. It should also be stressed that markets could continue to experience considerable volatility in the near term, as investors assess the extent of the global recession and the effectiveness of the government policy response,” TD concludes.

IE