How the U.S. Can Learn From Japan and Sweden

Can equities recover, given the severe losses in the markets and the see-saw volatility we've been experiencing?

Well, Craig Alexander, vice-president and deputy chief economist at TD has looked at the question and determined that while no one can yet predict a bottom, "the key question for long-term investors is whether equities can recover over the years ahead."

In a research note, Mr. Alexander concludes that while the Japanese experience almost two decades ago, in attempting to diminish the problems of its financial system didn't work and led to economic stagnation and deflation,

[the Swedish experience around the same time] 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.

In Japan, a real estate boom created a housing bubble, which popped in 1989. This led the domestic banking system to accumulate billions of dollars in bad loans, impairing their balance sheets. Mr. Alexander said the government response was slow - and it took five years for the bank of Japan to lower overnight rates from 8% in 1990 to 2% in 1995. The Bank eventually took the overnight rate down to zero, but the lower borrowing costs were never passed on to consumers and businesses due to limited lending, leading to economic weakness and deflation.

When Sweden and other Nordic countries experienced a similar real estate bubble in the late 1980s, leading to a 30% correction in the stock market, the government response was to nationalize the banking system to restore its balance sheets. "The successful policy actions eventually proved extremely positive for equities, which recovered all of their prior losses by 1993." 

The economist adds that while he expects that there will likely be a global recession this time around, and even the possibility of a "short period" of deflation, government policy actions should eventually help restore the global financial system.

He said:

First, some governments are injecting capital directly into bank balance sheets. Second, increased liquidity facilities are providing the financial system with additional funds, which helps first to weather the storm and give markets time to sort out the repricing of financial assets. Third, governments are likely to introduce additional  fiscal stimulus packages and easier monetary policy to bolster their economies during times of weakness.

All of this, says Mr. Alexander, is "ultimately good  news for equities, although the Swedish experiences highlights that the recovery could take an extended period of time." As well, he also stresses that the market could continue to experience considerable volatility in the near term, as investors asses the extent of the global recession and the effectiveness of the government policy response.