The crisis in Europe is weighing on U.S. economic confidence, but healing in the U.S. housing market is a glimpse that better economic times lay ahead, according to a report released today by TD Economics (www.td.com/economics), an affiliate of TD Bank, America's Most Convenient Bank®.

"The escalation of the European sovereign debt crisis has injected new fears into financial markets and is contributing to the slowdown in hiring and investment," says TD Chief Economist Craig Alexander. "However, while Europe gets the headlines, there's been an undercurrent of good news in the U.S. with the housing market entering the early stages of recovery. This is a major reason for optimism over the future pace of U.S. growth."

TD Economics forecasts U.S. economic growth to average 2.1% in 2012 and 2013. The unemployment rate is expected to edge down to 8.1% by the end of this year, improving gradually to 7.7% by the end of 2013. 

The European sovereign debt crisis has been a mainstay of TD Economics' forecast for more than a year. In March, a short reprieve from the crisis was granted as Greece successfully negotiated a debt swap with private bondholders and the European Central Bank injected a new round of liquidity into the banking system. Unfortunately, the good news proved short-lived.
 
"As fears over Greece have been replaced by fears over Spain and Italy, the crisis has heated up again," notes Alexander. "Its impact is visible in financial markets where riskier assets, such as stocks and high-yield corporate bonds, have been pummeled."
 
Meanwhile, global investors have sought the safety of U.S. Treasury bonds, sending the dollar up and government bond yields to new historic lows.
"The heightened global angst and deterioration in financial conditions since March have had a significant effect on confidence in the U.S. economy," says Alexander. "The uncertainty has led businesses to be cautious about investing and hiring new employees."

The other storm cloud on the economic horizon is the self-imposed fiscal cliff –the combination of tax hikes and spending cuts that is set to take place at the start of 2013. The total impact of current legislation is a hit to real GDP of close to 4%. In an economy struggling to grow by 2%, this runs the risk of derailing the recovery.

TD Economics expects Congress to act to remove roughly two-thirds of the total fiscal drag. Still, fiscal drag is expected to cut 1.5 percentage points from economic growth in 2013, with most of that falling in the first half of the year.

"There is every reason to believe that Congress will act to avoid the catastrophic hit to growth that is currently written into law, but it is becoming increasingly likely that this will have to wait until after the election in November," says Alexander. "Meanwhile, the policy uncertainty will have a negative impact on spending, investment and hiring."

Despite the threats posed from Europe and domestic fiscal policy, there is relative improvement in the one area of the economy that most needs it – the housing market.
 
"There's growing evidence that home prices are stabilizing across the country," says Alexander. "After several years of subtracting from economic growth, the housing market is now providing a modest lift."

The key impediment to faster growth in the housing market is the level of shadow inventory of distressed sales. Judicial backlogs are slowing the clearing process in certain states like Florida, New York and New Jersey, but there is evidence of progress in some of the worst hit states of Arizona, Nevada and California.

"Working through the foreclosure inventory is likely to take another one to two years, but the light at the end of the tunnel is becoming brighter," says Alexander.

As housing conditions normalize, the vicious cycle will become a virtuous one. The more people get mortgages, the more home prices stabilize, and the less risky lending becomes.

"We expect the improving U.S. housing market to become a dominant theme by the second half of next year. This will cause economic growth to push higher, and it'll finally start to feel like the U.S. is on its way to recovery," says Alexander.

TD Economics provides analysis of global economic performance and forecasting, and is an affiliate of TD Bank, America's Most Convenient Bank®.

The complete findings of the TD Economics report are available online at (http://www.td.com/document/PDF/economics/qef/qefjun12_us.pdf)