Despite encouraging signs of progress over the last few months, the U.S. economic recovery remains vulnerable, according to a report released today by TD Economics (www.td.com/economics), an affiliate of TD Bank. "Financial market volatility, Europe's dual banking and fiscal crises, and a highly polarized U.S. Congress have done little to support confidence in this recovery," says TD Chief Economist Craig Alexander. "Yet, despite some massive headwinds, the U.S. economy has proven to be surprisingly resilient."

The U.S. economy has managed to stage an impressive comeback in the second half of the year after supply chain disruptions and rising oil prices contributed to a lackluster opening. Between July and September, the economy grew at an annualized rate of 2%, driven by resilient consumer spending and a surge in business investment. TD Economics projects growth will accelerate to 3.2% in the closing months of the year, in what could mark the economy's best quarterly performance since mid-2010.

That is no small feat given the shock to consumer confidence this past summer. Alexander explains that a disconnect has emerged between actual measures of economic performance – which have been quite positive – and surveys of economic sentiment among businesses and households – which have become exceedingly pessimistic.
 
"A pattern has emerged since the summer whereby economic sentiment and actual data on the real economy have diverged," says Alexander.
 
Alexander feels that in some ways the sense of pessimism may be overdone.  Commercial bank lending has finally turned positive; and thanks to an improvement in credit quality since the last downturn, delinquency rates on consumer and business credit have returned to their pre-recession levels. Job growth is gaining some momentum, even if the unemployment rate remains stubbornly high. And some areas of the housing market, particularly the multi-unit residential sector, are showing flickering signs of life.

"Unfortunately," says Alexander, "these positive developments are being drowned out by rather significant downside risks: the specter of financial chaos in Europe and overzealous fiscal restraint in Washington."
 
Over the last three months, investors' fears over the solvency of the eurozone's most indebted nations have hit a feverish pitch. While Alexander believes the monetary union will ultimately emerge from this crisis intact, he predicts conditions in Europe are likely to get worse before they get better. TD Economics forecasts the eurozone economy to contract 1.2% in 2012.  

A sovereign default in Europe – or worse, the breakup of the common currency itself – could have profound consequences for the global economy; consequences from which the U.S. would not be immune. Though the U.S. banking system has relatively small exposure to the debt of the most troubled periphery nations, a failure on the part of European policymakers to contain the crisis could lead to financial contagion migrating West.

"Europe's policymakers face an enormous task," says Alexander. "Unfortunately, the eurozone's governing structure was not built to take on the kind of extraordinary decisions at the kind of extraordinary pace the situation requires. If Greece were to default tomorrow, it could prove a massive shock to the global financial system if it is not handled in an orderly way, and if European banks are not sufficiently capitalized to uphold investor confidence."

Although signs of increasing economic growth momentum are plentiful, the economy remains no less vulnerable.  "What makes forecasting in this environment so challenging," says Alexander, "is the degree by which economic outcomes have become so dependent on political decisions."
 
Alexander is hopeful that policymakers across the developed world will ultimately act in ways that support the recovery, rather than detract from it. However, he warns that even without the political risks, a relatively deep recession in Europe and spending cuts already passed by Congress will present a significant drag on growth over the next two years.

TD Economics forecasts economic growth to average 1.9% in 2012, which is little different to the performance of 2011. The economy should accelerate to 2.3% in 2013. The unemployment rate is expected to remain elevated at 8.8% by the end of next year, and 8.4% by 2013.
 
The complete findings of the TD Economics report are available online at: http://www.td.com/document/PDF/economics/qef/qefdec11_us.pd