The recent dramatic declines in equity markets worldwide are a response to the interaction of two factors: economic fundamentals and policy responses — or, rather, the lack of policy responses.
First, the fundamentals. Economic growth rates in the US and Europe are low — and well below even recent expectations. Slow growth has hit equity valuations hard and both economies are at risk of a major downturn.
A slowdown in one is bound to produce a slowdown in the other — and in the major emerging economies, which, until now, could sustain high growth in the face of sluggish performance in the advanced economies. Emerging countries’ resilience will not extend to double-dip recessions in the US and Europe: They cannot offset sharp falls in advanced-country demand by themselves, notwithstanding their healthy public-sector balance sheets.
The US’ domestic-demand shortfall reflects rising savings, balance-sheet damage in the household sector, unemployment and fiscal distress. As a result, the large non-tradable sector and the domestic-demand portion of the tradable sector cannot serve as engines of growth and employment. That leaves exports — goods and services sold to the global economy’s growth regions (mostly the emerging economies) — to carry the load. And strengthening the US export sector requires overcoming some significant structural and competitive barriers.
What the world is witnessing is a correlated growth slowdown across the advanced countries (with a few exceptions), and across all of the systemically important parts of the global economy, possibly including the emerging economies. And equity values’ decline toward a more realistic reflection of economic fundamentals will further weaken aggregate demand and growth. Hence the rising risk of a major downturn — and additional fiscal distress. Combined, these factors should produce a correction in asset prices that brings them into line with revised expectations of the global economy’s medium-term prospects.
But the situation is more foreboding than a major correction. Even as expectations adjust, there is a growing loss of confidence among investors in the adequacy of official policy responses in Europe and the US (and to a lesser extent in emerging economies). It now seems clear that the structural and balance-sheet impediments to growth have been persistently underestimated, but it is far less clear whether officials have the capacity to identify the critical issues and the political will to address them.
In Europe, risks spreads are rising on Italian and Spanish sovereign debt. Yields are in the 6 percent to 7 percent range (generally viewed as a danger zone) for both countries. Combined with their low and declining GDP growth prospects, their debt burdens are becoming sufficiently onerous to raise questions about whether they can stabilize the situation and restore growth on their own.
Italy and Spain expose the full extent of Europe’s vulnerability. Like Greece, Ireland and Portugal, membership in the euro denies Italy and Spain devaluation and inflation as policy tools. But the declining value of their sovereign debt — and the size of that debt relative to that of Europe’s smaller distressed countries — implies much greater erosion of banks’ capital base, raising the additional risk of liquidity problems and further economic damage.