Fear of recession/depression begins to stalk world equity markets

The last two days have been a period when the recent political turmoil in the euro zone and the sovereign debt crisis finally came home to roost in world equity markets. Over the past two days we have seen heavy falls with the Dow Jones Industrial Average falling by around 500 points. You might reasonably ask why markets which are supposed to be rational had not picked up on these facts and issues before, after all they have hardly been a secret. But the truth is that markets often progress in their own what I call “thought bubble” until they reach some sort of tipping point and are shaken out of it. World equity markets had been (happily) following forecasts of world economic recovery and improved individual company performance until three things impacted on them.

1. Officials and regulators began to impact on their zone of interest. For example the ban by Germany’s regulator BarFin on naked short-selling. In itself this was a small issue as professional investors will simply go offshore but the principle is more important. The US Senate vote on the IMF (to restrict the IMF’s ability to help countries who’s national debt exceeds 100% of its GDP) would have troubled them on two counts. The first is the 94-0 vote, after all you probably couldn’t get a 94-0 vote on a motion saying apple pie is nice! Also as this is an issue the US Senate has no power to decide on anyway, grandstanding by politicians is the face of a crisis is a continual theme at the moment.

In such a time even what I would call “favourable” official intervention such as the reform bill for the US banking sector passed by the US Senate last night gets an unwelcome tinge as it comes at the same time as other less well thought-out moves. This is something of an irony as the US banking sector badly needs reform as do many others around the world and this bill is a step along the way.

2. The increased number and severity of the austerity plans in Europe have made investors wonder about the prospects for world growth. Here we have one of life’s conundrums what is good for one country individually may not be good if several or more do it. A particular trigger here I think has been Spain’s passing of her 15 billion Euro plan to improve her public sector finances and the likely impact of this on her economic growth prospects. For example they are wondering what the impact on Spain will be of a planned reduction in her fiscal deficit from 11.2% of GDP in 2009 to 6% in 2011 on a country which already has 20% unemployment. We have already seen the beginnings of a severe austerity plan for Greece but Spain is a  larger and more systemically important economy and we are expecting austerity plans in Europe from other countries for example the UK on June 22nd and also France and we have already had one from Portugal. Just to really add to the mix at a difficult time Germany is proposing the following for euro zone countries.

Failing to comply with deficit reduction means temporary loss of EU Structural Funds.

Possible irrevocable loss of EU Structural Funds.

For serious budget failure voting rights in the European Council could be withdrawn.

 As a last resort, a managed insolvency proceeding for bankrupt states

Just to put this into perspective one might expect Spain’s austerity plan to knock around 2/3% off her economic output over its period.

3. Currency markets have got more and more volatile with quite extreme short-term movements and rumours of central bank intervention abounding. If you look at the action of the Euro over the past week there have been some extraordinary movements. A technical analyst (chartist) friend of mine contacted me on Thursday to say that he expected a short-term bounce in the Euro from 1.2130 against the US dollar and that the bounce would reach 1.245/1.25 and could go as far as 1.27. Ordinarily one might expect days for this to happen not about 3/4 hours for a sharp rally! Well played to him by the way. As to my view on this rally it is quite possible that central banks have intervened but also I have seen many other sharp short-covering rallies of this type where central banks were not involved.So far in its existence the European Central Bank has officially intervened in currency markets three times. There is a  phrase for this in financial markets and it is called a dead cat bounce. But other currencies including the Australian Dollar have been caught up in this and bring it closer to home so has UK sterling.

4. There is a fear that goes as follows. The banks of the world have been bailed out by sovereign government’s at great expense.This  when combined with the credit crunch recession has led to some governments particularly peripheral ones in the euro zone feeling the strain. They are now in effect being bailed out by the prudent countries of the euro zone. This leads to the question what about the prudent ones are they being destabilised by this?

4. Something odd has been happening in government bond markets which for anyone which analyses it is another sign of fear and uncertainty. Let me explain what has happened. I have written before about this subject with reference to Germany but it has carried on for example Germany’s ten-year government bond yield closed last night at 2.68% down from an average around 3.1% before this crisis accelerated. Another example of this has been the US Treasury bond market (or government debt) where here ten-year yields were at the beginning of this month 3.91% and are now 3.26% and also the UK where our equivalent yield was 3.91% at the beginning of this month and is now 3.53%.

If you remember this is the same US government which is the world’s largest debtor (and acclerating) and the same UK government which has not addressed its own fiscal deficit. You might quite reasonably feel that Greece has in a way been unfairly treated in the way her government bond yields shot up for not entirely dissimilar reasons and in a way you would be right. Fear, risk aversion and flight to (perceived) quality make for some strange bedfellows and not entirely rational results.

An irony is that economists use long-term bond yields in their equations so on their own these moves would be seen as something likely to improve economic growth. Of course in the current situation nobody is focusing on or really believes that, but as a stand-alone feature it is still there.

The truth is that long-term bond yields at these levels are exhibiting a fear of further recession and possible depression. That is what is contributing to the problems in equity markets. If you look at anything else none of these yield levels are justified. Let me turn the question around and ask you to consider the United States. Exactly what economic scenario would make you invest for ten years in her government bonds for a return of 3.26% per year? You might be thinking along the lines of one or two members of the US Federal Reserve who have been muttering about deflation again according to the official records. Yes that same deflation that all the official intervention was supposed to have saved us from…..

6. Something disturbing appears to be happening in China. Yes this is the same China who’s surging economic growth is supposed to help rescue us all. China’s major stock market indices appear to have entered bear market terrain and there is no great confidence that air can be let out of the property bubble/froth gently. I have been asked about China before and have not fully responded because I have no great confidence in individual figures and statistics from there but I think there has been enough news to venture the opinion above.


What has happened over the past couple of days has highlighted the fear and uncertainty that surrounds world investors at this time. Now markets ebb and flow and we will see rallies and falls but the uncertainty will remain and I think will continue to trouble investors. There has been a loss of faith in official bodies and their ability to influence events just as their expenditure and exposure has reached a maximum and this is not a good combination. There have been some odd and unexpected corollaries of this. For example examined on its own merits I would have expected UK government bond yields to have risen and not fallen over this period. So we have had an exogenous influence of enough fear and risk aversion to counter-act this.

I have recorded themes of the past few months of moral hazard and political grandstanding and these if anything are getting worse in my view. For example point 4 above is full of moral hazards. In terms of political grandstanding somebody commenting in the Financial Times referred to a quote by Albert Einstein which I believe sums up the situation and poses an intriguing question.

The definition of insanity is doing the same thing over and over again and expecting different results

I hadn’t thought before reading that of questioning their sanity.

As to today there are plenty of significant events to come. There is the vote in the German Bundestag on the Greek rescue package and also an Ecofin meeting of European Finance Ministers. After all European news at a weekend to give a market rally makes me think of groundhog day! But whilst I do not know what these events will imply I do know that the themes above will still be there at the end of today.


22 thoughts on “Fear of recession/depression begins to stalk world equity markets

  1. Worrying times, Shaun.

    “But the truth is that markets often progress in their own what I call “thought bubble” until they reach some sort of tipping point and are shaken out of it.” So true, more these days than ever before. This must be particularly so with the UK Gilt market at present, and most of all relevant to persistently and continually rising UK inflation? Why knowingly invest in a potential net value loss?

    • Hi Drf
      I was going to do a full analysis of the UK gilt market today and link it with the public finance figures. There is quite a lot to say on both and it is true to say as I hinted at in my article of today that just looking at the gilt market in isolation would lead one in the wrong direction as its own “thought bubble” has been swamped by the tailwind of world events. I still believe that UK conventional gilt yields will go higher but over the early part of this year I thought this too and the truth is that so far they have gone lower!

      However events overtook me and I wrote on another subject because right now the UK gilt market is something of a sideshow..

      • Thanks Shaun. As always you are amongst those most aware of the present realities. I fully understand how events “overtook you”. They have moved on again today of course.

        I wondered whether you might sometime later give us your considered opinion on the base of present Western fiscal problems? You have observed the toxic mix of Capitalism and Socialism as playing a significant part in it all. However, I wondered what your opinion was of where the real wealth which has effectively “vaporized” from the West, causing most of the current difficulties, has actually gone? Now of course, some has been due to the fractional reserve banking system, and so has been a matter of confidence rather than any true loss of real wealth value. Some has without doubt been redistributed to China and other Eastern countries.

        However, there has been a “flow” of other wealth out of the West, a significant part due to serious derivative value losses. When some lose in these things, there is always someone else who gains, except where apparent value losses are not losses of real wealth at all but of only a fall of confidence relative to perceived but unreal wealth. Real wealth is not destroyed but only transferred.

        So, in terms of the bank bail-outs, QE and total Western government borrowings, to where has the “lost” real value migrated? Difficult to quantify accurately I know, but in terms of the real net flow, where has all this supposed wealth value now gone, and who now holds it? There’s something of a quandary for you.

      • Drf,
        Do you really believe there is any significant ‘real wealth’ left? By its very nature doesn’t that rely on a finite and quantifiable resource? What we see now are governments using their own ‘Chaos Theories’ to justify their own sub prime investments, all in an attempt to keep a deeply flawed system in place. Even this ‘economic’ blog can’t escape the significance of interference by the political class and its impact. Course turkeys don’t vote for Xmas! Real wealth these days seems to be wrapped up in so much chicanery and smoke and mirrors as to be almost immeasurable. Maybe we need to redefine the term?

      • Hi Mac, I do indeed believe that there is significant real wealth left. As I mentioned in my comment, real wealth is not “normally” destroyed, but only transferred. The exceptions are in circumstances such as natural disasters or wars, where real wealth value is actually destroyed and lost. We must remember that money is a token of real wealth, and thus represents it.

        However, in cases such as losses in derivatives, one entity looses but another gains, and can gain massively due to any leverage. So, I feel that the present economic and fiscal difficulties have been caused principally by significant flows of real wealth value, impoverishing some, but enriching others. However, like many others I do not fully understand the detail of these real wealth flows in their terms of their destinations and algebraic values.

        For example, a number of banks lost large amounts of wealth in derivative trading which turned against them, and became insolvent as a direct result. Politicians then decided to use Public Funds (mostly instantly created by debauchery) to bail out those banks so as to rescue them from insolvency. Thus public money flowed to these banks and on to those making large profits from derivatives, and government debt was increased. Who now holds these profits? If they are in the UK then there is no resultant outflow of wealth, but if they are not in the UK then there probably was.

        • Hi Mac and Drf
          So the nature of wealth,capitalism and socialism in one go, you are not slacking between you!

          As to initial thougts I have one for each area. As to the capitalism/socialism debate I think that the world has got bogged down by political elites ( as in the main they are of low quality I dislike the world elite for this purpose). For example if you look at the EU and the Euro it does not matter in this sense if you are for or against, the reality is that those in charge have pursued their ends incompetently. Nearer to home we have had the HIPs debacle where politicians move on with no effect on their career but now people who have gone through training in this area will lose their jobs and have wasted their money on qualifications which have no value. Indeed the whole objective may have been worthy but the reality never remotely matched it and was again incompetent.

          In a way the paragraph above affects wealth to as you could argue that a qualification is part of “human wealth” as in ones own skills and abilities. But in this area I am reminded of UK Index linked gilts. About two years ago I made some investments in this area and as an aside I suspect readers of my blog will have bigger surprises than that today! I started to follow regularly the price movements of them and focused on the longest dated one which stretches out to 2055. This was for both professional and investment purposes. What I found over some of the period was what I thought were extraordinary price movements. On a price which last night closed at 125 just to give readers an idea of scale it was at times moving by 4 or 5 points in a day. For those unaware of this type of investment it guarantees you a real return as it’s capital value is indexed to the UK Retail Price Index plus some interest on top.

          This particular bond offers inflation linked returns out to 2055 so to my mind it should be the most stable investment one can have. From time to time perspectives change on inflation and other issues such as alternative investments but if you think of a 45 year timescale even the credit crunch period may for once justify the use of the word “blip” which is much misused in other economic concepts.

          So when what should be the most stable asset for someone in the UK is that volatile I think that it means that measuring wealth is a lot harder than one might initially think…

      • Drf:

        When credit is cheap real wealth can quickly be destroyed.

        Say person X a perfectly good TV with a repairable scratch.

        Person X throws it away and replaces it with a new one on cheap credit.

        Saver Y (lets say they build TVs for a living) saves the extra revenue from the sale to X.

        Well you can see where this is going. Even if saver Y gets the repossessed TV (or the benefits from its resale) they will get a fraction of the “wealth” they created and saved.

        In reality saver Y gets either a broken savings bank, or a very low rate of interest from a bailed out bank.

        From another angle I believe that corporate buyouts can destroy wealth. The good staff usually leave to form their own companies (they keep the wealth that the stock-holder of the merged company thinks he owns) and the resulting disorganisation doesn’t show up in the companies figures until next year. Meanwhile the new debt loaded onto the company shows up on the balance sheet, but analysts say that this is a sensible ratio “in these days of cheap credit”.

        Either way, the real wealth was lost or transferred long before the crash.

  2. Hi Shaun
    As a novice to economics I, like a lot of others, were drawn to the subject by pure self interest following the crash of 2008.Whilst at this stage I have nothing meaninful to contribute(save I believe we are on the precipice of an almighty depression) I would like to thank you and the other regular bloggers on this site for an excellent summary and comments on current economic events-it beats any other site I have seen hands down.

  3. I also want to thank you for your lucid analysis, that i have been following for some time now. Even though my ideas differ from yours, you are one of the very few commentators on these matters who not only have a wide enough view of things, but can also express it with flair. You never make for dull reading, and that’s more than what can be said for almost all other analysts.

  4. Firstly, thanks for all your efforts; I’m a regular reader.

    I like your idea of the “thought bubble”. I’ve never heard that term before but, as an ex- bank trader myself, I know exactly what you mean.

    I can’t argue with you over your logic about the recent movements in US bond yields implying a recession/depression scenario…except to say that such moves are, as you would well appreciate, often themselves subject to this “thought bubble” concept and could just as easily evaporate – markets think this one minute and something else the next.

    As for China: for what it’s worth, I live in China and teach economics here. I have little confidence that the property bubble will end well (that’s just my reading of the situation – I guess we’re all going to find out soon enough).

    • Hi Geoff and welcome
      My geographical spead is widening and is much wider than I think I conceived of when I began. I was being quoted the other day on a Spanish university economics website which as I have discussed/analysed Spain is not so unreasonable but then I was being used as a source of material in Bulgaria! Google translate helps but on specific issues often isnt very clear…. Altho’ a reader has a Bulgarian assistant who he is going to get to translate for me. Then I noticed one day last week quite a few people accessing my articles on Greece and Latvia…

      On wordpress I can only track back a very limited section of what comes in so it makes me wonder from where else visitors come from so thanks for coming out of “lurkdom” and letting me know I have reached China.

      Any thoughts on the Chinese economy would be of value…

  5. I too am a regular reader but from Wiltshire, UK (not so exotic although my daughter worked for 4 years in Beijing and filled me in on a lot of what was happening there). I too started to follow events at around the time of the credit crunch. Although not an economist I began to suspect a housing bubble as long ago as 2003 when my house started to “earn” more than my own then very modest salary!

    Surely (in response to Drf above) wealth depends on cashing in one’s assets and depending on sentiment can evaporate into thin air eg until I sell my house/shares etc and put the cash in a deposit account in the bank I don’t actually own the wealth. One minute my house/shares etc can be worth £x and within the space of a few mins/weeks/years worth much more or much less on paper.

    Assuming the bank doesn’t go bust and/or the currency become worthless then cash is king and wealth depending on the assets one owns can be illusionary.

    • Hi Janet, in “eg until I sell my house/shares etc and put the cash in a deposit account in the bank I don’t actually own the wealth”, I would suggest that you may be confusing real wealth with money? Whilst you own a house you own real wealth, but what that may yield as money at any particular time varies. For example, inflation will erode the value of the money which you have converted your house into, but if anything inflation will tend to cause the value of your house, before you converted it into money, to increase, partly because the cost of building such a house will increase with rising costs due to inflation.

      So although cash is king in a sense and at certain times, where you have criminally-minded and amoral politicians cash may easily be debauched by them, whereas real wealth may not. This I would suggest is the intrinsic difference between real wealth and money; money is only a token of real wealth, but is more convenient in advanced economies because it avoids the compulsion to barter. It is surely for this reason that many have recently been converting their wealth into gold, as a hedge against inflation?

  6. Isn’t one of the real problems the fact that we now index house prices as a marker of national wealth. This would seem to explain why the needed correction has not been allowed to happen.
    I lean much more towards Mr. K’s Zimbabwe/Singapore analogy where real wealth is measured in the resourcefulness, skill and humanity of the people.

  7. Geoff.. just how badly could China’s real estate bubble end with China’s nearly $3 trillion in reserves ? For me, the real estate bubble would be little more than a speed bump.. perhaps a third of their savings at worst ? Thanks..

    As for the socialism/capitalism debate, I see merit in both, but perhaps there is a middle path ? In all societies, the issues of wealth and poverty are daunting, causing hunger, revolutions and rivers of bloodshed. Socialism’s answer is for the state to tax and simply redistribute it to those who are at or near the bottom, irregardless of whether or not they are employed or even making an effort in life. Capitalism’s main fault lies in the over rewarding of the talented and successful; how many times have we seen $23mm/yr CEO’s order benefit cuts to their $8/hr employees ?? If I were made Imperator Walt I of America, one of the first things I’d do is to enact a Fair Wage Act, whereby in any company that has ten or more full time employees there can be no more than a 5-1 wage disparity between anyone in the company, including all benefits. I would also have a low tax, small government that simply cannot to provide for tens of millions of problem children. Third, I’d make it so no government entity at any level would be able to borrow or incur implied debt of any sort.. ie.. force government to learn to live within their means. Fourth, any tax increase of any aort must be approved by a 3/4 vote OF THE PEOPLE.

    • Mr.K,
      There would seem to be one overriding major flaw in any of the political systems we are talking about. That is none take into account human failings. We seem genetically imprinted to adopt hierarchical almost feudal systems in all of our structures and that leads by necessity to a ruling elite. At the moment we kid ourselves we control that elite by the ballot box as we ‘lend’ them the necessary powers of supervision and direction. That lends itself to a ‘get out clause’ for any of them by way of the transitory nature of their tenure and the fact that they are in the main abstract from the repercussions of their decisions.
      If we can see correlation between our present financial difficulties and decisions made by our political class then we have to call into question the very nature of the whole system as it can be equally applied throughout. How can a political system which owes more to 19th century philosophy oversee, say, financial services which have to be cutting edge and in a context unthought of before?

  8. Mr Kowalski, thanks for your question and for the opportunity to clear it up. China’s foreign exchange reserves are not, as is so regularly and wrongly reported, “the savings of the Chinese people”. They don’t represent anyone’s wealth and can’t be used for anything except for external shocks. The FX reserves are, if you like, an illusion – yes, a $3 trillion illusion – and are merely a by-product of the FX mechanism in China:

    The Chinese central bank buys USD from all sellers and simultaneously borrows RMB out of the local banking system. The central bank then buys USD assets. The central bank thus has a USD asset and an equal-and-opposite RMB liability. The FX reserves are thus little more than an accounting entry at the central bank: the mother of all cross-currency swaps.

    The “wealth of the Chinese people” is not in US treasuries but in RMB and, latterly, in real estate investments that are under a cloud.

    • Geoff,

      thank you for the info. But are we supposed to infer that China does not have a printing press? (they invented ink, didn’t they) And if they do, and my sense is that not only they have aplenty, but they have not been averse to using them either, who cares about any balance between FX reserves and RMB

      • … continuing what my computer sent off without my consent …

        Following Drf’s logic, the wealth of the Chinese people is in tangible assets, their manufacturing capacity and the legitimacy of their government. RMB and FX reserves are, to paraphrase Mao, just records in computers.


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