Fear of Financial Contagion

May 4, 2010

The world recession of 2008-9 demonstrated the interconnectedness of global financial markets and how quickly a localized malfunction can destabilize other seemingly insulated and unrelated areas.  Excessive sovereign deficit-spending and debt are not unique to Europe or the euro area.  Public finances were thrown out of whack in numerous countries by the policy response to a close brush with depression and in some cases like Japan and Greece compounded pre-existing imbalances.  What sets the euro area apart is the self-imposed loss of policy tools to address its problem.  Greece can neither depreciate its currency nor cut interest rates to restore eroded competitiveness and promote a convergence of unsustainably wide current account performances within the euro area.  The only remedies of extreme recession and internal price deflation are self-defeating.  High long-term interest rates are an additional burden on the economy, imposed by jittery investors convinced that Greece cannot escape the predicament without eventually renegotiating its debt or leaving the monetary union or both.

The fear of intensifying similar problems in Portugal, Spain, Italy, or Ireland have hung over continental Europe.  In contrast to America’s housing market implosion after 2006, however, contagion this time has been observed to be confined to the euro area.  Economic activity in most Asian economies has revived briskly, and the United States, Australia, Canada, and Brazil have also rebounded surprisingly sharply.  Because of its sheer size, the United States is critically important to the global economic outlook.  The latest IMF forecast pencils in U.S. growth of 3.1% this year and 2.6% in 2011.  Many private forecasters are projecting growth of 3-3.5% next year, and the Bank of Canada assumes U.S. growth of 3.1% this year followed by 3.5% in both 2011 and 2012.

These upbeat assumptions suggest that U.S. growth can handle any residual fragility in housing, the withdrawal of fiscal and monetary stimulus, and structural labor market weakness that will persist beyond 2012.  They also imply that the United States doesn’t suffer collateral damage from Europe’s sovereign debt crisis as Europe did earlier from America’s housing market and subprime mortgage crisis.  How realistic is it to for contagion to be unidirectional when the United States is concerned?

Market behavior today suggests that contagion has a longer reach.  The rebirth of the U.S. economy has relied upon an old habit, consumer spending that outstrips income growth.  The household savings rate in March was back under 3.0% at 2.7% versus 4.8% just three months earlier.  Workers, who manage to keep their jobs, feel more confident, and most people with asset wealth are much better off than a year ago.

Several channels exists that can transfer Europe’s problem across the Atlantic.

  • Dollar appreciation against the euro is counter-productive in current circumstances.  America doesn’t need less imported inflation or a drop in export competitiveness in products that compete against euro area goods.
  • A weak euro squeezes the dollar-translation value of the profits of U.S. subsidiaries in Europe.
  • European banks especially in Germany and France are heavily exposed to the euro area’s peripheral economies and would suffer badly when the debt of Greece and others is restructured.  Once the sovereign debt crisis bleeds into Europe’s banking system, it takes a shorter leap of the markets collective defensive emotions for U.S. financial institutions to be adversely affected.
  • After a huge run-up between March 2009 and the end of April 2010, U.S. equities would be susceptible to any persistent negative external shock

This rally in U.S. stocks was impressive in terms of its cumulating magnitude of 75% from 677 on the S&P 500 from 677 on March 9, 2009 to 1187 on April 30, 2010.  The infrequency and brevity of setbacks along the way also contributed to a feeling that good times are back.  From 03/09/09 to end-March 2009, stocks shot up 17.9% and followed that three-week advance with monthly gains of 9.4% in April and 5.3% in May.  June 2009 saw the market pause but close at the end-May level for no net change.  In the third quarter of 2009, the S&P climbed 7.4% in July, 3.4% in August, and 3.5% in September.  Again three months of strong appreciation were followed by only a single month’s regrouping.  A 2.0% drop in October was easily retraced with advances of 5.8% in November and 1.7% in the final month of 2009.  The present year began with a significant drop of 3.7% in January.  Hold that thought because January is often a harbinger of the whole calendar year’s performance.  At first, 2010 didn’t seem to fit that norm, because the S&P posted back-to-back-to-back advances of 2.8% in February, 5.9% in March and 1.5% in April.  But volatility picked up late last month and has continued in May.  Today’s sharp decline of 2.5% by 16:30 GMT was triggered by euro-related jitters.

Optimists will rightly say that U.S. stocks are long overdue for a corrective down-move of 10%, if not more, and that it’s premature to say that the scourge of contagion has jumped the ocean.  After all, yesterday’s solid readings in the U.S. manufacturing PMI of 60.4, 0.6% gain in personal consumer expenditures, and 19.8% advance in auto sales has been followed today by much better-than-forecast increases of 1.3% in factory orders and 5.3% in pending home sales.  Time will tell if stocks are in a temporary retrenchment or poised to resume the bear market of last decade.  At this moment, the U.S. economic recovery looks genuine.  My point is that the relationship between markets and real economic developments is two-way.  Equities reflect the business cycle but also can be a factor shaping domestic demand and confidence if struck by an exogenous good or bad shock.  If contagion eventually goes global, analysts may look back on May 4, 2010 — the fortieth anniversary of the Kent State massacre — as the day when that possibility became apparent.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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