Good investors are skeptical by nature. But not usually dour, depressed, or despondent.
These days, however, the worst-case scenarios are awfully dim. There's always something that can go wrong, but in today's economy, the shock absorbers are so worn that minor disruptions could have major consequences. The biggest worry, of course, is Europe, where there's a non-trivial chance that Greece and Italy could both default on their debts, plunging the continent and its banks into an unprecedented financial free-fall. In the United States, bungling policymakers grappling with ways to reduce the national debt could trigger further downgrades in the nation's credit rating and perhaps another recession. Then there's the bursting asset bubble and economic slowdown in China, which wouldn't be that much of a danger if the rest of the global economy were healthy. Unfortunately, it's not.
For many investors, this volatile economic environment has become such a head-spinning mess that they've simply stepped to the sidelines. Doomsday worries have caused an exodus from stocks, even though corporate profits remain strong. That's the kind of self-fulfilling "negative feedback loop" that recessions are often made of. Despite occasional rallies, the S&P 500 stock index is flat for the year, and 10 percent below the peak it attained in April, when it looked like U.S. and European policymakers would do a better job of managing the problems on their doorstep.
In a companion piece, I made the case for three upside surprises that could bring happy returns to investors and give consumers and business leaders a badly needed confidence boost. But these triggers are unusual because they mostly involve political decisions that are unpredictable and could easily break the wrong way. If policymakers fail to heed the better angels of their nature, here are three developments that could send financial markets into a prolonged tailspin.
Congressional failure on debt reduction. The summer deal to raise the U.S. debt ceiling established a 12-member "supercommittee" charged with cutting the $15 trillion national debt by at least $1.2 trillion over the next 10 years. Doing that will require a blend of spending cuts and tax increases that squeamish politicians may be unable to pass. Wall Street is pessimistic. "The 'not-so-super' deficit commission is very unlikely to come up with a credible deficit-reduction plan," Merrill Lynch recently warned its clients.
As the committee's November 23 deadline nears, the markets will likely begin to price in the cost of failure. The biggest immediate problem isn't the debt itself, or any Italian-style difficulty borrowing money. The most pressing worry is the chain reaction of unpredictable events that could occur if Congress fails to arrest the alarming growth of Washington's debt. One possibility is a downgrade in the U.S. credit rating by all the major rating agencies, which would amplify the starter downgrade issued over the summer by Standard & Poor's. That, in turn, could trigger credit downgrades for states and municipalities and for big financial institutions, whose credit ratings typically must reflect the rating of the sovereign nation they reside in. That could worsen debt problems and raise the cost of borrowing throughout the public and private sectors.
This scenario would be something that hasn't happened before in modern times, so nobody's sure how far the damage might spread. Merrill Lynch points out that on the first trading day after the S&P downgrade over the summer, the stock market fell by nearly 7 percent. Since there's now something of a precedent, further downgrades might not be as tumultuous. But if the supercommittee fails to hit its target, then existing law will require $1.5 trillion in across-the-board spending cuts that will kick in starting in 2013. Since those cuts would be indiscriminate, that's considered a far clumsier way to cut the debt than targeted reductions meant to minimize the impact. So Congress might even rescind its own debt-cutting law between now and then—demonstrating a total lack of leadership on the issue. Markets would promptly express their disapproval.
A European meltdown. The recent installation of new governments in Italy and Greece seems like a step forward, but most of the fundamental problems still remain. There's new talk in Greece about abandoning the strict austerity regime the country must adhere to in order to keep getting European bailout money. Italy still faces interest rates on newly issued debt that are close to unsustainable levels. If those pressures persist, and politicians can't come up with some kind of overarching solution, they will break the bonds of the euro zone before long. Forecasting firm IHS Global Insight, for example, pegs the odds of an eventual Italian default at 15 to 20 percent, which is far too high for comfort given the chaos that would ensue if the world's third-largest bond issuer couldn't finance its debts.
With Italy now in the crosshairs, the crisis that has ebbed and flowed for nearly two years may be building toward a decisive crest. Italy has about $420 billion worth of bonds coming due in 2012, and if rates on the new debt it must issue exceed 7 percent or so, financing costs could overwhelm the Italian economy. Italy, like Greece, can still assuage investors, by instituting reforms meant to make its languid economy more competitive. But those are the very types of strictures that voters may reject. So investors willing to gamble on an outcome in Europe have to make bets on political developments in troubled countries, plus the role that the European Central Bank may play and the ability of leaders in France, Germany, and other European nations to keep their own voters behind a unified Europe. There's no smartphone app for that.
Premature austerity. Another risk relating to the debt problems in Europe and the United States is that the cure, if not administered properly, could worsen the disease. There's little doubt that virtually all western countries need to cut spending, pare debt, and repair their balance sheets. But lower government spending reduces economic growth, at least in the short term, and there's a good chance that austerity measures could induce a recession if they're too aggressive.
That has already happened in Greece, where the economy was in such bad shape that a sharp contraction seemed inevitable, no matter what. In the United Kingdom, cuts in government spending are pushing up unemployment and dragging growth down close to zero. Growth throughout the euro zone has been weak as well, and many economists feel a European recession has begun, or will soon. Tougher austerity measures could clinch that, lowering tax receipts and raising borrowing costs for governments even more.
The United States suffers from the same dynamic. Pressure to cut the national debt is colliding with calls to extend costly stimulus measures that expire at the end of the year, including a payroll tax cut and extended unemployment benefits. At the end of 2012, a much broader set of "temporary" tax cuts is due to expire, which would reduce disposable income for the majority of consumers. Politicians may surprise investors, by coming up with deft solutions that boost the economy in the present while paying down debt in the near future. But investors are preparing for politicians to fail. We should all hope they're guessing wrong.