Wednesday, June 9, 2010

U.S. and Spain – the worst case scenario

North American stock markets are currently directionless, going up slightly one day and down slightly the next. The TSX's performance in the past 3 days is the perfect example of this. On Monday, the TSX ended lower by 64.87 points, while it rose 11.53 points on Tuesday, and fell 66.54 points today.

At this point in the correction triggered by the Greek debt crisis, risk-aversion has driven gold to a record high on Wednesday of over $1250/ounce. In addition, a RBS analyst said yesterday that the likelihood of a double-dip recession has reached 50%. Meanwhile, the US economic research institute ECRI has had its leading indicator index fall to 0, which is its lowest level in 43 years. 

Clearly, investors are waiting for developments that would drive the markets significantly higher or lower. At this point in time, it is worthwhile to take a look at the worst-case scenario for the two biggest factors driving the markets.

Worst-case scenario in Europe

The biggest factor is clearly Europe (and Spain in particular). I have written before that events in Spain will determine the directions of stock markets for the next few weeks. If there is wide-spread bankruptcy among the 45 regional savings banks in Spain, the effect would be similar to the Lehman Brothers collapse in the US in 2008. 

In addition, tough austerity measures are going to spread throughout the entire European Union. The first austerity measures passed in Greece has also been adopted in Portugal, with Hungary being the next country in line. These austerity measures will cut government spending significantly, with the result being slower economic growth for years to come. Thus, austerity measures coupled with a collapse in the Spanish banking sector would guarantee a double-dip recession in Europe.

In terms of the impact of Europe to the stock market, a widespread bankruptcy in the Spanish banking industry would quickly result in a correction of 20% to 30% in North American stock markets. A double-dip recession in Europe would weigh on markets for months after the correction.

Worst-case scenario in the US

In most months since the end of the recession, job growth in the US has been lower than economists' estimates. For example, in May, 41,000 private-sector jobs were added, which was significantly lower than estimates of 139,000 new jobs. With the unemployment rate currently at 9.7%, a prolonged period of 8% to 9% unemployment, which is higher than previous cycles, would cause anemic economic growth in the US.

This would result in lower demand for commodities such as copper, iron and oil, since demand from the US and Europe would be weakened. It would also cause lower Canadian exports to the US and Europe.

The impact of anemic economic growth in the US on stock markets would be a long-term phenomenon. Commodities rallies would be relatively muted, while bull market rallies will be dampened.

Therefore, while US economic growth will have a significant effect on markets in the long term, the outcome in Europe will be clearly felt worldwide in the next few weeks. It will likely either be a vindication of the Spanish banking sector that spells the end of the correction, or a collapse in the sector that plunges worldwide markets deep into correction.

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