We all breathed a sigh of relief when Congress agreed to a deficit reduction plan that included an increase in the debt limit - thus avoiding a potential default- but then the stock market fell out of bed. We have seen a decline of over a thousand points in the Dow Jones Industrial Average in just one week. So what happened?
Basically, we are witnessing a re-pricing of asset values to reflect the reality of the liquidity crisis of Europe and a global economic slowdown. It appears the stock market has gotten ahead of economic fundamentals, partly because that is the nature of Wall Street speculators, and also because investors knew Qe2 was inflating equity prices. In a sense, we were having a mini bubble in stock and commodity prices at the same time that global economic growth was slowing because of the burden of historically high national debt levels.
The never ending European country sovereign debt crises pricked the stock bubble. While efforts to refinance Greek debt were underway, it became clear that Spain and Italy were also under pressure, and that several of the major European banks were facing liquidity threats because of the European debt they hold on their books. Now there is broad concern about the liquidity of the European banking system, particularly in France.
It is also true that the European problems were surfacing at the same time that the U.S. economic data was turning south, which puts further downward pressure on stock prices. First and second quarter GDP data were shockingly low, the manufacturing and export numbers dropped for the first time in a while, activity in the service sector also slowed, and consumer sentiment hit an all-time low. To make matters worse, there are increasing signs that growth is slowing in emerging markets and around the world.
The Friday afternoon downgrade of U.S. debt from AAA to AA+ was literally the straw that broke the camel's back. You can fault S&P on the rationale for its decision, but it underlined the political gridlock in Washington, and the fact that the U.S. has a sovereign debt problem of its own. It is not clear how the U.S. and Europe can reduce their debt while at the same time encouraging economic growth. The pickup in growth for the second half has disappeared, and now people are asking if we don't face a double dip recession.
This multitude of uncertainties spiked the VIX, which is a measure of stock market volatility, to over 40. Polls of investors showed that roughly half thought the stock markets would go up while the other half felt we would slip into a recession, and the stock market would go down. We have lost our bearings, unclear about where the economic ship is sailing, and the stock market reflects that meandering aimlessness.
This environment of uncertainty and volatility will continue until we get our economic fundamentals into equilibrium. I will have more to say about that next week.
Jerry Jasinowski, an economist and author, served as President of the National Association of Manufacturers for 14 years and later The Manufacturing Institute.