BRUSSELS ― What if everything suddenly got really, really bad?
What if, instead of getting respite after years of pandemic, war, terrorism and, most recently, global IT paralysis, it all just kept getting worse?
Because in the past few days a wave of volatility has engulfed the world’s financial markets. It could mean nothing ― or it could mean Armageddon.
You can read POLITICO’s more sober explainer of what it was all about here.
But it got us thinking: What’s the worst that could happen?
Given that if a pessimist meets an optimist, the former says, “things can’t get worse” and the latter replies, “oh yes, they can,” POLITICO decided to talk you through how the wheels could fall off the bus.
And how the bus then explodes.
With you still in it.
(Warning: The majority of the analysts we talked to do not see the most negative outcome as the likeliest, but they were kind enough to paint for us ― and for you ― the worst-case scenario.)
Patient Zero
For now, the volatility has been limited to the world of finance. Stock exchanges are often prone to overreact in August, with U.S. job market data driving their downs and (less dramatic) ups in the past few days.
But market tremors can be an omen for trouble in the real economy — the world of factories, jobs and goods and services — with consequences for regular people in Europe.
Although the current consensus is that recent turmoil is due to what the wonks dismiss as “seasonal technical factors” rather than any impending economic crisis, there are some signs things are starting to wobble.
JP Morgan and Goldman Sachs have increased their probabilities the U.S. economy will slip into a recession by the end of the year to 35 percent and 25 percent respectively.
That would be bad news for Europe, which relies on demand from American consumers to purchase products manufactured on the continent.
America sneezes, Europe catches a cold
“If a recession happens in the U.S., it’s very likely that Europe will also go into recession,” Ken Wattret, chief economist at S&P Global Market Intelligence, said. He doesn’t think it’s a likely scenario, but the case cannot be ruled out.
For much of the year, attention has focused on whether U.S. policymakers and the country’s central bank, the Federal Reserve, will pull off what economists call a “soft landing.” That means that despite having hiked interest rates, which usually slows the economy down, the overall economy would keep growing without a recession.
Optimism abounded. GDP — the overall value of the economy — expanded at a healthy rate and stocks powered higher. And Europe has largely followed the same trend despite inflation falling a little less slowly than hoped, and growth being lower and uneven.
But investors are wondering if the U.S. economy is slowing, while a big package of fiscal incentives are fading. The Fed is expected to lower interest rates (and give more juice to the economy) in September. The risk is that the central bank has acted too late.
That is bad news for European industry which is already suffering, with manufacturing sectors underperforming. Germany, in particular, the economic powerhouse of the continent, has reported a set of not-so-healthy industrial readings and its economy even started to shrink.
Goodbye to Berlin
“Germany would probably be the most vulnerable to a hard landing in the U.S.,” Franziska Palmas, senior economist at Capital Economics, said. “Exports account for a larger share of its GDP. And a significant increase in exports to the U.S. has been compensating for reduced exports to China, especially cars, in the past few years.”
How does this work? Well, less money in Americans’ pockets means less spent on German goods — and that means another blow to Europe’s largest, and already ailing, economy.
As a consequence “Germany would not get out of this stagnation,” Carsten Brzeski, ING bank’s global head of macro, said.
The contagion spreads
But it doesn’t stop at Germany. Several European economies, from small export-oriented ones like Austria and Denmark, to western Europe’s largest nations like France and Italy, would be hit by an American slowdown.
And the effects would go far beyond trade, warned S&P Global Intelligence’s Wattret.
A big reaction in financial markets, particularly in equity markets ,“can have a very negative impact on confidence, both in the business sector and in the household sector,” he said.
Then come the exchange rates. To tackle a recession “it’s quite likely that the Fed will end up cutting interest rates very aggressively, and that combination of economic weakness and shifting interest-rate differentials is likely to mean … Europe’s currencies will appreciate, so you have a combination of adverse shocks,” he said.
Politicians like headless chickens
EU leaders don’t have a good track record in predicting financial crises, especially ones that comes from the U.S., with a widespread habit of underestimating its potential impact on this side of the Atlantic. Remember Lehman Brothers?
“They normally say, well, this is not an issue for us … then three to six months later, we all find out that we cannot escape,” ING’s Brzeski said.
A U.S. recession would make the European Central Bank’s already “too optimistic” forecast for growth “obsolete,” he said.
But, he said, if ECB chief Christine Lagarde were asked about the consequences of U.S. rates’ “hard landing” she would still reply by saying “we have a strong domestic economy, we are independent, and we stick to our forecasts.”
And, he added, “of course, this has never been true.”
EU governments also have limited tools to react to financial troubles, being forced to re-invent European self-defense equipment whenever each crisis strikes.
So your doomsday recap …
The U.S. enters into a recession, Europe follows, staying in a recession at least until mid-2025, and EU governments will start to … just discuss what to do.
Brzeski predicts new fuss about national spending rules, and debates on how to tackle the economic troubles.
Then there’s the mounting debt piles in some of Europe’s biggest countries — France and Italy first and foremost — which remain unlit powder-kegs, but which could go off if a 2008-style crisis were to return, raising the prospects of bailouts of entire economies.
That’s the point where you can wake up in a horror movie …
Oh, and one other thing
Another potential source of economic carnage is a little bit more arcane.
Japan’s central bank had made borrowing in the country very cheap. But now things are reversing.
A truly staggering amount of money — as much as $1 trillion worth of yen, according to investment research firm TS Lombard — was borrowed by investors. Some of that money went into European stocks, and now that debt needs paying off.
There are indications that more rate increases from the Japanese central bank are coming, which means that this kind of disruption to financial markets is likely to continue, according to S&P Global Intelligence’s Wattret.
“We’re moving into a period that we haven’t been in for decades,” he said. “We should still expect conditions to be more volatile going forward. It’s going to be a bumpy ride.”
In a worst-case scenario, a sell-off in European stocks to pay back debt in yen could drive down asset prices in Europe, and that in turn would impact investment in the real economy.
The ongoing slowdown in China — another big buyer of European goods — then risks turning that cold into a full-blown flu.
But cheer up …
… it might never happen.
