Why Markets Will Get Worse Before They Get Better

  • Share
  • Read Later

Hiroshi Watanabe / Getty Images

The market’s big swings are still going strong. Last week the Dow Jones industrial average ended in the negative for the fourth week in a row, as jilted investors continued to pull billions of dollars out of stocks to wait out the storm. The volatile dips are likely to continue, since major threats to the market still loom, which many on Wall Street are loathe to admit: a Lehman-like European bank run, the dissolution of the euro, a sharp slowdown in emerging markets, a double-dip recession at home. Here are some signposts for the pending drop-offs the market is bracing for:

European bank runs and slower growth: Shares of European banks have dropped more than 20% this month, partly due to rumors about France losing its AAA credit rating (all three major rating agencies have since reaffirmed their AAA ratings) and the financial problems of French banks. Those rumors may have subsided, but bigger problems remain for Europe’s banking sector. For one thing, a run on feeble French banks could still be coming, since they rely heavily on short-term financing, which fluctuates with market confidence. France’s heavy savers rely on money-market funds and insurance products, which don’t show up on banks’ balance sheets and leave them vulnerable to credit squeezes.

And what’s causing French banks to appear so feeble? Italian and Spanish debt. If Italy and Spain are forced to restructure their loans, French banks could be forced to take big write-downs on their sizable holdings, which could lead some to collapse. And if politics set back budget-cutting efforts in Italy and Spain, French banks could come under fire. Slowing European growth could also weigh down French bank stocks, since that would leave Italy and Spain with less government income to pay back French lenders. The number to watch in the next few months is the eurozone’s third-quarter GDP growth. If it slows more than expected, as it did in the second-quarter, investors will grow more impatient with all parties involved. U.S. stocks could take a hit too, as crimped European consumers buy less of our stuff. U.S. banks would also come under more pressure, since they hold default insurance on eurozone debt.

Parliamentary bickering in Europe: European markets are also suffering from uncertainty about longer-term euro reforms. Many investors are waiting for Germany and France, the eurozone’s biggest economies, to propose bolder solutions to keep European budgets in check. Those include issuing “eurobonds,” which all members would buy into and backstop, and a bigger bailout fund to avoid future quibbling over who foots the bill when countries get off track. So far, Germany and France have rejected those options, which put markets on edge last week. Instead, they want balanced-budget amendments  or “golden rules” adopted in all eurozone countries. But every parliament across Europe has to agree to those new measures, and that’s going to take time, not to mention more political infighting. As European governments return from August vacations, expect parliamentary quibbling to ramp up and more market jitters to follow.

(MORE: Is Market Volatility Here to Stay?)

Manufacturing slowdown in China: Chinese manufacturers are expecting a slump in exports in the coming months because of squeezed European and American consumers. As growth in Chinese manufacturing slows, so will the wages of Chinese consumers. And that’s bad news for big U.S. companies, which have been banking on emerging market consumers to drive company profits. As much as a third of revenues and profits for luxury brands like Tiffany and Coach already come from emerging markets, especially China. And Deutsche Bank predicts China will make up more than half that industry’s total gains over the next ten years. That’s why a sharper slowdown in China wouldn’t just bad for the Chinese; it would further depress U.S. stocks.

(MORE: Will Chinese Inflation Squeeze U.S. Consumers?)

The Fed’s meeting in Jackson Hole: The Fed’s early-August announcement that it would keep interest rates low until mid-2013 hit investors hard. A similar reaction could be in store after August 26, when Fed chair Ben Bernanke gives his annual Jackson Hole speech on the state of the U.S. economy. In last year’s speech, Bernanke signaled the launching of a second round of quantitative easing, the bond-buying spree that helped nudge skittish investors into riskier assets. Some in the market are hoping for another dose of QE to get markets moving again. But that would be politically difficult, since Republican presidential candidates like Rick Perry have demonized the move, accusing the Fed of “treasonous” money-printing. And yet, without some hint of more help for the markets, investors may lose more hope. Regardless of which route Bernanke takes, market turbulence is likely to follow.

Roya Wolverson is a writer for TIME. Find her on Twitter at @royaclare. You can also continue the discussion on TIME’Facebook page and on Twitter at @TIME.