Is a global recession on the cards?

The Shanghai Index ended down about 7.6% today while the European market and US futures are showing a rebound.

The view of most economists is the market is oversold and the economic fundamentals are not as bad as the magnitude of the selloff. This plunge will allow valuations to return to fundamentals.

Most economists seem to be looking mainly at the US market where the fundamentals are moderately strong. The numbers have been consistently getting better and corporate America has strong balance sheets.

When we look at the Global economy, the story looks quite different. For many OECD countries, house price to income ratios remain above historical averages. The initial rout we see in the current stock market has not hit the more illiquid asset classes like property. If all asset prices fall, the wealth effect from inflated assets will fade. This can lead to a further reduction in demand and a recessionary cycle.

The other issue is that central bank tools may no longer be as effective in revert a crisis. Interest rates are at historical lows and in some cases in Europe even negative. This form of government intervention has helped in artificially elevating asset prices but not done much for the real economy. Fiscal policy requires financial muscle and the deficits in many countries refrained the governments there from using those tools. Central banks do not have many more tools left on hand to contain a fallout. Thus, making a Global recession more likely.

The China slowdown story is one that everyone is familiar with. So one may ask how can the slowdown cause a global recession. In the last financial crisis, America was falling apart but it had China to help pull global grow along. Today, global growth is faltering, China GDP levels have fallen to around 7% with further drops expected. If a massive slowdown occurs, America is unlikely to have enough traction to be able to move the Global economy along. Although at best in a global recession, it may not be as heavily affected.

In many markets, housing prices are still red hot. Economic cycles can take a long time to develop. We will see in time if the current stock market rout is just a mere dip or more.