With growing uncertainty surrounding the European debt crisis, and the contagion spreading to much larger sovereigns, such as Italy, we now see risk aversion back on the table. US markets are down over 3%, the headlines seem to be getting progressively worse and many fear that the situation could deteriorate much further — giving up much of the gains achieved in October.
Growing concern as market whipsaws
This kind of volatility, both up and down, is historically an indicator of very large market moves. With the bias largely negative, it seems that a market crash could be coming if no resolution is found for the EU debt implosion. Alternatively, should a large scale bailout ($2T+) occur, we could see a significant rally, especially within precious metals spot prices and miners.
For investors and traders, this type of price action is stressful. Seeing fluctuations of multiple percentage points in indices and nearly 10% in stocks can cause forced position liquidation because of stop loss orders being triggered. For traders, who generally capitalize on multi-day moves rather than moves within a single day, this type of action can cause significant losses should one be caught on the wrong side of the market action. High frequency trading machines may capture gains, but are not providing liquidity or improving market efficiency, especially during periods of intense market moves. Instead, evidence seems to be growing that the machine-based traders are making the market less stable and more prone to large price swings.
World view deteriorates
Global markets plunged as well, with Italy down over 9%, Poland down nearly 9%, Germany down over 7% and other European markets leading weakness as stock prices bleed, especially within the financial sector. The lackadaisical response out of the EU, ECB and IMF leadership seems to be draining confidence and sparking fear in the markets.
US banks have hundreds of billions of dollars worth of exposure to European sovereign debt, banks and other related instruments. Many have written credit default swaps, a form of insurance that has no capital reserve (see AIG implosion circa 2008) against European debt, exposing them to significant risks should the EU situation worsen.
Broken bonds from backwards economies
Many Western countries now face the prospect of sovereign debt problems, as their economies continue to slow, while investors fear that they will not be able to pay back the debt. The United States is no exception, as its official debt reaches 100% of GDP, and by some estimates, their total outstanding unfunded liabilities have reached $75 trillion.
Japan has a 200% debt-to-GDP ratio, which is only made possible by the fact that most of their debt is held by Japanese banks and pensioners, but the situation there is deteriorating with growing political and economic instability. Even China is no exception, as their economy is slowing down and the yield curve on Chinese debt has inverted for the first time — causing serious concern for those that felt China would lead the world out of recession.
The coming crisis
What happens next is not clear, but what is evident is that the world is changing. Slowing economic growth, the bursting of the largest credit bubble in history, significant deterioration in debt-driven consumption and resource depletion all leads to a potential crisis. All of the new debt that has been created to attempt to stem the last debt crisis has only exacerbated the underlying structural economic problems we are facing. Papering over large amounts of fraud within the financial system and ignoring the peril of main street has divided the Western world. Growing civil unrest and lack of available employment, especially for the young, has created the potential for large scale disruptions (think of the “Occupy” movement, but on a global scale with a significant percentage of the population participating).
I feel that unless we start seeing accountability within the financial sector and governments of the world, prosecution of the enormous fraud, transparency within the political and electoral process and erosion of corporate personhood in so far as money is considered free speech, as well as more regulation of over the counter derivatives, we will look back at the 2008 crisis and think of it as a relatively calm and orderly time within the financial markets compared to what could happen next.