I would like to excuse myself beforehand for the ominous premise of this article (this might ruin your summer). It is important to mention that a few weeks ago I was extremely bullish on markets, especially on equities, but many things changed in the months leading up to June, which have led me to iterate my stance on the issue. In this piece, I will be sharing my complete economic forecast for the year and I will be explaining why we are on the brink of plunging back into financial abyss. Due to the plethora of factors covered, the article won’t go into intricate detail on each component, but hopefully enough to convince you that Europe will enter recession and the US stock market will go through a large-scale correction.

The return of the Eurozone crisis

The main root of the underlying problem, Europe is currently in a very delicate position. Although increasing sentiment and slow but steady growth have instilled themselves, there are still many issues the Eurozone will have to face. These growing concerns mainly originate from Germany and Greece, the “bailouter” and bailoutee” – respectively. Ever since receiving it’s infamous bailout package, Greece has been on a tear. Although declining recently, its stock market has moved over 8% higher, bond rates have come down more than 20% in less than 6 months and government forecasts could not be rosier. Then again, lets not forget that the rate of unemployment has hit a new high at 28% and even though bonds have been snatched up by international creditors at unprecedented speeds, the amount raised by the Greek government still isn’t enough to cover the 240 billion euros in loans received from Europe and the IMF since 2010. Furthermore, international economists are expecting Greece’s public debt to top 177% of GDP this year. A posse of Greek economists is now arguing that a third bailout package will not be necessary. This topic will consequently be debated over the coming months by the Greek government. Unless Greece wants to return to full-blown financial bankruptcy, it will end up voting for another round. If not, it will have to auction off all of its assets just to afford to spend more. Chances are that policy-makers will take two or more months to come to the same conclusion, and might even risk political gridlock because of the structure of the Greek legislature – many parties with different ideologies have to come to an agreement.

Now let’s take a look at the lender’s side of the issue – the ones who actually supply the bailout capital. Of the 110 billion euro loan to Greece in 2010, approximately 30% came from German taxpayers. They were the single largest backer in the massive bailout package meant to stimulate and save Greece’s faltering economy. The same case occurred in 2012, during the country’s second round of “stimulus” where Germany covered the largest share. As a result, it can only be assumed that Germany will again, pick up most of the tab in the upcoming round.

Germany sports the most robust economy in Eurozone and arguably one of the largest in the world. This is mainly due to conservative yet growth-oriented policies that have allowed the country to transform itself from a post war economic wasteland, to a miracle of Ancient Greek proportion (spot the irony?), all in the space of 50 years. In the face of the European financial crisis, it managed to shield itself and was left quite unscathed from the economic desolation that hit its fellow countries. Slowly though, this is coming to an end. What will cause the near collapse of the German economy won’t come from the spread of the financial virus – which has already hit France, for example – but instead will be the due to its faulty immune system and as a result will come from within.

We are all aware of the conflicts in Russia, so I will spare you the explanation. The only important thing to know is that the West has been placing mounting sanctions on Russia and has disregarded its economic relations to the former Soviet nation. Among the countries participating in this embargo, Germany has probably some of the greatest ties with Russia. These are mainly concentrated in two fields: automobile and general trade. Automobile is one of the industries Germany prides itself most on, and with good reason. German car companies generate over 700 billion dollars in revenue annually, trumping virtually all other manufacturers apart from the United States. It just so happens that a majority of Germany’s automobile production is located in Russia, and consequently will have a tremendously negative impact on the former. This will place a massive burden on Germany’s industrial sector, which heavily relies on imports from Russia. In addition, this move will lead to a drop in business confidence, which will hurt the country especially considering its reliance on investment. Therefore, what will cause the decline of the German economy will be the result of a geopolitical crisis, which could even place the country on the brink of recession.

Moving back to the case of Greece, a country that is in the desperate need of another financial bailout. The question now becomes, who will loan the capital? With Europe’s economic powerhouse on the brink of recession, the most likely scenario will be the withdrawal of other potential saviors. As a result, Greece would be left without a bailout, and Germany would be in a very weak position, thus debilitating Eurozone countries as a whole. To add to Europe’s negatives: Italian industrial output fell in December and many are warning that the government is on the verge of collapse, French business failures in 2013 were higher than any other year during the financial crisis, economic depression in Spain is projected to lead to a 15% plunge in housing prices, and finally the political and fiscal future of Turkey is baleful. And let’s not forget inflation. The ECB has constantly had to revise its inflation numbers lower. In July, inflation hit a four-and-a half year low of 0.4%. These numbers have fallen consistently since 2011 and seem to signal a trend. Lower inflation causes a decline in consumer spending, investment and business activity, which will force the ECB to carry out large-scale asset purchases, dubbed QE. It’s safe to say that Europe has entered a deflationary period and will likely be hitting negative inflation soon. We even risk a deflationary shock, a la 2008, where asset prices would decline on a massive scale. All of this would translate in mass panic in the global financial markets: European and global equities would sell-off, the Euro would hit rock bottom and Greek bond prices would plunge.

China’s slowing economy

China, often regarded as the beacon of international growth, is also on the path of economic slowdown. In the past three decades, China has managed to attain growth rates in the double digits, averaging roughly 12%. Lately this trend has changed course and the former communist nation has been reporting growth well below expectations, growing a meager 7.4% in Q1 2014. This puts fiscal growth at its lowest pace since the first half of the 2009 financial crisis. These numbers are an indicator of the progress of China’s new government in reforming the country’s economic system, shifting to consumption-driven growth. Signs of the housing bubble that China managed to deflate in 2012 seem to have resurfaced. Due to excess supply, home prices have fallen and investment has slacked. In addition, debt has skyrocketed and a few companies have defaulted on their loans. China’s slowing economy could encourage a political movement across the country, calling for more freedom. This would deal the largest blow to Beijing and could destabilize the country as a whole. China’s lackluster growth will lower investment into and outside of the country, contributing to the reduction of global economic activity.

The case for the United States

For the past five years, we have seen a surge in stock prices. Every year seems to be a more profitable one than the previous. Unfortunately, this utopia in the stock market cannot last – a correction is in sight. Below I will be outlining several points that will contribute to the correction in US stocks.

– Interest rates  are going to be the focus of the new central bank’s president, Janet Yellen’s agenda. She has already hinted to her plans of tapering on the Fed’s massive $80 bn in bond purchases, thus lifting short and long-term interest rates. In that regard, it’s important to look at the effect of those low rates on stock trading. Following the 2000 dot-com crash, the Fed decided to lower interest rates in hopes of sparking spending and investment. Their hopes were turned into reality when investors rejoiced and bought everything they could. As a result, traders were prompted to take higher risks than ever before, because if they failed, the Fed would simply lower rates once more. This is another factor that led to the 2008 meltdown. In 2014, rates are lower than ever before and traders have been loading up on stock, leveraging all their positions and taking additional risk. So much so, that we are entering pre-crisis highs in terms of leverage. As a measured by NYSE margin debt, leverage rose 28% YOY to $380 bn in March of 2013. Since then, it has risen to roughly $430 bn last month (June 2014). The importance of this is that once interest rates rise, investment activity will decrease dramatically. For example, high frequency traders – a new breed of computer traders – place millions of trades per day, amounting to over half of the Dow Jones’ volume. They depend on low rates to place more trades and profit on small price changes. Higher interest rates would render them obsolete. If stock prices were to decline due to higher rates, it would put pressure and lead to margin calls on most investment positions, forcing market players to exit positions. As a result, a vicious circle would be formed and stock prices would spiral down. This in itself is a factor to be wary of. In the end, a stock market plunge would leave the Fed with no choice but to leave rates at current lows to avoid a broader decline.

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– Fundamentals  are NOT to be blamed for the upcoming correction. Although valuations in most industries have climbed considerably in the past, apart from technology, they are more than often justified. The US economy is undoubtedly ameliorating itself. The housing market continues to improve, companies are returning to pre-crisis levels, and overall, consumer confidence is rising. So what is the issue with US companies? Not much actually. One flaw the stock market carries right now is that share prices have increased at incredible rates since 2009. The Dow Jones and NASDAQ are up over 150% and 225%, respectively. Based on basic market principles, stocks have to retreat after constantly reaching new all time highs. In addition, stocks remain overpriced in a historical context. This is illustrated by the ERP – equity risk premium –, which measures the return of stocks against bonds. This indicator is below what we saw before the meltdown. At roughly 5% risk premium, equities aren’t overwhelmingly overvalued, although they still remain above historical average. Therefore, regardless of macro events, stocks will have to correct if they wish to sustain their move higher.

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– Technology  has also been issue of controversy lately due to its ever-expanding valuations. This can be expected considering the near zero interest rate environment businesses have been operating under. Investors have more of an incentive to take large bets on small companies, a phenomenon that is also witnessed in the stock market. For example, in its latest venture capital round, according to the Guardian, Snapchat raised capital at a valuation close to $7 billion, even though it still hasn’t produced any revenue. Another reason for increasing valuations is because of the overflow of disposable cash generated from higher stock prices, which allow large companies to invest and acquire at a premium. As a result, although we are experiencing a second tech boom, many of the large technology companies listed on the stock market, do not necessarily have the fundamentals to sustain such high valuations. At the sight of a correction, those companies are set to be the biggest losers.

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– The Dollar  has gained a lot of attention from currency speculators this summer, who will either regard this period as being either very lucrative or terribly unprofitable. Since May, the dollar (index) has appreciated over 6%; a huge move which can be seen as both a good and bad thing. A strong dollar is abhorrent in the eyes of large US-based companies as it has negative implications in the balance of trade. Companies that rely part of their revenues on foreign sales will be heavily pressured. Most commonly, these companies tend to operate in industries such as technology, oil and automobile – three significant pillars of the American economy. In terms of the tech industry, according to Goldman Sachs, over 60% of revenue are generated from foreign countries. This factor, paired with unjustifiably high tech valuations, point to the weakness of the industry in the face of a market plunge. Oil companies will suffer from both a decrease in the value of foreign earnings but also from lower commodity prices due to the stronger dollar. Finally, the automobile industry will be most hurt because of competition coming from European and Japanese automakers, which can take advantage of the cheaper Euro and Yen to cut prices. Overall, companies will take a large hit from the added strength in the dollar, which will ultimately be seen in their earnings results.

The majority of the blame for the upcoming market correction should be attributed to the global economic slowdown. A stock market correction solely based on fundamentals of US companies would only contribute to a third of the total drop. The other third would result from investor panic caused by the Fed’s higher interest rate policy. As a result, both factors coupled with the fact that Europe is in crisis and the world’s second largest economy (China) is losing steam will deal a huge blow to the stock market. This blow will only lead to a correction in the US stock market, and not another financial recession.

In terms of the estimated timing of the whole unraveling, the period following Summer will be vital. Although its hard to make predictions during a time when most investors are on the beach and economic is lower than usual, it is essential to consider that Germany’s weakened financial state will only be reported once life everyone returns from their sun-bathing. Also US companies will need to report earnings before much can happen concerning the correction. Therefore, November – January will be decisive in that regard.

Conclusion

Hopefully by now I managed to convince you that a European recession will take place and that the US stock market will go through a period of correction. It is important to mention that this scenario has a chance of NOT occurring. IF the ECB manages to carry out its bond buying program, it could prevent such a catastrophe from even surfacing. Therefore this is only a potential scenario that will happen if the European Central Bank does not carry out the program. In the case the ECB is unsuccessful, the Eurozone’s plunge will be due to Germany’s weakness and inability to aid in Greece’s next bailout package. Without that capital, Greece won’t be able to sustain any growth without declaring bankruptcy or auctioning off considerable amounts of assets, which it has already done. The failure of the German economic powerhouse will cause uncertainty and global panic over the faith of Europe. This news will spill onto the US markets, which will trigger the plunge in the stock market. At the sight of this, the Fed will have no choice but to keep rates at a low just to avoid a full-blown bear market. As a result, bond prices will surge as the Fed decides to keep rates low to quell the equity market selloff and also as stock investors move from equities and pile into the “safest investment” in the world. The crisis would also cause a drop in inflation in both Europe and the US, and the former could even go through a period of negative inflation. In addition, the EURUSD currency pair would suffer greatly, as it has already started in July. Finally, there is no doubt that global equity markets would go through a tough period. Although the US stock market will recover, the same cannot be said about Europe’s. In the end, the actions of both the European Central Bank and the Federal Reserve will determine whether we plunge back into financial abyss.

Written on Jul. 26 2014

Update 30/08/15

Following the publishing of this article, many economic events occurred. In the month of October 2014, the U.S. equity markets underwent a period of correction, with the S&P 500 index falling roughly 7%. On the European side, as mentioned by the article, it was quintessential for the ECB to engage in a bond-buying program as was seen in the U.S. during the financial meltdown. In March of 2015, the ECB announced the start of its QE program, where 60bn euro worth of debt would be bought every month. This diverted Europe from slipping back into a recession. Nevertheless, political turmoil in Greece during the summer of 2015 weakened the European economy severely. Another immense factor that led to volatility in the markets and reduction in valuations was due to China. As said in the report above, the Chinese economy has performed worst year-over-year and with economic activity in the country slowing as well as skyrocketing debt, China has the potential to spark greater economic frailty.