What's caused the latest round of market volatility?

Provided by Mercer. The information in this article does not necessarily reflect the views of the Trustee.

Two key factors have whipped up the current volatility:

  • Sovereign debt issues in Europe
  • Problems in the US

1. Sovereign debt issues in Europe

In Europe, the debt crisis has been slowly building for over a year now, but every apparent "resolution" has proved to be very short-lived. The most recent agreement issued by the European Union (EU) Council on 21 July was greeted with relief, but this initial positive reaction has been overtaken by the rises above 6% in government bond yields in Spain and Italy, which has threatened these countries' ability to refinance maturing debt.

The apparent "piecemeal" approach by the EU to solving these problems and the slow moving nature of the EU bureaucracy has weakened market confidence and bolstered concerns that the sovereign bond problems in Spain and Italy could affect the ability of the European banks to fund these nations. Unlike Greece, Spain and Italy are substantial economies and European banks have substantial exposures to them.

There are potential solutions to these problems - but whether the Europeans are prepared to approve the necessary actions is by no means certain and investors remain sceptical about the EU's ability and willingness to control the situation.

2. Problems in the US - high debt levels, slowing economic growth with the possibility of a second recession

Political actions (and inaction) in the US has also taken a toll on financial market confidence, not just in the US but globally. While the President and Congress argued over extending the debt ceiling the media was filled with reports of the consequences of a US debt default and constant reminders of the extent of the US debt issue. Even the eleventh hour agreement reached by the President and Congress failed to satisfy many because the compromises negotiated angered both sides of politics, with economists worried that the President bound into by a promise of fiscal tightening at a time when recovery was looking fragile.

The political process was a major factor cited by Standard & Poor's in its decision on 5 August to downgrade the rating on US government debt from AAA to AA+, and leaving the US on negative ratings watch. It is unclear whether the downgrade itself was a material factor contributing to developments in financial markets in the past week because the downgrade was widely expected. It is the underlying arithmetic that is in dispute, and other ratings agencies (Moody's and Fitch) earlier re-affirmed their AAA ratings for the US. Nevertheless, it has underscored the notion that a policy vacuum is now emerging in the US at a time when recovery momentum appears to have faded.

The latest economic statistics also show a sharp slowing of the US economy, suggesting that the recession was deeper than previously reported and the recovery has been shallower, with a particular loss of momentum in 2011. Recent employment and manufacturing data also points to sluggish growth.

Over a period of little more than a week, the outlook for the US economy, which was widely predicted to rebound in the second half of 2011, has deteriorated significantly. The releases for 2011 suggest the recovery has slowed close to stalling point as the US heads into a period of fiscal tightening, raising fears a second recession may be around the corner over there.


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