From Nouriel Roubini:
Until the recent bout of financial-market turbulence, a variety of risky assets (including equities, government bonds, and commodities) had been rallying since last summer. But, while risk aversion and volatility were falling and asset prices were rising, economic growth remained sluggish throughout the world. Now the global economy’s chickens may be coming home to roost.
Japan, struggling against two decades of stagnation and deflation, had to resort to Abenomics to avoid a quintuple-dip recession. In the United Kingdom, the debate since last summer has focused on the prospect of a triple-dip recession. Most of the eurozone remains mired in a severe recession—now spreading from the periphery to parts of the core. Even in the United States, economic performance has remained mediocre, with growth hovering around 1.5 percent for the last few quarters.
And now the darlings of the world economy, emerging markets, have proved unable to reverse their own slowdowns. According to the IMF, China’s annual GDP growth has slowed to 8 percent, from 10 percent in 2010; over the same period, India’s growth rate slowed from 11.2 percent to 5.7 percent. Russia, Brazil, and South Africa are growing at around 3 percent, and other emerging markets are slowing as well.
This gap between Wall Street and Main Street (rising asset prices, despite worse-than-expected economic performance) can be explained by three factors. First, the tail risks (low-probability, high-impact events) in the global economy—a eurozone breakup, the U.S. going over its fiscal cliff, a hard economic landing for China, a war between Israel and Iran over nuclear proliferation —are lower now than they were a year ago.
Second, while growth has been disappointing in both developed and emerging markets, financial markets remain hopeful that better economic data will emerge in the second half of 2013 and 2014, especially in the U.S. and Japan, with the U.K. and the eurozone bottoming out and most emerging markets returning to form. Optimists repeat the refrain that “this year is different”: after a prolonged period of painful deleveraging, the global economy supposedly is on the cusp of stronger growth.
Third, in response to slower growth and lower inflation (owing partly to lower commodity prices), the world’s major central banks pursued another round of unconventional monetary easing: lower policy rates, forward guidance, quantitative easing (QE), and credit easing. Likewise, many emerging-market central banks reacted to slower growth and lower inflation by cutting policy rates as well.
This massive wave of liquidity searching for yield fueled temporary asset-price reflation around the world. But there were two risks to liquidity-driven asset reflation. First, if growth did not recover and surprise on the upside (in which case high asset prices would be justified), eventually slow growth would dominate the levitational effects of liquidity and force asset prices lower, in line with weaker economic fundamentals. Second, it was possible that some central banks—namely the Fed—could pull the plug (or hose) by exiting from QE and zero policy rates.
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