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Bracing for another round of wealth destruction

A trader on the floor of the New York Stock Exchange watches the Dow drop Wednesday. Mario Tama/Getty Images

Mario Tama/Getty Images

Stock markets, which have been showing increasing signs of stress in recent days, turned particularly ugly on Wednesday as investors weighed the rising possibility that the U.S. could lose its gold-plated credit rating or default on its debt obligations.

The Dow Jones industrial average sank 198.75 points, or 1.6 per cent, to 12,302.55, marking its fourth-straight decline and its biggest one-day drop in nearly two months. Canada's S&P/TSX composite index did even worse, falling 267.89 points, or 2 per cent, in its worst tumble in nearly a year.

"If the U.S. defaults, there would be massive consequences," warned Mohamed El-Erian, chief executive and co-chief investment officer at Pacific Investment Management Co. (Pimco), the world's largest bond-fund manager.

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Talk of the potential impact on markets was all the rage among investors, economists and strategists, and not only because of the historical novelty of such a move.

Given the devastating impact of the 2008 financial crisis, when global credit markets froze and stocks crumbled, people are clearly interesting in avoiding another wealth-destroying catastrophe so soon after markets have begun to recover.

No one is ruling out more volatility ahead. Sherry Cooper, chief economist at Bank of Montreal, pointed out that corporate cash balances are rising, while consumers and investors are retrenching and businesses could reduce spending - all ominous signs at a time when the economy is already showing signs of softness.

"Uncertainty is never good for markets or for the economy," she said in a research note. "This, in combination with what will inevitably be meaningful fiscal contraction over the next year and beyond, reduces the growth trajectory for the U.S. economy."

Ian Shepherdson, chief U.S. economist at High Frequency Economics, agreed: "An outbreak of common sense at the last minute cannot be ruled out, but it is becoming very hard now to maintain as a base case the idea that a debt deal will be done by Aug. 2. Accordingly, we think it is very dangerous to be exposed to a potentially big spike in Treasury yields over the next week. The market is heading into unknown territory, and safety first seems the most sensible strategy."

Yet, some indicators pointed to relative calm. Despite its recent string of declines, the Dow is less than 4 per cent below its recent high in April. The U.S. dollar rose against a basket of currencies, including the euro and the Canadian dollar, reflecting an appetite for the greenback.

The price of gold, which is seen by some investors as a barometer for economic calamity, retreated from its recent record high.

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As well, U.S. government bonds were relatively stable, suggesting that investors are willing to hold on.

The yield on the 10-year U.S. Treasury bond remained below 3 per cent. In a $35-billion (U.S.) auction of five-year notes, demand from buyers was below the average of the past 10 sales and drew a yield that was higher than some observers had expected. Nonetheless, the yield was well below where it stood earlier this month.

"If the debt ceiling was such a problem, there'd be a lot more volatility in the credit markets," said Leon Wagner of GoldenTree Asset Management, according to Bloomberg News.

One of the factors at work here is that the United States isn't facing a predicament where it is simply unable to pay its bills, which makes its situation considerably different from, say, Greece.

"We can pay this, no problem," said Robert Shiller, an economics professor at Yale University, in a video posted online at The Wall Street Journal. Instead, any default "is going to be judged as a decline in our moral character."

Meanwhile, the debt crisis in Europe continued to simmer, drawing some attention away from the U.S. problems and likely contributing to the rise in the U.S. dollar. Some observers pointed to the widening spread between yields on Italian government bonds and safer German bonds as an indication that more bailout money will be needed soon.

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About the Author
Investing Reporter

David Berman has been writing about business and investing since 1995. He has written for a number of magazines, including Canadian Business and MoneySense. He worked at the Financial Post as an investing writer and daily columnist before moving to the Globe and Mail in 2008. More

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