It was supposed to be a good week for investors.
Facing an Aug. 2 deadline, U.S. leaders reached a last-minute budget compromise and raised the country's $14.3-trillion (U.S.) borrowing limit. That paved the way for a relief rally in stocks, since the U.S. had narrowly avoided defaulting on its debt.
But the rally didn't happen. Instead, investors ran for the exits, selling stocks with abandon around the world. The S&P 500, the key measure of U.S. stocks, plunged more than 7 per cent on the week, the worst weekly performance since late 2008 when the global financial crisis exploded. The S&P/TSX index sank nearly 5 per cent.
For investors, it was the week that fear returned with a vengeance. Rather than celebrating the move to avert a U.S. debt crisis this week, investors confronted an unsettling question: is the world going back into recession?
Instead of giving the all-clear for companies and consumers to get back to business, the close call on the U.S. debt ceiling only served to put the spotlight on what a fiscal mess the U.S. is in. And in Europe, a debt crisis that was supposed to have been contained with the euro zone bailout of Greece last month erupted into a much more worrisome problem as investors dumped bonds of Italy and Spain, countries that are widely seen as too big to be bailed out under the Europe's current financial rescue mechanism.
Stocks plunged around the world Thursday, "the day that markets finally woke up to the very real prospects of another imminent and major financial crisis," London-based Deutsche Bank strategist Jim Reid said in a note to clients.
The rude wake-up call forced investors to take a cold look at economic trends of the past year, and reassess a global economy that was supposed to be on the mend.
"Markets seem to have concluded that the economy is weakening and policy makers, partly to blame for that and having exhausted their fiscal and monetary ammunition, do not have the ability, the will or the right formula to stop it," said Nomura chief economist Paul Sheard.
Europe's fiscal woes are "now past Greece. It's getting bigger than that, and so you're getting to that point where it's becoming serious where people are becoming focused," said John O'Connell, a portfolio manager with Davis Rea.
Now investors are paying a steep price for all the time that governments in the United States and Europe wasted by dithering over fixes for their fiscal messes without finding solutions.
If this week's stock market rout feels familiar for investors, that's because it was only 13 months ago when the market was coming off another fierce selloff sparked by debt concerns, mainly in Europe. The S&P 500 dropped 16 per cent from late April through to the bottom on July 2, when it closed at 1022.58.
Yet after that, it went on an absolute tear, peaking in late April of this year at 1363.61, a 33 per cent spike. Rising corporate profits and a belief that governments would do what was necessary to keep the global economy going powered the gains.
It was a rally, as Mr. O'Connell put it, based on "a lot of wings and prayers and hopes."
Overlooked in the optimism was a critical shift. The financial crisis of 2008 was triggered by excessive leverage in the banking system and huge mortgage and consumer debt in the U.S. and other countries. As governments spent massively to bail out companies and juice crumbling economies, the debt burden that swamped the private sector shifted to public finances.
But while companies were getting in better shape, governments were getting into deeper fiscal holes. Policy makers in Europe and the U.S. lacked the will and the cash to keep stimulating economic growth. And companies and consumers, while piling up savings, have as of yet been unwilling to start seriously spending to pick up the baton from governments.
One of the few things that has galvanized policy makers to decisive action on matters economic and fiscal over the past few years has been big market declines. The first American financial system bailout failed in a Congressional vote, and it was only a massive selloff in stocks that prompted Congress to try again, eventually passing TARP.
Without markets putting pressure on lawmakers over the past 13 months, not much happened to fix the underlying problem that many governments continue to spend far more than they bring in.
Late Friday, Prime Minister Silvio Berlusconi dropped his pretense that nothing was wrong and announced that Italy would speed up its move to close its budget gap and unveil plans for a balanced budget requirement. Mr. Berlusconi also said that a meeting of Group of Seven finance ministers to address the situation would happen shortly.
If markets and governments were awakened, the real question is how had they slept through the past year.
Europe wasted vital time that could have been used to find ways to recapitalize the weak banks in its financial system, and to strengthen the fiscal situations in countries such as Italy, which are now facing storms. The inability of banks that own European government bonds to absorb losses on debts is hampering any attempt to deal with the huge obligations of countries like Greece. Investors can't be forced to take haircuts on Greek bonds, because that risks putting banks that own them in crisis.
On this side of the Atlantic, even the successful conclusion of the debt ceiling debate drove home that there's little appetite for the kind of stimulus spending that some investors credit for the robust early days of the economic recovery from the 2008 crash.
Last year, there was the prospect of more support from the U.S. Federal Reserve in the form of a second round of so-called quantitative easing, known as QE II, which helped power the post-decline rally. This year, there's talk of QE III, but it's uncertain amid the toxic political climate in Washington and the heavy criticism the Fed has endured.
"Are there any bullets left if we need to provide more stimulus?" said David Graham, portfolio manager at CIBC Global Asset Management. "People have realized U.S. government can't decide on stimulus versus cuts, as proven by debt ceiling debate. That's scared people."
So have data showing economies are moving in the wrong direction.
In the first two quarters of 2010, U.S. GDP expansion clocked in at 3.9 per cent and 3.8 per cent. The readings in the first two quarters of this year were a dismal 0.4 per cent and 1.3 per cent. Confidence is at a low ebb.
"We have some American clients," Davis Rea's Mr. O'Connell said. "Boy, they are so pessimistic and negative on themselves. They are like Canadians were back when we were the northern peso."
The great hope, too, of China and emerging markets pulling the world behind their growth engines has faded as the country works to cool its economy and hot inflation with a series of rate hikes. Chinese expansion in the last quarter, while still a sparkling 9.5 per cent, is well off the 11.9 per cent pace in the first quarter of 2010, and concerns are growing about slackening demand for commodities.
Even Canada, supposedly a haven, has posted two straight months with no growth.
The biggest fear remains Europe, where there remains little consensus among the member states of the European Union about how to deal with entrenched fiscal problems. As investors flee Italy, suddenly they are concerned about a Group of Seven economy that is also the third-largest borrower globally after the U.S. and Japan.
Investors were dismayed earlier in the week when Mr. Berlusconi gave them talk, not action, saying the country was fine and the selloff in Italian bonds was unwarranted.
Of course, even if Mr. Berlusconi had sought help, it's unclear it would be forthcoming. Germany, tired of paying bailout bills, is looking increasingly reluctant. It fought the idea of expanding aid from the European Central Bank to the Italian bond market.
All the while, yields on government bonds in Europe climbed, making it more costly for countries to borrow and refinance their debts, deepening the hole.
"One assumes the ECB doesn't want to give governments a free pass and wants them to make appropriate structural reforms first," said Mr. Reid of Deutsche Bank. "However the longer they leave it to intervene aggressively the more they may actually have to do as more and more investors flee the euro government bond arena."
The lack of a fix brought a rebuke from former U.K. prime minister Gordon Brown, who wrote in a column Friday that Europe would just have to pay more to fix its problems because of the stalling.
Action "that is deferred at one point of crisis will mean even more radical action is required at the next juncture," he said. "Every time the big questions are avoided, and every time the outcome is a patchwork compromise, the next crisis gets ever closer and threatens even more danger."
The hope for bullish investors is that while governments are poor, especially in the U.S., companies and consumers are stockpiling cash.
During the worst of the recession, the world's major corporations got down to work, cutting costs, diversifying their revenues and stockpiling cash. Now, "most companies are in better shape than most governments," Mr. Graham says.
A Moody's Investor Service report last week showed U.S. non-financial companies sat on $1.2-trillion (U.S.) in cash and short-term liquid investments at the end of 2010. The total has only grown since.
But it's not just balance sheet strength. This earnings season tech darlings Apple Inc. and Intel Corp. blew past analysts' earnings expectations, and big consumer names like Coca-Cola Co. and McDonald's continue to grow rapidly.
The S&P 500's forward earnings yield, which is the reverse of the price-to-earnings ratio, is currently 9 per cent. That means that earnings per share are expected to be about 9 per cent of the share price, a hefty return considering that U.S. Treasuries are currently yielding next to nothing.
Yet investors continue to shed stocks. Paul Gardner, a portfolio manager at Avenue Asset Management can't make sense of it all. "No one wants to go in the equity markets, but tell me your alternatives," he says. "You want to earn 1 per cent on your GICs?"
No doubt, there are reasons to be cautious, even in Canada. Even though the country has been touted as an investor safe haven, much of our stock market's strength has been driven by commodities. If that rally ends, the economy could be in big trouble.
The flipside is that this country's corporations have expressed confidence – not so much in what they say, but in what they do. In the past year, the most stable companies have raised their dividends. That's something they are typically loathe to do during turmoil. "Companies do not want to raise dividends and then have to cut them six months later,' Mr. Graham said.
So will Monday bring the triumph of the optimists who see strong corporate balance sheets, or the pessimists fixated on the weak government ledgers?
Mr. Sheard of Nomura is hopeful. "If banks need more capital, governments will likely make sure they get it," he said. "And if markets shout out the need for more short-term fiscal stimulus loud enough, by pushing long-term yields down, don't be surprised if at least some governments listen. … We suspect that markets are overreacting."
Mr. Gardner is also optimistic, pinning his hopes on psychology. He's betting against expectations that this week is the prelude to a larger crash.
"We all keep thinking '08's around the corner," Mr. Gardner said. "You never get one when everyone's expecting it."
Tim Kiladze