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Cargo containers are stacked at a port in Lianyungang in China's eastern Jiangsu province on May 9.STR/AFP/Getty Images

What has stock markets so spooked? Think about the prospect of a global recession.

Such a scenario is not guaranteed to happen, but it is growing in probability as rising interest rates in North America and a bloody war in Europe collide with COVID lockdowns and a property bubble in China to create a sense of impending doom wherever traders look.

Their sense of foreboding was reflected in a mass sell-off on Monday of just about everything – domestic stocks, foreign stocks, gold, oil and bitcoin, for starters.

The silver lining here – if you can call it that – is that painful market declines don’t necessarily have to signal something fundamentally wrong with the underlying economy. In North America, at least, the recent losses seem to be largely about correcting asset values that soared to absurd heights during the pandemic.

As vicious as the sell-off on Wall Street has been, it has done little more so far than wipe out the past year of exuberant gains. An investor who has held an index fund tracking the S&P 500 benchmark of large U.S. companies since the start of the pandemic in February, 2020, is still sitting on an 18-per-cent profit over that stretch.

Consider that a sign of just how frothy pandemic-era valuations had grown. From their levels just before the pandemic hit in early 2020, U.S. stocks soared by more than 42 per cent to their peak at the end of 2021.

The close: TSX falls by most in nearly two years on recession fears

‘The ingredients for a global recession are on the table’: Morgan Stanley chief economist

This was truly remarkable: Why should stocks go up when the world was struggling with a dangerous virus?

Much of the gains reflected nothing more than near-zero interest rates and a flood of pandemic stimulus. Now interest rates are rocketing and governments are reeling back their spending.

Everything else being equal, that argues stocks should be giving back some of their pandemic gains. The question is how far they will have to fall to bring things back into balance.

The folks at Capital Economics see the S&P 500 dropping from its current level around 3,991 to a trough of 3,750 next year. David Rosenberg of Rosenberg Research sees stability beginning around 3,550.

But much depends on how far central banks will be willing to go in raising interest rates to stamp out the highest inflation in decades. Both the Bank of Canada and the U.S. Federal Reserve have left no doubt they intend to ratchet up their overnight policy rates, now tickling 1 per cent. Markets are braced for policy rates in both countries to go past 3 per cent next year.

In anticipation of those hikes to central banks’ short-term rates, the yields on longer-term bonds have already shot skyward. Ten-year government bonds in both Canada and the United States are now paying more than 3 per cent a year, a huge increase over the 0.5 per cent or so they were yielding in the depths of the pandemic.

Investors who can get a safe 3-per-cent yield on long-term government bonds are less inclined to take their chances with risky stocks. This simple math accounts for much of the recent stock market sell-off. But still to be determined is whether central banks will relent from hiking rates if their economies begin to display signs of serious weakness.

Stephen Brown, senior Canada economist at Capital Economics, argues that falling home prices will cause the Bank of Canada to back off from more hikes once the bank’s overnight rate nears 2.5 per cent.

The risks are considerable, he says, especially if home prices decline by more than the 10 per cent he is expecting. “If home prices fell by more than we expect – which should not be ruled out given their elevated level – a recession would be almost inevitable,” he wrote in a note Monday.

The Bank of Canada is not the only central bank that will face some tough choices. In the United States, the Federal Reserve is fighting consumer price inflation of 8.5 per cent, but it is also confronting an economy that shrank during the first quarter. If it were to hike rates aggressively at its next few meetings, it might be able to tame inflation but only at the cost of extending the downturn.

To make matters worse, other parts of the world are wrestling with their own problems. China’s export growth slumped to its lowest levels in two years last month, according to a report Monday. COVID lockdowns and a deflating property bubble are creating serious headwinds for its economy.

Europe is also feeling the pain. German manufacturing orders and French factory output both fell more than expected last month. Among the problems were supply-chain disruptions caused by the war in Ukraine.

There are scenarios where these stresses ease over the next few months, interest rates stop going up and growth resumes. But judging from Monday’s mass sell-off, investors aren’t counting on it.

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