Marathon turbulence for post-Olympic markets?

Are global markets about to succumb to a post-Olympic slump?

As the euphoria from the London Olympics subsides, and the US swimmers, the Jamaican runners, the Chinese gymnasts, the English cyclists and the Australian sailors all pack their bags and return home, others are warning that global markets are vulnerable.

The United Kingdom, for instance, will be forced to confront the grim economic trifecta of recession, high unemployment and a yawning budget deficit that is now tipped to climb above 8 per cent of GDP this year.

But the British won't be the only ones waking up in a bleak post-Olympic world. Europe is sliding deeper into recession, and there are growing fears that the German economic machine is now under threat. In the US, policymakers are despairing that their previous efforts to engineer a lasting recovery have failed. And the Chinese and Japanese economic growth is now flagging.

Some argue that markets, which have been artificially buoyed by Olympic spirit, could now be in for a sharp correction, similar to that which took place after the 2008 Beijing Olympics (which took place between August 8 and August 24 that year).

Within weeks of the Beijing Games ending, global markets commenced a marathon period of turbulence and decline that spanned a miserable seven months.

Others point out that the parallels with 2008 stretch far beyond the Olympics. John Hussman of Hussman Funds argues that now, as then, investors are turning a blind eye to the deteriorating global economy. "Investors remain so addicted to the temporary high of monetary intervention that they continue to ignore a very real downturn in global economic indicators, to an extent that we have not seen since the 2007-2009 recession”. For his part, Hussman argues that the sustained drops that we're now seeing in economic data from the US, Europe and China "suggest that a global recession is at hand”.

Despite these gathering storm clouds, the US stock market has surged over the past five weeks (although it softened a little overnight), although trading volumes have been unusually low. As Hussman notes: "It's understandable that people are reluctant to place trades in a weakening economy, yet one where quantitative easing is widely expected.

"Wall Street is scared to death of being out of the market when the perceived salvation of QE3 is announced, and at the same time is increasingly encouraged by negative economic data in the belief that this will accelerate delivery. In short, investors are practically begging to be shot, mauled by dogs, and diced by a Veg-O-Matic so they can get their next fix of pain-killers.”

And even though few believe QE3 will be effective in boosting economic activity or employment, there is a growing chorus from regional Fed governors such as Eric Rosengren (Boston) and John Williams (San Francisco) that the US central bank should "do something” about the US economy.

As Hussman notes, previous rounds of QE have merely produced marginal falls in interest rates that have had little effect on real economic activity. But previous bouts of QE have been quite effective in suppressing risk premiums, and sparking temporary speculative bouts in the financial markets, particularly when they came in the wake of hefty market declines.

However, he warns that there is a major risk that QE3 will fail to produce even these modest benefits, given current market conditions. "We should not be surprised if it turns out to be fairly ineffective in lowering risk premiums when they are already depressed, reducing interest rates that are already near record lows, or supporting stock prices that are already quite elevated.” Despite this, he notes that the US central bank is "virtually certain” and this expectation is likely to be already fully priced into the market.

But Hussman also highlights the fact that 2008 set a worrying historic precedent for a market backlash to a highly anticipated policy action. In that case it was Washington's $700 billion TARP program aimed at bailing out troubled US banks by buying up their distressed assets.

"The suspended animation of the market here is very reminiscent of the similar suspension that occurred in 2008, as the markets eagerly awaited the near-certain passage of the Troubled Assets Relief Program. If you recall, within one minute of the passage of that bill by the House of Representatives, the stock market entered a free fall. Buy the rumour, sell the news.”

It's interesting to note that on October 3, 2008 – the day the TARP package was passed by Congress and signed into law by then US President Bush – the Dow Jones Industrial Average was trading slightly above the 10,500 level. A week later, the index had plunged to around the 8,000 level.