Several seemingly unrelated factors, and the confluence of these factors within a day or two, precipitated a sharp sell-off that was magnified by bandwagon effects. The main factors were:

• Chinese government efforts to regulate securities markets and tighten up liquidity, precipitating major sell-off in the extremely volatile Chinese equity markets, which subsequently spread to Europe.
• Reports, both actual and anticipated, that the U.S. economy may be weaker than earlier expected.
• Some ill-timed remarks by Alan Greenspan, former chairman of the Federal Reserve Board, on the previous day in Hong Kong about recession risks in the United States.

China's Volatile Markets

The Chinese stock market dropped by a vertiginous 9% following Greenspan's comments and reports that Beijing may crack down on securities fraud and illegal margin lending, along with moves by the Bank of China to tighten up on bank liquidity. This occurred against the backdrop of growing concerns about historically high Chinese equity valuations, which have led to some wild, gut-wrenching swings in the Chinese market so far this year. In fact, the 9% drop on February 27 left the index where it had been just 10 days earlier. So these gyrations in the Chinese equity market should be viewed as part of the risky landscape in that part of the world. Global Insight does not believe that wide fluctuations in Chinese equity market, in and of themselves, will have a material impact on growth in the economy. Most of the funding and credit for Chinese growth is made available through a fairly tightly controlled banking system. GDP is still expected to grow by close to 10.0% in 2007, a modest slowdown from about 10.7% in 2006.

The U.S. Economy: Bloodied But Not Bowed

In recent months, the U.S. equity markets, and seemingly the economy, had shrugged off a number of fairly major shocks: a sharp spike in energy prices in the spring of 2006, a recession in the housing market, and a slowing of industrial output, partly related to a plunge in production of building materials and below-trend automotive sales. More recently, however, signs of stress in the U.S. economy have become more apparent in a pullback in business investment, an inventory overhang that has some persistence, signs of distress in the subprime mortgage lending market, and a tightening of mortgage lending standards. Nevertheless, growth in the U.S. economy is being sustained by fairly buoyant services industries, which account for two thirds of output and employment. We expect that services will not be totally immune from problems in the housing and industrial sectors, so some slowdown there is in the cards, but the overall business cycle expansion still has considerable forward momentum. The U.S. stock market did get ahead of itself, given the outlook for sluggish economic growth and single-digit earnings gains. However, based on historical P/E ratios, the market is not particularly overvalued. Going forward, markets will likely be less calm than in the past few months, but they are more likely to move sideways than experience a long contraction.

Greenspan's Recession Shoe Drops with a Loud Thud

The former Fed chairman's ill-timed comments in Hong Kong on February 26 referred to the fact that the U.S. business-cycle expansion—now in its sixth year—is showing signs of fatigue, and that the risks of recession later in 2007 were therefore higher than they were in the previous two years. The Asian markets seized on the "R" word and quickly extrapolated a fairly high probability of that event occurring—more that sufficient to precipitate the sharp 9% correction in Chinese equity markets, presuming that a U.S. recession would have a significant impact on growth in China. Unfortunately, Greenspan did not provide any specific probability to a U.S. recession, only that the probability is higher than it was a couple of years ago. However, what precipitates a recession is usually a combination of major shocks—an oil-price shock, a rise in real interest rates, a currency crisis, or a meltdown in equity valuations. Global Insight recently has assessed the probability of a recession in the 15–20% range. While this is certainly higher than the near-zero probabilities in 2003-05, it is actually below the risk levels in mid-2006, which approached 45% because of the oil-price spike last spring. So, even though recession risks are indeed higher that they were earlier in this expansion, they are still lower than they were last year. Therefore, Greenspan failed to provide a proper context and empirical support for his remarks about the likelihood of a U.S. recession in 2007.

What Does This All Add Up To?

While the severe price declines that we saw this week in world equity markets may well be an overreaction to an unusual confluence of events, the fact that the selling occurred with unusual intensity and that the contagion spread around the world quickly is a source of concern to the Federal Reserve and other major central banks. Anxieties about an imminent U.S. recession are clearly overblown. But persistent equity-market weakness due to further bandwagon and contagion effects at this juncture would push the probability of recession up quickly.

The program of monetary tightening that was initiated by the Federal Reserve in June 2004 has had its desired effects in terms of slowing down growth and quelling inflation pressures. For now, the Fed is expected to remain on hold. Should recession risks rise sharply, either due to protracted equity-market weakness or other reasons, the Fed is in a good position to provide additional liquidity and would lower interest rates accordingly.

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