The scary free fall in recent days of US and global stock markets is no surprise to the readers of this column as it has been analyzed and predicted for a while now. The collapse of global equity markets on Monday January 21st is not just an episode of financial contagion from the US stock market to other stock markets.   

It rather signals that global stock markets are now beginning to price the following things. 

First, the US recession is unavoidable and has already started; and this recession will be ugly, deep and severe, much more severe than the mild 8-month recessions in 1990-91 and 2001.  

Second, the rest of the world will not decouple from the US since – as discussed in detail below – many trade, financial, currency, policy, confidence links – lead to a transmission of negative growth shocks in the US to the rest of the world that will lead to a sharp global growth slowdown: 2008 will be the year of recoupling rather than decoupling.   

Third, the US stock market has already started to reflect in the last few weeks the consequences on earnings and corporate profitability of a severe US recession.

Fourth, a growing realization that even aggressive Fed easing will not prevent this severe recession, i.e. that we are at the last leg of the stock market’s sucker’s rally and that the Bernanke put has very little value as massive financial losses will increase regardless of what the Fed does. 

Fifth, now other global stock markets are now starting to price the effects of the US hard landing on the rest of the world growth, the phenomenon of recoupling.  

Thus, the Monday Massacre in global stock markets is – more than a case of financial contagion – a revenge of economic fundamentals as investors are waking up from the delusion that the US would avoid a hard landing and that the rest of the world could decouple from such hard landing. A reality check is now occurring after stock markets remained for too long in the delusional triple dream of a US soft landing, of a Fed being able to ease and avoid the hard landing, and of a world miraculously decoupling from the US hard landing. As predicted here at the beginning of the year 2008 will be ugly bearish for US and global equity markets. 

To understand this high correlation of equity markets that is now returning in this period of high financial turmoil and volatility one needs to consider in more detail why the world cannot decouple from a US hard landing. Already in June of 2006 this author wrote a paper and several blog items describing 12 reasons why the world would not decouple from a US hard landing. It is important to revisit these channels of international real and financial transmission to understand the current stock markets bloodbath and why the US recession will have severe effects on the rest of the world. 

Let me discuss next in more detail these channels of recoupling of financial markets and real economies…