What's Causing the Market Freak-Out? Europe, Not the Fed

Despite what some reports say, U.S. stocks are plunging because of problems abroad

600 trader worried REUTERS Brendan McDermid.jpg

In case you haven't noticed, the stock market isn't having a great day. The Dow Jones Industrial Average was off by about 360 points or 3.3% by around lunchtime. Other major indices are experiencing similar, but slightly smaller, declines. Most news on the market's plunge indicates that now that the market had some time to sleep on yesterday's Federal Reserve monetary policy statement, it's very worried about the economy. As usual, the media's vast oversimplification of stock market moves got it wrong again. The Fed has little to do with it: Europe is on the brink.

The Fed's Statement

Let's look at the Fed's prognosis of the economy that some say has investors so shaken. Here are the two blurbs that matter:

In August:

The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased.

In September:

The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.

In short, the Fed went from saying that 'downside risks have increased" in August to saying yesterday that "there are significant downside risks" and notes strains in global financial markets. Is this latter revelation really so surprising? Really, is it a revelation at all? Market watchers should already know this.

Europe's Problems Deepen

And they do. The market's reaction this morning is due to the conditions deteriorating in Europe. One piece of particularly disturbing evidence came this morning when financial data firm Markit announced that a major survey it conducts has slipped into contraction territory for the first time since Europe's recession ended in 2009.

And that's not all. One of the most respected investors out there -- PIMCO's Mohamed El-Erian -- wrote a particularly pessimistic opinion piece this morning at the Financial Times. He sees a Europe on the brink of a financial crisis. He notes that short term lending, particularly to French banks, is drying up. This is the sort of bank run-like behavior that led to the financial crisis of 2008. When investors stop providing short-term loans to banks, bad things happen.

How Far Will the Problems Spread?

So Europe's got the U.S. markets spooked. Investors likely assume that if Europe slips into recession, interconnectedness means that the U.S. won't be far behind. While this wouldn't necessarily be the case all the time, it probably would be this time.

Over the past several months the U.S. economy has slowed. Although July was better than June and May, it still wasn't great. In a vacuum, the U.S. might be able to stay on its slow-recovery path. But we don't live in a vacuum. Weakness abroad could push the U.S. economy over the line into recessionary territory -- a line it isn't far away from as it is.

As always, however, we have to see how this situation unfolds. If Europe does experience a financial crisis, then global markets will be in a heap of trouble. If it escapes that fate, however, then there may still be hope for a painfully slow U.S. recovery. That's not much of a best-case scenario.

Image Credit: REUTERS/Brendan McDermid