These are perilous times. Syria is in flames, with Western missile strikes increasingly likely in what had been only a bloody domestic affair. Emerging markets are in free fall; most dramatically, the Indian rupee has been plummeting, and cash has also been gushing out of Indonesia, Brazil and other nations. And the United States once again stands on the verge of a fiscal stand-off, with political dysfunction putting at risk the ability of the federal government to stay open and even to pay its debts.
So, let’s see how markets are responding to these threats. Here’s the Standard & Poor’s 500 stock index.
It has indeed been falling in August, all the way back to its level during those dark days of mid-July.
And here’s the Vix, an index that measures expected future volatility in the stock market and is sometimes called the fear index.
The Vix, too, has risen the last couple of weeks, but it's still far below its level in late June.
In other words, Wall Street is not really sweating the risks that face the U.S. economy and its markets and corporate earnings. There is a prevailing sense that the American economic recovery is so entrenched and steady that it can withstand whatever problems arise.
Is this complacency, or wisdom? After all, in the runup to the fiscal cliff last December, anyone who bet that the standoff would cause meaningful problems for the U.S. economy turned out to be dead wrong. Similarly, the “China is slowing down” story of last year has proven true as far as it goes, but it also hasn’t been a powerful enough downdraft to cause meaningful problems for the U.S. economy or financial markets.
Let’s take the risks that are flaring up one by one.
First, Syria and the Middle East. The biggest channel through which the region's turmoil can damage U.S. economic prospects is the price of oil. And, indeed, as Syria’s civil war has taken a dark turn in the last couple of months, global oil prices have risen, from $95 a barrel at the end of June to a recent high of $108.60 on Tuesday.
Syria itself isn’t a major oil producer, but it sits on the edges of the world’s oil production powerhouses. If the conflict heats up into a region-wide conflagration, it could be more problematic for the world oil supply. In effect, the price run-up so far seems less driven by the situation on the ground inside Syria and more by fears that the conflict will spread.
Another risk, the emerging market situation, is another that seems manageable now but could turn into something more dangerous. The most potential turmoil is in India, where the currency has fallen 20 percent against the dollar since the start of May and borrowing costs are going through the roof.
Countries from Turkey to Mexico and Indonesia to Brazil are coping with varying degrees of capital outflow, as investors reassess their longer-term growth prospects and begin to adjust to a world with less money-printing by the U.S. Federal Reserve. The situation creates grave risks for the emerging market economies themselves, and in particular for the possibility that years of rising living standards for those citizens could stall or decline. But it is harder to draw the line from those risks to a new recession or a steep fall in the economic prospects for the United States. The 1997 and 1998 emerging debt crises, particularly in East Asia, were more severe than anyone imagines the current troubles of the developing nations may become, yet the U.S. economy kept humming along.
Then there's the U.S. fiscal policy debate. There is a sharp divide right now between the mentality of Washington policy mavens and Wall Street traders. In Washington, fears are pervasive that the upcoming deadlock between the White House and House Republicans over funding the government and raising the federal debt ceiling could be the big one, a repeat of the destructive July 2011 debt stand-off. Markets, however, are seeing the Washington crowd as a bunch of Chicken Littles and betting that it will resolve itself in due time without an economy-destroying bout of uncertainty.
Treasury Secretary Jack Lew has said that the nation will hit the legal debt limit in mid-October, and that the Obama administration will not negotiate over raising the borrowing ceiling. Republicans, meanwhile, appear to be all over the map in sorting through their strategy for handling the standoff.
So, markets seem to be priced for things basically going right: Syria may be awful, but only in the sense that many Syrians will die, not in the sense of a complete conflagration of the Middle East. Emerging markets will come under strain, which hurts if you're just scraping by in Mumbai or Sao Paulo but which shouldn't undermine U.S. growth. And some reasonable compromise can be arrived at to keep the U.S. government from acting like a Banana Republic, much as was the case at the end of 2011 with the fiscal cliff.
We had all best hope that Mr. Market has it right.