Is the Whole World Going Into a Recession at the Same Time?

Published: Wednesday, 28 Sep 2011 | 4:57 PM ET

By: John Melloy

As the third quarter comes to an end, strategists and investors are beginning to prep their clients and portfolios for the chance that the whole globe slides into a recession at the same time.

The worse news is that with uncertainty in Europe, the U.S. and China as high as when the quarter began, they can’t find much to do about it.

“A more sinister scenario could also unfold, namely a global synchronous recession where deflation becomes more visible,” said Morgan Stanley’s Adam Parker, the head of U.S. equity strategy, in a note to clients this week. “In recent days, a number of clients have told us they are having great difficulty in getting defensive, even when they want to.”

The S&P 500 [.SPX 1160.40 9.34 (+0.81%) ] continued its churn Wednesday near its 2011 lows as copper [HGCV1 3.258 0.012 (+0.37%) ] plunged. European benchmarks zigzagged as member countries reportedly remain conflicted about increasing the size of the Greece bailout fund. China’s equity benchmark fell to a new low for the year.

Morgan Stanley’s Parker gives his worst-case scenario described above about a 10 percent chance of occurring, but some investors feel the chances of a global group recession are even greater.

“Their worst case is not the worst case of the prior two recessions in 2001 and 2008,” said Stephen Weiss of Short Hills Capital. “This time it could very well be worse since the global economies have more interdependence.”

In the 2001 and 2008 recessions, earnings dropped by more than 50 percent in one year and one can argue that those were primarily U.S.-driven pullbacks and not a “global synchronous recession.” But in its global worst case, Morgan Stanley sees the S&P 500 earnings only dropping 30 percent in 2012.

“The news flow for the balance of 2011 will continue to be dominated by geopolitical uncertainty on three continents led by the European sovereign debt crisis, ongoing budget negotiations in Washington, DC, risk of a U.S. recession, and slowing pace of economic activity in China,” said Goldman Sachs’ David Kostin, in a note last week.

Kostin’s highlighted the issue many investors are facing when problems occur on every continent: there’s no place to hide. With so many macro problems to deal with, investors have thrown fundamentals out the window.

The 3-month trailing correlation among the ten market sectors hit 0.94 earlier this month, higher than during the financial crisis, according to Kostin. In other words, it doesn’t matter whether you own a consumer staple or a high growth tech stock, they will move in the same direction.

Morgan Stanley illustrates this problem by looking at beta, which measures the movement of a security versus its benchmark. Defensive stocks like Coca-Cola will typically have lower betas because they are less dependent on the whims of the economic cycle or the stock market.

“The dispersion of beta across industries has fallen, making it more difficult to locate low or high beta industries within even the defensive sectors,” said Morgan Stanley’s Parker.

Beyond the money

The job of stopping this “global synchronous recession” falls (some would say ‘unfortunately’) on the hands of policy makers around the world. Germany’s parliament must agree with the French government and Greece’s parliament. China must orchestrate a ‘soft landing’ in their economy. And at home, Congress must cut the deficit while still fostering growth.

“The longer the sovereign crisis goes on without resolution or empty ‘we are having constructive talks’ type statements, the more the market believes that there are very large entities within the European financial sector that cannot take any type of Greek default or haircut,” said Alec Levine, a derivatives strategist with Newedge Group. “Time is not on the side of the policy makers