The tremors in financial markets have gone far beyond their beginnings in the US subprime mortgage sector, and indeed far beyond the borders of the US. The full impact on the markets and the repercussions on the global economy remain unclear, but a new report by the Economist Intelligence Unit forecasts that the most alarming threat to global financial markets arises from the re-pricing of risky assets, and the associated deleveraging by investors.

In its newly-released special report Heading for the rocks. Will financial turmoil sink the world economy?, the Economist Intelligence Unit puts forward three main routes through which market turmoil could have a major impact on global markets. The first is the direct effect on holders of subprime-related assets. The second is the liquidity crunch that is presently occurring in response to uncertainty over precisely who holds the dubious assets. But the key threat is the fundamental re-pricing of risky assets and a reduction of leverage.

According to Alasdair Ross, editor of the report, “unusually low volatility of asset prices in recent years has lured many investors into more speculative investments. Poor returns on low-risk assets and the easy availability of credit further raised the incentive to move to riskier instruments, and many investors borrowed heavily to purchase them. This wall of money has allowed many asset markets to appreciate dramatically in value.”

“However, with investors reappraising the risk in their portfolios, prices for many assets have fallen sharply. The need to match declining portfolio values with reduced leverage is expected to result in further asset sales in the months ahead, as investors sell holdings in order to repay debt. As a consequence, a sustained downwards movement in prices across most risk-asset markets seems inevitable. ”
Other key findings of the report include:

30% probability of the US falling into moderate recession. The Economist Intelligence Unit forecasts a 30% probability of the US falling into a moderate recession. This would have a substantial fall-out for the rest of the world.

Cascade of damage. Although the financial downturn will affect most directly the US economy, the effect on the rest of the world will come through two channels: deteriorating global financial conditions and weakening demand from the US.

The growing size and influence of European and Asian economies means the US has less influence on global growth than it did a decade ago. But a sharp slowdown in the United States would seriously affect global growth because no other economy is large enough and dynamic enough to pick up the slack.

10% probability of a US slump. If corrective monetary policy action fails, the cycle of repricing of risk-assets and consequent deleveraging could spiral out of control. This would result in a long- lived period of economic weakness in the US, with severe economic repercussions for the world economy.

When bubbles burst. What’s behind the financial storm that is ripping through the world economy? Nothing less than one of the biggest asset bubbles in history. The falling stock prices, soaring credit costs and roiling currencies that have shaken financial markets trace back to 1997, when the value of housing in the US began to jump. Nine years later, the value of property had surged by US$12trn.

Asset bubbles almost always end in tears, and the US housing market is no exception. Banks and investors are now being punished for ignoring risk, lending recklessly and thinking property prices would always rise.