Here's Who Would Suffer the Most From a Stock Market Correction

 | Aug 09, 2017 | 8:00 AM EDT
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The latest escalation in the war of words between President Donald Trump and North Korean dictator Kim Jong-un sent stocks down on Tuesday and could cause even more damage in the markets if it turns into a major policy mistake.

Trump promised "fire and fury like the world has never seen" if North Korea makes any more threats against the U.S. North Korean state media apparently responded by saying the regime was "carefully examining" plans to strike Guam, the Pacific island hosting the U.S. military bases that are closest to North Korea.

Even if the world is not destroyed in a nuclear war between these two, this escalation in rhetoric is very bad for the stock markets, which already are priced to perfection. And if stock markets suffer a correction, they will impact the global economy. Cheerful thoughts on the day that has been designated by the financial media to mark the 10th anniversary of the global financial crisis. 

The U.S. itself possibly would be among the worst hit, according to research into the impact of an equity correction on major economies by Gabriel Sterne, head of global macro research at Oxford Economics.

Sterne looked at a 10% correction caused by a reduction in "irrational exuberance" and concluded that it could have a big impact, reducing economic activity in developed economies by 0.3% on average.

The U.S. cyclically adjusted price-to-earnings ratio (CAPE) is above the 99th percentile of its 10-year historical performance, while the global MSCI CAPE is at the 77th percentile. CAPEs of most advanced markets are above the 70th percentile, Sterne noted.

Ranked by percentile, the U.S. is followed by Switzerland as the most overvalued market. France, Germany, the U.K., Taiwan, Australia, Japan, Turkey, South Korea and Poland all rank above the 50th percentile.

Oxford Economics' model simulations show that a 10% fall in stock prices triggered by a loss of market confidence would cut both consumption and GDP, with the peak impact after four to six quarters.

The impact on consumption will be worse the more wealth consumers start with and the sharper the consumers' reaction to any given change in wealth. There also will be indirect impacts via domestic and global demand and an increase in the cost of capital affecting business investment, and through trade.

The U.S. and U.K. consumption and GDP would decline by around 0.5% if there is a drop of 10% in the stock market, partly reflecting their higher rates of market capitalization compared with European economies.

The Netherlands is next, with a reduction in its economy and consumption of around 0.4%, followed by Italy, France, Spain, Canada and South Korea with declines of 0.2%. Germany, Japan and Australia would see declines of about 0.1%.

However, the declines could be even higher if there is a "spontaneous combustion" originating in markets, with high inflows into ETFs posing a liquidity risk, Sterne warned. "In such circumstances, a 10% decline in equities might just be the beginning of a bigger downturn in financial markets as leverage is unwound," he added.

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