Stock markets skidded across the world and investors retreated to safe-haven assets on fears that Europe’s festering crisis has spread to Germany and a bitterly-divided Washington may struggle to avert a fiscal crisis.
Mario Draghi, the European Central Bank’s president, warned that Germany is no longer insulated from the slump in southern Europe (Chicago Options: ^REURUSD - news) . "The latest data suggest that these developments are now starting to affect the German economy," he said, triggering an immediate sell-off on Europe’s bourses and pushing the euro down to almost $1.27 against the dollar.
Germany’s industrial output dropped 1.8pc in September and orders fell 3.3pc, far worse than expected. Spanish industrial output fell 7pc. Annalisa Piazza from Newedge said it was a shocking upset and implies that Germany may be in recession already.
Flight to safety pushed down yields on two-year German debt to -0.06pc, nearing the all-time low seen during the last eurozone debt spasm in July. Yields on 10-year US Treasuries fell 11 basis points to 1.63pc.
The jitters came as American voters delivere split government yet again, with the Republicans still in charge of the House of Representatives and the Democrats still shy of a 60-seat super-majority in the Senate.
Alan Greenspan, ex-chairman of the US Federal Reserve, said it is unclear whether President Barack Obama can reach a deal with Congress to head off the "fiscal cliff" in the few working days before recess in mid December. Unless the two sides agree there will be automatic tax rises and spending cuts worth $600bn or 4pc GDP at the end of the year.
"I’m concerned that the election per se has really not changed the balance. The solution to this going to be far more difficult than I think we believe," he told Bloomberg Television. The International Monetary Fund has warned that a fiscal shock of this scale would abort America’s fragile recovery and risk a full-fledged global recession.
The Dow industrials fell 312 points, or 2.4pc, in New York (Frankfurt: A0DKRK - news) - its biggest slump this year. In Europe, Italy’s MIB index was off 2.5pc and the FTSE 100 (FTSE Index: EO100.FGI - news) dopped 1.6pc. WTI Crude oil fell to $84.61 as funds retreated from commodity markets.
The European Commission tore up its growth forecasts, expecting the eurozone to contract 0.4pc this year and limp through 2013 with growth of just 0.3pc.
It admitted to "past errors" in judging the effects of budget cuts in a clutch of linked countries already in crisis, but disputed claims by the IMF (Other OTC: IMFAF.PK - news) that the "fiscal multiplier" is much higher than assumed. It denied that the eurozone’s austerity strategy is in any way flawed.
Spain’s economy will shrink 1.4pc this year and next, pushing Spanish unemployment to almost 27pc . The forecast makes a mockery of claims by Madrid that the country will soon be through the worst.
Spain’s budget deficit will be 8pc of GDP this year and will remain stuck at 6.4pc as far ahead in 2014, chiefly because the recession is eating into the tax base. "This is a tacit admission that the pace of austerity pursued by the Rajoy government in Spain is excessive and has become to all intents and purposes self-defeating," said sovereign debt strategist Nicholas Spiro.
Mr Spiro said Mr Draghi’s bond buying plan - known as the Draghi Put - has cut borrowing costs for southern Europe but cannot solve the deeper economic crisis. "People have been lulled into numbing complacency. There is still no eurozone banking union or fiscal union worth the name, and Europe is going to lurch from one crisis to the next until there is. We’re getting very close to the political snapping-point in Spain."
David Bloom from HSBC (LSE: HSBA.L - news) said the defeat of Republican challenger Mitt Romney does at least alay two worries on global markets, since he had threatened to replace Fed chairman Ben Bernanke with a monetary hawk and label China as "currency manipulator" from day one.
Mr Obama’s re-election ensures that quantitative easing will run its course, averting the danger of combined monetary and fiscal tightening. The risk of a trade war with China has abated. "The last thing the world needed, at a time of economic fragility, was a fresh stand-off between these two economic super-powers," said Mr Bloom.
Yet the fiscal cliff overshadows all else and it is unclear whether either side will yield ground. Mr Obama vowed to put aside party differences in his acceptance speech. "You voted for action, not politics as usual," he said. But he has previously threatened to let America go over the cliff if Congress blocks all tax rises.
Republican House Speaker John Boehner extended olive branch yesterday, calling for "both parties to find common ground" but he also claimed Republican victory in the House as a mandate for a defiant stand on taxes. Most Republicans in Congress have signed a no-tax pledge that is perillous to break.
Richard Lewis from Fidelity Worldwide Investment said the dispute will go to the wire with much collateral damage as companies hold back spending and investment. "After a lot of wailing and gnashing of teeth, we are hopeful of a budget agreement along the lines of the `Bowles-Simpson' proposal which is based on a ratio of 3-1 spending cuts versus tax increases."
Ethan Harris from Bank of America (NYSE: IKJ - news) said it is risky to assume that such profound ideological differences can be ironed out easily. There is no guarantee that "sane heads will prevail," he said.