Here’s why global economy watchers are so worried right now

Click to play video: 'Wall Street has worst yearly start in 84 years, investors blaming China, Middle East'
Wall Street has worst yearly start in 84 years, investors blaming China, Middle East
Wall Street has worst yearly start in 84 years, investors blaming China, Middle East. Jamie Yuccas reports – Jan 4, 2016

WASHINGTON – Fears escalated Monday that the global economy could struggle more than expected this year – a prospect that contributed to a plunge in financial markets.

The anxiety was heightened by reports that manufacturers extended their slumps last month in the United States and China, the world’s two largest economies. Factory activity contracted for a second straight month in the United States and for a 10th straight month in China.

By midafternoon, the Dow Jones industrial average had sunk more than 400 points – over 2 per cent – though the fall was also due in part to rising tensions in the Middle East. Chinese stocks fell 7 per cent before trading was halted.

The DAX index in Germany, whose export-led economy is sensitive to China’s prospects, tumbled 4.3 per cent. Britain’s FTSE 100 fell 2.4 per cent, France’s CAC 40 2.5 per cent.

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The manufacturing data made clear that the troubles that weighed on U.S. factories last year have yet to ease. Sluggish economies in major markets – from China to Europe to Japan – have depressed U.S. exports. That trend has been worsened by a strong dollar, which has made U.S. goods more expensive for foreigners.

MORE: TSX starts year with sharp drop, joining global stock sell-off

Not all the news was bad. A cheaper euro has helped European manufacturing, which expanded at the fastest pace in 20 months in December, according to data firm Markit.

Still, China’s persistent sluggishness may be causing broader damage than previously thought, analysts say. China’s government is trying to shift its economy toward domestic consumption and away from a reliance on exports and investment in roads, factories and real estate.

Yet that transformation has proved difficult: China’s growth in the July-September quarter fell to 6.9 per cent from a year earlier, the slowest pace in six years.

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China’s deceleration has been hugely disruptive for countries that have long exported commodities such as oil, copper and other metals to the Chinese market. China consumes, for example, about 60 per cent of the world’s iron ore, which is used to make steel. China’s declining appetite for such commodities has slowed growth in Australia, Brazil and Malaysia, among other economies.

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The U.S. economy has also taken a hit: Its exports to China fell 4 per cent in the first 10 months of last year compared with the same period in 2014.

“The global spillovers from China’s reduced rate of growth … have been much larger than we would have anticipated,” Maury Obstfeld, chief economist at the International Monetary Fund, said in an interview Monday with an IMF publication.

WATCH: World markets dropped on Monday, an ominous sign on the first day of trading in 2016.

Click to play video: 'Stock markets plunge overnight as mood turns grim to start 2016'
Stock markets plunge overnight as mood turns grim to start 2016

Daniel Meckstroth, chief economist at MAPI, a manufacturing research group, said that many commodity-exporting countries, such as Australia, Malaysia and Chile, have also been forced to reduce their purchases of U.S. goods as their own economies have slowed.

They “don’t have the export revenue, so they can’t import from the rest of us,” Meckstroth said. “China’s slowdown affects our ability to export to them.”

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Christine Lagarde, the IMF’s managing director, said last week that China’s slowdown would likely keep commodity prices low for a “prolonged period.”

Writing in the German newspaper Handelsblatt, Lagarde predicted that “global growth in 2016 will be disappointing and uneven.”

Michael Arone, an investment strategist at State Street Global Advisors, said such sentiments have unnerved financial markets.

“Investors were looking for a more hopeful start to 2016,” he said. “What they got were a lot of reminders of the risks that weighed on markets last year.”

Those concerns have been exacerbated by widespread doubts about the accuracy of Chinese economic data. Many analysts worry that China’s economy is faring even worse than its official figures suggest.

“Markets don’t like uncertainty, and when you look at the Chinese data, there is uncertainty surrounding that,” said Jay Bryson, global economist at Wells Fargo Securities.

Early Monday, a private survey of China’s manufacturers showed factory activity contracting more quickly than many economists expected. Those figures were from the Caixin/Markit index, a private trade association. A separate report from China’s government released last week had suggested that China’s factories improved slightly in December.

“They’ve been distorting the numbers,” Meckstroth said of Chinese government officials. He thinks China’s growth is closer to 5 per cent.

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Still, most economists remain relatively optimistic about the U.S. economy this year. Steady job growth and some early signs that companies are paying higher wages could boost consumer spending, which fuels about two-thirds of the U.S. economy.

Nariman Behravesh, chief economist at IHS, a consulting firm, said that two of the three headwinds the U.S. economy faces should fade in the coming months.

Businesses ordered too many goods in early 2015 and are now working off those excess stockpiles. Doing so slows growth because it leads companies to order fewer new goods. But that process should be completed by the end of the first quarter, Behravesh said.

And energy companies have sharply reduced their investment in drilling equipment in the face of lower oil prices. But that trend should also fade, Behravesh said, because there isn’t much left to cut.

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