The upswing in global equity markets that started in July is now runningout of steam, which comes as no surprise: with no significant improvement ingrowth prospects in either the advanced or major emerging economies, the rallyalways seemed to lack legs. If anything, the correction might have come sooner,given disappointing macroeconomic data in recent months.

Starting with the advanced countries, the eurozone recession has spreadfrom the periphery to the core, with France entering recession and Germanyfacing a double whammy of slowing growth in onemajor export market (China/Asia) and outright contraction in others (southernEurope). Economic growth in the United States has remained anemic, at 1.5-2% for most of the year, and Japan is lapsing into a new recession. The United Kingdom, likethe eurozone, has already endured a double-dip recession, and now even strongcommodity exporters – Canada, the Nordiccountries, and Australia – are slowing in the face of headwinds from the US,Europe, and China.

Meanwhile, emerging-market economies – including all of the BRICs (Brazil,Russia, India, and China) and other major players like Argentina, Turkey, andSouth Africa – also slowed in 2012. China’s slowdown may be stabilized for afew quarters, given the government’s latest fiscal, monetary, and creditinjection; but this stimulus will only perpetuate the country’s unsustainablegrowth model, one based on too much fixed investment and savings and too littleprivate consumption.

In 2013, downside risks to global growthwill be exacerbated by the spread of fiscalausterity to most advanced economies. Until now, the recessionaryfiscal drag has been concentrated in the eurozone periphery and the UK. But nowit is permeating the eurozone’s core. And in the US, even if President BarackObama and the Republicans in Congress agree on a budget plan that avoids thelooming “fiscal cliff,” spending cuts and tax increases will invariably lead to some drag on growth in 2013 – atleast 1% of GDP. In Japan, the fiscal stimulus from post-earthquakereconstruction will be phased out, while a newconsumption tax will be phased in by 2014.

The International Monetary Fund is thus absolutely right in arguing that excessively front-loaded and synchronized fiscal austerity in mostadvanced economies will dim global growth prospectsin 2013. So, what explains the recent rally in US and global asset markets?

The answer is simple: Central banks have turned on their liquidity hoses again, providing a boost to risky assets. The US Federal Reserve has embraced aggressive, open-ended quantitative easing (QE). The European Central Bank’s announcement of its“outright market transactions” program has reduced the risk of a sovereign-debtcrisis in the eurozone periphery and a breakup of the monetary union. The Bankof England has moved from QE to CE (credit easing),and the Bank of Japan has repeatedly increased the size of its QE operations.

Monetary authorities in many other advanced and emerging-market economieshave cut their policy rates as well. And, with slow growth, subdued inflation, near-zero short-term interestrates, and more QE, longer-term interest rates in most advanced economiesremain low (with the exception of the eurozone periphery, where sovereign riskremains relatively high). It is small wonder, then, that investors desperatelysearching for yield have rushed into equities, commodities, credit instruments, andemerging-market currencies.

But now a global market correction seems underway, owing, first andforemost, to the poor growth outlook. At thesame time, the eurozone crisis remains unresolved, despite the ECB’s bold actions and talk of a banking, fiscal, economic, and political union. Specifically, Greece, Portugal, Spain, and Italy arestill at risk, while bailout fatigue pervades the eurozone core.

Moreover, political and policy uncertainties – on thefiscal, debt, taxation, and regulatory fronts – abound.In the US, the fiscal worries are threefold: the risk of a “cliff” in 2013, as tax increases andmassive spending cuts kick in automatically ifno political agreement is reached; renewed partisancombat over the debt ceiling; and a new fight over medium-term fiscalausterity. In many other countries or regions – for example, China, Korea,Japan, Israel, Germany, Italy, and Catalonia – upcoming elections or politicaltransitions have similarly increased policy uncertainty.

Yet another reason for the correction isthat valuations in stock markets are stretched:price/earnings ratios are now high, while growth in earnings per share is slackening, and will be subject to further negativesurprises as growth and inflation remain low. With uncertainty, volatility, andtail risks on the rise again, the correctioncould accelerate quickly.

Indeed, there are now greater geopoliticaluncertainties as well: the risk of an Iran-Israel military confrontationremains high as negotiations and sanctions may not deter Iran from developingnuclear-weapons capacity; a new war between Israel and Hamas in Gaza is likely;the Arab Spring is turning into a grim winter of economic, social, and political instability; and territorial disputes in Asia between China, Korea, Japan, Taiwan, the Philippines,and Vietnam are inflaming nationalist forces.

As consumers, firms, and investors become more cautious and risk-averse,the equity-market rally of the second half of 2012 has crested.And, given the seriousness of the downside risks to growth in advanced andemerging economies alike, the correction could be a bellwetherof worse to come for the global economy and financial markets in 2013.