Worldwide stocks could lose 35 percent of their value if the euro zone sovereign debt crisis worsens, according to research from Deutsche Bank.
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With markets poised awaiting the results of the European Banking Authority's stress tests on Friday, confidence in policymakers' ability to find a lasting resolution to the ongoing debt issues is dangerously low.
The perceived by failure in the euro zone's politics to resolve the situation has pushed up the equity risk premium (ERP) on stocks, and if the trend persists and the crisis of confidence becomes a Lehman-style financial crisis, MSCI World stocks could lose 35 percent of their value, Deutsche has calculated.
Rising ERP rates would significantly increase the cost of capital, with financials paying as much as 10 percent more.
"A disorderly adjustment on the European sovereigns will inevitably lead to a global recession, leading to a significant fall in corporate profitability." the report's authors wrote.
In this scenario, the financial sector would significantly underperform, falling as much as two-thirds, Deutsche said. Financially levered sectors, including utilities, industrials, telecoms and consumer discretionary businesses would also be vulnerable. Asia, Japan and Europe, which are more operationally levered, would be hit hardest, according to the report.
A recovery would be long and slow, according to Deutsche. "Given the magnitude of the problem, we do not expect a sharp economic recovery like in 2009 and we model an economic recovery only in 2015," the report said.
Deutsche advises looking to the S&P and to the healthcare, energy and consumer staples sectors for protection.
A more moderate scenario - where the larger debt crisis is contained and does not have spillover effects in the real economy, but confidence remains low – would see a fall of around 12 percent in the value of the MSCI, according to the report.