“Our financial sector is built on sand,” Michael Lewis, the American author, told me last week. “After all, we’re in the middle of a huge monetary experiment, with central banks playing a bigger role in stimulating growth than we’ve ever seen”.
Back in 2010, Lewis wrote The Big Short – an expose of the banking shenanigans that sparked the 2008 financial crisis. It has since been made into a glitzy Hollywood movie, which enjoyed its UK premier last week.
It’s ironic the film is being released amidst serious financial volatility. Over £50bn was wiped off Britain’s biggest companies last Wednesday, as the FTSE-100 index of leading stocks plunged to a four-year low. For the first time since 2008, UK equities entered “bear market” territory, with stocks 20pc down on their previous peak. As panic-selling spread across the world, trillions of dollars of value vanished into thin air. Investors are contemplating a re-run of the global financial crisis, with all the associated economic costs.
It’s a cliché to claim this nerve-shredding market sell-off has been caused by China. While I fully accept the second-biggest economy on earth has slowed over the past year, I’m highly skeptical that a relatively small fall in Chinese growth is the real reason investors are so spooked. The main explanation, it seems to me, is the sharp fall in the price of oil – plus the fact that the US, Western Europe and Japan, despite years of unprecedented monetary and fiscal stimulus, have failed to stage a significant and sustainable economic recovery. In that sense, I agree with Michael Lewis.
The oil price hit its lowest level since 2003 last week. Even plunging crude is constantly attributed to China. Yes, of course, even a relatively minor slowdown in such a large, investment-heavy economy means less oil will be consumed than would otherwise have been the case, pushing the oil price down.
The reality is though, that despite GDP growth falling to 6.9pc in 2015 from 7.3pc the year before, Chinese oil use still rose 2.5pc. This year, too, even though growth will almost certainly fall further, China’s demand for crude is still set to grow 1.5-2pc.
China consumed 10.32m barrels of oil per day last year – an all-time high. The International Energy Agency, the leading oil think-tank, estimates that instead of growing by 600,000 barrels a day this year, total Chinese oil use will instead increase by around 400,000 barrels. This shortfall amounts to 0.2pc of projected global oil use in 2016 – hardly enough to drive crude to a 13-year low.
No, the main reason oil has tumbled 70pc since mid-2014, and over 40pc since early December is the extraordinary commercial and, ultimately, geo-political battle now ensuing between Saudi Arabia and the US. That’s resulted in an enormous supply glut, as the Desert Kingdom has flooded global markets with crude in a bid to push upstart American “shale” companies out of production. This fight for market share has destroyed the coherence of the Opec exporters’ cartel, driving up crude inventories even more.
Ultra-low oil is also causing havoc in America’s “junk bond” market. Junk bonds energy spreads – the average gap between the yields demanded by creditors of America’s shale energy producers, compared to investment-grade corporate bonds or Treasuries – have widened by more than 6pc over the last two months. This has piled pressure on such companies, as rising debt service costs and collapsing revenues push them closer to bankruptcy.
When oil prices were high, lots of banks, including some of the biggest names on Wall Street, extended highly-speculative loans to drilling companies in Texas, North Dakota and other centres of America’s “shale boom. An estimated $500bn of such debt is outstanding. Those loans are rapidly going bad – which is why this sector is increasingly being talked about, in another 2008 throwback, as “the next sub-prime”.
No wonder it’s easier to point constantly to “the Chinese slowdown” as the reason for skittish financial markets. Last week, while trimming its global growth forecasts for this year and next, the International Monetary Fund made numerous references to the People’s Republic. Yet, when you examine the fine print, the IMF’s estimate of Chinese growth in 2016 remains at 6.3pc, the same as it was back in October when markets were relatively calm. China, in fact, while it featured heavily in the IMF’s rhetoric, was one of the very few countries the Fund didn’t downgrade over the last three months.
Since these latest market squalls, various economic and political luminaries have been wheeled out to assert that there is “nothing in the economic fundamentals” to justify falling equity prices. I’m not so sure. For years, Western stock markets have been pumped-up by printed money, as the Federal Reserve has increased its balance sheet more than three-fold since 2009 – ably assisted in such bubble-blowing by the Bank of England and the Bank of Japan.
Now, despite all that monetary juice, and massive government borrowing, the US economy is starting to suffer. Industrial production has contracted year-on-year for three months in a row. Retail sales also fell 0.1pc in December, with consumption growing just 2.1pc during 2015 as a whole, the weakest increase in six years. And because of America’s wide share ownership, of course, falling equity prices themselves undermine consumer sentiment which, in turn, damages the economy further, feeding back into stocks.
Perhaps inevitably, the main policy response to last week’s volatility came in the form of more promised money-printing – which brought some relief to frazzled markets. While it was initially the US and the UK which engaged in “quantitative easing” after the 2008 crash, the European Central Bank has since taken up the baton. “We will review and possibly reconsider our monetary policy”, said ECB supremo Mario Draghi on Thursday. No matter that the eurozone’s central bank is already implementing QE to the tune of €60bn a month. We’re about to see even more, much of which will, one way or another, find its way into already over-priced stocks traded in London, New York and elsewhere.
The causes behind recent stomach-churning falls on stocks markets world-wide are many and varied. Of course, China is slowing. And, clearly, some of the other large emerging markets are on their economic uppers, not least those such as Brazil and Russia that are major energy exporters.
It is, though, disingenuous, simplistic and plain wrong for Western analysts constantly to absolve ourselves of any responsibility, insisting that our financial and economic woes are all because of “them”.
What is really gnawing away at investors is the sense that QE must end at some stage, Western interest rates must rise and no-body knows how our bloated financial markets will react when that finally happens. We have, engaged in an unprecedented – and, in my view, reckless – monetary experiment in an attempt to dig our way out of our post sub-prime malaise without facing up to the regulatory and structural problems which actually caused the crisis.
Since the Fed took the plunge and raised rates last month, financial markets have been extremely turbulent. That’s no coincidence. We were told, in the name of “forward guidance”, to expect four rate hikes in 2016 – yet only two are now priced-in. That points to an alarming truth – that the Fed is losing credibility. As Lewis says: “Our central bank has no more ammunition”.
I sincerely hope financial markets correct gradually and a ghastly crisis is avoided. If not, though, blame must be shouldered and lessons learnt – lest the same mistakes be made again.