Collapsing commodity prices, mounting corporate-debt burden and falling equity prices form a lethal combination
Few New Years have been as bleak as 2016. There have been premonitions of financial volatility for a while. Indeed, I have been worried about the delay in the Fed’s decision to raise interest rates above its near-zero level precisely because while zero rates may have been good for employment they were encouraging risky behaviour in financial markets. Now that the Fed has moved, there is a double effect. There is near certainty that the Fed will go on increasing the rates by 25 bps every three months or so. This has brought the crisis closer rather than not.
The vast sums of money pumped out during QE went either abroad to emerging economies in search of higher returns or stayed in corporate treasuries from where it was used for M&A activities. By 2015, the M&A activity had increased beyond its previous peak of 2007. Corporate debt in emerging economies was also quite high.
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The puzzle is that despite the long dithering period while the Fed was making up its mind none of the borrowers prepared themselves for the shock when it came. It was predictable that the dollar would appreciate and dollar debt would become more expensive. Normally, the received wisdom says the market has priced in the well-anticipated shock. But, here we are, and the Fed’s decision is being treated as a real unanticipated shock.
What happened in the first week of 2016 was that, once again, the Shanghai stock market collapsed and again, almost predictably, the Chinese authorities tried to cope with the decline in a clumsy fashion. The series of events and actions on the part of the Chinese authorities have looked like sheer lack of experience or expertise. While the economy was marching along a predictable path of exports and infrastructure investments, the Chinese authorities had a simple decision to make—how much more to invest. Now the infrastructure market is oversupplied with vast numbers of completed but unoccupied houses, enough to house a third of the Chinese population. Export markets have stagnated. Once, however, the economy requires to be tweaked into a transition to the domestic market-based path, the policy-makers seem lost. It is as if the old caricature of Communists being incapable of flexible thinking is true after all.
But whatever the Chinese economy may have done, why did the markets of the rich countries react so nervously and collapse? It is not that the rich-country investors were big into Chinese equity. The collapse of equity values in Shanghai made the Western investors realise how fragile their own valuations could be. Cheap money had led people to overprice equity and here we are correcting the initial error.
But other shocks have added to the volatility. The fall in oil price below $30 was a shock, and prices continue to fall. The floor could be $10, which is where the Saudis can still make a modest profit per barrel. Of course, no other member of OPEC can live with that low a price. So, there is panic among oil producers, most of whom are among the developing nations.
Along with oil, primary commodities have fallen as well. For the first time since 1940, there is almost universal collapse in inflation. For 75 years, from 1939 to 2014, there was a positive and sometimes high rate of inflation year after year. Now, the rate is just around 1% with Central Banks scrambling to get it up to their target of 2%. With oil and primary commodities cheap and manufacturing being supplied by Asian countries at low prices, there is only the non-traded sector to provide inflationary pressure in most economies.
The sheer novelty of low inflation and also low GDP growth for rich countries is causing jitters in financial markets. Western economies have been used to some inflation. It was good for buoyancy of public revenue which eased the fiscal burden. In areas like housing, inflation stokes demand by promising buyers that that house prices would rise and keep on rising. Inflation may be evil, but lack of inflation is also a danger.
Could we have another 2008-like crisis in 2016? Commentators are openly discussing the possibility. But, this time, it won’t be banks but the shadow banks—the hedge funds and private equity companies that have taken long positions and find themselves in doldrums. If hedge funds seize up, the central banks can do little to bail them out. A combination of collapsing oil and commodity prices, enhanced by equity prices falling as well, and the threat of corporate-debt dragging companies down could well be the lethal combination. But unlike 2008, there may be no failures of big banks and public authorities may not need to get into a rescue act like they did eight years ago. Of course, forecasts by economists are seldom accurate, except when, occasionally, they are.
The author is a prominent economist and Labour peer