For crude to fall this low, the US must slip into a recession and China must stop growing
This is not a forecast—rather, see it as a thought experiment. First of all, from a purely probabilistic standpoint, it is not outlandish, since it only represents an 83% drop from current levels, which is a little more than the amount oil has dropped in the past 15 months (70%).
From an implications standpoint, of course, there are several cans of worms that get opened. For oil to fall so low, China will have to virtually stop growing. Shocking as this may sound there are many analysts—serious ones—who believe China’s growth will fall to 2-3%, if it hasn’t already (given the notoriously opaque statistics).
The only certainty about the Chinese economy is nobody really knows what is going on. A couple of weeks ago I read about a very successful US hedge fund that was returning money to investors not because of poor performance but because the principal felt that with China (and, incidentally, India) becoming so important to the global economy and with information about these economies intrinsically unreliable, it was getting increasingly difficult to make sensible macro bets. I recall, for years, everybody said that the Chinese price was impossible and it must have been underpinned by a negative cost of funds, Chinese banks were simply being funded out of the government surplus, etc—again, nobody knows the truth but many businessmen who have long fought this battle will doubtless be nodding agreement.
It is a long-established natural law that if something appears unbelievable, it is because it is. Ponzi schemes can run for a long time—decades even, ask anyone who had money with Bernie Madoff. The pace at which money is leaving China—reportedly $ 1 trillion in the past four or five months—suggests that a rock-hard landing is not outside reasonable bounds of probability. The markets are certainly continuing to signal red.
While China has become the big daddy in hydrocarbon use, for oil to fall so low, the US will also need to slip back into a recession, a prospect you hear a lot about as the Fed struggles to make sense of continuously conflicting data. In fact, there is now open debate about whether the Fed erred in raising rates in December, putting an end to what was “…one of history’s most fruitful periods for investors.” Indeed, an associated, and important, fear is that whether the central banks puts that had contained volatility and allowed the growth of multiple bubbles (including China) are gone forever. This would increase uncertainty across the board and certainly depress asset markets.
Equity markets will fall further—whether they will grind lower or fall sharply will depend on how US statistics roll out. While it may not get as bad as 2008-09, when the Dow fell by over 50%, we would see a bear market through 2016 at least. OK, calm down; remember, this is just a thought experiment.
Now, let’s look at the upside of $5 oil. Most important, Saudi Arabia and its cohorts would no longer be able to afford to export Wahhabism, which, in its recent practice, is an insult to Sunni Islam. So, too, Iran would have to constrain its support for “armies of liberation” in the Middle East. Isis, Al Qaeda and associated “franchise” terrorist organisations (thank you, Raghu) would—after some perhaps even more horrible events—shrivel up and die.
One-fourth of humanity would, over time, be spared the blind prejudice that has been spawned over the past three or four decades; equally importantly, nearly 300 million people (the population of the Middle East) would be able to get onto the global bandwagon bringing their energy, their dreams, their commitment, their strength, all of which would certainly pick up global growth by at least 1%.
The other major positive of unrelentingly falling markets is it forces the power elite to address the real issues, just as, after 2008, the financial sector was taken down several pegs to where today it is on track to (re)start providing meaningful value to the world economy.
Today, the real issue in the world is inequality—the incomprehensible divergence in income and wealth amongst the global population. Leaving all politics and morals aside, inequality is the singular root cause of very low demand and, in turn, the near-terminal decline in growth in the developed economies. While everyone is hailing Thomas Piketty, nobody is—yet—even thinking about whether anything can be done and, if so, what that should be.
A key part of the solution is that the roles of capital and labour have to be reversed from a fiscal standpoint. Instead of pampering capital by keeping taxes on capital-based income low, income taxes on labour (primarily, salaries) should be reduced to as close to zero as possible; to keep the fiscal balance (or, perhaps, even give it a push), taxes on capital gains, dividends, interest income, property and the like should be raised.
This conceptually simple solution (which will need careful implementation to ensure safety nets for the elderly, to ensure that hedge fund carried interest continues to be taxed at the new capital gains rates, etc.) will certainly raise shouts of “socialism.” But the truth is that capitalism has run long enough to corrupt itself and the natural cycle is turning, like it or not.
Welcome, Bernie Sanders!
The author is CEO, Mecklai Financial