In the second half of last year an unprecedented event took place that economists and market analysts didn’t seem to notice. Oil prices were halved in a matter of six months, with the benchmark barrel of Brent crude going down from $115 to $58.
There had been a steeper price drop in the oil market the second half of 2008, but, first, it took place in an environment of a global financial collapse and, second, it followed a speculative run over the previous year and a half — during which oil prices nearly quadrupled, from less than $40 to $147.
What we saw last year was a sudden, inexplicable slide that followed years of remarkable stability, when oil averaged over $100 in 2011–13. Plus, it happened while the world economy continued to grow.
That price collapse should have put investors on high alert. Clearly it wasn’t as if oil production suddenly spiked or demand evaporated. Rather, it was the first warning sign that asset price bubbles that had been inflating since 2009 thanks to zero percent interest rates supplemented with quantitative easing were starting to pop even without any rate hikes by the Fed and while no other major central bank in the world was even thinking of raising its rates.
Since oil prices plunged last year — and then, after mid-2015, dropped further, revisiting their post-Lehman Brothers lows — there has been a typical pattern of asset price deflation. Some bubbles followed suit, such as emerging market bonds and currencies. The few bubbles that have popped so far have already caused considerable financial losses. For example, lower oil prices have reduced the revenues of crude producers worldwide by $4.8 billion a day. While they also bring savings to oil users, the $6 trillion-plus lost in the Chinese stock market since the bubble started to deflate there and the trillions lost worldwide during the August declines are a net negative.
Yet investors, despite living through two meltdowns over the past decade, refuse to throw in the towel. Other bubbles have already inflated since the oil price decline — and have even already popped, such as the Chinese stock market. Others are still going — for instance, 10-year German government bonds, which saw their yield plunge from nearly 3.5% in mid-2011 to zero earlier this year. The NASDAQ Composite index rose some 1,000 points, or more than a quarter of its value, in the year to July 2015, breaking its previous all-time high.
The Greatest Bubbles
Investors clearly still have faith in the two institutions that bailed the world economy and financial markets in 2008 — namely, the U.S. Federal Reserve and the government in Beijing.
This is especially worrisome, because we’re not talking about financial bubbles but reputational ones. If they pop, their deflation could prove far more damaging.
Of the two, the reputation of the Chinese government looks far more precarious. For two decades, it seemed to do nothing wrong. China was growing at double-digit rates, deftly sidestepping financial crises that rocked the regional and global economies. But now, once the situation changed and the old development model stopped working, the bureaucrats in Beijing are suddenly at a loss. The government is reverting to its old repressive ways, reminding everyone that it is a Communist regime that used to starve and imprison people and stifle the entrepreneurial spirit during the Mao Zedong years.
China is at a crossroads. For many years, the government has been artificially keeping the economy out of recessions at all costs. Yet, periodic recessions have a salubrious effect on the economy, wiping the slate clean and getting rid of excesses. The danger is that by avoiding smaller corrections, China has set itself up for a huge one. Meanwhile, its economy has grown to be the second largest in the world, which means its economic and financial problems will surely reverberate around the globe.
The likelihood that the Fed’s reputational bubble will deflate is smaller, but the stakes if this does happen are much higher. For the past two decades, the Fed has been spurring Wall Street to new heights with the so-called “Greenspan put,” named after the longtime Fed chairman Alan Greenspan. There has been an implicit understanding that the Fed will ride to the market’s rescue with easier monetary policy if things start going badly wrong. This has created a sense of complacency among investors that was recently on full display. Market declines — even scary ones like the ones in late August — are seen as buying opportunities.
The Greenspan put has worked so far. Market troughs have been short-lived, and buying after some carnage has brought exceptional rewards time and time again. This is why, more than in previous market downturns, investors seem to be piling into stocks.
Running on Empty