The
great bull market is over. Following at least two years during which the stock
market disconnected greatly from any sensible long term estimates of earnings
and economic fundamentals, speculators are in the process of landing on earth
once again. Greater fools are increasingly in short supply as around the world
stock markets have plunged since peaking during spring and summer time last
year. Many major stock markets have since “officially” entered a bear market. [1]
The S&P 500 is down 14.2%, Nikkei is down 28.3%, Shanghai has plunged
46.5%, stocks in Europe are down 26.6% while the oil dependent major stock
market index in Norway has shred 20.8%.
Even
more noteworthy, the stocks of major banks have crashed. Since their
(intermediary) peaks in Q2 last year, Goldman Sachs has dropped 35.6%, JP Morgan
24.3%, Bank of America 39.6% and last but not least, Deutsche Bank has
plummeted a full 57.0%.
What to blame this time around? Well, China of course. And sharply lower oil prices which today are even lower than in the midst of the previous banking crisis (December 2008).
That
oil prices consistently remained near $100 per barrel for almost four years
(2011-2014) no doubt helped fuel booms across all sectors benefiting from high
oil prices. These sectors faced great challenges during the whole of 2015 and
do so even more today as oil prices have continued to drop and are now eating away
at balance sheets and expected earnings. Of grave
concern is the exposure banks have to the oil sector as default- and delinquency
rates will increase as a result of lower oil prices. Furthermore, market values
of collateral will also decline due to the lower cash flows these assets now generate (e.g. oil rigs). To protect their balance sheets, a natural response by
the banking sector is not only to not extend further loans to the sector, but
also to tighten lending to other parts of the economy. One therefore should not
be surprised to see a sharp contraction in bank lending growth going forward. This
could trigger an economic collapse in the U.S. and world-wide for one primary
reason: ever since the Federal Reserve started tapering in 2014 and ending QE3
the same year, it has been the U.S. commercial banks that have supplied the economy
with ever more money. When bank lending growth stops the money supply growth
rate will stall as well, bringing with it a plethora of necessary economic
adjustments. The truth is however that, though it has remained high, the
lending growth rate in the U.S. has already stalled...
…resulting
in a money supply growth rate that has remained flat for the better part of the
last year, but which during the last week has collapsed to a level last seen toward the end of 2008.
And do keep in mind: though the money supply growth rate has been uncommonly stable for quite some time, it is considerably lower today than at any time since the 2008 banking crisis. The money supply growth rate has in effect been in a bear market for some time.
Some of
these economic adjustments caused by a slowing money supply growth rate are
already well under way, the most apparent ones perhaps being the sharp fall in
stock market prices and the dramatic increase in junk bond yields. [2]
A
feed-back loop is now in progress: the significant growth in money supply
following the 2008 banking crisis created an asset price boom that has now come
to an end and is rapidly deflating. The financial turmoil this creates will further
deter bank lending growth which will result in stock prices and other assets and
commodity prices deflating further. Margin calls will surge while margin lending
will contract pushing stocks down still further. The previously money
supply-inflated company earnings decline rapidly and stock prices fall
substantially quicker as expectations move quicker than earnings reports. Write-downs
and big bath accounting soon follow suit adding to the woes. When such events
unfold, stock prices easily shred 50% of their peak values and, if history is
any guide, fall back to pre-boom levels. Interest rates will rise and the
expectations of such an increase combined with a flight to safety will mirror a
decline in P/E ratios. Employment previously benefiting from ever new
injections of money will now to some extent be lost. Capital will also be partly lost. Consumption spending will
decline and savings rates will increase. Investment spending will also drop and
remain low until new savings have accumulated sufficiently and the economy has
adjusted to the new economic reality.
Way
before the economy has fully adjusted, but after the stock market has lost much
of its value, the Federal Reserve will intervene. QE4 is implemented and the
whole merry-go-round starts once again. But central bank interventions will become less
and less effective with every bust as savings and capital are becoming
increasingly scarce.
Such is the case not only in the U.S., but in most (developed)
countries around the world as only too evident in surging debt levels. This is
one reason “currency wars” might soon be replaced with “capital wars”, i.e. a
state where countries once again compete to attract savings and investments
from abroad. And such a war is not won by implementing negative interest rates
and destroying the local currency. Quite the opposite.
[1]
A drop of 20% or more from the peak say some financial pundits.
[2] Do keep in mind that the damage was actually done during the period the money supply was inflating.
Disclaimer: I am short U.S. mid-caps and the Norwegian Benchmark Index. Read the full disclaimer here.
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