GU 31Dec15

The Great Unwinding of policymaker stimulus was the major issue in financial markets in 2015.  And it is set to have even greater impact in 2016 once Phase 3 begins.  The chart above highlights the astonishing changes that have taken place since the Unwinding began in mid-August 2014;

  • Phase 1 has so far seen Brent oil prices rise 65%, and the US$’s value versus other major currencies rise 22%
  • Phase 2 of the Unwinding began a year ago, as US 10-year interest rates began rising – they are now up 25%

What is even more astonishing is the lack of response from most analysts, investors and companies to these changes.  One Board member of a major oil company told me recently that his company simply refused to discuss the possibility of any oil price below $60/bbl – yet today’s prices are already nearly half this level.

The problem is the history of the past 15 years.  This has seen continuous, and growing, interference by central banks in the process of price discovery in financial markets:

  • They first invented the electronic printing of money in 1999 at the time of the Y2K issue.  This fueled the disaster of the dotcom bubble, which caused investors to lose $5tn as tech shares crashed
  • One would have thought this was warning enough – but then they created the subprime bubble and crash, which cased the global financial crisis
  • Even this wasn’t warning enough, so they created the Quantitative Easing bubble, which is now Unwinding with consequences yet to be discovered

The root cause of the problem is the widespread belief that central banks can somehow control the economic destiny of the world’s 7.3bn people by printing electronic money, and making very minor shifts on short-term interest rates.  Future historians will look back in amazement, and ask themselves how this belief developed.

Anyone under the age of 40 has only known a world where the banks’ liquidity has overwhelmed markets’ ability to set prices on the basis of supply/demand fundamentals.  Most of those aged over 40, with experience of an earlier world, have either gone bankrupt or learnt the new rules for success.  ”Buy on the dips” has been the essential motto.

But this world has changed, now that China has abandoned stimulus.  It provided half of the lending bubble since 2008, and so its New Normal policies are far more critical for the global outlook in 2016 than anything the US Federal Reserve, European Central Bank, or Banks of England and Japan might do.

As a result, 2016 is almost certain to be a very bumpy ride:

  • We have not yet had a the final “give-up rally” in energy markets, which is almost inevitable after a fall of this magnitude.  The reason is that consensus wisdom still believes that prices will return to previous highs.  Of course they might be proved right – but the odds against must be 80% at this point
  • This means investors have not yet realised that much of the $1.2tn invested in new energy production, and the $150bn planned in petchem investment, will never be repaid.  This will be a great shock, when reality dawns
  • Even more worrying is the $19tn that has been invested in emerging market debt over the past 5 years – more than the size of the US economy.  How much of this will ever be repaid is anyone’s guess
  • And then there is the rise in the world’s major interest rate benchmark – the US 10-year yield.  It is almost unbelievable that this could have risen by 25% in a year, and yet investors and the media still instead obsess over the potential impact of a 0.25% rise in US short-term rates

Phase 3 of the great Unwinding start to register, as more and more markets return to enabling price discovery on the basis of supply/demand fundamentals rather than central bank liquidity