Market Pain

As those of you who take an interest in the global financial markets will be aware, the last week or so on the world’s stock markets has been unusually volatile in a mostly downward direction. The question now on everyone’s lips is of course “when or where will it end?” or “should we worry about this?” but as is typical at moments like this the hallowed economists who love to hog the camera during bull runs are either nowhere to be seen or issuing pointless statements like “Its a correction” (meaning they just don’t know). So why is it these experienced gentlemen don’t know what’s going on exactly? Well I suppose the simple answer is that the world has never been in a situation like this before and lets face it, economics is about extrapolation not sooth-saying.

So what started this bear run?

In spite of the fact that this has been expected for some time in some form or other it was really set in motion after the G7 finance ministers’ meeting in Washington last April warned :

“Excess volatility and disorderly movements in exchange rates are undesirable for economic growth”, and urged the US to cut its budget deficit and China to adjust its currency.

This was expanded upon at the recent Organisation for Economic Cooperation and Development (OECD) meeting in Paris :

“The large extent of deficits of some countries, combined with the surpluses of their trading partners and the oil-producing countries, can pose considerable risks to global economic stability, so it is crucial that we do something about them,” Mr Alogoskoufis (Greek finance minister) said.

Some of these imbalances “are clearly not sustainable and will have to be addressed in an effective manner as soon as possible,” he added.

Essentially, the American trade deficit and massive personal debt is being financed by cash and security surpluses held by Asian manufacturing blocs and oil rich Middle-Eastern countries. Added to this the dollar is too high and the Yuan is too low yet both governments have been resisting revaluation up until now for political reasons at home. Added to this we are in the middle of a commodities bubble, particularly crude oil, copper, steel and gold and if you didn’t think this was enough the world’s banking system is being inflated by the over-sale of complex derivative products, particularly the new kid on the block; credit derivatives.

Its a complex set of variables and a heady recipe for disaster, the only good side to all of this is that nobody can really benefit from a collapse and a lot of people will be doing their best to avert it but there is a real and ever-present threat.

Where are we going with this?

First of all lets look at the effect of the oil price rises we have seen over the last year. If you look at the price of crude it appears that we are at a heady all-time high but if you factor in inflation and compare it to prices in the ’80s you soon realise that oil prices are not high at all but the global economy has been enjoying dirt-cheap oil for the last decade or so, which is what has really been fuelling the manufacturing growth of the late ’90s and over the last five years in Asia. So it seems that the fear over high oil prices is somewhat over-stated.

Now conventional wisdom dictates that high oil prices stifle economic growth but somehow we have not been seeing that and American growth figures are healthy. That is because many of the world’s oil companies are American owned and with higher prices their profits are rising, these profits get re-invested in the wider economy and boost growth figures. The real concern is that this is not real growth in the classical sense and it may not last, particularly if prices dip. The second conventional wisdom is that higher oil prices boost inflation but we have not really been seeing this because of boosts in productivity (and efficiency) and a reliance on cheap imports from low wage economies such as Asia who are able to maintain this competitive edge and take the inflationary hit so to speak because they are already cash rich and they are keeping their currencies unnaturally low.

This imbalance in trade is unsustainable and worsening by the day, most economists recognise this and its why they are getting nervous. Normally this would cause modest market fluctuations but with the markets heavily dependent on complex derivatives these fluctuations are getting magnified out of all proportion giving rise to extreme volatility. The only winners are going to be the traders and the institutions they work for as these instruments change hands at the speed of light.

Where is it going to end?

Sadly the old rules no longer apply, the notion that the markets are still free is naive the “Markets” today are little more than Keynesian government-run mercantile systems and they’ve made a bit of a mess of things. There is going to have to be a correction, it may be a gentle manoeuvre or it may be a nasty jolt. When it will really come I just don’t know but lets hope its sooner rather than later because we are currently at the peak of the oil-production curve, if it happens on the downward curve it will be painful.