An investor's terrifying 2014 prediction for the market is coming true right now
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Stocks are crashing, hedge funds are closing, and investors around world are moving into cash.
If you're confused and perplexed about the market we're in right now, this should bring some clarity to the situation.
In the third quarter of 2014, Dylan Grice, a portfolio manager at equity fund Aeris Capital, wrote a note that perfectly describes the market we're in right now.
Of course, back then stocks were riding high. The S&P 500 had closed the year up 11%, M&A deals and initial public offerings (IPOs) were being executed left and right, and the Federal Reserve had just finished QE3, the bond-buying program it began at the start of the financial crisis.
The world, we thought, was on the road to recovery.
But Grice did not think that. He believed that we were at the end of a cycle, though not one economists normally discuss. The cycle Grice was writing about was a "cycle of trust."
He wrote:
In my opinion, the period between the Berlin Wall coming down and the September 11th, 2001 attacks on the United States was the peak of the recent cycle. The degree of cooperation and trust was probably as high as it had been since a century earlier, as the 19th century became the 20th century.
But cycles move, and it's important to notice the signs that they've peaked. Looking around in 2014, Grice saw them everywhere.
He continued:
What we do think we know is that the financial markets are playing with a very cooperative mind-set while the key players and factions in the outside world are not. Non-cooperators are in the ascendancy and the investment climate will ultimately reflect this.
Trust and cooperation, you see, is what the entire global economy is built on.
How he saw it then
To execute an IPO, lend money, or buy stocks, you have to believe that the person you're executing a transaction with is acting in good faith.
As Grice pointed out when he wrote the note, in 2014 good faith and trust were all around. Remember, 43% of the bonds issued in 2014 had junk ratings of CCC, but people bought them anyway. Those buyers were trusting in the economic recovery, an easy monetary policy, and the creditworthiness of the issuers.
Outside the markets, however, Grice saw trust receding. Russia was moving aggressively away from the West, and the West responded with crippling sanctions. Far-right groups were getting louder in Europe, and the Japanese and Chinese were trading barbs about the South China Sea.
Trust seemed to be evaporating on a national level, too. Governments were still hitting banks hard with fines for offenses dating back to the financial crisis. Quantitative easing, or "money printing" as Grice calls it, was ending at the same time it was losing credibility as a policy.
The massive Petrobras scandal was unfolding in Brazil — a scandal that would shake the country's faith in the government that had guided the seventh-largest economy in the world to prosperity for decades. Party candidate Dilma Rousseff would go on to win the presidency by just a hair.
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Grice reasoned that these were signs that trust was evaporating. He argued that that trust — between governments, corporations, banks, and even people — would be sorely missed, as it is necessary to grease the wheels of the global economy.
"We... see it in the economic data," he wrote. "The Latin word for 'credit' is 'credere,' which means to trust... And I think the cycle of trust has turned.
"I don't think Russia and the West will go back to being friends any time soon; that China and Japan will dial bank their resurfacing mutual animosity; that the Middle East is about to solve its problems... I think it's only just the beginning, because I think that's how these cycles work."
How we're seeing it now
In January, the Bank for International Settlements (BIS) released a report showing that lending from banks to entities across borders was drying up. Lending to emerging-market economies slowed the most. Out of those, China was hit the hardest, as lending to the country from foreign banks fell 17% in 2015 from the same time a year before.
Business Insider VideoOdd, since it's hardly the worst off of all the emerging markets. Its economy certainly isn't in as much danger as, say, Brazil or Nigeria. Yet banks were losing faith.
Meanwhile, international bank lending to China peaked around the time Grice wrote his note in 2014, according to BIS data.
It isn't as if China's GDP data changed much in 2015. It's not as if the Chinese banking system suddenly became drastically more indebted, either.
But all of a sudden hedge funds are calling out its debt load. The government is being forced to defend its currency, and warning the entire world not to even think about shorting the yuan.
Investors don't trust that the Chinese government can handle this mess. No one trusts anyone anymore.
The CCC-rated bonds that investors were scooping up in 2014 are now the bane of hedge fund land. Junk bonds have already closed a few shops and sent investors screaming for the exits.
Just this week, several scheduled IPOs have been canceled or delayed. Donald Trump is riding high on the support of people who don't trust that the government has their best interests in mind.
No one seems to be able to put their finger on why stocks keep falling. Is it oil? Is it earnings? Is it China?
Financial companies suddenly look shaky, too. Deutsche Bank suggested in a recent note that European banks may be "the next oil" — the next excuse for why the world is willing to sell.
But maybe the reason is less tangible than that. Any trader will tell you that markets have a sentiment. Right now, if you believe Grice, that sentiment is mistrust.
And we're just at the beginning.
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