The tide of global debt has peaked: 8 charts suggest what may happen next, as the tide retreats

The results of the central bankers’ great experiment with money printing are now in, and they are fairly depressing, as the charts above confirm:

  • On the left are the IMF’s annual forecasts from 2010 – 2018 (dotted lines) and the actual result (black)
  • Until recently, the Fund was convinced the world would soon see 5% GDP growth, or at least 4% growth
  • The actual outcome has been a steady decline until 2017 and this month’s forecast sees slowing growth by 2020

As the IMF headlined last week,current favorable growth rates will not last”.

  • On the right, is the amount of money the bankers have spent on money printing to achieve this result
  • China, the US, Japan, the Eurozone and the Bank of England printed over $30tn between 2009-2017
  • So far, only China – which did 2/3rds of the printing, has admitted its mistake, and changed the policy

The chart above shows what happens if you spend a lot of money without getting much return in terms of growth.  Again from the IMF, it shows that total global debt has risen to $164tn.  This is more than twice the size of global GDP – 225%, to be exact, based on latest 2016 data.  The IMF analysis also highlights the result of the money printing:

“Debt-to-GDP ratios in advanced economies are at levels not seen since World War II….In the last ten years, emerging market economies have been responsible for most of the increase. China alone contributed 43% to the increase in global debt since 2007. In contrast, the contribution from low income developing countries is barely noticeable.”

It doesn’t take a rocket scientist to work out the result of this failed policy, which is shown in the above IMF charts:

  • Global debt to GDP levels are higher than in 2008 and in the financial crisis; only World War 2 was higher
  • Debt ratios in the advanced economies are at their highest since the 1980s debt crisis
  • Emerging market ratios are lower (apart from China), but this is because of debt forgiveness at the Millennium

CAN ALL THIS DEBT EVER BE PAID PACK?  AND IF NOT, WHAT HAPPENS?
As everyone knows, borrowing is easy.  Almost all governments and commentators have lined up since 2009 to support the money-printing policy.  But the hard bit happens now as it starts to become obvious that the policy has failed.

We now have all the debt, but we don’t have the growth that would enable it to be paid off.

It would be easy to simply end here, and point out that John Richardson and I set out the reasons why money-printing could never work in 2011, when we published Boom, Gloom and the New Normal: How the Ageing of the BabyBoomers is Changing Demand Patterns, Again.  Our conclusion then was essentially based on common sense:

Central bankers simply confused cause and effect: demographics drive the economy, not monetary policy. 

Common sense tells us that young populations create a demographic dividend as their spending grows with their incomes.  But today’s ageing Western populations have a demographic deficit: older people already own most of what they need,and their incomes decline as they enter retirement.

But having been right in the past doesn’t help to solve today’s problem of excess debt and leverage:

  • Common sense also tells us that leverage equals risk – if it works out, everything is fine; if not…..
  • If you have a lot of debt and the world moves into recession, it becomes very hard to repay the debt

Financial markets are doing their best to warn us that the problems are growing.  Longer-term interest rates, which are not controlled by the central banks, have been rising for some time. They are telling us that some investors are no longer simply chasing yield.  They are instead worrying about risk – and whether their loan will actually be repaid.

Essentially, we are now in the and-game for stimulus policies.  Major debt restructuring is now inevitable – either on an organised basis, as set out by Bill White, the only central banker to warn of the 2008 Crisis – or more chaotically.

This restructuring is going to be painful, as the chart above on the impact of leverage confirms.  I originally highlighted it in August 2007, as the Crisis began to unfold – unfortunately, it now seems to have become relevant again..

PLEASE DON’T FIND YOURSELF SWIMMING NAKED WHEN THE TIDE OF DEBT GOES OUT 
Leverage makes people appear to be geniuses on the way up.  But on the way down, Warren Buffett’s famous warning is worth remembering: “Only when the tide goes out do you discover who’s been swimming naked”.

 

*Return on Equity is the fundamental measure of a company’s profitability, and is defined as the amount of profit or net income a company earns per investment dollar. 

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China’s central bank governor warns of ‘Minsky Moment’ risk

The world is coming to the end of probably the greatest financial bubble ever seen.  Since the financial crisis began in 2008, central banks in China, the USA, Europe, the UK and Japan have created over $30tn of debt.

China has created more than half of this debt as the chart shows, and its total debt is now around 260% of GDP.  Its actions are therefore far more important for global financial markets than anything done by the Western central banks – just as China’s initial stimulus was the original motor for the post-2008 “recovery”.

Historians are therefore likely to look back at last month’s National People’s Congress as a key turning point.

It is clear that although Premier Li retained his post, he has effectively been sidelined in terms of economic policy.  This is important as he was the architect of the stimulus policy.  Now, President Xi Jinping appears to have taken full charge of the economy, and it seems that a crackdown may be underway, as its central bank chief governor Zhou Xiaochuan has been explaining:

  • Zhou first raised the issue at the National Congress last month, warning of the risk of a “Minsky Moment” in the economy, where debt or currency pressures could park a sudden collapse in asset prices – as occurred in the US subprime crisis.  “If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment.  We should focus on preventing a dramatic adjustment.”
  • Then last week, he published a warning that “China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing. [China] should prevent both the “black swan” events and the “gray rhino” risks.”

We can be sure that Zhou was not speaking “off the cuff” or just in a personal capacity when he made these statements, as his comments have been carried on both the official Xinhua news agency and on the People’s Bank of China website.  As Bloomberg report, he went on to set out 10 key areas for action:

  • “China’s financial system faces domestic and overseas pressures; structural imbalance is a serious problem and regulations are frequently violated
  • Some state-owned enterprises face severe debt risks, the problem of “zombie companies” is being solved slowly, and some local governments are adding leverage
  • Financial institutions are not competitive and pricing of risk is weak; the financial system cannot soothe herd behaviors, asset bubbles and risks by itself
  • Some high-risk activities are creating market bubbles under the cover of “financial innovation”
  • More companies have been defaulting on bonds, and issuance has been slowing; credit risks are impacting the public’s and even foreigners’ confidence in China’s financial health
  • Some Internet companies that claim to help people access finance are actually Ponzi schemes; and some regulators are too close to the firms and people they are supposed to oversee
  • China’s financial regulation lags behind international standards and focuses too much on fostering certain industries; there’s a lack of clarity in what central and regional government should be responsible for, so some activities are not well regulated
  • China should increase direct financing as well as expand the bond market; reduce intervention in the equity market and reform the initial public offering system; pursue yuan internationalization and capital account convertibility
  • China should let the market play a decisive role in the allocation of financial resources, and reduce the distortion effect of any intervention
  • China should improve coordination among financial regulators”

Clearly, Xi’s reappointment as President means the end of “business as usual” for China, and for the support provided to the global economy by Li’s stimulus policies.  Xi’s own comments at the Congress confirm the change of direction, particularly his decision to abandon the idea of setting targets for GDP growth.  As the press conference following the Congress confirmed, the focus is now on the quality of growth:

“China’s main social contradiction has changed and its economic development is moving to a stage of high-quality growth from a high-rate of expansion of the GDP,” said Yang Weimin, deputy head of the Office of the Central Leading Group on Financial and Economic Affairs. “The biggest problem facing us now … is the inadequate quality of development.”

Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy.  China’s lending bubble – particularly in property, is likely coming to an end.  In turn, this will lead to a bumpy ride for the global economy.

 

Budgeting for the Great Unknown in 2018 – 2020

“There isn’t anybody who knows what is going to happen in the next 12 months.  We’ve never been here before.  Things are out of control.  I have never seen a situation like it.

This comment from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing companies, investors and individuals as we look ahead to the 2018 – 2020 Budget period.  None of us have ever seen a situation like today’s.  Even worse, is the fact that risks are not just focused on the economy, or politics, or social issues.  They are a varying mix of all of these.  And because of today’s globalised world, they potentially affect every country, no matter how stable it might appear from inside its own borders.

This is why my Budget Outlook for 2018 – 2020 is titled ‘Budgeting for the Great Unknown’.  We cannot know what will happen next.  But this doesn’t mean we can’t try to identify the key risks and decide how best to try and manage them.  The alternative, of doing nothing, would leave us at the mercy of the unknown, which is never a good place to be.

RISING INTEREST RATES COULD SPARK A DEBT CRISIS

Central banks assumed after 2008 that stimulus policies would quickly return the economy to the BabyBoomer-led economic SuperCycle of the previous 25 years.  And when the first round of stimulus failed to produce the expected results, as was inevitable, they simply did more…and more…and more.  The man who bought the first $1.25tn of mortgage debt for the US Federal Reserve (Fed) later described this failure under the heading “I’m sorry, America“:

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2

• And the Fed was not alone, as the chart shows.  Today, the world is burdened by over $30tn of central bank debt
• The Fed, European Central Bank, Bank of Japan and the Bank of England now appear to “own a fifth of their governments’ total debt
• There also seems little chance that this debt can ever be repaid.  The demand deficit caused by today’s ageing populations means that growth and inflation remain weak, as I discussed in the Financial Times last month

China is, of course, most at risk – as it was responsible for more than half of the lending bubble.  This means the health of its banking sector is now tied to the property sector, just as happened with US subprime. Around one in five of all Chinese apartments have been bought for speculation, not to be lived in, and are unoccupied.

China’s central bank chief, Zhou Xiaochuan, has warned that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008.  Similar risks face the main developed countries as they finally have to end their stimulus programmes:

• Who is now going to replace them as buyers of government debt?
• And who is going to buy these bonds at today’s prices, as the banks back away?
$8tn of government and corporate bonds now have negative interest rates, which guarantee the buyer will lose money unless major deflation takes place – and major deflation would make it very difficult to repay the capital invested

There is only one strategy to manage this risk, and that is to avoid debt.  Companies or individuals with too much debt will go bankrupt very quickly if and when a Minsky Moment takes place.

THE CHINA SLOWDOWN RISK IS LINKED TO THE PROPERTY LENDING BUBBLE

After 2008, it seemed everyone wanted to believe that China had suddenly become middle class by Western standards. And so they chose to ignore the mounting evidence of a housing bubble, as shown in the chart above.

Yet official data shows average incomes in China are still below Western poverty levels (US poverty level = $12060):

•  In H1, disposable income for urban residents averaged just $5389/capita
•  In the rural half of the country, disposable income averaged just $1930
•  The difference between income and expenditure was based on the lending bubble

As a result, average house price/earnings ratios in cities such as Beijing and Shanghai are now more than 3x the ratios in cities such as New York – which are themselves wildly overpriced by historical standards.

Having now been reappointed for a further 5 years, it is clear that President Xi Jinping is focused on tackling this risk.  The only way this can be done is to take the pain of an economic slowdown, whilst keeping a very close eye on default risks in the banking sector.  As Xi said once again in his opening address to last week’s National Congress:

“Houses are built to be inhabited, not for speculation. China will accelerate establishing a system with supply from multiple parties, affordability from different channels, and make rental housing as important as home purchasing.

China will therefore no longer be powering global growth, as it has done since 2008.  Prudent companies and investors will therefore want to review their business models and portfolios to identify where these are dependent on China.

This may not be easy, as the link to end-user demand in China might well be further down the supply chain, or external via a second-order impact.  For example, Company A may have no business with China and feel it is secure.  But it may suddenly wake up one morning to find its own sales under attack, if company B loses business in China and crashes prices elsewhere to replace its lost volume.

PROTECTIONISM IS ON THE RISE AROUND THE WORLD

Trade policy is the third key risk, as the chart of harmful interventions from Global Trade Alert confirms.

These are now running at 3x the level of liberalising interventions since 2008, as Populist politicians convince their voters that the country is losing jobs due to “unfair” trade policies.

China has been hit most times, as its economy became “the manufacturing capital of the world” after it joined the World Trade Organisation in 2001.  At the time, this was seen as being good news for consumers, as its low labour costs led to lower prices.

But today, the benefits of global trade are being forgotten – even though jobless levels are relatively low.  What will happen if the global economy now moves into recession?

The UK’s Brexit decision highlights the danger of rising protectionism. Leading Brexiteer and former cabinet minister John Redwood writes an online diary which even campaigns against buying food from the rest of the European Union:

There are many great English cheese (sic), so you don’t need to buy French.

No family tries to grow all its own food, or to manufacture all the other items that it needs.  And it used to be well understood that countries also benefited from specialising in areas where they were strong, and trading with those who were strong in other areas.  But Populism ignores these obvious truths.

•  President Trump has left the Trans-Pacific Partnership, which would have linked major Pacific Ocean economies
•  He has also said he will probably pull out of the Paris Climate Change Agreement
•  Now he has turned his attention to NAFTA, causing the head of the US Chamber of Commerce to warn:

“There are several poison pill proposals still on the table that could doom the entire deal,” Donohue said at an event hosted by the American Chamber of Commerce of Mexico, where he said the “existential threat” to NAFTA threatened regional security.

At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail.  But what if they are wrong?  It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.

Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.

POLITICAL CHAOS IS GROWING AS PEOPLE LOSE FAITH IN THE ELITES
The key issue underlying these risks is that voters no longer believe that the political elites are operating with their best interests at heart.  The elites have failed to deliver on their promises, and many families now worry that their children’s lives will be more difficult than their own.  This breaks a century of constant progress in Western countries, where each generation had better living standards and incomes.  As the chart from ipsos mori confirms:

•  Most people in the major economies feel their country is going in the wrong direction
•  Adults in only 3 of the 10 major economies – China, India and Canada – feel things are going in the right direction
•  Adults in the other 7 major economies feel they are going in the wrong direction, sometimes by large margins
•  59% of Americans, 62% of Japanese, 63% of Germans, 71% of French, 72% of British, 84% of Brazilians and 85% of Italians are unhappy

This suggests there is major potential for social unrest and political chaos if the elites don’t change direction.  Fear of immigrants is rising in many countries, and causing a rise in Populism even in countries such as Germany.

CONCLUSION
“Business as usual” is always the most popular strategy, as it means companies and investors don’t have to face the need to make major changes.  But we all know that change is inevitable over time.  And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.

At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“.  But, of course, this is nonsense.  What they actually mean is that “nobody wanted to see this coming“.  The threat from subprime was perfectly obvious from 2006 onwards, as I warned in the Financial Times and in ICIS Chemical Business, as was 2014’s oil price collapse. Today’s risks are similarly obvious, as the “Ring of Fire” map describes.

You may well have your own concerns about other potential major business risks. Nobel Prizewinner Richard Thaler, for example, worries that:

“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”

We can all hope that none of these scenarios will actually create major problems over the 2018 – 2020 period. But hope is not a strategy, and it is time to develop contingency plans.  Time spent on these today could well be the best investment you will make. As always, please do contact me at phodges@iec.eu.com if I can help in any way.

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Chemical industry downturn challenges stock market optimism

ACC Jun17Stock markets used to be a reliable indicator for the global economy, and for national economies. But that was before the central banks started targeting them as part of their stimulus programmes.  They have increased debt levels by around $30tn since the start of the Crisis in 2008, and much of this money has gone directly into financial markets.  Today, Japan is a great example of the distortions this has produced, as the Financial Times reports:

□  The Bank of Japan (BoJ) has been buying stocks via its purchases of Exchange Traded Funds (ETFs) since 2010
□   Last July, it doubled its purchases to ¥6tn of ETFs($58bn) per year, focused on supporting Abenomics policy
□   Analysis by Japanese bank Nomura suggests its purchases have since boosted the Nikkei Index by 1400 points

Even more importantly, the BoJ is particularly active if the market looks weak.  Between April 2013 – March 2017, it bought on more than half of the days when the market was down.

The distortion ins’t just limited to direct buying by the BoJ, of course.  It is magnified by the fact that everyone else in the market knows that the BoJ is buying.  So going short is a losing proposition.  Equally, investors know that the BoJ is guarding their back – so they are guaranteed to win when they buy.

This manipulation by the BoJ is just an extreme form of the intervention carried out by all the central banks.  It means that the stock market has lost its role as an indicator of the economy.  And so all those models which include stock market prices in their calculations are also over-optimistic.

This is why the global chemical industry has become the best real-time indicator for the real economy.  As I noted back in January, it has an 88% correlation with IMF data for global growth – far better than any other indicator:

The logic behind the correlation is partly because of the industry’s size.  But it also benefits from its global and application reach. Every country in the world uses relatively large volumes of chemicals, and their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles.

Latest data on Capacity Utilisation (CU%) from the American Chemistry Council is therefore very worrying, as the chart shows:

□   Since 2009, the CU% has never recovered even to the 1987 – 2008 low of 86.4%
□   It has been in a downward trend since January 2016, when it peaked at 81.4%
□   April’s CU% fell to 79.9% versus 80.7% in April last year
□   This was very close to the all-time low of 77% seen in March 2009

The problem is that central banks have moved from the pragmatism of the 1980s to ideology.  They have become, in Keynes’s famous phrase “slaves to some defunct economist” – in this case, Milton Friedman and Franco Modigliani, as we argued in our evidence earlier this year to the UK House of Commons Treasury Committee:

“Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid.  Modigliani’s “Life Cycle theory of consumption” is similarly out of date. … Friedman and Modigliani’s theories appeared to make sense at the time they were being developed, but they clearly do not fit the facts today.”

Instead of the promised economic growth, the central banks have in fact simply piled up more and more debt – which can never be repaid.  2 years ago, the global total was already $199tn, and 3x global GDP, according to McKinsey. Just in the US, this means net interest payments will cost $270bn this year, and total $1.7tn over the next 5 years, according to the impartial Congressional Budget Office.

Stock markets may continue in their optimistic mode for a while longer.  But in the end, the lack of promised growth will force the central banks to stop printing money.  They will then have to abandon their ideological approach, and instead accept the common sense argument of our Treasury Committee evidence:

Monetary policy should no longer be regarded as the key element of economic policy.   This would then free policymakers to focus on the real demographic issues that will determine growth in the future – namely how to encourage people to retrain in their 50s and 60s to take advantage of the extra 20 years of life expectancy that we can all now hope to enjoy.”