As the Financial Times wrote on Saturday:
“Earlier this year, it all seemed so straightforward. Central banks printed money and proffered soothing words, and markets went up. Now, it’s getting more complicated.”
In fact, nervous readers might want to stay away from financial markets for a while. Just 2 weeks ago, crude oil prices suddenly rose $2/bbl and then fell $4/bbl within a few hours. Last week it was the turn of the Japanese yen. In 2 hours on Thursday, it rose 4% to $1:¥95. And this time, the impact hit other financial markets. The S&P 500 Index fell to 1600 as the yen strengthened, but then hit 1640 again as it weakened on Friday.
Nothing really changed in terms of fundamentals in these few short hours, of course. Instead, the rising volatility is being caused by the impact of 4 major cross-currents:
• Traders expect the US Federal Reserve to slow down its liquidity programme. So they buy the US$ and sell commodities and US stocks: commodities because they no longer need a ‘store of value’ and stocks because they are over-priced versus the state of the real economy
• Other traders believe the Japanese government intends to drive down the value of the yen, to boost exports, and so they buy the US$, US stocks and commodities to provide them with a ‘store of value’. They also dump government bonds, as the Fed and premier Abe’s declared aim is to boost inflation – which destroys value for bonds
• Still other traders continue to play in Brent oil markets. As a major article in Petroleum Review reminds us, Brent has been “a broken benchmark since the early 2000s” – it now trades only 120kb/day, and the total volume traded as ‘Brent’ is only 1Mb/day. Yet its “price sets the value of about 2/3rds of global oil production”
• And, of course, the high-frequency traders with the computers trading in micro-seconds can take advantage of all of this confusion. Using central bank liquidity they can trade millions of contracts every second, up and then down – or down and then up. They don’t care, as long as there is a fraction of a cent to be gained on each contract
This is the problem when governments and those with deep pockets are allowed to manipulate markets. They have taken prices well away from fundamental values in the real economy. But now the cost of continued manipulation is becoming too high, and new players are seeing opportunities to drive prices back to values set by supply and demand.
The rest of us simply get caught in the cross-fire. Volatility rises to extreme lengths as the elephants fight with each other. Revisiting the blog’s Budget Outlook for 2010-13, it seems clear the end result is that we are now headed into the Downside Scenario of deflation. Today’s turmoil is only the start of this process. As JP Morgan’s CEO Jamie Dimon warned Thursday:
“As we go back to normal, it’s going to be scary, and it’s going to be kind of volatile.”
Even more scary is that Dimon is wrong to assume we will go back to ‘normal’. Ageing Western populations mean we are now entering a New Normal, which has never existed before.
The chart shows latest benchmark price movements since January and ICIS pricing comments are below:
PTA China, red line, down 11%. “Chinese filament yarn plants were running at 83% capacity, while PSF plants were running at 60% capacity”
Naphtha Europe, black, down 8%. “Market remains oversupplied”
Benzene NWE, green, down 9%. “Demand remains softer than expected given the time of year”
Brent crude oil, blue, down 7%
HDPE USA export, yellow, up 9%. “Supply for the export market has improved”
US$: yen, orange, up 11%
S&P 500 stock market index, up 12%
Outsourcing and offshoring took off in western industry during the 1990s. The babyboomers’ demand supercycle meant new manufacturing capacity was urgently needed. And the entry of East Europe, China and India into the global economy offered a seemingly cheap way of achieving this. But today, new factors are reversing this trend.
The tragic deaths of 1100 Bangladesh textile factory workers will clearly accelerate the process, as consumers pressure retailers to increase manufacturing standards. But the trend has been developing for some time, led by major companies such as GE, whose map above highlights their creation of 16k new US jobs since 2009.
A major MIT study last year highlighted several key reasons for the new approach:
• Desire to bring products to market faster, by making them in the West
• Need to respond more rapidly to customer orders
• Reduced costs for transportation and warehousing
• Better protection of IP
• Higher quality
As an important article in Atlantic magazine noted last December, GE expects 75% of its $5bn Appliance Division’s sales to come from US production by next year, up from 55% in 2012. It notes the real benefit comes from applying new thinking – particularly the concepts of lean manufacturing. Simply recreating old-fashioned assembly lines will miss the point:
“In the simplest terms, an assembly line is a way of putting parts together to make a product; lean production is a way of putting the assembly line itself together so the work is as easy and efficient as possible.”
GE trialled the approach with its dishwasher team and successfully eliminated 35% of the labour required. And once they had reshored assembly, they began to manufacture key parts as well.
The key, as the Reshoring Initiative argues, is to focus on the total cost of ownership, not just wage costs. This is because today’s manufacturing environment is quite different from 20 years ago. Companies who reshore using lean manufacturing models will often find they can achieve lower ‘delivered cost’, even if the initial ‘purchase cost’ appears to be cheaper.
US investors are continuing to excite themselves over the potential for a re-run of the sub-prime housing boom from 2003-7. Thus they welcomed last week’s news of higher house prices with a major rally, after having ignored earlier reports of a slower pace in housing starts themselves. As the chart shows:
• Starts dropped back sharply in April to 850k from 1 million in March
• Key to recent growth has been an increase in multi-unit starts for renting (light blue)
• These are now 33% of total housing starts, compared to 25% historically
Multi-unit homes are generally for rental, and so their increase is part of a major shift in US housing trends. Home ownership in fact peaked back in 2004 at 69% according to Census Bureau data, and is now back at 1996 levels of 65%.
The data does however confirm that the 2008-2012 phase of the house market decline is over:
• The sub-prime collapse from 2008 meant that many buyers with low credit scores lost their homes. They have had to move back into the rental sector, boosting demand there
• Analysts CoreLogic estimate 4.4m homes have suffered foreclosure since September 2008, and that the number in the foreclosure process is now only 1.1m, down 24% versus April 2012
But investors are entirely wrong to assume that everything is back to “normal”. The key factor dominating housing markets today is instead the fact that many homeowners are underwater on their mortgage. Whilst many would like to move, they cannot afford to pay the difference between the current value of their home and the mortgage secured on it. As RealtyTrac note:
“11.3m mortgages nationwide are seriously underwater, meaning the combined amount of mortgages secured by the home was at least 25% more than the estimated value of the home. That represented 26% of all outstanding mortgages.”
The fact that these owners cannot afford to sell is thus temporarily supporting prices in many cities, as potential buyers have only a small number of properties from which to choose. For example, 50% of Nevada’s mortgages are underwater, as are 40% in Florida, and over 30% in Illinois, Ohio, Arizona, Michigan and Georgia.
Optimists may argue that today’s higher prices will enable more people to sell. But they may well also encourage the large investment firms such as Blackstone and Colony Capital (who have spent $bns on buying foreclosed properties for rental) to sell out for a quick profit. And increasing supply will not increase the number of buyers.
Equally, as investor magazine Barron’s notes, 91.6% of all new mortgages are currently being guaranteed by the government, and one third have deposits of less than 5%. As they comment:
“This housing recovery has been so stuffed with government steroids, you wonder if it could make it on its own if these drugs were withdrawn.”
China has now published initial data on its key areas of GDP growth in 2012. As the chart shows, this highlights the major task ahead of the new leadership as they seek to rebalance the economy towards a more sustainable future:
• Infrastructure (green) continued to increase as a share of GDP to 46%
• Household consumption (red) was flat at 36%
• Net exports (black) declined to 3%
The major issue facing China’s economy has been the collapse of exports, which were 9% of GDP in 2007. These are unlikely to recover due to the ending of the BabyBoomer-led demand SuperCycle. Western manufacturers no longer need to outsource production to China and as the blog will discuss on Saturday, some production is already beginning to return to the West.
Thus President Xi and Premier Li have little choice but to refocus the economy on household consumption. Their problem is that the previous leadership allowed its share to fall from 44% over the past decade (yellow highlight), whilst infrastructure’s share increased from 36%.
By contrast, most developed countries base their economies on household consumption, which is 60% of Western GDP. Essentially, China’s ‘dash for growth’ on joining the World Trade Organisation in 2001 means it now has vast amounts of unneeded new capacity. Its dream of becoming the ‘manufacturing capital of the world’ risks turning into a nightmare.
Over-capacity not only exists in major industries such as steel, but also in housing. China’s statistics board notes that 3.7bn m² are currently under construction – 4 years’ worth of demand. And as the blog has noted before, cities such as Ordos are still waiting to be occupied.
Equally problematic is that since 2008, the previous leadership had avoided tough decisions by boosting credit. But this has been subject to the law of diminishing returns as Bloomberg note:
“(In Q1) each $1 in credit firepower added the equivalent of 17 cents in GDP, down from 29 cents last year and 83 cents in 2007, when global money markets began to freeze”.
Similarly ratings agency Fitch warn that China has effectively been “adding assets at the rate of an entire US banking system in 5 years.” These conclusions are very similar to the blog’s own concerns since 2010, that China’s attempt to reflate its economy via massive lending programmes could easily go badly wrong.
Fitch also worry about the growth of so-called wealth management products in China. As the Bank of China’s chairman warned in October “To some extent, this is fundamentally a Ponzi scheme“, where new investments are used to pay the high interest offered to earlier investors.
The new leadership clearly understand the risks they face. They also seem increasingly likely to try and clamp down hard on the major problems sooner rather than later. 5% GDP growth may therefore prove to be a maximum rather than a minimum level for the next couple of years.
The blog still owns the lapel button it was given when running ICI’s feedstock and petchem trading office in Houston, Texas. Its advice for any trader is excellent – ‘The Trend is Your Friend’. But as all traders learn over time, there are moments when the trend can change. And sometimes, when change happens, it takes place suddenly and with devastating effect for profits.
This is why it is very nervous about the current state of the oil market. There are more and more signs that the lengthy upward trend that began in 2009 is breaking down. As the chart of recent daily Brent oil prices shows, one warning sign is that volatility has increased quite sharply.
The issue is simple, whether traders still believe that the US Federal Reserve will provide enough liquidity to keep prices moving higher. Once they lose this faith, then prices will instead start to reconnect with the fundamentals of supply/demand. Friday morning’s Reuters’ oil report aptly describes the highly dangerous fairy tale world in which we are living:
“Oil prices were underpinned by a round of weak U.S. economic data, indicating growth was slower than expected in the first quarter and revealing a surprise rise in jobless claims on Thursday. The data was supportive because signs the economy was still fragile helped reassure investors money policy would remain accommodative.”
In other words, the market currently believes lack of demand is a ‘good thing’, as this means the US Federal Reserve will likely continue the supply of cheap liquidity to keep prices high.
US margin debt is also flashing a red alert, having just set a new record at 2.25% of GDP. It measures the amount borrowed to invest in financial markets, and confirms the speculative mania created by the liquidity programmes. It has only reached this level twice before – in 2000 and 2007. We all know what happened afterwards in terms of market performance.
Latest benchmark price movements since January and ICIS pricing comments are below:
PTA China, down 11%. “Market lacks upward momentum because of the weak macroeconomic environment and lower feedstock prices”
Naphtha Europe, black, down 11%. “Supply is lengthening as high-volume exports to Asia have come to a close.”
Benzene NWE, down 9%. “Any upturn on May pricing was limited by several styrene players selling benzene instead of consuming it for styrene production”
Brent crude oil, down 8%
HDPE USA export, up 9%. “Buyers are not eager to buy at the higher prices and are waiting to see if offers move lower”
S&P 500 stock market index, up 11%
US$: yen, up 14%