The litmus test for the global economy

Policy makers talk, whilst markets weaken

LeadIndic Nov11.pngPetchem markets are telling us something very important about the state of the global economy. They are doing their usual job as leading indicators. Prices for all 4 of the blog’s benchmark products are now down over 20% since it launched the IeC Downturn Monitor at the end of April.

The OECD’s leading indicators also “point more strongly to a slowdown”, as the chart above shows from the American Chemistry Council’s weekly report. All 3 indicators for the world’s major economies (green line), industrial production (red) and global trade (blue) are weakening.

The problem is that policy makers are ignoring the message.

Credit conditions are a key concern today for most companies. Bank lending has slowed everywhere. It is particularly tight in the Eurozone and in China, where bankruptcies seem set to increase quite sharply.

Today’s high oil prices make the position especially dangerous. 5kt of benzene costs $4.4m today, other products cost even more.

This means that consumers can’t afford to buy new stock, whilst producers have to worry more and more about credit risk. So we have fallen into a vicious circle, where we all live from hand to mouth, whilst the politicians behave as if today’s problems are merely temporary:

• In Europe, Germany is busy negotiating long-term changes to EU Treaties to “impose German-style financial discipline on its partners”
• In the USA, politicians are spending more and more time campaigning for next year’s elections, rather than governing
• In China, they are also jockeying for position, as up to two thirds of today’s leadership will be replaced at H2 2012’s Party Congress

Their complacency is a legacy from the BabyBoomer-led Supercycle. They all still believe in the concept of ‘pent-up’ demand, and the ability of central banks to avert major crisis. Therefore they think they have the luxury of ignoring today’s increasingly urgent problems.

If they are wrong, as seems almost certain to the blog, then we all risk paying a heavy price when their mistake becomes obvious.

ICIS pricing comments this week, and price movements since 29 April for the benchmark products in the IeC Downturn Monitor are below:

Benzene NWE (green), down 33%. “Demand eased on the back of wider economic uncertainty within the eurozone and fears of another recession”.
HDPE USA export (purple), down 24%. “Activity picking up in Central and Latin American markets.”
Naphtha Europe (brown dash), down 24%. “Market remains in oversupply and stock levels are building.”
PTA China (red), down 21%. “Producers have been running their plants at a loss since October. Downstream textile processors have either closed down or reduced their plants’ operating rates because of tight cash flow at the end of the financial year and few new orders.”
Brent crude oil (blue dash), down 12%.
S&P 500 Index (pink dot), down 11%

EU auto sales hit new lows

EU autos Nov11.pngAutos are now the single biggest market for petchem sales. They are also reported very quickly. So October’s EU auto sales provide the best real-time picture of the downturn now underway. As the chart shows:

• October’s sales (red square) were the lowest in recent years
• Total sales since January are also the lowest
• They are 16% below the 2007 peak

It is not difficult to write the script from here. People in the weaker economies such as Spain or Italy will not be buying many new cars in the next few months. Austerity programmes and rising unemployment do not encourage purchases of high cost items.

Equally, as Petromatrix report, consumers are cutting back on their driving, as they worry about high fuel costs. Germany’s diesel demand was down 6% in September versus 2010, whilst gasoline demand was down 3%. Data for the other 4 main markets (France, UK, Italy, Spain) shows similar trends.

Already the auto makers are starting to respond. GM said its results were “not sustainable and not acceptable”, adding that it was looking at ways to reduce costs. Others such as Peugeot have already announced production cuts and layoffs.

Q1 could be very difficult indeed, if current trends continue.

US farmland enters the New Normal

New Normal logo.pngThe downturn in the US housing market is turning out to have a silver lining, according to the Wall Street Journal.

It describes how farmers in some areas are now able to buy back land previously sold for housing development, and return it to agricultural use:

• Residential land value has fallen 70% since the Q2 2006 peak
• Agricultural land value is up ~20%

Thus one Arizona farmer has paid $8m to replant alfalfa and cotton on land sold in 2005 for $41m. Whilst a group of Chicago farmers have bought back land for $8k/acre that was originally sold for twice this value.

As one farmer notes “these prices are becoming the new normal”, due to the “major demographic shift” now underway in the USA. Land is no longer needed for new housing developments in the countryside. Instead the Boomers are preferring to stay close to the cities.

This is another example of the challenge facing chemical companies, as we transition to the New Normal. Most Boomers will have to cut back on spending as they face the prospect of living on a pension, rather than a salary. In turn, this will have a major impact on future demand patterns.

Brent oil prices stay in their "triangle"

Brent Nov11.pngEnglish children have a nursery rhyme that seems to summarise price movements in Brent oil markets:

Oh, The grand old Duke of York,
He had ten thousand men;
He marched them up to the top of the hill,
And he marched them down again.

And when they were up, they were up,
And when they were down, they were down,
And when they were only half-way up,
They were neither up nor down.”
It describes a set of futile actions, which always end in the same place. As the above chart shows, this is what has been happening to Brent oil prices during 2011:

• They reached a high of $127/bbl in April
• They hit a low of $99/bbl in August

But overall, they have traded in the same range since January.

This ‘triangle pattern’ highlights the battle between the bulls, led by the high-frequency traders, and the bears, led by those who focus on fundamentals of supply and demand.

The bulls are making desperate efforts to push prices higher. Most recently, as in July 2008, they have suggested Israel will soon bomb Iran’s alleged nuclear facilities. The bears note that demand is slowing globally, due to today’s high prices, whilst supply is steadily increasing.

The triangle formation is normally followed by a major move, upwards or downwards, as either the bulls or bears come out on top. So the blog will continue to keep a very close eye on what happens next.

China’s debt problems multiply

China lendNov11.pngIt seems increasingly clear that China’s economic policy took a wrong turning 10 years ago, when it joined the World Trade Organisation.

2001 was also the year when the Western BabyBoomers (those born between 1946-70), began to leave the peak consumption age group of 25-54 years. As they entered the 55+ age range, and the children left home, they began to spend less and save more.

China, however, decided to use its WTO membership to become the ‘manufacturing capital of the world’.

10 years later, the bill for this mistake is becoming very large indeed:

• China has $500bn invested in the US housing agencies, Fannie Mae and Freddie Mac. This was a form of vendor finance, to support its export drive. Unless the US housing markets stage a strong recovery, which looks increasingly unlikely, writedowns are inevitable.
• China’s personal consumption as a percentage of GDP has halved to just 35%. As we describe in chapter 6 of ‘Boom, Gloom and the New Normal’, the government instead sponsored the building of export-related factories and the infrastructure support they required.
• More recently, the Q4 2008 crash left many of these factories without work. So the government was forced to sponsor a domestic lending binge, as incomes were too low to support increased consumption.
• It doubled bank lending to $1.4trn, a third of GDP, and held it at this level in 2010. And it added a $580bn subsidy to support sales of cars and electrical goods, especially in the poorer rural areas.
• Its lending boom also encouraged speculative home purchases, as a ‘quick fix’ for employment. Prices are now 10 times average annual household incomes, double their peak during the US housing boom.

As one ‘quick fix’ led to another, so the government’s problems have multiplied. High house prices, for example, make it difficult for young men to marry. 70% of China’s women regard “housing, a stable income and some savings” as vital for any man wanting to get married.

Equally, current food price inflation at 11.9% is a major issue for a poor country like China. 96% of people earn less than $20/day, and so food costs are a major part of their budgets.

So over the past few months, the government has finally had to act. As the chart shows, bank lending is now down 29% (red square) versus the 2009 YTD total. And premier Wen has revealed the government is now targeting home price falls of 20% or more.

What happens next, is anyone’s guess. No country in history has ever lent out so much, so quickly, to so many people.

Credit bubbles need increasing amounts of debt to continue. China’s Minsky Moment is therefore approaching fast as lending gets cut back. Thus ratings agency Fitch worries that 30% of China’s loans could become non-performing.

This one statistic is alarming enough. It means $2.5trn of loans might not be repaid. Yet 2010’s GDP was only $5.9trn. Even if we halve Fitch’s estimate, this would still mean loans worth 21% of GDP will not be repaid. This is a big ‘haircut’, even by Eurozone standards.

And debt repayment is already becoming a major issue, as sources of new credit dry up.

• Operating cash flow at China’s listed firms fell 27% in the January-September period, despite 25% sales growth
• Whilst Bloomberg reports that loan sharks from China’s vast unofficial lending market cut off fingers if debts can’t be repaid.

China is thus paying an increasingly high price for its 2001 failure to recognise the importance of changing Western demographics. After all, if demographics don’t drive demand, it is hard to know what does.