Smartphone sales decline begins to impact global stock markets

The bad news continues for the world’s smartphone manufacturers and their suppliers.  And President Trump’s decision to add a 25% tariff on smartphone component imports from China from June 25 is unlikely to help. Morgan Stanley estimate it will add $160 to the current US iPhone XS price of $999, whilst a state-backed Chinese consumer boycott of Apple phones may well develop in retaliation for US sanctions on Huawei.

Chances are that a perfect storm is developing around the industry as its phenomenal run since 2011 comes to an end:

  • Global sales fell 4% in Q1 as the chart shows, with volume of 330m the lowest since Q3 2014
  • China’s market fell 3% to 88m, whilst US volume fell 18% to 36m
  • Apple has been badly hit, with US sales down 19% in Q1 and China sales down 25% in the past 6 months
  • Foldables have also failed to make a breakthrough, with Gartner estimating just 30m sales by 2023

This downbeat news highlights the fact that replacement cycles are no longer every year/18 months, but have already pushed out to 2.6 years.  Consumers see no need to rush to buy the latest model, given that today’s phones already cater very well for their needs.

Apple’s volumes confirm the secular nature of the downturn, as its volume continued the decline seen in 2018 as the iPhone comes to the end of its lifecycle. Its market share also fell back to 13%, allowing Huawei to take second place behind Samsung with a 17.9% share.  This decline came about despite Apple making major price cuts for the XS and XR series, as well as introducing a trade-in programme. Meanwhile, Samsung saw its profits fall 60%, the lowest since its battery problems in 2017.

The President’s tariffs are also set to impact sales, as manufacturers have to assume that today’s supply chains will need to be restructured. Manufacturing of low-end components can perhaps be easily relocated to countries such as Vietnam and other SE Asian countries.  But moving factories, like moving house, is a very disruptive process, and it is certainly not easy to find the technical skills required to make high-end components – which represent the core value proposition for consumers.

This highlights how second-order impacts are often overlooked when big announcements are made around tariffs and similar protectionist measures.  Not only do prices go up, as someone has to pay the extra costs involved. But companies along the supply chain see their margins squeezed as well – Apple suppliers Foxconn and Pegatron saw their gross margins fall to 5.5% and 2.3%, the lowest level since 2012, for example. So they will have less to spend on future innovations.

We can, of course, all hope that the current trade war proves only temporary. But President Trump’s decision to embargo Huawei from US telecom equipment markets suggests he is digging in for a long battle. Ironically, however, Huawei was one of the few winners in Q1, with its volume surging 50% despite its planned 2018 US entry being cancelled due to congressional pressure.  And other governments seem notable reluctant to follow the US lead.

The bigger risk, of course, for investors is that the profit downturn caused by protectionism cannot be “solved” by central bank stimulus. Since 2009, as the chart of the S&P 500 shows, they have rushed to support the market whenever it appeared poised for a return to more normal valuations. But it is hard to see how even their fall-back position of “helicopter money” can counter the impact of a fully-fledged trade war between the world’s 2 largest economies.

US-China trade war confirms political risk is now a key factor for companies and the economy

There are few real surprises in life, and President Trump’s decision to launch a full-scale trade war with China wasn’t one of them.  He had virtually promised to do this in his election campaign, as I noted here back in September 2015:

“The economic success of the BabyBoomer-led SuperCycle meant that politics as such took a back seat.  People no longer needed to argue over “who got what” as there seemed to be plenty for everyone.  But today, those happy days are receding into history – hence the growing arguments over inequality and relative income levels.

“Companies and investors have had little experience of how such debates can impact them in recent decades.  They now need to move quickly up the learning curve.  Political risk is becoming a major issue, as it was before the 1990s.”

Of course, I received major push-back for this view at the time, just as I did in 2007-8 when warning of a likely US subprime crisis.  Most people found it very hard to believe that politics could trump economic logic, as one American commentator wrote in response to my analysis:

“I have a very, very, very difficult time imagining that populist movements could have significant traction in the U.S. Congress in passing legislation that would seriously affect companies and investors”.

But, sadly or not, depending on your political persuasion, my conclusion after the election result was known seems to have stood the test of time:

“You may, or may not, approve of President-elect Trump’s policies. You may, or may not, think that these policies are destined to fail. But they do confirm that the world is moving into a New Normal, which will inevitably create Winners and Losers.

“The Winners are likely to come from those who accept that President Trump will at least try to introduce the policies proposed by Candidate Trump. And the Losers will almost inevitably include those who continue to believe he represents “business as usual”.

Now, of course, we will start to see these Winners and Losers appear, as there is little the Western central banks can do to counteract the economic cost for the global economy of a US-China trade war.

One sign of this was Uber’s miserable performance on its stock market debut – despite having been priced at the low end of the planned range, it still fell further on its opening, in line with my suggestion last month that Uber’s $91bn IPO marks the top for today’s debt-fuelled stock markets.

But there will be many more serious casualties over the next few months and years:

  • NE Asian countries such as Japan and S Korea are part of global supply chains which send a wide range of components to China, where they are incorporated into finished goods for sale to the USA
  • Germany and the major European countries have relied on sales to China to boost economic growth, as domestic demand has stagnated, and clearly this support is now going to weaken
  • The mining industry and other suppliers of commodities will also be hit – Rio Tinto, for example, depends on China for 45% of its revenue, and on the USA for 15%
  • The petrochemicals industry has been dependent on China for its growth since the 2008 financial crisis, as I noted last summer, US-China tariffs could lead to global Polyethylene price war

Back in 2011-12, John Richardson and I wrote ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’ to give our view of the likely consequences of the major demographic changes underway in the global economy.

Unfortunately, the politicians of the time took the seemingly easy route out of the crisis. They decided that printing money was so much easier than having a dialogue with the electorate about the implications of ageing populations, or the fact that Western fertility rates have been below replacement levels for the past 45 years.  Our warning is now coming true:

“The transition to the New Normal will be a difficult time. The world will be less comfortable and less assured for many millions of Westerners. The wider population will find itself following the model of the ageing boomers, consuming less and saving more. Rather than expecting their assets to grow magically in value every year, they may find themselves struggling to pay-down debt left over from the credit binge.

“Companies will need to refocus their creativity and resources on real needs. This will require a renewed focus on basic research. Industry and public service, rather than finance, will need to become the destination of choice for talented people, if the challenges posed by the megatrends are to be solved. Politicians with real vision will need to explain to voters that they can no longer expect all their wants to be met via endless ‘fixes’ of increased debt.

“We could instead decide to ignore all of this potential unpleasantness.

“But doing nothing is not a solution. It will mean we miss the opportunity to create a new wave of global growth from the megatrends. And we will instead end up with even more uncomfortable outcomes.

There’s a great future for the European plastics industry in recycled plastic

Europe’s plastics industry is under major threat from the growing legislative and consumer backlash against plastic packaging.

As with the global industry, its licence to operate is increasingly challenged by images of plastic rubbish polluting the world’s oceans, alongside photos of baby fish dying because their parents mistakenly fed them plastic instead of food.

EU legislation on plastic packaging is already in place to respond to this concern and promote the arrival of the circular economy. The industry therefore now needs to urgently reinvent itself by developing solutions to tackle these problems and help reduce carbon footprint.

History, luckily, is on its side.  There was a similar turning point in the 1960s, when it implemented the far-sighted decision to switch from coal to oil-based feedstocks. As a result, it transformed itself into a world-leading source of the products that have now become embedded in our daily lives. And it maintained this lead for more than fifty years, until finally China’s growth allowed Asia to overtake it.

But over the past twenty years, however, it has stagnated as China became the manufacturing capital of the world since joining the World Trade Organisation in 2001. Its newest steam cracker, a core technology for the production of chemicals and plastics, started up more than twenty years ago in 1994. And over the past decade, the North American industry has seen a $200bn renaissance due to the arrival of low-cost shale based feedstocks.

This decline matters as chemicals and plastics are central to the European economy, and a key enabler for a vast range of products from autos through to personal care. The industry directly employs 1.5 million people, and a much larger number indirectly in downstream manufacturing and service roles.

Plastics are also key to tackling a number of the challenges facing our society, as the EU has highlighted in its new Circular Economy strategy:

“Light and innovative materials in cars or planes save fuel and cut CO2 emissions. High-performance insulation materials help us save on energy bills. In packaging, plastics help ensure food safety and reduce food waste.”

But at the same time, the legislation highlights the urgent need to rethink the production, use and consumption of plastics in order to avoid the environmental damage currently being created.

The problem is that reuse and recycling of end-of-use plastics remains very low by comparison with other materials such as paper, glass or metals:

  • The Commission estimates that more than 2/3rds of plastics waste currently goes into landfill or incineration
  • As a result, 95% of the value of plastic packaging material, between €70bn – €105bn annually, is lost after a very short first-use cycle
  • It also estimates that recycling all global plastic waste could save the equivalent of 3.5bn barrels of oil each year, and help curb CO2 emissions

The European plastics industry is therefore now at a crossroads, as continuing with a business as usual strategy makes little sense. After all, the new EU legislation requires all plastics packaging to be reusable or cost-effectively recyclable by 2030. And the Ellen MacArthur Foundation is successfully encouraging the world’s major brand owners and retailers to make similar commitments with an even tighter deadline of 2025.

This paradigm shift gives the European plastics industry the opportunity to stage its own renaissance. It urgently needs to start the technical development programmes that will allow it to adopt the circular economy agenda, and start substituting recycled feedstock for oil.

China, after all, is already moving down this track, with Hainan planning to ban the production, sale and use of the 120kt  single-use plastics currently used each year in the province by 2025. And the government is starting to build dozens of local “comprehensive resource utilisation” centres to boost recycling, whilst at the same time restricting the use of single-use plastics by courier and food delivery firms.

Obviously there will be costs involved.  But in principle the industry’s assets are ageing and often below world-scale. The scale of the write-offs required is therefore manageable. And by beginning the transition today via the use of chemical and mechanical recycling technologies, these costs could be amortised over a longer timeframe.

The industry has a remarkable record of generating revenue and profit growth from innovation. Reinvention to become a more service-based industry, focused initially on making a major contribution to reducing marine pollution, would enable it to regain its global leadership in an area where long-term growth is assured.

And who knows, if Hollywood were ever to issue a remake of 1967’s The Graduate, maybe Mr McGuire’s famous advice to a young Dustin Hoffman would become “There’s a great future in recycled plastics”.

Uber’s $91bn IPO marks the top for today’s debt-fuelled stock markets

Uber’s IPO next month is set to effectively “ring the bell” at the top of the post-2008 equity bull market on Wall Street.  True, it is now expecting to be valued at a “bargain” $91bn, rather than the $120bn originally forecast. But as the Financial Times has noted:

“Founded in 2009, it has never made a profit in the past decade. Last year it recorded $3.3bn of losses on revenues of $11bn.”

And Friday’s updated prospectus confirmed that it lost up to $1.1bn in Q1 on revenue of $3.1bn. In more normal times, Uber would have been allowed to go bankrupt long ago,

So why have investors been so keen to continue to throw money at the business?  The answer lies in the chart above, which shows how debt has come to dominate the US economy.  It shows the cumulative growth in US GDP since 1966 (using Bureau of Economic Analysis data), versus the cumulative growth in US public debt (using Federal Reserve of St Louis data):

  • From 1966 – 1979, each dollar of debt was very productive, creating $4.70 of GDP
  • From 1980 – 1999, each dollar was still moderately efficient, creating $1.20 of GDP
  • Since 2000, however, and the start of the Federal Reserve’s subprime and quantitative easing stimulus programmes, each dollar of debt has destroyed value, creating just $0.38c of GDP

After all, if one ignores all the hype, Uber is just a very ordinary business doing very ordinary things.  Most people, after all, could probably run a serially loss-making taxi and food delivery service, as long as someone else agreed to keep funding it.

Yes, like the other “unicorns”, it has a very customer-friendly app to help customers to use its service. But in terms of its business model:

  • When one takes a ride with Uber, the driver often also drives for Lyft and for the local taxi firm, and her car is often also the same car
  • This means that in reality, Uber’s main competitive advantage is its ability to subsidise the ride or the food bought via Uber Eats

DEBT HAS CHANGED FINANCIAL MARKET BEHAVIOUR

This addiction to debt on such a scale, and for such a long period, has changed financial market behaviour.

Nobody now needs to do the hard graft of evaluating industry dynamics, business models and management capability.  Instead, they just need to focus on buying into a “hot sector” with a “story stock”, and then sit back to enjoy the ride. The chart above from Prof Jay Ritter confirms the paradigm shift that has taken place:

  • It highlights how 80% of all IPOs last year were loss-making, compared to around 20% before 2000
  • The only parallel is with the late 1990s, when dot.com companies persuaded credulous investors that website visits were a leading indicator for profit

Like other so-called “unicorns with $1bn+ valuations, today’s debt-fuelled markets have allowed Uber to raise money for years in the private markets. So why has Uber now chosen to IPO, and to accept a valuation at least 25% below its original target?.

CORPORATE DEBT IS INCREASINGLY FUNDING STOCK BUYBACKS TO SUPPORT SHARE PRICES

The above 2 charts from the Wall Street Journal start to suggest the background to its decision:

  • They show the ratio of US corporate debt to GDP has now reached an all-time high at 48%.  The quality of this debt has also reduced, with the majority now just BBB-rated and with record levels of leverage
  • BBB ratings are just above junk, and most major investment managers are not allowed to hold junk-rated bonds in their portfolio. So they would have to sell, quickly, if this debt was downgraded

The problem is that much of the corporate debt raised in recent years has gone to fund share buybacks rather than investment for the future. President Trump’s tax cuts meant buybacks hit a record $806bn last year, versus the previous record of $589bn in 2007.  According to Federal Reserve data, investors sold a net $1.1bn of shares over the past 5 years – yet stock markets powered ahead as buybacks totalled $2.95bn.  As Goldman Sachs notes:

“Repurchases have consistently been the largest source of US equity demand. Since 2010, corporate demand for shares has far exceeded demand from all other investor categories combined.”

THE FED’S RECENT PANIC OVER INTEREST RATES HIGHLIGHTS THE STOCK MARKET RISK

Against this background, it is not hard to see why the US Federal Reserve panicked in January as 10-year interest rates rose beyond 3%.  For years, the Fed has believed, as its then Chairman Ben Bernanke argued in November 2010 that:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Rising interest rates are likely to puncture the debt bubble that their stimulus policy has created – by reducing corporate earnings and increasing borrowing costs for buybacks.

Uber’s IPO suggests that the “smart money” behind Uber’s IPO – and that of the other “unicorns” now rushing to market – has decided to cash out whilst it still can, despite the valuation being cut. They must have worried that in more normal markets, they would never be able to float a serially loss-making company at a hoped-for $91bn valuation.

If they really believed Uber was finally about to turn the corner and become profitable at last, why would they accept a valuation some 25% below their original target of less than  a month ago?  The rest of us might want to worry about what they know, that we don’t.

The End of “Business as Usual”

In my interview for Real Vision earlier this month, (where the world’s most successful investors share their thoughts on the markets and the biggest investment themes), I look at what data from the global chemical industry is telling us about the outlook for the global economy and suggest it could be set for a downturn.

“We look at the world and the world economy through the lens of the chemical industry. Why do we do that? Because the chemical industry is the third largest industry in the world after energy and agriculture. It gets into every corner of the world. Everything in the room which you’ll be watching this interview is going to have chemicals in it. And the great thing is, we have very good, almost real time data on what’s happening.

“Our friends at the American Chemistry Council have data going back on production and capacity utilization since 1987. So 30 years of data, and we get that within 6 to 8 weeks of the end of the month. So whereas, if you look at IMF data, you’re just looking at history, we’re looking at this is what’s actually going on as of today.

“We look, obviously, upstream, as we would call it, at the oil and feedstocks markets, so we understand what’s happening in that area. But we also– because the chemical industry is in the middle of the value chain, you have to be like Janus. You have to look up and down at the same time, otherwise one of these big boys catches you out.

“And so we look downstream. And we particularly look at autos, at housing, and electronics, because those are the big three applications. And of course, they’re pretty big for investors as well. So we see the relative balance between what’s happening upstream, what’s  happening downstream, where is demand going, and then we see what’s happening in the middle of that chain, because that’s where we’re getting our data from.

“As the chart shows, our data matches pretty well to IMF data. It shows changes in capacity utilization, which is our core measurement. If if you go back and plot that against history from the IMF, there is very, very good correlation. So what we’re seeing at the moment– and really, we’ve been seeing this since we did the last interview in November— is a pretty continuous downturn.

“One would have hoped, when we talked in November, we were talking about the idea that things have definitely cooled off. Some of that was partly due to the oil price coming down. Some of that was due to end of year destocking. Some of that was due to worries about trade policy. Lots of different things, but you would normally expect the first quarter to be fairly strong.

“The reason for this is that the first quarter– this year, particularly– was completely free of holidays.  Easter was late, so there was nothing to interrupt you there. There was the usual Lunar New Year in China, but that always happens, so there’s nothing unusual about that.

And normally what happens is, that in the beginning of the new year, people restock. They’ve got their stock down in December for year end purposes, year end tax purposes, now they restock again. And of course, they build stock because the construction season is coming along in the spring and people tend to buy more cars in that period, and electronics, and so on.

“So everything in the first quarter was very positive. And one wouldn’t normally be surprised to start seeing stock outs in the industry, particularly after a quiet period in the fourth quarter. And unfortunately, we haven’t seen any of that. We’ve seen– and this is worth thinking about for a moment– we’ve seen a 25% rise in the oil price because of the OPEC Russia deal, but until very recently we haven’t seen the normal stock build that goes along with that.”

 

As we note in this month’s pH Report, however, this picture is now finally changing as concern mounts over oil market developments – where unplanned outages in Venezuela and elsewhere are adding to the existing cutbacks by the OPEC+ countries. Apparent demand is therefore now increasing as buyers build precautionary inventory against the risk of supply disruption and the accompanying threat of higher prices.

In turn, this is helping to support a return of the divergence between developments in the real economy and financial markets, as the rise in apparent demand can easily be mistaken for real demand. The divergence is also being supported by commentary from western central banks.  This month’s IMF meeting finally confirmed the slowdown that has been flagged by the chemical industry since October, but also claimed that easier central bank policies were already removing the threat of a recession.

We naturally want to hope that the IMF is right. But history instead suggests that periods of inventory-build are quickly reversed once oil market concerns abate.

Please click here if you would like to see the full interview.