The litmus test for the global economy

The world has wasted 3 months – there is little time now left to avoid a Covid-19 catastrophe

It is now 3 months since China’s state television broadcast the first news of the Wuhan virus, now known as Covid-19. And it is almost 3 months since China released the first genetic sequence for the virus on 9 January.

But with certain notable exceptions, governments since then have mostly failed to properly activate their pandemic contingency plans. Some have even refused to make the hard choices necessary to protect the public. And as we are now learning the hard way, avoiding painful decisions doesn’t make them go away. Instead, the available options narrow.

We will never now know, for example, whether prompt action by governments could have reduced the total impact of the virus. But, we do know that the delay has helped to create a global economic crisis to add to the health crisis, as the IMF’s head warned on Friday:

Never in the history of the IMF have we witnessed the world economy coming to a standstill. It is way worse than the financial crisis”.

So was this a so-called ‘Black Swan’ that nobody could have forecast? You might think so, reading consensus commentary.

These are the same people who failed to spot the problem in the first place, just as they failed to spot the 2008 crisis when it was building.

In reality, the path to today’s disaster – for that is what it has now become – was very clear from early February, as I have highlighted here each week:

9 February: Coronavirus disruptions make global recession almost certain
16 February: Financial markets head for (another) train crash as coronavirus starts to impact
23 February: China’s lockdown makes global debt crisis now almost certain
1 March: Oil markets hit perfect storm as coronavirus cuts demand
8 March: China’s smartphone and auto sales tumble as coronavirus hits demand
15 March: “They may ring their bells now, before long they will be wringing their hands”
22 March: A new recession era to emerge
29 March: China’s property sector is at the epicentre of the crisis

The problem, even today, is that people who shout loudest get the media attention. There is no analysis of what they have said before, or whether it made sense. This is quite different from the past, when people like Henry Kissinger were US Secretary of State.

Kissinger actually took tough decisions that upset people, because his rigorous analysis told him they had to be made.  And this is what he wrote on Saturday, under the heading “The Coronavirus Pandemic Will Forever Alter the World Order“:

“The coronavirus has struck with unprecedented scale and ferocity. Its spread is exponential: U.S. cases are doubling every fifth day. At this writing, there is no cure. Medical supplies are insufficient to cope with the widening waves of cases. Intensive-care units are on the verge, and beyond, of being overwhelmed. Testing is inadequate to the task of identifying the extent of infection, much less reversing its spread. A successful vaccine could be 12 to 18 months away.”

Please read this statement again, and tell your friends about it. The USA is the world’s wealthiest economy,and its senior statesman is warning that it is currently powerless in the face of the virus. And please then read this statement, and ponder what it means for the outlook for the global economy:

“The contraction unleashed by the coronavirus is, in its speed and global scale, unlike anything ever known in history. And necessary public-health measures such as social distancing and closing schools and businesses are contributing to the economic pain. Programs should also seek to ameliorate the effects of impending chaos on the world’s most vulnerable populations.”

We are already close to the point where the pandemic will kill hundreds of thousands of people, possibly millions. And we are also close to the point where today’s lockdowns will create a global depression on a scale not seen since the 1930’s.

This is now not just my opinion, but that of the IMF and of thoughtful, highly experienced public servants such as Henry Kissinger. We all need to act now, in whatever way we can, to avert this potential catastrophe. Otherwise, as Kissinger warns:

“The historic challenge for leaders is to manage the crisis while building the future. Failure could set the world on fire.”

China’s property sector is at the epicentre of the crisis

A branch of Centaline Property Agency in Hong Kong © Bloomberg

Indebted Chinese property developers threaten a domino effect on western credit markets , as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Second-order impacts are starting to appear as a result of China’s lockdowns. These are having a big impact on the critical property sector, which makes up as much as 25 per cent of gross domestic product.

Housing sales fell almost 40 per cent in February and seem likely to be down again in March, while developer Evergrande cut prices to try and maintain its cash flow. This creates growing risk in the offshore dollar market, where property developers have been significant borrowers, with Fitch already warning of possible defaults. It is unclear whether local authorities can provide much support, as their dependence on revenue from land sales means their own position is weakening.

Rightly, the world’s attention has focused on the impact on public health of the coronavirus pandemic and the best ways of mitigating it. But as Martin Wolf highlights in the Financial Times, the virus is an economic emergency too, with the ability to plunge the world into a depression. Talk of the reforms made to the world’s banking systems since 2008 misses the point. The risk is now centred on the vast build-up of corporate debt since the global financial crisis, under the easy money policies of the world’s central banks.


China’s property sector is unfortunately the epicentre of this debt. As we noted in the FT in August: “Its tier 1 cities boast some of the highest house-price-to-earnings ratios in the world, while profits from property speculation allowed car sales to rise fourfold from 500,000 a month in 2008 to 2m a month in 2017.” Last month’s collapse of car sales back to 2005 levels of 244,000 confirms the damage that has been done.

Sales by China’s top 100 property developers plunged by 44 per cent in February, and Caixin reports that over 100 builders went bust in the January-February period, normally one of the busiest times for property sales. Equally worrying, as Caixin’s chart below illustrates, is that, although the largest developer, Evergrande, bucked the trend, this was only because it cut prices by 25 per cent in February and offered 22 per cent reductions this month.

There are few signs of a sustained upturn, with S&P reporting that housing starts were down 45 per cent across January-February. S&P adds that property sales could fall 20 per cent this year, if the effects of the lockdowns are still being felt in April, as seems likely.


The issue is that we are now starting to see second-order impacts of the lockdowns emerge, particularly in terms of consumer affordability and supply chain disruption:

  • The economic impact of the initial lockdowns was focused on two areas — companies and consumers. Companies were shut down, and consumers were quarantined
  • In turn, this led to a number of key impacts within and outside China
  • Within China, demand disappeared for a wide range of products as consumers were unable to leave their homes; supply also disappeared as companies shut down
  • And ‘out of sight’, critical logistic arrangements were being completely upended by quarantine measures, and the need to prioritise essential food/medical supplies

We can probably assume that truck drivers have now been released from emergency duties and from quarantine (if they travelled from infected areas across provincial borders). But we have no idea if their basic equipment — containers, specialist materials, etc — is in its normal place. We do know, however, from the shipping industry that its activity has been severely disrupted, with ships away from their usual moorings and many idled due to lack of work; containers and crew are equally disrupted.

It is safe to assume that most Chinese companies and consumers are short of cash and that consumers will cut back on all but essential spending, further depressing demand. This creates the risk of a vicious circle, whereby property sales remain depressed, reducing developer cash flow still further after most building activity came to a standstill during the lockdowns.

Fitch Ratings identified five Chinese corporations with a high risk of refinancing in a recent report, four of which are in the homebuilding sector, citing concerns about near-term capital market debt maturities and the unpredictability of the epidemic. A further sign of stress, as the Financial Times has reported, is that land sales are now running at less than a quarter of average levels.

Two key facts highlight our concerns:

  • Chinese developers ramped up their offshore dollar borrowing by 52 per cent to an all-time high of $75.2bn last year, according to Centaline Property Agency, as onshore funding became more difficult. And as S&P reported in November, before coronavirus hit: “For some developers, offshore yields to maturity have surged well beyond the mid-teens, reflecting low investor confidence.”
  • Chinese borrowers also tend to operate on a short-term basis, with an ICE BofA index of Chinese high-yield securities in dollars having 2.7 years to maturity, compared with 5.9 years for a similar US index.

We have warned here for some time that China’s property market has been ‘subprime on steroids’. Property sales have been buoyed by vast government stimulus programmes. And western investors have flocked to lend in the offshore dollar market, attracted by the high interest rates on offer compared to those in their domestic markets under central banks’ zero-interest rate policies.

The renminbi’s weakening beyond Rmb7 to the US dollar adds to the difficulties developers will face in servicing their dollar debts.

The potential for a domino impact on western credit markets from a coronavirus-related downturn in China’s property market should already be keeping regulators up at night.

Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.

A new recession era to emerge

Contingency planning has become mission-critical. The longer the coronavirus pandemic continues, the more it will expose the underlying fragility of today’s debt-laden global economy.

Companies therefore have to move into crisis management mode, with a number of key areas requiring immediate attention:

• Employee health and safety is the top priority. Governments are slowly waking up to the risks and are starting to provide expert advice. In the meantime, of course, many companies have already taken steps to reduce all unnecessary travel and to encourage home-working wherever possible. It would be prudent to assume their measures will last for longer than initially expected, as nobody will want to take the risk of problems emerging as a result of precautions being relaxed – especially in litigious countries such as the USA
Value chain risks are clearly a key area of concern for the business itself. Upstream, the oil price collapse means that the new US shale gas expansions have lost their hoped-for feedstock advantage versus European and Asian producers. Downstream, China’s auto sales fell 80% in February, whilst smartphone sales were down 55%. We must assume that other affected countries will also see major declines, even if hopefully not on the same scale
Supply chain risks are another major area for review. Anyone who has tried to map a modern supply chain knows that the exercise quickly reveals a number of ‘black holes’ where nobody really understands all the inter-dependencies. For example, although it might seem obvious in hindsight, did anyone really expect freight volumes in Los Angeles to fall 25% last month – even given its role as the largest gateway for seaborne China imports? And even if China does now return to normal, it will still take weeks for new shipments to arrive given the disruption that has occurred to freight and logistic operations
Credit risks also have the potential to surprise the unwary. The lure of cheap money from the central banks, and investor pressure to maximise earnings, has unfortunately led many companies to over-leverage their balance sheets. Even a relatively small profit downturn will therefore put their financial viability at risk. And as we know, whilst banks are happy to lend when the outlook is sunny, they are very quick to withdraw when storms appear on the horizon
Paradigm shifts add to the complexity that we now face. Today’s population growth is largely due to a major post-War rise in life expectancy, rather than a new babyboom. But older people already own most of what they need, creating a ‘demographic deficit’ in terms of demand growth. As a result, sustainability is now replacing globalisation as a key driver for our business. Used car sales, for example, are already cannibalising new car sales in China and elsewhere. Similarly, analysts see the used smartphone market growing by 50% over the next 3 years from the current 207 million sales.

Every business will have its own priority list of key risks. And, of course, I understand the feeling that ‘one can’t plan until one knows what is happening’. But whilst this was entirely logical in a world of ‘business as usual’, we now face the necessity of learning how to plan for uncertainty.

Reasonable people can disagree about whether the risks I have identified are a 10%, 50% or a 90% probability. But even if you assume they are just a 10% probability, their potential downside impact is so large that they cannot be ignored.

Contingency planning has therefore become mission-critical. One key uncertainty is that nobody can know how long the virus pandemic will last. But we can be sure that the longer it continues, the more it will expose the underlying fragility of today’s debt-laden global economy.

This crisis means it has therefore become mission-critical for businesses to build scenarios covering different timescales.

The aim is to understand what can be done today to mitigate the consequences of the epidemic extending beyond the end of this quarter, or into the second half of the year, in key markets? It will also provide a framework for assessing how recession might impact prices and margins for your products, as well as accelerating the trend towards buying second-hand products?

As the saying goes – “to fail to plan, is to plan for failure.”

Please click here (no registration required) if you would like to read my full analysis in this week’s ICIS Chemical Business.

“They may ring their bells now, before long they will be wringing their hands”

The wisdom of Sir Robert Walpole, the UK’s first premier, seems the only possible response to this weekend’s headline from the Wall Street Journal. How can a National Emergency ever be the basis for a major rise in stock markets?

Of course, we all know that stock markets have become addicted to stimulus. But the problem with stimulus is that the patient needs more and more of it, to keep markets moving higher:

But the headlines surrounding the National Emergency clearly did the job as far as the High-Frequency Traders were concerned. They still dominate equity and other major markets, and Friday afternoon was exactly the kind of bumper payday that they adore.

The only problem is that neither stock markets, nor even the Federal Reserve, can cure coronavirus. And if the pandemic continues as the experts expect:

  • Between 160 million and 214 million Americans will become infected
  • Between 2.4 million and 21 million people could require hospitalisation

Clearly, no hospital system in the world could cope with the higher end of this range, particularly if they all come at once. And although the US system is easily the most expensive in the world, its performance is relatively poor by comparison with other major Western nations.

One key issue, of course, is testing. Nobody can know the actual size of the problem until we know how many people are already affected. And yet, as the WSJ reports from the President’s speech on Friday:

“By early next week, Mr. Trump said, there would be a half-million additional tests available, with 5 million tests available within a month.”

By comparison, China already has the capacity to do 1.7 million tests a week, according to the World Health Organisation.

This, of course, is why the experts are talking about trying to ‘delay’ the pandemic, rather than ‘contain’ it, as the chart based on US Centers for Disease Control and Prevention analysis (interpreted by Vox) confirms.

The US lack of a proper social support system is also a major disadvantage. Around 34 million American workers have no access to paid sick leave, for example, and 27 million don’t have health insurance.  These people may well feel they have to keep working even if infected in order to pay the rent.

Hopefully, the new support package agreed on Friday night will help solve these problems. But who knows how long it will take to actually roll out the measures, and how many people will benefit?

The essence of populism, of course, is that it supplies simple answers to complex problems. And coronavirus is likely to prove a classic case of this weakness in action:

  • Experts suggest the virus will keep returning unless ‘herd immunity’ can be established
  • They estimate this means around 60% of the population therefore need to be infected

Data from China and Italy confirms that the main risk from coronavirus is to people over the age of 70, as the chart shows. The CDC also recommend that people with serious chronic medical conditions such as heart disease, diabetes and lung disease need to take special precautions.

But their voice is being drowned out. People are understandably frightened, and they need wise and well-informed leaders to give them clear messages. Leaders should be focused on aiming to manage the pandemic and on taking the obvious steps to protect those most vulnerable.  Unfortunately, the opposite is happening as former UK Finance Minister, Lord Darling  has noted:

“There is a striking lack of global cooperation in dealing with coronavirus”.

The issue is that effectively closing down large parts of the economy in response to coronavirus is a very high risk strategy:

  • Millions of businesses could well go bankrupt around the world, and tens of millions lose their jobs
  • And as watchdog the Institute of International Finance already warned on Thursday:

“Global growth is potentially approaching 1% this year (anything below 2.5% is essentially recession). The multitude of shocks in the system now risks a global “sudden stop”. Falling oil prices potentially accelerate mounting credit stress in the US. Vulnerable emerging markets are already seeing large outflows”.

Friday saw Wall Street celebrating its latest “fix” of easy money. But as Bloomberg also noted:

“For context, this was the S&P 500’s best day since Oct. 28, 2008. At the end of that day, the bottom was more than 4 months away, and there was a 29% fall before hitting the intraday low.”

We may well all come to regret, as we wring our hands in the summer, that the bells rang too soon.

 

 

Chain’s smartphone and auto sales tumble as coronavirus hits demand

China is the world’s largest market for smartphones and autos – responsible for c30% of global sales for both.  Yet as Reuters notes:

“Most western policymakers and journalists view the world economy through a framework that is 10-15 years out of date, failing to account fully for the enormous shift in activity towards China and the rest of Asia.”

The critical fact is that both markets are now about to go into a severe downturn as a result of the coronavirus epidemic. This is already having a major impact on domestic sales in China, and is starting to create major disruption to today’s globalised supply chains.

SMARTPHONES SALES HAVE BEEN IN DECLINE SINCE 2017

As the chart shows, global smartphone sales were down again in Q4.  2019 sales were 1.4bn, versus their 2017 peak of 1.5bn. And, of course, Q1 is going to be a terrible period for sales, given the coronavirus impacts.

China has been the world’s largest market since 2012, but sales were down 37% in January as consumers began to worry about the risks from the virus.  February will clearly be much worse, as a result of the major lockdowns in place.  As Strategy Analytics warn:

“The smartphone market will be adversely impacted by the slowing GDP growth and the plunging consumer spending. It will also impact global smartphone supply and manufacturing, because China makes 70% of all smartphones sold on the planet.”

Research firms IDC and Canalys are already forecasting that China’s market will be down 40% in Q1. But this is likely an under-estimate, given the impact of the lockdowns.  Most retail stores, including Apple’s, have been shut during February, after all. And as Chinese business paper Caixin reported:

“China’s capital might be officially back to work, but it would be hard to tell from walking around the normally congested city. Tourist sites and other popular destinations remain unusually free of sightseers, customers or pedestrians.”

Outside China, parts arriving in the West today came from factories that were still open before Lunar New Year.  But now, supply chain problems are about to become evident:

  • Port calls in China fell 30% last month, as ships worried about crews being quarantined
  • Los Angeles – the largest US gateway for seaborne China imports – saw volumes drop 25%
  • Things will now get worse, as shipping times of 4 – 6 weeks mean new supplies are reducing
  • And back in China, it seems workers are often frightened to return – Apple’s main supplier, Foxconn, is having to offer $1k bonuses to persuade new workers to join

And, of course, the recession is also seeing major paradigm shifts take place.

For example, used smartphones are now becoming a viable market in their own right for the first time.  207m were sold last year, up 18% from 2018, and IDC see the market growing to over 300m phones by 2023. As they note:

“In contrast to the recent declines in the new smartphone market, as well as the forecast for minimal growth in new shipments over the next few years, the used market for smartphones shows no signs of slowing down across all parts of the globe. Refurbished and used devices continue to provide cost-effective alternatives to both consumers and businesses that are looking to save money when purchasing a smartphone.”

CHINA’S AUTO MARKET IS IN CRISIS

China’s auto market also matters. It is easily the largest in the world, with peak sales in 2017 of 24.7m, versus 17.9m in the USA and 15.3m in Europe.  And without China’s four-fold stimulus-powered sales increase since 2008, the global market would have seen no growth at all.

But today, the used market has become key to auto sales growth, as the chart confirms.  Consensus opinion still believes that its new car sales would continue to grow until at least the end of the decade. But this conclusion fails to reflect the unique nature of China’s market:

  • Back in 2000, there were just 16m cars on the road – and the quality was so bad, they mostly fell apart within a few years. There were still only 65m cars in 2008, before stimulus began
  • As a result, used car sales hardly existed. Instead, as in most poor countries, local mechanics would strip out parts from abandoned cars and reuse them to keep others on the road
  • It was only when China’s “subprime on steroids” stimulus programme began in 2009, with shadow banks funding speculative house purchases, that Western companies introduced their technology
  • Even then, it took until 2014 for used sales to start motoring, and they have still not reached a 50:50 ratio with new cars. And the direction of travel is clear, as used sales are normally 2x-3x new in most countries

China’s used sales rose 8% in 2019, whilst new sales fell 9%. They may well equal new sales this year for the first time, given the collapse underway in new sales.

Thus the virtuous circle of the last decade is turning vicious.  China’s new car sales fell by 90% in February, and salary losses during the lockdowns make it unlikely that the crisis has left a backlog of pent-up demand to create a V-shaped recovery.

Similarly, used car sales are set to cannibalise new car sales in all the major markets. Lending standards are already tightening, making new cars simply unaffordable.

THE WORLD WILL SEE MAJOR CHANGE DURING THE RECESSION

People sometimes say they ‘can’t plan until they know what is happening’. But in reality, what they mean is that they have become used to doing tactical planning, based on the idea of ‘business as usual’.  Today, however, we all have to relearn how to plan for uncertainty.

The question now for investors and companies is to start contingency planning for what may happen next.  We have to ask the question – how quickly will used smartphones and cars cannibalise new sales over the next year? Will they take 10%, 20% or more?  And what will happen to prices and margins as a result?

As the saying goes – “to fail to plan, is to plan for failure.”