Contingency planning is essential in 2020 as “synchronised slowdown” continues

The IMF has now confirmed that the world economy has moved into the synchronised slowdown that I forecast here a year ago. Its analysis also confirms the importance of the issues highlighted then, including “rising trade barriers and increasing geopolitical tensions”, a sharp decline in manufacturing, contraction in the auto industry and structural forces such as the impact of ageing populations.

Capacity Utilisation (CU%) data from the American Chemistry Council has therefore once again proved to be the best leading indicator for the global economy. It has been far more reliable than stock markets, where valuations continue to be massively distorted by central bank stimulus. And unfortunately, the latest data shows no sign of any improvement as the chart confirms, with November’s CU% now back at November 2012’s level at 81.7%.

Of course, it remains very easy to ignore the warning signs. ‘Business as usual’ is always the most popular forecast, as we saw a year ago when the consensus assumed a sustainable economic recovery was finally underway. And it would be no great surprise if, in a year’s time, consensus opinion starts to claim that “nobody could have seen recession coming”.

This is why it seems likely that businesses will now start to divide into Winners and Losers. As the IMF note in their analysis, the current situation is “precarious”, with a number of potential downsides starting to crystallise. On a macro view, these include the growing supply chain risks created by Brexit, where the UK expects to leave the EU at the end of this month.

Anyone with experience of trade negotiations knows that these normally take years rather than months to complete. No Deal is therefore the most likely outcome in a year’s time at the end of the transition period.

This will have a major impact on industries with complex and highly integrated downstream value chains like autos, chemicals and aerospace. Contingency planning is therefore on the critical path for any company that currently relies on product flowing seamlessly and tariff-free across the UK-EU27 border.

Of course, potential Losers will continue to nurse the hope that the UK government might reverse its refusal to accept the 2-year extension offered by the EU. But anyone who followed the recent UK election campaign knows this is an unlikely outcome.

The chemical industry also has its own specific challenges to face, given the growing impact of US shale gas-based expansions in the polyethylene area. This is no great surprise, as I have been warning about the likely consequences of these supply-led expansions since they were first announced in 2014 . But unfortunately, the combination of stock market euphoria over the shale gas revolution and the Federal Reserve’s easy money policy meant that the core assumptions were never properly challenged.

Euphoria remained the rule even after the oil price collapse at the end of 2014 disproved the assumption that prices would always be above $100/bbl. And it continued despite President Trump’s election. As a self-confessed “tariff man”, his policies were always likely to upset the idea that plants could be sited half-way across the world from their markets.

Warning signs were also obvious around the assumption that China’s growth would remain at double-digit rates, creating an ongoing need for major imports. And more recently, concerns over climate change and plastic waste issues have created further question marks over the outlook for single-use plastic demand.

Incumbents are often slow to understand the likely impact of potentially disruptive developments on their businesses. Business discussions around the boardroom and water cooler can often take place in a parallel universe to those that happen outside the office with friends and family.

The upstream oil industry is currently providing a classic example of this phenomenon as it promotes the idea that despite mounting concerns over the role of fossil fuels in climate change, chemicals can somehow replace lost oil demand into transport. Yet as former Saudi Oil Minister Yamani warned back in 2000, “the Stone Age didn’t end for lack of stones, and the Oil Age will end long before the world runs out of oil”.

Unfortunately, therefore, it seems likely that 2020 will see today’s synchronised slowdown continuing to challenge consensus optimism. Contingency planning around recession risks should therefore be top of the agenda, particularly for companies with high debt levels.

But at the same time, better placed companies have a once in a generation opportunity to take advantage of the paradigm shifts now underway, as adoption rates accelerate up the typical S-curve. These Winners are likely to discover that their best days still lie ahead of them, given the range and scale of the new opportunities that are emerging.

Please click here to download my full 2019 Outlook (no registration necessary).

Will stock markets see a Minsky Moment in 2020?

Few investors now remember the days when price discovery was thought to be the key role of stock markets. Instead, we know that prices are really now set by central banks, on the model of the Politburo in the old Soviet Union.

How else can one explain the above chart? It shows the US S&P 500 Index has risen 50% over the past 5 years, even though US corporate profits have fallen 5% (using US Bureau of Economic Analysis data).

As in the old USSR, central banks have also abolished “bad news”.

All news is now good news, as any ‘bad news’ means the Federal Reserve will rush to provide more price support. It has been so successful that the Index hasn’t even suffered a 20% correction over the past decade, as my Chart of the Decade confirmed.

But does this mean that stock markets will never fall again?  That is the real question as we enter 2020.

On the positive side, we know that companies have also provided major support via buybacks.  Apple alone did $240bn of buybacks between 2014 – 2018. Companies spent $800bn in total in 2018, but cash now seems to be tighter with 2019 purchases down around 15% to $700bn.

We also know that President Trump believes a strong stock market is key to his re-election this year. His Trade Adviser, Peter Navarro, has already suggested 2020 will be another record:

“It’s going to be the roaring 2020s. ”Dow 32,000 is a conservative estimate of where we’ll be at the end of the year.”

Certainly investors seem to be very positive, as the above charts confirm.  Share prices for the FANGAM stocks – Facebook, Apple, Netflix, Google and Amazon stocks have soared to new heights:

  • Apple for example, was up 32% in Q4 and nearly doubled in 2019
  • On its own, it provided 14% of the S&P’s gain in the quarter, and 8.5% of the annual gain

This wonderful performance took place even though Apple’s net income has fallen for the past 4 quarters. It is also hard to argue that Microsoft or the other FANGAM companies are suddenly about to see supercharged growth.

So is there a negative side?  Maybe old-fashioned investors were simply wrong to believe stock markets’ key role as price discovery and the efficient allocation of capital?

If one wants to worry, one has to instead look to the insights of Hyman Minsky, who warned that:

  • A long period of stability eventually leads to major instability
  • This is because investors forget that higher reward equals higher risk
  • Instead, they believe that a new paradigm has developed
  • They therefore take on high levels of debt to finance ever more speculative investments

His argument was that liquidity is not the same as solvency. Central banks can pump out trillions of dollars in stimulus, and make it ridiculously easy for companies to justify new investments. It is hard to argue with a CEO who claims:

“Why not borrow, as it’s not costing us anything with today’s interest rates“.

But what happens if the earnings from the new investments are too low to pay the interest due on the debt?

That is the risk we face today, given there is now a record $3tn of BBB grade debt – the lowest level of ‘investment grade’ debt. If some of these companies start to default, then confidence in the central banks’ ‘new paradigm’ will quickly disappear – and, with it, market liquidity

Investors will then find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid.  In turn, this will prompt a rush for the exits. Prices will drop quite sharply, as ‘distress sales’ start to take place.

China’s former central bank governor has already warned that it may be facing its own Minsky Moment. As investors finish celebrating their 2019 success, they might find it prudent to ponder whether the good times can really continue forever.

Chart of the Decade – the Fed’s support for the S&P 500 will end with a debt crisis

Each year, there has been only one possible candidate for Chart of the Year.  Last year it was the collapse of China’s shadow banking bubble; 2017 was Bitcoin’s stratospheric rise; 2016 the near-doubling in US 10-year interest rates; and 2015 the oil price fall.

This year, the ‘Chart of the Decade’ is in a league of its own. Produced by Goldman Sachs, it shows that the S&P 500 is in its longest-ever run without a 20% downturn.

The reason for this amazing performance is not hard to find.  It has been caused by the US Federal Reserve’s adoption of Ben Bernanke’s concept that:

“Higher stock prices will boost consumer wealth and help increase confidence“.

Set out in 2010, it replaced the previous policy set out by William McChesney Martin that their job was:

“To take away the punchbowl as the party gets going”.

“Don’t fight the Fed” is one of the best short-term investment principles, but the Fed’s success is quite extraordinary when one looks back over the past decade.  Each time the market has threatened to slide, they have rushed in with yet more support:

  • In QE1, the Fed pumped out $1.3tn of support for financial markets, in addition to reducing interest rates to near-zero
  • This free money mostly went straight into asset markets such as stocks, which weakened when the stimulus stopped
  • QE2 came to the rescue with another $600bn of support – but again, stocks then weakened
  • QE3 provided longer-term support, with $40bn/month then increasing to $85bn/month

President Trump’s tax cuts provided even further support when the Fed finally paused, as the Financial Times chart confirms, by encouraging a massive wave of share buybacks.

Remarkably, these buybacks came at a time when profits were actually falling as a percentage of GDP, as the third chart shows. Investors should really have been pulling out of shares, rather than buying more. But after so many years of Fed support, most asset managers had either forgotten how to read a Profit & Loss account and Balance Sheet – or had decided these were irrelevant to stock valuation.

Since September, we have been in a new Fed stimulus cycle. As I noted then, a $50bn hole had appeared in New York financial markets.  Regulators and consensus commentators combined to explain this was only due to temporary factors. But since then, the support has reached $376bn, and the Fed has announced it will happily supply another $500bn of support to cover possible year-end problems, probably taking the total close to $1tn since September.

Behind this panic is the IMF’s warning that the $8.1tn of Treasury bonds available as collateral for the repo market, are in fact “owned” by an average of 2.2 different banks at the same time. Understandably, bank CFOs are pulling back, and trying to establish if “their” Treasury bonds in fact belong to someone else.

Regulators should never have allowed this to happen.  They should also have focused long ago – as I suggested this time last year – on the implications of the decline in China’s shadow banking sector.  Just as I expected, China is now exporting deflation around the world, with its PPI falling since June.

China’s slowdown also means an end to the flow of Chinese cash that flooded into New York financial markets, which hedge funds have then leveraged into outsize profits in financial markets.

The Fed turned a blind eye to this, just as it allowed BBB corporate debt to expand at a record rate, as the chart from S&P confirms.   As we noted in June’s pH Report:

“US BBB grade debt, the lowest grade in which most funds are allowed to invest, is now more than $3tn, with 19% of this total ($579bn) in the very lowest BBB– grade. And this BBB– total jumps to $1tn if one includes financial sector debt. S&P also report that global BBB debt is now $7tn, with US companies accounting for 54% of the total.

“The problem is that BBB- debt becomes speculative debt if it is downgraded by just one notch to BB grade. And most investors are then forced by their mandate to sell their holding in a hurry, creating the potential for a vicious circle, as the most liquid bonds will inevitably be sold first. In turn, this creates the potential for a “waterfall effect” in the overall bond market – and to contagion in the stock market itself.”

The Fed’s focus on boosting the stock market is clearly going to end in a debt crisis.  But when warning of this, the consensus responds as in 2006-8, when I was warning of a global financial crash, “That’s impossible”.  And no doubt, once the debt crisis has occurred, it will again claim “nobody could have seen this coming”.

This is why the S&P 500 chart is my ‘chart of the decade’.

Boris Johnson will have to disappoint someone in 2020 as the UK finally leaves the EU

Finally, after three and a half years, the UK has reached “the end of the beginning” with Brexit, in Winston Churchill’s famous phrase.

Since the referendum, its leaders have consistently refused to confront the real choices that have to be made over what type of Brexit it wants to have:

  • In June 2016, then premier David Cameron walked away from the issue by resigning immediately after the referendum
  • His successor, Theresa May, followed this by setting out her ’red lines’, as shown in the chart. But she never said what she did want, effectively leaving No Deal as the default option
  • On the Labour side, Jeremy Corbyn indulged in the same game-playing, even refusing to say which way he would vote in a new referendum

As a result, the myth grew up that there was a wonderful option called ‘WTO terms’, which would allow the UK to do exactly as it liked on standards, regulations, freedom of movement etc. Yet it would still have complete access to the EU27 market without any need for quotas or Customs barriers.

Unfortunately for all those who have indulged in such wishful thinking, 2020 is likely to provide an abrupt and painful wake-up call.  Once the UK has left the EU in January, Johnson will have to make major choices, and on a very tight timescale.

The government’s key mistake all along was to table its Article 50 notification to leave without having first decided what it wanted from the new relationship with the EU27. And by dismissing the role of “experts” and key Brussels negotiators such as Sir Ivan Rogers, it also never properly understood what might be possible from an EU27 perspective.

Now the need for choices is going to become apparent, as the Transition Agreement only runs to December 2020, and any request for an extension has to be agreed by June.  Johnson has said he will not ask for an extension, and so this narrows the choices:

  • France has said the UK can leave with a ”unique” trade deal encompassing most of the current arrangements, if the UK agrees to maintain today’s standards and regulations into the future. In effect, this would be a Norway-type deal, where the UK becomes a rule-taker, without any say in how the rules are made
  • The alternative is to leave with No Deal, as anyone with experience of trade deals knows that it is simply impossible to square all the necessary circles involved in reaching a new deal in less than 5 – 7 years. The reason is simply that trade deals create winners and losers, and the losers always complain, very loudly

One likely example of a deal-breaker is fisheries policy.

Fishing accounts for just 0.1% of the UK economy, and employs only 24k people out of a total workforce of 33m. And contrary to popular belief, not only have foreign boats been fishing in UK waters for centuries, but 70% of the fish eaten in the UK is imported (cod etc) – with 80% of fish caught by UK fishermen  exported (herring, shellfish etc).

But it was core to the Leave campaign, and Johnson is likely to find it hard to ignore – even if that means fishermen end up facing quotas, tariffs, Customs barriers and a collapse of conservation policies.

Johnson is happy to break promises, as he did over N Ireland when agreeing to the EU27’s terms for the Withdrawal Agreement. But it would be rather soon after the election to break his promise over fishing or, indeed, his promise not to extend the Transition period.

As a result, Theresa May’s legacy will finally be fulfilled, as No Deal remains the default option.  And at that point, the UK will learn very painfully that you really cannot “have your cake and eat it”, despite Johnson’s claims to the contrary.

ACS Chemistry & the Economy webinar on Thursday

Please join me for the next ACS Chemicals & Economy webinar on Thursday, at 2pm Eastern Standard Time, USA, when we will discuss:

  • The contrast between the downbeat outlook for the chemical market and the upbeat stock market
  • The challenges facing US shale gas polyethylene exports due to the US-China trade war and concerns over single-use packaging
  • The problem of drug shortages, and whether pharmaceutical supply chains are still ‘fit for purpose’

As usual, the webinar will be moderated by Bill Carroll, former ACS President.

Registration is free, and you can sign up by clicking here.