It was almost exactly 10 years ago that then Citibank boss, Chuck Prince, unintentionally highlighted the approach of the subprime crisis with his comment that:
‘We are not scared. We are not panicked. We are not rattled. Our team has been through this before.’ We are ’still dancing’.”
On Friday JP Morgan’s CEO, Jamie Dimon, provided a new and more considered warning:
“Since the Great Recession, which is now 8 years old, we’ve been growing at 1.5% – 2% in spite of stupidity and political gridlock….We have become one of the most bureaucratic, confusing, litigious societies on the planet. It’s almost an embarrassment being an American citizen traveling around the world and listening to the stupid s— we have to deal with in this country. And at one point we all have to get our act together or we won’t do what we’re supposed to [do] for the average Americans.”
The chart above, from OECD data, highlights one key result of the dysfunctionality that Dimon describes:
Central bank stimulus has proved to be a complete failure, as it cannot compensate for today’s “demographic deficit”
UK debt as a percentage of GDP has more than doubled from 51% in 2007 to 123% last year
US debt has risen from an already high 77% in 2007 to 128% last year
Japanese debt has risen from an insane 175% in 2007 to an impossible-to-repay 240%
Debt is essentially just a way of bringing forward demand from the future. If I can borrow money today, I don’t have to wait till tomorrow to buy what I need. But, I do then have to pay back the debt – I can’t borrow forever. So high levels of debt inevitably create major headwinds for future growth.
Unfortunately, central banks and their admirers thought this simple rule didn’t apply to them. They imagined they could print as much money as they liked – and then, magically, all the debt would disappear through a mix of economic growth and inflation. But as the second chart shows, they were completely wrong:
In April 2011, the IMF forecast global GDP in 2016 would be 4.7%
In April 2013, they were still convinced it would be 4.5%
Even in April 2015, they were confident it would be 3.8%
But in reality, it was just 3.1%
And meanwhile inflation, which was supposed to help the debt to disappear in real terms, has also failed to take off. US inflation last month was just 1.6%, and is probably now heading lower as oil prices continue to decline.
In turn, this dysfunctionality in economic policy is creating political and social risk:
The UK has a minority government, which now has to implement the Brexit decision. This represents the biggest economic, social and political challenge that the UK has faced since World War 2. But as the former head of the UK civil service warned yesterday:
“The EU has clear negotiating guidelines, while it appears that cabinet members haven’t yet finished negotiating with each other, never mind the EU”. He calls on ministers to “start being honest about the complexity of the challenge. There is no chance all the details will be hammered out in 20 months. We will need a long transition phase and the time needed does not diminish by pretending that this phase is just about ‘implementing’ agreed policies as they will not all be agreed.”
The US faces similar challenges as President Trump aims to take the country in a completely new direction. As of Friday, 6 months after the Inauguration, there are still no nominations for 370 of the 564 key Administration positions that require Senate confirmation. And last week, his Secretary of State, Rex Tillerson, highlighted some of the challenges he faces when contrasting his role as ExxonMobil CEO with his new position:
“You own it, you make the decision, and I had a very different organization around me… We had very long-standing, disciplined processes and decision-making — I mean, highly structured — that allows you to accomplish a lot, to accomplish a lot in a very efficient way. [The US government is] not a highly disciplined organization. Decision-making is fragmented, and sometimes people don’t want to take decisions. Coordination is difficult through the interagency [process]…and in all honesty, we have a president that doesn’t come from the political world either.”
Then there is Japan, where Premier Abe came to power claiming he would be able to counter the demographic challenges by boosting growth and inflation. Yet as I noted a year ago, his $1.8tn of stimulus has had no impact on household spending – and consumer spending is 60% of Japanese GDP. In fact, 2016 data shows spending down 2% at ¥2.9 million versus 2012, and GDP growth just 1%, whilst inflation at only 0.4% is far below the 2% target.
As in the UK and US, political risk is now rising. Abe lost the key Tokyo election earlier this month after various scandals. Voter support is below 30%, and two-thirds of voters “now back no party at all” – confirming the growing dysfunctionality in Japanese politics.
WOULD YOU LEND TO A FRIEND WHO RUNS UP DEBT WITH NO CLEAR PLAN TO PAY IT BACK?
So what is going to happen to all the debt built up in these 3 major countries? There are already worrying signs that some investors are starting to pull back from UK, US and Japanese government bond markets. Over the past year, almost unnoticed, major moves have taken place in benchmark 10-year rates:
UK rates have nearly trebled from 0.5% to 1.3% today
US rates have risen from 1.4% to 2.3% today;
Japanese rates have risen from -0.3% to +0.1% today.
What would happen if these upward moves continue, and perhaps accelerate? Will investors start to agree with William White, former chief economist of the central bankers’ bank (Bank for International Settlements), that:
“To put it in a nutshell, if it’s a debt problem we face and a problem of insolvency, it cannot be solved by central banks through simply printing the money. We can deal with illiquidity problems, but the central banks can’t deal with insolvency problems”.
White was one of the few to warn of the subprime crisis, and it seems highly likely he is right to warn again today.
Yesterday’s failure of the Doha oil producers meeting will hopefully reintroduce a note of sanity into oil markets. After all, Saudi leaders have made it clear, time and time again, that they were no longer interested in operating a cartel where they take the pain of cutting production, and everyone else gains the benefit of higher prices.
Veteran Oil Minister Ali al-Naimi was quite explicit about this a year ago, saying that:
“Saudi Arabia cut output in the 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell. So we lost on output and on prices at the same time. We learned from that mistake.”
And there was a very clear statement from the deputy Crown Prince last Thursday, which made it abundantly clear there would be no deal at yesterday’s meeting:
“If all major producers don’t freeze production, we will not freeze production”
As Iran was never scheduled to attend the meeting, surely it was obvious that no deal was possible?
The Saudis have also been very clear about why they have adopted this new policy. They recognise that oil, like coal, will end up being left in the ground. So it makes no sense for them, as the world’s lowest-cost producer, to provide a price umbrella that enables higher-cost producers to monetise their oil at Saudi’s expense.
Naimi has been saying this for years, to anyone who would listen, telling reporters in 2012 in Qatar that Saudi policy was based on the fact that:
“Demand will peak way ahead of supply”
The same message was repeated earlier this month by Saudi’s deputy Crown Prince, who told Bloomberg that the country was now planning for the post-oil world and highlighted:
“His obsession with moving the Saudi economy away from oil…Aramco’s new strategy will transform it from an oil and gas company to an energy/industrial company”.
Despite these clear statements, oil prices have rallied 50% since January. But lets be clear. This move was never based on the improbable idea that a production freeze by Russia and some OPEC members (excluding Iran and probably Iraq), would somehow change today’s 2mbd surplus of oil into a more balanced market.
In reality, the real story has been buying of oil market futures by financial speculators.
They realised during January that the US Federal Reserve was unlikely to follow through with its proposed 4 further interest rate rises in 2016. So they decided to rewind the clock, and buy up commodities such as oil and copper – repeating the “store of value” trades that were so profitable during the post-2009 US$ devaluation period:
- At its peak in 2013, $80bn had been speculatively invested in this trade
- Pension and hedge funds knew that a key purpose of the Fed’s easy money policies was to devalue the dollar
- And so it seemed obvious that commodities such as oil and copper would do well as potential “stores of value”
- China’s stimulus policy, which peaked in 2013 at $28tn/year, also artificially boosted commodity demand
And as I noted 2 weeks ago, by the end of March, the funds had built a record long position of 579m bbls in Brent/WTI – equivalent to almost 6 days of global demand
But as the futures market data showed then, the smart traders were already banking their profits and moving on to new opportunities. The Doha story had done its job, as far as they were concerned. And they knew that in a weak market, profits come from “buying on the rumour, selling on the news”.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 58%
Naphtha Europe, down 57%. “Asian price gains were capped by a rising supply of arbitrage material for May at a time of receding Chinese demand for May delivery”
Benzene Europe, down 54%. “Europe remains the highest-priced region for benzene….US Gulf material is now being fixed for export to Europe for May onwards as Asian styrene numbers weaken.”
PTA China, down 40%. “Prices were assessed as mixed week on week, as choppy upstream energy prices caused prices to be volatile.”
HDPE US export, down 31%. “China market outlook is bearish due to reduced buying interest.”
¥:$, down 6%
S&P 500 stock market index, up 6%
3 years of massive stimulus spending in Japan has had no impact on the problem it was supposed to solve. This is highlighted by new government data on household spending for 2015, as the charts above confirm – they compare 2015 data with that for 2012, before Abenomics began:
- Spending was almost exactly the same at every age group in 2015 versus 2012, when premier Abe took office
- Spending in the peak age range of 50 – 59 was just ¥250/year higher, and ¥7900 lower in the 40 -49 age group
- It still declines 31% once people reach the age of 70 – critically important with Japan’s ageing population
- In US$ terms, of course, the numbers are lower due to Abe’s focus on devaluing the yen since he took office
- US$ spending in the two peak age groups of 40 – 49, and 50 – 59, has fallen by $15k/year to $29k/year
This matters, because consumer spending is 60% of Japanese GDP.
The quite scary result is that the Bank of Japan has spent ¥200tn ($1.84tn) since Abe came to power on its quantitative easing programme. Yet the Abenomics policy has completely failed to achieve its major objectives of boosting GDP and inflation:
As a result, Japan now has the world’s highest level of government debt as a percentage of GDP at 226%.
Yet premier Abe and Bank of Japan Governor Kuroda refuse to accept that their policies have failed. Instead, just like the European Central Bank yesterday, they have decided to implement their policies on a greater scale. Thus Japan introduced negative interest rates in January, meaning that the Bank now charges you to deposit money with it.
Clearly these are increasingly desperate measures, which have a vanishingly small chance of being successful. Past performance is no guarantee of future results, but it is usually the best guide that we have. And understandably, Japan’s Diet (its parliament) is becoming very concerned – Governor Kuroda has been summoned for questioning a record 25 times so far this year.
One major concern is that Japan’s value proposition for foreign investors is looking increasingly unattractive:
- Foreigners have to pay the government to lend it money (and so are guaranteed to get back less than they lend)
- They also know devaluation remains a key policy, meaning that the return in their currency will probably be lower
- And GDP growth is almost impossible with Japan’s median age now 47 years and its population will decline 600k/year by 2020
Premier Abe initially promised that he would restore the country to growth within 2 years, and push inflation to at least 2%. Today, 3 years later, his Abenomics policies have entered the end-game. Some investors will no doubt continue to maintain positions in Japan, as it is still the world’s 3rd largest economy.
But they will no doubt be keeping a close eye on their exit opportunities. When the rush starts, nobody will want to be left behind.
This week’s economic data from Japan confirmed, once again, that demographic changes are far more important for the economy than monetary stimulus.
Japan’s premier Abe took power in 2012, promising to end the decline in Japan’s economic growth. He appointed a new Governor for the Bank of Japan, and claimed that his “3 arrows policy” would quickly create an economic boom. But as the chart shows from the Guardian/Zerohedge, Monday’s data showed that Japan has gone back into recession again.
It didn’t take rocket science to forecast this back in April 2013, after Abe had announced his new policies:
“Unfortunately, however, this bold new initiative is also doomed to fail, for one simple reason. As in all developed economies, household consumption accounts for almost 2/3rds of Japan’s GDP. And Japan not only has the oldest population in the world (median age is 45 years). Nearly half of its population are over 50 and so are already in their low-spending years”.
The latest data for Japan’s consumer spending confirms there has been little change since 2013, as the chart shows:
- It highlights how spending declines past the age of 50 in virtually all major areas
- The reason is simple common sense – older people already own most of what they need, and their incomes decline as they move into retirement
Instead, the main result of the stimulus has been to boost Japan’s financial markets, and to devalue the currency. It has been a wonderful ride for the speculators, as the Nikkei Index has soared from 8750 at the end of 2012 to a peak of over 20000 last August. Similarly the value of the yen has fallen over 50% versus the US$ over the same period. The Bank of Japan claimed this would boost inflation by causing import prices to rise, but this theory has also proved incorrect with Japan’s consumer price inflation back at 0% in September.
Unfortunately, Abe’s failed experiment has not been cost free. The Bank of Japan began its stimulus programme in April 2013 by spending Yen 60tn/month, and increased this spend to Yen 80tn/month in October last year, making the total cost roughly equal to $1tn by the end of this year. This debt still has to be repaid, putting a further burden on the economy. And, of course, there is no guarantee that premier Abe will now abandon his failed experiment – as last year, he may simply decide to increase the cost still further.
Even more worrying is that the lesson of the failure is still not recognised by other policymakers. Thus the European Central Bank seems likely to repeat Japan’s mistake of “doubling down” on its own stimulus policy, despite clear evidence that it has also failed to achieve the promised results.
Financial markets are slowly descending into chaos. The process began in China over the summer, and has now started to impact Wall Street and other developed markets as the Great Unwinding of policymaker stimulus continues. The problem is that successful investment, whether in financial or chemical markets, requires the combination of
- A clear understanding of the outlook for the product or asset (the ‘fundamentals’)
- A clear idea of how the market already values this asset (‘sentiment’)
- And, perhaps most importantly, the courage to take an unfashionable position and wait for it to work out
It is very difficult to make money over the medium to long-term if everyone has already had the same idea. But one doesn’t need to be brave to simply follow the crowd and do what everyone else has already done. This, of course, is a key reason why many investors and companies invest at market peaks, and don’t invest at market bottoms.
The chart above highlights the linkages between movements in the S&P 500 Index (black line) and the Consensus Index (blue) – which tracks market sentiment:
- Before 2000, sentiment used to peak before market tops, and was a good leading indicator
- But from 2000, central banks began to destroy the market’s role of price discovery via their stimulus programmes
- As a result, players began to ignore market fundamentals, and focused on central bank activity instead
- Thus peaks and troughs in sentiment have coincided with peaks and troughs in the markets themselves
This pattern has become more extreme since the vast central bank stimulus programmes began in 2009. Companies and investors were convinced that policymakers had become all-wise and far-seeing. So they only needed to read central bank statements in order to know what would happen next.
But since the summer, people have begun to take off their rose-tinted glasses and started to realise that reality is quite different:
- In China, for example, the consensus now no longer believes in the published GDP figures
- It is also alarmed by the failure of policymakers’ attempts to support the stock market during its recent 40% fall
- Over the past month, similar worries about developed country central banks have begun to surface
- Thus ratings agency S&P downgraded Japanese government bonds last week, saying not much had yet been achieved by Abenomics
Last week also saw investors start to lose faith in the US Federal Reserve. It has constantly told investors that the US economy was recovering and that interest rates would increase this year. But now it has failed to act either in June and September. Naturally, investors are starting to worry about whether the Fed knows what it is doing.
The problem is that the market no longer knows what policymakers believe about the outlook. As the Wall Street Journal reports, market insiders had 4 scenarios for last week’s Fed meeting:
- The base case was “the Fed would keep rates steady but indicate that a rate increase was right around the corner“
- Others believed the Fed “would raise rates but indicate there wouldn’t be any more increases coming for quite some time“
- A third scenario was “the Fed would raise interest rates and indicate more were coming in short order. That was seen as a real outlier”
- Then there was the most unlikely outcome, that “would have the Fed standing pat and toning down the language on future rate increases“
And the last scenario turned out to be what happened. So suddenly, investors began to worry about how they could have been so wrong. In turn, this led to concern about how the market is currently valuing different assets. If the Fed doesn’t know what it is doing, and the economy is weaker than it expected, then have investors overpaid when buying at peak consensus sentiment levels? This is a worrying thought.
It also highlights the rocky road ahead as the Great Unwinding continues. Investors now have to start to re-learn how to form judgments for themselves about the fundamentals of supply and demand, and suitable valuations for these. They can’t just trust the Fed, buy Exchange Traded Funds, and sit back to wait for the profits to roll in.
As we have seen in China, once confidence is lost in the markets, they can become chaotic very quickly.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 54%
Naphtha Europe, down 52%. “Demand remained stable and a few cracker operators have increased their run rates as margins remain workable”
Benzene Europe, down 63%. “Given the current macroeconomic bearishness stemming from the recent jitters seen in China, it was no surprise that end-user demand was down, adding more length to the global benzene market.”
PTA China, down 43%. “Textile demand is being be driven by the year-end consumption boost for fibre products, however, total gains may be capped as PET demand would likely start to decline sometime in October”
HDPE US export, down 36%. “Prices slipped a few pennies during the week on sporadic trading, with many buyers continuing to wait for lower prices”
¥:$, down 16%
S&P 500 stock market index, unchanged
‘Peter Pan’ is one of the world’s most-loved children’s stories.But I hadn’t realised it had also become an economics textbook, at least in Japan. Yet the Governor of the Bank of Japan (BoJ), Haruhiko Kuroda, described his stimulus policy last week as follows to an invited audience:
“I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it.’ Yes, what we need is a positive attitude and conviction,”
As readers will know, I have consistently argued that the central banks were guilty of wishful thinking, with their idea that printing money could somehow stimulate growth in an ageing population. So it is good to know they recognise there might be some truth in the argument.
The chart above, based on Statistics Japan data, highlights the impossibility of Kuroda’s wish to restore inflation and constant growth to the levels seen before Japan’s population began to age:
- Its BabyBoom began earlier than in the West, and averaged 2.2m babies/year between 1920 – 1952
- Births then slowed between 1953 – 1983 to average only 1.7m/year
- Births have since fallen further to average just 1.2m/year over the 30 years between 1984 – 2014
- Last year actually saw a record low level of only 1m births
Thus Japan has simply run out of realistic options for growth. Its population is now set for steady decline from 2010′s level of 127m to just 108m by 2050, according to UN Population Division forecasts.
We also know, again from Statistics Japan data, that spending peaks in the 25 – 54 age group, as the second chart shows. After this, people already own most of what they need, and their incomes decline as they enter retirement. These spending patterns also matter for the economy, as consumption is around 60% of Japan’s GDP.
Japan has one of the oldest populations in the world, with a quarter aged over 65 years. Therefore it really is wishful thinking of the first order to imagine that it can possibly return to the growth levels seen when its BabyBoom was in its peak spending mode . After all, the youngest Boomer, born in 1952, is now 63 years old.
And it is also hard to imagine that the problem can be solved by either increasing fertility rates dramatically, or boosting immigration:
- Adding more babies now would simply increase the dependency ratio, which measures the number of young and old as a ratio of the working -age population. It would do nothing to boost growth for another 20+ years, till the babies began to enter the workforce
- Boosting immigration would require millions of people to migrate to Japan, and would create enormous social tensions as a result. Japan has never accepted the idea of immigration, and it is unlikely to be accepted now
The great moral of ‘Peter Pan’ is that children have to grow up and join an adult world. They cannot live in the magic world of Neverland forever. What a pity that Japan’s policymakers obviously never read to the end of the story.
Of course, if you hand out Yen 80tn/year ($480bn) in stimulus, as the BoJ is now doing, and devalue 50% versus the dollar, you will get a short-term jump in the growth rate. But then the rate will fall back again, as Japan’s working age population has to pay for the cost of this short-term stimulus through higher taxes.
The greatest pity is that premier Abe chose to ignore the wisdom of the BoJ’s previous Governor, Masaaki Shirakawa. He understood all too well that demographics are far more powerful than monetary policy.