Europe’s auto sector suffers as Dieselgate and China’s downturn hit sales

Trade wars, Dieselgate and recession risk are having a major impact on the European auto industry, as I describe in my new video interview with ICIS Chemical Business deputy editor, Will Beacham.

One key pressure point is created by the downturn in China’s auto industry. As the chart shows, it has been a fabulous growth market in recent years due to China’s stimulus policies, with sales growing nearly five-fold from 550k/month in 2008 to a peak of 2.5m/month last year. And German car exports did incredibly well as a result, due to their strong reputation amongst consumers.

But the start of the US/China trade war last year – plus the $2tn taken out of China’s speculative shadow banking sector over the past 2 years by the government’s deleveraging campaign – means sales have been in decline for almost a year. 2018 saw the first downturn in the market since 1992, and since then the pace of decline has been accelerating with May volumes down 17%.

European car sales have also been falling since September as the second chart confirms. And unfortunately, the industry is confronted by a near-perfect storm of problems, which make it likely that the current downward trend will continue and probably accelerate.

The most immediate issue is the slowdown in the EU economy, with consumers becoming nervous about making high-ticket car purchases. Added to this, of course, are concerns over Brexit – which led sales in the UK (the 2nd largest market) to hit a 6-year low in the normally buoyant sales month of March, 14.5% below the 2017 level.

And then, of course, there are concerns over China’s slowdown, particularly for Germany’s export-oriented manufacturers such as BMW, Audi, Mercedes and Porsche – plus rising concerns over the potential for a European trade war with the USA.

But the real concern arises from the continuing fall-out from Dieselgate, which led diesel’s share of the EU market to fall by 18% in 2018 versus 2017 to 5.59m. Diesel cars accounted for only 35% of EU auto sales, the lowest level since 2001. And in turn this is wrecking the industry’s plans for meeting the new EU rules on CO2 emissions, which VW estimates has already cost it around €30bn, at a time when all the carmakers are also having to invest heavily in EV technology.

As the European Environment Agency (EEA) noted last month:

“For the first year since 2009, petrol cars constituted the majority of new registrations in 2017 (53 %). New diesel cars, which were on average around 300kg heavier than new petrol cars, emitted on average 117.9g CO2/km, which is 3.7g CO2/km less than the average petrol car. The average fuel efficiency of new petrol cars has been constant in 2016 and 2017, whereas the fuel-efficiency of new diesel cars has worsened compared to 2016 (116.8 g CO2/km). If similar petrol and diesel segments are compared, new conventional petrol cars emitted 10%-40% more than new conventional diesel cars.”

Manufacturers have no easy options. They can, of course, aim to accelerate Electric Vehicle (EV) sales in order to gain “super-credits” towards the new limits. But EVs are currently less than 2% of the EU market, so the scope for a major ramp-up in volume is very limited, and their profit margins are much lower due to the battery cost. UBS therefore suggest that automakers earnings per share will be badly hit, with PSA down 25%, VW down 13%, Renault down 10%, Daimler down 9% and BMW down 7%.

The saga highlights how the diesel makers’ decision to cheat on reported emission levels in order to maximise short-term profit has led to major long-term damage for many manufacturers. FCA’s need to enter a “pooling arrangement“ with Tesla to reduce its potential fines, and to exit sales of its most heavily polluting models, highlights the scale of the problems.

In turn, as I discuss, this is all very bad news for major suppliers to the auto industry such as the petrochemical sector.  Please click here if you would like to see the full interview.

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.

CEOs need new business models amid downturn

Many indicators are now pointing towards a global downturn in the economy, along with paradigm shifts in demand patterns. CEOs need to urgently build resilient business models to survive and prosper in this New Normal world, as I discuss in my 2019 Outlook and video interview with ICIS.

Global recession is the obvious risk as we start 2019.  Last year’s hopes for a synchronised global recovery now seem just a distant memory.  Instead, they have been replaced by fears of a synchronised global downturn.

Capacity Utilisation in the global chemical industry is the best leading indicator that we have for the global economy.  And latest data from the American Chemistry Council confirms that the downtrend is now well-established.  It is also clear that key areas for chemical demand and the global economy such as autos, housing and electronics moved into decline during the second half of 2018.

In addition, however, it seems likely that we are now seeing a generational change take place in demand patterns:

  • From the 1980s onwards, the demand surge caused by the arrival of the BabyBoomers into the Wealth Creating 25 – 54 cohort led to the rise of globalisation, as companies focused on creating new sources of supply to meet their needs
  • At the same time the collapse of fertility rates after 1970 led to the emergence of 2-income families for the first time, as women often chose to go back into the workforce after childbirth. In turn, this helped to create a new and highly profitable mid-market for “affordable luxury”
  • Today, however, only the youngest Boomers are still in this critical generation for demand growth. Older Boomers have already moved into the lower-spending, lower-earning 55+ age group, whilst the younger millennials prefer to focus on “experiences” and don’t share their parents’ love of accumulating “stuff”

The real winners over the next few years will therefore be companies who not only survive the coming economic downturn, but also reposition themselves to meet these changing demand patterns.  A more service-based chemical industry is likely to emerge as a result, with sustainability and affordability replacing globalisation and affordable luxury as the key drivers for revenue and profit growth.

Please click here to download the 2019 Outlook (no registration necessary) and click here to view the video interview.

Chart of the Year – China’s shadow banking collapse means deflation may be round the corner

Last year it was Bitcoin, in 2016 it was the near-doubling in US 10-year interest rates, and in 2015 was the oil price fall.  This year, once again, there is really only one candidate for ‘Chart of the Year’ – it has to be the collapse of China’s shadow banking bubble:

  • It averaged around $20bn/month in 2008, a minor addition to official lending
  • But then it took off as China’s leaders panicked after the 2008 Crisis
  • By 2010, it had shot up to average $80bn/month, and nearly doubled to $140bn in 2013
  • President Xi then took office and the bubble stopped expanding
  • But with Premier Li still running a Populist economic policy, it was at $80bn again in 2017

At that point, Xi took charge of economic policy, and slammed on the brakes. November’s data shows it averaging just $20bn again.

The impact on the global economy has already been immense, and will likely be even greater in 2019 due to cumulative effects.  As we noted in this month’s pH Report:

“Xi no longer wants China to be the manufacturing Capital of the world. Instead his China Dream is based on the country becoming a more service-led economy based on the mobile internet.  He clearly has his sights on the longer-term and therefore needs to take the pain of restructuring today.

“Financial deleveraging has been a key policy, with shadow bank lending seeing a $609bn reduction YTD November, and Total Social Financing down by $257bn. The size of these reductions has reverberated around Emerging Markets and more recently the West:

  • The housing sector has nose-dived, with China Daily reporting that more than 60% of transactions in Tier 1 and 2 cities saw price drops in the normally peak buying month of October, with Beijing prices for existing homes down 20% in 2018
  • It also reported last week under the heading ’Property firms face funding crunch’ that “housing developers are under great capital pressure at the moment”
  • China’s auto sales, the key to global market growth since 2009, fell 14% in November and are on course for their first annual fall since 1990
  •  The deleveraging not only reduced import demand for commodities, but also Chinese citizens’ ability to move money offshore into previous property hotspots
  • Real estate agents in prime London, New York and other areas have seen a collapse in offshore buying from Hong Kong and China, with one telling the South China Morning Post that “basically all Chinese investors have disappeared “

GLOBAL STOCK MARKETS ARE NOW FEELING THE PAIN

As I warned here in June (Financial markets party as global trade wars begin), the global stock market bubble is also now deflating – as the chart shows of the US S&P 500.  It has been powered by central bank’s stimulus policies, as they came to believe their role was no longer just to manage inflation.

Instead, they have followed the path set out by then Federal Reserve Chairman, Ben Bernanke, in November 2010, believing 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.”

Now, however, we are coming close to the to the point when it becomes obvious that the Fed cannot possibly control the economic fortunes of 325m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted by central banks in this  failed experiment.

The path back to fiscal sanity will be very hard, due to the debt that has been built up by the stimulus policies.  The impartial Congressional Budget Office expects US government debt to rise to $1tn.

Japan – the world’s 3rd largest economy – is the Case Study for the problems likely ahead:

  • Consumer spending is 55% of Japan’s GDP.  It falls by around a third at age 70+ versus peak spend at 55, as older people already own most of what they need, and are living on a pension
  • Its gross government debt is now 2.5x the size of its economy, and with its ageing population (median age will be 48 in 2020), there is no possibility that this debt can ever be repaid
  • As the Nikkei Asian Review reported in July, the Bank of Japan’s stimulus programme means it is now a Top 10 shareholder in 40% of Nikkei companies: it is currently spending ¥4.2tn/year ($37bn) buying more shares
  • Warning signs are already appearing, with the Nikkei 225 down 12% since its October peak. If global stock markets do now head into a bear market, the Bank’s losses will mount very quickly

CHINA MOVE INTO DEFLATION WILL MAKE DEBT IMPOSSIBLE TO REPAY

Since publishing ‘Boom, Gloom and the New Normal: how the Ageing Boomers are Changing Demand Patterns, Again“, in 2011 with John Richardson, I have argued that the stimulus policies cannot work, as they are effectively trying to print babies.  2019 seems likely to put this view to the test:

  • China’s removal of stimulus is being matched by other central banks, who have finally reached the limits of what is possible
  • As the chart shows, the end of stimulus has caused China’s Producer Price Inflation to collapse from 7.8% in February 2017
  • Analysts Haitong Securities forecast that it will “drop to zero in December and fall further into negative territory in 2019

China’s stimulus programme was the key driver for the global economy after 2008.  Its decision to withdraw stimulus – confirmed by the collapse now underway in housing and auto sales – is already putting pressure on global asset and financial markets:

  • China’s lending bubble helped destroy market’s role of price discovery based on supply/demand
  • Now the bubble has ended, price discovery – and hence deflation – may now be about to return
  • Yet combating deflation was supposed to be the prime purpose of Western central bank stimulus

This is why the collapse in China’s shadow lending is my Chart of the Year.

BASF’s second profit warning highlights scale of the downturn now underway

The chemical industry is easily the best leading indicator for the global economy.  And thanks to Kevin Swift and his team at the American Chemistry Council, we already have data showing developments up to October, as the chart shows.

It confirms that consensus hopes for a “synchronised global recovery” at the beginning of the year have again proved wide of the mark.  Instead, just as I warned in April (Chemicals flag rising risk of synchronised global slowdown), the key  indicator – global chemical industry Capacity Utilisation % – has provided fair warning of the dangers ahead.

It peaked at 86.2%, in November 2017, and has fallen steadily since then. October’s data shows it back to June 2014 levels at 83.6%. And even more worryingly, it has now been falling every month since June. The last time we saw a sustained H2 decline was back in 2012, when the Fed felt forced to announce its QE3 stimulus programme in September.  And it can’t do that again this time.

The problem, as I found when warning of subprime risks in 2007-8 (The “Crystal Blog” foresaw the global financial crisis), is that many investors and executives prefer to adopt rose-tinted glasses when the data turns out to be too downbeat for their taste.  Whilst understandable, this is an incredibly dangerous attitude to take as it allows external risks to multiply, when timely action would allow them to be managed and mitigated.

It is thus critical that everyone in the industry, and those dependent on the global economy, take urgent action in response to BASF’s second profit warning, released late on Friday, given its forecast of a “considerable decrease of income” in 2018 of “15% – 20%”, after having previously warned of a “slight decline of up to 10%”.

I have long had enormous respect for BASF and its management. It is therefore deeply worrying that the company has had to issue an Adjustment of outlook for the fiscal year 2018 so late in the year, and less than 3 weeks after holding an upbeat Capital Markets Day at which it announced ambitious targets for improved earnings in the next few years.

The company statement also confirmed that whilst some problems were temporary, most of the issues are structural:

  • The impact of low water on the Rhine has proved greater than could have been earlier expected
  • But the continuing downturn in isocyanate margins has been ongoing for TDI since European contract prices peaked at €3450/t in May — since when they had fallen to €2400/t in October and €2050/t in November according to ICIS, who also reported on Friday that
    “Supply is still lengthy at year end in spite of difficulties at German sellers BASF and Covestro following low Rhine water levels”
  • The decline is therefore a very worrying insight into the state of consumer demand, given that TDI’s main applications are in furniture, bedding and carpet underlay as well as packaging applications.
  • Even more worrying is the statement that:
    “BASF’s business with the automotive industry has continued to decline since the third quarter of 2018; in particular, demand from customers in China slowed significantly. The trade conflict between the United States and China contributed to this slowdown.”

This confirms the warnings that I have been giving here since August when reviewing H1 auto sales (Trump’s auto trade war adds to US demographic and debt headwinds).

I noted then that President Trump’s auto trade tariffs were bad news for the US and global auto industry, given that markets had become dangerously dependent on China for their continued growth:

  • H1 sales in China had risen nearly 4x since 2007 from 3.1m to 11.8m this year
  • Sales in the other 6 major markets were almost unchanged at 23m versus 22.1m in 2007

Next year may well prove even more challenging if the current “truce” over German car exports to the USA breaks down,

INVESTORS HAVE WANTED TO BELIEVE THAT INTEREST RATES CAN DOMINATE DEMOGRAPHICS

The recent storms in financial markets are a clear sign that investors are finally waking up to reality, as Friday night’s chart from the Wall Street Journal confirms:

“In a sign of the breadth of the global selloff in stocks, Germany’s main stock index fell into a bear market Thursday, the latest benchmark to have tumbled 20% or more from its recent peak….Other markets already in bear territory are home to companies exposed to recent trade fights between the U.S. and China.

The problem, as I have argued since publishing ‘Boom, Gloom and the New Normal: how the Ageing Boomers are Changing Demand Patterns, again“, in 2011 with John Richardson, is that the economic SuperCycle created by the dramatic rise in the number of post-War BabyBoomers is now over.

I highlighted the key risks is my annual Budget Outlook in October, Budgeting for the end of “Business as Usual”.  I argued then that 2019 – 2021 Budgets needed to focus on the key risks to the business, and not simply assume that the external environment would continue to be stable.  Since then, others have made the same point, including the president of the Council on Foreign Relations, Richard Haas, who warned on Friday:

“In an instant Europe has gone from being the most stable region in the world to anything but. Paris is burning, the Merkel era is ending, Italy is playing a dangerous game of chicken with the EU, Russia is carving up Ukraine, and the UK is consumed by Brexit. History is resuming.

It is not too late to change course, and focus on the risks that are emerging.  Please at least read my Budget Outlook and consider how it might apply to your business or investments. And please, do it now.

 

You can also click here to download and review a copy of all my Budget Outlooks 2007 – 2018.

Budgeting for the end of “Business as Usual”

Companies and investors are starting to finalise their plans for the coming year.  Many are assuming that the global economy will grow by 3% – 3.5%, and are setting targets on the basis of “business as usual”.  This has been a reasonable assumption for the past 25 years, as the chart confirms for the US economy:

  • US GDP has been recorded since 1929, and the pink shading shows periods of recession
  • Until the early 1980’s, recessions used to occur about once every 4 – 5 years
  • But then the BabyBoomer-led economic SuperCycle began in 1983, as the average Western Boomer moved into the Wealth Creator 25 – 54 age group that drives economic growth
  • Between 1983 – 2000, there was one, very short, recession of 8 months.  And that was only due to the first Gulf War, when Iraq invaded Kuwait.

Since then, the central banks have taken over from the Boomers as the engine of growth.  They cut interest rates after the 2001 recession, deliberately pumping up the housing and auto markets to stimulate growth.  And since the 2008 financial crisis, they have focused on supporting stock markets, believing this will return the economy to stable growth:

  • The above chart of the S&P 500 highlights the extraordinary nature of its post-2008 rally
  • Every time it has looked like falling, the Federal Reserve has rushed to its support
  • First there was co-ordinated G20 support in the form of low interest rates and easy credit
  • This initial Quantitative Easing (QE) was followed by QE2 and Operation Twist
  • Then there was QE3, otherwise known as QE Infinity, followed by President Trump’s tax cuts

In total, the Fed has added $3.8tn to its balance sheet since 2009, whilst China, the European Central Bank and the Bank of Japan added nearly $30tn of their own stimulus.  Effectively, they ensured that credit was freely available to anyone with a pulse, and that the cost of borrowing was very close to zero.  As a result, debt has soared and credit quality collapsed.  One statistic tells the story:

“83% of U.S. companies going public in the first nine months of this year lost money in the 12 months leading up to the IPO, according to data compiled by University of Florida finance professor Jay Ritter. Ritter, whose data goes back to 1980, said this is the highest proportion on record.  The previous highest rate of money-losing companies going public had been 81% in 2000, at the height of the dot-com bubble.

And more than 10% of all US/EU companies are “zombies” according to the Bank of International Settlements (the central banks’ bank), as they:

“Rely on rolling over loans as their interest bill exceeds their EBIT (Earnings before Interest and Taxes). They are most likely to fail as liquidity starts to dry up”.

2019 – 2021 BUDGETS NEED TO FOCUS ON KEY RISKS TO THE BUSINESS
For the past 25 years, the Budget process has tended to assume that the external environment will be stable.  2008 was a shock at the time, of course, but time has blunted memories of the near-collapse that occurred.  The issue, however, as I noted here in September 2008 is that:

“A long period of stability, such as that experienced over the past decade, 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, where high leverage and ‘balance sheet efficiency’ should be the norm. They therefore take on high levels of debt, in order to finance ever more speculative investments.

This is the great Hyman Minsky’s explanation for financial crises and panics. Essentially, it describes how confidence eventually leads to complacency in the face of mounting risks.  And it is clear that today, most of the lessons from 2008 have been forgotten.  Sadly, it therefore seems only a matter of “when”, not “if”, a new financial crisis will occur.

So prudent companies will prepare for it now, whilst there is still time.  You will not be able to avoid all the risks, but at least you won’t suddenly wake up one morning to find panic all around you.

The chart gives my version of the key risks – you may well have your own list:

  • Global auto and housing markets already seem to be in decline; world trade rose just 0.2% in August
  • Global liquidity is clearly declining, and Western political debate is ever-more polarised
  • Uncertainty means that the US$ is rising, and geopolitical risks are becoming more obvious
  • Stock markets have seen sudden and “unexpected” falls, causing investors to worry about “return of capital”
  • The risks of a major recession are therefore rising, along with the potential for a rise in bankruptcies

Of course, wise and far-sighted leaders may decide to implement policies that will mitigate these risks, and steer the global economy into calmer waters.  Then again, maybe our leaders will decide they are “fake news” and ignore them.

Either way, prudent companies and investors may want to face up to these potential risks ahead of time.  That is why I have titled this year’s Outlook, ‘Budgeting for the end of “Business as Usual“.  As always, please contact me at phodges@thephreport.com if you would like to discuss these issues in more depth.

Please click here to download a copy of all my Budget Outlooks 2007 – 2018.