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.
Global interest rates have fallen dramatically over the past 25 years, as the chart shows for government 10-year bonds:
UK rates peaked at 9% in 1995 and are now down at 1%: US rates peaked at 8% and are now at 2%
German rates peaked at 8% and are now down to 0%: Japanese rates peaked at 4% and are now also at 0%
But what goes down can also rise again. And one of the most reliable ways of investing is to assume that prices will normally revert to their mean, or average.
If this happens, rates have a long way to rise. Long-term UK interest rates since 1703 have averaged 4.5% through wars, booms and depressions. If we just look more recently, average UK 10-year rates over the past 25 years were 4.6%. We are clearly a very long way away from these levels today.
This doesn’t of course mean that rates will suddenly return to these levels overnight. But there are now clear warning signs that rates are likely to rise as central banks wind down their Quantitative Easing (QE) and Zero Interest Rate stimulus policies. The problem is the legacy these policies leave behind, as the Financial Times noted recently:
“In total, the six central banks that have embarked on quantitative easing over the past decade — the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, along with the Swiss and Swedish central banks — now hold more than $15tn of assets, according to analysis by the FT of IMF and central bank figures, more than four times the pre-crisis level.
“Of this, more than $9tn is government bonds — one dollar in every five of the $46tn total outstanding debt owed by their governments. The ECB’s total balance sheet recently topped that of the Fed in dollar terms. It now holds $4.9tn of assets, including nearly $2tn in eurozone government bonds.”
The key question is therefore ‘what happens next’? Will pension funds and other buyers step in to buy the same amount of bonds at the same price each month?
The answer is almost certainly no. Pension funds are focused on paying pensions, not on supporting the national economy. And higher rates would really help them to reduce their current deficits. The current funding level for the top US S&P 1500 companies is just 82%, versus 97% in 2011. They really need bond prices to fall (bond prices move inversely to yields), and rates to rise back towards their average, in order to reduce their liabilities.
The problem is that rising yields would also pressure share prices both directly and indirectly:
Some central banks have been major buyers of shares via Exchange Traded Funds (ETFs) – the Bank of Japan now owns 71% of all shares in Japan-listed ETFs
Lower interest rates also helped to support share prices indirectly, as investors were able to borrow more cheaply
Margin debt on the New York Stock Exchange (money borrowed to invest in shares) is now at an all time high in $2017. Ominously, company buy-backs of their shares have already begun to slow and are down $100bn in the past year.
House prices are also in the line of fire, as the second chart shows for London. They have typically traded on the basis of their ratio to earnings
The average ratio was 4.8x between 1971 – 1999
But this ratio has more than doubled to 12x since 2000 as prices rose exponentially during subprime and then QE
The reason was that after the dotcom crash in 2000, the Bank of England deliberately allowed prices to move out of line with earnings. As its Governor, Eddie George, later told the UK Parliament in March 2007:
“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption….
“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
Of course, as the chart shows, George’s successors did the very opposite. Ignoring the fact that a bubble was already underway, they instead reduced interest rates to near-zero after the subprime crisis of 2008, and flooded the market with liquidity. Naturally enough, prices then took off into the stratosphere.
Today, however, the Bank is finally recognising – too late – that it has created a bubble of historical proportions, and is desperately trying to shift the blame to someone else. Thus Governor Mark Carney warned last week:
“What we’re worried about is a pocket of risk – a risk in consumer debt, credit card debt, debt for cars, personal loans.”
Of course, the biggest “pocket of risk” is in the housing market:
Lower interest rates meant lower monthly mortgage payments, creating the illusion that high prices were affordable
But higher prices still have to be paid back at the end of the mortgage – very difficult, when wages aren’t also rising
The Bank has therefore now imposed major new restrictions on lenders. They have ordered them to keep new loans at no more than 4.5x incomes for the vast majority of their borrowers. And lenders themselves are also starting to get worried as the average deposit is now close to £100k ($135k).
Of course, London prices might stay high despite these new restrictions. Anything is possible.
But fears over a hard Brexit have already led many banks, insurance companies and lawyers to start moving highly-paid people out of London, as the City risks losing its “passport” to service EU27 clients. Over 50% of surveyors report that London house prices are now falling, just as a glut of new homes comes to market. In the past month, asking prices have fallen by £300k in Kensington/Chelsea, and by £75k in Camden, as buyers disappear.
The next question is how low could prices go if they return to the mean? If London price/earning ratios fell back from today’s 12x ratio to the post-2000 average of 8.2x level, average prices would fall by nearly a third to £332k. If ratios returned to the pre-2000 level of 4.8x earnings, then prices would fall by 60% to £195k.
Most Britons now expect a price crash within 5 years, and a quarter expect it by 2019. Brexit uncertainty, record high prices and vast overs-supply of new properties could be a toxic combination, perhaps even taking ratios below their average for a while – as happened in the early 1990s slump. As then, a crash might also take years to unwind, making life very difficult even for those who did not purchase when prices were at their peak.
Stock markets used to be a reliable indicator for the global economy, and for national economies. But that was before the central banks started targeting them as part of their stimulus programmes. They have increased debt levels by around $30tn since the start of the Crisis in 2008, and much of this money has gone directly into financial markets. Today, Japan is a great example of the distortions this has produced, as the Financial Times reports:
□ The Bank of Japan (BoJ) has been buying stocks via its purchases of Exchange Traded Funds (ETFs) since 2010
□ Last July, it doubled its purchases to ¥6tn of ETFs($58bn) per year, focused on supporting Abenomics policy
□ Analysis by Japanese bank Nomura suggests its purchases have since boosted the Nikkei Index by 1400 points
Even more importantly, the BoJ is particularly active if the market looks weak. Between April 2013 – March 2017, it bought on more than half of the days when the market was down.
The distortion ins’t just limited to direct buying by the BoJ, of course. It is magnified by the fact that everyone else in the market knows that the BoJ is buying. So going short is a losing proposition. Equally, investors know that the BoJ is guarding their back – so they are guaranteed to win when they buy.
This manipulation by the BoJ is just an extreme form of the intervention carried out by all the central banks. It means that the stock market has lost its role as an indicator of the economy. And so all those models which include stock market prices in their calculations are also over-optimistic.
This is why the global chemical industry has become the best real-time indicator for the real economy. As I noted back in January, it has an 88% correlation with IMF data for global growth – far better than any other indicator:
“The logic behind the correlation is partly because of the industry’s size. But it also benefits from its global and application reach. Every country in the world uses relatively large volumes of chemicals, and their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles.”
Latest data on Capacity Utilisation (CU%) from the American Chemistry Council is therefore very worrying, as the chart shows:
□ Since 2009, the CU% has never recovered even to the 1987 – 2008 low of 86.4%
□ It has been in a downward trend since January 2016, when it peaked at 81.4%
□ April’s CU% fell to 79.9% versus 80.7% in April last year
□ This was very close to the all-time low of 77% seen in March 2009
The problem is that central banks have moved from the pragmatism of the 1980s to ideology. They have become, in Keynes’s famous phrase “slaves to some defunct economist” – in this case, Milton Friedman and Franco Modigliani, as we argued in our evidence earlier this year to the UK House of Commons Treasury Committee:
“Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid. Modigliani’s “Life Cycle theory of consumption” is similarly out of date. … Friedman and Modigliani’s theories appeared to make sense at the time they were being developed, but they clearly do not fit the facts today.”
Instead of the promised economic growth, the central banks have in fact simply piled up more and more debt – which can never be repaid. 2 years ago, the global total was already $199tn, and 3x global GDP, according to McKinsey. Just in the US, this means net interest payments will cost $270bn this year, and total $1.7tn over the next 5 years, according to the impartial Congressional Budget Office.
Stock markets may continue in their optimistic mode for a while longer. But in the end, the lack of promised growth will force the central banks to stop printing money. They will then have to abandon their ideological approach, and instead accept the common sense argument of our Treasury Committee evidence:
“Monetary policy should no longer be regarded as the key element of economic policy. This would then free policymakers to focus on the real demographic issues that will determine growth in the future – namely how to encourage people to retrain in their 50s and 60s to take advantage of the extra 20 years of life expectancy that we can all now hope to enjoy.”
Monetary policy used to be the main focus for running the economy. If demand and inflation rose too quickly, then interest rates would be raised to cool things down. When demand and inflation slowed, interest rates would be reduced to encourage “pent-up demand” to return.
After the start of the Financial Crisis, central banks promised that lower interest rates and money-printing would have the same impact. They were sure that reducing interest rates to near-zero levels would create vast amounts of “pent-up demand”, and get the economy moving again. But as the chart shows for US GDP, they were wrong:
□ It shows the rolling 10-year average for US GDP since 1950, to highlight longer-term trends
□ It confirms the stability seen between 1983 – 2007 during the BabyBoomer-led economic SuperCycle
□ The economy suffered just 16 months of recession in 25 years, as monetary policy balanced supply and demand
□ But the trend has been steadily downwards since 2008, despite the record levels of stimulus
The clear conclusion is that monetary policy is no longer effective for managing the economy.
Encouragingly, the UK Parliament’s Treasury Committee has now launched a formal Inquiry to investigate ‘The Effectiveness and impact of post-2008 UK monetary policy‘. We have therefore taken the opportunity to submit our evidence, showing that demographics, not monetary policy, is now key to economic performance. We argue that:
It was clearly important until 2000, when the great majority of people were in the Wealth Creator 25 – 54 age group (which dominates consumption and therefore drives GDP growth). But its impact is now declining year by year as more and more BabyBoomers move into the 55+ age group – when incomes and spending begin to decline quite rapidly
Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid. Modigliani’s “Life Cycle theory of consumption” is similarly out of date
The issue is simply that both Friedman and Modigliani were working in an environment which assumed that people were born, educated, worked – and then died soon after reaching pension age. In these circumstance, their theories were perfectly valid and extremely useful for modelling the economy
Today, however, the rapid increase in life expectancy, together with the collapse of Western fertility rates below replacement level, means that a paradigm shift has taken place. People are now born, educated, work – and then continue to live for another 20 years after retirement, before dying
The essential issue is that “you can’t print babies”. Monetary policy cannot solve the demographic challenges that now face the UK (and global) economy
We therefore hope that the Committee will conclude that monetary policy should no longer be regarded as the major mechanism for sustaining UK growth
Please click here if you would like to read the evidence in detail.
Markets have one main function in life – price discovery. If I want to buy, and you want to sell, the existence of a market allows us to discover the price at which the market will balance in terms of supply and demand.
History, however, provides many examples of times when rulers decided they knew best, and destroyed market economics. The Soviet Union was one recent example, where the Central Committee of the Communist Party would decide what was going to be made and where, and the price at which it was being sold. That system of course collapsed with the Berlin Wall in 1989, but the collapse took decades to happen.
Today, we have another central organisation which is attempting to carry out the same manoeuvre – the main central banks in the West. They have also destroyed price discovery by flooding markets with endless supplies of free cash. The evidence for this statement is in the 3 charts shown here.
The chart above shows capacity utilisation (CU%) in the global chemical industry – the best real-time indicator that we have for the global economy. New data from the American Chemistry Council shows CU% fell yet again in August to 78.7%, nearly 2 percentage points below August 2015:
This pattern has only been seen before in 2001 and 2008, which were not good years for the industry or the global economy
It has now fallen every month this year, and the 2009 – 2016 average is nearly 10 percentage points below the average seen before the Financial Crisis began in 2008
The second chart confirms the downturn underway. It shows earnings for the UK’s FT 500 Index since 1985, set against the price/earnings ratio. As one would expect, given the CU% decline, earnings have been tumbling in the past year:
They peaked at almost 400 in mid-2011, and had eased to around 200 by mid-2015
Since then, they have more than halved to just 93 on Friday
Normally, of course, this would mean that market prices also fell, as the outlook for earnings worsened.
But the opposite has in fact happened, as the central banks have simply pumped out more and more free cash. They have even taken interest rates to negative levels in many major markets such as Japan, Germany and the UK.
Investors, increasingly desperate to try and meet their target returns for paying pensions etc, have responded by bidding up the price/earnings ratio from 18 a year ago to 49 today – easily the highest level ever seen in the period.
This takes us to the 3rd chart, showing the IeC Boom/Gloom Index. It measures sentiment versus the US S&P 500 Index, and shows this has fallen back to danger levels once more.
All the investors to whom I talk, recognise that the market is being completely rigged by the central banks. But, they say, “what can we do? We cannot go into cash, as it yields nothing, and benchmark Western government bonds also yield nothing”: $12tn of bonds even have negative yields. The fact that some of the best performing US$ debt markets in Q3 were El Salvador, Mongolia and Zambia highlights how desperate the “search for yield” has become.
How long will the central banks be able to keep markets artificially high and defy economic reality? We cannot know. But we do know they are providing a fertile breeding ground for populist politicians, as I will discuss on Wednesday.
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%. “Petchem demand remains strong”
Benzene Europe, down 54%. “European derivative demand was struggling after the traditional seasonal slowdown in August. Many in the market had been braced for a strong upturn this month and into the fourth quarter, but this has yet to materialise”
PTA China, down 41%. “Some producers increasing their offers due to turnarounds in China and South Korea”
HDPE US export, down 27%. “China’s import prices fell in the week tracking lower offers of import cargoes from some suppliers”
S&P 500 stock market index, up 11%
The world’s 4 main central bankers love being in the media spotlight. After decades climbing the academic ladder, or earning millions with investment banks, they have the opportunity to rule the world’s economy – or so they think.
But their background is rather strange preparation to take on this role – even if it was achievable:
Janet Yellen, Chair of the US Federal Reserve, is a former academic
Haruhiko Kuroda, Governor of the Bank of Japan, is a career civil servant
Mario Draghi, President of the European Central Bank; and Mark Carney, Governor of the Bank of England, are former Goldman Sachs bankers
None of these roles are noted for their contact with ordinary people. Nor does their habit of flying First Class and staying in top-class hotels, or being chauffeur-driven to meetings, help them to engage with the real world. Mark Carney’s travel expenses currently average £100k/year ($130k), in addition to his £250k/year housing allowance.
But the main disadvantage is simply that common sense is not a core requirement for the job. If it was, then none of the stimulus policies enacted since 2000 – subprime, QE, Abenomics etc – would ever have been considered.
Common sense would have told them that people create demand – not economic models or financial markets. And anyone used to working with real people would know that the key to demand is (a) the existence of a “need”, or at least a “want” and (b) the ability to afford the purchase.
Last week’s announcements by the Federal Reserve and the Bank of Japan highlight the disconnect. Unsurprisingly, Yellen and Kuroda’s stimulus policies have completely failed to create sustained demand. Instead, they have destroyed price discovery in financial markets and created asset bubbles instead.
The above chart highlights the irrelevance of their current policies. As Bloomberg comment in respect of Japan:
“Japan’s economy has been in trouble for decades. Massive monetary and fiscal stimulus have so far failed to spur faster growth. (Last) week, the Bank of Japan met to decide whether to apply yet more economic shock therapy. Here’s the situation the country’s leaders face:
“Japan has the world’s oldest population, as well as a low birth rate and little immigration, but its growth problems go far deeper. In the early 1990s, the country’s postwar growth boom collapsed—decades of deflation followed and Japan started to suffer a shortage of workers….
“Japan’s debt burden far outstrips that of other countries, largely a result of the stimulus introduced to help fix the economy. Abenomics, Prime Minister Shinzo Abe’s rescue plan, has helped to weaken the yen and boost corporate profits but wages and domestic spending have remained fragile.
“Higher debt led the government to consider a sales tax increase for revenue. But the last time it was imposed in 2014, consumer spending and gross domestic product fell, sending the economy into a recession.”
The chart (interactive on Bloomberg itself) confirms this analysis:
26% of Japan’s population is aged over-65. And the OECD median is now 18%. People of this age already own most of what they need or want, and their incomes are declining as they enter retirement
Japan’s fertility rate is just 1.4 babies/woman, only 2/3rds of the 2.1 replacement level needed to maintain a stable population. The OECD median is almost as low at 1.7 babies
Immigration might just be a way of compensating for these factors, but only 1.6% of Japan’s population are immigrants. The OECD median is also too low to really make a difference at just 12%
Japanese government debt is more than twice GDP at 247%. The OECD median is equally worrying at 82%: debt in the other G7 economies ranges from 82% (Germany) up to 156% for Italy.
Slowly but surely, the world is realising that central bank policies have been a disaster for the global economy.
Common sense tells us that simplistic “solutions”, such as printing money and lowering interest rates, will never succeed in creating sustainable economic growth. The real need is for policy to address the cause of the growth slowdown – the impact of the 50% rise in global life expectancy since 1950, and the 50% fall in fertility rates.
Until discussion takes place around the implications of these key facts (highlighted in the second chart), nothing will change, and the debt will continue to rise. And as the Financial Times commented at the weekend:
“The problem with the authorities rigging the markets is it could be painful when they stop doing it.”
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 56%
Naphtha Europe, down 53%. “A build-up in products supply has punctured refiners’ margins, according to the International Energy Agency, which warned that global refinery runs are experiencing their lowest growth rates in a decade.”
Benzene Europe, down 54%. “A drop in consumption was felt by numerous players”
PTA China, down 41%. “Bearish demand for spot cargoes as endusers laid off buying due to the proximity to the upcoming week-long National Day celebrations in China”
HDPE US export, down 27%. “Weak overall demand in China weighed down on prices”
S&P 500 stock market index, up 11%