The chemical industry is the best leading indicator for the global economy. And my visit to Singapore last week confirmed that the downturn underway in the Asian market creates major risks for developed and emerging economies alike.
The problem is focused on China’s likely move into recession, now its stimulus policies are finally being unwound. And the result is shown in the above chart from The pH Report, updated to Friday:
- It confirms that the downturn began before oil prices peaked at the beginning of October, confirming that companies were responding to a downturn in end-user demand
- Since then, of course, the oil price has – rather dramatically – entered a bear market, with prices down by nearly a third
The question now is whether finance directors will choose to aggressively destock ahead of year-end results, to mitigate the volume decline with a decline in working capital. This would be a bold move given continuing geo-political uncertainty in the Middle East, and would also conflict with the more upbeat guidance that was given earlier with Q3 results.
But a review of ICIS news headlines over the past few days suggests they may have little choice. Inventories are described as “piling up” in a wide range of major products, including polyethylene – the biggest volume polymer. Indian producers are even offering “price protection” packages on polypropylene, to safeguard customers from losses if prices fall further.
Asian countries and their major partners (eg Argentina, S Africa, Turkey) were, of course, the first to be hit by China’s downturn. But Q3’s fall in German GDP shows the downturn has now spread to the Western economy that most benefited from China’s post-2008 stimulus bubble. As The Guardian noted:
“Goods exports make up 40% of German GDP – a much bigger proportion than for the next two biggest eurozone economies, France and Italy.”
OIL MARKETS CONFIRM THE RECESSION RISK
Of course, consensus opinion still believes that the US economy is sailing along, regardless of any problems elsewhere. But the chart of oil prices relative to recession tells a different story:
- The problem is that oil prices have been rising since 2016, with the summer proving the final blow-off peak. As always, this meant consumers had to cut back on discretionary spending as costs of transport and heating rose
- The cost of oil as a percentage of GDP reached 3.1% in Q3 – a level which has always led to recession in the past, with the exception of the post-2008 stimulus period when governments and central banks were pouring $tns of stimulus money into the global economy
- In turn, this means a downturn is now beginning in US end-user demand in critical areas such as housing, autos and electronics
Oil markets have therefore provided a classic example of the trading maxim for weak markets – “Buy on the rumour, sell on the news”.
- Prices had risen by 75% since June on supply shortage fears, following President Trump’s decision to exit the Iran nuclear deal on November 4
- As always, this created “apparent demand” as buyers in the US and around the world bought ahead to minimise the impact of higher prices
- But the higher prices also negated the benefit of the earlier tax cuts for his core supporters just ahead of the mid-term elections, causing Trump to undertake a policy u-turn
- He is now pushing Saudi Arabia and Russia to maintain production, and has announced 180-day exemptions for Iran’s 8 largest customers – China, India, S Korea, Japan, Italy, Greece, Taiwan and Turkey.
Understandably, oil traders have now decided that his “bark is worse than his bite“. And with the downturn spreading from Asia to the West, markets are now refocusing on supply/demand balances, with the International Energy Agency suggesting stocks will build by 2mb/d in H1 2019. In response, OPEC are reportedly discussing potential cuts of up to 1.4mb/d from December.
CHINA’S SHADOW BANKING COLLAPSE IS CREATING A NEW FINANCIAL CRISIS
Unfortunately, as in 2008, the collapse in oil prices is coinciding with the end of stimulus policies, particularly in China, as the chart of its shadow bank lending confirms. This has hit demand in two ways, as I discussed earlier this month in the Financial Times:
- Just 3 years ago, it was pumping out an average $140bn/month in mainly property-related lending *
- This created enormous demand for EM commodity exports
- It also boosted global property prices as wealthy Chinese rushed to get their money out of the country
- But during 2018, lending has collapsed by more than 80% to average just $23bn in October
China’s post-2008 stimulus programme was the growth engine for the global economy – with the efforts of the Western central banks very much a sideshow in comparison. It was more than half of the total $33tn lending to date. But now it is unwinding, prompting the Minsky Moment forecast a year ago by China’s central bank governor:
“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous.”
As I warned then:
“Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy. China’s lending bubble – particularly in property – is likely coming to an end. In turn, this will lead to a bumpy ride for the global economy.”
The bumps are getting bigger and bigger as we head into recession. Asia’s downturn is now spreading to the rest of the world, and is a major wake-up call for anyone still planning for “business as usual”.
* Lending has major seasonal peaks in Q1, so I use rolling 12 month averages to avoid distortions
Oil and commodity markets long ago lost contact with the real world of supply and demand. Instead, they have been dominated by financial speculation, fuelled by the vast amounts of liquidity pumped out by the central banks. The chart above from John Kemp at Reuters gives the speculative positioning in the oil complex as published last Monday:
- It shows hedge fund positioning in terms of the ratio of long to short positions across the complex
- The ratio had been at a near-record low of 1.55x back in June last year, before the rally took off
- On 30 January it had risen to a record 11.9x – far above even the 2014 and 2017 peaks
The size of the rally has also been extraordinary, as I noted 2 weeks ago. At its peak, the funds owned 1.5bn barrels of oil and products – equivalent to an astonishing 16 days of global oil demand. They had bought 1.2bn barrels since June, creating the illusion of very strong demand. But, of course, hedge funds don’t actually use oil, they only trade it.
The funds also don’t normally hang around when the selling starts. And so last week, as the second chart shows, they began to sell their positions and take profits. The rally peaked at $71/bbl at the end of January, and then topped out on 2 February at $70/bbl. By last Friday, only a week later, Brent was at $63/bbl, having fallen 11% in just one week.
Of course, nothing had changed in the outlook for supply/demand, or for the global economy, during the week. And this simple fact confirms how the speculative cash has come to dominate real-world markets. The selling was due to nervous traders, who could see prices were challenging a critical “technical” point on the chart:
- Most commodity trading is done in relation to charts, as it is momentum-based
- The 200 day exponential moving average (EMA) is used to chart the trend’s strength
- When the oil price reached the 200-day EMA (red line), many traders got nervous
- And as they began to sell, so others began to follow them as momentum switched
The main sellers were the legal highwaymen, otherwise known as the high-frequency traders. Their algorithm-based machines do more than half of all daily trading, and simply want a trend to follow, milli-second by milli-second. As the Financial Times warned in June:
“The stock market has become a battlefield of algorithms, ranging from the simple – ETFs bought by retirees that may invest in the entire market, an industry, a specific factor or even themes like obesity – to the complex, commanded by multi-billion dollar “quantitative” hedge funds staffed by mathematicians, coders and data scientists.”
JP Morgan even estimates that only 10% of all trading is done by “real investors”:
“Passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago, and reckons that only roughly 10% of trading is done by traditional, “discretionary” traders, as opposed to systematic rules-based ones.”
Probably prices will now attempt to stabilise again before resuming their downward movement. But clearly the upward trend, which took prices up by 60% since June, has been broken. Similar collapses have occurred across the commodity complex, with the CRB Index showing a 6% price fall across major commodities:
- Typically, inventory build ahead of price rises can add an extra month of “apparent demand” to real demand
- This inventory will now have to be run down as buyers destock to more normal levels again
- This means we can expect demand to slow along all the major value chains
- Western companies will now see slow demand through Easter: Asia will see slow demand after Lunar New Year
This disappointment will end the myth that the world is in the middle of a synchronised global recovery. In turn, it will cause estimates of oil demand growth to be reduced, further weakening prices. It will also cause markets to re-examine current myths about the costs of US shale oil production:
- As the charts from Pioneer Natural Resources confirm, most shale oil breakeven costs are below $30/bbl
- Pioneer’s own operating costs, typical of most of the major players, are below $10/bbl
- So the belief that shale oil needs a price of $50/bbl to support future production is simply wrong
PREPARE FOR PROFIT WARNINGS AND POTENTIAL BANKRUPTCIES BY THE SUMMER
Over the summer, therefore, many industrial companies will likely need to start issuing profit warnings, as it becomes clear that demand has failed meet expectations. This will put stock markets under major pressure, especially if interest rates keep rising as I discussed last month.
Smart CEOs will now start to prepare contingency plans, in case this should happen. We can all hope the recent downturn in global financial markets is just a blip. But hope is not a strategy. And the risk of profit warnings turning into major bankruptcies is extremely high, given that global debt now totals $233tn, more than 3x global GDP.
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.
Since January, I have also been monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. Today’s forecast for oil prices to fall initially to $50/bbl is therefore now added to those on ethylene/polyethylene and the US 10-year interest rate. I am also increasing the confidence level for the interest rate forecast to 70%, and will continue to update these levels when circumstances change.
The post Economy faces slowdown as oil/commodity prices slide appeared first on Chemicals & The Economy.
4 years ago, Brazil’s polyethylene market flagged up the first warning signs that its GDP was hitting headwinds, as China’s stimulus programme begin to slow. Today, sadly, the economy is in major recesssion, with the impeachment process against President Rousseff adding further pressure:
- World Bank data shows GDP fell 3.7% last year: they forecast “only” a 2.5% fall in 2016, but this looks optimistic
- The impeachment process is intensely bitter, with Rousseff in New York today to denounce what she calls “a coup d’état without weapons” at the United Nations
- Whatever happens, it is hard to see a quick return to normal, where all sides agree to work together
- And all this is taking place just before Brazil becomes the first LatAm country to host the Olympics in August
I saw the problems at first hand last December, when giving a keynote presentation at the 20th Annual Meeting of Brazil’s chemical industry association. The industry itself is run by people with plenty of energy and vision. But they are let down by a weak and seemingly corrupt political leadership, that blocks progress.
Now, of course, Brazil’s problems are starting to impact the wider world. As I noted last week, Brazil’s domestic car market is in crisis, with sales down 44% in Q1 versus 2013. As a result, auto manufacturers are starting to ramp up their exports, which grew 24% versus 2015, and accounted for 1 in 6 of all cars made in Brazil.
Polyethylene (PE) is following the same pattern, as the chart shows:
- Brazil used to be a net importer of PE, but Q1 saw net exports of 60kt versus net imports of 60kt in 2015
- Imports from the Middle East, plus NE and SE Asia, virtually disappeared; even NAFTA imports fell 16%
- Instead, Brazil’s own exports to Latin America jumped 49%, and rose 35% to China
This would be bad enough in terms of regional impact. But, of course, there is a much bigger impact just around the corner. This month has seen the start-up of 1.05 million tonnes of new PE capacity in Mexico from the Ethylene XX1 JV between Brazil’s Braskem and Mexico’s Idesa. This volume will have attractive economics, being based on advantaged cost ethane from Pemex.
As ICIS news reported, sales will be focused on both the domestic Mexican market and internationally. Inevitably, therefore, it will displace more exports from the US – just ahead of the vast expansions due to start up next year. Its production will also boost downstream output from local convertors, adding to pressure in these markets.
It is hard to see how all these new volumes can be accommodated without a major price war taking place. And whilst the war will start in Latin America, it must inevitably spread to other regions. Those companies which have lost their sales to Brazil, are already fighting to gain market share elsewhere in order to maintain their volumes.
The only solution, as we discuss in ‘Demand – the New Direction for Profit’, is for producers to invest in new business development. Areas such as water and food could potentially absorb major new volumes, if the effort was made to understand their currently unmet needs.
Common sense says this needs to be the top item on every CEO and business manager’s agenda. There really is no “business as usual” option, given the tsunami of product that is about to appear. And the the Losers in any price war will almost inevitably go bankrupt.
More details continue to surface of the wasteful spending that underpinned much of China’s GDP growth in recent years. The empty city of Ordos (first highlighted 3 years ago in the blog) is just one example. House prices there have recently fallen 50%, and the shadow banking system (critical for privately-owned companies) is reportedly in chaos. Another is the city of Tieling, pictured above.
In 2009, it was told to build a satellite city 6 miles away. Today, $bns later, the new city is a ghost town. Affordable housing that won UN recognition for its quality is empty. The businesses that were supposed to underpin growth by providing jobs, have simply failed to appear.
This highlights the problem facing the new leadership. Do they stop the flow of money, or do allow spending to continue, hoping this might be the catalyst for the jobs to arrive? Its a big decision, and for the moment it is being deferred. Thus Tieling is spending $1.3bn this year on projects including an art gallery, swimming pool and gym.
Yet the decision cannot be deferred too long. As Qiao Runling, a senior official with the powerful National Reform and Development Commission has warned:
“Reckless expansion of cities in China has left many of them empty. Nearly every big or medium-sized city across China has plans to erect a new town… (and these) new towns are usually bigger than old ones and many cities are left empty as a result.”
His conclusion was stark. “China now has an oversupply of cities, given the number of new urban districts that we have, (with) the excess of new urban districts are especially serious in medium and small-sized cities in central and western parts of the country.”
Whilst Yu Yongding, a former senior Bank of China official was even more blunt:
“Why am I so concerned about the debt issue? Because based on my experience of dealing with local governments, I am sceptical whether they are willing and are able to repay the debts,”
Nobody yet knows the size of the debts run up by local government in pursuit of this policy. But in a sign of their mounting alarm over the issue, China’s new leadership have told the National Audit Office (NAO) to give top priority to finding out the answer. At the same time, the country’s 4 largest banks have been told to raise $44bn in new capital, presumably to help them meet the cost of the bad debts that will be found.
Worryingly, it seems they are finding it difficult to raise this money in China itself, as market sentiment towards the banks is very bad. Thus the Wall Street Journal (WSJ) reports they are “considering selling the debt in markets outside mainland China”. But it is hard to see why foreign investors would be prepared to invest, if local players find the offer unattractive.
Blog readers will not be surprised by these developments. 2 years ago, when the China boom was at its peak, the blog warned that it would all unravel, just as we had seen with the US subprime boom. One clear sign of crisis emerging is that the bank regulator felt forced to appear on national television earlier this month to reassure people that their money was safe. Thus Shang Fulin, chairman of the China Banking Regulatory Commission, admitted that:
“Banks face a large quantity of maturing local-government debt this year (and) that important risks stem from loans to local governments and those created outside banks’ balance sheets”.
So far, as with Tieling, the banks have been allowed to indulge in the game of “pretend and extend”. As the WSJ notes, “many Chinese banks have resorted to extending maturing loans to avoid defaults”. The alternative, of course, would be to declare the loans a bad debt.
Thus for the moment, Mr Shang can claim, “China’s banking industry remains relatively stable and healthy.” But his use of the word “relatively” confirms that all may not be as it seems. We will only know the true position when the NAO has done their work. And even more worrying is the fact that, as the Journal also notes, “based on market capitalization, four of the 10 largest banks in the world are Chinese”.
Presumably, therefore, a large number of non-Chinese banks have cross-lending commitments with these banks. And so there is clear scope for contagion to spread across the global banking system.