We are living in a strange world. As in 2007 – 2008, financial news continues to be euphoric, yet the general news is increasingly gloomy. As Nobel Prizewinner Richard Thaler, has warned, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” Both views can’t continue to exist alongside each other for ever. Whichever scenario comes out on top in 2018 will have major implications for investors and companies.
It therefore seems prudent to start building scenarios around some of the key risk areas – increased volatility in oil and interest rates, protectionism and the threat to free trade (including Brexit), and political disorder. One key issue is that the range of potential outcomes is widening.
Last year, for example, it was reasonable to use $50/bbl as a Base case forecast for oil prices, and then develop Upside and Downside cases using a $5/bbl swing either way. But today’s rising levels of uncertainty suggests such narrow ranges should instead be regarded as sensitivities rather than scenarios. In 2018, the risks to a $50/bbl Base case appear much larger:
- On the Downside, US output is now rising very fast given today’s higher prices. The key issue with fracking is that the capital cost is paid up-front, and once the money has been spent, the focus is on variable cost – where most published data suggests actual operating cost is less than $10/bbl. US oil and product exports have already reached 7mbd, so it is not hard to see a situation where over-supplied energy markets cause prices to crash below $40/bbl at some point in 2018
- On the Upside, instability is clearly rising in the Middle East. Saudi Arabia’s young Crown Prince, Mohammad bin Salman is already engaged in proxy wars with Iran in Yemen, Syria, Iraq and Lebanon. He has also arrested hundreds of leading Saudis, and fined them hundreds of billions of dollars in exchange for their release. If he proves to have over-extended himself, the resulting political confusion could impact the whole Middle East, and easily take prices above $75/bbl
Unfortunately, oil price volatility is not the only risk facing us in 2018. As the chart shows, the potential for a debt crisis triggered by rising interest rates cannot be ignored, given that the current $34tn total of central bank debt is approaching half of global GDP. Most media attention has been on the US Federal Reserve, which is finally moving to raise rates and “normalise” monetary policy. But the real action has been taking place in the emerging markets. 10-year benchmark bond rates have risen by a third in China over the past year to 4%, whilst rates are now at 6% in India, 7.5% in Russia and 10% in Brazil.
An “inflation surprise” could well prove the catalyst for such a reappraisal of market fundamentals. In the past, I have argued that deflation is the likely default outcome for the global economy, given its long-term demographic and demand deficits. But markets tend not to move in straight lines, and 2018 may well bring a temporary inflation spike, as China’s President Xi has clearly decided to tackle the country’s endemic pollution early in his second term. He has already shutdown thousands of polluting companies in many key industries such as steel, metal smelting, cement and coke.
His roadmap is the landmark ‘China 2030’ joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition: “From policies that served it so well in the past to ones that address the very different challenges of a very different future”.
But, of course, transitions can be a dangerous time, as China’s central bank chief, Zhou Xiaochuan, highlighted at the 5-yearly Party Congress in October, when warning that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008 in the west.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t face a need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. Nobody wanted to be focusing on contingency plans when everybody else seemed to be laughing all the way to the bank.
I discuss these issues in more detail in my annual Outlook for 2018. Please click here to download this, and click here to watch the video interview with ICB deputy editor, Will Beacham.
The post The return of volatility is the key market risk for 2018 appeared first on Chemicals & The Economy.
Saudi Arabia’s U-turn to revive oil output quotas is not working and fails to address the changing future of oil demand, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Saudi Arabia’s move into recession comes at an unfortunate time for its new Crown Prince, Mohammed bin Salman (known to all as MbS).
Unemployment is continuing to rise, threatening the social contract. In foreign affairs, the war in Yemen and the dispute with Qatar appear to be in stalemate. And then there is the vexed issue of King Salman’s ill health, and the question of who succeeds him.
This was probably not the situation that the then Deputy Crown Prince envisaged 18 months ago when he launched his ambitious “Vision 2030” programme and set out his hopes for a Saudi Arabia that was no longer dependent on oil revenues. “Within 20 years, we will be an economy that doesn’t depend mainly on oil . . . We don’t care about oil prices — $30 or $70, they are all the same to us. This battle is not my battle.”
The problems began a few months later after he abruptly reversed course and overturned former oil minister Ali al-Naimi’s market share policy by signing up to repeat the failed Opec quota policy of the early 1980s.
His hope was that by including Russia, the new deal would “rebalance” oil markets and establish a $50 a barrel floor under prices. In turn, this would boost the prospects for his proposed flotation of a 5 per cent stake in Saudi Aramco, with its world record target valuation of $2tn.
But, as the chart above shows, the volte face also handed a second life to US shale producers, particularly in the Permian basin, which has the potential to become the world’s largest oilfield. Its development had been effectively curtailed by Mr Naimi’s policy.
The number of high-performing horizontal drilling rigs had peaked at 353 in December 2014. By May 2016, the figure had collapsed to just 116. But since then, the rig count has trebled and is close to a new peak, at 336, according to the Baker Hughes Rig Count.
Even worse from the Saudi perspective is that oil production per Permian rig has continued to rise from December 2014’s level of 219 barrels a day. Volume has nearly trebled to 572 b/d, while the number of DUC (drilled but uncompleted) wells has almost doubled from 1,204 to 2,330.
Equally disturbing, as the second chart from Anjli Raval’s recent FT analysis confirms, is that Saudi Arabia has been forced to take the main burden of the promised cutbacks. Its 519,000 b/d cut almost exactly matches Opec’s total 517,000 b/d cutback.
Of course, other Opec members will continue to cheer on Saudi Arabia because they gain the benefit of higher prices from its output curbs.
But we would question whether the quota strategy is really the right policy for the Kingdom itself. A year ago, after all, Opec had forecast that its new quotas would “rebalance the oil market” in the first half of this year. When this proved over-optimistic, it expected rebalancing to have been achieved by March 2018. Now, it is suggesting that rebalancing may take until the end of 2018, and could even require further output cuts.
Producers used to shrug off this development, arguing that demand growth in China, India and other emerging markets would secure oil’s future. But they can no longer ignore rising concerns over pollution from gasoline and diesel-powered cars.
India has already announced that all new cars will be powered by electricity by 2030, while China is studying a similar move. China has a dual incentive for such a policy because it would not only support President Xi Jinping’s anti-pollution strategy, but also create an opportunity for its automakers to take a global lead in electric vehicle production.
It therefore seems timely for Prince Mohammed to revert to his earlier approach to the oil price. The rebalancing strategy has clearly not produced the expected results and, even worse, US shale producers are now enthusiastically ramping up production at Saudi Arabia’s expense.
The kingdom’s exports of crude oil to the US fell to just 795,000 b/d in July, while US oil and product exports last week hit a new record level of more than 7.6m b/d, further reducing Saudi Arabia’s market share in key global markets.
The growing likelihood that oil demand will peak within the next decade highlights how Saudi Arabia is effectively now in a battle to monetise its reserves before demand starts to slip away.
Geopolitics also suggests that a pivot away from Russia to China might be opportune. The Opec deal clearly made sense for Russia in the short term, given its continuing dependence on oil revenues. But Russia is never likely to become a true strategic partner for the kingdom, given its competitive position as a major oil and gas producer, and its longstanding regional alliances with Iran and Syria. China, however, offers the potential for a much more strategic relationship, which would allow Saudi Arabia as the world’s largest oil producer to boost its sales to the world’s second-largest oil market.
China also offers a potential solution to the vexed question of the Saudi Aramco flotation, following the recent offer by an unnamed (but no doubt state-linked) Chinese buyer to purchase the whole 5 per cent stake. This would allow Prince Mohammed to avoid embarrassment by claiming victory in the sale while avoiding the difficulties of a public float.
The Chinese option would also help the kingdom access the One Belt, One Road (OBOR) market for its future non-oil production. This option could be very valuable, given that OBOR may well become the largest free-trade area in the world, as we discussed here in June.
In addition, and perhaps most importantly from Prince Mohammed’s viewpoint, the China pivot might well tip the balance within Saudi Arabia’s Allegiance Council, and smooth his path to the throne as King Salman’s successor.
Paul Hodges and David Hughes publish The pH Report.
The post Saudi Arabia’s ‘Vision 2030’ is looking a lot less clear appeared first on Chemicals & The Economy.
“There isn’t anybody who knows what is going to happen in the next 12 months. We’ve never been here before. Things are out of control. I have never seen a situation like it.“
This comment from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing companies, investors and individuals as we look ahead to the 2018 – 2020 Budget period. None of us have ever seen a situation like today’s. Even worse, is the fact that risks are not just focused on the economy, or politics, or social issues. They are a varying mix of all of these. And because of today’s globalised world, they potentially affect every country, no matter how stable it might appear from inside its own borders.
This is why my Budget Outlook for 2018 – 2020 is titled ‘Budgeting for the Great Unknown’. We cannot know what will happen next. But this doesn’t mean we can’t try to identify the key risks and decide how best to try and manage them. The alternative, of doing nothing, would leave us at the mercy of the unknown, which is never a good place to be.
RISING INTEREST RATES COULD SPARK A DEBT CRISIS
Central banks assumed after 2008 that stimulus policies would quickly return the economy to the BabyBoomer-led economic SuperCycle of the previous 25 years. And when the first round of stimulus failed to produce the expected results, as was inevitable, they simply did more…and more…and more. The man who bought the first $1.25tn of mortgage debt for the US Federal Reserve (Fed) later described this failure under the heading “I’m sorry, America“:
“You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2”
• And the Fed was not alone, as the chart shows. Today, the world is burdened by over $30tn of central bank debt
• The Fed, European Central Bank, Bank of Japan and the Bank of England now appear to “own a fifth of their governments’ total debt”
• There also seems little chance that this debt can ever be repaid. The demand deficit caused by today’s ageing populations means that growth and inflation remain weak, as I discussed in the Financial Times last month
China is, of course, most at risk – as it was responsible for more than half of the lending bubble. This means the health of its banking sector is now tied to the property sector, just as happened with US subprime. Around one in five of all Chinese apartments have been bought for speculation, not to be lived in, and are unoccupied.
China’s central bank chief, Zhou Xiaochuan, has warned that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008. Similar risks face the main developed countries as they finally have to end their stimulus programmes:
• Who is now going to replace them as buyers of government debt?
• And who is going to buy these bonds at today’s prices, as the banks back away?
• $8tn of government and corporate bonds now have negative interest rates, which guarantee the buyer will lose money unless major deflation takes place – and major deflation would make it very difficult to repay the capital invested
There is only one strategy to manage this risk, and that is to avoid debt. Companies or individuals with too much debt will go bankrupt very quickly if and when a Minsky Moment takes place.
THE CHINA SLOWDOWN RISK IS LINKED TO THE PROPERTY LENDING BUBBLE
After 2008, it seemed everyone wanted to believe that China had suddenly become middle class by Western standards. And so they chose to ignore the mounting evidence of a housing bubble, as shown in the chart above.
Yet official data shows average incomes in China are still below Western poverty levels (US poverty level = $12060):
• In H1, disposable income for urban residents averaged just $5389/capita
• In the rural half of the country, disposable income averaged just $1930
• The difference between income and expenditure was based on the lending bubble
As a result, average house price/earnings ratios in cities such as Beijing and Shanghai are now more than 3x the ratios in cities such as New York – which are themselves wildly overpriced by historical standards.
Having now been reappointed for a further 5 years, it is clear that President Xi Jinping is focused on tackling this risk. The only way this can be done is to take the pain of an economic slowdown, whilst keeping a very close eye on default risks in the banking sector. As Xi said once again in his opening address to last week’s National Congress:
“Houses are built to be inhabited, not for speculation. China will accelerate establishing a system with supply from multiple parties, affordability from different channels, and make rental housing as important as home purchasing.”
China will therefore no longer be powering global growth, as it has done since 2008. Prudent companies and investors will therefore want to review their business models and portfolios to identify where these are dependent on China.
This may not be easy, as the link to end-user demand in China might well be further down the supply chain, or external via a second-order impact. For example, Company A may have no business with China and feel it is secure. But it may suddenly wake up one morning to find its own sales under attack, if company B loses business in China and crashes prices elsewhere to replace its lost volume.
PROTECTIONISM IS ON THE RISE AROUND THE WORLD
Trade policy is the third key risk, as the chart of harmful interventions from Global Trade Alert confirms.
These are now running at 3x the level of liberalising interventions since 2008, as Populist politicians convince their voters that the country is losing jobs due to “unfair” trade policies.
China has been hit most times, as its economy became “the manufacturing capital of the world” after it joined the World Trade Organisation in 2001. At the time, this was seen as being good news for consumers, as its low labour costs led to lower prices.
But today, the benefits of global trade are being forgotten – even though jobless levels are relatively low. What will happen if the global economy now moves into recession?
The UK’s Brexit decision highlights the danger of rising protectionism. Leading Brexiteer and former cabinet minister John Redwood writes an online diary which even campaigns against buying food from the rest of the European Union:
“There are many great English cheese (sic), so you don’t need to buy French.”
No family tries to grow all its own food, or to manufacture all the other items that it needs. And it used to be well understood that countries also benefited from specialising in areas where they were strong, and trading with those who were strong in other areas. But Populism ignores these obvious truths.
• President Trump has left the Trans-Pacific Partnership, which would have linked major Pacific Ocean economies
• He has also said he will probably pull out of the Paris Climate Change Agreement
• Now he has turned his attention to NAFTA, causing the head of the US Chamber of Commerce to warn:
“There are several poison pill proposals still on the table that could doom the entire deal,” Donohue said at an event hosted by the American Chamber of Commerce of Mexico, where he said the “existential threat” to NAFTA threatened regional security.
At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail. But what if they are wrong? It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.
Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.
POLITICAL CHAOS IS GROWING AS PEOPLE LOSE FAITH IN THE ELITES
The key issue underlying these risks is that voters no longer believe that the political elites are operating with their best interests at heart. The elites have failed to deliver on their promises, and many families now worry that their children’s lives will be more difficult than their own. This breaks a century of constant progress in Western countries, where each generation had better living standards and incomes. As the chart from ipsos mori confirms:
• Most people in the major economies feel their country is going in the wrong direction
• Adults in only 3 of the 10 major economies – China, India and Canada – feel things are going in the right direction
• Adults in the other 7 major economies feel they are going in the wrong direction, sometimes by large margins
• 59% of Americans, 62% of Japanese, 63% of Germans, 71% of French, 72% of British, 84% of Brazilians and 85% of Italians are unhappy
This suggests there is major potential for social unrest and political chaos if the elites don’t change direction. Fear of immigrants is rising in many countries, and causing a rise in Populism even in countries such as Germany.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t have to face the need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. The threat from subprime was perfectly obvious from 2006 onwards, as I warned in the Financial Times and in ICIS Chemical Business, as was 2014’s oil price collapse. Today’s risks are similarly obvious, as the “Ring of Fire” map describes.
You may well have your own concerns about other potential major business risks. Nobel Prizewinner Richard Thaler, for example, worries that:
“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”
We can all hope that none of these scenarios will actually create major problems over the 2018 – 2020 period. But hope is not a strategy, and it is time to develop contingency plans. Time spent on these today could well be the best investment you will make. As always, please do contact me at email@example.com if I can help in any way.
The post Budgeting for the Great Unknown in 2018 – 2020 appeared first on Chemicals & The Economy.
“Those who cannot remember the past are condemned to repeat it“. George Santayana
9 months ago, it must have seemed such a good idea. Ed Morse of Citi and other oil market analysts were calling the hedge funds with a sure-fire winning strategy, as the Wall Street Journal reported in May:
“Dozens of hedge-fund managers and oil traders attended a series of closed-door meetings in recent months with OPEC leaders—the first of their kind, according to Ed Morse, Citigroup Inc.’s global head of commodities research, who helped organize some of the events.
“Group officials made the case for how supply cuts from the Organization of the Petroleum Exporting Countries would reduce the global glut…. Mr. Morse of Citigroup said he arranged introductions between OPEC Secretary-General Mohammad Barkindo and the more than 100 hedge-fund managers and other oil buyers who have met with Mr. Barkindo in Washington, D.C., New York and London since October…
“After asking what OPEC planned to do to boost prices, fund managers came away impressed, Mr. Morse said, adding that some still text with the OPEC leader.”
Today, however, hype is disappearing and the reality of today’s over-supplied oil market is becoming ever more obvious. As the International Energy Agency warned in its latest report:
“In April, total OECD stocks increased by more than the seasonal norm. For the year-to-date, they have actually grown by 360 kb/d…”Whatever it takes” might be the (OPEC) mantra, but the current form of “whatever” is not having as quick an impact as expected.”
As a result, the funds are counting their losses and starting to withdraw from the market they have mis-read so badly:
Pierre Andurand of Andurand Capital reportedly made a series of bullish bets after meeting a Saudi OPEC official in November, but saw his fund down 16% by May 5
Once nicknamed “God” for his supposed ability to forecast the oil market, Andy Hall’s $2bn Astenbeck Capital fund lost 17% through April on bullish oil market bets
In a sign of the times, Hall has told his investors that he expects “high levels of inventories” to persist into next year. Consensus forecasts in April/May that prices would rally $10/bbl to $60/bbl have long been forgotten.
OIL MARKET FUNDAMENTALS ARE STARTING TO MATTER AGAIN
This therefore has the potential to be a big moment in the oil markets and, by extension, in the global economy.
It may well be that supply/demand fundamentals are finally starting to matter again. If so, this will be the final Act of a drama that began around a year ago, when the young and inexperienced Mohammed bin Salman became deputy Crown Prince and then Crown Prince in Saudi Arabia:
He abandoned veteran Oil Minister Naimi’s market-share strategy and aimed for a $50/bbl floor price for oil
This gave US shale producers a “second chance” to drill with guaranteed profits, and they took it with both hands
Since then, the number of US drilling rigs has more than doubled from 316 in May 2016 to 763 last week
Even more importantly, the introduction of deep-water horizontal drilling techniques means rig productivity in key fields such as the vast Permian basin has trebled over the past 3 years from 200bbls/day to 600 bbls/day
The chart above shows what the hedge funds missed in their rush to jump on the OPEC $50/bbl price floor bandwagon.
They only focused on the weekly inventory report produced by the US Energy Information Agency (EIA). They forgot to look at the EIA’s other major report, showing US oil and product exports:
US inventories have indeed remained stable so far this year as the blue shaded area confirms
But US oil and product exports have continued to soar – adding nearly 1mb/day to 2016′s 4.6mb/day average
This means that each week, an extra 6.6mbbls have been moving into export markets to compete with OPEC output
Without these exports, US inventories would have risen by another 13%, as the green shaded area highlights
In addition, the number of drilled but uncompleted wells – ready to produce – has risen by 10% since December
These exports and new wells are even more damaging to the OPEC/Russia pricing strategy than the inventory build:
Half-way across the world, India’s top refiner is planning to follow China and Japan in buying US oil
US refiners are ramping up gasoline/diesel exports, with Valero planning 1mb of storage in Mexico
As Naimi warned 2 years ago, Saudi risked being marginalised if it continued to cut production to support prices:
“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.”
How low oil prices will go as the market now rebalances is anyone’s guess.
But they remain in a very bearish pattern of “lower lows and lower highs”. This suggests it will not be long before they go below last year’s $27/bbl price for Brent and $26/bbl for WTI.
Companies and investors have some big decisions ahead of them as we start the second half of the year. They can be summed up in one super-critical question:
“Do they believe that global reflation is finally now underway?”
The arguments in favour of this analysis were given last week by European Central Bank President, Mario Draghi:
“For many years after the financial crisis, economic performance was lacklustre across advanced economies. Now, the global recovery is firming and broadening…monetary policy is working to build up reflationary pressures…we can be confident that our policy is working and its full effects on inflation will gradually materialise.”
The analysis has been supported by other central bankers. The US Federal Reserve has raised interest rates 3 times since December, whilst the Bank of England has sent the pound soaring with a hint that it might soon start to raise interest rates. Most importantly, Fed Chair Janet Yellen told a London conference last week that she:
“Did not expect to see another financial crisis in our lifetime”.
The chart above from Nobel Prizewinner Prof Robert Shiller confirms that investors certainly believe the reflation story. His 10-year CAPE Index (Cyclically Adjusted Price/Earnings Index) has now reached 30—a level which has only been seen twice before in history – in 1929 and 2000. Neither were good years for investors.
Even more striking is the fact that veteran value-investor, Jeremy Grantham, now believes that investors will have “A longer wait than any value manager would like, including me” before the US market reverts to more normal valuation metrics. Instead, he argues that “this time seems very, very different” – echoing respected economist Irving Fisher in 1929 who suggested “stock prices have reached what looks like a permanently high plateau“.
But are they right?
One concern is that central bankers might be making a circular argument. We saw this first with Fed Chair Alan Greenspan, who flooded stock markets with free cash before the dot-com crash in 2000, and then flooded housing markets with free cash to cause the subprime crash in 2008. His successor, Ben Bernanke continued the free cash policy, arguing in November 2010 that boosting the stock market was critical to the recovery:
“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.”
The second chart highlights how the Fed’s zero interest rate policy has driven the rally since the US S&P 500 Index bottomed in March 2009:
Margin debt in the New York market (money borrowed to invest in stocks) is at an all-time record of $539bn ($2017)
It has increased 197% since March 2009, almost exactly matching the S&P’s rise of 216%
Stock market capitalisation (the total value of stocks) versus GDP is close to a new all-time high at 133%
Meanwhile, the Bank of Japan now owns 2/3rds of the entire Japanese ETF market (Exchange Traded Funds). And the Swiss National Bank owns $100bn of US/European stocks including 26 million Microsoft shares.
Unsurprisingly, given central bank policies, the world is now awash with debt. New data from the Institute of International Finance shows total world debt has now reached $217tn – more than 3x global GDP. As a result, respected financial commentator Andreas Evans-Pritchard argued last week:
“The Fed caused the dotcom bubble in the 1990s. It caused the pre-Lehman subprime bubble. Whatever Ms Yellen professes, it has already baked another crisis into the pie. The next downturn may be so intractable that it calls into question the political survival of capitalism. The Faustian pact is closing in.”
Evans-Pritchard’s concern is echoed by Claudio Borio, head of the central bankers’s bank – the Bank for International Settlements (BIS). Under his predecessor, William White, the BIS was the only central bank to warn of the subprime crisis. And Borio has warned:
“Financial booms can’t go on indefinitely. They can fall under their own weight.”
WHO IS RIGHT – THE CENTRAL BANKS OR THEIR CRITICS?
This is why companies and investors have some big decisions ahead of them. Of course, it is easy to assume that everything will be just wonderful, when everyone else seems to believe the same thing. Who wants to spoil the party?
But then there is the insight from one of the world’s most famous analysts, Bob Farrell, captured in the headline to this post. The chart of The pH Report’s Boom/Gloom Index highlights how the concept of the Trump reflation trade has sent the S&P into an exponential rally – even whilst sentiment, as captured in the Index, has been relatively subdued.
You could argue that this means the market can continue to go higher for years to come, as Grantham and the central banks believe. Or you could worry that “the best view is always from the top of the mountain” and that there are now very few people left to buy. And you might also be concerned that:
Political uncertainty is rising across the Western world, as well as in the Middle East and Latin America
Oil prices are already in a bear market
China’s growth and lending is clearly slowing
And Western central banks also seem set on trying to unwind their expansionary policies
We can all hope that today’s exponentially rising markets continued to rise.
But what would happen to your business and your investments if instead they began to correct – and not by going sideways? It might be worth developing a contingency plan, just in case.
Oil markets have been at the centre of the recent myth that economic recovery was finally underway. The theory was that rising inflation, caused by rising oil prices, meant consumer demand was increasing. In turn, this meant that the central banks had finally achieved their aim of restoring economic growth via their zero interest rate policy.
This theory was first undermined in 2014, when oil prices began their fall. There had never been a shortage of oil. Prices rose to $125/bbl simply because the hedge funds saw commodities like oil as a ‘store of value’ against the Federal Reserve’s policy of weakening the dollar.
The theory sounded attractive and plenty of people had initially made a lot of money from believing it. But it didn’t mean that the global economy had recovered. And by August 2014, as I highlighted at the time, oil prices were starting to collapse under the weight of excess supply. As I also suggested in the same post, this meant “major oil price volatility is now likely”. By luck or judgement, this has indeed since occurred, as the chart shows:
□ The 2009 – 2014 rally was dominated by “technical trading”, as oil markets lost their role of “price discovery”
□ August – December 2014 then saw prices crash to $45/bbl
□ Prices rose nearly 50% in early 2015 in a “failed rally”, as hedge funds assumed prices would quickly recover
□ Prices then halved to $27/bbl in January 2016 as the reality of over-supply swamped the market
□ Since then prices have doubled as OPEC combined with the hedge funds to try and push prices higher
□ This rally now seems to have failed, as US shale supply continues to increase
In reality, as I discussed last month, this final rally merely enabled new US production to be financed. The US oil rig count has doubled over the past year, and each rig is now 3x more productive than in 2014. At the same time, the medium-term outlook for oil demand in the key transport sector is becoming more doubtful, with China and India both now moving towards Electric Vehicles as a way of reducing their high levels of air pollution.
A measure of how far the market has moved was seen at last week’s Clean Energy Ministerial meeting, which:
“Set a collective aspirational goal for all EVI members of a 30% market share for electric vehicles (EVs) by 2030. It does so with the aim of taking advantage of the multiple benefits offered by electric mobility for innovation, economic and industrial development, energy security, and reduction of local air pollution.”
Already oil price targets, even amongst the optimists, are now being revised downwards. Nobody now talks about a “quick return” to $100/bbl, or even to $70/bbl. Instead the hope is that possibly they might return to $60/bbl at some point in the future – others merely hope that today’s $50/bbl level can be maintained.
Hope, however, is not a strategy. And in the absence of major geopolitical disruption, it seems likely that the hedge funds will continue to withdraw from the market and leave supply/demand fundamentals to once again set the price. In turn, this will challenge the reflation and recovery myth that grew up whilst the funds were boosting their bets on the oil and commodity markets.
As the second chart shows, inflation has already begun to weaken in China as well as in the US and Eurozone economies. China’s move away from stimulus will help to accelerate this move in H2, In turn, markets will likely return to worrying about deflation once more.
Japan is an excellent indicator of this development. Its inflation rate completely failed to take off despite the major rise in oil and other commodity prices. As I have long argued, Japan’s ageing population means that its previous demographic dividend has now been replaced by a demographic and demand deficit.
The US and Eurozone economies are both going through the same process. 10k Americans and 18k Europeans have been retiring every day since 2011 as the BabyBoomer generation reaches the age of 65. They already own most of what they need, and their incomes generally suffer a major hit as they leave the workforce.
Companies and investors therefore need to prepare for a difficult H2. The failure of the latest oil price rally, and the return of deflation worries, will puncture the myth that reflation and economic recovery are finally underway. Political stalemate will increase, until policymakers finally accept that demographics, not central banks, drive demand.