Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same. Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.
The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story. So the chart above instead combines 5 “shock, horror” stories, showing quarterly oil production since 2015:
- Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015. OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
- Russia has also been much in the news since joining the OPEC output agreement in November 2016. But in reality, it has done little. Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
- Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
- Venezuela is an OPEC member, but its production decline began long before the OPEC deal. The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
- The USA, along with Iran, has been the big winner over the past 2 years. Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!
But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April. Not much “shock, horror” there over a 3 year period. More a New Normal story of “Winners and Losers”.
So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday? Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble. The answer lies in the second chart from John Kemp at Reuters:
- It shows combined speculative purchases in futures markets by hedge funds since 2013
- These hit a low of around 200mbbls in January 2016 (2 days supply)
- They then more than trebled to around 700mbbls by December 2016 (7 days supply)
- After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)
Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently: “Several of them had little or no experience or even a basic understanding of how the physical market works.”
This critical point is confirmed by Citi analyst Ed Morse: “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.”
Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:
“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).
OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION
The hedge funds have been the real winners from all the “shock, horror” stories. These created the essential changes in “crowd behaviour”, from which they could profit. But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:
- Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
- This level has been linked with a US recession on almost every occasion since 1970
- The only exception was post-2009 when China and the Western central banks ramped up stimulus
- The stimulus simply created a debt-financed bubble
The reason is simple. People only have so much cash to spend. If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy. Chemical markets are already confirming that demand destruction is taking place.:
- Companies have completely failed to pass through today’s high energy costs. For example:
- European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
- They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)
Even worse news may be around the corner. Last week saw President Trump decide to withdraw from the Iran deal. His daughter also opened the new US embassy to Jerusalem. Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.
As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities. Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz. It is just 21 miles wide (34km) at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.
As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”. Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets. We must all learn to form our own judgments about the real risks that might lie ahead.
Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.
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Chemicals are easily the best leading indicator for the global economy. And if the global economy was really in recovery mode, as policymakers believe, then the chemical industry would be the first to know – because of its early position in the value chain. Instead, it has a different message as the chart confirms:
- It shows changes in global production and key sectors, based on American Chemistry Council (ACC) data
- It highlights the rapid inventory build in H2 as oil and commodity prices soared
- But since then, all the major sectors have moved into a slowdown, and agchems into decline
As the ACC note:
“The global chemical industry ended the first quarter on a soft note. Global chemicals production fell 0.3% in March after a 1.0% drop in February, and a 0.6% decline in January. The last gain was 0.3% in December.”
This, of course, is the opposite of consensus thinking at New Year, when most commentators were confident that a “synchronised global recovery” was underway. It is therefore becoming more and more likely, as I warned in January, that policymakers have been fooled once again by the activities of the hedge funds in boosting “apparent demand”:
“For the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford. In turn, of course, this has made it appear that demand has suddenly begun to recover. At last, it seems, the “synchronised global recovery” has arrived.
“Except, of course, that it hasn’t. The hedge funds didn’t buy 15 days-worth of oil to use it. They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.”
This downturn is worrying not only because it contradicts policymakers’ hopes, but also because Q1 volumes should be seasonally strong:
- Western companies should be restocking to meet the surge of spring demand
- Similarly, China and the Asian markets should now be at peak rates after the Lunar New Year
HIGHER OIL AND COMMODITY PRICES ARE CAUSING DEMAND DESTRUCTION
The problem is that most central bankers and economists don’t live in the real world, where purchasing managers and sales people have bonuses to achieve. As one professor told me in January:
“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”
But in the real world, H2’s inventory build has now been replaced by destocking – whilst today’s higher oil prices are also causing demand destruction. We have seen this many times before when prices have risen sharply:
- Consumers only have limited amounts of spare cash
- When oil prices jump, they have to cut back in other areas
- But, of course, this is only confirmed afterwards, when the spending data is reported
- Essentially, this means that policymakers today are effectively driving by looking in the rear-view mirror
RISING DEBT LEVELS CREATE FURTHER HEADWINDS FOR GROWTHNew data from the US Federal Reserve Bank of St Louis also highlights the headwinds for demand created by the debt build-up that I discussed last week. As the chart shows:
- US borrowing was very low between 1966-79, and $1 of debt created $4.49 in GDP growth
- Borrowing rose sharply in the Boomer-led SuperCycle, but $1 of debt still created $1.15 in GDP growth
- Since stimulus programmes began in 2000, however, $1 of debt has created just $0.36 of GDP growth
In other words, value destruction has been taking place since 2000. The red shading tells the story very clearly, showing how public debt has risen out of control as the Fed’s stimulus programmes have multiplied – first with sub-prime until 2008, and since then with money-printing.
RISING INTEREST RATES CREATE FURTHER RISKS
Last week saw the yield on the benchmark US 10-year Treasury Bond reach 3%, double its low in June 2016. It has risen sharply since breaking out of its 30-year downtrend in January, and is heading towards my forecast level of 4%.
Higher interest rates will further slow demand, particularly in key sectors such as housing and autos. And in combination with high oil and commodity prices, it will be no surprise if the global economy moves into recession.
Chemicals is providing the vital early warning of the risks ahead. But as usual, it seems policymakers prefer to wear their rose-coloured spectacles. And then, of course, as with subprime, they will all loudly declare “Nobody could have seen this coming”.
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As promised last week, today’s post looks at the impact of the ageing of the BabyBoomers on the prospects for economic growth.
The fact that people are living up to a third longer than in 1950 should be something to celebrate. But as I noted in my Financial Times letter, policymakers are in denial about the importance of demographic changes for the economy.
Instead, their thinking remains stuck in the past, with the focus on economists such as Franco Modigliani, who won a Nobel Prize for “The Life Cycle Hypothesis of Savings”, published in 1966. This argued there was no real difference in spending patterns at different age groups.
Today, it is clear that his Hypothesis was wrong. He can’t be blamed for this, as he could only work with the data that was available in the post-War period. But policymakers should certainly have released his theories were out of date.
The chart highlights the key issue, by comparing average US and UK household spending in 2000 v 2017:
- In 2000, there were 65m US households headed by someone in the Wealth Creator 25-54 cohort, and 12.5m in the UK. They spent an average of $62k and £33.5k each ($2017/£2017)
- There were 36m US households headed by someone in the 55-plus New Older cohort, and 12.4m in the UK, who spent an average of $45k and £22.8k each
- In 2017, the number of Wealth Creator households was almost unchanged at 66m in the US and 11.9m in the UK. Their average spend was also very similar at $64k and £31.9k each
- But the number of New Older householders had risen by 55% in the US, and by 24% in the UK, and their average spend was still well below that of the Wealth Creators at $51k and £26.4k respectively
Amazingly, despite this data, many policymakers still only see the impact of today’s ageing Western populations in terms of likely increases in pension and health spending. They appear unaware of the fact that ageing populations also impact economic growth, and that they need to abandon Modigliani’s Hypothesis.
As a result, they have spent trillions of dollars on stimulus policies in the belief that Modigliani was right. Effectively, of course, this means they have been trying to “print babies” to return to SuperCycle levels of growth. The policy could never work, and did not work. Sadly, therefore, for all of us, the debt they have created can never be repaid.
This will likely have major consequences for financial markets.
As the chart from Ed Yardeni shows, company earnings estimates by financial analysts have become absurdly optimistic since the US tax cut was passed.
The analysts have also completely ignored the likely impact of China’s deleveraging, discussed last month.
And they have been blind to potential for a global trade war, once President Trump began to introduce the populist trade policies he had promised in the election. Last week’s moves on steel and aluminium are likely only the start.
Policymakers’ misguided faith in Modigliani’s Hypothesis and stimulus has instead fed the growth of populism, as the middle classes worry their interests are being ignored. This is why the return of volatility is the key market risk for 2018.
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Rising life expectancy, and falling fertility rates, mean that a third of the Western population is now in the low spending 55-plus age group. Given that consumer spending is around two-thirds of the economy in developed countries, the above charts provide critically important information on the prospects for economic growth.
They show official data for household spending in 3 of the major G7 economies in 2017 – the USA, Japan and the UK:
- Each country reports on a slightly different basis in terms of age range and headings, but the basics are similar
- US spending peaks in the 45 – 54 age group: Japanese spending peaks at age 55; UK spending peaks at age 50
- After the age of 75, US spending falls 46% from its peak and UK spend falls 53%: after the age of 70, Japanese spending falls 34%
The data confirms the common sense conclusion that youthful populations create a potential demographic dividend in terms of economic growth. Conversely, ageing populations have a demographic deficit and will see lower growth, as.older people already own most of what they need, and their incomes go down as they enter retirement.
The Western world has been, and still is, a classic case study for this demographic effect in action, as the second chart shows:
- In 1950, only 16% of Westerners were in the New Old 55-plus age group; 39% were in the 25-54 age group that drives economic growth and wealth creation; and 45% were under 25 as the BabyBoom got underway
- But by 2015, the percentage of New Olders had doubled to 31%, whilst the percentage of Wealth Creators was virtually unchanged at 41% and only 28% were under 25 (as fertility rates collapsed after 1970)
The Boomers were the largest and wealthiest generation that the world has ever seen, and as they joined the workforce they created an economic Super-Cycle. This was turbo-charged by the fact that, for the first time in history, Western women began to re-enter the workforce after childbirth:
- In the US, for example, women’s participation rate nearly doubled from 34% in 1950 to a peak of 60% in 1999
- And after the Equal Pay Act of 1963, their earnings rose to 62% of men’s by 1979 and to 81% by 2005 (since when it has flatlined)
But since 2001, the oldest Boomer, born in 1946, has been leaving the Wealth Creator age group. By 2013, the average Boomer had left it. And since 1970, Western fertility rates have been below replacement levels (2.1 babies/woman). So the Western economy now faces a double squeeze:
- The Boomers who created the SuperCycle are no longer making a major contribution to economic growth
- The number of new Wealth Creators is now relatively smaller, due to the collapse of fertility rates
In the past, very few Boomers would have lived beyond retirement age, as the 3rd chart confirms based on UN Population Division data. So, sadly, they would have been irrelevant in terms of economic growth. But, wonderfully, this is no longer true today:
- In 1950, average US life expectancy for men was just 66 years and 72 years for women. UK men died at age 67, and women at age 72. Japanese men died at age 61, and women at age 65
- Today, US men are living an extra 11 years and women 9 years more. UK men are living an extra 12 years and women 11 years more. Japanese men are living an extra 19 years and women 22 years more
- By 2030, the UN forecasts suggest US men will be living 20% longer than in 1950, and women 16% longer. In the UK, men will be living 23% longer and women 18% longer. In Japan, men will be living 35% longer, and women 37% longer
By 2030, 36% of the Western population will be New Olders, almost equal to the 37% who are Wealth Creators.
Clearly there is no going back to SuperCycle growth levels. I will look at this critical issue in more detail next week.
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Commentators have confused cause with effect when analysing this month’s sudden downturn in financial markets, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Surprise and confusion seem to have been the main reactions to this month’s sudden downturn in western financial markets. Yet across the world in China, warning signs of a potential downturn have been building for some months, as discussed here in June.
As the chart below shows, President Xi Jinping’s decision to move away from stimulus policy will have a direct impact on the global economy, as this has been the main source of the liquidity that has boosted financial markets over the past decade.
China’s official and shadow bank lending totalled more than $20tn between 2009 and 2017. By comparison, the US Federal Reserve, Bank of Japan, European Central Bank and Bank of England added “only” $13tn between them.
The critical importance of China’s policy shift was highlighted in December by the state-owned Xinhua news service when it announced Mr Xi’s priorities for 2018 as being to fight “three tough battles” to secure China’s goal of “becoming a moderately prosperous society” by 2020.
“Financial deleveraging” was described as the first battle, and it seems the opening salvos have already been fired, given that China’s capital outflows collapsed from $640bn in 2016 to just $60bn in 2017.
The People’s Bank of China then reinforced this priority in January with a statement emphasising that “slower M2 growth than before will become the ‘new normal’, as the country’s deleveraging process deepens and the financial sector gets back to the function of serving the economy”.
Western financial markets, however, seemed to adopt the “Road Runner approach” to this major paradigm shift in economic policy. Like the cartoon character Wile E Coyote, the new year saw them continuing to hang in mid-air before finally realising they were about to plummet into the chasm.
Even more worrying, now calm has been temporarily restored, is their failure to learn from the experience. Instead, commentators have mostly gone back to their comfort zone and are again focusing on the minutiae of policy statements from the major western central banks.
This could prove a costly mistake for investors and companies. As the FT reported in December, Mr Xi has already “made controlling debt at state-owned enterprises a top policy priority”, and it seems likely he will follow the IMF’s advice by increasing budget constraints for China’s zombie companies and allowing more corporate defaults. January’s shadow bank lending was the lowest January level since 2009 at just $25bn, and it was 90 per cent lower than in January 2017.
The recent rush of asset sales by major Chinese corporates such as HNA and Dalian Wanda is another clear sign of the new discipline being imposed. Foreign investors must hope the companies realise a good return from these disposals, given that they provided $221bn in dollar-denominated loans to Chinese borrowers last year.
Deleveraging is only one of Mr Xi’s “three battles”, however. And while his second battle on poverty reduction is unlikely to impact the global economy, his third battle, the “War on Pollution”, has a number of potentially critical implications.
It has already led to thousands of company closures and forcible relocations, and has severely disrupted major parts of China’s economy — causing China’s producer price index to peak at 6.9 per cent in the fourth quarter. In turn (as we had forecast here in November), this surge has created today’s “inflation surprise” as its impact rippled round the world.
One key component of the “surprise” was the disruption caused by the unexpected loss of production in key commodity markets. Oil prices have surged, for example, as China’s move away from coal has powered a short-term increase in oil demand. And, as always, the surge has been boosted by the inventory build typically associated with such unexpected and sudden price hikes. This can be seen in the second chart, which focuses on volume changes in the chemicals market, normally an excellent leading indicator for the global economy.
It confirms that consumers put aside their initial scepticism over Opec’s ability to support the oil market, as China’s excess demand helped prices to rise 60 per cent from June’s $44 a barrel to January’s $71 peak. Purchasers scrambled to build stock ahead of likely price rises for their own raw materials.
This time round, it even led buyers to abandon their normal tactic of reducing stock at year-end to flatter working capital data. Instead, inventories rose quite sharply all down the value chains, creating the illusion that demand was suddenly increasing in a co-ordinated fashion around the world.
The world has seen many similar increases in such “apparent demand” over the years, and these can temporarily add up to an extra month’s demand to underlying levels. This increase is, of course, only a temporary effect, as it is quickly unwound again once prices start to stabilise. The chart also shows that this was already starting to happen in January, with the normal seasonal stock-build being replaced by destocking.
In turn, of course, these developments raise a major question mark over the current assumption that the world is now seeing a synchronised global recovery. We suspect that by the summer, policymakers may well find themselves repeating the famous lament of Stanley Fischer in August 2014, when the Fed’s vice-chairman sadly noted that “year after year we have had to explain from midyear on why the global growth rate has been lower than predicted as little as two quarters back”.
Paul Hodges, Daniël de Blocq van Scheltinga and Paul Satchell publish The pH Report.
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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.
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