Brazil, Russia, India and China disappoint as manufacturers face investment demands of EVs © Bloomberg
Less than a third of China’s 31,000 auto dealers were profitable in the first half of 2019, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Auto markets in the Bric countries are facing two major challenges. The first relates to the downturn already under way in the two largest markets, China and India, where 2019 sales seem likely to be at least 10 per cent below the previous year’s levels.
The second is the need for manufacturers and parts suppliers to spend billions of dollars on the transition to electric vehicles in order to meet Chinese government production targets in 2021-23.
It therefore seems probable that winners and losers will emerge over the next 18 months, as companies along the value chain find themselves short of cash to fund the new investments required.
China’s downturn is particularly important as sales in Brazil, Russia and India have already fallen by 20 per cent since peaking in 2012, as the chart below shows (January-November basis). Chinese sales have been in a downturn for more than a year, and the impact is broadening along the supply chain.
As Automotive News reported: “We knew China had been in a prolonged auto sales slump, and we knew the market was under pressure from tougher municipal and provincial emissions standards. Now, we’re seeing how these factors are devastating dealerships, to the tune of half of them being sold and several hundred being driven out of business.”
Less than a third of China’s 31,000 dealerships were profitable in the first half of 2019. The downturn is particularly bad news for western manufacturers, whose global profits have depended on China volumes.
US brands are worst hit, with January-November sales down 23 per cent due to frictions caused by the US-China trade war. General Motors reported third-quarter China sales down 17.5 per cent, continuing their slide since the second quarter of 2018, with sales also hit by strong competition in the key mid-priced sport utility vehicle segment. Ford saw its third-quarter sales fall 30 per cent — accelerating the downturn that began at the end of 2017.
French brands are having a difficult time, with volume down 54 per cent in January-November. Seventy per cent of Peugeot, Citroën and Renault’s dealerships were lossmaking in the first half of last year.
Korean brands were down 15 per cent, and even German brands had no growth over the previous year.
The problem is magnified by the fact that China’s market has seen rapid growth since 2008. Many companies and dealerships therefore assumed that the sales ramp-up from 550,000 vehicles a month in 2008 to 2m a month by 2016 was somehow “normal”. They have no concept of a slowdown, or how to survive it.
The downturn is likely to intensify as the government continues to squeeze the shadow banking sector and hence the property market. As the chart below shows, shadow lending remains well down on its earlier peaks, averaging just $67bn a month in the 10 months to October. This means, as we noted here a year ago, that “buyers can no longer count on windfall gains from property speculation to finance their purchase”.
As Reuters notes, the scale of the previous stimulus-driven growth also means that today, “much of the urban middle class has already purchased a vehicle. Household ownership rates were nearing 50 per cent in the provincial-level cities of Beijing and Tianjin and the wealthy province of Zhejiang by the end of 2017… Pushing ownership further down the income scale in urban areas as well as out into the poorer countryside is harder without generous tax incentives, plentiful credit and fast growth in incomes.”
Sales in the other Bric markets are also slowing. India’s sales were down 13 per cent at the end of November, while in Russia the industry is now forecasting a 2 per cent decline. Even in Brazil, industry trade group Anfavea has reduced its growth forecast to 8 per cent, due to the slowing Latin American economy.
The downturn creates a major dilemma for the industry, as it coincides with the need to commit to major new investments in EV manufacture.
China is proposing to set a 14 per cent target for EV production in 2021, rising to 16 per cent in 2022 and 18 per cent in 2023. Similarly, the industry ministry has called for EVs to be 25 per cent of total new car sales by 2025, and announced that “regions with ripe conditions have our support if they establish trial projects to establish no-go zones for gasoline-powered vehicles and replace them with new energy vehicles in the urban public transport system”.
Companies therefore have to move forward with EV investments, even though their profits are under pressure from the sales downturn.
Volkswagen, for example, is planning to open two Chinese EV factories this year with total capacity of 600,000 cars, and aims to produce 11.6m EVs in China by 2028. Tesla is opening capacity for 250,000 cars and plans to double production in the future.
With other manufacturers following suit, some in the industry expect EV prices to fall below those for internal combustion engines within the next two years, which would further accelerate the transition.
The industry is therefore faced with a stark choice. The need to commit to EV manufacture means there is no “business as usual” strategy for either manufacturers or parts suppliers. Those who decide to conserve their cash risk finding themselves without the relevant products and services in the world’s largest auto market.
Paul Hodges publishes The pH Report.
Few investors now remember the days when price discovery was thought to be the key role of stock markets. Instead, we know that prices are really now set by central banks, on the model of the Politburo in the old Soviet Union.
How else can one explain the above chart? It shows the US S&P 500 Index has risen 50% over the past 5 years, even though US corporate profits have fallen 5% (using US Bureau of Economic Analysis data).
As in the old USSR, central banks have also abolished “bad news”.
All news is now good news, as any ‘bad news’ means the Federal Reserve will rush to provide more price support. It has been so successful that the Index hasn’t even suffered a 20% correction over the past decade, as my Chart of the Decade confirmed.
But does this mean that stock markets will never fall again? That is the real question as we enter 2020.
On the positive side, we know that companies have also provided major support via buybacks. Apple alone did $240bn of buybacks between 2014 – 2018. Companies spent $800bn in total in 2018, but cash now seems to be tighter with 2019 purchases down around 15% to $700bn.
We also know that President Trump believes a strong stock market is key to his re-election this year. His Trade Adviser, Peter Navarro, has already suggested 2020 will be another record:
“It’s going to be the roaring 2020s. ”Dow 32,000 is a conservative estimate of where we’ll be at the end of the year.”
Certainly investors seem to be very positive, as the above charts confirm. Share prices for the FANGAM stocks – Facebook, Apple, Netflix, Google and Amazon stocks have soared to new heights:
- Apple for example, was up 32% in Q4 and nearly doubled in 2019
- On its own, it provided 14% of the S&P’s gain in the quarter, and 8.5% of the annual gain
This wonderful performance took place even though Apple’s net income has fallen for the past 4 quarters. It is also hard to argue that Microsoft or the other FANGAM companies are suddenly about to see supercharged growth.
So is there a negative side? Maybe old-fashioned investors were simply wrong to believe stock markets’ key role as price discovery and the efficient allocation of capital?
If one wants to worry, one has to instead look to the insights of Hyman Minsky, who warned that:
- A long period of stability eventually leads to major instability
- This is because investors forget that higher reward equals higher risk
- Instead, they believe that a new paradigm has developed
- They therefore take on high levels of debt to finance ever more speculative investments
His argument was that liquidity is not the same as solvency. Central banks can pump out trillions of dollars in stimulus, and make it ridiculously easy for companies to justify new investments. It is hard to argue with a CEO who claims:
“Why not borrow, as it’s not costing us anything with today’s interest rates“.
But what happens if the earnings from the new investments are too low to pay the interest due on the debt?
That is the risk we face today, given there is now a record $3tn of BBB grade debt – the lowest level of ‘investment grade’ debt. If some of these companies start to default, then confidence in the central banks’ ‘new paradigm’ will quickly disappear – and, with it, market liquidity
Investors will then find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this will prompt a rush for the exits. Prices will drop quite sharply, as ‘distress sales’ start to take place.
China’s former central bank governor has already warned that it may be facing its own Minsky Moment. As investors finish celebrating their 2019 success, they might find it prudent to ponder whether the good times can really continue forever.
Polyethylene markets (PE) are moving into a crisis, with margins in NE Asia already negative, as I have been forecasting. Scenario planning is now a matter of potential life or death for companies likely to be impacted over the next 12-18 months.
The collapse in margins is already quite dramatic as the chart based on ICIS data shows:
- NEA margins were $657/t in January 2017, and are now -$100/t; SE Asian margins have fallen from $909/t to $103/t
- NW Europe margins are down from $739/t to $300/t; US Gulf margins are down from $965/t to $603/t: Middle East margins are down from $1125/t to $833/t
The same pattern is also true for the other main grade, High Density PE (HDPE).
And, of course, today is only the start of the problems. As the second chart shows, there are vast amounts of new product coming online between 2019 – 2021 in both LLDPE and HDPE:
- LLDPE: China is adding 3.4 million tonnes; USA 1.8Mt; Russia and S Korea 800kt each; with India, Oman, Malaysia and Indonesia also adding capacity
- HDPE: China is adding 4.4Mt; USA 1.9Mt, S Korea 900kt, Russia 700kt; with India, Oman, Malaysia, Indonesia, Philippines, Iran and Azerbaijan also adding
The problem is that the fundamental assumptions behind the shale gas investments were simply wrong:
- Oil was most unlikely to always be >$100/bbl, providing a feedstock advantage with shale gas
- China wasn’t likely to be growing at double-digit rates, and always importing more petchems
- Globalisation was already ending, meaning that plants couldn’t be sited half-way across the world from their market
- Plastics will not always be the material of choice for single-use packaging applications
Essentially what happened is that companies stopped planning for themselves and allowed Wall Street to set their strategy, as one CEO told me:
“You may be right, but every time I mention shale on an earnings call, the share price goes up $5.”
It is now too late to wind back the clock. The US product from the integrated players has to go somewhere as their ethane feedstock is essentially a distressed product. If they don’t use the ethane to make ethylene and its derivatives, they cannot produce the shale gas.
The result is shown in the charts above, based on data from Trade Data Monitor
- 2019 has seen vast amounts of new US ethylene-based exports, and more is still to come
- Most of it was exported as PE, where exports have risen 85% so far this year versus 2018
- The trade war means exports to China have actually dropped, so Europe, SEA and NEA have suffered major disruption
- US PE exports to these regions were up 98%, 240% and 246% respectively, causing margins to start their collapse
The world is therefore starting to divide into Winners and Losers, as the chart suggests. Non-integrated ethylene producers around the world are particularly at risk:
- They have to buy their feedstock at market prices, and they will have to sell into an increasingly over-supplied market
- As a result, it is quite likely that their margins will become negative – as they have done before in periods of over-supply
- At this point, integrated producers have the advantage as they are still making money upstream on oil/gas/refining
But there are also wider risks for European and Asian consumers down all the major value chains, as they will be impacted by lower cracker rates.
Scenario analysis must now be a top priority for potential Loser companies. There really is very little time left, as the margins chart confirms.
Most people would quickly notice if $50 went missing from their purse or wallet. They would certainly notice if $50k suddenly disappeared from their bank account. But a fortnight ago, it took the New York Federal Reserve more than a day to notice that $50bn was missing from the money markets it was supposed to regulate.
Worse was to come. By the end of last week, the NY Fed was being forced to offer up to $100bn/day of overnight money. And it was also clear that the authorities still have no idea of what is going wrong.
This is perhaps not surprising when one remembers, as I charted here between 2007-8, that the Fed failed to notice the subprime crisis until Lehman went bankrupt in September 2008.
For the past 2 weeks, extraordinary things have been happening in a critical part of the world’s financial markets. And unfortunately, the NY Fed didn’t notice until after it had begun, as the Financial Times later reported:
- First, on Monday 16th, the repo market suddenly began to trade higher – reaching a high of 7%
- Then as the market opened at 7am on Tuesday, “Rates rocketed upward again, to 6% within a few minutes and then to a high of 10%. That was four times the rate the repo market was trading the week before. Typically, repo prices move around by a few basis points each day — a few hundredths of a percentage point.“
Finally, someone at the Fed woke up – or perhaps, somebody woke them up – and they announced $75bn of support to try and stop rates moving even higher. Even that had its problems, as “technical difficulties” meant the lending was delayed.
As Reuters then reported next day, this cash wasn’t enough. The shortage “forced the Fed to make an emergency injection of more than $125bn …. its first major market intervention since the financial crisis more than a decade ago.”
Of course, as with the early signs of the subprime crisis, the Fed then went into “don’t frighten the children mode“. We were told it was all due to corporations needing cash to pay their quarterly tax bills, and banks needing to pay for the Treasury bonds they had bought recently.
Really! Don’t companies pay their tax bills every quarter? And don’t banks normally pay for their bonds? Was this why some large banks found themselves forced to pay 10% for overnight money, when they would normally have paid around 2%? And in any case, isn’t repo a $2.2tn market – and so should be easily able to cope with both events?
Equally, if it was just a one-off problem, why did the NY Fed President next have to announce daily support of “at least $75bn through 10 October” as well as other measures? And why did the Fed have to scale this up to $100bn/day last Wednesday, after banks needed $92bn of overnight money?
Was it that corporations were suddenly paying much more tax than expected, or banks buying up the entire Treasury market? The explanation is laughable, and shows the degree of panic in regulatory circles, that their explanation isn’t even remotely plausible.
We can expect many such stories to be put around over the next few days and weeks. As readers will remember, we were told in March 2008 that Bear Stearns’ collapse was only a minor issue. As I noted here at the time, S&P even told us that it meant “the end of the subprime write downs was now in sight“.
I didn’t believe these supposedly calming voices then, and I don’t believe them now. Common sense tells us that something is seriously wrong with the financial system, if large borrowers have to pay 10% for overnight money in a $2.2tn market.
And what is even more worrying is that, just as with subprime, the regulators clearly don’t have a clue about the nature of the problem(s).
My own view, as I warned in the Financial Times last month, is that “China’s (August 5) devaluation could prove to be the trigger for an international debt crisis”. Current developments in the repo market may be a sign that this is more likely than many people realise. I hope I am wrong.
Major disruption is starting to occur in the world’s largest manufacturing industry. Hundreds of thousands of jobs will likely be lost in the next few years in auto manufacturing and its supply chains, as consumers move over to Electric Vehicles (EVs).
As the chart from Idaho National Laboratory confirms, EVs have relatively few parts – less than 20 in the drive-train, for example – versus 2000 for internal combustion engines (ICEs). There is much less to go wrong, so many servicing jobs will also disappear.
The auto industry itself was the product of such a paradigm shift in the early 19th century, when the horse-drawn industry mostly went out of business. Now it is seeing its own shift, as battery costs start to reach the critical $100/kWh levels at which EVs become cheaper to own and operate than ICEs.
Unfortunately, this paradigm shift is coming at a time when global sales and profits are already falling. As the chart shows, sales were down 5.4% in January-August in the Top 7 markets versus 2018. And in the Top 6 markets, outside China, they were only 4% higher than in 2007, highlighting the industry’s current over-dependence on China:
- India is suffering the most, with sales down 15% this year
- But China’s woes matter most as it is the largest global market; its sales were down 13%
- Europe was down 3% YTD, but on a weakening trend with August down 8%
- All the major countries were negative in August, with Spain down 31%
- Russia was down 2%, despite the economic boost provided by today’s relatively high oil prices
- The USA and Japan were marginally positive, up 0.4% and 0.6% respectively
- Only Brazil was showing strong growth at 9%, but was still down 28% versus its 2011 peak
EV sales, like those of used cars, are heading in the opposite direction. China currently accounts for 2/3rds of global EV sales and sold nearly 1.3m EVs in 2018 (up 62% versus 2017). They may well take 50% of the Chinese market by 2025, as the government is now focused on accelerating the transition via the rollout of a national charging network.
Interestingly, it seems that Europe is likely to emerge as the main challenger to China in the global EV market. The US has Tesla, which continues to attract vast investment from Wall Street, but it is only expected to produce a maximum of 400k cars this year. Europe, however, is ramping up EV output very fast as the Financial Times chart confirms:
- The left-hand scale shows EV prices v range (km) for EVs being released in Europe
- The right-hand scale shows the dramatic acceleration in EV launches in 2019-21
One key incentive is the manufacturers’ ability to use EV sales to gain “super-credits” in respect of the new mandatory CO2 emission levels. These are now very valuable given the loss of emission credits due to the collapse of diesel sales.
2020 is the key year for these “super-credits” as they are the equivalent of 2 cars, before scaling down to 1.67 cars in 2021 and 1.33 cars in 2022. Every gram of CO2 emissions above 95g/km will incur a fine of €95/car sold. And as Ford’s CEO has noted:
“There’s only going to be a few winners who create the platforms for the future.”
VW NOW HAVE BATTERY COSTS AT BELOW $100/kWh
VW is likely to be one of the Winners in the new market. It is planning an €80bn spend to produce 70 EV models based on standardised motors, batteries and other components. This will enable it to reduce costs and accelerate the roll-out:
- Its new new flagship ID.3 model will go on sale next year at a typical mid-market price of €30k ($34k)
- Having disrupted that market segment, it will then expand into cheaper models
- And it expects a quarter of its European sales to run on battery power by 2025.
The key issue, of course, is battery cost. $100/kWh is the tipping point at which it becomes cheaper to run an EV than an ICE. And now VW are claiming to have achieved this for the ID.3 model.
Once this becomes clearly established, EV sales will enter a virtuous circle, as buyers realise that the resale value of ICE models is likely to fall quite sharply. Diesel cars have already seen this process in action as a result of the “dieselgate” scandal – they were just 31% of European sales in Q2, versus 52% in 2015 .
One other factor is likely to prove critical. The media hype around Tesla has led to an assumption that individuals will lead the transition to battery power. But in reality, fleet owners are far more likely to transition first:
- They have a laser-like focus on costs and often operate on relatively regular routes in city centres
- They don’t have the “range anxiety” of private motorists and can easily recharge overnight in depots
The problem for auto companies, their investors and their supply chain, is that the disruption caused by the paradigm shift will create a few Winners – and many Losers – as Ford warned.
Those who delay making the investments required are almost certain to become Losers. The reason is simple – if today’s decline in auto sales accelerates, as seems likely, the investment needed for EVs will simply become unaffordable for many companies.
Oil markets remain poised between fear of recession and fear of a US attack on Iran. But gradually it seems that fears about a war are reducing, whilst President Trump’s decision to ramp up the trade war with China makes recession far more likely.
The chart of Brent prices captures the current uncertainties:
- It shows monthly prices for Brent since 1983 and highlights the conflicting risks
- The bulls have been battling to push prices higher, but their confidence is weakening
- The bears were hurt by the stimulus from US tax cuts and OPEC output cuts
- But June’s abandonment of the Iran attack lifted their confidence
As a member of the President’s national security advisory team has noted:
“This is a president who was elected to get us out of war. He doesn’t want war with Iran.”
With fears about a potential war reducing, at least for the moment, attention has instead turned to issues of supply and demand. And here, again, the balance of different factors has turned negative:
- As the second chart shows, supply from the 3 major countries remains at a high level
- The US is the largest producer, and August’s output is now recovering after the slowdown in the Gulf of Mexico due to Hurricane Barry, and the EIA is forecasting new record highs this year and 2020
- 3 new pipelines are also coming online during H2, which will boost US oil export potential
- Meanwhile Russia, as usual, has failed to follow through on its commitment to the OPEC cuts. Its output rose by 2% in January-July versus 2018, despite May/June’s contamination problems
- As always with OPEC output cuts, Saudi Arabia has been forced to fill the gap. Its volume dipped to 9.8mbd in July, well below the 11mbd peak last November
Overall, global supply has remained strong with EIA estimating Q2 output at 100.6mbd versus 99.8mbd in Q2 last year. Contrary to last year’s optimism over global economic recovery, EIA suggests Q2 consumption only rose to 100.3mbd, versus 99.6mbd in Q2 last year.
And the normally bullish International Energy Agency last week cut its demand forecast for this year and 2020 warning:
“The outlook is fragile with a greater likelihood of a downward revision than an upward one…Under our current assumptions, in 2020, the oil market will be well supplied.”
The third chart, from Orbital Insight, highlights the changes that have been taking place in inventory levels in the major regions.
Generated from satellite images of floating roof tank farms, it is based on estimates of the volume of oil in each tank, which are then aggregated to regional or country level.
Oil markets are by nature opaque. But Orbital’s data does show a very high correlation with EIA’s estimates for Cushing – where the official data is very reliable.
As discussed here many times before, the chemical industry is the best leading indicator for the global economy, due to its wide range of applications and geographic coverage. The fourth chart shows the steady downward trend since December 2017 in the data on Capacity Utilisation from the American Chemistry Council.
Q2 has shown the usual seasonal ‘bounce’, but key end-user markets such as electronics, autos and housing are also clearly weakening, as discussed last week for smartphones. And Bloomberg has reported that US inventory levels at major warehouses are close to being full.
I suggested back in May that prudent companies would develop a scenario approach that planned for both war and recession, given that the outcome was then essentially unknowable.
Today, both scenarios are clearly still possible. But it would seem sensible to now step up planning for recession, given the downbeat signals from oil and chemical markets.