Western central bankers are convinced reflation and economic growth are finally underway as a result of their $14tn stimulus programmes. But the best leading indicator for the global economy – capacity utilisation (CU%) in the global chemical industry – is saying they are wrong. The CU% has an 88% correlation with actual GDP growth, far better than any IMF or central bank forecast.
The chart shows June data from the American Chemistry Council, and confirms the CU% remains stuck at the 80% level, well below the 91% average between 1987 – 2008, and below the 82% average since then. This is particularly concerning as H1 is seasonally the strongest part of the year – July/August are typically weak due to the holiday season, and then December is slow as firms de-stock before Christmas.
The interesting issue is why these historically low CU% have effectively been ignored by companies and investors. They are still pouring money into new capacity for which there is effectively no market – one example being the 4.5 million tonnes of new N American polyethylene capacity due online this year, as I discussed in March.
The reason is likely shown in the above chart of force majeures (FMs) – incidents when plants go suddenly offline, creating temporary shortages. These are at record levels, with H1 2017 seeing 4x the number of FMs in H1 2009.
In the past, most companies prided themselves on their operating record, having absorbed the message of the Quality movement that “there is no such thing as an accident”. Companies such as DuPont and ICI led the way in the 1980s with the introduction of Total Quality Management. They consciously put safety ahead of short-term profit and at the top of management agendas. As the Chartered Quality Institute notes:
“Total quality management is a management approach centred on quality, based on the participation of an organisation’s people and aiming at long-term success.”
Today, however, the pressure for short-term financial success has become intense
The average “investor” now only holds their shares for 8 months, according to World Bank data
This time horizon is very different from that of the 1980s, when the average NYSE holding period was 33 months
And it is a very long way from the 1960s average of 100 months
As a result, even some major companies appear to have changed their policy in this critical area, prioritising concepts such as “smart maintenance”. Such cutbacks in maintenance spend mean plants are more likely to break down, as managers take the risk of using equipment beyond its scheduled working life. Similarly, essential training is delayed, or reduced in length, to keep within a budget.
ICIS Insight editor Nigel Davies highlighted the key issue 2 years ago as the problems began to become more widespread around the world:
“The situation in Europe has exposed underlying trends and issues that will need to be addressed. Companies appear not to have sustained an adequate pace of maintenance capital expenditure. That has been for economic as well as structural (cost) reasons. Spending in high feedstock and energy cost Europe has certainly not been considered de rigeur….Having maintained plants to run at between 80% and 85% of capacity, suddenly pushing them hard does little good. Sometimes, they fail.”
The end-result has been to mask the growing problem of over-capacity, as plants fail to operate at their normal rates. This has supported profits in the short-term by making actual supply/demand balances far tighter than the nominal figures would suggest. But this trend cannot continue forever.
THE END OF CHINA’S STIMULUS WILL HIGHLIGHT TODAY’S EXCESS CAPACITY
The 3rd chart suggests its end is now fast approaching. It shows developments in China’s shadow banking sector, which has been the real cause of the apparent “recovery” and reflation seen in recent months:
Premier Li began a major stimulus programme a year ago, hoping to boost his Populist faction ahead of October’s 5-yearly National People’s Congress, which decides the new Politburo and Politburo Standing Committee (PSC)
Populist Premier Wen did the same in 2011-2 – shadow lending rose six-fold to average $174bn/month
But Wen’s tactic backfired and President Xi’s Princeling faction won a majority in the 7-man PSC, although the Populist Li still had responsibility for the economy as Premier
Li’s efforts have similarly run into the sand
As the 3-month average confirms (red line), Li’s stimulus programme saw shadow lending leap to $150bn/month. Unsurprisingly, as in 2011-2, commodity and asset prices rocketed around the world,funding ever-more speculative investments. But in February, Xi effectively took control of the economy from Li and put his foot on the brakes. Lending is already down to $25bn/month and may well go negative in H2, with Xi highlighting last week that:
“China’s development is standing at a new historical starting point, and … entered a new development stage”.
“Follow the money” is always a good option if one wants to survive the business cycle. We can all hope that the IMF and other cheerleaders for the economy are finally about to be proved right. But the CU% data suggests there is no hard evidence for their optimism.
There is also little reason to doubt Xi’s determination to finally start getting China’s vast debts under control, by cutting back on the wasteful stimulus policies of the Populists. With China’s debt/GDP now over 300%, and the prospect of a US trade war looming, Xi simply has to act now – or risk financial meltdown during his second term of office.
Prudent investors are already planning for a difficult H2 and 2018. Companies who have cut back on maintenance now need to quickly reverse course, before the potential collapse in profits makes this difficult to afford.
The clash of priorities between President Xi and Premier Li over the role of stimulus in China’s economy is close to being decided, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
The stakes are rising in China’s power battle ahead of October’s 19th Party Congress. Normally, the meeting would simply reappoint President Xi Jinping and Premier Li Keqiang for their second five-year terms. Its main business would then be to anoint their likely successors in 2022 and to replace the other five members of the powerful Politburo Standing Committee (PSC) who, by the convention known as qishang baxia, have reached the unofficial age limit of 68.
But, most unusually, signs are emerging that all may not proceed according to historical precedent. Instead, it seems that the president’s Princeling faction may have won the battle against the premier’s Populists for control of the politburo and the PSC.
Following Li’s failed “dash for growth” last year, a recent report in Xinhua, the official news agency, has suggested that Li may move to become chairman of the Standing Committee of the National People’s Congress and be replaced by vice-premier Wang Yang as premier.
This would allow Xi to consolidate his control of economic policy at Li’s expense. Top of his agenda must be the need to stem the decline in foreign exchange reserves, which have fallen by $1tn to below $3tn since their June 2014 peak. The issue is particularly urgent given President Trump’s threat to label China a currency manipulator, as the government cannot take the risk of allowing the renminbi to fall below 7 to the US dollar. As we suggested in January, interest rates have already started to rise, while capital controls have been intensified.
Commodity markets therefore seem likely to find themselves in a new round of the snakes and ladders game that began with China’s first stimulus programme in 2009. As the first chart shows, this provided a firm ladder for commodities to climb, until Xi’s first effort at reform from 2013 sent them down a snake again.
Not only did the reforms lead to a decline in total social financing (TSF) but, even more importantly, the shadow banking sector — the main source of finance for property speculation — saw its share of TSF lending collapse from 48 per cent in 2012 to 24 per cent in 2015.
Last year, however, a new ladder appeared thanks to the “dash for growth”, as the second chart shows. TSF lending increased by 14 per cent in renminbi terms, and the share lent by shadow banks rose to 28 per cent. Unsurprisingly, housing markets boomed, and Old Normal industries enjoyed a new lease of life. Oil markets also appeared to benefit as imports rose — although in reality, as Reuters has reported, “China’s additional imports of crude oil were simply processed and exported as refined products”.
Now, commodity markets may be about to find themselves at the top of a new snake. Last year’s inflationary mini-rally in commodities, sparked by Li’s policy reversal, is already running out of steam.
In oil, for example, the contango has disappeared, leading traders to start selling out of floating storage in Singapore before their profit disappears. In the west, the housing market bubbles in London and New York are also feeling the chill, as the intensification of capital controls marks the end of the Chinese-led property speculation that has powered recent gains.
The power struggle also highlights the potential importance of Xi’s recent elevation to the status of “core leader”, a title only previously held by Mao Zedong, Deng Xiaoping and Jiang Zemin. It implies that Xi’s leadership style will move away from “consensus-building” towards autocracy. In turn, this suggests that although Xi’s New Normal reforms will probably be put on hold until the Congress to avoid upsetting critical vested interests, he may well then focus on pushing through key reforms, especially the restructuring of the state-owned enterprises.
The connection was made explicit in a recent lengthy Xinhua analysis: “The new position is key for China to keep itself and the Party on the right track of development, and it marks the turning of a new chapter in the long march toward achieving the Chinese dream of national rejuvenation.”
Understandably, many investors have become entranced by the “will she, won’t she” debate now under way on whether Janet Yellen is about to raise US interest rates again. But they would be prudent to keep at least one eye on developments in China’s lending policies. Any new clampdown is likely to have a far greater and more immediate impact than any minor increases in the Fed funds rate.
Companies and investors now need to prepare for the Great Reckoning, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
We have reached the second anniversary of the Great Unwinding of policymaker stimulus. Almost inevitably, this now seems likely to be followed by a Great Reckoning, a consequence of the policy mistakes made in response to the 2008 financial crisis.
The Great Unwinding began with China’s decision to move away from the stimulus policies adopted by the previous leadership. Since then, those who expected stimulus to return have been disappointed. The leader of the Populist faction in the Politburo, Premier Li Keqiang, has attempted to manoeuvre in this direction several times, most notably with last year’s failed stock market rally. But in the end, strategy has continued to be set by President Xi Jinping and his Princeling faction, who has consistently focused on the need for structural reform with his New Normal economic programme.
Oil and commodity markets, along with the value of the US dollar, have been the leading indicators for the paradigm shift set off by the Unwinding. Oil prices have fallen by more than 50 per cent, and the USD Index has risen by around 15 per cent, as two core assumptions from the stimulus period have been over-turned, namely that:
□ Oil would always trade above $100 a barrel
□ China’s economy would always grow at double-digit rates
Chart 1: the median price of oil since 1861 has been $23 a barrel
It therefore seems highly likely, as chart 1 suggests, that oil is now returning to its median price for the past 150 years of $23 per barrel. In modern times, there have been only two occasions when it has moved away from this level:
□ The twin OPEC crises of the 1970s and 1980s, which caused a genuine shortage of product
□ The twin stimulus programmes in the 2000s and 2010s, where central bank liquidity overwhelmed the normal process of price discovery in the market
The end of stimulus has similarly impacted other major commodities, as chart 2 shows. Their pricing soared during the subprime period of the early 2000s, and went even higher during the post-2008 period. But this proved to be a temporary illusion, as the promised economic recovery was unsustainable in the long term.
Chart 2: copper and other commodities have been hit by China’s slowdown
The past two years of the Great Unwinding have, therefore, seen investors facing, Janus-like, in opposite directions at once. They could not ignore the mounting evidence of over-supply in oil markets, for example, where the International Energy Agency’s latest monthly report has warned that June saw OECD commercial stocks of crude and products “swelling by 5.7 mb (million barrels) to a record 3,093 mb”. But nor could they simply ignore the impact of new stimulus measures by central banks in Japan, Europe and the UK, as these provided the firepower to fund some short-lived but spectacular speculative rallies in futures markets.
Today, however, the chickens are coming home to roost with regard to the policy failures of the stimulus period. Pension funding has now reached “crisis point”, in the words of the UK’s former pension minister, while Deutsche Bank’s CEO has argued that ECB policies are “working against the goals of strengthening the economy and making the European banking system safer.”
The critical issue is that central banks have been in denial about the changes taking place in demand patterns as a result of ageing populations and falling fertility rates. Their Federal Reserve/US-type forecasting models still assume that raising interest rates will reduce demand, and lowering them will release this pent-up demand. But today’s increasing life expectancy and falling fertility rates are completely changing historical demand patterns. We are no longer in a world where the vast majority of the adult population belongs to the wealth creator cohort of those aged 25–54, which dominates consumer spending:
□ Increasing life expectancy means people no longer routinely die around pension age. Instead, a whole New Old generation of people in the low spending, low earning 55+ generation is emerging for the first time in history. The average western baby boomer can now expect to live for another 20 years on reaching the age of 65
□ Fertility rates in the developed world have fallen by 40 per cent since 1950. They have also been below replacement levels (2.1 babies per woman) for the past 40 years. Inevitably, therefore, this has reduced the relative numbers of those in today’s Wealth Creator cohort, just as the New Old generation is expanding exponentially
The Fed/US models are therefore long past their sell-by date. The New Olders already own most of what they need and their incomes decline as they approach retirement. So they have no pent-up demand to release when interest rates are reduced. In fact, they have to save more and spend even less, in order to avoid running out of cash during their unexpectedly extended retirement. A more modern forecasting model, based on these demographic realities, would immediately recognise that demand growth and inflation are therefore likely to be much weaker than in the past.
“You cannot print babies” should be the motto hanging on every central bankers’ wall. Unfortunately, it is too late to quickly reverse their demographic myopia. Instead, the Great Unwinding is now set to evolve into the Great Reckoning. Investors, companies and individuals must prepare for heightened levels of volatility, as markets continue their return to being based on the fundamentals of supply and demand, rather than central bank liquidity.
Paul Hodges publishes The pH Report, providing investors and companies with insight on the impact of demographic changes on the economy.
Cotton markets are poised for another testing month in April. The outcome will also have potentially major implications for the polyester chain – and in turn for commodities markets more generally.
The reason is that China has announced that its long-awaited cotton auction will take place in the second half of the month. Cotton stocks are at all-time record highs – enough to make 3 pairs of jeans for everyone in the world – following the disastrous impact of stimulus policies, and China currently holds 11 million tonnes in store.
A lot is hanging on this auction, which will also tell us whether President Xi Jinping has now taken full charge of economic policy:
- Last year, an auction was announced for 1 million tonnes, but prices were set so high that only 63kt was sold
- The problem was resistance from an army-owned company, Xinjiang Production and Construction Corps
- It produces around 30% of China’s cotton, and opposed policies that would reduce its income by lowering prices
- It is also an important employer in Xinjiang province, accounting for 17% of its GDP
- But recently, as I noted in January, there have been signs that Xi is determined to make progress on the issue
This will have important implications for the polyester chain, as the chart above confirms.
Retailers vary their blends of polyester/cotton depending on relative prices, and the oil price fall has helped to support PTA/polyester demand in recent months. But as we note in the new “Demand – the New Direction for Profit” Study, China now also has enough PTA capacity to supply total world demand. So lower prices on cotton will likely lead to major price pressure on polyester, and across the textile chain.
In turn, this will pressure commodity markets more generally.
China’s New Normal policies have burst the commodities bubble created by policymaker stimulus. There has been a brief respite in recent weeks, as hedge funds realised the central banks were about to panic, once again. They knew the stimulus policies weren’t working, and that more free cash would soon become available. Oil prices jumped 50% as a result, along with other commodities.
But China is the real key to the outlook, as it has been since Xi became President in 2013. His most logical policy is to take the pain of restructuring this year. He can then move towards reappointment in 2017 by stressing that he has dealt with the problems he inherited, and can promise a better future ahead.
The outcome of the cotton auctions will be a key indicator for the global economic outlook for the rest of 2016.
Shell Chemicals General Manager, Kate Johnson, asked a great question at our Conference last week, to which not a single hand went up in reply, as everyone had forecast an oil price around $100/bbl :
“How many of your companies used $60/bbl as their oil price forecast in the 2015 Budget?”
“Group think” is clearly alive and well in the chemical industry. And according to some delegates, it means that executives routinely refuse to mention the potential for low oil prices within their company. This would “only cause trouble”, said one, “as it would undermine the investment case for our US projects”.
Budgets and strategies are, of course, supposed to be about reality. And one topic on which everyone agreed at the Conference was that we were seeing chaos in both feedstock and end-product markets:
- Chaos in the feedstock markets caused by the ongoing collapse of oil prices, combined with the collapse of natural gas and coal prices, due to over-supply
- Chaos in end-product markets caused by China’s decision to move away from its previous stimulus policies, and by the drop in demand linked to the ageing of the global population
Is it sensible, therefore for companies and investors to continue to ignore the impact of these factors on their likely future sales and profits? Or, to put it another way, how much money have they lost this year by having failed to prepare for the impact of over-supplied energy markets and the demand downturn?
This, of course, is why we have launched our 5 Critical Questions Study with ICIS, to look at the potential impact of different Scenarios:
- Clearly it would be foolish to ignore the fact that Brent prices have been around $50/bbl for most of this year
- It would also be foolish to ignore that they were at $100/bbl before this
- But isn’t it equally foolish to ignore that, as the chart shows, they have averaged much lower prices over history?
They have averaged $34/bbl in $2015 since 1861 when BP data begins. And they average just $24/bbl if one leaves out the price peaks due to the OPEC crisis and recent central bank liquidity programmes.
Developments in the US oil sector also confirm the danger of indulging in wishful thinking over prices. As Reuters reported, CEOs learnt a painful lesson earlier this year, when they failed to hedge their production at higher prices:
“Oil producers’ rapid response to the latest move upward comes in contrast to the second quarter, when a moderate price recovery was met with only modest hedging interest as many executives bet – wrongly – that the worst was already behind them….for some, hedging is now less an insurance policy than a lifeline as those who have scrimped on protection watched with despair oil prices shuffling between $43 and $48 for six weeks.
Other key indicators are also indicating the potential for further price weakness:
- US oil companies routinely sell off inventory in December to avoid year-end taxes
- Inventories for US natural gas (which competes with oil) have risen to all-time highs of 4tn cu ft
- There are queues of oil tankers waiting to discharge at many major ports
- Iran has said it will continue to increase production even if prices drop to $20/bbl
- The International Energy Agency says global inventories are at a record 3bn barrels (a month’s world supply)
- Iraq is already selling its heavy crude at $30/bbl for December as it ramps up exports
Plus of course, there is ample evidence from other commodity markets that China’s slowdown is causing prices to return to historical levels, or lower. The Baltic Dry Index, which reflects demand for copper, iron ore, fertiliser and other commodities is now trading at all-time low.
Of course, oil markets are always full of surprises. But is it really sensible for companies to refuse to even consider perfectly reasonable oil price Scenarios?
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 58%
Naphtha Europe, down 52%. “Naphtha refining margins rose to a near five-year high this week on the back of high-volume exports to Asia, and helped by a fresh wave of West African gasoline demand.”
Benzene Europe, down 56%. “US benzene markets as well as crude oil and energy movements have steered prices.”
PTA China, down 41%. “An increase in export volumes is expected next year as China looks for sales outlets for locally-produced product”
HDPE US export, down 33%. “Prices for domestic exports moved up on thinning supply”
¥:$, down 20%
S&P 500 stock market index, up 7%
China’s New Normal policies are taking global commodity markets in a new direction, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Commodity prices could well have further to fall, now China’s business model has changed. It is no longer aiming to achieve high levels of economic growth by operating an export-focused development model, supported by vast infrastructure spending. Instead, its New Normal policies aim to boost domestic consumption, by creating a services-led model based on exploiting the opportunities created by the power of the internet.
The only problem is that markets have failed to notice this change. They have fallen victim to the phenomenon of “anchoring” as identified by Nobel Prizewinner Daniel Kahneman, and assume the New Normal is similar to the Old Normal. Thus, much analysis on commodity markets still focuses on guessing “when will the rally begin?”
This approach ignores the potential for prices to instead fall further, back to the levels common before their China-inspired boom began in 2003, as no other country or region can possibly replace China now its demand has stalled.
The problem is that the vast expansions of recent years have been based on two false assumptions. The first was that up to 3bn people were about to become middle class by western standards. The second was that this would drive a ‘super-cycle’ of new demand.
In its paper The rise of the middle class in the PRC in 2011, the Asian Development Bank argued: “Using $2–$20 (purchasing power parity) per capita daily income as the definition of middle class, majority of households in the PRC have become middle class by 2007.”
Understandably, many people heard the words “middle class” but didn’t understand the definition. Yet as the Pew Research Center reported recently: “People who are middle income live on $10-20 a day, which translates to an annual income of $14,600 to $29,200 for a family of four. That range merely straddles the official poverty line in the United States—$23,021 for a family of four in 2011.”
Pew’s report also confirmed that 84 per cent of the world’s population have incomes below the US poverty line. It also noted that 87 per cent of all those earning more than $50 a day live in North America and Europe, with just 1 per cent living in Africa, 4 per cent in Latin America and 8 per cent in Asia.
The wishful thinking was compounded by the stimulus policies adopted by central banks from 2004, first through the subprime bubble and then through quantitative easing. By keeping interest rates very low and then printing trillions of dollars, they created massive bubbles in financial and property markets. In turn, this created one-off ‘wealth effects’ which temporarily appeared to have boosted consumer demand.
Prices of key raw materials such as oil, copper, iron ore and cotton raced higher, in some cases to new all-time highs. The investment thesis was simple: the coming supercycle would inevitably require unprecedented volumes of raw materials, and provide earnings to match for those companies who chose to invest in the new capacity required. The commodity bubble thus paralleled earlier dotcom and subprime bubbles in featuring extravagant optimism and a surge in debt. Investors came to believe that a new investment paradigm was in place, under which previous valuation models no longer mattered.
Importantly also, they felt they had the power of the US Federal Reserve behind them, as the Fed continued to assume that creating a wealth effect through a rising stock market was key to economic stability. Since 2000, a whole generation of investors has been brought up to believe that the ability to forecast the Fed’s intentions is therefore more important than understanding the fundamentals of supply and demand. Investment success has instead flowed from following the ‘buy-on-the-dips’ theory.
Now it seems the commodity bubble is bursting. And, as before, investors may discover to their cost that leading companies of the bubble era have been, in Warren Buffett’s immortal phrase, “swimming naked” – paralleling Enron and WorldCom in dotcom times, Lehman Bros and AIG in subprime. The recent share price performance of some commodity bubble companies certainly suggests this time may not be so different after all.
Equally worrying is that commodity-exporting countries in a wide arc from Brazil through South Africa, Asia, Australia, the Middle East and Russia are now seeing major downturns in their economies, whilst vast surpluses have been created in key products. For example, oil inventory is at record levels around the world; aluminium surpluses are enough to build 16,000 747s; cotton inventories are enough to produce 129bn T-shirts.
A further problem with the commodity bubble is that the downturn is not contained within national borders. Developed country investors and companies had been delighted to fund EM commodity export expansions, due to the higher prospective yields on offer. Thus a recent paper from the Bank for International Settlements noted: “Outstanding USD-denominated debt of non-banks located outside the US stood at $9.2tn at September 2014, having grown from $6tn at the beginning of 2010.”
Too many companies and investors remain in denial about recent developments in commodity prices. They seem determined to wear their rose-tinted glasses until the last possible minute, suggesting that prices still have further to fall. But more rational observers may instead worry about the after-shocks that will impact those companies, countries, investors and lenders who chose to believe that China’s seemingly insatiable appetite for commodities had created a new investment paradigm