Think back a moment to September 16 2008. Newly released transcripts analysed by the Wall Street Journal and Financial Times reveal for the first time what was really going on that day at the world’s most important central bank.
Lehman Bros, one of Wall Street’s largest investment banks, had just gone bust. Merrill Lynch, another giant, had had to be rescued. But the chairman of the US Federal Reserve, Ben Bernanke, opened the Fed’s monthly meeting that morning with the following comment:
“I think that our policy is looking actually pretty good. Overall I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change”
Janet Yellen, now Fed Chairman, was worried about minor issues such as reservations at high-end restaurants:
“My contacts report that cutbacks in spending are widespread, especially for discretionary items . . . East Bay plastic surgeons and dentists note that patients are deferring elective procedures. Reservations are no longer necessary at many high-end restaurants. And the Silicon Valley Country Club, with a $250,000 entrance fee and seven-to-eight-year waiting list, has seen the number of would-be new members shrink to a mere 13.”
These reactions would be breath-taking, if one had not already become resigned to the fact that modern central bankers are completely out of touch with the real world:
- Some, like Bernanke and Yellen, are academics who believe that the economy operates according to the principles of mathematical models. For them, there is always constant growth if the right policies are followed
- Others, like Mark Carney (then Bank of Canada; now Bank of England) and Mario Draghi (European Central Bank), are ex-Goldman Sachs deal-makers. Reality for them is closing the deal and outsmarting the other guy
As the Fed’s transcripts confirm, none of the Fed Governors had any understanding of the crisis that was developing, even as late as September 16 2008. Yet as then US Treasury Secretary Hank Paulson told the BBC’s Robert Preston last week “we were quite close to having a collapse of the financial system that was catastrophic.”
As senior editor Gretchen Morgenson of the New York Times wrote yesterday:
“My initial takeaway from these voluminous transcripts is that they paint a disturbing picture of a central bank that was in the dark about each looming disaster throughout 2008. That meant that the nation’s top bank regulators were unprepared to deal with the consequences of each new event.”
Equally worrying is that anyone with an ounce of common sense could see that a disaster was unfolding. Thus the blog wrote on September 15 2008, before the Fed meeting (after having warned consistently of this risk since 2006):
LEHMAN GOES BUST, MERRILL RESCUED
“The blog has never liked disaster movies, but it was quite a weekend for those who do. First, there was the hurricane hitting Houston and Texas.
“Then, the financial hurricane arrived in New York. By Sunday night, Lehman, the 4th largest investment bank in the US was preparing for bankruptcy. And the world’s largest brokerage firm, Merrill Lynch, had been rescued by Bank of America. Ken Lewis, head of BofA, was quoted last October as saying that ‘I’ve had all the fun I can stand in investment banking’. Many more people will be echoing that thought this morning.
“The scale of the US banking crisis is now starting to become clear to the world. The US government last week had to nationalise the two largest mortgage lenders, Fannie and Freddie. Both Bear Stearns and Merrill Lynch have had to be rescued by other banks. And now Lehman has been let go, whilst 10 of the world’s largest banks have had to establish a $70bn fund to try and mitigate the fallout from its collapse.
“Slowly but surely, what began a year ago as a sub-prime collapse, is becoming a financial disaster of epic proportions. As the Wall Street Journal, the house magazine of Wall Street, writes this morning, ‘The American financial system was shaken to its core on Sunday’. These are strong words from a publication not given to exaggeration. And more problems are round the corner, with insurance giant AIG now seeking a $40bn lifeline from the Federal Reserve.
“Company CEO’s need to start preparing contingency plans for surviving a major economic downturn. After the events of the last 48 hours, the chances of this occurring are becoming uncomfortably high. “
Yet the Fed’s senior Governors were still living in the dream-world of their mathematical models, and seemingly failed to realise even at their 16 September meeting that AIG was about to go bust that evening.
The blog makes these points for just one reason. We are now living in even more dangerous times than in September 2008. Since then, global central banks have believed they could reflate the economy via wave after wave of stimulus. They have spent $16tn of our money in this fruitless endeavour so far. They have even ignored the recent public apology to the American people from the man who ran their stimulus programme:
“We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street”
But now, the blog fears, payback time is coming near. And once again, the central bankers will be the last to realise what is happening.
What happens next could therefore be very scary indeed as the new Chinese leadership tackles the 3rd wave of the crisis that began with subprime in 2008, and was followed by the Eurozone crisis in 2011.
China’s new leadership have woken up to the risk of an “economic crash“, and have started to put their foot hard on their brakes. The outside world thinks they are bluffing, and are busy positioning themselves for another stimulus package perhaps as early as Q2.
The blog doubts that they will. It believes they understand they cannot risk ‘kicking the can down the road’ again. That is why premier Li described their new policy as “cutting one’s own wrist” in order to save the rest of the body.
We have already seen the first impact of this new policy hit an arc of countries from Argentina through S Africa, Indonesia, India and Turkey. And this is only the start of the process. Nobody can possibly know what the final impact will be, as China continues to remove its $10tn stimulus (nearly 15% of global GDP). Nobody knows, because nobody has ever had to attempt this before.
But what the history of September 2008 teaches us, is that the world’s central banks will only become aware of the impact after it has happened. We simply cannot rely on them to be the wise and far-sighted experts who can guide us safely through difficult times.
Benchmark product markets continue to show accelerating weakness in the Chinese market, with ICIS pricing comments and overall changes since January 2013 below:
PTA China, down 21%. “Weak downstream demand, coupled with an oversupplied condition in the key China markets exerted a downward pressure”
Brent crude oil, down 1%
Benzene, Europe, flat. “Players in Asia expect more March volume to be fixed for export to the US by the end of February, as it is the only outlet for sellers left due to limited demand from the Chinese market”
Naphtha Europe, down 2%. “Europe is structurally long on naphtha, and sellers need to export to the US gasoline and Asian petrochemical sectors to keep stocks in balance”
HDPE US export, up 16%. “China’s prices fell amid bearish market sentiment, based on high inventories among domestic producers and market talk that a large quantity of Iranian cargos are set to arrive at Chinese ports at the end of the month”
US$: yen, up 16%
S&P 500 stock market index, up 25%
Autos remain the world’s largest manufacturing industry, and the single biggest source of demand for chemicals and plastics. According to detailed analysis by the American Chemistry Council, each new US auto is worth $3,539 in terms of sales – and involves a wide range of products including antifreeze, plastic dashboards, bumpers and windows, as well as upholstery fibres, tyres and coatings.
So the chart above, which summarises sales in the world’s 7 largest markets since 2007, is cause for concern. These markets account for over 80% of all auto sales:
- Including China (yellow), sales have increased 18% from 47m to 55m
- But excluding China, they have fallen 2% from 41m to 40m
Equally of concern is the detailed picture:
- US sales (green) have fallen 4% over the period, EU sales (red) are down 18%
- The smaller markets have done well until recently, but have now slowed
- Brazil is up 42%, but fell 1% in 2013 (pink) despite the boost from soccer World Cup and Olympics activity
- Russia is up 4% (orange), but fell 6% in 2013: India is up 77%, but fell 7% in 2013 (blue)
- Japan is up only 4%, and was flat in 2013 (dark blue) despite the Abenomics stimulus
So a lot depends on China to power future growth. This, however, looks most unlikely to happen, for reasons discussed in the blog’s detailed analysis last week. The new leadership are already cutting back lending in the shadow banking sector, which has been the main source of finance for auto sales.
Supporting evidence for this analysis comes from developments in those countries who had been major suppliers of raw materials to China. Brazil and others have all seen their economies go into reverse as China cools.
Equally, the blog is quite doubtful about the bullish forecasts for US sales this year. It continues to believe these have been largely driven by financing deals – which made new cars more attractive than used cars. Only 42m used cars were sold in 2013, as the average price has risen 18% since 2007, due to relatively few new cars being sold in 2008-11. But now more cars are now coming on the market, and dealers expect prices to fall again.
Globally, analysts WardsAuto also report that manufacturers’ inventory in the major markets in December was 9% higher than in 2012 in both the US and Asia-Pacific, and 4% higher in Europe.
Of course, policymakers’ optimism over a sustained recovery may still turn out to be well-founded. But behind the hype, the detail of current auto industry performance suggests that any company without a Plan B risks finding themselves in a difficult position by the middle of the year.
Back in April, the blog suggested that capital controls might remain for rather longer in Cyprus than the “few days or weeks” suggested by the central bank. And a month later, the bank was still unrealistically claiming they would be lifted “as soon as possible”.
Today, the blog’s own view that they could be in place “for a decade or more” is looking more and more likely.
As the chart from the Wall Street Journal shows, the decline in GDP is accelerating, contrary to all the official forecasts. GDP fell 4.8% in Q1 and 5.4% in Q2. As the Journal notes:
“Christopher Pissarides, a Nobel laureate and head of the government’s council of economic advisers, acknowledges that the economy is sinking faster than expected.”
Credit has basically stopped on the island, with most transactions now in cash. And the economy’s downward spiral is likely to intensify. Unemployment was 17.3% in June, well above the forecast of 15.5%.
Basic industries are suffering badly. Cement sales are only 25% of those in 2008. And as Mr Pissarides added in an unguarded moment ”disaster is still some way off. But times are getting tougher.”
Clearly this is very bad news for Cypriots. But it is equally ominous for the Eurozone for 3 key reasons:
- Cyprus is in the Eurozone. Its use of capital controls means they could happen in other member countries
- Its bailout was the first one where depositors suffered major losses, also setting a precedent for the future
- The policy prescription has now had 6 months to work, and has clearly failed
This would not matter if the rest of the Eurozone was healthy. But it isn’t. Germany’s finance minister has said Greece may another bailout of perhaps €10bn.
Click here to view the embedded video.
And then there is Portugal, whose economy is also getting worse, not better, as this Financial Times video shows.
So what will happen with Greece and Portugal? Will the German taxpayer be asked to pay the bill all on their own? Or will investors instead be forced to take another ‘haircut’ – to use the phrase popularised with Cyprus?
Neither option looks good. As the blog noted in its 4 Butterflies post last month, we all know that these issues cannot be discussed before the German election on 22 September, for fear of frightening voters. Markets clearly expect Germany to then pick up the bill on 23 September. But the blog is not so sure.
Investors are complacent today, but they are not stupid. If Germany forces them to take a haircut or suffer capital controls in Portugal or Greece, they will immediately worry about what might happen next in Spain and Italy? Both will likely need outside help before too long. Spain is not a small island like Cyprus, but the 13th largest economy in the world. And Italy is not a minor country like Greece, but the world’s 9th largest economy. Combined, their economies are the same size as Germany’s.
Most large companies have some exposure to both Spain and Italy either directly or indirectly. Any CFO who hasn’t already developed a contingency plan for the period after 22 September, clearly has a few sleepless nights ahead.
2 years ago, Italy was paying 3.82% to borrow for 10 years (red column). Spain was paying 4.11%. These rates were similar to the UK’s 3.07%.
A year ago (blue column), the world was clearly changing. This led the blog to introduce the concept of the JUUGS (Japan, UK, US, Germany, Switzerland), as a ‘safe haven’ compared to the PIIGS (Portugal, Ireland, Italy, Greece, Spain).
Its argument was that investors were becoming much more interested in return of capital, rather than return on capital. This was due to the:
• Ageing population in the West, which needs to save more (and securely), for its retirement
• Loss of confidence in stock markets, which seem to have become a casino ruled by computerised trading
As the chart shows, these trends have continued in 2012 (green). Rates in Spain and Italy are now close to the 7% level where repayment becomes impossible. Thus they are in danger of joining the other PIIGS as candidates for formal debt restructuring.
Meanwhile, rates continue to fall in the JUUGS. They now average 1.2%, compared to 1.7% a year ago and 2% in August 2010. Even more remarkable is that investors are now paying interest to Germany and Switzerland when they lend money for a 2 year period:
• Investors pay Switzerland 0.36% when they lend
• They pay Germany 0.03%
Thus, as we argue in chapter 2 of Boom, Gloom and the New Normal, the Western world is following the Japanese model. Sadly, policymakers are pursuing exactly the samed failed policies as Japanese central bankers a decade ago.
Japan’s current central bank Governor has spelt out the issue very clearly in a series of speeches:
“The implications of population aging and decline are also very profound, as they contribute to a decline in growth potential, a deterioration in the fiscal balance, and a fall in housing prices.”
But it seems nobody in a position of power in the West wants to listen.
The chemical industry has a long track record as a leading indicator for the global economy. Its position in the value chain means that it sees what is happening upstream in energy markets, and downstream in consumer markets.
Anyone studying Q2 results will therefore be concerned about the outlook.
This is a major shift from Q1. Then, some companies were relatively optimistic, whilst others were more cautious. This uncertainty led the blog to suggest that “Scenario planning, based on Dow’s Upside view and Unilever’s Downside view, could prove a very valuable exercise“.
Today, there are still some companies such as Bayer and DuPont who remain optimistic about their specific market sectors. But Dow’s change of heart is a clear sign of the likely problems that lie ahead: “the global macro environment is not improving at the rate previously anticipated, and we have structured our business plans accordingly”.
In difficult times, there is a natural tendency to hide under the bedclothes, and hope the problems will go away. But wishful thinking is not a strategy, and it could easily lead to disaster. Thus the blog recommends Shell’s comment ‘moving forward in volatile times’ as a motto.
As always, it stands ready to help and advise any Board or business who would value an external perspective on the challenges and opportunities that likely lie ahead.
Air Products. “Current economic uncertainty continues to impact our near-term volume growth”
AkzoNobel. “Concerns are focused on the risk of recession in Europe, delayed recovery of the US property market and the potential of a slowdown in Asia”
Arkema. “Challenging macroeconomic environment, marked by contrasted market conditions between the various geographic regions of the world and the price fluctuations of raw materials”
BASF. “”No-one can tell when business will pick up again… Customers continued to act cautiously”
BP. “Particular weakness in aromatics margins, resulting from growing capacity and subdued demand”
Bayer. “Confident for the second half of the year”
Borealis. “Weak economic sentiment in a decreasing price environment”
Brenntag. “Brenntag operates successfully even in the current challenging economic conditions”
Celanese. “Weakened economic environment in Europe and slower growth in Asia contributed to lower sales”
CEPSA. “The burgeoning economic crisis in Europe, and particularly in Spain, continues to weigh on the company’s results”
Clariant. “Slowdown in global economic growth and the crisis in Europe did not materially impact the non-cyclical business units”
DSM. “Global economic outlook in H2 is ‘more uncertain'”
Dow. “The global macro environment is not improving at the rate previously anticipated, and we have structured our business plans accordingly”
Dow Corning. “Oversupply and high raw material costs challenged the company’s profits”
DuPont. “Agriculture, food and bioscience businesses are performing exceptionally well globally”
Evonik. “We are on course in waters that are getting rougher”
ExxonMobil. “Underlying performance weakened because of lower margins and volumes”
INEOS. “Impact of steeply declining oil prices during Q2 adversely affected May and June”
Indorama. “The last 12 months have witnessed extreme volatility that closely shadows what we experienced in H2 2008”
LG Chem. “Expects a gradual improvement in demand from China in Q3”
Lanxess. “Expects raw material and energy costs to remain volatile ”
LyondellBasell. “Fundamentals look good for the rest of the year”
Methanex. “Methanol demand has remained good and the pricing environment has been relatively stable”
Mitsubishi. “Sluggish demand from overseas markets”
Olin. “Improved prices and higher bleach and hydrochloric acid volumes, more than offset lower chlorine and caustic soda volumes”
PKN Orlen. “Market expectations of falling prices because of decreasing crude oil prices”
Oxychem. “Lower exports and prices”
PPG. “Challenging business conditions in Europe in tH”, and North America and Asia growth to remain inconsistent by end-use market”
PTT. “Weakening demand for intermediate and downstream derivative products”
Praxair. “N American business compensated for weakness in Europe and S America”
Reliance. “Weaker profit margins for polyester and polyester intermediates were slightly offset by margin deltas on polymer products”
SABIC. “Continuous slowdown in global economic growth, especially in Europe, China and North America, negatively impacted prices”
Shell. “We are moving forward in volatile times”
Siam Cement. “Negative effects of a global chemicals trough in Q1”
Solvay. “Business dynamics should remain healthy for our growth engines and challenging for our cycle sensitive businesses”
Sumitomo. “Feedstock prices spiked while selling prices of products fell”
TOTAL. “Operating margins also recovered in Q2 as a result of the decline in crude prices and reduced supply”
Unilever. “Deteriorating global economic conditions and a competitive environment which remains intense”
versalis. “Weak commodity demand impacted by the downturn”
Wacker. “Significantly lower prices, especially in the solar-silicon and semiconductor-wafer businesses
On 7 September 2008, in its now famous warning that a financial crisis was imminent, the blog noted that “‘Deleveraging’ is an ugly word, and it has ugly implications“.
The chart above shows just how ugly these implications are becoming for the PIIGS countries (Portugal, Italy, Ireland, Greece, Spain).
It is based on data produced since 2009 by the Bank for International Settlements (the central bankers’ bank), and shows the major EU lending flows to the PIIGS. It includes data just published for December 2011:
• Lending to Italy (a G7 group member) has fallen 37%
• Lending to Spain (the world’s 12th largest economy) has fallen 40%*
• Lending to Greece (now in default) is down 54%
• Lending to Portugal is down 32%, and to Ireland down 41%
Major countries simply cannot continue to operate ‘as normal’ when these vast sums of money are being withdrawn from their banking systems:
• Italy has lost $352bn, equal to 32% of its GDP
• Spain has lost $$313bn, 21% of GDP
• Greece has lost $99bn, 33% of GDP
• Portugal has lost $75bn, 32%: Ireland has lost $203bn, 93%
Overall, $1.04tn has been withdrawn, a 39% reduction since December 2009. This is equal to 23% of the PIIGS’ combined GDP.
These numbers, of course, explain why the European Central Bank (ECB) made its emergency €1tn ($1.4tn) loans at the end of December. It says it was seriously concerned “a dangerous loop involving low economic activity, funding stress for banks and a reduction in lending” might occur. This is central bank-speak for saying that the European banking system might well have collapsed.
But the ECB’s lending under the Long Term Refinancing Obligation was just that, lending. It dealt with the immediate cash-flow problem in December. But it did not deal with the solvency issue. Many of these loans will never be repaid, as the assets behind them are now worthless.
* Netherlands lending to Spain is estimated in line with June 2011 levels, as the data is not yet available