We are living in a strange world. As in 2007 – 2008, financial news continues to be euphoric, yet the general news is increasingly gloomy. As Nobel Prizewinner Richard Thaler, has warned, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” Both views can’t continue to exist alongside each other for ever. Whichever scenario comes out on top in 2018 will have major implications for investors and companies.
It therefore seems prudent to start building scenarios around some of the key risk areas – increased volatility in oil and interest rates, protectionism and the threat to free trade (including Brexit), and political disorder. One key issue is that the range of potential outcomes is widening.
Last year, for example, it was reasonable to use $50/bbl as a Base case forecast for oil prices, and then develop Upside and Downside cases using a $5/bbl swing either way. But today’s rising levels of uncertainty suggests such narrow ranges should instead be regarded as sensitivities rather than scenarios. In 2018, the risks to a $50/bbl Base case appear much larger:
- On the Downside, US output is now rising very fast given today’s higher prices. The key issue with fracking is that the capital cost is paid up-front, and once the money has been spent, the focus is on variable cost – where most published data suggests actual operating cost is less than $10/bbl. US oil and product exports have already reached 7mbd, so it is not hard to see a situation where over-supplied energy markets cause prices to crash below $40/bbl at some point in 2018
- On the Upside, instability is clearly rising in the Middle East. Saudi Arabia’s young Crown Prince, Mohammad bin Salman is already engaged in proxy wars with Iran in Yemen, Syria, Iraq and Lebanon. He has also arrested hundreds of leading Saudis, and fined them hundreds of billions of dollars in exchange for their release. If he proves to have over-extended himself, the resulting political confusion could impact the whole Middle East, and easily take prices above $75/bbl
Unfortunately, oil price volatility is not the only risk facing us in 2018. As the chart shows, the potential for a debt crisis triggered by rising interest rates cannot be ignored, given that the current $34tn total of central bank debt is approaching half of global GDP. Most media attention has been on the US Federal Reserve, which is finally moving to raise rates and “normalise” monetary policy. But the real action has been taking place in the emerging markets. 10-year benchmark bond rates have risen by a third in China over the past year to 4%, whilst rates are now at 6% in India, 7.5% in Russia and 10% in Brazil.
An “inflation surprise” could well prove the catalyst for such a reappraisal of market fundamentals. In the past, I have argued that deflation is the likely default outcome for the global economy, given its long-term demographic and demand deficits. But markets tend not to move in straight lines, and 2018 may well bring a temporary inflation spike, as China’s President Xi has clearly decided to tackle the country’s endemic pollution early in his second term. He has already shutdown thousands of polluting companies in many key industries such as steel, metal smelting, cement and coke.
His roadmap is the landmark ‘China 2030’ joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition: “From policies that served it so well in the past to ones that address the very different challenges of a very different future”.
But, of course, transitions can be a dangerous time, as China’s central bank chief, Zhou Xiaochuan, highlighted at the 5-yearly Party Congress in October, when warning that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008 in the west.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t face a need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. Nobody wanted to be focusing on contingency plans when everybody else seemed to be laughing all the way to the bank.
I discuss these issues in more detail in my annual Outlook for 2018. Please click here to download this, and click here to watch the video interview with ICB deputy editor, Will Beacham.
The post The return of volatility is the key market risk for 2018 appeared first on Chemicals & The Economy.
The world is coming to the end of probably the greatest financial bubble ever seen. Since the financial crisis began in 2008, central banks in China, the USA, Europe, the UK and Japan have created over $30tn of debt.
China has created more than half of this debt as the chart shows, and its total debt is now around 260% of GDP. Its actions are therefore far more important for global financial markets than anything done by the Western central banks – just as China’s initial stimulus was the original motor for the post-2008 “recovery”.
Historians are therefore likely to look back at last month’s National People’s Congress as a key turning point.
It is clear that although Premier Li retained his post, he has effectively been sidelined in terms of economic policy. This is important as he was the architect of the stimulus policy. Now, President Xi Jinping appears to have taken full charge of the economy, and it seems that a crackdown may be underway, as its central bank chief governor Zhou Xiaochuan has been explaining:
- Zhou first raised the issue at the National Congress last month, warning of the risk of a “Minsky Moment” in the economy, where debt or currency pressures could park a sudden collapse in asset prices – as occurred in the US subprime crisis. “If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. We should focus on preventing a dramatic adjustment.”
- Then last week, he published a warning that “China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing. [China] should prevent both the “black swan” events and the “gray rhino” risks.”
We can be sure that Zhou was not speaking “off the cuff” or just in a personal capacity when he made these statements, as his comments have been carried on both the official Xinhua news agency and on the People’s Bank of China website. As Bloomberg report, he went on to set out 10 key areas for action:
- “China’s financial system faces domestic and overseas pressures; structural imbalance is a serious problem and regulations are frequently violated
- Some state-owned enterprises face severe debt risks, the problem of “zombie companies” is being solved slowly, and some local governments are adding leverage
- Financial institutions are not competitive and pricing of risk is weak; the financial system cannot soothe herd behaviors, asset bubbles and risks by itself
- Some high-risk activities are creating market bubbles under the cover of “financial innovation”
- More companies have been defaulting on bonds, and issuance has been slowing; credit risks are impacting the public’s and even foreigners’ confidence in China’s financial health
- Some Internet companies that claim to help people access finance are actually Ponzi schemes; and some regulators are too close to the firms and people they are supposed to oversee
- China’s financial regulation lags behind international standards and focuses too much on fostering certain industries; there’s a lack of clarity in what central and regional government should be responsible for, so some activities are not well regulated
- China should increase direct financing as well as expand the bond market; reduce intervention in the equity market and reform the initial public offering system; pursue yuan internationalization and capital account convertibility
- China should let the market play a decisive role in the allocation of financial resources, and reduce the distortion effect of any intervention
- China should improve coordination among financial regulators”
Clearly, Xi’s reappointment as President means the end of “business as usual” for China, and for the support provided to the global economy by Li’s stimulus policies. Xi’s own comments at the Congress confirm the change of direction, particularly his decision to abandon the idea of setting targets for GDP growth. As the press conference following the Congress confirmed, the focus is now on the quality of growth:
“China’s main social contradiction has changed and its economic development is moving to a stage of high-quality growth from a high-rate of expansion of the GDP,” said Yang Weimin, deputy head of the Office of the Central Leading Group on Financial and Economic Affairs. “The biggest problem facing us now … is the inadequate quality of development.”
Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy. China’s lending bubble – particularly in property, is likely coming to an end. In turn, this will lead to a bumpy ride for the global economy.
It was almost exactly 10 years ago that then Citibank boss, Chuck Prince, unintentionally highlighted the approach of the subprime crisis with his comment that:
‘We are not scared. We are not panicked. We are not rattled. Our team has been through this before.’ We are ’still dancing’.”
On Friday JP Morgan’s CEO, Jamie Dimon, provided a new and more considered warning:
“Since the Great Recession, which is now 8 years old, we’ve been growing at 1.5% – 2% in spite of stupidity and political gridlock….We have become one of the most bureaucratic, confusing, litigious societies on the planet. It’s almost an embarrassment being an American citizen traveling around the world and listening to the stupid s— we have to deal with in this country. And at one point we all have to get our act together or we won’t do what we’re supposed to [do] for the average Americans.”
The chart above, from OECD data, highlights one key result of the dysfunctionality that Dimon describes:
Central bank stimulus has proved to be a complete failure, as it cannot compensate for today’s “demographic deficit”
UK debt as a percentage of GDP has more than doubled from 51% in 2007 to 123% last year
US debt has risen from an already high 77% in 2007 to 128% last year
Japanese debt has risen from an insane 175% in 2007 to an impossible-to-repay 240%
Debt is essentially just a way of bringing forward demand from the future. If I can borrow money today, I don’t have to wait till tomorrow to buy what I need. But, I do then have to pay back the debt – I can’t borrow forever. So high levels of debt inevitably create major headwinds for future growth.
Unfortunately, central banks and their admirers thought this simple rule didn’t apply to them. They imagined they could print as much money as they liked – and then, magically, all the debt would disappear through a mix of economic growth and inflation. But as the second chart shows, they were completely wrong:
In April 2011, the IMF forecast global GDP in 2016 would be 4.7%
In April 2013, they were still convinced it would be 4.5%
Even in April 2015, they were confident it would be 3.8%
But in reality, it was just 3.1%
And meanwhile inflation, which was supposed to help the debt to disappear in real terms, has also failed to take off. US inflation last month was just 1.6%, and is probably now heading lower as oil prices continue to decline.
In turn, this dysfunctionality in economic policy is creating political and social risk:
The UK has a minority government, which now has to implement the Brexit decision. This represents the biggest economic, social and political challenge that the UK has faced since World War 2. But as the former head of the UK civil service warned yesterday:
“The EU has clear negotiating guidelines, while it appears that cabinet members haven’t yet finished negotiating with each other, never mind the EU”. He calls on ministers to “start being honest about the complexity of the challenge. There is no chance all the details will be hammered out in 20 months. We will need a long transition phase and the time needed does not diminish by pretending that this phase is just about ‘implementing’ agreed policies as they will not all be agreed.”
The US faces similar challenges as President Trump aims to take the country in a completely new direction. As of Friday, 6 months after the Inauguration, there are still no nominations for 370 of the 564 key Administration positions that require Senate confirmation. And last week, his Secretary of State, Rex Tillerson, highlighted some of the challenges he faces when contrasting his role as ExxonMobil CEO with his new position:
“You own it, you make the decision, and I had a very different organization around me… We had very long-standing, disciplined processes and decision-making — I mean, highly structured — that allows you to accomplish a lot, to accomplish a lot in a very efficient way. [The US government is] not a highly disciplined organization. Decision-making is fragmented, and sometimes people don’t want to take decisions. Coordination is difficult through the interagency [process]…and in all honesty, we have a president that doesn’t come from the political world either.”
Then there is Japan, where Premier Abe came to power claiming he would be able to counter the demographic challenges by boosting growth and inflation. Yet as I noted a year ago, his $1.8tn of stimulus has had no impact on household spending – and consumer spending is 60% of Japanese GDP. In fact, 2016 data shows spending down 2% at ¥2.9 million versus 2012, and GDP growth just 1%, whilst inflation at only 0.4% is far below the 2% target.
As in the UK and US, political risk is now rising. Abe lost the key Tokyo election earlier this month after various scandals. Voter support is below 30%, and two-thirds of voters “now back no party at all” – confirming the growing dysfunctionality in Japanese politics.
WOULD YOU LEND TO A FRIEND WHO RUNS UP DEBT WITH NO CLEAR PLAN TO PAY IT BACK?
So what is going to happen to all the debt built up in these 3 major countries? There are already worrying signs that some investors are starting to pull back from UK, US and Japanese government bond markets. Over the past year, almost unnoticed, major moves have taken place in benchmark 10-year rates:
UK rates have nearly trebled from 0.5% to 1.3% today
US rates have risen from 1.4% to 2.3% today;
Japanese rates have risen from -0.3% to +0.1% today.
What would happen if these upward moves continue, and perhaps accelerate? Will investors start to agree with William White, former chief economist of the central bankers’ bank (Bank for International Settlements), that:
“To put it in a nutshell, if it’s a debt problem we face and a problem of insolvency, it cannot be solved by central banks through simply printing the money. We can deal with illiquidity problems, but the central banks can’t deal with insolvency problems”.
White was one of the few to warn of the subprime crisis, and it seems highly likely he is right to warn again today.
“There is a distinct difference between “suspense” and “surprise.” Alfred Hitchcock
It is now 2 years since the start of the Great Unwinding of policymaker stimulus. On 15 August 2014, Brent was at $105/bbl, and the US$ Index was at 81. Since then, as the chart shows, Brent oil prices have fallen 53%, whilst the US$ Index has risen 16%.
These are astonishing moves, given that they were more or less totally unexpected by consensus thinking. What is even more astonishing is that they have not yet prompted any major changes in consensus assumptions about the outlook for the global economy.
“Yet”, of course, is the operative word. As the great film director Alfred Hitchcock explained:
“We are now having a very innocent little chat. Let’s suppose that there is a bomb underneath this table between us. Nothing happens, and then all of a sudden, “Boom!” There is an explosion. The public is surprised, but prior to this surprise, it has seen an absolutely ordinary scene, of no special consequence.
“Now, let us take a suspense situation. The bomb is underneath the table and the public knows it, probably because they have seen the anarchist place it there. The public is aware the bomb is going to explode at one o’clock and there is a clock in the decor. The public can see that it is a quarter to one. In these conditions, the same innocuous conversation becomes fascinating because the public is participating in the scene. The audience is longing to warn the characters on the screen: “You shouldn’t be talking about such trivial matters. There is a bomb beneath you and it is about to explode!”
“In the first case we have given the public fifteen seconds of surprise at the moment of the explosion. In the second we have provided them with fifteen minutes of suspense.”
This exactly describes the state of financial markets today. Some people have seen the bomb being placed under the table – not by the anarchist, but the the central banks. It is the debt they have created, that can never been repaid.
But consensus thinking is still chatting idly away, convinced that markets are in an absolutely ordinary state. When the debt bomb explodes, they will claim to be surprised – just as they claimed after 2008 that “nobody could have seen the financial crisis coming“.
The rest of us remain in a state of suspense. We know the bomb will explode, even though – unlike in Hitchcock’s movie – there is no clock visibly ticking away to tell us exactly when this will take place. What we do know, however – after 2 years of the Great Unwinding – is that the Great Reckoning is coming close:
□ Until now, we have merely seen the unwinding of policymakers’ ability to hijack markets in their desired direction
□ Today, however, markets are rediscovering their core role of price discovery, based on supply/demand fundamentals
□ The rise in oil market volatility is one clear sign of this – one moment, traders worry about new liquidity from the central banks; next, they worry about where to store all the surplus oil and gasoline that is being produced
Today, on the second anniversary of the Great Unwinding, the focus is now moving to the next scene, the Great Reckoning. That is the moment when people no longer worry about anticipating the impact of stimulus policies on financial markets. Instead, they will worry, once again, about real world issues.
Suspense is therefore rising for those of us who have seen this movie before in 2008. But for everyone else, life simply appears to be going on as normal.
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 53%
Naphtha Europe, down 54%. “A few European refiners are beginning to cut back on crude processing because of the lower margins”
Benzene Europe, down 49%. “Strong downstream demand in Asia has also pushed benzene prices in the region higher”
PTA China, down 41%. “Market expected to remain bearish until mid-September”
HDPE US export, down 27%. “Subdued buying appetite at the high-end prices weighed on prices”
S&P 500 stock market index, up 12%
US$ Index, up 16%
Central bankers remain in Denial about the failure of their stimulus policies. Yet new IMF data for global GDP shows GDP fell by $3.8tn in 2015 – the biggest fall on record – as the world hits the “demographic cliff”. We have now seen 2 record falls in 6 years, as the previous record was $3.3tn in 2009.
This confirms that the fault lines are now opening in the ‘Ring of Fire’, as discussed on Monday. As William White has warned:
“The global financial system has become dangerously unstable and faces an avalanche of bankruptcies that will test social and political stability. The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up.”
Sadly, today’s central bankers are just as blind to his warnings as they were in 2007-8. Thus European Central Bank head Mario Draghi set off another mini-rally in shares and oil markets on Thursday, promising he would print more money to boost financial markets. He made the same promise last month, also causing markets to rally sharply.
Yet common sense tells us that you cannot have the same levels of growth today as in the past. As the chart shows, the world has now reached the “demographic cliff“. We now have 1bn people moving into the low-spending, low-earning New Old 55+ generation for the first time in history. They will be more than 1 in 5 of the population by 2030, twice the percentage in 1950.
So as White warns, the next recession will reveal that many of today’s debts will never be repaid:
- White mentions a major Chinese devaluation as one potential cause of recession
- The European refugee crisis is anther potential flashpoint, with the President of the European Commission continually warning that “a single currency does not exist if the Schengen (open European border Treaty) fails“. This problem is increasingly urgent, as more and more countries re-introduce border controls, and public opinion polarises after the Paris and Cologne attacks
- Then there are potential flashpoints in the Middle East and, of course, in Eastern Europe
- Plus, there is the vast debt associated with US financial markets, which complacently believe the central banks will never let prices fall
I am sure White is right again this time. It is very hard to see how this debt can possibly be repaid, as the global economy continues to slow under the influence of its rapidly ageing population. Historically, as he says, debt Jubilees used to occur every 50 years, going back to Sumerian times, and were when all debts were forgiven.
This will have to happen again in our society. McKinsey’s report last year highlighted the vast debt that has been built up since 2007 – which is now 3x world GDP. A simple calculation reveals the scale of the problem:
- McKinsey estimated world debt increased by $57tn between 2007 – 2014
- Global GDP grew by $19.8tn from $57.5tn to $77.3tn over the same period (IMF data)
- It therefore took $2.9tn of debt to add $1tn of GDP growth
- To put it another way round, $1 of debt gave only 35 cents of GDP growth
- In the 2000-7 period, each $1 of debt gave 45 cents of growth – so the trend is clearly getting worse
And yet, of course, central bankers still insist that adding more debt is the way to solve today’s crisis. They seem to be in total Denial about the fact that if $1 of lending creates only 35 cents of growth, you are effectively wasting the other 65 cents. I therefore fear that White’s warning supports the forecast in my 2016-18 Budget Outlook:
“2016 will see China putting its foot hard on the brakes of the Old Normal economy – whilst Western policymakers compete to ramp up stimulus to compensate. It could easily prove to be as difficult a year as 2008. Companies owe it to themselves to plan ahead for this Scenario. ’Flash crashes’ take place in a flash, not over months. It could prove too late afterwards to regret that you had failed to put the necessary contingency plan in place.”
Its not what we know that causes the major problems. Its what we think we know, but don’t.
We know, for example, that markets balance supply and demand by shifting prices up and down. Too much demand and/or too little supply, will mean higher prices and inflation. This is what happened as the BabyBoom took place:
- Medical advances and high fertility rates meant that the world population nearly doubled between 1950 – 1980, from 2.5bn to 4.4bn
- Yet supply was still recovering after the destruction caused during World War 2
- The result was major inflation, as prices moved higher to effectively ration demand.
But central banks instead think they know from their theoretical models that inflation is really caused by printing too much money. They follow Milton Friedman’s theory, who won a Nobel Prize in 1976 for his argument that:
“Inflation is always and everywhere a monetary phenomenon”
As a result, they have now spent nearly $25tn since 2009 in stimulus spending. Overall, global debt has risen by $57tn since 2007, taking it to 3x GDP at $199tn. The idea was that printing all this money would generate inflation, and lead to economic recovery.
But as the chart shows, the policy has failed, utterly and completely. Inflation did rise temporarily as the stimulus began. It then peaked in 2011, and has since been falling quite sharply. This is despite the major new stimulus spending from Abenomics in Japan since 2012, and Draghinomics in the Eurozone since March this year.
Instead, the gradual removal of stimulus in China, under its New Normal policies, is creating long-term deflation:
- China’s Producer Price Inflation has been negative for 3 years, and was -5.4% last month (red line)
- China’s role as the manufacturing capital of the world means this deflation is being exported to consumers
- UK Consumer Price Inflation (CPI) peaked at 5.2% but is now just 0.1% (purple)
- Japan’s CPI peaked at 3.7% after the start of Abenomics, but is now back at 0.4% (yellow)
- US and Eurozone CPI are also now close to zero at just 0.2% (green, blue)
And, of course, these CPI levels will likely fall further under the impact of the ongoing collapse in commodity prices and the lower import prices caused by China’s devaluation.
Debt and deflation are a toxic combination, as the value of debt increases with inflation. Debt reduces spending power, whilst deflation leads consumers to defer purchases as prices will be lower tomorrow. It therefore seems most unlikely that the next few years will be “business as usual” for most companies and investors.