Paradigm shifts create Winners and Losers

MY ANNUAL BUDGET OUTLOOK WILL BE PUBLISHED NEXT WEEK
Next week, I will publish my annual Budget Outlook, covering the 2020-2022 period. The aim, as always, will be to challenge conventional wisdom when this seems to be heading in the wrong direction.

Before publishing the new Outlook each year, I always like to review my previous forecast. Past performance may not be a perfect guide to the future, but it is the best we have:

The 2007 Outlook ‘Budgeting for a Downturn‘, and 2008′s ‘Budgeting for Survival’ meant I was one of the few to forecast the 2008 Crisis.  2009′s ‘Budgeting for a New Normal’ was then more positive than the consensus, suggesting “2010 should be a better year, as demand grows in line with a recovery in global GDP“.  Please click here if you would like to download a free copy of all the Budget Outlooks.

LAST YEAR’S OUTLOOK WARNED OF KEY RISKS TO THE ECONOMY AND BUSINESS
My argument last year was that companies should be ‘Budgeting for the end of ‘Business as Usual‘:

A year later, this view is starting to become consensus:

  • Global auto markets are now clearly in decline, down 5% in January-September versus 2018, whilst the authoritative CPB World Trade Monitor showed trade down 0.8% in Q2 after a 0.3% fall in Q1
  • Liquidity is clearly declining in financial markets as China’s slowdown spreads, and US repo markets confirm: Western political debate is ever-more polarised
  • The US$ has been rising due to increased uncertainty, creating currency risk for those who have borrowed in dollars; geopolitical risks are becoming more obvious
  • “Bubble stocks” such as WeWork, Uber and Netflix have seen sharp falls in their valuations, leading at least some investors to worry about “return of capital”
  • The ongoing decline in global chemicals Capacity Utilisation, the best leading indicator for the global economy, suggests recession is close. This will lead to bankruptcies in over-leveraged firms and to major downgrades in the BBB corporate bond market

The rising risks in the US repo market confirm the concerns over the level of debt in global markets.

Developments over the past month suggest New York markets are now systemically short of overnight money, with the Fed’s balance sheet suddenly starting to expand again. It was $3.76tn on 4 Sept, but reached $3.97tn on 16 October, a $210bn rise in just 5 weeks.

It is therefore looking more and more likely that we are at the start of a  global debt crisis.

The last 10 years have proved that stimulus programmes cannot substitute for a lack of babies. They generate debt mountains instead of sustainable demand, and so make the problems worse, not better.

Unfortunately, they also have a political dimension, as they encourage voters to listen to new voices, such as the Populists, who offer seemingly simple solutions to the problems which have been ignored by the elites.

The one redeeming feature of the 2008 Crisis was that global leaders did at least manage to come together to restore financial liquidity.  It is hard to be confident that this would happen again, if a debt crisis does begin.

$50bn hole appears in New York financial markets – Fed is “looking into it”

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.

 

G7 births hit new record low, below Depression level in 1933

If a country doesn’t have any babies, then in time it won’t have an economy. But that’s not how the central banks see it.

For the past 20 years, through subprime and now their stimulus policies, they have believed they could effectively “print babies”.  Even today, they are still lining up to take global interest rates even further into negative territory.

But common sense tells us their policy cannot work:

  • New data shows 2018 births in the G7 richest Western countries were just 7.8m
  • This was the lowest level seen since records began in 1921
  • It was even lower than at the height of the Depression in 1933 when births dropped to 7.99m/year
  • By comparison during the 1946-70 BabyBoom, they averaged 10.1m/year and peaked at 10.6m

The chart above confirms the unique nature of the Western BabyBoom.  Births jumped by 15% versus the previous 25 years, and since then they have fallen by an average 17%. Every single country is now having fewer births than at the peak of the Boom:

  • US births were 3.79m last year, versus a peak of 4.29m in 1959
  • Japan had 0.92m versus 2.7m in 1949; Germany had 0.79m versus 1.36m in 1963

The BabyBoom mattered because the Boomers were part of the richest society the world has ever seen.  In 1950, the G7 were half of the global economy, and they were still 45% in 2000. The “extra babies” born during the Boom, effectively created a new G7 economy the size of Canada.

But since 1970, the West has not been replacing its population, as fertility rates have been below 2.1/babies per woman.  This matters, as the second chart shows for the USA, the world’s largest economy.

Consumer spending is 70% of GDP, and it peaks in the 25-54 Wealth Creator generation – when people are building their careers and often settle down and have children.  Spend then drops by over 40% by the age of 75.

This didn’t matter very much for the economy in the past, when most people died around pension age:

  • In 1950, for example, there were just 130m Westerners in the Perennials 55+ age group.  By comparison, there were 320m Wealth Creators and 360m under 25
  • But today, there are 390m Perennials compared to 515m Wealth Creators and just 350m under-25s

This means it is impossible to recreate the growth of the Boomer-led SuperCycle.

Does this matter? Not really.

Most of us would prefer to have the extra 15-20 years of life that we have gained since 1950.  But because policymakers have pretended they could print babies via their stimulus programmes, they were able to avoid difficult discussions with the electorate about the impact of the life expectancy bonus.

Now, this failure is catching up with them.  Perennials are, after all, effectively a replacement economy. They already own most of what they need, and their incomes decline as they move into retirement. So we need to adjust to this major change:

  • In 1950, it was normal for people to be born and educated, before working to 65 and then dying around pension age
  • Today, we need to add a new stage to this paradigm – where we retrain around the age of 55, probably into less physically demanding roles where we can utilise the experience we have gained
  • This would have tremendous benefits for individuals in terms of their physical and mental health and, of course, it would reduce the burden on today’s relatively fewer Wealth Creators
  • It is completely unfair, after all, for the Boomers to demand their children should have a lower standard of living, and instead support their parents in the Perennials cohort

There is, of course, one other fantasy peddled by the central banks as part of their argument that monetary policy can always create growth.

This is that the emerging economies have all now become middle class by Western standards, and so global growth is still going to power ahead. But as the third chart shows, this simply isn’t true:

  • It shows the world’s 10 largest economies (the circle size) ranked by fertility rate and median age
  • Only India still has a demographic dividend, with its fertility rate just above replacement levels
  • But India’s GDP/capita is only $2036: Brazil’s is just $8968 and China’s $9608
  • By comparison, the US is at $62606, Germany is at $48264 and France/UK are at $42600

Companies and voters have been completely fooled by these claims of a “rising middle class” in the emerging economies.  In reality, most people have to live on far less than the  official US “poverty level” of $20780 for a 3-person household.

In China, average disposable income in the major cities was just $5932 last year, and only $2209 in the poorer rural half of the country. Its great success has actually been to move 800m people out of extreme poverty (income below $1.90/day) since 1990.

Demographics don’t lie, and they clearly challenge the rose-tinted view of the central banks that further interest rate cuts will somehow return us to SuperCycle days.

Their real legacy has been to create record levels of debt, which can probably never be repaid.

From subprime to stimulus…and now social division

The blog has now been running for 12 years since the first post was written from Thailand at the end of June 2007. A lot has happened since then:

Sadly, although central banks and commentators have since begun to reference the impact of demographics on the economy, they refused to accept the fundamental issue – namely that economic growth is primarily driven by the needs of the Wealth Creator 25-54 age group:

  • Their numbers are reducing because Western fertility rates have been below replacement level (2.1 babies/woman) for nearly 50 years
  • Central bank attempts to effectively “print babies” via stimulus policies have therefore only increased debt to record levels

As a result, the world has become a much more complex and dangerous place. None of us can be sure what will happen over the next 12 months, as I noted last week.  But clearly, the risks are rising, as UK Justice minister, David Gauke, has highlighted:

“A willingness by politicians to say what they think the public want to hear, and a willingness by large parts of the public to believe what they are told by populist politicians, has led to a deterioration in our public discourse.  This has contributed to a growing distrust of our institutions – whether that be parliament, the civil service, the mainstream media or the judiciary.

“A dangerous gulf is emerging, between the people and the institutions that serve them. Such institutions – including the legal system and the judiciary – provide the kind of confidence and predictability that underpins our success as a society. 

“Rather than recognising the challenges of a fast-changing society require sometimes complex responses, that we live in a world of trade-offs, that easy answers are usually false answers, we have seen the rise of the simplifiers. 

“Those grappling with complex problems are not viewed as public servants but as engaged in a conspiracy to seek to frustrate the will of the public. They are ‘enemies of the people’.”

THANK YOU FOR YOUR SUPPORT OVER THE PAST 12 YEARS
It is a great privilege to write the blog, and to be able to meet many readers in workshops and conferences around the world. Thank you for all your support.

Don’t get carried away by Beijing’s stimulus

Residential construction work in Qingdao, China. Government stimulus is unlikely to deliver the economic boost of previous years © Bloomberg

China’s falling producer price index suggests it could soon be exporting deflation, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
On the surface, this year’s jump in China’s total social financing (TSF) seems to support the bullish argument. TSF was Rmb5.3tn ($800bn) in January-February, a 26 per cent rise on 2018’s level.By comparison, it rose 61 per cent in 2009 as the government panicked over the impact of the 2008 financial crisis, and 23 per cent in 2016, when the government wanted to consolidate public support ahead of 2017’s five-yearly Party Congress session, which reappointed the top leadership for their second five-year term.

The markets were certainly right to view both these increases positively, as we discussed here two years ago. But we also added a cautionary note, suggesting that 2017’s Congress might well be followed by a “new clampdown”, as Xi’s leadership style was likely to “move away from consensus-building towards autocracy”. This analysis seems to have proved prescient, and it makes us cautious about assuming that Xi has decided to reverse course in 2019.

Consumer markets are also indicating a cautious response. Passenger car sales, for example, were down 18 per cent in January-February compared with the same period last year, after having fallen in 2018 for the first time since 1990. Smartphone sales were also down 14 per cent over the same period. In the important housing market, state-owned China Daily reported that sales by industry leader Evergrande fell by 43 per cent.

There is little evidence on the ground to suggest that Xi has decided to return to stimulus to revive economic growth. Last month’s government Work Report to the National People’s Congress said it would “refrain from using a deluge of stimulus policies”.

Instead, it seems likely that this year’s record level of lending was used to bail out local government financing vehicles (LGFVs) and other casualties of China’s post-2008 debt bubble. The second chart illustrates the potential problem, with TSF suddenly taking off into the stratosphere after 2008, when stimulus began, while GDP growth hardly changed its trajectory.

The stimulus programme thus dramatically inflated the amount of debt needed to create a unit of GDP. And given the doubts over the reliability of China’s GDP data, it may well be that the real debt-to-GDP ratio is even higher. These data therefore support the argument that debt servicing is now becoming a major issue for China after a decade of stimulus policies.


One example comes from the FT’s analyses of the debt problems affecting China Rail and China’s vast network of city subways. The FT reported that China has 25,000km of high-speed rail tracks, two-thirds of the world’s total, and that China Rail’s debt burden had reached Rmb5tn — of which around 80 per cent related to high-speed rail construction. Its interest payments have also exceeded its operating profits since at least 2015.

Unsurprisingly, given China’s relative poverty (average disposable income was just $4,266 in 2018), income from ticket sales has been too low even to cover interest payments since 2015. And yet the company is planning to expand capacity to 30,000km of track by 2030, with budgets increased by 10 per cent in 2018 as a result of the decision to boost infrastructure.

The same problem can be seen in city subway construction, where China accounted for 30 per cent of global city rail at the end of last year by track length, but only 25 per cent of ridership, which suggests that some lines may be massively underused and economically unviable.

The issue is not whether this level of investment is justifiable over the longer term in creating the infrastructure required to support growth. Nor is it whether the debt incurred can be repaid over time. Instead, the real question is whether the need to support economic expansion has led to a financially-risky acceleration of the infrastructure programme and whether, in turn, Beijing is now being forced to cover potential losses in order to avoid a series of credit-damaging defaults.


So where does this alternative narrative lead us? It suggests that far from supporting consumer spending, the TSF increase is flagging a growing risk in Asian debt markets — where western investors have rushed to invest in recent years, attracted by the relatively high interest rates compared with those enforced by central banks in their home markets. In 2017, for example, Chinese borrowers raised $211bn in dollar-denominated issuance, at a time when corporate debt levels had already reached 190 per cent of GDP.

This risk is emphasised if we revisit our suggestion here at the end of last year, that data for chemicals output — the best leading indicator for the global economy — was suggesting “that we may now be headed into recession”. More recent data give us no reason to change this conclusion, and therefore highlight the risk that some Chinese debts may prove more equal than others in terms of the degree of state support that they can command. Missed interest and capital repayments are now becoming common among the weaker borrowers.

The performance of China’s producer price index provides additional support for our analysis. As the third chart shows, this is now flirting with a negative reading, suggesting that a decade of over-investment means that China now has a major problem of surplus capacity. This problem will, of course, be exacerbated if demand continues to slow in key areas. In turn, this suggests that the implications of our analysis go beyond Asian markets.

China still remains, after all, the manufacturing capital of the world, and its falling PPI implies that 2019 could see it exporting deflation. This would be exactly the opposite conclusion to that assumed by today’s rallying equity markets, although it would chime with the increasingly downbeat messages coming from global bond markets. Investors may therefore want to revisit their recent euphoria over the level of lending in China, and their new confidence that the so-called “Powell put” can really protect them from today’s global market risks.

Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.

Déjà vu all over again for oil markets as recession risks rise

Back in 2015, veteran Saudi Oil Minister Ali  Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.

As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4.  But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand.  And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.

Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:

  • Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
  • But its short-term need is to support prices by cutting production, in order to fund its spending priorities

The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past.  It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.

The reason is that high oil prices reduce discretionary spending.  Consumers have to drive to work and keep their homes warm (and cool in the summer).  So if oil prices are high, they have to cut back in other areas, slowing the economy.

CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014

There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.

They were creating tens of $tns of free cash to support consumer spending.  But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report.  It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:

“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.

SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS

Oil prices are therefore now on a roller-coaster ride:

  • Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
  • The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December

Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd).  But as always, its “allies” have let it down.  So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.

Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:

Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds.  As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.

But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.

Companies and investors therefore need to be very cautious.  Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.

Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.

 

*Total cost is number of barrels used multiplied by their cost