Boomer SuperCycle unique in human history – Deutsche Bank

“The 1950-2000 period is like no other in human or financial history in terms of population growth, economic growth, inflation or asset prices.”

This quote isn’t from ‘Boom, Gloom and the New Normal: How Western BabyBoomers are Changing Demand Patterns, Again‘, the very popular ebook that John Richardson and I published in 2011.  Nor is the chart from one of the hundreds of presentations that we have since been privileged to give at industry and company events around the world.

It’s from the highly-respected Jim Reid and his team at Deutsche Bank in their latest in-depth Long-Term Asset Return Study, ‘The History (and future) of inflation’.  As MoneyWeek editor, John Stepek, reports in an excellent summary:

The only economic environment that almost all of us alive today have ever known, is a whopping great historical outlier….inflation has positively exploded during all of our lifetimes. And not just general price inflation – asset prices have surged too.  What is this down to? Reid and his team conclude that at its root, this is down to rampant population growth.” (my emphasis)

As Stepek reports, the world’s population growth since 1950’s has been far more than phenomenal:

“From 5000BC, it took the global population 2,000 years to double; it took another 2,000 years for it to double again. There weren’t that many of us, and lots of us died very young, so it took a long time for the population to expand.  Fast forward another few centuries, though, and it’s a different story.

“As a result of the Industrial Revolution, lifespans and survival rates improved – the population doubled again in the period between 1760-1900, for example. That’s just 140 years.  Yet that pales compared to the growth we’ve seen in the 20th century. Between 1950-2000,  a mere 50 years, the population more than doubled from 2.5bn to 6.1bn.”

Actually, it was almost certainly Jenner’s discovery of smallpox vaccination that led to the Industrial Revolution, as discussed here in detail in February 2015, Rising life expectancy enabled Industrial Revolution to occur’:

“Vaccination against smallpox was almost certainly the critical factor in enabling the Industrial Revolution to take place. It created a virtuous circle, which is still with us today:

  • Increased life expectancy meant adults could learn from experience instead of dying at an early age
  • Even more importantly, they could pass on this experience to their children via education
  • Thus children stopped being seen as ’little adults’ whose role was to work as soon as they could walk
  • By 1900, the concept of ‘childhood’ was becoming widely accepted for the first time in history*

The last point is especially striking, as US sociologist Viviana Zelizer has shown in Pricing the Priceless Child: The Changing Social Value of Children. We take the concept of childhood for granted today, but even a century ago, New York insurance firms refused to pay death awards to the parents of non-working children, and argued that non-working children had no value.

Deutsche’s topic is inflation, and as Stepek notes, they also take issue with the narrative that says central banks have been responsible for taming this in recent years:

“The Deutsche team notes that inflation became less fierce from the 1980s. We all think of this as being the point at which Paul Volcker – the heroic Federal Reserve chairman – jacked up interest rates to kill off inflation.  But you know what else happened in the 1980s?

“China rejoined the global economy, and added a huge quantity of people to the working age population. A bigger labour supply means cheaper workers.  And this factor is now reversing. “The consequence of this is that labour will likely regain some pricing power in the years ahead as the supply of it now plateaus and then starts to slowly fall”.”

THE CENTRAL BANK DEBT BUBBLE IS THE MAIN RISK

The chart above from the New York Times confirms that that the good times are ending.  Debt brings forward demand from the future.  And  since 2000 central banks have been bringing forward $tns of demand via their debt-based stimulus programmes.  But they couldn’t “print babies” who would grow up to boost the economy.

Today, we just have the legacy of the debt left by the central banks’ failed experiment.  In the US, this means that the Federal government is almost at the point where it will be spending more on interest payments than any other part of the budget – defence, education, Medicaid etc.

Relatively soon, as the Congressional Budget Office has warned, the US will face decisions on whether to default on the Highway Trust Fund (2020), the Social Security Disability Insurance Trust Fund (2025), Medicare Hospital Insurance Trust Fund (2026) and then Social Security itself (2031).  If it decides to bail them out, then it will either have to make cuts elsewhere, or raise taxes, or default on the debt itself.

THE ENDGAME FOR THE DEBT BUBBLE IS NEARING – AND IT INVOLVES DEFAULT
Global interest rates are already rising as investors refocus on “return of capital”.  Investors are becoming aware of the risk that many countries, including the USA, could decide to default – as I noted back in 2016 when quoting William White of the OECD, “World faces wave of epic debt defaults” – central bank veteran:

It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something. The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.

The next recession is just round the corner, as President Reagan’s former adviser, Prof Martin Feldstein, warned last week.  This will increase the temptation for Congress to effectively default by refusing to raise the debt ceiling.  Ernest Hemingway’s The Sun also Rises probably therefore describes the end-game we have entered:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

 

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Greece introduces capital controls; IMF says it needs to default

Greece Jun15This morning, Greece introduced capital controls.  People can only withdraw €60/day ($65) from their bank accounts.  The government has also called a referendum on Sunday, after Eurozone talks on a new bailout package collapsed.

The key issue is that Greece will never be able to repay its debts.  These are currently estimated at €322bn ($365bn) – far larger than its economy, which is only $238bn after having shrunk by 25% since 2008.  Greece also needs new money to be invested in the country, if it is to make a new start and fund new growth.

If Greece was a company, everyone would know what needed to be done.   The business would have to be put into bankruptcy; debt-holders would have to write off some debt and swap the rest for equity; and a new business plan would have to be developed to be funded with new money from existing and new investors.

But Greece isn’t a company, of course.  And today’s politicians don’t like to take hard decisions or to deliver difficult messages to their electorates.  This is why I feared 2 weeks ago that the “Slow motion Greek train wreck was getting ready to hit another buffer‘.  The heart of the problem is very simple:

  • Political union in the Eurozone was essential if economic and monetary union was to succeeed
  • But although this was rejected by France in the 1990s, the Eurozone project still went ahead in 1999

Politicians instead pretended that political union existed, and banks have since lent vast sums to Greece. And although it has been clear since 2009 that these loans cannot be repaid, they failed to explain this to their electorates. Instead the Greek and Eurozone leaders decided to extend repayment to 2050.This policy of “pretend and extend” means Greece is now bankrupt on an epic scale.

None of us can now know what will happen next.  But we can assume Eurozone politicians will continue to try and avoid telling their electorates what has been done in their name.  The German part of the bill could easily be €86bn, and in a worst case could be the entire €322bn according to the respected IFO Institute.

But the game of “Pretend and Extend” is clearly complicated by the involvement of the IMF.  It is not allowed to lend to countries who cannot repay their loan, and it has powerful members outside the Eurozone in Asia and Latin America, who want it to enforce this rule.  Thus Christine Lagarde, the head of the IMF, told CNBC yesterday:

Our objective is clearly to restore the financial independence, the stability of Greece – to make sure that growth can start again. And that Greece can be sustainable from an economic and financial standpoint. As I’ve said, it is a balancing act. There has to be measures taken by Greece, there has to be support by the Europeans. And they come in sequence. Measures have to be taken, they have to be implemented. And that triggers a different attitude and a willingness to look at both financing and debt sustainability.”

The IMF is thus coming out on the side of those who want realism to be injected into the debate.  The Greeks have to develop a functioning tax system, and realistic social policies.  In turn, the Eurozone governments have to agree to write off debt and finance the new start.  That is the real meaning of Ms Lagarde’s emphasis on the need to look at “both financing and debt sustainability” in sequence.

This is why the concept of political union should have been agreed alongside economic and monetary union.  But today, German taxpayers face a different decision – and one that has not yet been explained to them.  This is simply that if they don’t refinance Greece, they stand to lose all the money that has been lent to Greece in their name.

Greece’s decision to hold a referendum highlights the impasse that has been reached:

  • Greece can only implement one side of the necessary deal – reforming its taxation and spending policies.  It cannot come up with the new money needed to reverse the current decline in its economic performance
  • The Eurozone is in an equally bad position, as it cannot force Greece to undertake this restructuring.  And so it may end up having to write off the Greek debt, and getting nothing in return

This is always the problem with ‘pretend and extend’ policies. In the end, reality has a habit of intruding.

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 40%
Naphtha Europe, down 40%. “Values are coming down gradually from recent highs as the product is long and its use in summer gasoline blending is limited”
Benzene Europe, down 39%. “There is still a steady stream of imports moving into the region from the Middle East and India. As a result, some traders believed that this would readjust the current supply/demand dynamic before long”
PTA China, down 29%. “The two major producers Yisheng Petrochemical and Hengli Petrochemical currently have no plans for any run rates reduction in July. This was largely to faciliate cash flow, several market participants added”
HDPE US export, down 19%. “Domestic  export  prices  slipped  during  the week  on oversupply, verified by industry data released on Friday.”
¥:$, down 21%
S&P 500 stock market index, up 8%

Germany could face €86bn bill from a Greek default

ECB Mar15Who would pay the bill, if Greece defaulted on its current €320bn debt ($340bn)?

This is no longer just a theoretical question.  Of course, we have all known since 2012 that Greece would never be able to repay its debt.  But the EU covered up this hard truth by a ‘pretend and extend’ policy:

  • The default deal deferred repayment over many years, in some cases out to 2050
  • Interest payments were also reduced and deferred in some cases for up to 10 years
  • But not all the repayments have been postponed:  €20bn is due to the IMF, EU and ECB over the next 6 months
  • Yesterday, the Greek government suggested it might not be able to repay $1bn due next month

The 2012 deal also involved one very critical element.  The debt had been lent by German and other banks, who clearly couldn’t afford to ‘pretend and extend’ the loans.  So governments, led by the European Central Bank, repaid these loans and effectively took responsibility for Greece’s debt.

Thus around 75% of Greece’s debt is now owed to governments – only €34bn is now owed to private lenders.  This, of course, is the reason why Greece’s unemployment rate is still at 25% – very little ‘new money’ has actually gone into support for the Greek economy itself.

In turn, this is why the left-wing Syriza government won power in January.  No country is going to put up with 50% of its young people being unemployed forever.  And Syriza’s stance on the debt issue is also far more aggressive, tabling a €279bn reparations bill to Germany for a forced loan taken during World War 2.

So now the question arises – what would happen if Greece and the Troika (IMF, ECB, EU) fail to agree on another ‘pretend and extend’ default deal?  The answer seems clear – the ECB countries would have to pick up the bill.

This is where the chart above begins to matter, as it shows the ownership of the ECB itself, based on official ECB data.  Germany has the largest share at 18%, and so it would face the biggest bill, which could reach €86bn on some calculations, given related losses which would likely occur in the ECB’s Target 2 payments system.

This figure has not been mentioned to the German electorate.  Nor have they been told that the bill might well be higher if countries such as Italy (12%) and Spain (9%) decided they couldn’t afford to pay their share.  This seems highly likely, given the poor financial state of both economies.

And this is not just my view.  Germany’s highly respected Ifo Institute analyses the risk as follows:

If Greece leaves the euro and defaults, Germany’s maximum loss from foregone Target claims would be €24bn. Germany’s maximum loss in the case of a Greek exit would amount to 86.2 billion euros.  Should all crisis countries (Greece, Ireland, Portugal, Spain, Italy and Cyprus) default and exit the euro, Germany’s … overall loss from all rescue operations would amount to €322bn.”

A bill for €322bn, or even €86bn, would create a political firestorm in Germany.  Electorates in other northern EU states would also be shocked by what had been done in their name.  It would also probably create a major political crisis in non-Eurozone members such as the UK, which owns 14% of the ECB’s capital.

Of course, the EU may still come up with another version of the ‘pretend and extend’ policy.  Experienced observers such as Commerzbank suggest there is at least a 50% chance of this happening.

But positions are clearly hardening on both sides.  In turn, the fault lines around the global debt-fuelled ‘Ring of Fire’ could well widen still further, if reality overtakes the ‘pretend and extend’ policy.

Prime Beijing house prices drop 40% since December

China map aChina’s property market is the epicentre of the global debt bubble discussed yesterday.  It has been red-hot since urban residents became free to buy their own home in 1998.  Before then, they lived where the state told them.  With interest rates held low to boost state-funded infrastructure spending, people had few options for investing their money.

The result is that prices have become totally unaffordable for new buyers.  Beijing house prices average 34 times average earnings, and Shanghai sells at 29 times average earnings.  Even worse is that property has provided massive opportunity for corrupt officials to feather their nest.  30% of all property is owned by just 1% of the population, and around 2.1 million households own between 40% – 50% of China’s $10.5tn real estate and financial assets.

Now these same officials are selling in a frenzy, panicked by the thought that their property holdings will soon have to be published on the internet, for anyone to see.  As China Daily reports:

“Once sky-high priced houses in Hua Qing Jia Yuan, a famous residential district near a key primary school, are witnessing a decline in prices to less than 60,000 yuan per square meter.  A homebuyer said properties in that district were being sold at 100,000 yuan per square meter just six months ago, but recently she was shown a 106–square-meter house priced at 6.2 million yuan.”

The downturn is also now beginning to widen, as the government’s efforts to control shadow bank lending have led house prices across China to start falling.  Thus the research unit of real estate developer Soufun reported:

“Rising market supply and sharp falls in transactions have put relatively heavy pressure on property developers’ sales, leading some to beef up promotions and adjust their pricing strategy.”

And there will likely be more falls to come, as the government wins its battles with local authorities who have been keen to support prices in order to boost their income from land sales – often their major revenue source.

The size of the earthquake now underway is highlighted in private remarks by Mao Daqing, vice chairman of China’s largest developer, China Vanke.  Leaked online, they apparently suggested that China’s land bubble now parallels that of Japan before its crash in 1990:

Tokyo’s total land value in 1990, prior to the property bust there, was equal to 63% of U.S. GDP in 1990, he said. During the Hong Kong bubble in 1997, land values there reached 66% of U.S. GDP.  In 2012, the total land value in Beijing was 62% of U.S. GDP, “which is a scary number”, Mr Mao said”.

An unofficial report of the speech by JL Warren Capital highlights the core problems:

Mao singles out three major trends in the Chinese real estate sector in 2014:

  • Tier 2 and Tier 3 cities: Supply exceeds demand, by a lot
  • Tier 1 cities: Continue to see robust demand; however, land prices have gone up more than Actual Selling Price for projects
  • Credit has tightened.

China’s anti-corruption campaign has had a greater impact on high-end property projects than most have realized. Investigations are ongoing into owners of property priced around 40K-50K RMB/sqm, ($6.5 – $8k/sq metre) not to mention more expensive properties. The increased scrutiny surrounding the anti-corruption campaign has caused demand to fall off in the high-end property market.

“The second-hand housing market has been even more impacted by the anti-corruption campaign. New listings for sale surged to 10-12 units per day, twice as many as before.

“Many owners are trying to get rid of high-priced houses as soon as possible, even at the cost of deep discount, because many corrupted officers have illegally accumulated several or more houses through bribery or embezzlement. As a result, ordinary people who want to sell homes in the secondary market must face deep price cuts….

“Most cities have witnessed an increase in inventory-sale ratios for residential buildings. Among the 27 key cities we surveyed, more than 21 cities have Days Sale of Inventory (DSI) exceeding 12 months, among which 9 have DSI greater than 24 months….

The second critical issue is the demographics in China. Our research shows that by 2033, the total population aged 60 and above will reach 400 million, as well as an additional 270 million people living on social welfare. That is, by the end of 2033, there will be approximately 670 million people, or 50% of the Chinese population, will be living on social welfare”.

The detail behind the remarks makes it clear this was not a ‘top of the head’ speech, but carefully considered.  Mao, along with China’s leadership, seems to recognise that there comes a point where the can cannot be kicked down the road any more, as it is likely instead to end up over a cliff.

Total housing activity totalled nearly a quarter of China’s GDP last year, according to Moody’s.  So as China’s Academy of Social Sciences has warned, “we’ve got to let the growth rate go down”.

The fault lines from this earthquake thus run very deep indeed.

Eurozone crisis gets worse, not better

JUUGS Jun12.pngGlobal bond investors have found a new worry. 10 year interest rates in Spain, the world’s 12th largest economy, have risen alarmingly in recent weeks. As the chart shows, they are now above 7% (blue column) compared to 4% when the blog first focused on the Eurozone crisis (red).

7% is a critical level, as it marks the point at which countries can usually no longer support the burden of interest cost involved. During the current crisis, it has also marked the moment when countries such as Ireland and Portugal have had to receive a bail-out.

This is why the blog has continued to argue that there are sound reasons for the current record differentials between interest rates being paid by the PIIGS (Portugal, Ireland, Italy, Greece, Spain) and the JUUGS (Japan, UK, USA, Germany, Switzerland).

Interestingly, some major bond fund managers have recently begun to express similar views. Thus Jeffrey Rosenberg, chief fixed income investment strategist for Blackrock (who have $3.7tn under management), noted recently in respect of the low interest rates in the JUUGS:

“You’re not talking about a bubble because a bubble is about greed. That’s not a reflection of ‘I expect prices to go higher and I have to jump in,’ that’s a reflection of ‘I want to preserve my principal.’ Negative yields reflect fear.”

Europe’s banks turn to bullfight loans

Index Apr12.pngThe blog’s IeC Boom/Gloom sentiment indicator (blue column) continues to be neutral on the outlook. As the chart shows, this is quite unlike its performance in early 2009. Then it rose rapidly from February – accurately forecasting the major recovery that was about to start.

The problem, of course, is that the austerity reading (red line) remains too strong for comfort. Central bank lending has masked the issue, as banks have always been able to borrow more money from them. But lending only helps with cash flow, it doesn’t help with solvency problems.

The major problems today are in Europe. The European Central Bank averted near-catastrophe in December with its €1tn ($1.4tn) LTRO, Long-Term Refinancing Operation. This was meant to provide the banks with time to rebuild their balance sheets.

Instead, just as one would expect, they have chosen to play even more games in the hope of boosting short-term profits. Thus in Spain, probably next in line after Portugal for another bailout, they have been busy doing deals with bullfighting companies. As the Wall Street Journal reports:

• Fans can’t afford to go to bullfights, with the economy in recession
• This means loans to the bullfight companies are at risk of default
• So now, the banks are lending season-ticket money to bullfight fans

In the short-term, this means the banks avoid a costly default. But instead, they will probably face bigger losses next year. With Spain suffering rising unemployment, repaying a bullfight loan is unlikely to be high on the priority list for many fans in 2013.