Western central bankers are convinced reflation and economic growth are finally underway as a result of their $14tn stimulus programmes. But the best leading indicator for the global economy – capacity utilisation (CU%) in the global chemical industry – is saying they are wrong. The CU% has an 88% correlation with actual GDP growth, far better than any IMF or central bank forecast.
The chart shows June data from the American Chemistry Council, and confirms the CU% remains stuck at the 80% level, well below the 91% average between 1987 – 2008, and below the 82% average since then. This is particularly concerning as H1 is seasonally the strongest part of the year – July/August are typically weak due to the holiday season, and then December is slow as firms de-stock before Christmas.
The interesting issue is why these historically low CU% have effectively been ignored by companies and investors. They are still pouring money into new capacity for which there is effectively no market – one example being the 4.5 million tonnes of new N American polyethylene capacity due online this year, as I discussed in March.
The reason is likely shown in the above chart of force majeures (FMs) – incidents when plants go suddenly offline, creating temporary shortages. These are at record levels, with H1 2017 seeing 4x the number of FMs in H1 2009.
In the past, most companies prided themselves on their operating record, having absorbed the message of the Quality movement that “there is no such thing as an accident”. Companies such as DuPont and ICI led the way in the 1980s with the introduction of Total Quality Management. They consciously put safety ahead of short-term profit and at the top of management agendas. As the Chartered Quality Institute notes:
“Total quality management is a management approach centred on quality, based on the participation of an organisation’s people and aiming at long-term success.”
Today, however, the pressure for short-term financial success has become intense
The average “investor” now only holds their shares for 8 months, according to World Bank data
This time horizon is very different from that of the 1980s, when the average NYSE holding period was 33 months
And it is a very long way from the 1960s average of 100 months
As a result, even some major companies appear to have changed their policy in this critical area, prioritising concepts such as “smart maintenance”. Such cutbacks in maintenance spend mean plants are more likely to break down, as managers take the risk of using equipment beyond its scheduled working life. Similarly, essential training is delayed, or reduced in length, to keep within a budget.
ICIS Insight editor Nigel Davies highlighted the key issue 2 years ago as the problems began to become more widespread around the world:
“The situation in Europe has exposed underlying trends and issues that will need to be addressed. Companies appear not to have sustained an adequate pace of maintenance capital expenditure. That has been for economic as well as structural (cost) reasons. Spending in high feedstock and energy cost Europe has certainly not been considered de rigeur….Having maintained plants to run at between 80% and 85% of capacity, suddenly pushing them hard does little good. Sometimes, they fail.”
The end-result has been to mask the growing problem of over-capacity, as plants fail to operate at their normal rates. This has supported profits in the short-term by making actual supply/demand balances far tighter than the nominal figures would suggest. But this trend cannot continue forever.
THE END OF CHINA’S STIMULUS WILL HIGHLIGHT TODAY’S EXCESS CAPACITY
The 3rd chart suggests its end is now fast approaching. It shows developments in China’s shadow banking sector, which has been the real cause of the apparent “recovery” and reflation seen in recent months:
Premier Li began a major stimulus programme a year ago, hoping to boost his Populist faction ahead of October’s 5-yearly National People’s Congress, which decides the new Politburo and Politburo Standing Committee (PSC)
Populist Premier Wen did the same in 2011-2 – shadow lending rose six-fold to average $174bn/month
But Wen’s tactic backfired and President Xi’s Princeling faction won a majority in the 7-man PSC, although the Populist Li still had responsibility for the economy as Premier
Li’s efforts have similarly run into the sand
As the 3-month average confirms (red line), Li’s stimulus programme saw shadow lending leap to $150bn/month. Unsurprisingly, as in 2011-2, commodity and asset prices rocketed around the world,funding ever-more speculative investments. But in February, Xi effectively took control of the economy from Li and put his foot on the brakes. Lending is already down to $25bn/month and may well go negative in H2, with Xi highlighting last week that:
“China’s development is standing at a new historical starting point, and … entered a new development stage”.
“Follow the money” is always a good option if one wants to survive the business cycle. We can all hope that the IMF and other cheerleaders for the economy are finally about to be proved right. But the CU% data suggests there is no hard evidence for their optimism.
There is also little reason to doubt Xi’s determination to finally start getting China’s vast debts under control, by cutting back on the wasteful stimulus policies of the Populists. With China’s debt/GDP now over 300%, and the prospect of a US trade war looming, Xi simply has to act now – or risk financial meltdown during his second term of office.
Prudent investors are already planning for a difficult H2 and 2018. Companies who have cut back on maintenance now need to quickly reverse course, before the potential collapse in profits makes this difficult to afford.
Companies and investors have some big decisions ahead of them as we start the second half of the year. They can be summed up in one super-critical question:
“Do they believe that global reflation is finally now underway?”
The arguments in favour of this analysis were given last week by European Central Bank President, Mario Draghi:
“For many years after the financial crisis, economic performance was lacklustre across advanced economies. Now, the global recovery is firming and broadening…monetary policy is working to build up reflationary pressures…we can be confident that our policy is working and its full effects on inflation will gradually materialise.”
The analysis has been supported by other central bankers. The US Federal Reserve has raised interest rates 3 times since December, whilst the Bank of England has sent the pound soaring with a hint that it might soon start to raise interest rates. Most importantly, Fed Chair Janet Yellen told a London conference last week that she:
“Did not expect to see another financial crisis in our lifetime”.
The chart above from Nobel Prizewinner Prof Robert Shiller confirms that investors certainly believe the reflation story. His 10-year CAPE Index (Cyclically Adjusted Price/Earnings Index) has now reached 30—a level which has only been seen twice before in history – in 1929 and 2000. Neither were good years for investors.
Even more striking is the fact that veteran value-investor, Jeremy Grantham, now believes that investors will have “A longer wait than any value manager would like, including me” before the US market reverts to more normal valuation metrics. Instead, he argues that “this time seems very, very different” – echoing respected economist Irving Fisher in 1929 who suggested “stock prices have reached what looks like a permanently high plateau“.
But are they right?
One concern is that central bankers might be making a circular argument. We saw this first with Fed Chair Alan Greenspan, who flooded stock markets with free cash before the dot-com crash in 2000, and then flooded housing markets with free cash to cause the subprime crash in 2008. His successor, Ben Bernanke continued the free cash policy, arguing in November 2010 that boosting the stock market was critical to the recovery:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
The second chart highlights how the Fed’s zero interest rate policy has driven the rally since the US S&P 500 Index bottomed in March 2009:
Margin debt in the New York market (money borrowed to invest in stocks) is at an all-time record of $539bn ($2017)
It has increased 197% since March 2009, almost exactly matching the S&P’s rise of 216%
Stock market capitalisation (the total value of stocks) versus GDP is close to a new all-time high at 133%
Meanwhile, the Bank of Japan now owns 2/3rds of the entire Japanese ETF market (Exchange Traded Funds). And the Swiss National Bank owns $100bn of US/European stocks including 26 million Microsoft shares.
Unsurprisingly, given central bank policies, the world is now awash with debt. New data from the Institute of International Finance shows total world debt has now reached $217tn – more than 3x global GDP. As a result, respected financial commentator Andreas Evans-Pritchard argued last week:
“The Fed caused the dotcom bubble in the 1990s. It caused the pre-Lehman subprime bubble. Whatever Ms Yellen professes, it has already baked another crisis into the pie. The next downturn may be so intractable that it calls into question the political survival of capitalism. The Faustian pact is closing in.”
Evans-Pritchard’s concern is echoed by Claudio Borio, head of the central bankers’s bank – the Bank for International Settlements (BIS). Under his predecessor, William White, the BIS was the only central bank to warn of the subprime crisis. And Borio has warned:
“Financial booms can’t go on indefinitely. They can fall under their own weight.”
WHO IS RIGHT – THE CENTRAL BANKS OR THEIR CRITICS?
This is why companies and investors have some big decisions ahead of them. Of course, it is easy to assume that everything will be just wonderful, when everyone else seems to believe the same thing. Who wants to spoil the party?
But then there is the insight from one of the world’s most famous analysts, Bob Farrell, captured in the headline to this post. The chart of The pH Report’s Boom/Gloom Index highlights how the concept of the Trump reflation trade has sent the S&P into an exponential rally – even whilst sentiment, as captured in the Index, has been relatively subdued.
You could argue that this means the market can continue to go higher for years to come, as Grantham and the central banks believe. Or you could worry that “the best view is always from the top of the mountain” and that there are now very few people left to buy. And you might also be concerned that:
Political uncertainty is rising across the Western world, as well as in the Middle East and Latin America
Oil prices are already in a bear market
China’s growth and lending is clearly slowing
And Western central banks also seem set on trying to unwind their expansionary policies
We can all hope that today’s exponentially rising markets continued to rise.
But what would happen to your business and your investments if instead they began to correct – and not by going sideways? It might be worth developing a contingency plan, just in case.
Oil markets have been at the centre of the recent myth that economic recovery was finally underway. The theory was that rising inflation, caused by rising oil prices, meant consumer demand was increasing. In turn, this meant that the central banks had finally achieved their aim of restoring economic growth via their zero interest rate policy.
This theory was first undermined in 2014, when oil prices began their fall. There had never been a shortage of oil. Prices rose to $125/bbl simply because the hedge funds saw commodities like oil as a ‘store of value’ against the Federal Reserve’s policy of weakening the dollar.
The theory sounded attractive and plenty of people had initially made a lot of money from believing it. But it didn’t mean that the global economy had recovered. And by August 2014, as I highlighted at the time, oil prices were starting to collapse under the weight of excess supply. As I also suggested in the same post, this meant “major oil price volatility is now likely”. By luck or judgement, this has indeed since occurred, as the chart shows:
□ The 2009 – 2014 rally was dominated by “technical trading”, as oil markets lost their role of “price discovery”
□ August – December 2014 then saw prices crash to $45/bbl
□ Prices rose nearly 50% in early 2015 in a “failed rally”, as hedge funds assumed prices would quickly recover
□ Prices then halved to $27/bbl in January 2016 as the reality of over-supply swamped the market
□ Since then prices have doubled as OPEC combined with the hedge funds to try and push prices higher
□ This rally now seems to have failed, as US shale supply continues to increase
In reality, as I discussed last month, this final rally merely enabled new US production to be financed. The US oil rig count has doubled over the past year, and each rig is now 3x more productive than in 2014. At the same time, the medium-term outlook for oil demand in the key transport sector is becoming more doubtful, with China and India both now moving towards Electric Vehicles as a way of reducing their high levels of air pollution.
A measure of how far the market has moved was seen at last week’s Clean Energy Ministerial meeting, which:
“Set a collective aspirational goal for all EVI members of a 30% market share for electric vehicles (EVs) by 2030. It does so with the aim of taking advantage of the multiple benefits offered by electric mobility for innovation, economic and industrial development, energy security, and reduction of local air pollution.”
Already oil price targets, even amongst the optimists, are now being revised downwards. Nobody now talks about a “quick return” to $100/bbl, or even to $70/bbl. Instead the hope is that possibly they might return to $60/bbl at some point in the future – others merely hope that today’s $50/bbl level can be maintained.
Hope, however, is not a strategy. And in the absence of major geopolitical disruption, it seems likely that the hedge funds will continue to withdraw from the market and leave supply/demand fundamentals to once again set the price. In turn, this will challenge the reflation and recovery myth that grew up whilst the funds were boosting their bets on the oil and commodity markets.
As the second chart shows, inflation has already begun to weaken in China as well as in the US and Eurozone economies. China’s move away from stimulus will help to accelerate this move in H2, In turn, markets will likely return to worrying about deflation once more.
Japan is an excellent indicator of this development. Its inflation rate completely failed to take off despite the major rise in oil and other commodity prices. As I have long argued, Japan’s ageing population means that its previous demographic dividend has now been replaced by a demographic and demand deficit.
The US and Eurozone economies are both going through the same process. 10k Americans and 18k Europeans have been retiring every day since 2011 as the BabyBoomer generation reaches the age of 65. They already own most of what they need, and their incomes generally suffer a major hit as they leave the workforce.
Companies and investors therefore need to prepare for a difficult H2. The failure of the latest oil price rally, and the return of deflation worries, will puncture the myth that reflation and economic recovery are finally underway. Political stalemate will increase, until policymakers finally accept that demographics, not central banks, drive demand.
The bond market vigilantes are back. And they clearly don’t like what they are seeing. That is the clear message from the charts above, showing movements in 10 year government bond interest rates for the major economies, plus their exchange rate against the US$ and the value of the US$ Index:
As I warned in the Financial Times in August, You’ve seen the Great Unwinding; get ready for the Great Reckoning
The financial world has completely changed since the Brexit vote in June, and then Donald Trump’s election
The Brexit vote saw rates begin to surge and the US$ to rise; these moves have accelerated since Trump’s win
Since the Brexit vote, US rates have risen by more than a half from 1.4% to 2.3%
UK rates have trebled from 0.5% to 1.5%
Chinese rates have risen by more than a tenth from 2.6% to 2.9%; Japanese rates have risen from -0.3% to zero
German rates have risen from -0.2% to a positive 0.3%; Italian rates have doubled from 1% to 2%
At the same time, the value of the US$ has been surging against all these currencies, as the black line in each chart confirms. And the value of the US$ Index against the world’s major currencies has risen by 8% to $101.
These are quite extraordinary moves, and it is most unlikely they will be quickly reversed. They mark the start of the Great Reckoning for the failure of the stimulus packages introduced on an ever-larger scale over the past 15 years.
Now investors are going to find out the hard way that return on capital is not the same as return of capital, due to the return of the bond market vigilantes. As James Carville, an adviser to President Bill Clinton once warned:
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
The key issue is that the demographic dividend of the BabyBoomer-led SuperCycle is now creating a demand deficit. The 50% rise in global life expectancy since 1950, combined with the 50% decline in fertility rates, means that we have effectively traded 10 years of increased life expectancy for economic growth. That’s not a bad trade, and I have yet to meet anyone who would volunteer to die early, in order to allow growth to return.
The problem is that in recent years, policymakers have chosen to ignore these demographic realities. They have instead assumed they can always create growth via stimulus programmes based on ever-increasing amounts of debt.
Today, we therefore now face the problem of high debt ($199tn according to McKinsey. and 3x global GDP, last year), and no growth. So as I warned in January (“World faces wave of epic debt defaults” – central bank veteran), investors are now beginning to realise all this debt can never be repaid.
These developments also highlight how central banks are now starting to lose control of interest rates. Instead, markets are beginning to rediscover their real role of price discovery based on supply/demand fundamentals. They are no longer being overwhelmed by central bank liquidity:
The interest rate rises will have major impact on individuals and companies, as prices realign with fundamentals
A rising dollar is also deflationary for the global economy, as it further reduces growth levels outside the USA
In addition, it is bad news for anyone who borrowed in dollars, thinking they would benefit from a lower interest rate from that available in their own country, as their capital repayments increase
As I warned last month in Budgeting for the Great Reckoning:
“The problem, of course, is that it will take years to undo the damage that has been done. Stimulus policies have created highly dangerous bubbles in many financial markets, which may well burst before too long. They have also meant it is most unlikely that governments will be able to keep their pension promises, as I warned a year ago. .
“It is still possible to hope that “something may turn up” to support “business as usual” Budgets. But hope is not a strategy. Today’s economic problems are already creating political and social unrest. And unfortunately, the outlook for 2017 – 2019 is that the economic, political and social landscape will become ever more uncertain.
“I always prefer to be optimistic. But I fear that this is one of those occasions when it is better to plan for the worst, even whilst hoping that it might not happen. Those who took this advice in October 2007, when I suggested Budgeting for a Downturn, will not need reminding of its potential value.”
”History doesn’t repeat itself, but it often rhymes“, Mark Twain
Bob Farrell of Merrill Lynch was rightly considered one of the leading Wall Street analysts in his day. His 10 Rules are still an excellent guide for any investor. Equally helpful is the simple checklist he developed, echoing Mark Twain’s insight, to help investors avoid following the crowd:
He worried that emotion often caused investors to buy at peaks or sell at lows, due to following the herd
He identified how most equity market downturns ended with a 10% annual fall, and major downturns with a 20% fall
He also found that most rallies ended with a 20% gain, and major speculative blowoffs ended after a 40% gain
The above chart applies Farrell’s insight to the US 10-Year Treasury bond market, using Federal Reserve data for the monthly interest rate (NB rates move inversely to the price, so a higher yield means a lower price, and vice versa). We only have to adjust the downside levels, as most downturns end with a 20% fall, and major downturns with a 40% fall.
It is hard to overstate the importance of the 10-Year Bond. It is the benchmark interest rate for the global economy, and so should not suffer speculative blowoffs. In fact, it has only seen 2 blowoffs since 1973 – and both were due to the US Federal Reserve’s recent attempts to manipulate the market:
The first was during the 2008 Financial Crisis, when investors rushed for a “safe haven” after the subprime collapse
The second was after 2011, when the major central banks pushed rates lower during the Eurozone debt crisis
Both were followed by 20%+ falls, confirming Farrell’s Rule 1 – that “markets tend to return to the mean over time”
This suggests that Farrell’s simple checklist is a very powerful tool for an investor who wants to avoid being driven by market fear or greed. It also shows that today’s market is close to blowoff levels, with July seeing a peak after a 35% gain. Another warning of potential stress is that this rally ended with the interest rate at 1.5% – the lowest ever recorded by the Fed (the series goes back to 1953). Is this level really sustainable for a 10-year bond?
If not, the recent rally in the Treasury bond market could have been the last in the series. We may learn more from market reaction to the Fed and Bank of Japan’s meetings this week. Any change in sentiment could have important consequences for Emerging Markets and those in the developed world, as the Financial Times warned recently:
“Institutional investors across the developed world have been pouring money into emerging market assets at a rate of more than $20bn a month since the middle of this year — quite a turnround after the outflows that dominated much of the previous 12 months….the big imperative driving the flows comes from the more than $13tn of bonds in developed markets that now charge investors for the privilege of owning them”.
Investors are so desperate for yield, due to central bank interest rate policy, that they have abandoned their normal caution. Many have invested in countries which they would be hard-pressed to find on a map. Others have bought developed country bonds at higher and higher prices – assuming that interest rates will never, ever, rise again.
Of course, markets can always go higher temporarily. But the logic of Farrell’s Rule 1 suggests that developments in the US 10-Year bond market are warning us that the start of the Great Reckoning is not far away. As the Bank for International Settlements (the central bankers’ bank) warned yesterday:
“Developments in the period under review have highlighted once more just how dependent on central banks markets have become”
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 55%
Naphtha Europe, down 56%. “A build up in products supply has punctured refiners’ margin”
Benzene Europe, down 53%. “Pricing and consumption was expected to see an upturn this month following the lull in activity over the summer holiday period, but this has yet to materialise.”
PTA China, down 41%. “Lack of demand for spot cargoes”
HDPE US export, down 27%. “Exports in July accounted for roughly 23% of PE sales.”
S&P 500 stock market index, up 9%
US$ Index, up 18%
There was one bit of good news this week. For the first time since the financial crisis began, a Governor of the US Federal Reserve acknowledged that today’s demographic changes are having a major impact on the US economy. John Williams, of the San Francisco Fed, argued that:
“Shifting demographics….(mean that) interest rates are going to stay lower that we’ve come to expect in the past…In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher…We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.”
Williams thus confirmed our conclusion from 5 years ago in chapter 2 of Boom, Gloom and the New Normal:
“The Boomers have moved on from being a high-spending generation. Instead, they are becoming a high-saving generation, as they need to save more to survive a longer retirement. And therefore the failure of the various government stimulus programmes since the crisis began should be no surprise. The concept of pent-up demand is now wishful thinking.
“The key issue is that we need a change in mindset. Those companies who continue to expect stimulus measures to deliver a return to the Golden Age are likely to be disappointed. Instead, the winners will focus on understanding how to profit from the demographic changes now underway, as we transition to the New Normal.”
It is good news that one leading central banker now accepts that stimulus policies cannot return the economy to SuperCycle levels. The chart above, showing the labour market participation rates for the US Wealth Creator 25 – 54, and New Old 55+, cohorts, highlights two core issues:
□ Fewer Wealth Creators are working today than in 2000, when the oldest BabyBoomer was about to become 55
□ The US has also done very badly at keeping the New Olders in the work force – their participation rate today at 40% is half that of the Wealth Creators, and is lower than in the pre-1965 era
It is really no surprise that the US economy is struggling, given these figures.
One of the key problems is that current US Social Security rules penalise people who want to work, but need to take their benefits early. This matters, as 10k Boomers are retiring every day until 2030. Only around 2% of these retirees can afford to wait until the age of 70 to take their benefits – even though this would increase their benefits by an astonishing 76% versus taking them at 62:
□ More than 1/3rd of all retirees rely on Social Security for 90% or more of their income, and 2/3rds rely on it for more than half of their income.
□ More than half of American households in the New Old 55+ cohort have nothing saved for retirement
□ A quarter of these households will also not receive any kind of company pension
Company pensions themselves are another issue that Congress needs to tackle urgently. As the second chart from Bloomberg notes
□ Pension plans in S&P 500 companies are currently in deficit by $500bn
□ Congress actually made the situation worse in 2012 by allowing companies to value their pension liabilities by using a “smoothed” discount rate based on average interest rates over the past 25 years
□ This makes no sense, in the light of John Williams’ conclusion that “interest rates are going to stay lower than we have come to expect in the past“.
□ The reason, of course, was that Congress wanted to join the Fed in supporting financial markets by prioritising share buybacks and boosting stock prices. Thus since 2012, many companies haven’t had to fund their pensions plans – and on average, those with large plans have been able to cut their contributions by half
THE NEW CONGRESS WILL HAVE TO FOCUS ON SUPPORTING RETIREMENT INCOME
So here’s the nub of the issue. The Fed, like other major central banks, is close to admitting that its monetary experiments have failed to produce the expected results. The next Administration will therefore be faced with a need to unwind many of the policies put in place since the financial crisis began 8 years ago.
3 key issues will therefore confront the next President. He or she:
□ Will have to design measures to support older Boomers to stay in the workforce
□ Must reverse the decline that has taken place in corporate funding for pensions
□ Must also tackle looming deficits in Social Security and Medicare, as benefits will otherwise be cut by 29% in 2030
It has always been obvious that the Fed could not possibly control the economic fortunes of 321m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted as a result. The path back to fiscal sanity will be very hard indeed.