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.
First, the good news. It has long been recognised that the UK economy is over-dependent on financial services, and that its housing market – particularly in London – is wildly over-priced in relation to earnings. The Brexit vote should ensure that both these problems are solved:
- Many banks and financial institutions are already planning to move out of the UK to other locations within the EU, so they can continue to operate inside the Single Market
- There is no reason for those which are foreign-owned to stay in the country, now the UK is leaving the EU
- This will also undermine the London housing market by removing the support provided by these high-earners
- In addition, thousands of Asians, Arabs, Russians and others will now start selling the homes they bought when the UK was seen as a “safe haven”
This is probably not the result that most Leave voters expected when they voted on Thursday. These voters will also soon find out that Thursday was not the Independence Day they were promised. It is already obvious that Leave campaigners have no clear idea of what to do next. They are even divided about whether to immediately trigger the 2-year departure period under Article 50 of the Lisbon Treaty.
Leave voters have more shocks ahead of them, of course:
- Most believed that the UK would immediately be able to “take control of its borders” and dramatically reduce immigration. But as I noted during the campaign, the majority of immigration has always been from outside the EU – and could already have been stopped, had the current or previous governments chosen to do this
- Nor will the National Health Service suddenly benefit from the promised £350m/week ($475m) by stopping UK contributions to the EU. For a start, more than half of this money already came back to the UK from the EU, and so can’t be spent a second time
- Even more importantly, nothing is going to happen for at least 2 years whilst the Leave negotiations take place
This, of course, is where the bad news starts. What will be the reaction of Leave voters as they discover they have been fed half-truths on these and other critical issues? And what will happen as house prices begin to fall, and jobs in financial services – as well as manufacturing – begin to disappear as companies relocate elsewhere within the EU?
BREXIT VOTE WILL HIT EUROPE AND THE GLOBAL ECONOMY
The bad news is, unfortunately, not restricted to the UK. Already, alarm has begun to spread across the rest of the EU. There are strong calls for referendums to take place in 3 of the EU’s 6 founding members – France, Italy and The Netherlands. It is hard to see how the EU could survive if even one of these votes resulted in a Leave decision.
In turn, of course, this is bound to draw attention once more to the unsolved Eurozone debt crisis. Can anyone now really continue to believe the European Central Bank’s 2012 promise to do “whatever it takes” to preserve the euro, as set out by its President, Mario Draghi?
The simple fact is that the Brexit vote is the canary in the coalmine. It is the equivalent of the “Bear Stearns collapse” in March 2008, ahead of the financial crisis. And as I have argued for some time, the global economy is in far worse shape today than in 2008, due to the debt created by the world’s major central banks.
THE BREXIT VOTE, LIKE THE 2008 CRISIS, WAS NOT A ‘BLACK SWAN’ EVENT
I am used, by now, to my forecasts being ignored by conventional wisdom. The Brexit vote saw a repeat of the complacency that greeted my warnings in the Financial Times and here before the 2008 financial crisis. Thus my March warning was again mostly ignored, namely that:
“A UK vote to leave the European Union is becoming more likely”.
Instead, like the 2008 crisis, the Brexit vote is already being described as a ‘black swan’ event – impossible to forecast. This attitude merely supports the status quo, as it means consensus wisdom does not have to challenge its core assumptions. Instead, it takes comfort in the view that “nobody could have foreseen this happening”.
Critically, this means that the failure of the post-2008 stimulus programmes is still widely ignored. Yet these have caused global debt levels to climb to more than 3x total GDP, according to McKinsey. As the map above shows, they have created a debt-fuelled ‘ring of fire’, which now threatens to collapse the entire global economy:
- China’s reversal of stimulus policies has led to major downturns in the economies of all its commodity suppliers
- Latin America, Africa, Russia and the Middle East can no longer rely on exports to China to support their growth
- Japan’s unwise efforts at stimulus via Abenomics have also proved a complete failure
- Now Brexit will almost inevitably cause a major collapse in London house prices
- And it will focus attention on the vast debts created by the Eurozone debt crisis
- It will also unsettle US investors, who have taken margin debt to record levels in the belief that the US Federal Reserve will never let stock market prices fall
TIME FOR STRAIGHT TALKING ON THE IMPACT OF AGEING POPULATIONS ON ECONOMIC GROWTH
It is therefore vital that policymakers now make a new start, whilst there is still time to avoid total financial collapse. Once people begin to realise that all this debt can never be repaid, then interest rates will soar and many currencies collapse. This is not being alarmist – this is just stating obvious facts.
The critical need is to recognise that demographics, not monetary policy, drive economies. A world with lots of young BabyBoomers in the Wealth Creating 25-54 age group will inevitably see strong growth. And if more and more women return to the workforce after childbirth, this will turbo-charge an economic SuperCycle.
This is what happened between 1983 – 2007, when the world saw almost constant growth. The US recorded just 16 months of recession in 25 years. But last year saw global GDP decline by a record amount in current dollars, more than in 2009 – a clear warning sign of major trouble ahead.
The issue is very simple. Common sense tells us that the combination of a 50% increase in global life expectancy since 1950, and a 50% fall in fertility rates, means that the world has now reached the “demographic cliff“:
- 1bn ageing Boomers are joining 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 global population by 2030, twice the percentage in 1950
This is good news, not bad. Who amongst us, after all, would not choose to have 20 years of life expectancy at age 65 instead of dying? That is today’s position in the Western world. And people in the emerging economies are catching up fast. They can already now expect to live another 15 years at age 65.
The trade-off is lower, or negative growth. People in this New Old 55+ age group already own most of what they need, and their incomes decline dramatically as they approach retirement.
But this simple fact of life has never been explained to voters. Instead they have been told since 2008 that policymakers are confident of returning the economy to SuperCycle levels of growth. No wonder they are growing restless, and starting to mistrust everything they are being told by the supposed experts.
CONCLUSION – TIME TO RESTORE TRUST WITH PLAIN SPEAKING
Policymakers and the media now have a grave responsibility, as do do all of us.
It is critically important that policymakers now recognise they must immediately reverse course on stimulus policies, and come clean with voters about the real economic situation.
Of course this will result in very painful conversations. But the alternative, of ignoring the warning provided by the Brexit vote, is simply too awful to contemplate.
The world’s central bankers would have been sacked long ago if they were CEOs running companies. They would also have been voted out, if they were elected officials. Not only have they failed to achieve their promised objectives – constant growth and 2% inflation – they have kept failing to achieve them since the Crisis began in 2008.
But they are neither, So instead, they cling on to office, becoming more discredited with every year that passes. Even the IMF is now warning that:
“Advanced economies are facing the triple threat of low growth, low inflation, and high public debt. This combination of factors could create downward spirals where economic activity and prices decline—leading to increases in the ratio of debt to GDP—and further, self-defeating attempts to reduce debt.”
Much of the IMF’s analysis could easily have come from the blog – with just one exception. It, like central bankers themselves, is still too proud to admit that demographics drive the world’s economies – not central bankers:
- Central banks revelled in the idea they were geniuses during the Boomer-led SuperCycle
- Like UK Finance Minister, Gordon Brown, they claimed to have conquered the cycle of “boom and bust”
- But their economic models were so out of date, they couldn’t even forecast the subprime crash
- Yet its inevitability was obvious even to the blog, long before it happened, as documented in “The Crystal Blog“
Finally, however, 8 years later, the voice of common sense is starting to be heard. As the World Bank’s country director for Indonesia told the Financial Times:
“No country becomes rich after it gets old. The rate at which you grow [with] a whole bunch of old people on your back is much lower than the rate of growth at which you can grow when people are active, are educated, are healthy.”
Nobel Prize-winner, Prof Joseph Stiglitz has also argued the need for change:
“It should have been apparent that most central banks’ pre-crisis models – both the formal models and the mental models that guide policymakers’ thinking – were badly wrong. None predicted the crisis; and in very few of these economies has a semblance of full employment been restored. The ECB famously raised interest rates twice in 2011, just as the euro crisis was worsening and unemployment was increasing to double-digit levels, bringing deflation ever closer.
“They continue to use the old discredited models, perhaps slightly modified. In these models, the interest rate is the key policy tool, to be dialled up and down to ensure good economic performance. If a positive interest rate doesn’t suffice, then a negative interest rate should do the trick….If central banks continue to use the wrong models, they will continue to do the wrong thing.”
But central bankers can’t be sacked by shareholders or voted out by the electorate. And now they are starting to cover up for their own mistakes by blaming each other. Thus as the Wall Street Journal headlined over the weekend:
“U.S. chides five economic powers over policies
“U.S. officials are increasingly concerned other countries aren’t doing enough to boost demand at home, relying too heavily on exports to bolster growth. “Counting on cheap currencies as a shortcut to boosting exports can create risks across the global economy, as nations fight to stay ahead of their competitors”.
This would be sound advice, if it wasn’t for the awkward fact that the US Federal Reserve is currently relying on a devaluation of the US$ to support the US economy. Just as in Japan and Europe, the Fed’s optimism about its policies creating the magical 2% inflation and a return to SuperCycle growth have just been proved wrong again:
But still, they refuse to recognise the economic impact of demographic change. Instead central bankers are now starting to fight amongst themselves. Each wants a lower value for their currency – even though common sense says this is impossible – and is also irrelevant to meeting the challenge of ageing populations.
So we continue to move through the Cycle of Deflation, as the chart shows. We are heading, if nothing changes, towards major currency wars. And it is no surprise that populist politicians such as likely Republican Presidential candidate, Donald Trump, are now starting to argue for trade protectionism to preserve jobs.
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 58%
Naphtha Europe, down 53%. “Naphtha prices rise to fresh 2016 highs on Brent crude”
Benzene Europe, down 53%. “Both benzene and oil initially moved lower due to uncertainty deriving from the decisions expected from the Bank of Japan and the US Federal Reserve”
PTA China, down 39%. “Buyers could book PTA cargoes earlier in the May/June period due to the upcoming preparations for the G20 meetings in China from July onwards, when producers in the entire polyester chain are expected to reduce operating rates.”
HDPE US export, down 27%. “Continuous weak buying interest weighed on the market sentiment in China.”
¥:$, down 4%
S&P 500 stock market index, up 5%