Europe’s auto sector suffers as Dieselgate and China’s downturn hit sales

Trade wars, Dieselgate and recession risk are having a major impact on the European auto industry, as I describe in my new video interview with ICIS Chemical Business deputy editor, Will Beacham.

One key pressure point is created by the downturn in China’s auto industry. As the chart shows, it has been a fabulous growth market in recent years due to China’s stimulus policies, with sales growing nearly five-fold from 550k/month in 2008 to a peak of 2.5m/month last year. And German car exports did incredibly well as a result, due to their strong reputation amongst consumers.

But the start of the US/China trade war last year – plus the $2tn taken out of China’s speculative shadow banking sector over the past 2 years by the government’s deleveraging campaign – means sales have been in decline for almost a year. 2018 saw the first downturn in the market since 1992, and since then the pace of decline has been accelerating with May volumes down 17%.

European car sales have also been falling since September as the second chart confirms. And unfortunately, the industry is confronted by a near-perfect storm of problems, which make it likely that the current downward trend will continue and probably accelerate.

The most immediate issue is the slowdown in the EU economy, with consumers becoming nervous about making high-ticket car purchases. Added to this, of course, are concerns over Brexit – which led sales in the UK (the 2nd largest market) to hit a 6-year low in the normally buoyant sales month of March, 14.5% below the 2017 level.

And then, of course, there are concerns over China’s slowdown, particularly for Germany’s export-oriented manufacturers such as BMW, Audi, Mercedes and Porsche – plus rising concerns over the potential for a European trade war with the USA.

But the real concern arises from the continuing fall-out from Dieselgate, which led diesel’s share of the EU market to fall by 18% in 2018 versus 2017 to 5.59m. Diesel cars accounted for only 35% of EU auto sales, the lowest level since 2001. And in turn this is wrecking the industry’s plans for meeting the new EU rules on CO2 emissions, which VW estimates has already cost it around €30bn, at a time when all the carmakers are also having to invest heavily in EV technology.

As the European Environment Agency (EEA) noted last month:

“For the first year since 2009, petrol cars constituted the majority of new registrations in 2017 (53 %). New diesel cars, which were on average around 300kg heavier than new petrol cars, emitted on average 117.9g CO2/km, which is 3.7g CO2/km less than the average petrol car. The average fuel efficiency of new petrol cars has been constant in 2016 and 2017, whereas the fuel-efficiency of new diesel cars has worsened compared to 2016 (116.8 g CO2/km). If similar petrol and diesel segments are compared, new conventional petrol cars emitted 10%-40% more than new conventional diesel cars.”

Manufacturers have no easy options. They can, of course, aim to accelerate Electric Vehicle (EV) sales in order to gain “super-credits” towards the new limits. But EVs are currently less than 2% of the EU market, so the scope for a major ramp-up in volume is very limited, and their profit margins are much lower due to the battery cost. UBS therefore suggest that automakers earnings per share will be badly hit, with PSA down 25%, VW down 13%, Renault down 10%, Daimler down 9% and BMW down 7%.

The saga highlights how the diesel makers’ decision to cheat on reported emission levels in order to maximise short-term profit has led to major long-term damage for many manufacturers. FCA’s need to enter a “pooling arrangement“ with Tesla to reduce its potential fines, and to exit sales of its most heavily polluting models, highlights the scale of the problems.

In turn, as I discuss, this is all very bad news for major suppliers to the auto industry such as the petrochemical sector.  Please click here if you would like to see the full interview.

Recession risk rises as Iran tensions and US-China trade war build

Oil markets are once again uneasily balanced between two completely different outcomes – and one again involves Iran.

Back in the summer of 2008, markets were dominated by the potential for an Israeli attack on Iranian nuclear facilities, as I summarised at the time:

“Nothing is certain in life, except death and taxes. But it is hard to see markets becoming less volatile until either an attack takes place, or a peaceful solution is confirmed. And with oil now around $150/bbl, two quite different outcomes seem possible:

• In the event of an Israeli attack, prices might well rise $50/bbl to reach $200/bbl, at least temporarily

• But if diplomacy works, they could easily fall $50/bbl to $100/bbl”

In the event, an attack was never launched and prices quickly fell back to $100/bbl – and then lower as the financial crisis began.

Today, Brent’s uneasy balance around $70/bbl reflects even more complex fears:

  • One set of worries focuses on potential supply disruption from a war in the Middle East
  • The other agonises over the US-China trade war and the rising risk of recession

It is, of course, possible that both fears could be realised if war did break out in the Gulf and oil prices then rose above $100/bbl.

The issue is highlighted in the Reuters chart on the left, which shows that Brent has moved from a contango of $1/bbl at the beginning of the year into a backwardation of nearly $4/bbl on the 6-month calendar spread. As they note:

“Backwardation is associated with periods of under-supply and falling inventories, while contango is associated with the opposite, so the current backwardation implies stocks are expected to fall sharply.”

But as the second Reuters chart confirms, traders are also aware that forecasts for oil demand are based on optimistic IMF forecasts for global growth. And recent hedge fund positioning confirms that caution may be starting to appear.

Traders are also aware of the key message from the above chart, which shows that periods when oil prices cost 3% of global GDP have almost always led to recession.  The only exception was after the financial crisis when central banks were printing as much money as possible to boost liquidity.

The reason is that consumers only have a certain amount of discretionary income.  If oil prices are low, then they have spare cash to buy the products and services that create economic growth. But if prices are high, their cash is instead spent on transport and heating/cooling costs, and so the economy slows.

“To govern is to choose” and President Trump therefore has some hard choices ahead:

  • His trade war with China currently appeals to many voters, Democrat and Republican.  But will that support continue as the costs bite?  The New York Federal Reserve reported on Friday that the latest round of tariffs will cost the average American household $831/year
  • Similarly, many voters favour taking a hard line with Iran.  But average US gasoline prices are already $2.94/gal as the US driving season starts this weekend, and today’s high prices will particularly impact the President’s core blue collar and rural voters

History doesn’t repeat, but it often rhymes as the famous American writer, Mark Twain, noted. If the President now chooses to fight a trade war with China and a real war with Iran, then he risks losing popularity very quickly as the costs in terms of lives and cash become more apparent.  Yet as we have seen since Lyndon Johnson’s time, this is usually something that politicians only learn after the event.

Investors and companies therefore have little to lose, and potentially much to gain, by accepting that we can only guess at how the two situations may play out.  Developing a scenario approach that plans for all the possible outcomes – as in 2008 – is much the most prudent option.

US-China trade war confirms political risk is now a key factor for companies and the economy

There are few real surprises in life, and President Trump’s decision to launch a full-scale trade war with China wasn’t one of them.  He had virtually promised to do this in his election campaign, as I noted here back in September 2015:

“The economic success of the BabyBoomer-led SuperCycle meant that politics as such took a back seat.  People no longer needed to argue over “who got what” as there seemed to be plenty for everyone.  But today, those happy days are receding into history – hence the growing arguments over inequality and relative income levels.

“Companies and investors have had little experience of how such debates can impact them in recent decades.  They now need to move quickly up the learning curve.  Political risk is becoming a major issue, as it was before the 1990s.”

Of course, I received major push-back for this view at the time, just as I did in 2007-8 when warning of a likely US subprime crisis.  Most people found it very hard to believe that politics could trump economic logic, as one American commentator wrote in response to my analysis:

“I have a very, very, very difficult time imagining that populist movements could have significant traction in the U.S. Congress in passing legislation that would seriously affect companies and investors”.

But, sadly or not, depending on your political persuasion, my conclusion after the election result was known seems to have stood the test of time:

“You may, or may not, approve of President-elect Trump’s policies. You may, or may not, think that these policies are destined to fail. But they do confirm that the world is moving into a New Normal, which will inevitably create Winners and Losers.

“The Winners are likely to come from those who accept that President Trump will at least try to introduce the policies proposed by Candidate Trump. And the Losers will almost inevitably include those who continue to believe he represents “business as usual”.

Now, of course, we will start to see these Winners and Losers appear, as there is little the Western central banks can do to counteract the economic cost for the global economy of a US-China trade war.

One sign of this was Uber’s miserable performance on its stock market debut – despite having been priced at the low end of the planned range, it still fell further on its opening, in line with my suggestion last month that Uber’s $91bn IPO marks the top for today’s debt-fuelled stock markets.

But there will be many more serious casualties over the next few months and years:

  • NE Asian countries such as Japan and S Korea are part of global supply chains which send a wide range of components to China, where they are incorporated into finished goods for sale to the USA
  • Germany and the major European countries have relied on sales to China to boost economic growth, as domestic demand has stagnated, and clearly this support is now going to weaken
  • The mining industry and other suppliers of commodities will also be hit – Rio Tinto, for example, depends on China for 45% of its revenue, and on the USA for 15%
  • The petrochemicals industry has been dependent on China for its growth since the 2008 financial crisis, as I noted last summer, US-China tariffs could lead to global Polyethylene price war

Back in 2011-12, John Richardson and I wrote ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’ to give our view of the likely consequences of the major demographic changes underway in the global economy.

Unfortunately, the politicians of the time took the seemingly easy route out of the crisis. They decided that printing money was so much easier than having a dialogue with the electorate about the implications of ageing populations, or the fact that Western fertility rates have been below replacement levels for the past 45 years.  Our warning is now coming true:

“The transition to the New Normal will be a difficult time. The world will be less comfortable and less assured for many millions of Westerners. The wider population will find itself following the model of the ageing boomers, consuming less and saving more. Rather than expecting their assets to grow magically in value every year, they may find themselves struggling to pay-down debt left over from the credit binge.

“Companies will need to refocus their creativity and resources on real needs. This will require a renewed focus on basic research. Industry and public service, rather than finance, will need to become the destination of choice for talented people, if the challenges posed by the megatrends are to be solved. Politicians with real vision will need to explain to voters that they can no longer expect all their wants to be met via endless ‘fixes’ of increased debt.

“We could instead decide to ignore all of this potential unpleasantness.

“But doing nothing is not a solution. It will mean we miss the opportunity to create a new wave of global growth from the megatrends. And we will instead end up with even more uncomfortable outcomes.

Uber’s $91bn IPO marks the top for today’s debt-fuelled stock markets

Uber’s IPO next month is set to effectively “ring the bell” at the top of the post-2008 equity bull market on Wall Street.  True, it is now expecting to be valued at a “bargain” $91bn, rather than the $120bn originally forecast. But as the Financial Times has noted:

“Founded in 2009, it has never made a profit in the past decade. Last year it recorded $3.3bn of losses on revenues of $11bn.”

And Friday’s updated prospectus confirmed that it lost up to $1.1bn in Q1 on revenue of $3.1bn. In more normal times, Uber would have been allowed to go bankrupt long ago,

So why have investors been so keen to continue to throw money at the business?  The answer lies in the chart above, which shows how debt has come to dominate the US economy.  It shows the cumulative growth in US GDP since 1966 (using Bureau of Economic Analysis data), versus the cumulative growth in US public debt (using Federal Reserve of St Louis data):

  • From 1966 – 1979, each dollar of debt was very productive, creating $4.70 of GDP
  • From 1980 – 1999, each dollar was still moderately efficient, creating $1.20 of GDP
  • Since 2000, however, and the start of the Federal Reserve’s subprime and quantitative easing stimulus programmes, each dollar of debt has destroyed value, creating just $0.38c of GDP

After all, if one ignores all the hype, Uber is just a very ordinary business doing very ordinary things.  Most people, after all, could probably run a serially loss-making taxi and food delivery service, as long as someone else agreed to keep funding it.

Yes, like the other “unicorns”, it has a very customer-friendly app to help customers to use its service. But in terms of its business model:

  • When one takes a ride with Uber, the driver often also drives for Lyft and for the local taxi firm, and her car is often also the same car
  • This means that in reality, Uber’s main competitive advantage is its ability to subsidise the ride or the food bought via Uber Eats

DEBT HAS CHANGED FINANCIAL MARKET BEHAVIOUR

This addiction to debt on such a scale, and for such a long period, has changed financial market behaviour.

Nobody now needs to do the hard graft of evaluating industry dynamics, business models and management capability.  Instead, they just need to focus on buying into a “hot sector” with a “story stock”, and then sit back to enjoy the ride. The chart above from Prof Jay Ritter confirms the paradigm shift that has taken place:

  • It highlights how 80% of all IPOs last year were loss-making, compared to around 20% before 2000
  • The only parallel is with the late 1990s, when dot.com companies persuaded credulous investors that website visits were a leading indicator for profit

Like other so-called “unicorns with $1bn+ valuations, today’s debt-fuelled markets have allowed Uber to raise money for years in the private markets. So why has Uber now chosen to IPO, and to accept a valuation at least 25% below its original target?.

CORPORATE DEBT IS INCREASINGLY FUNDING STOCK BUYBACKS TO SUPPORT SHARE PRICES

The above 2 charts from the Wall Street Journal start to suggest the background to its decision:

  • They show the ratio of US corporate debt to GDP has now reached an all-time high at 48%.  The quality of this debt has also reduced, with the majority now just BBB-rated and with record levels of leverage
  • BBB ratings are just above junk, and most major investment managers are not allowed to hold junk-rated bonds in their portfolio. So they would have to sell, quickly, if this debt was downgraded

The problem is that much of the corporate debt raised in recent years has gone to fund share buybacks rather than investment for the future. President Trump’s tax cuts meant buybacks hit a record $806bn last year, versus the previous record of $589bn in 2007.  According to Federal Reserve data, investors sold a net $1.1bn of shares over the past 5 years – yet stock markets powered ahead as buybacks totalled $2.95bn.  As Goldman Sachs notes:

“Repurchases have consistently been the largest source of US equity demand. Since 2010, corporate demand for shares has far exceeded demand from all other investor categories combined.”

THE FED’S RECENT PANIC OVER INTEREST RATES HIGHLIGHTS THE STOCK MARKET RISK

Against this background, it is not hard to see why the US Federal Reserve panicked in January as 10-year interest rates rose beyond 3%.  For years, the Fed has believed, as its then Chairman Ben Bernanke argued in November 2010 that:

“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.”

Rising interest rates are likely to puncture the debt bubble that their stimulus policy has created – by reducing corporate earnings and increasing borrowing costs for buybacks.

Uber’s IPO suggests that the “smart money” behind Uber’s IPO – and that of the other “unicorns” now rushing to market – has decided to cash out whilst it still can, despite the valuation being cut. They must have worried that in more normal markets, they would never be able to float a serially loss-making company at a hoped-for $91bn valuation.

If they really believed Uber was finally about to turn the corner and become profitable at last, why would they accept a valuation some 25% below their original target of less than  a month ago?  The rest of us might want to worry about what they know, that we don’t.

Asian downturn worsens, bringing global recession nearer

The chemical industry is the best leading indicator for the global economy.  And my visit to Singapore last week confirmed that the downturn underway in the Asian market creates major risks for developed and emerging economies alike.

The problem is focused on China’s likely move into recession, now its stimulus policies are finally being unwound.  And the result is shown in the above chart from The pH Report, updated to Friday:

  • It confirms that the downturn began before oil prices peaked at the beginning of October, confirming that companies were responding to a downturn in end-user demand
  • Since then, of course, the oil price has – rather dramatically – entered a bear market, with prices down by nearly a third

The question now is whether finance directors will choose to aggressively destock ahead of year-end results, to mitigate the volume decline with a decline in working capital. This would be a bold move given continuing geo-political uncertainty in the Middle East, and would also conflict with the more upbeat guidance that was given earlier with Q3 results.

But a review of ICIS news headlines over the past few days suggests they may have little choice.  Inventories are described as “piling up” in a wide range of major products, including polyethylene – the biggest volume polymer.  Indian producers are even offering “price protection” packages on polypropylene, to safeguard customers from losses if prices fall further.

Asian countries and their major partners (eg Argentina, S Africa, Turkey) were, of course, the first to be hit by China’s downturn.  But Q3’s fall in German GDP shows the downturn has now spread to the Western economy that most benefited from China’s post-2008 stimulus bubble.  As The Guardian noted:

“Goods exports make up 40% of German GDP – a much bigger proportion than for the next two biggest eurozone economies, France and Italy.”

OIL MARKETS CONFIRM THE RECESSION RISK

Of course, consensus opinion still believes that the US economy is sailing along, regardless of any problems elsewhere.  But the chart of oil prices relative to recession tells a different story:

  • The problem is that oil prices have been rising since 2016, with the summer proving the final blow-off peak.  As always, this meant consumers had to cut back on discretionary spending as costs of transport and heating rose
  • The cost of oil as a percentage of GDP reached 3.1% in Q3 – a level which has always led to recession in the past, with the exception of the post-2008 stimulus period when governments and central banks were pouring $tns of stimulus money into the global economy
  • In turn, this means a downturn is now beginning in US end-user demand in critical areas such as housing, autos and electronics

Oil markets have therefore provided a classic example of the trading maxim for weak markets – “Buy on the rumour, sell on the news”.

  • Prices had risen by 75% since June on supply shortage fears, following President Trump’s decision to exit the Iran nuclear deal on November 4
  • As always, this created “apparent demand” as buyers in the US and around the world bought ahead to minimise the impact of higher prices
  • But the higher prices also negated the benefit of the earlier tax cuts for his core supporters just ahead of the mid-term elections, causing Trump to undertake a policy u-turn
  • He is now pushing Saudi Arabia and Russia to maintain production, and has announced 180-day exemptions for Iran’s 8 largest customers – China, India, S Korea, Japan, Italy, Greece, Taiwan and Turkey.

Understandably, oil traders have now decided that his “bark is worse than his bite“.  And with the downturn spreading from Asia to the West, markets are now refocusing on supply/demand balances, with the International Energy Agency suggesting stocks will build by 2mb/d in H1 2019. In response, OPEC are reportedly discussing potential cuts of up to 1.4mb/d from December.

CHINA’S SHADOW BANKING COLLAPSE IS CREATING A NEW FINANCIAL CRISIS

Unfortunately, as in 2008, the collapse in oil prices is coinciding with the end of stimulus policies, particularly in China, as the chart of its shadow bank lending confirms.  This has hit demand in two ways, as I discussed earlier this month in the Financial Times:

  • Just 3 years ago, it was pumping out an average $140bn/month in mainly property-related lending *
  • This created enormous demand for EM commodity exports
  • It also boosted global property prices as wealthy Chinese rushed to get their money out of the country
  • But during 2018, lending has collapsed by more than 80% to average just $23bn in October

China’s post-2008 stimulus programme was the growth engine for the global economy – with the efforts of the Western central banks very much a sideshow in comparison.  It was more than half of the total $33tn lending to date.  But now it is unwinding, prompting the Minsky Moment forecast a year ago by China’s central bank governor:

China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous.”

As I warned then:

“Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy. China’s lending bubble – particularly in property – is likely coming to an end. In turn, this will lead to a bumpy ride for the global economy.

The bumps are getting bigger and bigger as we head into recession.  Asia’s downturn is now spreading to the rest of the world, and is a major wake-up call for anyone still planning for “business as usual”.

 

* Lending has major seasonal peaks in Q1, so I use rolling 12 month averages to avoid distortions 

“What could possibly go wrong?”

I well remember the questions a year ago, after I published my annual Budget Outlook, ‘Budgeting for the Great Unknown in 2018 – 2020‘.  Many readers found it difficult to believe that global interest rates could rise significantly, or that China’s economy would slow and that protectionism would rise under the influence of Populist politicians.

MY ANNUAL BUDGET OUTLOOK WILL BE PUBLISHED NEXT WEEK
Next week, I will publish my annual Budget Outlook, covering the 2019-2021 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.

THE 2017 OUTLOOK WARNED OF 4 KEY RISKS
My argument last year was essentially that confidence had given way to complacency, and in some cases to arrogance, when it came to planning for the future.  “What could possibly go wrong?” seemed to be the prevailing mantra.  I therefore suggested that, on the contrary, we were moving into a Great Unknown and highlighted 4 key risks:

  • Rising interest rates would start to spark a debt crisis
  • China would slow as President Xi moved to tackle the lending bubble
  • Protectionism was on the rise around the world
  • Populist appeal was increasing as people lost faith in the elites

A year later, these are now well on the way to becoming consensus views.

  • Debt crises have erupted around the world in G20 countries such as Turkey and Argentina, and are “bubbling under” in a large number of other major economies such as China, Italy, Japan, UK and USA.  Nobody knows how all the debt created over the past 10 years can be repaid.  But the IMF reported earlier this year that total world debt has now reached $164tn – more than twice the size of global GDP
  • China’s economy in Q3 saw its slowest level of GDP growth since Q1 2009 with shadow bank lending down by $557bn in the year to September versus 2017.  Within China, the property bubble has begun to burst, with new home loans in Shanghai down 77% in H1.  And this was before the trade war has really begun, so further slowdown seems inevitable
  • Protectionism is on the rise in countries such as the USA, where it would would have seemed impossible only a few years ago.  Nobody even mentions the Doha trade round any more, and President Trump’s trade deal with Canada and Mexico specifically targets so-called ‘non-market economies’ such as China, with the threat of losing access to US markets if they do deals with China
  • Brexit is worth a separate heading, as it marks the area where consensus thinking has reversed most dramatically over the past year, just as I had forecast in the Outlook:

“At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail. But what if they are wrong? It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.

“Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.”

  • Populism is starting to dominate the agenda in an increasing number of countries.  A year ago, many assumed that “wiser heads” would restrain President Trump’s Populist agenda, but instead he has surrounded himself with like-minded advisers; Italy now has a Populist government; Germany’s Alternativ für Deutschland made major gains in last year’s election, and in Bavaria last week.

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.  As a result, voters start to listen to Populists, who offer seemingly simple solutions to the problems which have been ignored by the elites.

Next week, I will look at what may happen in the 2019 – 2021 period, as we enter the endgame for the policy failures of the past decade.

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