The litmus test for the global economy

“They may ring their bells now, before long they will be wringing their hands”

The wisdom of Sir Robert Walpole, the UK’s first premier, seems the only possible response to this weekend’s headline from the Wall Street Journal. How can a National Emergency ever be the basis for a major rise in stock markets?

Of course, we all know that stock markets have become addicted to stimulus. But the problem with stimulus is that the patient needs more and more of it, to keep markets moving higher:

But the headlines surrounding the National Emergency clearly did the job as far as the High-Frequency Traders were concerned. They still dominate equity and other major markets, and Friday afternoon was exactly the kind of bumper payday that they adore.

The only problem is that neither stock markets, nor even the Federal Reserve, can cure coronavirus. And if the pandemic continues as the experts expect:

  • Between 160 million and 214 million Americans will become infected
  • Between 2.4 million and 21 million people could require hospitalisation

Clearly, no hospital system in the world could cope with the higher end of this range, particularly if they all come at once. And although the US system is easily the most expensive in the world, its performance is relatively poor by comparison with other major Western nations.

One key issue, of course, is testing. Nobody can know the actual size of the problem until we know how many people are already affected. And yet, as the WSJ reports from the President’s speech on Friday:

“By early next week, Mr. Trump said, there would be a half-million additional tests available, with 5 million tests available within a month.”

By comparison, China already has the capacity to do 1.7 million tests a week, according to the World Health Organisation.

This, of course, is why the experts are talking about trying to ‘delay’ the pandemic, rather than ‘contain’ it, as the chart based on US Centers for Disease Control and Prevention analysis (interpreted by Vox) confirms.

The US lack of a proper social support system is also a major disadvantage. Around 34 million American workers have no access to paid sick leave, for example, and 27 million don’t have health insurance.  These people may well feel they have to keep working even if infected in order to pay the rent.

Hopefully, the new support package agreed on Friday night will help solve these problems. But who knows how long it will take to actually roll out the measures, and how many people will benefit?

The essence of populism, of course, is that it supplies simple answers to complex problems. And coronavirus is likely to prove a classic case of this weakness in action:

  • Experts suggest the virus will keep returning unless ‘herd immunity’ can be established
  • They estimate this means around 60% of the population therefore need to be infected

Data from China and Italy confirms that the main risk from coronavirus is to people over the age of 70, as the chart shows. The CDC also recommend that people with serious chronic medical conditions such as heart disease, diabetes and lung disease need to take special precautions.

But their voice is being drowned out. People are understandably frightened, and they need wise and well-informed leaders to give them clear messages. Leaders should be focused on aiming to manage the pandemic and on taking the obvious steps to protect those most vulnerable.  Unfortunately, the opposite is happening as former UK Finance Minister, Lord Darling  has noted:

“There is a striking lack of global cooperation in dealing with coronavirus”.

The issue is that effectively closing down large parts of the economy in response to coronavirus is a very high risk strategy:

  • Millions of businesses could well go bankrupt around the world, and tens of millions lose their jobs
  • And as watchdog the Institute of International Finance already warned on Thursday:

“Global growth is potentially approaching 1% this year (anything below 2.5% is essentially recession). The multitude of shocks in the system now risks a global “sudden stop”. Falling oil prices potentially accelerate mounting credit stress in the US. Vulnerable emerging markets are already seeing large outflows”.

Friday saw Wall Street celebrating its latest “fix” of easy money. But as Bloomberg also noted:

“For context, this was the S&P 500’s best day since Oct. 28, 2008. At the end of that day, the bottom was more than 4 months away, and there was a 29% fall before hitting the intraday low.”

We may well all come to regret, as we wring our hands in the summer, that the bells rang too soon.

 

 

UK election offers voters no middle ground in December

Pity the poor UK voters as they prepare to vote in probably the most critical election of their lives.

As they battle the wind and rain to vote in the first December election for 100 years, they already know there are only 3 likely outcomes:

  • Tory majority, Brexit by end-January, EU trade deal uncertain
  • Labour majority, Brexit postponed, hard socialist agenda
  • Another minority government, outcome uncertain

The first option is less likely than the polls suggest, for the simple reason that Johnson will lose probably 40+ seats in Remain areas – to the LibDems in the South/London, and to the SNP in Scotland. To win, he therefore has to persuade large numbers of traditionally Labour Leave voters in the North/Midlands to vote Tory, for the first time in their family’s history.

President Trump’s proposed solution – an alliance with the Brexit Party – would avoid splitting the Leave vote and might gain the Brexit Party some Labour seats. But Trump’s personal unpopularity with most UK voters means his intervention on Friday is unlikely to help. Britons, like Americans, don’t like foreigners interfering in their domestic elections.

And then, of course, there are the dark arts of social media. Johnson’s chief of staff, Dominic Cummings, pioneered the UK’s use of these when running the Leave campaign.  Who knows what lies and half-truths will be circulated this time, and what impact they might have?

The second option depends critically on whether Labour can neutralise the Brexit issue by saying they will ‘trust the people’ with a second vote in a summer referendum – and not go into detail about the question that would be asked.

If they can, then their leader, Jeremy Corbyn, has a perfect opening for the old-fashioned campaigning at which he excels. He can simply attack the Tory record of the past 10 years and focus on issues such as the economy, climate change, the NHS and education, which are natural vote winners for Labour.

In normal circumstances, Labour would then be odds-on favourites to win.  But their leader, Jeremy Corbyn, has the lowest favourability ratings of any recent Opposition leader. He seen as an hard-line socialist and as weak on tackling anti-semitism in the party. As a result, the party struggles in the polls.

The 3rd option of another minority government includes a wide range of outcomes.  It could put the UK back in the chaos of the past 3 years, with nobody able to agree anything. Or, it could mean a second referendum on both Brexit and Scottish independence.

The key will be the level of LibDem support. Can they get to 75+ seats, and become ‘kingmakers’ along with the SNP and the other smaller parties?

Both Tories and Labour are vulnerable to them in Remain seats, due to their clear anti-Brexit policy.

Their focus on the characters of the Tory and Labour leaders is also a likely vote-winner.  But their problem is the UK’s ‘first-past-the-post’ electoral system, which usually means they win a lot of votes, but relatively few seats.

THE MAIN UK PARTIES HAVE ABANDONED THE MIDDLE GROUND
The problem for most voters is that there is no middle ground for them to choose, as in the past:

  • The Tory Party has swung to the right and is promoting English nationalism to avoid losing votes to the Brexit Party
  • The Labour Party has swung to the left and wants to overturn capitalism and adopt 1970s-style socialism
  • The LibDems and SNP agree on Remain, but the SNP also wants to break-up the UK

Johnson’s gamble depends on him winning a large number of seats from Labour to compensate for his losses in Remain areas.

Despite today’s poll ratings, Labour could therefore well take power as a minority government if they campaign effectively. The reason is that it is easier for them to do a deal with the other parties – by offering a referendum with a Remain option to the LibDems, and one on Scottish independence to the SNP.

Pity, therefore, the traditional middle-of-the-road Tory, Labour and LibDem voters,. They need to choose their ‘least worst option’ if they want to affect the result – Brexit, socialism or possible UK break-up. This would not be a great choice for a G7 country at the best of times. It would be even worse today, as an increasingly protectionist world slides into recession,

 

China’s renminbi and the global ring of fire

China’s property bubble puts it at the epicentre of the ring of fire © Reuters 

China’s devaluation could be the trigger for an international debt crisis, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

August has often seen the start of major debt crises. The Latin American crisis began on August 12, 1982. The Asian crisis began with Thailand’s IMF rescue on August 11, 1997. The Russian crisis began on August 17, 1998.

We fear that the renminbi’s fall below Rmb7 per dollar on August 5 will act as just such a catalyst — this time, for the onset of a global debt crisis that has long been in the category of an accident waiting to happen.

The risk is summarised in the chart below from the Institute of International Finance, showing the seemingly inexorable rise in global debt over the past 20 years

Central banks came to believe that business cycles could be abolished by the use of stimulus, first through subprime and then through quantitative easing. This would encourage the return of the legendary “animal spirits” and allow the debt created to be wiped out by a combination of growth and inflation.

© Institute of International Finance

Unfortunately, as we have argued here before, this belief took no account of demographics or the impact of today’s ageing populations in slowing demand growth.

The baby boomers, who created the growth supercycle when they moved into the wealth creator 25-54 generation, have now joined the cohort of perennials aged 55 and above. They already own most of what they need. The focus on stimulus means that policymakers have failed to develop the new social/economic policies needed to maintain soundly-based growth in a world of increasing life expectancy and falling fertility. Instead, stimulus policies have created overcapacity and today’s record levels of debt.

As William White, a former chief economist of the Bank for International Settlements, warned at Davos in 2016: “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.” Presciently, he suggested that the trigger for the crisis could be a Chinese devaluation.

Central banks have created a debt-fuelled ‘ring of fire’ with multiple fault-lines

The risk, outlined in our second chart, is that central banks have created a debt-fuelled global “ring of fire”. China has undertaken around half of all global stimulus since 2008, in effect creating subprime on steroids. As we noted here last year, its tier 1 cities boast some of the highest house-price-to-earnings ratios in the world, while profits from property speculation allowed car sales to rise fourfold from 500,000 a month in 2008 to 2m a month in 2017.

As the FT reported in April, investors have already been spooked by rising levels of dollar debt in China’s property sector. This debt is set to open the global ring of fire, as US president Donald Trump raises the stakes in his trade war. The president and his advisers seem to have chosen to ignore the very real risk of currency devaluation, as markets respond to the impact of tariffs on the economy:

  • China’s property bubble puts it at the epicentre of the ring of fire
  • This is now spreading out across Asia, impacting other Asian currencies and economies
  • The Bank of Japan is about to become the largest owner of Japanese stocks
  • The end of the property bubble is causing the end of the commodity bubble
  • In turn, this is impacting Australia, South Africa, Brazil, Russia and the Middle East
  • ECB stimulus means eurozone government bonds have negative interest rates
  • Banks cannot make a profit and savers have no income
  • President Trump’s China trade war risks connecting all the dots
  • The UK’s potential no-deal Brexit in October further threatens global supply chains

The issue is the risk of contagion from one market to another. Risks in individual silos can be bad enough, but if they spread across boundaries it quickly becomes hard to know who is holding the risk. As US Federal Reserve chairman Jay Powell warned in May while discussing potential problems in the market for collateralised loan obligations (CLO):

“Regulators, investors, and market participants around the world would benefit greatly from more information on who is bearing the ultimate risk associated with CLOs. We know that the US CLO market spans the globe . . . But right now, we mainly know where the CLOs are not — only $90bn of the $700bn in total CLOs are held by the largest US banks . . . In a downturn institutions anywhere could find themselves under pressure, especially those with inadequate loss-absorbing capacity or runnable short-term financing.”

The CLO market is just one part of the problem. As S&P Global reported recently, more than $3tn of US corporate debt is rated triple B, with $1tn rated triple B minus, the lowest level of investment grade. US companies account for 54 per cent of the world’s $7tn total triple B debt. The risk of contagion in any sell-off is clear, as many institutions would have to sell if recession forced rating agencies into downgrades, taking debt below investment grade.

In turn, this would add to the risks in US equity markets, which are already at extreme valuations. Pension funds would be most at risk as they have been major investors in corporate debt and in recent years have entered markets such as the Asian offshore US dollar market in their search for higher yields. A downturn in their returns would risk creating a vicious circle, forcing companies to increase their pension contributions just at the moment when their earnings are already under pressure as the trade war slows the global economy.

Mr Trump may come to regret his comment that “trade wars are good and easy to win”. We envisage a testing time ahead, particularly as only those over 60 have personal experience of even the “normal” business cycles seen before the boomer supercycle began.

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

Resilience amidst headwinds is key for H2

Resilience is set to become the key issue as we look forward to H2, as I note in a new analysis for ICIS Chemical Business. None of us have ever seen the combinations of events that are potentially ahead of us. And none of us can be sure which way they will develop. So it seems essential that we start to create contingency plans to build corporate resilience ahead of their possible arrival.

Of course, we can all hope that we are just seeing a series of false alarms, and that business as usual will end up as the outcome. But hope is not a strategy. Even if we optimistically believe it is an 80% probability, the scale of the potential problems under more pessimistic scenarios suggests it would be prudent to decide ahead of time how to tackle them. Everyone will have their own list of possible outcomes. Mine is as follows:

  • Business as usual. Central bank rate cuts avoid recession risk; Presidents Trump and Xi reach stable agreement to roll back tariffs; oil market tensions disappear in the Middle East; Brexit uncertainty is put on hold with another extension period; sustainability concerns over single use plastics are put on back-burner
  • Gathering clouds. China’s vast offshore borrowing creates increasing risk of corporate defaults as growth slows, particularly if the trade war continues; geo-political risks mount in the Middle East; Brexit leads to major friction between the UK and EU27; more major consumer products companies decide to end use of single-use plastics
  • Storm warnings issued. Debt problems morph into major bankruptcies, impacting a range of supply chains around the world; US – Iran tensions mount in the Middle East causing oil prices to rise sharply; regional tensions mount as the world settles into a new Cold War between the USA and China; polymer volumes are hit by a rapid escalation of consumer concerns over single-use plastics

Asia is likely to prove the catalyst for this potential next crisis, if it hits. China has begun to deleverage over the past 2 years, taking $2tn out of its high-risk shadow banking sector. But unfortunately this tightening has driven many of the riskiest businesses into the offshore dollar markets, where naïve western fund managers have rushed to place their bets – driven by their need to achieve higher returns than are available in their domestic bond markets.

If world trade continues to slow as the chart from Reuters shows, and the remnimbi starts to weaken, then some of these borrowers will inevitably default. In turn, this risks a chain reaction across world markets, impacting not only the zombies but also their supply chain partners.

What would your company do in these circumstances? As the American writer Ernest Hemingway noted in ‘The Sun also Rises’, there are two ways to go bankrupt, “gradually, then suddenly”. And the suddenness of the final stage makes it almost impossible for companies to survive if they have not used the gradual stage to create contingency plans. History unfortunately shows that when markets turn, executives suddenly find they have very little time in which to think through how to respond.

Governments will also be in the line of fire, due to their debt levels. And it is unlikely that politicians will know how to respond. They used to be clear about the key issue for the voters, as Bill Clinton famously observed in 1992 – “it’s the economy, stupid”. But today’s politicians instead simply assume that central banks can always print more money to overcome financial and economic crises. They have forgotten the simple mnemonic that many of us learnt at school, namely that “to ASSUME can make an ASS of U and ME”.

Time spent now on building your company’s resilience to potential future challenges may therefore prove time very well spent, if hopes for ‘business as usual’ turn out to have been wishful thinking.

Please click here if you would like to download the full article.

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.

D-Day commemorations mark end of a political era

Last week, 95 year-old Harry Read repeated the jump that he and his fellow parachutists had made as the advance party for the D-Day landings. He told ITV News in a video interview that before the 1944 jump, their Commanding Officer had explained in matter of fact terms  that:

“50% of them would be casualties so the odds would be very much against their survival  If you die in the process, you’ll be one of a lot who do so”

In fact, nearly 200 died as they landed, because the fields had been flooded by the enemy.  Yet none had tried to turn back as they boarded the aircraft.  And hundreds of thousands of young men and women made the same choice, in support of an objective they believed was worth this supreme sacrifice.

Contrast that history with the quality of leadership today and it is immediately obvious there are very few “leaders” today, particularly in the political sphere. Instead, our politicians believe in ‘leadership by focus group’, where members of the public are used to develop “talking points” for use in a 3 minute media interview.

Unsurprisingly, people often come to believe that the politicians themselves have no principles of their own.  Unlike the leaders of the War such as Churchill, Roosevelt and de Gaulle, we increasingly have populists who believe in offering simple solutions to complex problems, and a media which highlights “excitement” over serious analysis.

The result is a collapse of confidence, as confirmed by the chart from the latest IPSOS Mori poll of “What Worries the World”.  As I first discussed here in November 2016, most people in the world’s major economies believe that their country is heading in the wrong direction:

  • Only China, Saudi Arabia, India, Malaysia, Mexico and Serbia have more than 50% of their populations believing that their country is headed in the right direction
  • By comparison, 77% of French, 76% of Spanish, 73% of British, 67% of Germans, 64% of Japanese and Italians, and 63% of Americans, believe their country is headed in the wrong direction. And these numbers are generally getting worse

One can see the change in terms of what wasn’t said at the commemorations last week, and what was:

  • At the 20th anniversary in 1965, former President Eisenhower (who had commanded the D Day troops as General Eisenhower) had argued,These people gave us a chance, and they bought time for us, so that we can do better than we have before.”  In spite of the Cold War and the Vietnam War, there was a sense that the world could and would become a better place in which to live
  • On Thursday, the last leader to have taken part in the War effort made probably her last visit to the site of the landings. As 93 year-old Queen Elizabeth II told the assembled veterans, “The wartime generation — my generation — is resilient, and I am delighted to be with you in Portsmouth today.  It is with humility and pleasure, on behalf of the entire country — indeed the whole free world — that I say to you all, thank you.”

It is hard to escape the conclusion that we are reaching the end of an era.