BASF’s second profit warning highlights scale of the downturn now underway

The chemical industry is easily the best leading indicator for the global economy.  And thanks to Kevin Swift and his team at the American Chemistry Council, we already have data showing developments up to October, as the chart shows.

It confirms that consensus hopes for a “synchronised global recovery” at the beginning of the year have again proved wide of the mark.  Instead, just as I warned in April (Chemicals flag rising risk of synchronised global slowdown), the key  indicator – global chemical industry Capacity Utilisation % – has provided fair warning of the dangers ahead.

It peaked at 86.2%, in November 2017, and has fallen steadily since then. October’s data shows it back to June 2014 levels at 83.6%. And even more worryingly, it has now been falling every month since June. The last time we saw a sustained H2 decline was back in 2012, when the Fed felt forced to announce its QE3 stimulus programme in September.  And it can’t do that again this time.

The problem, as I found when warning of subprime risks in 2007-8 (The “Crystal Blog” foresaw the global financial crisis), is that many investors and executives prefer to adopt rose-tinted glasses when the data turns out to be too downbeat for their taste.  Whilst understandable, this is an incredibly dangerous attitude to take as it allows external risks to multiply, when timely action would allow them to be managed and mitigated.

It is thus critical that everyone in the industry, and those dependent on the global economy, take urgent action in response to BASF’s second profit warning, released late on Friday, given its forecast of a “considerable decrease of income” in 2018 of “15% – 20%”, after having previously warned of a “slight decline of up to 10%”.

I have long had enormous respect for BASF and its management. It is therefore deeply worrying that the company has had to issue an Adjustment of outlook for the fiscal year 2018 so late in the year, and less than 3 weeks after holding an upbeat Capital Markets Day at which it announced ambitious targets for improved earnings in the next few years.

The company statement also confirmed that whilst some problems were temporary, most of the issues are structural:

  • The impact of low water on the Rhine has proved greater than could have been earlier expected
  • But the continuing downturn in isocyanate margins has been ongoing for TDI since European contract prices peaked at €3450/t in May — since when they had fallen to €2400/t in October and €2050/t in November according to ICIS, who also reported on Friday that
    “Supply is still lengthy at year end in spite of difficulties at German sellers BASF and Covestro following low Rhine water levels”
  • The decline is therefore a very worrying insight into the state of consumer demand, given that TDI’s main applications are in furniture, bedding and carpet underlay as well as packaging applications.
  • Even more worrying is the statement that:
    “BASF’s business with the automotive industry has continued to decline since the third quarter of 2018; in particular, demand from customers in China slowed significantly. The trade conflict between the United States and China contributed to this slowdown.”

This confirms the warnings that I have been giving here since August when reviewing H1 auto sales (Trump’s auto trade war adds to US demographic and debt headwinds).

I noted then that President Trump’s auto trade tariffs were bad news for the US and global auto industry, given that markets had become dangerously dependent on China for their continued growth:

  • H1 sales in China had risen nearly 4x since 2007 from 3.1m to 11.8m this year
  • Sales in the other 6 major markets were almost unchanged at 23m versus 22.1m in 2007

Next year may well prove even more challenging if the current “truce” over German car exports to the USA breaks down,

INVESTORS HAVE WANTED TO BELIEVE THAT INTEREST RATES CAN DOMINATE DEMOGRAPHICS

The recent storms in financial markets are a clear sign that investors are finally waking up to reality, as Friday night’s chart from the Wall Street Journal confirms:

“In a sign of the breadth of the global selloff in stocks, Germany’s main stock index fell into a bear market Thursday, the latest benchmark to have tumbled 20% or more from its recent peak….Other markets already in bear territory are home to companies exposed to recent trade fights between the U.S. and China.

The problem, as I have argued since publishing ‘Boom, Gloom and the New Normal: how the Ageing Boomers are Changing Demand Patterns, again“, in 2011 with John Richardson, is that the economic SuperCycle created by the dramatic rise in the number of post-War BabyBoomers is now over.

I highlighted the key risks is my annual Budget Outlook in October, Budgeting for the end of “Business as Usual”.  I argued then that 2019 – 2021 Budgets needed to focus on the key risks to the business, and not simply assume that the external environment would continue to be stable.  Since then, others have made the same point, including the president of the Council on Foreign Relations, Richard Haas, who warned on Friday:

“In an instant Europe has gone from being the most stable region in the world to anything but. Paris is burning, the Merkel era is ending, Italy is playing a dangerous game of chicken with the EU, Russia is carving up Ukraine, and the UK is consumed by Brexit. History is resuming.

It is not too late to change course, and focus on the risks that are emerging.  Please at least read my Budget Outlook and consider how it might apply to your business or investments. And please, do it now.

 

You can also click here to download and review a copy of all my Budget Outlooks 2007 – 2018.

Chemical industry is the best indicator of EM outlook – and the outlook is not good

Policymakers would be better off following the fortunes of the chemical industry, if they wanted to forecast the global economy, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Capacity utilisation (CU%) in the chemical industry has long been the best leading indicator for the global economy. The IMF’s recent downward revision of its global GDP forecast is further confirmation of the CU%’s predictive power. As the first chart shows, the CU% went into a renewed decline last October, negating hopes that output might have stabilised. March shows it at a new low for the cycle at just 80.1 per cent, according to American Chemistry Council (ACC) data.

By comparison, the CU% averaged 91.3 per cent during the baby boomer-led economic supercycle from 1987 to 2008. This ability to outperform conventional economic models is based on the industry’s long history and wide variety of end-uses. It touches almost every part of the global economy, enabling it to provide invaluable insight on an almost real-time basis along all the key value chains – covering upstream markets such as energy and commodities through to downstream end-users in the auto, housing and electronics sectors. Chemical industry production growth provides similar real-time insight into the major economies, using a year-on-year comparison. Current data for the Bric economies is particularly revealing, as the second chart highlights.

China’s post -2008 stimulus programme had provided critical support for all four countries. But as discussed on beyondbrics last year, China’s adoption of its New Normal economic policies during 2013 initiated a Great Unwinding. Chemical industry production growth has nearly halved since 2014 to just 5.7 per cent a year today. And as discussed last month, much of this output is now aimed at boosting exports (to preserve jobs) rather than to supply domestic demand. There are an increasing number of key products where China has moved from being the world’s major importer to a net exporter – with a consequent negative effect on margins.

Brazil was the early loser from China’s change of economic direction. Its monthly output declined very sharply in early 2014 as China’s stimulus-related infrastructure and construction demand slowed, and growth turned negative in June 2014. Output then staged a minor recovery in the middle of 2015, but has since fallen back to -4.6 per cent again. Brazil now no longer needs to import major polymers such as polyethylene, and has instead become a net exporter.

Russia was similarly impacted by China’s policy reversal, and its monthly output went negative in mid-2014. The collapse of the rouble then temporarily mitigated the downturn, by supporting exports and increasing the attractions of local production versus more expensive imports. But output growth has since staged a precipitate decline since last summer, falling by more than two-thirds from September’s peak of 14.9 per cent to just 4.2 per cent in March.

India has seen similar volatility. Output growth turned negative during 2014, but then staged a mild recovery in 2015 before a renewed decline took place, leaving March output barely positive at 0.4 per cent. In principle, India’s domestically oriented economy should make it more resilient to China’s slowdown, but it is still impacted by the second-order effects of increased competition in Asian markets. Not only is China ramping up its own exports of key products, but companies that had formerly relied on exporting to China are now having to find new homes for their product.

These developments in capacity utilisation and output confirm that major changes are taking place in the global economy and the formerly high-flying Bric economies. Policymakers would perhaps do better with their forecasts if they looked beyond their theoretical models – and focused instead on the chemical industry’s proven ability to provide real-time insight into the underlying transformation taking place in global demand patterns.

US chemicals slip back into Contraction mode as cycle peaks

US inventory Apr14The above chart from the excellent American Chemistry Council (ACC) weekly report may look a bit baffling at first.  But it is worth attention, as it highlights the current state of the industry in real time:

  • It shows US chemical shipments on the vertical axis, and change in inventory on the horizontal axis
  • Both are shown on a 3 month moving average (3MMA), to allow easy identification of turning points
  • It starts in the top half of the graph labelled Expansion in December 2007 (12-07)
  • Shipments then reduce and inventories build to take it into Contraction by December 2008 (12-08)
  • Next, inventories gradually reduce and shipments rise, taking it back to Expansion by December 2009 (12-09)
  • The Expansion peak was in 2010 (12-10), and the line moved back into Contraction by December 2011 (12-11)
  • Since then it hovered between Expansion and Contraction, with a short period in Expansion in 2012 (12-12)

As the ACC comment on the latest data, showing January/February 2014 moving back into Contraction mode (1-14)

The most recent data indicate that for the industry as a whole (excluding pharmaceuticals) inventories posted a 1.9% Y/Y gain on a 3MMA basis. Inventories continued to outpace shipments (with a 1.6% Y/Y deterioration on a 3MMA basis) in this comparison. The gap (shipment growth over inventories growth) narrowed from -4.5 percentage points in January to -3.5 percentage points in February suggesting that the balance is moving away from normal. This is in the wrong direction but is far from its widest (at -21.2 percentage points) deficit gap in January 2009.”

Now, of course, this could simply be the effect of the unusually cold weather in the US, as was originally claimed by the US Federal Reserve.  But the failure of the line to maintain a strongly positive position in the Expansion section since the end of 2011 is a worrying sign.

During this period, we have seen unprecedented stimulus efforts by policymakers, with interest rates at historic lows.  Yet last week’s US employment report showed employment was still 2 million people lower than at the pre-Crisis peak in November 2007.  Employment has never before failed to recover over a 6-year period after a downturn, since records began in 1939.

As the Wall Street Journal commented on the detail of the employment report, the number of those working part-time but wanting full-time jobs also rose by 224k to 7.4m, adding:

The manufacturing sector, for instance, shed 1,000 positions as it struggles to gain traction as firms work through high inventories, weather-related slowdowns and a weak global backdrop.”

Seasonally, we are now moving past the strongest months of the year.  Easter next week will clearly slow demand in much of the West.  Hopefully, there will then be some recovery in May before the holiday period and seasonally weaker H2.

It thus looks increasingly likely that Dow CEO Andrew Liveris was right to warn back in 2012 that the chemical industry cycle would peak by 2015-16. 

Against this background, it becomes increasingly hard to understand why companies are still planning to bring major new capacity online from 2017 onwards.  The new capacity, coinciding with an overall market downturn, could well have a disastrous impact on operating rates and profits.

 

 

BBC reports ‘How China Fooled the World’

BBC China Feb14Last night, the BBC ran a 1 hour documentary by its senior editor Robert Peston, who won countless awards for his work during the subprime crisis.  It completely confirmed the arguments put forward by the blog in recent months about the scale of the economic crisis now facing China.  The BBC introduced the documentary as follows:

Robert Peston travels to China to investigate how this mighty economic giant could actually be in serious trouble. China is now the second largest economy in the world and for the last 30 years China’s economy has been growing at an astonishing rate. While Britain has been in the grip of the worst recession in a generation, China’s economic miracle has wowed the world.

“Now, Peston reveals what has actually happened inside China since the economic collapse in the west in 2008. It is a story of spending and investment on a scale never seen before in human history – 30 new airports, 26,000 miles of motorways and a new skyscraper every five days have been built in China in the last five years. But, in a situation eerily reminiscent of what has happened in the west, the vast majority of it has been built on credit. This has now left the Chinese economy with huge debts and questions over whether much of the money can ever be paid back.

“Interviewing key players including the former American treasury secretary Henry Paulson, Lord Adair Turner, former chairman of the FSA, and Charlene Chu, a leading Chinese banking analyst, Robert Peston reveals how China’s extraordinary spending has left the country with levels of debt that many believe can only end in an economic crash with untold consequences for us all”

Peston himself sees China’s current economic slowdown as the 3rd wave of the global financial crisis, following on from the subprime crash in 2008 and the Eurozone crisis of 2011:

“Over the past few years, China has built a new skyscraper every five days, more than 30 airports, metros in 25 cities, the three longest bridges in the world, more than 6,000 miles of high speed railway lines, 26,000 miles of motorway, and both commercial and residential property developments on a mind-boggling scale.

“Now there are two ways of looking at a remaking of the landscape that would have daunted Egypt’s pharaohs and the Romans. It is, of course, a necessary modernisation of a rapidly urbanising country. But it is also symptomatic of an unbalanced economy whose recent sources of growth are not sustainable.

“Perhaps the big point of the film I have made, How China Fooled the World, is that the economic slowdown evident in China, coupled with recent manifestations of tension in its financial markets, can be seen as the third wave of the global financial crisis which began in 2007-08 (the first wave was the Wall Street and City debacle of 2007-08; the second was the eurozone crisis).”

The blog fears that many companies are going to be caught unawares by the problems now emerging in China.  If you need help to reorient yourself quickly, please get in touch at phodges@iec.eu.com.  We are able to help.

Seven global implications of China’s new policies

China mapEveryone remembers the old joke, “Why did the elephant wear dark glasses?”, and the answer, “So that she wouldn’t be recognised”.  A new version popped into the blog’s mind this week, when finishing its new Research Note on the impact of China’s new policies on the global economy:

“Why did nobody notice that China was the ‘elephant in the room’, in terms of being the main cause of today’s downturn in global demand and financial markets?”  Answer: “Because we were all wearing rose-tinted glasses”.

Over the past 5 years, China’s boom has stabilised the global economy.  But it was based on the largest debt bubble in history.  Lending went from $1tn in 2008 to $10tn last year,

Our rose-tinted glasses make us want to believe that the boom will return, and that the new leadership will soon begin another major lending programme.  This was the pattern since 2008, as in Japan’s ‘lost decades’.

But what if we are all wrong?

The blog came to know of President Xi Jinping’s father back in 1987, when helping to lead ICI’s major expansion in the Asia-Pacific region.  Xi Zhongxun had then been in charge of Guangdong for almost ten years.  He had torn up the Maoist rulebook, and pushed forward with major economic reform, telling his nervous team:

We have to do this, even if we have to lose our lives.

Xi Jinping is his son, and grew up whilst his father was being purged under Mao.  The blog thus suspects we are missing the key fact:  “Like father, Like son”.  History suggests instead that Xi Jinping will stay the course.  Thus the new Research Note expects his new policies to have 7 major impacts on the global economy:

  • Domino effect.  US-centric observers have understandably but wrongly assumed that concern over the Federal Reserve’s taper is solely responsible for destabilising emerging  economies in a wide arc from Argentina through India and Indonesia to Turkey.  Historians, however, will almost certainly recognise these economic tremors as also being an early warning of the policy shift now underway in China
  • Double-digit growth.   The leadership have already made clear they intend to bulldoze polluting factories, and devote major resource to cleaning up the one-sixth of China’s farmland currently contaminated with toxic waste. Therefore the days of double-digit economic growth are unlikely to ever return
  • Deflation.  Premier Li confirmed in October that maintaining employment was his key priority.  China’s producer price index has been negative for 22 months, and it is likely exports will be a key focus for policy during the transition.  This will effectively export deflation – as volume rather than profit will be the priority
  • Export Demand.  China’s main export focus will no longer be the cheap textiles and plastic products of the past.  Instead it will create jobs via an aggressive drive to sell affordable carssmartphones and relatively high-value chemicals into emerging and Western markets, based on the major new capacity installed in recent years
  • Dollar strength.  China’s economic crisis will come as a shock to most of the financial community, as did the US subprime crisis.  We can therefore expect China’s currency to begin to fall in value, and the US$ to rise, all other things being equal.  This, of course, will also help to boost China’s exports
  • Domestic Demand.  Similarly, the focus of China’s domestic demand will change. Sales of high-end western luxury goods will continue to decline as the corruption campaigns continue.  Instead, the focus will be on affordable necessities such as $50 refrigerators for the 90% of the population who earn less than $20/day
  • Debt.  China’s record $1.3tn holding of US debt was built up as a form of vendor finance, to support US purchases of China’s products.  But this strategy is no longer relevant, so we may well see China slowly reduce its holdings for use at home – potentially putting upward pressure on Western interest rates

The new leadership have spent 2 years preparing for this moment.  They know that we are at the end of China’s latest ‘Boom and Bust Cycle’ of the post-Mao period.  Like Deng Xiaoping in 1977, and Jiang Zemin in 1993, Xi knows he has to push forward with the plan that has been developed.  Once we take off our rose-tinted glasses, we realise the obvious truth – the risks of continuing with the old policies are simply too great.

Xi’s reforms mean major change is underway in China.  His policy shifts are already impacting the global economy, directly and indirectly.  We cannot know if he will succeed in moving the economy towards a more sustainable future.  But the blog hopes this Research Note will help readers to better understand the scale of what is being proposed, and to prepare themselves accordingly.

Please take a moment to download the Research Note, and circulate it to your colleagues and friends for discussion.

Global economy approaches a T-junction

D'turn 4Jan14

Intuition’s great benefit is that it provides a different perspective.  Thus the intuitive concept behind the launch of the IeC Downturn Monitor was that April 2011 would prove a watershed moment for policymakers’ Recovery Scenario after 2008′s financial crisis.  Their Scenario essentially had two elements:

  • Acting as a ‘lender of last resort’ when the major banks stopped lending to each other and the rest of the world
  • Building a framework for a full and sustained recovery in the global economy

Policymakers’ first target was achieved by April 2011, but the second target looks as far away as ever as the chart shows for the benchmark portfolio:

  • The central banks have mistakenly focused on liquidity programmes (brown arrows) to support financial markets. Thus the S&P 500 Index has gained 34% (purple line)
  • Similarly the new Japanese policy of  ‘Abenomics‘ has pushed the US$ up 29% versus the yen (brown) as it aimed to create inflation by devaluing the currency
  • But chemical prices – the best leading indicators for the real economy – have instead mostly fallen, as weak demand has caused loss of pricing power

The worst result has been in China.  Its prices for PTA (red), the raw material for polyester, have fallen 25%.  But naphtha (black), the main feedstock for Asian and European petchems, has also fallen 17%.  Whilst Brent oil (blue) has fallen 12% as the ‘correlation trade’ has begun to unwind.  Even US polyethylene (orange) has struggled, with its price down 10%, despite benefiting from the shale gas boom.  Only benzene (green), with its supply greatly reduced by the downturn in refining and petchems, has seen prices remain in a more stable pattern.

2014 now sees policymakers in a race against time.  The major central banks have so far spent $16tn in boosting liquidity, whilst a total $33tn has been spent on overall stimulus efforts.  This money can only be repaid if growth does now start to return to SuperCycle levels.

We are thus at the T-junction described by PIMCO, the world’s largest bond fund manager.  One road leads to strong growth: the other to a world where lack of growth in the real economy leads to default in financial markets – either via major spending cutbacks and tax rises, or via an inability to repay the money borrowed.

The blog didn’t know how developments would play out when it first launched the Monitor nearly 3 years ago.  But the way the Monitor now highlights the dilemma we face, confirms the insight that intuition can provide.

Benchmark price movements since April 2011 are below with ICIS pricing comments, and the Monitor chart above:
PTA China, red, down 25%. “Sellers and buyers seeing squeezed margins because of high production costs, coupled with prevailing weak demand on poor downstream market conditions”
Naphtha Europe, black, down 17%. “Europe is structurally long on naphtha, and sellers need to export to the US gasoline and Asian petrochemical sectors to keep stocks in balance”
Brent crude oil, blue, down 12%
HDPE USA export, orange, down 10%. “ Interest was weak as most global buyers have made arrangements to purchase January cargoes and are in no hurry to pursue February material”
Benzene Europe, green, up 5%. ”Outlook for the upcoming month was less certain”
US$: yen, brown, up 29%
S&P 500 stock market index, purple, up 34%