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.

The End of “Business as Usual”

In my interview for Real Vision earlier this month, (where the world’s most successful investors share their thoughts on the markets and the biggest investment themes), I look at what data from the global chemical industry is telling us about the outlook for the global economy and suggest it could be set for a downturn.

“We look at the world and the world economy through the lens of the chemical industry. Why do we do that? Because the chemical industry is the third largest industry in the world after energy and agriculture. It gets into every corner of the world. Everything in the room which you’ll be watching this interview is going to have chemicals in it. And the great thing is, we have very good, almost real time data on what’s happening.

“Our friends at the American Chemistry Council have data going back on production and capacity utilization since 1987. So 30 years of data, and we get that within 6 to 8 weeks of the end of the month. So whereas, if you look at IMF data, you’re just looking at history, we’re looking at this is what’s actually going on as of today.

“We look, obviously, upstream, as we would call it, at the oil and feedstocks markets, so we understand what’s happening in that area. But we also– because the chemical industry is in the middle of the value chain, you have to be like Janus. You have to look up and down at the same time, otherwise one of these big boys catches you out.

“And so we look downstream. And we particularly look at autos, at housing, and electronics, because those are the big three applications. And of course, they’re pretty big for investors as well. So we see the relative balance between what’s happening upstream, what’s  happening downstream, where is demand going, and then we see what’s happening in the middle of that chain, because that’s where we’re getting our data from.

“As the chart shows, our data matches pretty well to IMF data. It shows changes in capacity utilization, which is our core measurement. If if you go back and plot that against history from the IMF, there is very, very good correlation. So what we’re seeing at the moment– and really, we’ve been seeing this since we did the last interview in November— is a pretty continuous downturn.

“One would have hoped, when we talked in November, we were talking about the idea that things have definitely cooled off. Some of that was partly due to the oil price coming down. Some of that was due to end of year destocking. Some of that was due to worries about trade policy. Lots of different things, but you would normally expect the first quarter to be fairly strong.

“The reason for this is that the first quarter– this year, particularly– was completely free of holidays.  Easter was late, so there was nothing to interrupt you there. There was the usual Lunar New Year in China, but that always happens, so there’s nothing unusual about that.

And normally what happens is, that in the beginning of the new year, people restock. They’ve got their stock down in December for year end purposes, year end tax purposes, now they restock again. And of course, they build stock because the construction season is coming along in the spring and people tend to buy more cars in that period, and electronics, and so on.

“So everything in the first quarter was very positive. And one wouldn’t normally be surprised to start seeing stock outs in the industry, particularly after a quiet period in the fourth quarter. And unfortunately, we haven’t seen any of that. We’ve seen– and this is worth thinking about for a moment– we’ve seen a 25% rise in the oil price because of the OPEC Russia deal, but until very recently we haven’t seen the normal stock build that goes along with that.”

 

As we note in this month’s pH Report, however, this picture is now finally changing as concern mounts over oil market developments – where unplanned outages in Venezuela and elsewhere are adding to the existing cutbacks by the OPEC+ countries. Apparent demand is therefore now increasing as buyers build precautionary inventory against the risk of supply disruption and the accompanying threat of higher prices.

In turn, this is helping to support a return of the divergence between developments in the real economy and financial markets, as the rise in apparent demand can easily be mistaken for real demand. The divergence is also being supported by commentary from western central banks.  This month’s IMF meeting finally confirmed the slowdown that has been flagged by the chemical industry since October, but also claimed that easier central bank policies were already removing the threat of a recession.

We naturally want to hope that the IMF is right. But history instead suggests that periods of inventory-build are quickly reversed once oil market concerns abate.

Please click here if you would like to see the full interview.

Most businesses were nowhere near Ready for Brexit last Friday – we mustn’t make the same mistake again

Thank goodness for backbench MPs and the European Union. Without their efforts, the UK would by now have left the EU without any trade deals, or ongoing relationship with it’s biggest export market.  And as the Duke of Wellington said in another context, “It was a damn close-run thing”:

  • In a historic vote, MPs decided by just 1 vote to force the government to ask for a longer extension
  • The EU Council argued into the night on its response, but decided to give the UK “a second chance”

The problem was well expressed in a tweet by former Brexit Secretary, David Davis, on Friday morning:

His tweet completely ignored the views of all the main business organisations and trade unions, who had spent weeks trying to point out that issuing government statements and Guidance Notes was not the same as actually being prepared, as The Guardian noted:

“Frances O’Grady, the general secretary of the TUC, and Carolyn Fairbairn, the CBI’s director-general, wrote last month before the crunch EU summit in Brussels: “Our country is facing a national emergency. Decisions of recent days have caused the risk of No Deal to soar. Firms and communities across the UK are not ready for this outcome. The shock to our economy would be felt by generations to come.””

On Friday, confirming their lack of understanding of business needs – and against the advice of senior civil servants – ministers decided to completely stand down No Deal preparations.  Yet as the independent Institute for Government have warned:

“Despite the delay, a No Deal exit is still very much on the table, either on 31 May or 31 October… Businesses and the public should not be left to read between the lines of individual departmental press notices.”

It is therefore critical that UK and EU27 businesses now take the opportunity of the extension to understand and prepare for the changes that will affect them if the UK does leave the EU.  For all the talk of a new referendum, this is still the law of the land.

Our surveys at Ready for Brexit have consistently shown that 80% of small businesses weren’t ready for Brexit. Some had stockpiled some essential goods, but only around one fifth had actually thought through a detailed plan.  As a result, many people have had sleepless nights in recent weeks as they realised the UK might well be leaving with No Deal.

Now that the UK has an extension, it is time to stop panicking and start preparing. None of us can afford to be complacent – No Deal remains the default position and businesses need to know how Brexit will affect them in key areas for their future:

  • Customs, Tariffs and Regulations.  No one has needed to fill out Customs Declarations for EU trade for 25 years. HMRC has warned that following Brexit, businesses may need to make 400 million Customs Declarations at an expected cost of £32.50 each. Compliance with Rules of Origin could easily cost more, if legal advice is needed. Companies need to identify how Customs and Regulatory requirements could impact their business and plan to put the correct procedures in place
  • Supply Chains.  Will your business be affected by interruptions in supply chains following Brexit? You need to audit your supply chain partners to identify potential weak links. It only takes one missing item to shut down a production line. And think about what may happen to your cash flow if forecast delays take place at the ports
  • Sales Agreements.  Do you have Material Change clauses in your commercial contracts?  You need to check out key areas such as your ability to pass on the costs of tariffs, customs delays and exchange rate movements, as well as the impact of possible regulatory changes. Governing contract law also needs checking as the UK will no longer be a member of the EU
  • Employment. You need to understand how the status of UK-employed EU citizens may change and check out the position of UK staff working temporarily or permanently in EU countries. Don’t forget basic areas such as whether professional qualifications obtained in the UK will still be valid in the EU after Brexit, and the possible need for international driving licences

We have all had a lucky escape in the past few days. But we can’t rely on our luck holding.  Planning now for whatever may happen in the next few months may well save you months of heartache later on.

This is why, with some highly experienced colleagues, I helped set up Ready for Brexit.  As I wrote here in June:

“We are particularly concerned that many small and medium-sized businesses (SMEs) – the backbone of the European economy – are failing to plan ahead for Brexit’s potential impact.”

We can all hope that politicians now step back, and work together to avoid the disaster of a No Deal at the end of May or October.

But hope is not a strategy – particularly when the future of your business may be at stake.  If you need detailed help in the form of Brexit Checklists and planning tools, they are all there on the Ready for Brexit site.

 

Don’t get carried away by Beijing’s stimulus

Residential construction work in Qingdao, China. Government stimulus is unlikely to deliver the economic boost of previous years © Bloomberg

China’s falling producer price index suggests it could soon be exporting deflation, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
On the surface, this year’s jump in China’s total social financing (TSF) seems to support the bullish argument. TSF was Rmb5.3tn ($800bn) in January-February, a 26 per cent rise on 2018’s level.By comparison, it rose 61 per cent in 2009 as the government panicked over the impact of the 2008 financial crisis, and 23 per cent in 2016, when the government wanted to consolidate public support ahead of 2017’s five-yearly Party Congress session, which reappointed the top leadership for their second five-year term.

The markets were certainly right to view both these increases positively, as we discussed here two years ago. But we also added a cautionary note, suggesting that 2017’s Congress might well be followed by a “new clampdown”, as Xi’s leadership style was likely to “move away from consensus-building towards autocracy”. This analysis seems to have proved prescient, and it makes us cautious about assuming that Xi has decided to reverse course in 2019.

Consumer markets are also indicating a cautious response. Passenger car sales, for example, were down 18 per cent in January-February compared with the same period last year, after having fallen in 2018 for the first time since 1990. Smartphone sales were also down 14 per cent over the same period. In the important housing market, state-owned China Daily reported that sales by industry leader Evergrande fell by 43 per cent.

There is little evidence on the ground to suggest that Xi has decided to return to stimulus to revive economic growth. Last month’s government Work Report to the National People’s Congress said it would “refrain from using a deluge of stimulus policies”.

Instead, it seems likely that this year’s record level of lending was used to bail out local government financing vehicles (LGFVs) and other casualties of China’s post-2008 debt bubble. The second chart illustrates the potential problem, with TSF suddenly taking off into the stratosphere after 2008, when stimulus began, while GDP growth hardly changed its trajectory.

The stimulus programme thus dramatically inflated the amount of debt needed to create a unit of GDP. And given the doubts over the reliability of China’s GDP data, it may well be that the real debt-to-GDP ratio is even higher. These data therefore support the argument that debt servicing is now becoming a major issue for China after a decade of stimulus policies.


One example comes from the FT’s analyses of the debt problems affecting China Rail and China’s vast network of city subways. The FT reported that China has 25,000km of high-speed rail tracks, two-thirds of the world’s total, and that China Rail’s debt burden had reached Rmb5tn — of which around 80 per cent related to high-speed rail construction. Its interest payments have also exceeded its operating profits since at least 2015.

Unsurprisingly, given China’s relative poverty (average disposable income was just $4,266 in 2018), income from ticket sales has been too low even to cover interest payments since 2015. And yet the company is planning to expand capacity to 30,000km of track by 2030, with budgets increased by 10 per cent in 2018 as a result of the decision to boost infrastructure.

The same problem can be seen in city subway construction, where China accounted for 30 per cent of global city rail at the end of last year by track length, but only 25 per cent of ridership, which suggests that some lines may be massively underused and economically unviable.

The issue is not whether this level of investment is justifiable over the longer term in creating the infrastructure required to support growth. Nor is it whether the debt incurred can be repaid over time. Instead, the real question is whether the need to support economic expansion has led to a financially-risky acceleration of the infrastructure programme and whether, in turn, Beijing is now being forced to cover potential losses in order to avoid a series of credit-damaging defaults.


So where does this alternative narrative lead us? It suggests that far from supporting consumer spending, the TSF increase is flagging a growing risk in Asian debt markets — where western investors have rushed to invest in recent years, attracted by the relatively high interest rates compared with those enforced by central banks in their home markets. In 2017, for example, Chinese borrowers raised $211bn in dollar-denominated issuance, at a time when corporate debt levels had already reached 190 per cent of GDP.

This risk is emphasised if we revisit our suggestion here at the end of last year, that data for chemicals output — the best leading indicator for the global economy — was suggesting “that we may now be headed into recession”. More recent data give us no reason to change this conclusion, and therefore highlight the risk that some Chinese debts may prove more equal than others in terms of the degree of state support that they can command. Missed interest and capital repayments are now becoming common among the weaker borrowers.

The performance of China’s producer price index provides additional support for our analysis. As the third chart shows, this is now flirting with a negative reading, suggesting that a decade of over-investment means that China now has a major problem of surplus capacity. This problem will, of course, be exacerbated if demand continues to slow in key areas. In turn, this suggests that the implications of our analysis go beyond Asian markets.

China still remains, after all, the manufacturing capital of the world, and its falling PPI implies that 2019 could see it exporting deflation. This would be exactly the opposite conclusion to that assumed by today’s rallying equity markets, although it would chime with the increasingly downbeat messages coming from global bond markets. Investors may therefore want to revisit their recent euphoria over the level of lending in China, and their new confidence that the so-called “Powell put” can really protect them from today’s global market risks.

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

Businesses thrilled by Brexit uncertainty: “It’s exhilarating” says small business owner

With the European Commission saying that a No Deal is now “likely“, small businesses across the UK and EU27 have begun to look forward to the opportunities that it will create, as this 1 April report from Ready for Brexit suggests.

Businesses across Europe are thrilled by the uncertainty of Brexit. “We’re absolutely loving it” said Colin Potts, whose Wolverhampton based company exports wall brackets. His wife and business partner Brenda agrees. “Because we mostly export to the EU, I’ve never had to fill in a customs declaration before – it’s something new and you know what they say, a change is as good as a rest,” she said.

In the event of a No Deal Brexit, UK/EU27 businesses will need to fill in an extra 400 million customs declarations a year, but that doesn’t faze Brenda. “Wow, 400 million! It’s exhilarating to be part of something that big”, she gushed. “As a small business owner, I have plenty of leisure time and am often bored. This is what I am looking for to fill those long empty hours.

Pete Micklethwaite, who owns a road haulage company in Doncaster is also excited. “Will there be a deal, won’t there – it’s creating a real buzz. If there’s no deal our drivers will need three separate driving licences for some of our longer jobs and looking on the bright side, you can never have too many photo IDs.

The EU nationals in Pete’s team aren’t missing out on the excitement either, he explains. “One of our longest serving drivers, Jim, who’s from Romania, asked me the other day whether if he sets off on a job on the continent he’ll be allowed back in. Some people take up gambling for that kind of thing but our lads just need to come to work, if they’ve still got jobs!

“Some of the doom merchants were saying that we needed to be ready for a so-called cliff edge on March 29, but now we’ve got at least two weeks longer than that,” mused Brenda Potts. “These naysayers have obviously never run a small business and don’t understand the grinding boredom of being able to plan ahead.

The opportunities of a No Deal Brexit aren’t passing haulier Pete by either. “A guy I know got involved with a ferry company with no ferries and still landed some big contracts. When he told me about it I had to check the date to make sure it wasn’t an April fool but it wasn’t. Now that’s entrepreneur-ship.”

 

If  you’re worried about the impact of a No Deal Brexit on your business, download the Ready for Brexit No Deal Survival Kit