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.

Chemical output signals trouble for global economy

A petrochemical plant on the outskirts of Shanghai. Chinese chemical industry production has been negative on a year-to-date basis since February

Falling output in China and slowing growth globally suggest difficult years ahead, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Chemicals are the best leading indicator for the global economy. Data for both Chinese and global chemical production, shown in the first chart, are warning that we may now be headed into recession.

China’s stimulus programme has been the key driver for the world’s post-2008 recovery, as we discussed here in May (“China’s lending bubble is history”).

It accounted for about half of the global $33tn in stimulus programmes and its decline is currently having a dual impact, as it reduces both demand for EM commodities and the availability of global credit.

In turn, this reversal is impacting the global economy — already battling headwinds from trade tariffs and higher oil prices.

Initially the impact was most noticeable in emerging markets but the scale of the downturn is now starting to hit the wider economy:

  • China’s demand has been the growth engine for the global economy since 2008, and its scale has been such that this lost demand cannot be compensated elsewhere
  • China’s shadow banking bubble has been a major source of speculative lending, helping to finance property bubbles in China and many global cities
  • It also financed a domestic construction boom in China on a scale never seen before, creating excess demand for a wide range of commodities

But now the lending bubble is bursting. The second chart shows the extent of the downturn this year. Shadow banking is down 84%  ($557bn) in the year to September, according to official People’s Bank of China data. Total Social Financing is down 12% ($188bn), despite an increase in official bank lending to support strategic companies.

It seems highly likely that the property bubble has begun to burst, with China Daily reporting that new home loans in Shanghai were down 77% in the first half. In turn, auto sales fell in each month during the third quarter, as buyers can no longer count on windfall gains from property speculation to finance their purchases.

The absence of speculative Chinese buyers, anxious to move their cash offshore, is also having a significant impact on demand outside China in former property hotspots in New York, London and elsewhere.

The chemical industry has been flagging this decline with increasing urgency since February, when Chinese production went negative on a year-to-date basis. The initial decline was certainly linked to the government’s campaign to reduce pollution by shutting down many older and more polluting factories.

But there has been no recovery over the summer, with both August and September showing 3.1% declines according to American Chemistry Council data. Inevitably, Asian production has also now started to decline, due to its dependence on exports to China. In turn, like a stone thrown into a pond, the wider ripples are starting to reach western economies.

President Trump’s trade wars aren’t helping, of course, as they have already begun to increase prices for US consumers. Ford, for example, has reported that its costs have increased by $1bn as a result of steel and aluminium tariffs. Trump’s withdrawal from the Iran nuclear deal has also caused oil prices as a percentage of GDP to rise to levels typically associated with recession in the past.

The rationale is simply that consumers only have so much cash to spend, and money they spend on rising gasoline and heating costs can’t be spent on the discretionary items that drive GDP growth.

It seems unlikely, however, that Trump’s trade war with China will lead to his expected “quick win”. China has faced far more severe hardships in recent decades, and there are few signs that it is preparing to change core policies. The trade war will inevitably have at least a short-term negative economic impact but, paradoxically, it also supports the government’s strategy to escape the “middle income trap” by ending China’s role as the “low-skilled factory of the world”, and moving up the ladder to more value-added operations and services.

The trade war therefore offers an opportunity to accelerate the Belt and Road Initiative (BRI), initially by moving unsophisticated and often polluting factories offshore. It also emphasises the priority given to the services sector:

  • Already companies, both private and state-owned, are focusing their international acquisitions in BRI countries. According to EY, 12 per cent of overall Chinese (non-financial) outbound investment was in BRI countries in 2017, versus 9 per cent in 2016, and 2018 is likely to be considerably higher. Apart from south-east Asia, we expect eastern and central Europe to be beneficiaries, given the new BRI infrastructure links, as the map highlights
  • Data from the Caixin/Markit services purchasing managers’ index for September suggests the sector remains in growth mode. And government statistics suggest the services sector was slightly over half of the economy in the first half, with its official growth reported at 7.6 per cent versus overall GDP growth of 6.8 per cent

We expect China to come through the pain caused by the unwinding of the stimulus bubbles, and ultimately be strengthened by the need to refocus on sustainable rather than speculative growth. But it will not be an easy few years for China and the global economy.

The rising tide of stimulus has led many investors and chief executives to look like geniuses. Now the downturn will probably lead to the appearance of winners and losers, with the latter likely to be in the majority.

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

“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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Petrochemicals must face up to multiple challenges

Europe’s petrochemical sector must prepare now for the trade war, US start-ups, Brexit and the circular economy, as I discuss in this interview with Will Beacham of ICIS news  at the European Petrochemical Association Conference.

With higher tariff barriers going up between the US and China, the market in Europe is likely to experience an influx of polymers and other chemicals from exporters looking for a new home for their production, International eChem chairman, Paul Hodges said.

Speaking on the sidelines of the European Petrochemical Association’s annual meeting in Vienna, he said: “The thing we have to watch out for is displaced product which can’t go from the US any more to China and therefore will likely come to Europe.

In addition to polyethylene, there is an indirect effect as domestic demand in China is also falling, he said, leaving other Asian producers which usually export there to also seek new markets and targeting Europe.

The US isn’t buying so many consumer goods from China any more – and that seems to be the case because container ships going from China to the US for Thanksgiving and Christmas aren’t full. So NE and SE Asian chemical producers haven’t got the business they expect in China and are exporting to Europe instead.  We don’t know how disruptive this will be but it has quite a lot of potential.”

US polymer start-ups
Hodges believes that the new US polymer capacities will go ahead even if the demand is not there for the product. This is because the ethane feedstocks they use need to be extracted by the producers and sellers of natural gas who must remove ethane from the gas stream to make it safe.

For these producers some of the cost advantages have already disappeared because of rising ethane prices.

The exports of US ethane are adding one or two more crackers to the total. And without sufficient capacity ethane prices have become higher and more volatile.”

Hodges points out that pricing power is being lost as poor demand means producers cannot pass on the effect of rising oil prices. “Margins are being hit with some falling by 50-60%,” he said.

Circular economy
EU targets mean that all plastic packaging must be capable of being recycled, reused or composted in Europe by 2025. For the industry this could be a huge opportunity, but only if it acts fast, said Hodges: “We have to develop the technology that allows that to happen. We will need the [regulatory] approvals and if we don’t get moving in the next 12-18 months we are in trouble.”

Brexit beckons
According to Hodges: “We are in the end game for Brexit. We talk to senior politicians from both sides who don’t think there is a parliamentary majority for any Brexit option.”

He fears that if no deal can be agreed there is a chance the UK will refuse to pay its £39bn divorce bill.

Then what happens to chemical regulation and transport? Although the bigger companies have made preparations, only one in seven in the supply chains are getting prepared,” he added.  This is why we have launched ReadyforBrexit.

You can listen to the full podcast interview by clicking here.

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Is your business Ready for Brexit?

Time is running out for the UK government to agree a Brexit deal with Europe.  As my new analysis for ICIS Chemical Business highlights, companies need to move quickly to prepare for the “No Deal” scenario

Legendary England footballer Gary Lineker best summarised the general sense of disbelief over the state of 
the Brexit negotiations when tweeting in July:

“A wealthy nation putting itself in a position where it has to stockpile food, medicine, etc., in times of peace is utter madness. What Are We Doing?”

Lineker’s concern was confirmed last month by the head of the British Chambers of Commerce who warned that “precision is what is required” regarding the Brexit process, rather than “declaratory statements”.

Yet today, with less than six months to go before the UK officially leaves the EU, businesses still do not know if the UK will simply crash out with no deal on 29 March, with no transition agreement in place. This is almost unbelievable, given that the EU is the UK’s largest trading partner, taking 44% (£274bn) of UK exports in 2017, and provides 53% (£341bn) of all UK imports, according to a July report from the House of Commons library.

One problem is that the cabinet only finally agreed on its chosen option for the new EU relationship in August. In turn, this means the civil service is only now starting to be able to advise sector groups, trade associations and other experts on the key issues involved.

A second problem is that the new Brexit department had to be created virtually overnight after the June 2016 referendum, and the average age of its staff is just 31 years. Many have no personal experience of the enormously complex issues involved.

CHEMICALS IN NO-MAN’S LAND
Chemical companies are, of course, right in the middle of this no-man’s-land. They depend on frictionless movements of raw materials and intermediates between their various EU sites, and they are heavily integrated into just-in-time supply chains with key customers such as the auto and food industries.

The UK government has recently warned of possible major disruption if there is a No Deal Brexit, and the Key UK Risks chart highlights the key economic and business risks that lie ahead.

The current gap between the UK and EU positions was emphasised in chief EU negotiator Michel Barnier’s recent evidence to the UK Parliament:

  • He confirmed that the EU did not believe key proposals in the Chequers Plan for the Irish border and other super-critical issues can either work or be agreed
  • Instead, Barnier proposed the idea of a “Canada plus plus” deal in the form of a Free Trade Agreement covering goods (but not services), plus customs cooperation, plus participation in health, research, Erasmus, aviation and internal security
  • He also emphasised that the UK’s £39bn payment was a divorce settlement covering past UK commitments, not an up-front payment for a good trade agreement

THREE MAIN SCENARIOS AHEAD

‘May achieves a withdrawal agreement’
The UK and EU will both lose from a No Deal Brexit and so in principle they could simply “fudge” the trade issue for future discussion during the transition period until December 2020. But although both sides emphasise that 80% of the withdrawal agreement is now agreed, this only highlights that the most difficult 20% still lies ahead – issues such as Ireland, immigration and EU citizen rights, and future trade relations.

‘Markets cause a panic on Tory benches’
What happens if May does stumble at this point and fails either to gain an agreement with the EU27 or to get it safely through the Cabinet, Tory party and Parliament? As the Risks chart shows, this might well lead to financial market pressure on the pound and interest rates. This would also represent more bad news for chemical companies. If even 20 Tory Eurosceptics vote against a deal, then May would have to rely on opposition party votes, and their support looks unlikely given Labour’s “six tests” for approving any deal.

‘No deal’ scenario
Exchange rate volatility could become a critical issue for companies and investors if this scenario is reached, with the pound possibly falling towards parity with the US dollar and the euro, causing interest rates to rise. Foreign investors currently own 28% of the government’s £1.9tn debt, and concern over the value of the pound could lead some to reduce their holdings of government bonds.The Brexit Directory chart from Ready for Brexit shows the scale of the risks involved.  It highlights how Brexit potentially involves almost every aspect of business – from Customs & Tariffs through Finance and Legal issues, to Services & Employment and the Supply Chain.

Of course, many major companies have already spent months and millions of euros in preparing detailed contingency plans. Some are already stockpiling key raw materials and products, and revising relevant contract clauses.

But smaller businesses do not have these resources. Surveys show that only one in seven have done any forward planning for a No Deal Brexit, and official government guidance for a No Deal has only just begun to appear. In turn, this creates a clear risk of widescale disruption, as today’s highly integrated supply chains are only as strong as their weakest link. The lack of just one raw material can stop a production line.

As Gary Lineker says, it is hard to believe this is happening. But it is, and so far “declaratory statements” rather than precise detail continue to dominate the process.

It is also easy to forget that a No Deal Brexit will not just impact the UK. US and EU-based businesses involved in a supply chain that involves a UK company face a clear risk of disruption.

This is why I have helped to launch Ready for Brexit with other industry colleagues. As the Scout motto reminds us, to ‘Be Prepared’ could be critical for business survival if a No Deal Brexit does occur.

 

Please click here to visit Ready for Brexit, and click here to download the full ICB analysis.

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