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.

CEOs need new business models amid downturn

Many indicators are now pointing towards a global downturn in the economy, along with paradigm shifts in demand patterns. CEOs need to urgently build resilient business models to survive and prosper in this New Normal world, as I discuss in my 2019 Outlook and video interview with ICIS.

Global recession is the obvious risk as we start 2019.  Last year’s hopes for a synchronised global recovery now seem just a distant memory.  Instead, they have been replaced by fears of a synchronised global downturn.

Capacity Utilisation in the global chemical industry is the best leading indicator that we have for the global economy.  And latest data from the American Chemistry Council confirms that the downtrend is now well-established.  It is also clear that key areas for chemical demand and the global economy such as autos, housing and electronics moved into decline during the second half of 2018.

In addition, however, it seems likely that we are now seeing a generational change take place in demand patterns:

  • From the 1980s onwards, the demand surge caused by the arrival of the BabyBoomers into the Wealth Creating 25 – 54 cohort led to the rise of globalisation, as companies focused on creating new sources of supply to meet their needs
  • At the same time the collapse of fertility rates after 1970 led to the emergence of 2-income families for the first time, as women often chose to go back into the workforce after childbirth. In turn, this helped to create a new and highly profitable mid-market for “affordable luxury”
  • Today, however, only the youngest Boomers are still in this critical generation for demand growth. Older Boomers have already moved into the lower-spending, lower-earning 55+ age group, whilst the younger millennials prefer to focus on “experiences” and don’t share their parents’ love of accumulating “stuff”

The real winners over the next few years will therefore be companies who not only survive the coming economic downturn, but also reposition themselves to meet these changing demand patterns.  A more service-based chemical industry is likely to emerge as a result, with sustainability and affordability replacing globalisation and affordable luxury as the key drivers for revenue and profit growth.

Please click here to download the 2019 Outlook (no registration necessary) and click here to view the video interview.

London house prices slip as supply/demand balances change

London house prices are “falling at the fastest rate in almost a decade” according to major property lender, Nationwide.  And almost 40% of new-build sales were to bulk buyers at discounts of up to 30%, according of researchers, Molior.  As the CEO of builders Crest Nicholson told the Financial Times:

 “We did this sale because we knew we would otherwise have unsold built stock.”

They probably made a wise decision to take their profit and sell now.  There are currently 68,000 units under construction in London, and nearly half of them are unsold.  Slower moving builders will likely find themselves having to take losses in order to find a buyer.

London is a series of villages and the issues are different across the city:

Nine Elms, SW London.  This $15bn (US$20bn) transformation has been ‘an accident waiting to happen‘ for some time.  It plans to build 20000 new homes in 39 developments at prices of up to £2200/sq ft.  Yet 2/3rds of London buyers can only afford homes costing up to $450/sq ft – thus 43% of apartments for sale have already cut their price.

West End, Central London.  This is the top end of the market, and was one of the first areas to see a decline.  As buying agent Henry Pryor notes:

“Very few people want to buy or sell property in the few months leading up to our monumental political divorce from Europe next March, which is why 50% of homes on the market in Belgravia and Mayfair have been on the market for over a year. Yet there are people who have to sell, whether it be because of divorce, debt or death, so if you have money to spend I can’t remember a time since the credit crunch in 2007 when you could get a better deal.”

NW London.  Foreign buyers flooded into this area as financial services boomed.  Rising bonuses meant many didn’t need a mortgage and could afford to pay £1m – £2.5m in cash.  But now, many banks are activating contingency plans to move some of their highly paid staff out of London ahead of Brexit.  Thus Pryor reports buying a property recently for £1.7m, which had been on the market for £2.25m just 2 years ago.

W London.  Also popular with foreign buyers, even areas such as Kew (with its world-famous Royal Botanic Gardens) have seen a dramatic sales volume decline.  In Kew itself, volume is down 40% over the past 2 years.  And, of course, volume always leads prices – up or down.  Over half of the homes now on sale have cut prices by at least 5% – 10%, and the pace of decline seems to be rising.  One home has cut its offer price by 17.5% since March.

Outer London.  This is the one area bucking the trend, due to the support provided by the government’s ‘Help to Buy’ programme.  This provides state-backed loans for up to £600k with a deposit of just 5%.  As Molior comment, this is “the only game in town” for individual purchasers, given that prices in central London are out of reach for new buyers.

The key issue is highlighted in the charts above – affordability:

  • The first chart shows how prices were very cyclical till 2000, due to interest rate changes.  They doubled between 1983 – 1989, for example, and then almost halved by 1993.  In turn, the ratio of prices to average earnings fluctuated between 4x – 6x
  • But interest rates have been relatively low over the past 20 years, and new factors instead drove home prices
  • The second chart shows the impact in terms of first-time buyer affordability and mortgage payments.  Payments were 40% of take-home pay until 1998, but then rose steadily to above 100% during the Subprime Bubble.  After a brief downturn, the Quantitative Easing (QE) bubble then took them back over 100% in 2016

The paradigm shift was driven by policy changes after the 2000 dot-com crash.  As in the USA, the Bank of England decided to support house prices via lower interest rates to avoid a downturn, and then doubled down on the policy after the financial crash – despite the Governor’s warning in 2007 that:

“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”

  • The 2000 stock market collapse and subprime’s low interest rates led many to see property as safer than shares.  They created the buy-to-let trend and decided property would instead become their pension pot for the future
  • The 2008 financial crisis, and upheavals in the Middle East, Russia, and parts of the Eurozone led many foreign buyers to join the buying trend, seeing London property as a “safe place” in a more uncertain investment world
  • Asian buyers also flooded in to buy new property “off-plan”.  As I noted in 2015, agents were describing the Nine Elms development as: ” ‘Singapore-on-Thames’. Buying off-plan was the ultimate option play for a lot of the buyers [who are] Asian. You only need to put down 10% and then see how the market goes. A lot of buyers are effectively taking a financial position rather than buying a property”

But now all these factors are unraveling, leaving prices to be set by local supply/demand factors again.  Recent governments have taken away the tax incentives behind buy-to-let, and have raised taxes for foreign buyers.  As the top chart shows, this leave prices looking very exposed:

  • They averaged 4.8x earnings from 1971 – 2000, but have since averaged 8.7x and are currently 11.8x
  • Based on average London earnings of £39.5k, a return to the 4.8x ratio would leave prices at £190k
  • That compares with actual average prices of £468k today

And, of course, there is the issue of exchange rates.  Older house-owners will remember that the Bank of England would regularly have to raise interest rates to protect the value of the pound.  In 1992, they rose to 15% at the height of the ERM crisis.  But policy since then has been entirely in the other direction.

Nobody knows whether what will happen next to the value of the pound.  But if interest rates do become more volatile again, as in 1971-2000, cyclicality might also return to the London housing market.

The post London house prices slip as supply/demand balances change appeared first on Chemicals & The Economy.

Hurricane Harvey: lack of insurance will hit Houston’s recovery

Buffalo Bayou

“By Monday, the third straight day of flooding, the aftermath of Hurricane Harvey had left much of the region underwater, and the city of Houston looked like a sea dotted by small islands.  ’This event is unprecedented,’ the National Weather Service tweeted. ‘All impacts are unknown and beyond anything experienced.’”

This summary from the New York Times gives some idea of the immensity of the storm that struck large parts of Texas/Louisiana last week, including the 4th largest city in the US.  And this was before the second stage of the storm.

I worked in Houston for 2 years, living alongside the Buffalo Bayou which flooded so spectacularly last week.  The photo above from the Houston Chronicle shows the area around our former home on Saturday, still surrounded by water.  Today, as the rest of America celebrates the Labor Day holiday, the devastated areas in Texas and Louisiana will be starting to count the cost of rebuilding their lives and starting out anew:

  Some parts of the Houston economy will recover remarkably quickly. It is a place where people aim to get things done, and don’t just sit around waiting for others to do the heavy lifting
  But as Texas Governor Abbott has warned, Harvey is “one of the largest disasters America has ever faced. We need to recognize it will be a new normal, a new and different normal for this entire region.”

The key issue is that the Houston metro area alone is larger in size than the economies of Sweden or Poland.  And as Harris County Flood Control District meteorologist Jeff Lindner tweeted:

An estimated 70% of the 1,800-square-mile county (2700 sq km), which includes Houston, was covered with 1½ feet (46cm) of water”

Already the costs are mounting.  Abbott’s current estimate is that Federal funding needs alone will be “far in excess of $125bn“, easily topping the costs of 2005′s Hurricane Katrina in New Orleans.  And, of course, that does not include the cost, and pain, suffered by the majority of homeowners – who have no flood insurance – or the one-third of auto owners who don’t have comprehensive insurance. They will likely receive nothing towards the costs of cleaning up.

SOME PARTS OF THE ECONOMY HAVE THE POTENTIAL FOR A QUICK RECOVERY
Companies owning the large refineries and petrochemical plants in the affected region have all invested in the maximum amount of flood protection following Katrina, when some were offline for 18 months

  Oil platforms in the Gulf of Mexico are used to hurricanes and are already coming back – Reuters reports that only around 6% of production is still offline, down from a peak of 25% at the height of the storm
  It is hard currently to estimate the impact on shale oil/gas output in the Eagle Ford basin, but the Oil & Gas Journal reports that 300 – 500 kb/d of oil production is shut-in, and 3bcf/d of gas production
  ExxonMobil is now restarting the country’s second-biggest refinery at Baytown, and Phillips 66 and Valero are also restarting some operations, whilst ICIS reports that a number of major petrochemical plants are now being inspected in the expectation that they can soon be restarted

Encouragingly also, it seems that insurance companies are planning to speed up inspections of flooded properties by using drone technology, which should help to process claims more quickly.  Loss adjusters using drones can inspect 3 homes an hour, compared to the hour taken to inspect on roof manually.  But even Farmers Insurance, one of the top Texas insurers, only has 7 drones available – and has already received over 14000 claims.

RECOVERY FOR MOST PEOPLE AND BUSINESSES WILL TAKE MUCH LONGER
For the 45 or more people who have died in the floods, there will be no recovery.

Among the living, 1 million people have been displaced and up to 500k cars destroyed.  481k people have so far requested housing assistance and 25% of Houston’s schools have suffered severe or extensive flood damage.

These alarming statistics highlight why clean-up after Harvey will take a long time.  Basic services such as water and sewage are massively contaminated, with residents being told to boil water in many areas.  The “hundreds of thousands of people across the 38 Texas counties affected by Harvey” using their own wells are particularly at risk.

And as the New York Times adds:

Flooded sewers are stoking fears of cholera, typhoid and other infectious diseases. Runoff from the city’s sprawling petroleum and chemicals complex contains any number of hazardous compounds. Lead, arsenic and other toxic and carcinogenic elements may be leaching from some two dozen Superfund sites in the Houston area”

FEW IN HOUSTON HAVE FLOOD INSURANCE
Insurance Aug17Then there is the issue that, as the chart from the New York Times shows, most of those affected by Harvey don’t have home insurance policies that cover flood damage.  Similarly, a survey in April by insurer Aon found that:

“Less than one-sixth of homes in Harris County, Texas, whose county seat is Houston, currently have active National Flood Insurance Program policies. The county has about 1.8 million housing units.”

As the Associated Press adds:

Experts say another reason for lack of coverage in the Houston area was that the last big storm, Tropical Storm Allison, was 16 years ago. As a result, people had stopped worrying and decided to use money they would have spent for insurance premiums on other items.”

Even those with insurance will get hit by the low levels of coverage – just $250k for a house and $100k for contents. Businesses carrying insurance also face problems, according to the Wall Street Journal, as they depend on the same Federal insurance scheme, which:

Was primarily designed for homeowners and has had few updates since the 1970s. Standard protections for small businesses, including costs of business interruption and significant disaster preparation, aren’t covered, and maximum payouts for damages haven’t risen since 1994.

The maximum coverage for business property is $500k, and the same cap applies to equipment and other contents, far below many businesses’ needs.  And even those with insurance find it difficult to claim, according to a study by the University of Pennsylvania and the Federal Reserve Bank of New York after Hurricane Sandy in 2012:

“More than half of small businesses in New York, New Jersey and Connecticut that had flood insurance and suffered damages received no insurance payout. Another 31% recouped only some of their losses.”

Auto insurance is a similar story. Only those with comprehensive auto insurance are likely to be covered for their loss – and even then, people will still suffer deductions for depreciation.  According to the Insurance Council of Texas:

15% of motorists have no car insurance, and of those who do, (only) 75% have comprehensive insurance. That leaves a lot of car owners without any protection.”

In other words, around 1/3rd of car owners probably have no insurance cover against which to claim for flood damage.

HARVEY’S IMPACT WILL BE LONG-TERM
It is clearly too early, with flood waters still rising in some areas, to be definitive about the implications of Hurricane Harvey for Houston and the affected areas in Texas and Louisiana.

Of course there are supply shortages today, and the task of replacement will created new demand for housing and autos.  But over the medium to longer term, 3 key impacts seem likely to occur:

  It will take time for the supply of oil, gas, gasoline and other refinery products, petrochemicals and polymers to fully recover.  There will inevitably also be some short-term shortages in some value chains. But within 1 – 3 months, most if not all of the major plants will probably be back online
  It will take a lot longer for most people affected by Harvey to recover their losses.  Some may never be able to do this, especially if they have no insurance to cover their flooded house or car.  And those working in the gig economy have little fall-back when their employers have no need for their services
  The US economy will also be impacted, as Slate magazine warned a week ago, even before the full magnitude of the catastrophe became apparent:

“For the U.S. economy to lose Houston for a couple of weeks is a human disaster—and an economic disaster, too….Given that supply chains rely on a huge number of shipments making their connections with precision, the disruption to the region’s shipping, trucking, and rail infrastructure will have far-reaching effects.

 

US home-ownership returns to 1960′s levels

US house May16US home ownership is back at levels seen briefly in the mid-1980s, and before that in the mid-1960s.  One key issue today is that while the US population is still growing, the younger population has quite a different profile from the Boomer generation, as the Pew Institute have reported.

  • In 1980, only 1 in 10 young Boomers were still living at home with parents
  • But today we are “going back to the future”, with 1 in 5 young adults living at home with their parents, due to economic pressures

In addition, there is a growing trend for retiring Boomers to reverse the “flight to the suburbs” that they undertook in the 1960s/1970s, and instead return to apartment living in the cities.

US house May16aAs the second chart confirms, these trends are steadily reducing the demand for single family homes. Multi-family units are now (as in the pre-Boomer SuperCycle era) around one-third of total housing starts, and are likely set for further increases.  This is not good news for industries or companies focused supplying the housing industry, as it means they are being hit by 2 adverse trends:

  • Contrary to policymaker promises, housing starts have not bounced back quickly to subprime highs. In fact, they are continuing to disappoint as the support for new home building from shale gas and oil-related development disappears as migrant workers return to their home state.  This is a major reversal for petrochemical demand as the average new home uses around $15,000 of petrochemical products. At its peak (when housing starts reached 2.1m in 2005) the US housing market was worth $31bn to the industry
  • Even worse from the demand viewpoint is that the SuperCycle trend towards single family homes has sharply reversed. Starts for apartment living have doubled as a percentage of the total back to around a third, equal to levels seen 40 years ago.   This trend towards apartment living further reduces potential chemical and polymer demand. Although no detailed analysis yet exists on this factor, due to its relatively recent appearance, estimates suggest each apartment only uses around 50% of the materials required for a single-family home.

The combination of these factors has had a major impact on US home-ownership rates. These were given a major boost under President Clinton in 1995, when he introduced his major housing initiative as follows:

The goal of this strategy, to boost home ownership to 67.5% by the year 2000, would take us to an all-time high, helping as many as 8 million American families across that threshold”.

This target was maintained by President George W Bush. And in the subprime bubble, home ownership rose beyond Clinton’s target to reach 69.2% in 2005. But it has since fallen back to pre-1995 levels and the current figure of under 64% equals 1964 levels.

A major part of the problem is simple affordability. Younger people are the key demographic for home buying, as they constitute the critical first-time buyer group. But Pew data shows that 92% of recent population growth has been in minority communities, whose earnings are generally less than those of the white population.

US Bureau of Labor Statistics data show that while average annual US earnings were around $42,000 in 2015, there was a wide variation between the main racial groups:

  • Whites earned $43,000 on average, and Asians $51,000
  • But Blacks earned $32,000 on average and Hispanics $31,000

This means that the average ratio of house prices to earnings of 9.0x disguises a wide variation. Whites are close to the average at 8.7x, while Asians are below it at 7.4x. But for the younger Black and Hispanic populations, which are critical for driving first-time home buyer sales, the ratio rises to 11.6x for Blacks and 12.0x for Hispanics, based on US Census Bureau data for new home prices.

Unsurprisingly, latest National Association of Realtors data show the share of first-time home buyers is now at its lowest level since 1987 at just 32%, having fallen for the past 3 years.

What are companies and investors to do?  As the infographic below describes, they have a clear choice ahead:

  • They can either hope that somehow new stimulus policies will succeed despite past failure
  • Or, they can join the Winners who are now starting to develop new revenue and profit growth by adopting demand-led strategies

These are the issues that we focus on in the Demand – the New Direction for Profit study.  And since we published this just 2 months ago, it has become clear that the risks of assuming stimulus programmes will deliver their promised results are rising all the time.

 

US housing sees major change as middle-market is squeezed

US house pricesJul15US house prices have recovering for 3 years, as the chart from the Wall Street Journal confirms.  It shows two lines:

  • The dark blue line is money of the day: prices rose steadily from 1989, peaking in 2006 at 141% of 1989 value
  • The grey line adjusts for inflation: “real prices” were negative until 2000, and peaked 51% higher in 2006
  • Both prices then fell until 2012, since when they have staged a modest recovery, but are still below 2006 peaks
  • Nominal prices are 8% below their peak, and inflation-adjusted prices are 21% lower
  • Overall, the inflation-adjusted price of the average house has risen by just 20% over the 26 years since 1989

These, of course, are national figures, and the picture for individual cities can be different.  Equally, other national indices such as those from the National Association of Realtors and the Federal Housing Finance Agency have different methodologies and provide slightly different results.

But this does not mean that today’s US housing market is the same as it was pre-2009:

  • One key issue is that starts have virtually halved from their 2.3m peak in January 2006, to 1.2m in June
  • A second is that the price data masks the changes that are taking place in the size of single-family homes
  • A third is that the S&P index only measures single-family home prices, yet the trend is to multi-home living

SOMETHING QUITE FUNDAMENTAL HAS CHANGED IN US HOUSING MARKETS

US housing Jul15

These changes have gone largely unremarked by investors and companies supplying the housing industry.  Yet they have enormous implications for future demand.  They also help to explain the subdued nature of the recovery in US GDP growth since 2008, as housing is such a key part of the economy.

They are another sign of the major paradigm shift now underway in most consumer markets.  The middle ground of “affordable luxury” is fast disappearing, as markets return to being segmented between high-cost luxury and and low-cost mass-market.

The size of the median US single-family home today is 20% larger than in 2000, at 2400 square feet (220 square metres), and 10% larger than in 2006.  Builders of single-family homes have been responding to changes in demand, where sales of homes priced above $600k have trebled, whilst sales of those priced below $400k are down 16%.

The middle market is thus being squeezed quite hard, as the second chart confirms:

  • It shows that a remarkable increase has taken place in the ratio of multi-home starts to single family home starts
  • In 1989, this ratio was around 21%, meaning that 4 out of 5 starts were of single family homes
  • The ratio then dropped to an all-time low of 9% in 1992, when 9 out 10 starts were single family
  • Last month, however the ratio soared to 41% – if this trend continues, half of all starts will soon be multi-home

The future of the US housing market will thus be quite different from the past.  Luxury homes are getting larger and more expensive: mass-market homes are more likely to be smaller – quite probably apartments – and less expensive.

And, of course, the new home market itself remains close to all-time lows.  2014′s volume of just 437k equaled 1981 levels, and was just a third of 2005′s peak of 1.283m.