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.

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.

China’s lending bubble is history

As China’s shadow banking is reined in, the impact on the global economy is already clear, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

China’s shadow banking sector has been a major source of speculative lending to the global economy. But 2018 has seen it entering its end-game, as our first chart shows, collapsing by 64% in renminbi terms in January to April from the same period last year (by $274bn in dollar terms).

The start of the year is usually a peak period for lending, with banks getting new quotas for the year.

The downturn was also noteworthy as it marked the end of China’s lending bubble, which began in 2009 after the financial crisis. Before then, China’s total social financing (TSF), which includes official and shadow lending, had averaged 2 times gross domestic product in the period from 2002 to 2008. But between 2009 and 2013, it jumped to 3.2 times GDP as China’s stimulus programme took off.

It is no accident, for example, that China’s Tier 1 cities boast some of the highest house price-to-earnings ratios in the world or, indeed, that Chinese buyers have dominated key areas of the global property market in recent years.

The picture began to change with the start of President Xi Jinping’s first term in 2013, as our second chart confirms. Shadow banking’s share of TSF has since fallen from nearly 50% to just 15% by April, almost back to the 8% level of 2002. TSF had already slowed to 2.4 times GDP in 2014 to 2017.

The start of Mr Xi’s second term has seen him in effect take charge of the economy through the mechanism of his central leading groups. He has also been able to place his supporters in key positions to help ensure alignment as the policy changes are rolled out.

This year’s lending data are therefore likely to set a precedent for the future, rather than being a one-off blip. Although some of the shadow lending was reabsorbed in the official sector, TSF actually fell 14% ($110bn) in the first four months of the year. Already the economy is noticing the impact. Auto sales, for example, which at the height of the stimulus programme grew more than 50% in 2009 and by a third in 2010, have seen just 3% growth so far this year.

The downturn also confirms the importance of Mr Xi’s decision to make “financial deleveraging” the first of his promised “three tough battles” to secure China’s goal of becoming a “moderately prosperous society” by 2020, as we discussed in February.

It maps on to the IMF’s warning in its latest Global Stability Financial Report that:

In China, regulators have taken a number of steps to reduce risks in the financial system. Despite these efforts, however, vulnerabilities remain elevated. The use of leverage and liquidity transformation in risky investment products remains widespread, with risks residing in opaque corners of the financial system.”

The problems relate to the close linkage between China’s Rmb250tn ($40tn) banking sector and the shadow banks, through its exposure to the Rmb75tn off-balance-sheet investment vehicles. The recent decision to create a new Banking and Insurance Regulatory Commission is another sign of the changes under way, as this will eliminate the previous opportunity for arbitrage created by the existence of separate standards in the banking and insurance industries for the same activity, such as leasing.

As the IMF’s chart below highlights, lightly regulated vehicles have played a critical role in China’s credit boom. Banks, for example, have been able to use the shadow sector to repackage high-risk credit investments as low-risk retail savings products, which are then made available in turn to consumers at the touch of their smartphone button. This development has heightened liquidity risks among the small and medium-sized banks, whose reliance on short-term non-deposit funding remains high. The IMF notes, for example, that “more than 80% of outstanding wealth management products are billed as low risk”.

Mr Xi clearly knows he faces a tough battle to rein-in leverage, given the creativity that has been shown by the banks in ramping up their lending over the past decade. The stimulus programme has also created its own supporters in the construction and related industries, as large amounts of cash have been washing around China’s property markets, and finding its way into overseas markets.

But Mr Xi is now China’s most powerful leader since Mao, and it would seem unwise to bet against him succeeding with his deleveraging objective, even if it does create short-term pain for the economy as shadow banking is brought back under control.

As Gabriel Wildau has reported, the official sector is already under pressure from Beijing to boost its capital base. Analysts are suggesting that $170bn of new capital may be required by the mid-sized banks, whilst Moody’s estimates the four megabanks may require more than double this amount by 2025 in terms of “special debt” to meet new Financial Stability Board rules.

Essentially, therefore, China’s lending bubble is now history and the tide of capital flows is reversing. It is therefore no surprise that global interest rates are now on the rise, with the US 10-year rate breaking through 3%. Investors and companies might be well advised to prepare for some big shocks ahead. As Warren Buffett once wisely remarked, it is “only when the tide goes out, do you discover who’s been swimming naked”.

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

The post China’s lending bubble is history appeared first on Chemicals & The Economy.

Chemical industry data shows reflation remains hope, not reality

ACC Jul17Western central bankers are convinced reflation and economic growth are finally underway as a result of their $14tn stimulus programmes.  But the best leading indicator for the global economy – capacity utilisation (CU%) in the global chemical industry – is saying they are wrong.  The CU% has an 88% correlation with actual GDP growth, far better than any IMF or central bank forecast.

The chart shows June data from the American Chemistry Council, and confirms the CU% remains stuck at the 80% level, well below the 91% average between 1987 – 2008, and below the 82% average since then.  This is particularly concerning as H1 is seasonally the strongest part of the year – July/August are typically weak due to the holiday season, and then December is slow as firms de-stock before Christmas.

FMs Jul17

The interesting issue is why these historically low CU% have effectively been ignored by companies and investors. They are still pouring money into new capacity for which there is effectively no market – one example being the 4.5 million tonnes of new N American polyethylene capacity due online this year, as I discussed in March.

The reason is likely shown in the above chart of force majeures (FMs) – incidents when plants go suddenly offline, creating temporary shortages.  These are at record levels, with H1 2017 seeing 4x  the number of FMs in H1 2009.

In the past, most companies prided themselves on their operating record, having absorbed the message of the Quality movement that “there is no such thing as an accident”. Companies such as DuPont and ICI led the way in the 1980s with the introduction of Total Quality Management. They consciously put safety ahead of short-term profit and at the top of management agendas. As the Chartered Quality Institute notes:

“Total quality management is a management approach centred on quality, based on the participation of an organisation’s people and aiming at long-term success.”

  Today, however, the pressure for short-term financial success has become intense
  The average “investor” now only holds their shares for 8 months, according to World Bank data
 This time horizon is very different from that of the 1980s, when the average NYSE holding period was 33 months
  And it is a very long way from the 1960s average of 100 months

As a result, even some major companies appear to have changed their policy in this critical area, prioritising concepts such as “smart maintenance”. Such cutbacks in maintenance spend mean plants are more likely to break down, as managers take the risk of using equipment beyond its scheduled working life. Similarly, essential training is delayed, or reduced in length, to keep within a budget.

ICIS Insight editor Nigel Davies highlighted the key issue 2 years ago as the problems began to become more widespread around the world:

“The situation in Europe has exposed underlying trends and issues that will need to be addressed. Companies appear not to have sustained an adequate pace of maintenance capital expenditure. That has been for economic as well as structural (cost) reasons. Spending in high feedstock and energy cost Europe has certainly not been considered de rigeur….Having maintained plants to run at between 80% and 85% of capacity, suddenly pushing them hard does little good. Sometimes, they fail.”

The end-result has been to mask the growing problem of over-capacity, as plants fail to operate at their normal rates. This has supported profits in the short-term by making actual supply/demand balances far tighter than the nominal figures would suggest. But this trend cannot continue forever.

THE END OF CHINA’S STIMULUS WILL HIGHLIGHT TODAY’S EXCESS CAPACITY
Shadow Jul17The 3rd chart suggests its end is now fast approaching.  It shows developments in China’s shadow banking sector, which has been the real cause of the apparent “recovery” and reflation seen in recent months:

  Premier Li began a major stimulus programme a year ago, hoping to boost his Populist faction ahead of October’s 5-yearly National People’s Congress, which decides the new Politburo and Politburo Standing Committee (PSC)
  Populist Premier Wen did the same in 2011-2 – shadow lending rose six-fold to average $174bn/month
  But Wen’s tactic backfired and President Xi’s Princeling faction  won a majority in the 7-man PSC, although the Populist Li still had responsibility for the economy as Premier
  Li’s efforts have similarly run into the sand

As the 3-month average confirms (red line), Li’s stimulus programme saw shadow lending leap to $150bn/month. Unsurprisingly, as in 2011-2, commodity and asset prices rocketed around the world,funding ever-more speculative investments.  But in February, Xi effectively took control of the economy from Li and put his foot on the brakes.  Lending is already down to $25bn/month and may well go negative in H2, with Xi highlighting last week that:

“China’s development is standing at a new historical starting point, and … entered a new development stage”.

“Follow the money” is always a good option if one wants to survive the business cycle.  We can all hope that the IMF and other cheerleaders for the economy are finally about to be proved right.  But the CU% data suggests there is no hard evidence for their optimism.

There is also little reason to doubt Xi’s determination to finally start getting China’s vast debts under control, by cutting back on the wasteful stimulus policies of the Populists.  With China’s debt/GDP now over 300%, and the prospect of a US trade war looming, Xi simply has to act now – or risk financial meltdown during his second term of office.

Prudent investors are already planning for a difficult H2 and 2018.  Companies who have cut back on maintenance now need to quickly reverse course, before the potential collapse in profits makes this difficult to afford.

The global economy’s best leading indicator forecasts a downturn

NewIf you want to know what is happening to the global economy, the chemical industry will provide the answers. It has an excellent correlation with IMF data, and also benefits from the fact it has no “political bias”.  It simply tells us what is happening in real-time in the world’s 3rd largest industry.  The chart above confirms the extremely high correlation:

   It shows annual GDP % growth figures from the IMF on the vertical axis from 2000, including the 2016 forecast
   The  horizontal axis shows the annual change in Capacity Utilisation % data for the global chemical industry

The correlation is remarkable at 88%.  Nothing that I have ever seen comes anywhere close to this level of accuracy.

The logic behind the correlation is partly because of the industry’s size.  But it also benefits from its global and application reach. Every country in the world uses relatively large volumes of chemicals, and their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles.

ACC all Jan17

We can also use the data to look forward, given its timeliness, as the ACC also produce detailed reports on the major Regions and countries.  And as the second chart shows, the outlook is unfortunately not good:

   N America’s recovery since 2014 has faded away, and is at -1%; Latin America is very weak at -3.9%
   W Europe has also slowed to 1.6%; Asia has collapsed from 7.5% in 2014 to just 1.4%
   The Middle East/Africa has halved from 5.3% to 2.7%; only Central/Eastern Europe has grown, from 1.9% to 4.4%

This rather negative picture is in complete contrast with the official views of forecasters such as the IMF.   They currently suggest that global growth will rebound from 3.1% in 2016 to 3.4% in 2017, and then move higher.  But sadly, their optimism has been wrong for the past few years, as I noted in my Budget Outlook in October.

They have forecast a similar recovery every year since 2011, but growth has continued to slow.

The problem is that their models ignore the influence of demographics, and today’s ageing populations, on demand. The result, as the deputy chairman of the US Federal Reserve, Stanley Fischer, observed in 2014 is that:

Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back.”

Clearly, it is encouraging that economists such as Andy Haldane at the Bank of England now recognise that demographics “have been under-emphasised for too long“.  We can certainly hope that future forecasts may start to take account of the fact that older people do not consume as much as when they were young.

But in the meantime, it seems wise to take the chemical industry data very seriously.

It is clearly suggesting that the global economy is moving into a downturn. And whilst we must all hope this turns out to be wrong, hope is not a strategy.  We also cannot ignore the major upheavals now underway in economic policy in both the USA and the UK, with President Trump taking office and the UK starting to leave the European Union.

These developments may well produce good results in the longer term.  But in the short-term, they create major uncertainty.  And if we look across the G20 countries – such as China, Russia, Brazil, India, S Africa, Saudi Arabia and Turkey – many are experiencing from similar political and economic uncertainty.

Uncertainty usually makes everyone – companies and consumers – more cautious in their spending. And lower spending inevitably means less growth.

Forget the IMF: global chemicals are your guide to future performance

The chemical industry provides a far better guide to the economic outlook than the IMF or any economic forecaster, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
ACC Nov16

The global chemical industry has long been the best real-time indicator of the global economy. This is partly because of its size, as the third-largest industry in the world after agriculture and energy, but also because of its global and application reach. Every country in the world uses relatively large volumes of chemicals, and their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles.

The first chart confirms the position, showing the latest IMF data for global GDP versus the American Chemistry Council’s (ACC) data for global chemical Capacity Utilisation (CU%) since 1988, in terms of percentage change from the previous year:

  The IMF data are for the percentage change in global GDP at constant prices (their “headline number”), using the October 2016 World Economic Outlook
  The ACC data show the percentage change in CU% updated to include reported data for August 2016

As can be seen, there is extremely close historical correlation between the two sets of data. But crucially, the ACC data are real-time. They are produced within a few weeks of the end of each month, whereas the IMF data only appear after a time lag of many months.

Equally important is that the IMF’s forecasts have proved to be wildly over-optimistic since the start of the financial crisis, as demographic headwinds have now replaced the tailwinds which created the baby boomer-led supercycle that began in 1983. Had the ACC’s data been used as the base case, unnecessary investment would have been discouraged. Even more importantly, policymakers’ wishful thinking about the ability of monetary policy to restore economic growth would have been challenged much earlier.

ACC Nov16a

The ACC data are equally valuable when it comes to understanding the outlook for individual country economies, as the second chart confirms. It shows developments since 2014 for the Bric countries:

Brazil has been the most consistent, but unfortunately in a negative sense. Its chemical production went negative in mid-June 2014, providing investors and companies with ample warning that major problems lay ahead for the economy. The chart provides some hope that the situation may be improving, but cautious observers may be forgiven for worrying that production has yet to record a positive performance after more than two years.

Russia has provided the most volatile performance, due to oil price movements. The key issue is that lower oil prices support chemical demand, as consumers need to spend less on essentials such as transport and heating and have more discretionary income. Production was down 11 per cent in July 2014, just before the oil price collapse, but then rebounded to a positive 15 per cent by September 2015. Since them, of course, the doubling of oil prices since the New Year has hit output again, leaving it up by around 5 per cent.

India has also been volatile. Production tumbled during the run-up to premier Narendra Modi’s election in 2014, and remained negative into the early part of 2015. Since then, production has been in positive territory, averaging around 4 per cent since March 2015, as tangible evidence of economic reform has begun to appear.

China has provided the most stable performance, with production fluctuating between a low of 3 per cent and a high of 10 per cent over the period. Key support has been provided by the government’s drive to increase China’s self-sufficiency. This has often meant that imports, rather than domestic production, have taken the pain of slowing domestic demand. In some major products, such as PVC, China has actually moved from being the world’s leading importer to become a net exporter.

Chemical industry performance is therefore not just an excellent guide to the outlook for the global economy. It is also a reliable indicator of the economic state of the world’s major economies. The fact that the global CU% has fallen every month this year, and is now at just 78.8 per cent – nearly equal to its post-crisis low of 77.7 per cent in March 2009 – is therefore grounds for concern. It contradicts the buoyancy being seen in a number of major financial markets and suggests that investors may find it is better to travel in hope than to arrive.

Paul Hodges publishes The pH Report, providing investors and companies with insight on the impact of demographic changes on the economy.