Chemicals are easily the best leading indicator for the global economy. And if the global economy was really in recovery mode, as policymakers believe, then the chemical industry would be the first to know – because of its early position in the value chain. Instead, it has a different message as the chart confirms:
- It shows changes in global production and key sectors, based on American Chemistry Council (ACC) data
- It highlights the rapid inventory build in H2 as oil and commodity prices soared
- But since then, all the major sectors have moved into a slowdown, and agchems into decline
As the ACC note:
“The global chemical industry ended the first quarter on a soft note. Global chemicals production fell 0.3% in March after a 1.0% drop in February, and a 0.6% decline in January. The last gain was 0.3% in December.”
This, of course, is the opposite of consensus thinking at New Year, when most commentators were confident that a “synchronised global recovery” was underway. It is therefore becoming more and more likely, as I warned in January, that policymakers have been fooled once again by the activities of the hedge funds in boosting “apparent demand”:
“For the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford. In turn, of course, this has made it appear that demand has suddenly begun to recover. At last, it seems, the “synchronised global recovery” has arrived.
“Except, of course, that it hasn’t. The hedge funds didn’t buy 15 days-worth of oil to use it. They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.”
This downturn is worrying not only because it contradicts policymakers’ hopes, but also because Q1 volumes should be seasonally strong:
- Western companies should be restocking to meet the surge of spring demand
- Similarly, China and the Asian markets should now be at peak rates after the Lunar New Year
HIGHER OIL AND COMMODITY PRICES ARE CAUSING DEMAND DESTRUCTION
The problem is that most central bankers and economists don’t live in the real world, where purchasing managers and sales people have bonuses to achieve. As one professor told me in January:
“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”
But in the real world, H2’s inventory build has now been replaced by destocking – whilst today’s higher oil prices are also causing demand destruction. We have seen this many times before when prices have risen sharply:
- Consumers only have limited amounts of spare cash
- When oil prices jump, they have to cut back in other areas
- But, of course, this is only confirmed afterwards, when the spending data is reported
- Essentially, this means that policymakers today are effectively driving by looking in the rear-view mirror
RISING DEBT LEVELS CREATE FURTHER HEADWINDS FOR GROWTHNew data from the US Federal Reserve Bank of St Louis also highlights the headwinds for demand created by the debt build-up that I discussed last week. As the chart shows:
- US borrowing was very low between 1966-79, and $1 of debt created $4.49 in GDP growth
- Borrowing rose sharply in the Boomer-led SuperCycle, but $1 of debt still created $1.15 in GDP growth
- Since stimulus programmes began in 2000, however, $1 of debt has created just $0.36 of GDP growth
In other words, value destruction has been taking place since 2000. The red shading tells the story very clearly, showing how public debt has risen out of control as the Fed’s stimulus programmes have multiplied – first with sub-prime until 2008, and since then with money-printing.
RISING INTEREST RATES CREATE FURTHER RISKS
Last week saw the yield on the benchmark US 10-year Treasury Bond reach 3%, double its low in June 2016. It has risen sharply since breaking out of its 30-year downtrend in January, and is heading towards my forecast level of 4%.
Higher interest rates will further slow demand, particularly in key sectors such as housing and autos. And in combination with high oil and commodity prices, it will be no surprise if the global economy moves into recession.
Chemicals is providing the vital early warning of the risks ahead. But as usual, it seems policymakers prefer to wear their rose-coloured spectacles. And then, of course, as with subprime, they will all loudly declare “Nobody could have seen this coming”.
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The results of the central bankers’ great experiment with money printing are now in, and they are fairly depressing, as the charts above confirm:
- On the left are the IMF’s annual forecasts from 2010 – 2018 (dotted lines) and the actual result (black)
- Until recently, the Fund was convinced the world would soon see 5% GDP growth, or at least 4% growth
- The actual outcome has been a steady decline until 2017 and this month’s forecast sees slowing growth by 2020
As the IMF headlined last week, “current favorable growth rates will not last”.
- On the right, is the amount of money the bankers have spent on money printing to achieve this result
- China, the US, Japan, the Eurozone and the Bank of England printed over $30tn between 2009-2017
- So far, only China – which did 2/3rds of the printing, has admitted its mistake, and changed the policy
The chart above shows what happens if you spend a lot of money without getting much return in terms of growth. Again from the IMF, it shows that total global debt has risen to $164tn. This is more than twice the size of global GDP – 225%, to be exact, based on latest 2016 data. The IMF analysis also highlights the result of the money printing:
“Debt-to-GDP ratios in advanced economies are at levels not seen since World War II….In the last ten years, emerging market economies have been responsible for most of the increase. China alone contributed 43% to the increase in global debt since 2007. In contrast, the contribution from low income developing countries is barely noticeable.”
It doesn’t take a rocket scientist to work out the result of this failed policy, which is shown in the above IMF charts:
- Global debt to GDP levels are higher than in 2008 and in the financial crisis; only World War 2 was higher
- Debt ratios in the advanced economies are at their highest since the 1980s debt crisis
- Emerging market ratios are lower (apart from China), but this is because of debt forgiveness at the Millennium
CAN ALL THIS DEBT EVER BE PAID PACK? AND IF NOT, WHAT HAPPENS?
As everyone knows, borrowing is easy. Almost all governments and commentators have lined up since 2009 to support the money-printing policy. But the hard bit happens now as it starts to become obvious that the policy has failed.
We now have all the debt, but we don’t have the growth that would enable it to be paid off.
It would be easy to simply end here, and point out that John Richardson and I set out the reasons why money-printing could never work in 2011, when we published Boom, Gloom and the New Normal: How the Ageing of the BabyBoomers is Changing Demand Patterns, Again. Our conclusion then was essentially based on common sense:
Central bankers simply confused cause and effect: demographics drive the economy, not monetary policy.
Common sense tells us that young populations create a demographic dividend as their spending grows with their incomes. But today’s ageing Western populations have a demographic deficit: older people already own most of what they need,and their incomes decline as they enter retirement.
But having been right in the past doesn’t help to solve today’s problem of excess debt and leverage:
- Common sense also tells us that leverage equals risk – if it works out, everything is fine; if not…..
- If you have a lot of debt and the world moves into recession, it becomes very hard to repay the debt
Financial markets are doing their best to warn us that the problems are growing. Longer-term interest rates, which are not controlled by the central banks, have been rising for some time. They are telling us that some investors are no longer simply chasing yield. They are instead worrying about risk – and whether their loan will actually be repaid.
Essentially, we are now in the and-game for stimulus policies. Major debt restructuring is now inevitable – either on an organised basis, as set out by Bill White, the only central banker to warn of the 2008 Crisis – or more chaotically.
This restructuring is going to be painful, as the chart above on the impact of leverage confirms. I originally highlighted it in August 2007, as the Crisis began to unfold – unfortunately, it now seems to have become relevant again..
PLEASE DON’T FIND YOURSELF SWIMMING NAKED WHEN THE TIDE OF DEBT GOES OUT
Leverage makes people appear to be geniuses on the way up. But on the way down, Warren Buffett’s famous warning is worth remembering: “Only when the tide goes out do you discover who’s been swimming naked”.
*Return on Equity is the fundamental measure of a company’s profitability, and is defined as the amount of profit or net income a company earns per investment dollar.
The post The tide of global debt has peaked: 8 charts suggest what may happen next, as the tide retreats appeared first on Chemicals & The Economy.
Oil and commodity markets long ago lost contact with the real world of supply and demand. Instead, they have been dominated by financial speculation, fuelled by the vast amounts of liquidity pumped out by the central banks. The chart above from John Kemp at Reuters gives the speculative positioning in the oil complex as published last Monday:
- It shows hedge fund positioning in terms of the ratio of long to short positions across the complex
- The ratio had been at a near-record low of 1.55x back in June last year, before the rally took off
- On 30 January it had risen to a record 11.9x – far above even the 2014 and 2017 peaks
The size of the rally has also been extraordinary, as I noted 2 weeks ago. At its peak, the funds owned 1.5bn barrels of oil and products – equivalent to an astonishing 16 days of global oil demand. They had bought 1.2bn barrels since June, creating the illusion of very strong demand. But, of course, hedge funds don’t actually use oil, they only trade it.
The funds also don’t normally hang around when the selling starts. And so last week, as the second chart shows, they began to sell their positions and take profits. The rally peaked at $71/bbl at the end of January, and then topped out on 2 February at $70/bbl. By last Friday, only a week later, Brent was at $63/bbl, having fallen 11% in just one week.
Of course, nothing had changed in the outlook for supply/demand, or for the global economy, during the week. And this simple fact confirms how the speculative cash has come to dominate real-world markets. The selling was due to nervous traders, who could see prices were challenging a critical “technical” point on the chart:
- Most commodity trading is done in relation to charts, as it is momentum-based
- The 200 day exponential moving average (EMA) is used to chart the trend’s strength
- When the oil price reached the 200-day EMA (red line), many traders got nervous
- And as they began to sell, so others began to follow them as momentum switched
The main sellers were the legal highwaymen, otherwise known as the high-frequency traders. Their algorithm-based machines do more than half of all daily trading, and simply want a trend to follow, milli-second by milli-second. As the Financial Times warned in June:
“The stock market has become a battlefield of algorithms, ranging from the simple – ETFs bought by retirees that may invest in the entire market, an industry, a specific factor or even themes like obesity – to the complex, commanded by multi-billion dollar “quantitative” hedge funds staffed by mathematicians, coders and data scientists.”
JP Morgan even estimates that only 10% of all trading is done by “real investors”:
“Passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago, and reckons that only roughly 10% of trading is done by traditional, “discretionary” traders, as opposed to systematic rules-based ones.”
Probably prices will now attempt to stabilise again before resuming their downward movement. But clearly the upward trend, which took prices up by 60% since June, has been broken. Similar collapses have occurred across the commodity complex, with the CRB Index showing a 6% price fall across major commodities:
- Typically, inventory build ahead of price rises can add an extra month of “apparent demand” to real demand
- This inventory will now have to be run down as buyers destock to more normal levels again
- This means we can expect demand to slow along all the major value chains
- Western companies will now see slow demand through Easter: Asia will see slow demand after Lunar New Year
This disappointment will end the myth that the world is in the middle of a synchronised global recovery. In turn, it will cause estimates of oil demand growth to be reduced, further weakening prices. It will also cause markets to re-examine current myths about the costs of US shale oil production:
- As the charts from Pioneer Natural Resources confirm, most shale oil breakeven costs are below $30/bbl
- Pioneer’s own operating costs, typical of most of the major players, are below $10/bbl
- So the belief that shale oil needs a price of $50/bbl to support future production is simply wrong
PREPARE FOR PROFIT WARNINGS AND POTENTIAL BANKRUPTCIES BY THE SUMMER
Over the summer, therefore, many industrial companies will likely need to start issuing profit warnings, as it becomes clear that demand has failed meet expectations. This will put stock markets under major pressure, especially if interest rates keep rising as I discussed last month.
Smart CEOs will now start to prepare contingency plans, in case this should happen. We can all hope the recent downturn in global financial markets is just a blip. But hope is not a strategy. And the risk of profit warnings turning into major bankruptcies is extremely high, given that global debt now totals $233tn, more than 3x global GDP.
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.
Since January, I have also been monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. Today’s forecast for oil prices to fall initially to $50/bbl is therefore now added to those on ethylene/polyethylene and the US 10-year interest rate. I am also increasing the confidence level for the interest rate forecast to 70%, and will continue to update these levels when circumstances change.
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We are living in a strange world. As in 2007 – 2008, financial news continues to be euphoric, yet the general news is increasingly gloomy. As Nobel Prizewinner Richard Thaler, has warned, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” Both views can’t continue to exist alongside each other for ever. Whichever scenario comes out on top in 2018 will have major implications for investors and companies.
It therefore seems prudent to start building scenarios around some of the key risk areas – increased volatility in oil and interest rates, protectionism and the threat to free trade (including Brexit), and political disorder. One key issue is that the range of potential outcomes is widening.
Last year, for example, it was reasonable to use $50/bbl as a Base case forecast for oil prices, and then develop Upside and Downside cases using a $5/bbl swing either way. But today’s rising levels of uncertainty suggests such narrow ranges should instead be regarded as sensitivities rather than scenarios. In 2018, the risks to a $50/bbl Base case appear much larger:
- On the Downside, US output is now rising very fast given today’s higher prices. The key issue with fracking is that the capital cost is paid up-front, and once the money has been spent, the focus is on variable cost – where most published data suggests actual operating cost is less than $10/bbl. US oil and product exports have already reached 7mbd, so it is not hard to see a situation where over-supplied energy markets cause prices to crash below $40/bbl at some point in 2018
- On the Upside, instability is clearly rising in the Middle East. Saudi Arabia’s young Crown Prince, Mohammad bin Salman is already engaged in proxy wars with Iran in Yemen, Syria, Iraq and Lebanon. He has also arrested hundreds of leading Saudis, and fined them hundreds of billions of dollars in exchange for their release. If he proves to have over-extended himself, the resulting political confusion could impact the whole Middle East, and easily take prices above $75/bbl
Unfortunately, oil price volatility is not the only risk facing us in 2018. As the chart shows, the potential for a debt crisis triggered by rising interest rates cannot be ignored, given that the current $34tn total of central bank debt is approaching half of global GDP. Most media attention has been on the US Federal Reserve, which is finally moving to raise rates and “normalise” monetary policy. But the real action has been taking place in the emerging markets. 10-year benchmark bond rates have risen by a third in China over the past year to 4%, whilst rates are now at 6% in India, 7.5% in Russia and 10% in Brazil.
An “inflation surprise” could well prove the catalyst for such a reappraisal of market fundamentals. In the past, I have argued that deflation is the likely default outcome for the global economy, given its long-term demographic and demand deficits. But markets tend not to move in straight lines, and 2018 may well bring a temporary inflation spike, as China’s President Xi has clearly decided to tackle the country’s endemic pollution early in his second term. He has already shutdown thousands of polluting companies in many key industries such as steel, metal smelting, cement and coke.
His roadmap is the landmark ‘China 2030’ joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition: “From policies that served it so well in the past to ones that address the very different challenges of a very different future”.
But, of course, transitions can be a dangerous time, as China’s central bank chief, Zhou Xiaochuan, highlighted at the 5-yearly Party Congress in October, when warning that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008 in the west.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t face a need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. Nobody wanted to be focusing on contingency plans when everybody else seemed to be laughing all the way to the bank.
I discuss these issues in more detail in my annual Outlook for 2018. Please click here to download this, and click here to watch the video interview with ICB deputy editor, Will Beacham.
The post The return of volatility is the key market risk for 2018 appeared first on Chemicals & The Economy.
“There isn’t anybody who knows what is going to happen in the next 12 months. We’ve never been here before. Things are out of control. I have never seen a situation like it.“
This comment from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing companies, investors and individuals as we look ahead to the 2018 – 2020 Budget period. None of us have ever seen a situation like today’s. Even worse, is the fact that risks are not just focused on the economy, or politics, or social issues. They are a varying mix of all of these. And because of today’s globalised world, they potentially affect every country, no matter how stable it might appear from inside its own borders.
This is why my Budget Outlook for 2018 – 2020 is titled ‘Budgeting for the Great Unknown’. We cannot know what will happen next. But this doesn’t mean we can’t try to identify the key risks and decide how best to try and manage them. The alternative, of doing nothing, would leave us at the mercy of the unknown, which is never a good place to be.
RISING INTEREST RATES COULD SPARK A DEBT CRISIS
Central banks assumed after 2008 that stimulus policies would quickly return the economy to the BabyBoomer-led economic SuperCycle of the previous 25 years. And when the first round of stimulus failed to produce the expected results, as was inevitable, they simply did more…and more…and more. The man who bought the first $1.25tn of mortgage debt for the US Federal Reserve (Fed) later described this failure under the heading “I’m sorry, America“:
“You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2”
• And the Fed was not alone, as the chart shows. Today, the world is burdened by over $30tn of central bank debt
• The Fed, European Central Bank, Bank of Japan and the Bank of England now appear to “own a fifth of their governments’ total debt”
• There also seems little chance that this debt can ever be repaid. The demand deficit caused by today’s ageing populations means that growth and inflation remain weak, as I discussed in the Financial Times last month
China is, of course, most at risk – as it was responsible for more than half of the lending bubble. This means the health of its banking sector is now tied to the property sector, just as happened with US subprime. Around one in five of all Chinese apartments have been bought for speculation, not to be lived in, and are unoccupied.
China’s central bank chief, Zhou Xiaochuan, has warned that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008. Similar risks face the main developed countries as they finally have to end their stimulus programmes:
• Who is now going to replace them as buyers of government debt?
• And who is going to buy these bonds at today’s prices, as the banks back away?
• $8tn of government and corporate bonds now have negative interest rates, which guarantee the buyer will lose money unless major deflation takes place – and major deflation would make it very difficult to repay the capital invested
There is only one strategy to manage this risk, and that is to avoid debt. Companies or individuals with too much debt will go bankrupt very quickly if and when a Minsky Moment takes place.
THE CHINA SLOWDOWN RISK IS LINKED TO THE PROPERTY LENDING BUBBLE
After 2008, it seemed everyone wanted to believe that China had suddenly become middle class by Western standards. And so they chose to ignore the mounting evidence of a housing bubble, as shown in the chart above.
Yet official data shows average incomes in China are still below Western poverty levels (US poverty level = $12060):
• In H1, disposable income for urban residents averaged just $5389/capita
• In the rural half of the country, disposable income averaged just $1930
• The difference between income and expenditure was based on the lending bubble
As a result, average house price/earnings ratios in cities such as Beijing and Shanghai are now more than 3x the ratios in cities such as New York – which are themselves wildly overpriced by historical standards.
Having now been reappointed for a further 5 years, it is clear that President Xi Jinping is focused on tackling this risk. The only way this can be done is to take the pain of an economic slowdown, whilst keeping a very close eye on default risks in the banking sector. As Xi said once again in his opening address to last week’s National Congress:
“Houses are built to be inhabited, not for speculation. China will accelerate establishing a system with supply from multiple parties, affordability from different channels, and make rental housing as important as home purchasing.”
China will therefore no longer be powering global growth, as it has done since 2008. Prudent companies and investors will therefore want to review their business models and portfolios to identify where these are dependent on China.
This may not be easy, as the link to end-user demand in China might well be further down the supply chain, or external via a second-order impact. For example, Company A may have no business with China and feel it is secure. But it may suddenly wake up one morning to find its own sales under attack, if company B loses business in China and crashes prices elsewhere to replace its lost volume.
PROTECTIONISM IS ON THE RISE AROUND THE WORLD
Trade policy is the third key risk, as the chart of harmful interventions from Global Trade Alert confirms.
These are now running at 3x the level of liberalising interventions since 2008, as Populist politicians convince their voters that the country is losing jobs due to “unfair” trade policies.
China has been hit most times, as its economy became “the manufacturing capital of the world” after it joined the World Trade Organisation in 2001. At the time, this was seen as being good news for consumers, as its low labour costs led to lower prices.
But today, the benefits of global trade are being forgotten – even though jobless levels are relatively low. What will happen if the global economy now moves into recession?
The UK’s Brexit decision highlights the danger of rising protectionism. Leading Brexiteer and former cabinet minister John Redwood writes an online diary which even campaigns against buying food from the rest of the European Union:
“There are many great English cheese (sic), so you don’t need to buy French.”
No family tries to grow all its own food, or to manufacture all the other items that it needs. And it used to be well understood that countries also benefited from specialising in areas where they were strong, and trading with those who were strong in other areas. But Populism ignores these obvious truths.
• President Trump has left the Trans-Pacific Partnership, which would have linked major Pacific Ocean economies
• He has also said he will probably pull out of the Paris Climate Change Agreement
• Now he has turned his attention to NAFTA, causing the head of the US Chamber of Commerce to warn:
“There are several poison pill proposals still on the table that could doom the entire deal,” Donohue said at an event hosted by the American Chamber of Commerce of Mexico, where he said the “existential threat” to NAFTA threatened regional security.
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.
POLITICAL CHAOS IS GROWING AS PEOPLE LOSE FAITH IN THE ELITES
The key issue underlying these risks is that voters no longer believe that the political elites are operating with their best interests at heart. The elites have failed to deliver on their promises, and many families now worry that their children’s lives will be more difficult than their own. This breaks a century of constant progress in Western countries, where each generation had better living standards and incomes. As the chart from ipsos mori confirms:
• Most people in the major economies feel their country is going in the wrong direction
• Adults in only 3 of the 10 major economies – China, India and Canada – feel things are going in the right direction
• Adults in the other 7 major economies feel they are going in the wrong direction, sometimes by large margins
• 59% of Americans, 62% of Japanese, 63% of Germans, 71% of French, 72% of British, 84% of Brazilians and 85% of Italians are unhappy
This suggests there is major potential for social unrest and political chaos if the elites don’t change direction. Fear of immigrants is rising in many countries, and causing a rise in Populism even in countries such as Germany.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t have to face the need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. The threat from subprime was perfectly obvious from 2006 onwards, as I warned in the Financial Times and in ICIS Chemical Business, as was 2014’s oil price collapse. Today’s risks are similarly obvious, as the “Ring of Fire” map describes.
You may well have your own concerns about other potential major business risks. Nobel Prizewinner Richard Thaler, for example, worries that:
“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”
We can all hope that none of these scenarios will actually create major problems over the 2018 – 2020 period. But hope is not a strategy, and it is time to develop contingency plans. Time spent on these today could well be the best investment you will make. As always, please do contact me at email@example.com if I can help in any way.
The post Budgeting for the Great Unknown in 2018 – 2020 appeared first on Chemicals & The Economy.
Global interest rates have fallen dramatically over the past 25 years, as the chart shows for government 10-year bonds:
UK rates peaked at 9% in 1995 and are now down at 1%: US rates peaked at 8% and are now at 2%
German rates peaked at 8% and are now down to 0%: Japanese rates peaked at 4% and are now also at 0%
But what goes down can also rise again. And one of the most reliable ways of investing is to assume that prices will normally revert to their mean, or average.
If this happens, rates have a long way to rise. Long-term UK interest rates since 1703 have averaged 4.5% through wars, booms and depressions. If we just look more recently, average UK 10-year rates over the past 25 years were 4.6%. We are clearly a very long way away from these levels today.
This doesn’t of course mean that rates will suddenly return to these levels overnight. But there are now clear warning signs that rates are likely to rise as central banks wind down their Quantitative Easing (QE) and Zero Interest Rate stimulus policies. The problem is the legacy these policies leave behind, as the Financial Times noted recently:
“In total, the six central banks that have embarked on quantitative easing over the past decade — the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, along with the Swiss and Swedish central banks — now hold more than $15tn of assets, according to analysis by the FT of IMF and central bank figures, more than four times the pre-crisis level.
“Of this, more than $9tn is government bonds — one dollar in every five of the $46tn total outstanding debt owed by their governments. The ECB’s total balance sheet recently topped that of the Fed in dollar terms. It now holds $4.9tn of assets, including nearly $2tn in eurozone government bonds.”
The key question is therefore ‘what happens next’? Will pension funds and other buyers step in to buy the same amount of bonds at the same price each month?
The answer is almost certainly no. Pension funds are focused on paying pensions, not on supporting the national economy. And higher rates would really help them to reduce their current deficits. The current funding level for the top US S&P 1500 companies is just 82%, versus 97% in 2011. They really need bond prices to fall (bond prices move inversely to yields), and rates to rise back towards their average, in order to reduce their liabilities.
The problem is that rising yields would also pressure share prices both directly and indirectly:
Some central banks have been major buyers of shares via Exchange Traded Funds (ETFs) – the Bank of Japan now owns 71% of all shares in Japan-listed ETFs
Lower interest rates also helped to support share prices indirectly, as investors were able to borrow more cheaply
Margin debt on the New York Stock Exchange (money borrowed to invest in shares) is now at an all time high in $2017. Ominously, company buy-backs of their shares have already begun to slow and are down $100bn in the past year.
House prices are also in the line of fire, as the second chart shows for London. They have typically traded on the basis of their ratio to earnings
The average ratio was 4.8x between 1971 – 1999
But this ratio has more than doubled to 12x since 2000 as prices rose exponentially during subprime and then QE
The reason was that after the dotcom crash in 2000, the Bank of England deliberately allowed prices to move out of line with earnings. As its Governor, Eddie George, later told the UK Parliament in March 2007:
“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption….
“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, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
Of course, as the chart shows, George’s successors did the very opposite. Ignoring the fact that a bubble was already underway, they instead reduced interest rates to near-zero after the subprime crisis of 2008, and flooded the market with liquidity. Naturally enough, prices then took off into the stratosphere.
Today, however, the Bank is finally recognising – too late – that it has created a bubble of historical proportions, and is desperately trying to shift the blame to someone else. Thus Governor Mark Carney warned last week:
“What we’re worried about is a pocket of risk – a risk in consumer debt, credit card debt, debt for cars, personal loans.”
Of course, the biggest “pocket of risk” is in the housing market:
Lower interest rates meant lower monthly mortgage payments, creating the illusion that high prices were affordable
But higher prices still have to be paid back at the end of the mortgage – very difficult, when wages aren’t also rising
The Bank has therefore now imposed major new restrictions on lenders. They have ordered them to keep new loans at no more than 4.5x incomes for the vast majority of their borrowers. And lenders themselves are also starting to get worried as the average deposit is now close to £100k ($135k).
Of course, London prices might stay high despite these new restrictions. Anything is possible.
But fears over a hard Brexit have already led many banks, insurance companies and lawyers to start moving highly-paid people out of London, as the City risks losing its “passport” to service EU27 clients. Over 50% of surveyors report that London house prices are now falling, just as a glut of new homes comes to market. In the past month, asking prices have fallen by £300k in Kensington/Chelsea, and by £75k in Camden, as buyers disappear.
The next question is how low could prices go if they return to the mean? If London price/earning ratios fell back from today’s 12x ratio to the post-2000 average of 8.2x level, average prices would fall by nearly a third to £332k. If ratios returned to the pre-2000 level of 4.8x earnings, then prices would fall by 60% to £195k.
Most Britons now expect a price crash within 5 years, and a quarter expect it by 2019. Brexit uncertainty, record high prices and vast overs-supply of new properties could be a toxic combination, perhaps even taking ratios below their average for a while – as happened in the early 1990s slump. As then, a crash might also take years to unwind, making life very difficult even for those who did not purchase when prices were at their peak.