Asian downturn worsens, bringing global recession nearer

The chemical industry is the best leading indicator for the global economy.  And my visit to Singapore last week confirmed that the downturn underway in the Asian market creates major risks for developed and emerging economies alike.

The problem is focused on China’s likely move into recession, now its stimulus policies are finally being unwound.  And the result is shown in the above chart from The pH Report, updated to Friday:

  • It confirms that the downturn began before oil prices peaked at the beginning of October, confirming that companies were responding to a downturn in end-user demand
  • Since then, of course, the oil price has – rather dramatically – entered a bear market, with prices down by nearly a third

The question now is whether finance directors will choose to aggressively destock ahead of year-end results, to mitigate the volume decline with a decline in working capital. This would be a bold move given continuing geo-political uncertainty in the Middle East, and would also conflict with the more upbeat guidance that was given earlier with Q3 results.

But a review of ICIS news headlines over the past few days suggests they may have little choice.  Inventories are described as “piling up” in a wide range of major products, including polyethylene – the biggest volume polymer.  Indian producers are even offering “price protection” packages on polypropylene, to safeguard customers from losses if prices fall further.

Asian countries and their major partners (eg Argentina, S Africa, Turkey) were, of course, the first to be hit by China’s downturn.  But Q3’s fall in German GDP shows the downturn has now spread to the Western economy that most benefited from China’s post-2008 stimulus bubble.  As The Guardian noted:

“Goods exports make up 40% of German GDP – a much bigger proportion than for the next two biggest eurozone economies, France and Italy.”

OIL MARKETS CONFIRM THE RECESSION RISK

Of course, consensus opinion still believes that the US economy is sailing along, regardless of any problems elsewhere.  But the chart of oil prices relative to recession tells a different story:

  • The problem is that oil prices have been rising since 2016, with the summer proving the final blow-off peak.  As always, this meant consumers had to cut back on discretionary spending as costs of transport and heating rose
  • The cost of oil as a percentage of GDP reached 3.1% in Q3 – a level which has always led to recession in the past, with the exception of the post-2008 stimulus period when governments and central banks were pouring $tns of stimulus money into the global economy
  • In turn, this means a downturn is now beginning in US end-user demand in critical areas such as housing, autos and electronics

Oil markets have therefore provided a classic example of the trading maxim for weak markets – “Buy on the rumour, sell on the news”.

  • Prices had risen by 75% since June on supply shortage fears, following President Trump’s decision to exit the Iran nuclear deal on November 4
  • As always, this created “apparent demand” as buyers in the US and around the world bought ahead to minimise the impact of higher prices
  • But the higher prices also negated the benefit of the earlier tax cuts for his core supporters just ahead of the mid-term elections, causing Trump to undertake a policy u-turn
  • He is now pushing Saudi Arabia and Russia to maintain production, and has announced 180-day exemptions for Iran’s 8 largest customers – China, India, S Korea, Japan, Italy, Greece, Taiwan and Turkey.

Understandably, oil traders have now decided that his “bark is worse than his bite“.  And with the downturn spreading from Asia to the West, markets are now refocusing on supply/demand balances, with the International Energy Agency suggesting stocks will build by 2mb/d in H1 2019. In response, OPEC are reportedly discussing potential cuts of up to 1.4mb/d from December.

CHINA’S SHADOW BANKING COLLAPSE IS CREATING A NEW FINANCIAL CRISIS

Unfortunately, as in 2008, the collapse in oil prices is coinciding with the end of stimulus policies, particularly in China, as the chart of its shadow bank lending confirms.  This has hit demand in two ways, as I discussed earlier this month in the Financial Times:

  • Just 3 years ago, it was pumping out an average $140bn/month in mainly property-related lending *
  • This created enormous demand for EM commodity exports
  • It also boosted global property prices as wealthy Chinese rushed to get their money out of the country
  • But during 2018, lending has collapsed by more than 80% to average just $23bn in October

China’s post-2008 stimulus programme was the growth engine for the global economy – with the efforts of the Western central banks very much a sideshow in comparison.  It was more than half of the total $33tn lending to date.  But now it is unwinding, prompting the Minsky Moment forecast a year ago by China’s central bank governor:

China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous.”

As I warned then:

“Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy. China’s lending bubble – particularly in property – is likely coming to an end. In turn, this will lead to a bumpy ride for the global economy.

The bumps are getting bigger and bigger as we head into recession.  Asia’s downturn is now spreading to the rest of the world, and is a major wake-up call for anyone still planning for “business as usual”.

 

* Lending has major seasonal peaks in Q1, so I use rolling 12 month averages to avoid distortions 

Oil prices flag recession risk as Iranian geopolitical tensions rise

Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same.  Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.

The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story.  So the chart above instead combines 5 “shock, horror”  stories, showing quarterly oil production since 2015:

  • Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015.  OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
  • Russia has also been much in the news since joining the OPEC output agreement in November 2016.  But in reality, it has done little.  Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
  • Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
  • Venezuela is an OPEC member, but its production decline began long before the OPEC deal.  The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
  • The USA, along with Iran, has been the big winner over the past 2 years.  Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!

But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April.  Not much “shock, horror” there over a 3 year period.  More a New Normal story of “Winners and Losers”.

So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday?  Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble.  The answer lies in the second chart from John Kemp at Reuters:

  • It shows combined speculative purchases in futures markets by hedge funds since 2013
  • These hit a low of around 200mbbls in January 2016 (2 days supply)
  • They then more than trebled to around 700mbbls by December 2016 (7 days supply)
  • After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)

Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently:  “Several of them had little or no experience or even a basic understanding of how the physical market works.”

This critical point is confirmed by Citi analyst Ed Morse:  “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.

Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:

“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).

OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION

The hedge funds have been the real winners from all the “shock, horror” stories.  These created the essential changes in “crowd behaviour”, from which they could profit.  But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:

  • Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
  • This level has been linked with a US recession on almost every occasion since 1970
  • The only exception was post-2009 when China and the Western central banks ramped up stimulus
  • The stimulus simply created a debt-financed bubble

The reason is simple.  People only have so much cash to spend.  If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy.  Chemical markets are already confirming that demand destruction is taking place.:

  • Companies have completely failed to pass through today’s high energy costs.  For example:
  • European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
  • They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)

Even worse news may be around the corner.  Last week saw President Trump decide to withdraw from the Iran deal.  His daughter also opened the new US embassy to Jerusalem.  Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.

As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities.  Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz.  It is just 21 miles wide (34km)  at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.

As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”.  Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets.  We must all learn to form our own judgments about the real risks that might lie ahead.

 

Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.

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