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
Companies and investors are starting to finalise their plans for the coming year. Many are assuming that the global economy will grow by 3% – 3.5%, and are setting targets on the basis of “business as usual”. This has been a reasonable assumption for the past 25 years, as the chart confirms for the US economy:
- US GDP has been recorded since 1929, and the pink shading shows periods of recession
- Until the early 1980’s, recessions used to occur about once every 4 – 5 years
- But then the BabyBoomer-led economic SuperCycle began in 1983, as the average Western Boomer moved into the Wealth Creator 25 – 54 age group that drives economic growth
- Between 1983 – 2000, there was one, very short, recession of 8 months. And that was only due to the first Gulf War, when Iraq invaded Kuwait.
Since then, the central banks have taken over from the Boomers as the engine of growth. They cut interest rates after the 2001 recession, deliberately pumping up the housing and auto markets to stimulate growth. And since the 2008 financial crisis, they have focused on supporting stock markets, believing this will return the economy to stable growth:
- The above chart of the S&P 500 highlights the extraordinary nature of its post-2008 rally
- Every time it has looked like falling, the Federal Reserve has rushed to its support
- First there was co-ordinated G20 support in the form of low interest rates and easy credit
- This initial Quantitative Easing (QE) was followed by QE2 and Operation Twist
- Then there was QE3, otherwise known as QE Infinity, followed by President Trump’s tax cuts
In total, the Fed has added $3.8tn to its balance sheet since 2009, whilst China, the European Central Bank and the Bank of Japan added nearly $30tn of their own stimulus. Effectively, they ensured that credit was freely available to anyone with a pulse, and that the cost of borrowing was very close to zero. As a result, debt has soared and credit quality collapsed. One statistic tells the story:
“83% of U.S. companies going public in the first nine months of this year lost money in the 12 months leading up to the IPO, according to data compiled by University of Florida finance professor Jay Ritter. Ritter, whose data goes back to 1980, said this is the highest proportion on record. The previous highest rate of money-losing companies going public had been 81% in 2000, at the height of the dot-com bubble.”
And more than 10% of all US/EU companies are “zombies” according to the Bank of International Settlements (the central banks’ bank), as they:
“Rely on rolling over loans as their interest bill exceeds their EBIT (Earnings before Interest and Taxes). They are most likely to fail as liquidity starts to dry up”.
2019 – 2021 BUDGETS NEED TO FOCUS ON KEY RISKS TO THE BUSINESS
For the past 25 years, the Budget process has tended to assume that the external environment will be stable. 2008 was a shock at the time, of course, but time has blunted memories of the near-collapse that occurred. The issue, however, as I noted here in September 2008 is that:
“A long period of stability, such as that experienced over the past decade, eventually leads to major instability.
“This is because investors forget that higher reward equals higher risk. Instead, they believe that a new paradigm has developed, where high leverage and ‘balance sheet efficiency’ should be the norm. They therefore take on high levels of debt, in order to finance ever more speculative investments.”
This is the great Hyman Minsky’s explanation for financial crises and panics. Essentially, it describes how confidence eventually leads to complacency in the face of mounting risks. And it is clear that today, most of the lessons from 2008 have been forgotten. Sadly, it therefore seems only a matter of “when”, not “if”, a new financial crisis will occur.
So prudent companies will prepare for it now, whilst there is still time. You will not be able to avoid all the risks, but at least you won’t suddenly wake up one morning to find panic all around you.
The chart gives my version of the key risks – you may well have your own list:
- Global auto and housing markets already seem to be in decline; world trade rose just 0.2% in August
- Global liquidity is clearly declining, and Western political debate is ever-more polarised
- Uncertainty means that the US$ is rising, and geopolitical risks are becoming more obvious
- Stock markets have seen sudden and “unexpected” falls, causing investors to worry about “return of capital”
- The risks of a major recession are therefore rising, along with the potential for a rise in bankruptcies
Of course, wise and far-sighted leaders may decide to implement policies that will mitigate these risks, and steer the global economy into calmer waters. Then again, maybe our leaders will decide they are “fake news” and ignore them.
Either way, prudent companies and investors may want to face up to these potential risks ahead of time. That is why I have titled this year’s Outlook, ‘Budgeting for the end of “Business as Usual“. As always, please contact me at firstname.lastname@example.org if you would like to discuss these issues in more depth.
Please click here to download a copy of all my Budget Outlooks 2007 – 2018.
I well remember the questions a year ago, after I published my annual Budget Outlook, ‘Budgeting for the Great Unknown in 2018 – 2020‘. Many readers found it difficult to believe that global interest rates could rise significantly, or that China’s economy would slow and that protectionism would rise under the influence of Populist politicians.
MY ANNUAL BUDGET OUTLOOK WILL BE PUBLISHED NEXT WEEK
Next week, I will publish my annual Budget Outlook, covering the 2019-2021 period. The aim, as always, will be to challenge conventional wisdom when this seems to be heading in the wrong direction.
Before publishing the new Outlook each year, I always like to review my previous forecast. Past performance may not be a perfect guide to the future, but it is the best we have:
The 2007 Outlook ‘Budgeting for a Downturn‘, and 2008′s ‘Budgeting for Survival’ meant I was one of the few to forecast the 2008 Crisis. 2009′s ‘Budgeting for a New Normal’ was then more positive than the consensus, suggesting “2010 should be a better year, as demand grows in line with a recovery in global GDP“. Please click here if you would like to download a free copy of all the Budget Outlooks.
THE 2017 OUTLOOK WARNED OF 4 KEY RISKS
My argument last year was essentially that confidence had given way to complacency, and in some cases to arrogance, when it came to planning for the future. “What could possibly go wrong?” seemed to be the prevailing mantra. I therefore suggested that, on the contrary, we were moving into a Great Unknown and highlighted 4 key risks:
- Rising interest rates would start to spark a debt crisis
- China would slow as President Xi moved to tackle the lending bubble
- Protectionism was on the rise around the world
- Populist appeal was increasing as people lost faith in the elites
A year later, these are now well on the way to becoming consensus views.
- Debt crises have erupted around the world in G20 countries such as Turkey and Argentina, and are “bubbling under” in a large number of other major economies such as China, Italy, Japan, UK and USA. Nobody knows how all the debt created over the past 10 years can be repaid. But the IMF reported earlier this year that total world debt has now reached $164tn – more than twice the size of global GDP
- China’s economy in Q3 saw its slowest level of GDP growth since Q1 2009 with shadow bank lending down by $557bn in the year to September versus 2017. Within China, the property bubble has begun to burst, with new home loans in Shanghai down 77% in H1. And this was before the trade war has really begun, so further slowdown seems inevitable
- Protectionism is on the rise in countries such as the USA, where it would would have seemed impossible only a few years ago. Nobody even mentions the Doha trade round any more, and President Trump’s trade deal with Canada and Mexico specifically targets so-called ‘non-market economies’ such as China, with the threat of losing access to US markets if they do deals with China
- Brexit is worth a separate heading, as it marks the area where consensus thinking has reversed most dramatically over the past year, just as I had forecast in the Outlook:
“At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail. But what if they are wrong? It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.
“Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.”
- Populism is starting to dominate the agenda in an increasing number of countries. A year ago, many assumed that “wiser heads” would restrain President Trump’s Populist agenda, but instead he has surrounded himself with like-minded advisers; Italy now has a Populist government; Germany’s Alternativ für Deutschland made major gains in last year’s election, and in Bavaria last week.
The last 10 years have proved that stimulus programmes cannot substitute for a lack of babies. They generate debt mountains instead of sustainable demand, and so make the problems worse, not better. As a result, voters start to listen to Populists, who offer seemingly simple solutions to the problems which have been ignored by the elites.
Next week, I will look at what may happen in the 2019 – 2021 period, as we enter the endgame for the policy failures of the past decade.
The post “What could possibly go wrong?” appeared first on Chemicals & The Economy.
2016 data highlights one startling statistic about the world’s Top 7 auto markets. They are 85% of total world sales and as the chart shows, their overall sales growth since 2007 has been entirely due to China:
China’s sales have risen nearly four-fold since 2007, from 6.3m to 24.2m
Sales in the other 6 markets were exactly the same in 2016 as in 2007, at 43m
This has been very good news for those who were in China. Everyone has seen their sales rise – the car companies, the component suppliers and all the service-based industries that supported this fabulous expansion.
There have also been good opportunities in other parts of the world over the period, but also major risks:
US sales hit a new record in 2016, after a great run since 2009 following GM and Chrysler’s bankruptcy
The 27-member European Union (EU) has done well since 2013, up nearly a quarter to 14.6m, but is still below 2007′s 15.6m. (The market peaked back in 1999, when 14.6m cars were sold to the then 15 EU members)
Japan did well to 2013, but has since fallen to 4.2m; well down on 2004′s peak of 4.8m. (It is back to 1992 levels)
India set a new record at 2.9m in 2016, double 2007′s level, but fell 19% in December as demonetisation impacted
Brazil did well till 2012 when sales hit 2.8m, but are now below 2007′s level at 2m
Russia also soared from 2009, hitting 2.8m in 2012, but has since halved to just 1.4m in 2016
Now global sales are likely heading for a fall. They would already have been much lower without the support of major stimulus measures. Governments have been desperate to keep auto sales rising, due to their impact on jobs:
When China’s sales began to slow in 2015, the sales tax was cut from 10% to 5% for smaller cars with engines below 1.6l – which are mostly produced by Chinese manufacturers. But now China has raised the tax back to 7.5%, leading the manufacturers’ association to forecast sales growth will fall from 21% in 2016 to just 3% in 2017
Europe has seen widespread and continuous discounting. Ford’s European profit was just $259m in 2015: it and Fiat Chrysler made operating margins of less than 1% of sales, and GM continued to lose money. UK sales have relied on $25.8bn ($28bn) of payments since 2011 for insurance mis-selling, as many claimants used their average £3k compensation as a deposit on a car loan. VW’s diesel scandal will also have long-term negative impact, given that over half of all European new car sales have been diesel vehicles for the past decade. Paris, Madrid and Athens have already decided to ban diesel cars completely by 2025.
The USA has seen discounts reach an average $4k in December, up 20% on 2015. Leasing and financing deals have also been critical in maintaining auto sales. Experian data shows 86% of new cars were bought with financing in Q3 2016; the average loan amount is at a record high of $30k, and loan terms average 68 months
Logic therefore suggests the consensus is being extremely optimistic in ignoring today’s increasingly uncertain political background, and assuming global sales will continue to grow in 2017:
China faces political uncertainty ahead of the critical 19th National Party Congress in Q4. President Xi is almost certain to be re-nominated for a second 5-year term, but cannot currently rely on maintaining control of the critical Politburo Standing Committee – China’s main decision-making body.
Europe also faces major political uncertainty, with elections due in The Netherlands, France and Germany – and possibly Italy. In addition, the UK is highly likely to table its decision to leave the EU in the next few weeks.
In the US, every two-term Presidency for 100 years has been followed by recession. President Trump is highly likely to take difficult decisions this year, before next year’s mid-term elections and his own re-election bid in 2020
Another key issue is the impact of falling prices for used cars. Their volumes are already increasing as all the new cars sold in recent years come back for resale. China’s Auto Dealer Association expects used car sales to equal those for new cars by 2020, whilst Barclays has warned that US new car “prime and subprime net loss rates are close to multi-year highs because of softening used car values.”
Then there is the growing impact of taxi services such as Uber and Did, and the rise of car-sharing business models and self-driving cars. Most Americans, after all, waste a week of their lives in traffic jams each year, and many auto manufacturers are now introducing more service-driven business models as BMW have argued:
“Our core business in the ’70s was selling cars; in the ’80s, late ’70s came the great innovation of leasing and financing. Now you can pay per use of a car. It’s like the music industry. You used to have to buy an album, now you can pay per play.”
It is not yet clear how bad the downturn will be. But it would seem prudent to plan for at least a 5% global decline this year, given today’s rising levels of uncertainty and global interest rates. It will be too late to panic later in the year, once the detail of the downturn has become more obvious.
The changes underway in China’s lending policies are far more significant that anything being planned by central banks in Tokyo, Frankfurt or Washington as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Investors’ attention remains focused on the minutiae of central bank policies in the developed world. But they might spare a thought for developments in China’s lending policies.
The implications of these dwarf anything being considered in Tokyo, Frankfurt, London or Washington, as the chart below highlights. It shows the changes since 2008 in official and shadow lending, which together constitute China’s total social financing (TSF).
- Phase 1, 2009. TSF lending doubled to $20tn, after President Hu and Premier Wen pressed the panic button in response to China’s loss of exports following the start of the financial crisis
- Phase 2, 2010–2013. After stabilising in 2010–2011, lending soared again to peak at $28tn in 2013 as the shadow sector went out of control. By 2013, it was $11tn higher than in 2008 and equal to official lending at $14tn a year.
- Phase 3, 2013 onwards. President Xi Jinping’s appointment in March 2013 changed everything. Shadow lending has since more than halved to $6tn, while TSF lending is down $4tn – despite an expansion in official lending to maintain banking sector liquidity
According to the Brookings Institution, the period between Q4 2008 and Q1 2014 saw TSF rise from 129 per cent to 207 per cent of GDP. Unsurprisingly, this caused the global commodities market to glow red-hot as China’s property sector became a speculator’s heaven.
The key moment was probably 2011, when the myth began to take hold that China had suddenly become “middle class”. Companies and investors devoured the headlines from the Asian Development Bank’s 2011 Report, which suggested that the majority of Chinese households had “become middle class by 2007”. And they chose to ignore as mere detail, its caveat that this was based on “$2 – $20 purchasing power parity per capita daily income”. Yet even two adults earning $20 a day, every day of the year, would have an annual combined income of just $14,600, well below the poverty line in any western country.
Worryingly, it seems many are still reluctant to remove their rose-tinted glasses. As a result, risks are rising in financial markets, as Xi is most unlikely to suddenly allow lending to ramp up again in support of China’s Old Normal economy. His focus is instead on November 2017, when the National Congress meets to reappoint him for a second five-year term. Any wavering now would undermine his core narrative, which highlights his success in tackling the problems of debt, pollution and corruption that he inherited. And it would distract from the key message of his New Normal policies, which aim to rebalance growth in favour of the long-neglected rural half of the country.
This scenario, of course, implies further pain ahead in the EMs and the west for those who have invested in building new capacity to supply China’s mythical middle classes. This pain will likely be intensified by the decision to focus China’s new Five-Year Plan for 2016–2020 on a supply-side revolution, modelled on those carried out by Margaret Thatcher and Ronald Reagan in the 1980s. Anyone who lived through that period needs no reminding that restructuring an outdated economy is an extremely painful process, as over-capacity is reduced and inefficient industries downsized.
The key issue is that China’s lending bubble until 2013 was like a balloon. And as we learnt to our cost with the US subprime bubble, it is highly dangerous to keep on pumping until the balloon bursts. Xi’s core problem is that China’s lending bubble has essentially been subprime on steroids: as the FT reported back in 2011, house price to earnings ratios in the Tier 1 cities had already reached 14: 1, compared with an average of 5: 1 in the US. There are simply no precedents for safely deflating a bubble of this size.
Xi’s only option is to try and deflate the bubble by following Deng Xiaoping’s advice “to cross the river by feeling the stones”. Investors therefore need to spend much more time on studying developments in China’s lending policies. Obsessing about central bank policy in developed markets may provide much needed light relief, but means they are in great danger of finding themselves all at sea as Xi continues to reverse the tide of leverage.
‘Bad news’ seems to have become ‘good news’ as far as China’s economy is concerned. In the past, most analysts simply ignored the possibility of a major slowdown. Now that the slowdown is underway, they still ignore it – this time, because they are sure further stimulus is just around the corner.
But time passes, and the lending data still points in a downwards direction, as the chart above shows:
- Shadow lending is now just a quarter of total lending, less than half the previous ratio (red area)
- This was the area the government wanted to squeeze, as it had created the property bubble
- Official lending has been maintained at previous levels, but not increased (green)
- This is essential as the government needs to keep liquidity in the banking system
Ironically, the analysts are in fact right, for the wrong reasons. It is actually very good news that China has stopped trying to create ‘wealth effects’ via stimulus and an unsustainable property bubble. As the editor-at-large of China Daily explained recently:
“Here’s why Chinese banks are reluctant to lend even though the central bank has cut both the interest rates and banks’ reserve requirements: Their clients－mostly those on the corporate level－are besieged by more and more difficulties in the market and are less and less able to pay back their borrowings Local housing developers cannot sell all the apartments they have built.”
A new investigation by the New York Times confirms his conclusion:
“Despite recent signs that housing prices are stabilizing, a backlog of unsold homes and unleased shops means that builders simply are not doing much building“.
China’s construction market came to dominate the economy under the stimulus programme. Now other key data are confirming the slowdown, with electricity consumption up just 1.6% in May, as the chart above shows. This takes us back to the pattern in early 2009, before the stimulus programme began to have its full impact. And it reflects the policy statement made at the end of 2014:
“China’s economy has entered a “new normal” of slower but higher-quality growth. From top leadership to small-business owners, the “new normal” status has become the new consensus.
“The popularity of the catchphrase marks a shift in mindset of the Chinese people – lower growth is likely to continue for a while and is not a sign of failure, but a lack of reform can be fatal to long-term sustainable growth. For policymakers, they are less worried about missing official growth targets, but rather hold fast to the belief that giving up growth spurts for stringent reforms will eventually pay off.
“A nationwide acceptance of and disenchantment with growth figures will help build a stronger economy — slower growth but lower unemployment driven by innovation and services industry, compared with high growth and high unemployment in an economy led by investment and exports in the past.”
China’s new leadership made it clear on taking office that they would not continue with stimulus policies. They knew they had to change course, and move away from the investment and export-led focus of the past. But most analysts have continued to wear their rose-tinted glasses and have ignored the changes underway.
It may be a painful awakening, when the reality of China’s New Normal policies finally forces them to accept this has been wishful thinking.