First, the good news. It has long been recognised that the UK economy is over-dependent on financial services, and that its housing market – particularly in London – is wildly over-priced in relation to earnings. The Brexit vote should ensure that both these problems are solved:
- Many banks and financial institutions are already planning to move out of the UK to other locations within the EU, so they can continue to operate inside the Single Market
- There is no reason for those which are foreign-owned to stay in the country, now the UK is leaving the EU
- This will also undermine the London housing market by removing the support provided by these high-earners
- In addition, thousands of Asians, Arabs, Russians and others will now start selling the homes they bought when the UK was seen as a “safe haven”
This is probably not the result that most Leave voters expected when they voted on Thursday. These voters will also soon find out that Thursday was not the Independence Day they were promised. It is already obvious that Leave campaigners have no clear idea of what to do next. They are even divided about whether to immediately trigger the 2-year departure period under Article 50 of the Lisbon Treaty.
Leave voters have more shocks ahead of them, of course:
- Most believed that the UK would immediately be able to “take control of its borders” and dramatically reduce immigration. But as I noted during the campaign, the majority of immigration has always been from outside the EU – and could already have been stopped, had the current or previous governments chosen to do this
- Nor will the National Health Service suddenly benefit from the promised £350m/week ($475m) by stopping UK contributions to the EU. For a start, more than half of this money already came back to the UK from the EU, and so can’t be spent a second time
- Even more importantly, nothing is going to happen for at least 2 years whilst the Leave negotiations take place
This, of course, is where the bad news starts. What will be the reaction of Leave voters as they discover they have been fed half-truths on these and other critical issues? And what will happen as house prices begin to fall, and jobs in financial services – as well as manufacturing – begin to disappear as companies relocate elsewhere within the EU?
BREXIT VOTE WILL HIT EUROPE AND THE GLOBAL ECONOMY
The bad news is, unfortunately, not restricted to the UK. Already, alarm has begun to spread across the rest of the EU. There are strong calls for referendums to take place in 3 of the EU’s 6 founding members – France, Italy and The Netherlands. It is hard to see how the EU could survive if even one of these votes resulted in a Leave decision.
In turn, of course, this is bound to draw attention once more to the unsolved Eurozone debt crisis. Can anyone now really continue to believe the European Central Bank’s 2012 promise to do “whatever it takes” to preserve the euro, as set out by its President, Mario Draghi?
The simple fact is that the Brexit vote is the canary in the coalmine. It is the equivalent of the “Bear Stearns collapse” in March 2008, ahead of the financial crisis. And as I have argued for some time, the global economy is in far worse shape today than in 2008, due to the debt created by the world’s major central banks.
THE BREXIT VOTE, LIKE THE 2008 CRISIS, WAS NOT A ‘BLACK SWAN’ EVENT
I am used, by now, to my forecasts being ignored by conventional wisdom. The Brexit vote saw a repeat of the complacency that greeted my warnings in the Financial Times and here before the 2008 financial crisis. Thus my March warning was again mostly ignored, namely that:
“A UK vote to leave the European Union is becoming more likely”.
Instead, like the 2008 crisis, the Brexit vote is already being described as a ‘black swan’ event – impossible to forecast. This attitude merely supports the status quo, as it means consensus wisdom does not have to challenge its core assumptions. Instead, it takes comfort in the view that “nobody could have foreseen this happening”.
Critically, this means that the failure of the post-2008 stimulus programmes is still widely ignored. Yet these have caused global debt levels to climb to more than 3x total GDP, according to McKinsey. As the map above shows, they have created a debt-fuelled ‘ring of fire’, which now threatens to collapse the entire global economy:
- China’s reversal of stimulus policies has led to major downturns in the economies of all its commodity suppliers
- Latin America, Africa, Russia and the Middle East can no longer rely on exports to China to support their growth
- Japan’s unwise efforts at stimulus via Abenomics have also proved a complete failure
- Now Brexit will almost inevitably cause a major collapse in London house prices
- And it will focus attention on the vast debts created by the Eurozone debt crisis
- It will also unsettle US investors, who have taken margin debt to record levels in the belief that the US Federal Reserve will never let stock market prices fall
TIME FOR STRAIGHT TALKING ON THE IMPACT OF AGEING POPULATIONS ON ECONOMIC GROWTH
It is therefore vital that policymakers now make a new start, whilst there is still time to avoid total financial collapse. Once people begin to realise that all this debt can never be repaid, then interest rates will soar and many currencies collapse. This is not being alarmist – this is just stating obvious facts.
The critical need is to recognise that demographics, not monetary policy, drive economies. A world with lots of young BabyBoomers in the Wealth Creating 25-54 age group will inevitably see strong growth. And if more and more women return to the workforce after childbirth, this will turbo-charge an economic SuperCycle.
This is what happened between 1983 – 2007, when the world saw almost constant growth. The US recorded just 16 months of recession in 25 years. But last year saw global GDP decline by a record amount in current dollars, more than in 2009 – a clear warning sign of major trouble ahead.
The issue is very simple. Common sense tells us that the combination of a 50% increase in global life expectancy since 1950, and a 50% fall in fertility rates, means that the world has now reached the “demographic cliff“:
- 1bn ageing Boomers are joining the low-spending, low-earning New Old 55+ generation for the first time in history
- They will be more than 1 in 5 of the global population by 2030, twice the percentage in 1950
This is good news, not bad. Who amongst us, after all, would not choose to have 20 years of life expectancy at age 65 instead of dying? That is today’s position in the Western world. And people in the emerging economies are catching up fast. They can already now expect to live another 15 years at age 65.
The trade-off is lower, or negative growth. People in this New Old 55+ age group already own most of what they need, and their incomes decline dramatically as they approach retirement.
But this simple fact of life has never been explained to voters. Instead they have been told since 2008 that policymakers are confident of returning the economy to SuperCycle levels of growth. No wonder they are growing restless, and starting to mistrust everything they are being told by the supposed experts.
CONCLUSION – TIME TO RESTORE TRUST WITH PLAIN SPEAKING
Policymakers and the media now have a grave responsibility, as do do all of us.
It is critically important that policymakers now recognise they must immediately reverse course on stimulus policies, and come clean with voters about the real economic situation.
Of course this will result in very painful conversations. But the alternative, of ignoring the warning provided by the Brexit vote, is simply too awful to contemplate.
Over the past 20 years, the financial sector has captured an increasing share of the wealth created by the rest of the economy. At its peak before the Crisis, it accounted for 40% of all profits in the US corporate sector, allowing financiers to claim they were ‘masters of the universe’.
A key reason for this growth was their success in creating the illusion that finance was too complex for most people to understand.
Prior to 1990, very few people had heard of EBITDA, quantum, VAR or the host of other acronyms that now dominate finance-speak. Instead, bankers, companies and regulators cheerfully talked about financial issues in simple terms that everyone could understand:
• Companies tracked Operating Profit for individual businesses
• Shareholders monitored net Profit after tax and interest payments
• Regulators checked to see if a bank’s capital could support its lending
But gradually, it came to be believed that only ‘the brightest of the best’ could truly understand finance. Simple terms were replaced by jargon and complex algorithms.
The end-result of the change is shown in the graph above, from a paper by the blog’s favourite regulator, Andy Haldane of the Bank of England. It shows the leverage of major global banks in 2006 (before the Crisis):
• The banks on the left of the chart had the lowest amount of capital
• The banks on the right had most capital
It also shows which banks have since gone bust, and which survived:
• Banks which have gone bust are shown in red
• Those that have survived are shown in blue
The conclusion is simple:
• No bank with a capital ratio above 8:1 went bust
• Most banks with ratios of less than 5:1 did go bust
As Haldane comments:
“Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, it requires a regulatory response grounded in simplicity, not complexity.
“Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will.”
It is 5 months since the blog launched its IeC Downturn Alert, using prices from 29 April. It wrote then that:
“They don’t ring bells at market turning points. Otherwise, we could all retire to the Bahamas.”
But its argument was that a peak was likely, as crude oil had remained stable at $125/bbl for 4 weeks.
Buyers had previously bought forward as prices rose, to protect downstream margins. Now they would try to reduce this unwanted inventory. Equally, oil prices at April’s level had always led to recession in the past, and it was unlikely that ‘this time it may be different’.
Evidence that a Downturn is now underway is all around us:
• European cracker operators are mostly at 70-75% operating rates
• A major naphtha surplus has developed in India and the Middle East
• Crackers in Japan, Taiwan and parts of SEA are running at 80-90% rates, with S Korea set to join them
• The US Federal Reserve is forecasting GDP growth of just 1.6%, half its June estimate
Coincidentally, as the chart shows, financial markets such as the US S&P 500 Index also peaked on 29 April, although their decline has so far been less dramatic. The high frequency traders who dominate these markets, have no interest in the fundamentals of supply and demand.
Today, however, the only question is ‘how long will the downturn last, and how deep will it be?’ Mario Draghi, the new head of the European Central Bank, forecasts “a mild recession” in Europe. We can all share this hope, but hope is not a strategy. Sensible Boards will develop scenarios that also include a worst case of a sustained and deep recession.
The blog was in a small minority when it launched its Downturn Alert.
Having run major businesses in the past, it knows that buyers always give seemingly convincing reasons when cancelling or deferring orders. It therefore felt it might be helpful to present a global overview, covering benchmark products and regions, to highlight that the problems were general, and not specific.
The industry’s current laser-like focus on year-end inventories means that we should avoid the problems seen in Q4 2008, when inventories piled up around the world. Instead, lower operating rates will mean that buyers occasionally find themselves short of product, as has happened this week in China on polyethylene.
But these short-term issues should not be confused with the potential for a quick recovery.
The Downturn Alert has hopefully helped the industry to navigate the last few difficult months. It will now be renamed the IeC Downturn Monitor, to reflect its new role of charting the problems that lie ahead.
ICIS pricing comments this week, and price movements since the IeC Downturn Alert launched on 29 April, are below:
Benzene NWE (green), down 29%. “Demand remains subdued for the current month”.
HDPE USA export (purple), down 24%. “Prices were rising, as global buyers began to restock, including in China and S American markets.”
Naphtha Europe (brown dash), down 20%. “The market continues to suffer soft demand, and has lengthened from the previous week.”.
PTA China (red), down 18%. “Most players were worried that the downturn may extend into the rest of the year because of the poor demand for polyester in China, India and parts of SEA.”
Brent crude oil (blue dash), down 12%.
S&P 500 Index (pink dot), down 8%
Financial markets have become increasingly nervous in recent weeks, since the blog last reviewed developments in global bond markets.
Its conclusion then was that investors are worrying more about return of capital, than return on capital, as we transition to the New Normal. This is because 272 million westerners are now over 55 years old, and they need security of income as they prepare for retirement.
The chart above updates market moves in the JUUGS (Japan, UK, USA, Germany, Switzerland) and the PIIGS (Portugal, Ireland, Italy, Greece, Spain). Since August (blue column), the 2 groups have seen very different interest rate trends for 10-year government bonds (red line):
• Rates in the JUUGS have been extremely stable. UK and Swiss rates have edged down 0.1%, whilst German rates moved up 0.1%. US and Japanese rates are unchanged.
• The PIIGS have been much more volatile. Greece is now paying 34% vs 22% in August: Portugal’s rate is 12% vs 11%: Italy’s is 6.4% vs 5.7%: Spain’s is 5.5% vs 5.3%: only Ireland’s reduced, from 8.8% to 8.3%.
This suggests Portugal will also need to default on its debts, alongside Greece. Otherwise the burden of interest payments will simply become too large, particularly as austerity programmes lead to recession.
Italy, of course, is the real problem child. It is a rich and large G7 country. But its interest rate is now also close to being unaffordable. Two key questions are looming on the horizon:
• Will it really now allow the IMF to dictate its economic policy?
• What will happen to French and German banks if investors start to question Italy’s ability to repay its debt?
Italy currently owes $416bn to French banks, and $162bn to German banks. It owes a total of $788bn to European lenders. This is the concept of ‘contagion’:
• If Italy’s rates move into the 6.5%-7% area, and remain there, then its default becomes almost certain.
• France, another G7 member, would then be in the firing line.
• Its 3.3% interest rate is already 50%+ higher than those of the JUUGS. This suggests underlying nervousness amongst investors.
The blog will continue to monitor the situation closely.
Last week’s New Normal seminar in Houston continued the success of the Singapore and Frankfurt events. It sparked lively debate about the major opportunities for future growth in the New Normal. These include:
• The over-55 age group in the West – already 272m in number
• Those millions emerging from poverty in the East
One key discussion was around the different outlooks of Western companies, versus many of those in the Middle East and China. As the chart shows:
• Western companies focus on economics, with some input from politicians eg taxes, employment law. American companies in particular believe the Profit & Loss (P&L) account is the key driver of success
• This is not so true in the Middle East. Companies there have a focus on the P&L, but usually have close linkages to government, and are very mindful of social needs such as providing employment
• Companies in China start from a different perspective. The majors such as Sinopec are largely state-owned, and their prime role is to act as utilities, providing raw materials to the factories to keep people employed
These distinctions are now taking on growing importance. In 1980, almost all the major companies were Western in orientation, and focused on the P&L. But today, half of the Top 10 companies are from the Middle East and China. So their views matter.
This is another example of the power of the Shared Value concept. As Harvard’s Prof Michael Porter has argued, it creates the potential for “the next wave of innovation and productivity growth”. It enables companies to focus on long-term opportunities and not just short-term financial metrics.
There is no going back to the post-1980 Supercycle world. Companies who now adopt the Shared Value approach will position themselves for success in the New Normal.
The next New Normal courses are later this month in Singapore, and in London in December. Please click here for more details of how to join.
The brave new world of modern finance continues to amaze the blog.
It still has problems with the idea that the answer to having too much debt is to borrow some more. But last week’s Eurozone summit not only did this (as noted by the German central bank), but added a new element.
Its new bailout plan suggests that the European rich should now borrow from the emerging country poor, via the IMF. Thus the support of Italy (income per capita of $34k) depends on loans from China (income of $3k). Or, to put it another way, the world’s second wealthiest region aims to borrow from people who have some of the lowest incomes in the world.
Of course, President Sarkozy made some reference to ‘old style reality’ when he told the French people on Thursday night that “the problem is that we spend too much and we must work more.” But this is unlikely to be the message on which he campaigns for re-election next year.
Naturally financial markets rallied strongly at the news, with the US S&P 500 Index jumping 4% during the week. But in the real world, where those of us in the chemical industry work, markets failed to show similar enthusiasm, as this week’s IeC Downturn Alert chart above shows. Even Brent crude oil managed only a $0.85/bbl rise, whilst naphtha actually fell.
This caution was shared in the world of electical appliances, a key market for chemicals. Whirlpool and Electrolux, the two largest companies reported:
• “Sales gains in Asia and Latin America are slowing and aren’t sufficient to make up for sluggish demand in the U.S. and Europe”
• Electrolux estimate “N American appliance sales this year will be 25% below the 2005 peak; W European sales will be down 15% from 2006”
• Whirlpool’s CEO noted that the only “people who are buying, are people whose appliances break”.
ICIS pricing comments this week, and price movements since the IeC Downturn Alert launched on 29 April, are below:
Benzene NWE (green), down 30%. “Market remains under downward pressure this week, largely due to continued weak demand.”
HDPE USA export (purple), down 28%. “The window of opportunity for sales into China has basically closed as prices in Asia and the Middle East continue to fall.”
Naphtha Europe (brown dash), down 21%. “Demand from gasoline is reasonably healthy, while from petchems remains poor”.
PTA China (red), down 14%. “Demand remains weak on the back of limited procurement from the cloth and weaving sectors amid tight credit and higher inventory.”
Brent crude oil (blue dash), down 11%.
S&P 500 Index (pink dot), down 6%