The litmus test for the global economy

China’s lockdown makes global debt crisis now almost certain

Beijing has a population of 21.5 million, but you wouldn’t know it from this BBC video from last Thursday.  Normally busy streets and transport systems are eerily empty, with food deliveries often the main traffic on the roads.

It’s the same picture in industry, with the Baidu Migration Index reporting only 26% of migrant workers had returned to work across 19 sample cities by 19 February, compared with 101% a year earlier.

The position is even worse in Hubei province, the most important industrial manufacturing province in the country, as this South China Morning Post video, also from last Thursday, confirms.


China is clearly nowhere near getting “back to normal”, as the SCMP reports:

“Choked off from suppliers, workers, and logistics networks, China’s manufacturing base is facing a multitude of unprecedented challenges, as coronavirus containment efforts hamper factories’ efforts to reopen. 

“Many of those that have been granted permission to resume operations face critical shortages of staff, with huge swathes of China still under lockdown and some local workers afraid to leave their homes. Others cannot access the materials needed to make their products, and even if they could, the shutdown of shops and marketplaces around China means demand has been sapped. 

“Those who manage to assail the challenges, meanwhile, have found that trucking, shipping and freight services are thin on the ground, as China’s famed logistical machine also struggles to find workers and navigate provincial border checkpoints that have popped up across the country.”

Cash-flow is also drying up at thousands of companies, large and small.  It is now a month since the emergency began. Bloomberg reports, for example, that the Hainan provincial government is in talks to takeover HNA’s $143bn airline to property development business empire.

THE LOCKDOWN CONTINUES TO HAVE MAJOR IMPACT ON THE ECONOMY
It would be nice to believe that the epidemic will have no impact on China’s economy. But common sense tells us this can’t be true. We just have to ask ourselves 5 obvious questions.  What would happen to:

  1. Our own country’s economy, if our capital and a major manufacturing base shutdown for a month?
  2. Businesses, large and small, if orders stopped and transport was severely disrupted?
  3. Imports and exports, if critical shipping schedules and flights were cancelled?
  4. Cash-flow, if the above happened and we still had to pay interest bills on debt?
  5. Supply chains, if workers at one or more partners couldn’t get to work for a month?

South Korea’s president Moon-Jae has given the obvious answer as the Financial Times reports:

“We should take all possible measures we can think of” to support the economy, Mr Moon told a cabinet meeting on Tuesday. “The current situation is more serious than we thought . . . we need to take emergency steps in this time of emergency.”

Of course, ‘this time may be different’. But common sense tells us that China’s economy is under enormous pressure today. The charts above highlight the range of areas that are affected:

  • Property sales are down 79%, with Evergrande offering 22% discounts through March
  • Construction is 25% of GDP, with Fitch identifying 6 developers with high risk of default
  • Ports are often at a standstill – and many shippers have simply stopped calling at Chinese ports
  • Car sales collapsed by 92% in the world’s largest auto market in the first two weeks of February

5 LIKELY IMPACTS FROM THE LOCKDOWN
1. Domestic sales.  Thousands of stores have been shut since the epidemic began, and people are understandably too scared to venture out – even if this was allowed. So we must assume most areas of domestic consumption are being hit.

2. Imports for manufacturing. Chemicals are an excellent guide to the overall position, as the charts show based on Trade Data Monitor data. Given the shipping problems, large volumes of cancelled imports must now be sitting in suppliers’ tanks and warehouses, waiting to find a new market

3. Exports as part of supply chains. Apple’s profit warning highlights how even major companies have been caught out, as they cannot obtain the component supplies on which their global sales depend. Car and electronics companies are probably most at risk, and we will no doubt see more profit warnings as companies realise inventory is running short

4. Domestic suppliers. There is little data available about the virus’ impact on smaller Chinese companies. But presumably many have already gone bust, especially if they were unlucky enough to be in the centre of the downturn, such as those in Hubei and Wuhan

5. Oil and currency markets.  Caixin reports that Chinese refinery runs are at just 10mbd, compared to an average 13mbd in 2019:

“The deepening run cuts belie optimism that the impact of the epidemic may have peaked, a sentiment that’s helped spur a recovery in oil prices over the last week and a half. Many people are still trapped in their homes and unable to go to work, while curbs on travel have pummeled demand for transport fuels.”

Currency markets are also realising the worst may yet be to come.  Companies such as HNA have been major borrowers in the offshore dollar market – hoping to take advantage of low US interest rates. But as we have seen many times before, when the currency starts to fall, those debts quickly become impossible to service.

A GLOBAL DEBT CRISIS SEEMS ALMOST INEVITABLE
Observers such as myself have warned about this problem for years.  Earlier this month, an international G20 task force of currency experts warned:

“Central banks have lost control of global liquidity. The dollarised international financial system has become treacherously unstable and vulnerable to a sudden reversal in capital flows.  A decade of ultra-low interest rates and quantitative easing has flooded the globe with highly unstable forms of funding denominated in dollars, with no guarantor standing behind them. Glaring currency and maturity mismatches have accumulated.

“This structure is prone to an abrupt “dollar crunch” should borrowers in China, east Asia, emerging markets, or even parts of Europe suddenly start scrambling for scarce US currency to repay bonds and loans in a crisis.”

Central banks and governments either didn’t realise the risks or, more likely, simply hoped the problem would only hit once they had left the job.  But today, this “dollar crunch” may well be about to arrive:

  • After a brief rally, the Rmb has gone back below Rmb 7: US$ 1
  • This will make it even more impossible for many companies to repay their dollar loans

Many western pension funds felt forced to rush into the offshore dollar market in a ‘search for yield’. Zero rate interest policies meant they couldn’t get the level of yield they needed to fund future pensions in ‘safer’ markets at home. And employers weren’t willing to fill the gap, as this would have hit their earnings and share prices.

Unfortunately, as I noted 18 months ago, Ernest Hemingway’s The Sun also Rises probably describes the end-game we have entered:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

Resilience amidst headwinds is key for H2

Resilience is set to become the key issue as we look forward to H2, as I note in a new analysis for ICIS Chemical Business. None of us have ever seen the combinations of events that are potentially ahead of us. And none of us can be sure which way they will develop. So it seems essential that we start to create contingency plans to build corporate resilience ahead of their possible arrival.

Of course, we can all hope that we are just seeing a series of false alarms, and that business as usual will end up as the outcome. But hope is not a strategy. Even if we optimistically believe it is an 80% probability, the scale of the potential problems under more pessimistic scenarios suggests it would be prudent to decide ahead of time how to tackle them. Everyone will have their own list of possible outcomes. Mine is as follows:

  • Business as usual. Central bank rate cuts avoid recession risk; Presidents Trump and Xi reach stable agreement to roll back tariffs; oil market tensions disappear in the Middle East; Brexit uncertainty is put on hold with another extension period; sustainability concerns over single use plastics are put on back-burner
  • Gathering clouds. China’s vast offshore borrowing creates increasing risk of corporate defaults as growth slows, particularly if the trade war continues; geo-political risks mount in the Middle East; Brexit leads to major friction between the UK and EU27; more major consumer products companies decide to end use of single-use plastics
  • Storm warnings issued. Debt problems morph into major bankruptcies, impacting a range of supply chains around the world; US – Iran tensions mount in the Middle East causing oil prices to rise sharply; regional tensions mount as the world settles into a new Cold War between the USA and China; polymer volumes are hit by a rapid escalation of consumer concerns over single-use plastics

Asia is likely to prove the catalyst for this potential next crisis, if it hits. China has begun to deleverage over the past 2 years, taking $2tn out of its high-risk shadow banking sector. But unfortunately this tightening has driven many of the riskiest businesses into the offshore dollar markets, where naïve western fund managers have rushed to place their bets – driven by their need to achieve higher returns than are available in their domestic bond markets.

If world trade continues to slow as the chart from Reuters shows, and the remnimbi starts to weaken, then some of these borrowers will inevitably default. In turn, this risks a chain reaction across world markets, impacting not only the zombies but also their supply chain partners.

What would your company do in these circumstances? As the American writer Ernest Hemingway noted in ‘The Sun also Rises’, there are two ways to go bankrupt, “gradually, then suddenly”. And the suddenness of the final stage makes it almost impossible for companies to survive if they have not used the gradual stage to create contingency plans. History unfortunately shows that when markets turn, executives suddenly find they have very little time in which to think through how to respond.

Governments will also be in the line of fire, due to their debt levels. And it is unlikely that politicians will know how to respond. They used to be clear about the key issue for the voters, as Bill Clinton famously observed in 1992 – “it’s the economy, stupid”. But today’s politicians instead simply assume that central banks can always print more money to overcome financial and economic crises. They have forgotten the simple mnemonic that many of us learnt at school, namely that “to ASSUME can make an ASS of U and ME”.

Time spent now on building your company’s resilience to potential future challenges may therefore prove time very well spent, if hopes for ‘business as usual’ turn out to have been wishful thinking.

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High-flying “story stocks” hit air pockets as credit finally tightens

“Nobody could ever have seen this coming” is the normal comment after sudden share price falls.  And its been earning its money over the past week as “suddenly” share prices of some of the major “story stocks” on the US market have hit air pockets, as the chart shows:

  • Facebook was the biggest “surprise”, falling 20% on Thursday to lose $120bn in value
  • Twitter was another “surprise”, falling 21% on Friday to lose $7bn 
  • Netflix has also lost 15% over the past 16 days, losing $27bn
  • Tesla has lost 20% over the past 6 weeks, losing $13bn

These are quite major falls for stocks which were supposed to be unstoppable in terms of their market advances.

Of course, their supporters could say it was just a healthy correction and a “buying opportunity”.  And they might add that so far, other “story stocks” such as Alphabet, Apple and Amazon are still doing well.  But others might say a paradigm shift is underway, and these sudden shocks are just the early warning that the central banks’ Quantitative Easing bubble is finally starting to burst.

They might have a point, looking at the second set of charts:

  • Twitter stopped being a major growth story as long ago as 2015, since when its user growth has been relatively slow, even going negative in some quarters
  • Facebook stopped showing major growth in active users 18 months ago – and in 2018, it has been flat in N America and losing subscribers in Europe, whilst Asia and the Rest of the World are also heading downwards
  • Tesla, of course, has been a serial disappointment.  Its founder, Elon Musk, was brutally honest when founding the company in 2003, saying it had a 10% chance of success.  Since then, it has mostly failed to meet its production targets.  It was supposed to be making 5000 Tesla 3 cars a week by the end of last year, but according to Bloomberg’s Model 3 tracker, it is currently producing only 2825/week.  Around 0.5 million buyers have paid their $1k deposits and are still waiting for their car – and Tesla needs their cash if its not to run out of money
  • Netflix is another “story stock” now seeing a downturn in subscriber growth.  Yet at its peak it had a market value of $181bn, with net income for this quarter forecast by the company at just $307m.  Like Tesla, it was valued at a higher value than comparable businesses such as Disney, which have had solid earnings streams for decades.

The common factor with all 4 stocks is that they have a great “narrative” or “story”.  Elon Musk has held investors spellbound whilst he told them of unparalleled riches to come from his innovation.  This seemed to be the same with Facebook until the furore arose over the data user scandal with  Cambridge Analytica.  Twitter and Netflix have also had a great “story”, which overcame the need to show real earnings even after years of investment.

THE LIQUIDITY BUBBLES ARE STARTING TO BURST AS CENTRAL BANK STIMULUS SLOWS
In other words, reality seems to be starting to intrude on the “story”, just as it did at the end of the dot-com bubble in 2000, and the US subprime bubble in 2008.  The key, then as now, is the end of the stimulus policies that created the bubbles, as the 3rd set of charts shows:

  • Slowly but surely, the US Federal Reserve is finally raising interest rates back to more normal levels
  • And more importantly, China’s shadow bank lending is declining – H1 was down by $468bn versus 2017

Even the European Central Bank and the Bank of Japan have signalled they might finally be about to cut back on the combined $5.75tn of lending, often at negative rates, that they pumped into the markets between 2015 – March 2018.

The issue is simple. All bubbles need more and more air to be pumped into them to keep growing. Once the air stops being added, they start to burst. And for the moment, at least, Facebook, Twitter, Netflix and Tesla are all acting as the proverbial canary in the coal mine, warning that the great $33tn Quantitative Easing bubble may be starting to burst.

The post High-flying “story stocks” hit air pockets as credit finally tightens appeared first on Chemicals & The Economy.

Chemical industry warns of likely global recession in 2017

ACC Nov16bThe chemical industry is the best leading indicator for the global economy, and it is flagging major warning signs about the outlook for 2017.  As the chart above shows, based on American Chemistry Council (ACC) data:

  Since 2009, Capacity Utilisation (CU%) has never returned to the 91.3% averaged between 1987 – 2008
  It hit an all-time low at 77.7% in March 2009 after the financial crisis began
  Despite $27tn of global stimulus lending since then, it was back at 78.8% in September
  Even more worrying is that it has seen a steady decline for the past year, from 81.3% in September 2015

And as the ACC warn:

“Growth in the industry has been nearly flat most of the year thus far”.  

ACC G7 Nov16a

The second chart highlights the position in the G7 countries, responsible for nearly half of global GDP, over the past 12 months.  It shows the change in chemical production, using a 3 month average:

  Canada, the smallest G7 economy, has been stable due to its strong export position, at 6%
  Japan has also been stable at 4%, with its trade balance gaining from the yen’s weakness since September 2012
  France has declined from 5.4% to 3.4%, despite benefiting from the euro’s weakness
  Italy has been broadly stable, also benefiting from the euro’s decline, at 2.1%
  The USA, the world’s largest economy, has fallen steadily from 2.2% to just 0.5%
  Germany, Europe’s largest economy, has seen production fall from 2.4% to a negative 0.2% over the past year
  The UK, the world’s 4th largest economy, has fallen from 3.4% to a negative 2.9%

This adds to the disappointing picture in the BRIC economies, which account for over a fifth of the global economy, as I discussed on Friday.  Brazil has been negative for the past 12 months: Russia has collapsed from 15% to 5%;  India has been the best performer, being stable at around 4.5%; China has slowed further from 4% to 3%.

The industry is generally around 6 months ahead of the global economy, because of its early position in the supply chain. Thus in 2008, it was clear from around March that the world was heading into a major downturn.  The Bear Stearns collapse was effectively the “canary in the coalmine”.  My view remains that the Brexit vote at the end of June marked a similar tipping point, as I warned on 27 June.  And as I noted then:

The global economy is in far worse shape today than in 2008, due to the debt created by the world’s major central banks.”

As in 2008, of course, most commentators are still convinced that everything in the garden is rosy.

I fear, however, that soon they will once again be excusing their mistake, by telling anyone who will listen that “nobody could have seen this downturn coming”.  The reason for their mistake, as in 2008, will simply be that they were looking in the wrong place, by focusing on the positive signals from financial markets.  But these lost their key role of price discovery long ago, due to the vast wave of liquidity provided by stimulus programmes.

Unless we see a rapid recovery in the next few weeks, prudent companies and investors would be well advised to heed the clear warning from chemical markets that global recession is just around the corner.

Oil market speculators profit as central banks hand out free cash

Oil Mar16

Oil markets are entering a very dangerous phase.  Already, many US energy companies have gone bankrupt, having believed that $100/bbl prices would justify their drilling costs.  Now the pain is moving downstream.

The problem is the central banks.  Hedge funds have piled into the oil futures markets since January, betting that there would be lots more free cash from the Bank of Japan and the European Central Bank.  They also gambled correctly that the US Federal Reserve and Bank of England would back off the idea of interest rate rises.

Brent Mar16So, once again, markets have lost their role of price discovery, based on the fundamentals of supply and demand. Instead, prices have jumped 50%  in 2 months, as financial speculators have rushed to buy oil in the futures markets:

  • As Reuters noted at the beginning of March, “Hedge funds have switched from a very bearish view on crude oil prices at the end of last year to a much more bullish one
  • The red line in the chart highlights the dramatic shift that has taken place
  • By 1 March, they had created a 445 million barrels net long position – equal to 5 days of total world demand
  • They added 61mbbls in just the first week of March, building their longest position since the summer

This move had nothing to do with the fundamentals of supply and demand, which are still getting worse, not better.

As I describe in the video interview with ICIS deputy news editor, Tom Brown, the rally mirrors what happened a year ago in the SuperBowl rally – when traders put about the story that a fall in the number of US drilling rigs would reduce production.  Of course that didn’t happen, because the rigs are becoming very much more productive.

But the hedge funds did’t care about that – they simply knew there was money to be made as the central banks handed out vast quantities of free cash.

Now the central banks are doing it again.  And so, once again, oil prices have jumped 50% in a matter of weeks, along with prices for other major commodities such as iron ore and copper, as well as Emerging Market equities and bonds. In turn, this will force companies to buy raw materials at today’s unrealistically high prices, as the seasonally strong Q2 period is just around the corner.  Some may even build inventory, fearing higher prices by the summer.

If this happens, and prices collapse again as the hedge funds take their profits, many companies will face the risk of bankruptcy as we head into Q3.  They will be sitting on high prices in a falling market – just as happened in January. Only Q3 could be worse, being seasonally weak, and so it may take a long time to work off high-priced inventory.

We cannot stop the central banks handing out free cash to their friends in the hedge fund industry.  They think high commodity prices are good news, as they might create inflation and reduce the real cost of central bank debt.  All companies and genuine investors can do is to instead avoid taking any positions, long or short.

As experienced poker players say, “If you don’t know who the sucker is at the poker table, then it is probably you”.

WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 62%
Naphtha Europe, down 58%. “Petrochemical cracker margins drop off”
Benzene Europe, down 55%. “The upward momentum on crude oil was keeping the market volatile, and perhaps also limiting any spot trading as players waited for clearer direction.”
PTA China, down 42%. “Dips in upstream crude oil and energy prices in the first part of the trading week exerted downward pressure on PTA prices”
HDPE US export, down 35%. “Expectations of tightening supply because of the onset of the plant turnaround season.”
¥:$, down 9%
S&P 500 stock market index, up 5%

New oil price fall is matter of “when”, not “if”, as inventory builds

Oil storage Jun15bFinancial players have become convinced in recent months that the oil price will rise.  And so far, this has been a self-fulfilling prophecy.  Their buying has led to oil being stored all over the world – in tankers floating at sea and in shale oil wells, as well as in storage tanks.

Unsurprisingly, prices have rallied as all this product was being taken off the market.  But whilst it easy to buy oil in an over-supplied market, the buyers now face the more difficult task of trying to resell it at a profit as we move into the seasonally weaker months of Q3.

The chart above from the Wall Street Journal shows how the volume of oil in floating storage more than trebled between January – May, and is still more than twice the earlier level.  The volume comes from traders taking advantage of the difference between current and future prices (the contango) to buy today and sell to hedge funds and other financial buyers at a guaranteed profit in the future.

But Iran has also been storing oil on ships, to release on world markets if sanctions are lifted following a deal on the nuclear issue, perhaps in the next few weeks

In addition, of course, there is the record volume of oil inventory in the US, as I discussed last week.  Plus US shale producers have drilled 3000 wells in preparation to pump up to 1.3mbbls/day of oil once prices have moved higher.

Oil storage Jun15cAnd in Europe, as the second WSJ chart shows, oil storage has hit a record level of 61mbbls.

And finally, recent months have seen strong buying by China to fill its strategic petroleum reserve.  It had decided to raise the reserve to 100 days of normal demand.  But as a Sinopec executive told Reuters back in March this programme will soon be complete.

It clearly makes no sense for prices to rise on such artificial/temporary types of demand, when the International Energy Agency suggests surplus production is currently running at 2mb/day.

The problem is the record amounts of money that have gone into commodity hedge funds.  This has fallen slightly from the $80bn peak seen in 2013, but still stands at $69bn today.  And, of course, $69bn buys a lot more oil today than it did when prices were at $100/bbl in 2013.

These mounting surpluses are making life more and more difficult for producers in Europe and W Africa.  As I noted last year, Nigeria has lost its entire export market to the US, worth 1.3mb/day, and is instead having to send its oil all the way to Asia.  Now N Sea producers are facing the same problem, with tankers carrying the equivalent of a week’s consumption by the UK now heading to Asia instead.

Of course, as the saying goes, “money talks”.  So as long as financial players keep buying in financial markets, oil supplies will keep increasing.  But unused oil can’t keep being held in storage forever.  Eventually the fundamentals of supply/demand balances will cause prices to fall back to historical levels of $30/bbl or lower.

We cannot know what might be the catalyst for this development.  Perhaps it will be a panic over Greece, or an Iranian agreement, or something else entirely.  But barring geopolitical upset, it is not a question of “if”, but of “when”.