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 email@example.com 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.
The West has been living with cheap money from the central banks for over 5 years. Credit has been very easy to obtain in the financial sector, and interest rates have been at all-time lows. The result can be seen in the chart above from Business Insider of total lending to fund stock purchases on the New York Stock Exchange (margin debt)
- US margin debt has been at all-time record highs this year, higher even than in 2000 and 2007 (red line)
- Rises and falls in the amount of this margin debt are 96% correlated with movements in the S&P 500 (blue)
China’s ‘collateral trade’ has also been a major part of the ‘unseen hand’ of easy credit that has propelled world financial markets to record highs since the financial Crisis began. The risk now, as China starts to unwind this trade, is that ‘what went up together, also goes down together’.
We last saw this effect in September 2008. The cause is simply explained by the work of Hyman Minsky:
- His insight was that a long period of stability 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
- They therefore take on high levels of debt, in order to finance ever more speculative investments
This, course, is exactly what is happening today. Investors believe that the US Federal Reserve will never let stock prices fall. And at the same time they are being given zero-cost money by the Fed with which to speculate, due to the Fed’s belief that higher stock prices will increase consumer confidence and restore economic growth.
At some point, however, as in 2008, another ‘Minsky moment’ will occur:
- Earnings from the new investments will prove too low to pay the interest due on the debt
- Confidence in the ‘new paradigm’ will disappear and, with it, market liquidity
- Investors will find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid
- In turn, this will prompt a rush for the exits. Prices will drop quite sharply, as ‘distress sales’ start to take place
The chart also highlights one even more worrying development. The amount of margin needed to boost the real value of the S&P 500 to its peaks (adjusting for inflation), has risen from $280bn in 2000 to $440bn in 2007, and to $465bn today. Yet in real terms, the S&P 500 is still below its 2000 peak. As Nobel Prize winner Robert Shiller’s data shows, the S&P 500 reached 2057 in 2000 when adjusted for inflation – versus 1763 in 2007 and its recent peak of 1900.
This highlights the fundamental instability of today’s stock market peak. The blog fears that the second Minsky Moment may not be far away. Then investors will find out for a third, and perhaps final time, that even the Fed cannot print enough money to maintain the speculative bubble forever.
Exchange Traded Funds (ETFs) will likely be the instrument of destruction this time, rather than subprime loans to the housing market, or over-valued dot-com shares. As US investment magazine Barrons has warned:
“ETFs will be the delivery mechanism. There was just $531bn in ETFs at the end of 2008, so the now-$1.7tn industry has been largely untested in a major selling panic, replete with disappearing liquidity and credit system seize-ups. We suspect that these funds could exacerbate the selloff that may be impending. Our best advice: Be vigilant, don’t get carried away, and look out below.”
The UK housing market has led a charmed life in recent years. Unlike the US, Spain, Ireland and many other Western countries, prices have not collapsed. Instead, near zero interest rates, and the high proportion of mortgages on variable rates, meant that UK homeowners have seen their monthly payments reduce dramatically.
There is just one potential cloud on the horizon, captured in the chart above from the Financial Times. This is that most borrowers in many parts of the country are not making any repayments of capital. For example:
• In London, 52.6% of loans are to borrowers in this position
• Similarly in the southwest and southeast, the figures are 51.2% and 52.4%
• Even in the north, the figure is 32.4%
Overall, the Financial Services Authority, the main regulator, calculates that over 40% of the UK’s home loans are interest only. Even more worrying, it believes 75% of purchases made at the top of the boom till 2007 were in this category.
Not to worry, say the optimists. People can always sell their house when the mortgage comes to an end, and pay the bill that way. Or they can take out another loan.
The boring blog worries that this may not be possible. After all, the reason that most mortgages became interest-only was that repayment became too expensive, as house prices boomed between 1991-2007. Instead, lenders and borrowers chose to assume that prices would always rise, and that sellers would always be able to find a willing buyer at their asking price.
What happens if these assumptions prove wrong? What happens, for example, now that most younger buyers are simply unable to afford the repayments on the large amounts required to buy a home? Or if increasing numbers of the UK’s ageing population decide to downsize their home as they find climbing the stairs more difficult?
The work of the great Hyman Minsky, whose work features in chapter 2 of ‘Boom, Gloom and the New Normal’, explains the risks. Just as in US subprime, the classic conditions for a ‘Minsky moment’ are now starting to appear in the UK housing market.
The use of leverage is reducing, and by 2014 borrowers will have to prove they can repay the loan from other resources. Already, several major lenders such as Nationwide have stopped offering interest only loans to new borrowers. Whilst new buyers already need much higher deposits than in the boom years.
House prices outside London have been slipping for some time. London prices may now follow the same path, as the financial services industry contracts and large bonuses become a thing of the past. Once the illusion of constantly rising prices is shattered, then the Minsky Moment will have arrived.
The next few years may therefore prove a lot more difficult than the recent past.
The global economy is now in the middle of its 3rd downturn in the past 4 years. The chart above shows how the blog’s benchmark products have acted as leading indicators on each occasion (yellow highlight):
• In 2008, naphtha (red line) PTA (purple), benzene (green) and polyethylene (PE, blue) all peaked around the middle of July, and fell sharply for the rest of the year
• In 2011, benzene and PTA led the downturn, peaking in March. Naphtha and PE followed, causing the blog to launch the IeC Downturn Alert
• This year, the downturn again began in March. And as in 2008, all 4 benchmark products peaked at the same time
In 2008 and 2011, policymakers assumed that the world faced a cash-flow shortage. So they reacted by flooding the markets with borrowed money. Many governments also introduced major stimulus programmes to enable the economy to reach escape velocity again, and return to the steady growth of the 1982-2007 supercycle.
Unfortunately, as is now becoming clear to a wider public, they made a terrible mistake. The real problem in the world economy is excess debt. And one cannot solve a debt crisis by adding more debt. The short-term ‘sugar high’ that it creates soon disappears.
The best guide to what is happening comes from Hyman Minsky. As the blog wrote in September 2008, when the crisis began to unfold, a long period of stability, such as that seen during the supercycle, leads investors to become complacent about risk:
“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.
“Eventually, however, a ‘Minsky moment’ occurs. Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.”
If policymakers had dealt with the debt issue in 2008, we would by now be in recovery mode. Instead, as the benchmark products indicate, we are back on the same path as in 2008. The only difference is that the economy is suffering from even more debt.
The risk from a second Minsky Moment is thus even higher than in 2008.
Benchmark price movements since the IeC Downturn Monitor’s 29 April 2011 launch, with latest ICIS pricing comments, are below:
Naphtha Europe (brown), down 38%. “Prices fell to their lowest level since September 2010”
PTA China (red), down 30%. “Production cutbacks in China’s polyester sector continued, as producers needed to offload inventories with high feedstock costs”
HDPE USA export (purple), down 28%. “Producers unwilling to drop prices further with weak global demand ”
Benzene NWE (green), down 4%. “Market is totally detached from movements in the value of Brent crude because the market is so tight”