Whisper it not to your friends in financial markets, but the global economy is moving into recession.
The US stock markets keep making new highs, thanks to the support from the major western central banks. But in the real world, where the rest of us live, the best leading indicator for the global economy is clearly flashing a red light:
- On the left is Prof Robert Shiller’s CAPE Index, showing the US S&P 500’s valuation is at levels only seen before in 1929 and 2000
- On the right is the American Chemistry Council’s global chemical Capacity Utilisation (CU%), which has fallen back to May 2013’s level
They can’t both be right about the outlook.
Chemicals are known to be the best leading indicator for the global economy. Their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles. And every country in the world uses relatively large volumes of chemicals.
The chart shows the very high correlation with IMF GDP data. Even more usefully, the data is never more than a few weeks old. So we can see what is happening in almost real time.
And the news is not good. The CU% has been in decline since January 2018, and it is showing no sign of recovery. In fact, our own ‘flash report’ on the economy, The pH Report’s Volume Proxy Index, is showing a very weak performance as the charts confirm:
- The Index focuses on the past 6 months, and shows a very weak performance. It has gone negative even though September – November should be seasonally strong months, as businesses ramp up their activity again after the holidays
- Even more worrying is that the main Regions are currently in a synchronised slowdown. And each time they have tried to rally, they have fallen back again – a sign of weak underlying demand
And, of course, we are now moving into the seasonally slower part of the year, when companies often destock for year-end inventory management reasons. So it is unlikely that we will see a recovery in the rest of 2019, whether or not a US-China trade deal is signed.
The problem is very simple:
They see no need to focus on understanding major challenges such as the potential impact of ageing populations on economic growth, the retreat from globalisation and the rise of protectionism, or the increasing importance of sustainability.
Perhaps they are right. But the evidence from the CU% on developments in the real world suggests a wake-up call is just around the corner.
Credibility is hard to gain. And once gone, it is very hard to regain. That is the challenge facing the US Federal Reserve today. The New York Times is just one of the mainstream media now starting to highlight the issue, as last week’s Feb meeting led to a further deferral of the promised rise in interest rates:
“Fed officials said they expected to begin the process in June, but they are now delaying at least until September in part because economic growth has once again disappointed. In a retreat that has become a ritual for the overly optimistic central bank, officials said in a new round of economic forecasts published Wednesday that they expected the economy to grow this year by 1.8% to 2%. In March, they predicted growth of 2.3% to 2.7%.”
Major fund managers are also giving up on Fed-watching, as Columbia Threadneedle told the Financial Times:
“There’s a real dichotomy out there. We’ve got central banks where models of inflation and price expectations have failed. They can’t explain a lot of what has actually happened in their domestic economies. Yet market participants still rely ever more on their guidance to deliver market expectations, and that relationship at some point has to change.”
Even more importantly, investors are not just talking but acting. $9.3bn was withdrawn from emerging markets 2 weeks ago; and last week saw $10.3bn withdrawn from US bond funds.
This behavior confirms the analysis I received from one of the world’s top money managers in December:
“His view was that the lower oil price would help to keep inflation low, and so delay interest rate rises till Q4 2015. This view means he has to continue investing in the markets, even though he thinks they are all wildly over-valued.
“His argument was simple, namely that the Fed and Bank of Japan and others are forcing him to invest in stocks as the money earns nothing sitting in the bank. He is being effectively held hostage by the central banks.
“His own personal worry, having experienced the bond crash of 1994, is that whilst everyone thinks they will get out ‘before the market turns’, common sense also says everyone will try to stay in until the last possible moment, to maximise returns. Then everyone will charge for the exits at the same moment, and there could be blood on the street.”
There has never been any evidence for the Fed’s belief that boosting stock markets to create a ’wealth effect‘ would deliver economic recovery. But it suited investors to go along with the story, as it made their lives easier and kept the bonuses rolling in. Now, however, reality may well be starting to dawn:
- The Fed assured us that its $4tn of debt would be wiped out by a mix of economic growth and inflation
- But now investors are starting to worry that growth and inflation may continue to remain elusive
This may well be the reason why 10 year interest rates have begun to climb around the world. Many bond market gurus are now forecasting the end of the 30-year SuperCycle. And if they are right, it would certainly be safest to head for the exits today, before more bullish investors start to stampede in that direction.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 41%. “In Europe, the upcoming holiday season across July and August is likely to curtail derivative production and demand for benzene.”
Brent crude oil, down 39%
Naphtha Europe, down 39%. “Prices have declined on the back of a drop in upstream Brent crude oil futures, abundant supply from refineries and softening demand from the gasoline blending sector.”
PTA China, down 30%. “Despite the squeezed margins faced by PTA producers in China, operating rates at PTA facilities were maintained at high levels. This had spot prices to come under downward pressure due to oversupply conditions, especially on the back of weak demand in the downstream sectors.”
HDPE US export, down 17%. “Domestic export prices remained unchanged”
¥:$, down 20%
S&P 500 stock market index, up 8%
The chemical industry remains the best leading indicator for the global economy. The only problem is that most policymakers continue to ignore its obvious message about the failure of their stimulus policies to restore growth.
2 months ago the blog highlighted how its IeC Downturn Monitor was indicating that:
“Markets appear to be continuing to move, slowly but surely, into their expected ‘scary phase’. The reason is the massive distortions that have been created in financial markets, and in China’s housing market, by the $35tn+ of stimulus from governments and central banks since 2009.
August’s survey of regional operating rates from the American Chemistry Council (ACC) reinforced the message, as the blog noted:
“The chemical industry is the best leading indicator for the global economy. The slide in operating rates around the world during the seasonally strong Q2 period. is a clear warning that global economic growth may be stalling”.
And then last month, it reported new ACC data showing that “the weak performance is continuing with production slowing slowing almost everywhere”, whilst countries such as ”Germany, for example, have gone from 4.8% growth in February to a fall of 3.5% in August”.
But it was only last week that the wider world began to wake up to what is happening. Suddenly the headlines were all about a potential German recession.
A STEEP DECLINE NOW SEEMS UNDERWAY
In oil markets, the International Energy Agency has warned that “the recent slowdown in demand growth is nothing short of remarkable.” And worryingly, as the chart above confirms, this week’s update on key products in the blog’s Downturn Monitor portfolio confirms that a steep decline may now be underway:
- Naphtha prices, the basic petrochemical feedstock, are down 22% since January (black line)
- PTA prices in China are down 16%, with their earlier rally completely wiped out (red)
- Brent oil prices have been under pressure since July, and are now down 14% (blue)
- The S&P is also showing weakness, with some panic selling taking place last week (purple)
The blog will look at oil prices in more detail from Wednesday. But the chart is confirming that the Great Unwinding of policymakers’ failed stimulus policies is now underway. The problem is that these policies had the effect of increasing prices to record annual levels – thus creating a vicious circle of increased supply and demand destruction.
And now, most significantly, the S&P 500 Index is coming under pressure as well. Lack of demand translates into lower earnings, which means lower stock prices. Yet these are currently priced for perfection, so the Unwinding could prove very scary indeed.
One critical question, of course, is what might be the signal for this scary phase to develop? The most likely answer to the question in an interview with Prof Robert Shiller (a key influence in the blog’s Great Unwinding series). He told the Wall Street Journal:
“If a sudden consensus about economic stagnation forms, that could be a dangerous “turning point.”
Worryingly, some very recent headlines – on Germany, for example – suggest we may now be moving in this direction.
WEEKLY MARKET ROUND-UP
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
Naphtha Europe, down 22%. “Prices have fallen on continual downward pressure from exceptionally long supply and low upstream ICE Brent crude oil values.”
PTA China, down 16%. ”Demand did not pick up even after the week-long Chinese holiday, and inventories were heard to be building up”
Brent crude oil, down 14%
Benzene Europe, down 7%. “Prices saw an uplift this week, largely on the news that Shell has declared force majeure on certain products out of its Moerdijk facility in the Netherlands”
US$: yen, up 3%
S&P 500 stock market index, up 4%
HDPE US export, up 13%. “A PE buyer said the export market was dried up.”
Nobel Prizewinner Prof Robert Shiller correctly forecast the dot-com collapse in 2000, and the 2008 financial Crisis, using the chart above. Now he is warning we risk a 3rd collapse.
The problem is that Western central banks have undertaken the largest financial experiment in history. Their policy has been to boost financial markets, particularly the US S&P 500 – the world’s most important equity market index.
This policy has failed twice before in 2000 and 2007, and Shiller fears we will now see a further collapse. This is a major risk as today’s Great Unwinding of policymaker stimulus gets underway.
US STOCK MARKET VALUATIONS ARE AT DANGEROUS LEVELS
Shiller’s original insight was that it was possible to recognise when investors had become over-enthusiastic:
- Traditional values for the P/E ratio simply divide the daily market price by current earnings
- But Shiller’s CAPE version instead uses average earnings across the 10-year business cycle*
Using a 10-year average for earnings enables his CAPE Index to highlight peaks and troughs in investor enthusiasm.
The ratio shot to fame in 2000, when published in Shiller’s book Irrational Exuberance, where Shiller correctly argued that markets were about to collapse:
- 1929 had been the only previous example when markets had traded above a CAPE ratio of 25 (red line)
- But in 2000, the ratio surged to nearly 45, as central banks allowed the dot-com mania to develop
- Until then, they had seen their role as being “to take away the punch-bowl as the party develops“
- Instead, under Fed Chairman Alan Greenspan, they came to believe their role was to support the stock market
Over the past 15 years, stock markets have become more and more dependent on central bank support. As we noted in chapter 2 of Boom, Gloom and the New Normal, Bank of England Governor Eddie George explained the policy to the UK Parliament in 2007 as follows:
“When we were in an environment of global economic weakness at the beginning of the decade it meant that external demand was declining… we knew that we had to stimulate consumer spending. We knew that we had pushed it up to levels that could not possibly be sustained in the medium and longer term…That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
But central banks have since refused to remove this ‘life-support’ and have instead increased it to all-time record levels, whilst taking interest rates to all-time record lows. As then US Fed chairman Ben Bernanke boasted in January 2011:
“Policies have contributed to a stronger stock market just as they did in March 2009, when we did the last iteration of this. The S&P 500 is up 20%-plus and the Russell 2000, which is about small cap stocks, is up 30%-plus.”
Shiller, like Warren Buffett and the blog, is a follower of Ben Graham’s work. Known as the ‘Father of Security Analysis’, Graham developed a simple formula to explain the importance of the Price/Earnings ratio:
- He showed that a P/E ratio of 8.5 meant markets were expecting zero earnings growth over the next 10 years
- Each 2 point change, up or down, meant they expected earnings to rise or fall by 1% a year for the next 10 years
Thus today’s CAPE ratio of 26.5 means investors are expecting S&P 500 earnings to rise by 9%/year till 2024. Yet earnings are already at near-record levels, so this is clearly impossible. Hence Shiller’s concern that the market is heading for a collapse.
For a fuller analysis by the Harvard Business Review of Graham’s pioneering work, and its triumphant confirmation during the 1987 stock market crash, please click here.
CENTRAL BANK STIMULUS HAS FAILED TO SUSTAIN CONSUMER SPENDING
Despite all their efforts, it is clear today that the central banks’ policy has failed. The main US Consumer Confidence Index remains well below Boomer-led SuperCycle peaks. Instead, we are moving into the Boomer-led New Normal, where spending will be much lower due to the impact of globally ageing populations.
Sensible central banks would have celebrated the fact that life expectancy has increased by 50% since 1950 across the world. They would have accepted that demand must slow as a result – particularly as fertility rates had fallen by 50% over the same period. After all, only people can create demand.
Instead of increasing debt levels, they would have ensured that the budget surpluses of the late-1990s were maintained, in order to pay the bills for pensions and healthcare spending.
But they chose to deny the impact of this demographic change, and so have instead created a ‘debt-fuelled ring of fire’. China’s reversal of its stimulus policy is the initial earthquake that is now opening up the fault-lines they have created.
Thus it seems that the Great Unwinding of these failed policies is now underway. We can have no idea how it will end.
As Shiller’s chart shows, the modern world has never seen such an experiment in monetary policy carried out on such a scale, and for so long. It highlights how policy has become entirely focused on the progress of the S&P 500:
- Policymakers believe that as long as it continues to climb, everything must be going well in the wider economy
- Thus they are ignoring China’s reverse-course, just as they ignored early signs of collapse in sub-prime housing
- Fed Chairman Bernanke at first said in July 2007 that losses would be no more than $100bn
They are also completely ignoring even the major changes now underway in oil, currency and interest rate markets.
Yet any impartial observer would see these as a clear warning sign that market direction was changing.
And when an informed observer such as Shiller, with a proven track record, gives the following warning, the blog feels we need to listen very carefully:
“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. … We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. …
“One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking that way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
*The detailed calculation for the CAPE 10 year ratio is as follows: (1) calculate annual Earnings Per Share for the S&P 500 over the past 10 years. Adjust these earnings for inflation using the Consumer Price Index and average these adjusted figures over the 10-year period. Then divide the current level of the S&P 500 by this 10-year average number to get the P/E 10 ratio, or CAPE ratio.