The chemical industry is the best leading indicator that we have for the global economy. It has an excellent correlation with IMF data, and also benefits from the fact it has no “political bias”. It simply tells us what is happening in real-time in the world’s 3rd largest industry.
Sadly, the news is not good.
As the chart shows, based on the latest American Chemistry Council data, Capacity Utilisation (CU%) fell to just 78.4% in October. This is only just above the lowest reading ever seen, of 77% at the bottom of the sub-prime crisis in March 2009. The pattern is also worryingly familiar:
Then the CU% peaked in May 2007 at 95.1%, before declining to 88% by October 2008, and collapsing to 77%
This time, the CU% peaked at 80.7% in December 2015 and has been falling ever since, month by month
Given that the industry is normally around 8 – 12 months ahead of the wider economy, due to its early position in the supply chain, this means it is highly likely that the global economy will move into recession during 2017
Of course, nobody ever wants to forecast recession. And there are always plenty of reasons why something might be “different this time”. But it would certainly seem prudent for companies and investors to develop a Recession Scenario for their business for 2017. given the track record of the CU% indicator.
Indeed, there are a number of reasons to suggest that any recession might be severe. Bill White, the only central banker to warn of the subprime crisis, warned in January that “the world faces wave of epic debt defaults“, and then added in September that:
“The global situation we face today is arguably more fraught with danger than was the case when the crisis first began. By encouraging still more credit and debt expansion, monetary policy has ‘‘dug the hole deeper.’’…In practice, ultraeasy policy has not stimulated aggregate demand to the degree expected but has had other unexpected consequences. Not least, it poses a threat to financial stability and to potential growth going forward….the fundamental problem is not inadequate liquidity but excessive debt and possible insolvencies. The policy stakes are now very high.”
When White spoke, the implications of the UK’s Brexit vote were still only just beginning to be recognised
Since then, US President-elect Donald Trump has announced his 100-Day Plan to reshape America’s world role
Major uncertainty is building in Europe with Italy’s referendum plus Dutch, French and German elections
India’s economy is weakening as the currency reforms have taken 86% of its cash out of circulation
Plus, there are ever-present risks from China’s housing bubble, and the potential for a trade war with the USA
Of course, many of the same people who said that Brexit would never happen, and that Trump would never win, are now lining up to tell us everything will still be the same in the end. But they should really have very little credibility.
What many investors also seem to be forgetting is that Trump has been a long-time CEO. And new CEOs normally write-off everything in their first year of office. This gives them the double bonus of being able to (a) blame the previous CEO and (b) then take credit for any improvement.
As Trump would no doubt like a second term of office from 2021, he has every incentive to “clear the decks” in 2017.
The 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”.
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.
Will 2014 turn out to be a repeat of 2008 for the US economy?
6 years ago, after all, not a single mainstream forecaster – including the IMF and World Bank – was forecasting a recession. Even in September 2008, the consensus was still confident about the economic outlook. Yet the National Bureau for Economic Research later confirmed the official start of the recession as being December 2007.
Interestingly, a number of the same people who were wary of the outlook in 2008 are equally wary today. Thus Nobel Prize-winner Robert Shiller warned last week:
“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.”
And, of course, there is the fact that Q1 GDP was a negative 2.9%. Of course, all the professional optimists immediately told us that this was just due to bad weather, and we would see an immediate and sustained recovery. They may turn out to be right, of course. But it seems many forecasts are now quietly being revised down..
The Bank for International Settlements (BIS, the central bankers’ bank) has also warned explicitly of the dangers for the global economy:
“Obviously, market participants are pricing in hardly any risks….Financial markets are euphoric, but progress in strengthening banks’ balance sheets has been uneven and private debt keeps growing. Macroeconomic policy has little room for manoeuvre to deal with any untoward surprises that might be sprung, including a normal recession.”
The BIS issued similar warnings in July 2007 and July 2008 which were, as now, mostly ignored.
The key issue is complacency. Markets believe that central banks would never again make the mistake of allowing a Lehman Brothers to go bankrupt. Therefore they believe that it is perfectly safe to chase stock prices higher and higher. As the above chart of the IeC Boom/Gloom Index shows:
- The US S&P 500 Index is making new highs month by month, despite bad news on the real economy (red line)
- The key is the liquidity programmes from the US, Europe and Japan, which provide free cash to investors
- But the Index itself seems likely to have peaked in March (blue column)
It is also not hard to identify a catalyst for a future panic as investors insist on continuing to wear their rose-tinted spectacles. They seem totally unaware of the massive potential downside that could be inflicted on an over-leveraged global economy by the unwinding now underway of China’s ‘collateral trade’.
The reason is they have completely failed to understand that China has abruptly changed economic course under its new leadership. President Xi and Premier Li know only too well that disaster could follow if they continue with the old policies of stimulus-led growth. Thus on a tour of central China last week, premier Li brushed aside concerns from senior province governors that:
“The aluminum, coal and steel sectors are still suffering heavy losses. … Lending rates, especially for smaller businesses, have grown by at least 20% on average,” and that ”footwear and textile exporters are struggling with weak foreign demand”.
This is a major development in the world’s second largest economy. But nobody talks about it, or its possible consequences.
Maybe Shiller is wrong to be worried. Maybe the BIS is also wrong. But they were right before when everyone else was wrong. And if they are right again, then as the BIS has also warned, central banks now “have little room for manoeuvre to deal with any untoward surprise”.
WEEKLY MARKET ROUND-UP
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
PTA China, flat 0%. “Buying interest for higher-priced cargoes were curbed by prevailing weak downstream demand”
US$: yen, down 3%
Brent crude oil, up 2%
Benzene, Europe, up 6%. “Several players in Europe are uncertain whether prices are sustainable at current levels”
Naphtha Europe, up 6%. “Europe is structurally long on naphtha and has to export to petrochemical markets in Asia and the gasoline sector in the US”
S&P 500 stock market index, up 8%
HDPE US export, up 7%. “International buyers are not interested in building inventory at high prices”
Milton Friedman received a Nobel Prize for economics in 1976, partly on the basis of his analysis that ‘inflation is everywhere and always a monetary phenomenon’. It sounds an appealing insight, but of course it is wrong. The reason is that it confuses cause and effect.
The above chart presents a different view, highlighting the true cause of inflation as being a surplus of demand relative to supply. In turn, this explains why we now face the prospect of deflation:
- Logic suggests that the true cause of inflation must be excess demand compared to potential supply
- This is what began to happen as the BabyBoomers began to create increased demand as they grew up
- Supply was, of course, limited due to the effect of World War 2 and the small size of the inter-War generation
- This growth can be seen in the blue columns, as the Boomers grew up and began to reach their Wealth Creator years (25-54 years)
- Thus whilst nominal GDP was rising all the time (red line), so were inflation and interest rates on the US Treasury 10 Year bond (black)
It is of course quite understandable that Friedman should have come to his conclusion, and that the Nobel Committee should award their Prize. Historical data on births was extremely limited at that point, even in the wealthy G7 economies. As the blog found when writing chapter 1 of Boom, Gloom and the New Normal, annual reporting of Italian data only began in 1921 and US data itself only in 1909.
Equally, whilst it is now commonplace to describe the US Boomer period as being from 1946-1964, nobody realised it at the time. Web research suggests the word was only first used in this context as late as 1977. Certainly the blog’s 1973 edition of the Oxford English Dictionary (OED) does not reference the word, whilst the online OED gives no reference for first use.
Clearly one cannot blame Friedman, or the Nobel committee, for failing to recognise the critical importance of something of which nobody was then aware. However, with the advantage of hindsight, we can now easily see that demographics was the critical reason for the rise in inflation that Friedman observed. Similarly, the chart shows how the story has developed since then:
- The good news was that the average US Boomer (born 1955) reached their Wealth Creator years in 1980
- Unsurprisingly at this point, inflation began to fall as supply caught up with demand
- The Wealth Creator wave then came to its full force, as Boomers from across the Western world reached this period of their lives
- It created an unique period of constant growth over 25 years, and introduced the concept of globalisation
- But then, due to the miracle of increased life expectancy, the Boomers didn’t simply die as their ancestors had usually done
- Western life expectancy, just 46 years in 1900, and still only 66 in 1950, has now reached around 80 years
- This New Old 55+ generation has never been alive in such numbers before, and will soon be 40%+ of Western adult populations
Unfortunately, misled by Friedman’s analysis, policymakers have assumed for the past decade that monetary policy can restore growth and inflation. Firstly they boosted the US subprime boom, and since 2009 they have spent vast sums (nearly half of global GDP) in a fruitless effort to turn back the demographic tide.
But any rational and impartial observer can see they are wrong, and that we are instead entering a New Normal. What this will mean for the economy is unknown, as there is no precedent to guide us.
Equally, it is only now, thanks to books like ‘Boom, Gloom and the New Normal’, that the link between demographics and economic performance is becoming clear for the first time. Until recently, most people thought of older people as simply being a market for health care and walking sticks. Like Friedman, they had simply not realised the now increasingly obvious fact, that demographics drive demand.
So this is as good as it gets in 2013. That seems to be the sad conclusion from analysis of Q3 operating rate (OR%) data for Europe’s crackers. Actual Q3 OR% inched up to 81%, which was slightly better than 2012′s 80% rate and 2009′s 79% rate. But its a very long way from the 90%+ level that used to be considered ‘normal’.
Equally, as the chart shows, overall performance January – September was worse:
- 2013 OR% so far has been just 79% (red square)
- This was only just above 2009′s 77% (green)
- Total ethylene volume so far this year is 14.1MT, just 23kt above 2009 levels
We already know that Q4 will see no recovery. Dow have announced the temporary closure of their Tarragona cracker in Spain from 1 December because of “challenging market conditions and an unclear demand picture”. Whilst ICIS polymer expert Linda Naylor noted “this is not the end of the year that many players had envisaged”.
It thus appears markets are indeed following the path forecast by the blog at the beginning of Q4:
- “Base chemical demand has broadly fallen from peak levels in Q3
- “Most chemical buyers built inventory in Sept. because they thought Syrian issues would take oil prices higher
- “Wiser counsels prevailed over Syria, however, but buyers have no need to buy further volumes in October
- “November is also likely to be weak as Q3 inventory is worked down
- “December will see the usual low volumes, as everyone looks to de-stock inventory into year-end”
The other worry is that the Eurozone seems to be slipping back into recession, whilst deflation is looming. 2014 could be a very tricky period indeed.
The blog was speaking last week at the major Euromoney investor conference on bond markets. It followed a keynote by the head of the UK’s Debt Management Office, who noted that the Bank of England now ‘owned’ ~30% of total UK government debt compared to none in 2008
The reaction to his speech revealed just how investor attitudes to the central banks have changed. All through the day, it was clear that neither the US Federal Reserve, European Central Bank or Bank of England now command total confidence. Some very large investors privately expressed the view that central banks no longer knew what they were doing. And they shared the blog’s concern that the outlook could become quite scary as a result.
Also changing is the attitude to the 4 ‘butterflies’ that the blog discussed in its New Statesman analysis last month. Its argument was that these could cause a cold winter, just as butterflies flapping their wings in the Amazon can cause snow elsewhere:
- Interest rates Nobody now knows what central banks want. Are rates at their desired level, too high or too low? Equally, does it matter what they want? Have they any power to change things?
- Eurozone. Nobody also knows what will happen now the German election is over. Will there be a ‘grand coalition’? And if so, on what terms might the SPD join Chancellor Merkel’s government? In addition, what will happen to Italy’s government? Nobody knows if it will survive the resignation of Berlusconi’s ministers
- What about the US budget/debt ceiling talks? The consensus has ignored this issue until very recently. But on Saturday, the New York Times described it as “a double-barrelled fiscal crisis”
- Then there is China’s economic plenum in November. One major initiative opened yesterday – the new Shanghai free trade zone (FTZ). “Like father, like son” is clearly the message: President Xi’s father set up the first-ever FTZ in Shenzhen in 1979, which began reopening China to the world after the Mao period. Now he has done the same, but on a bigger scale
Markets hate uncertainty, but the major investors with whom the blog spoke were not feeling depressed. Instead, they were starting for the first time in years to do their own thinking, and not just relying on central bank ‘guidance’. Encouragingly, they were very interested in the arguments of ‘Boom, Gloom and the New Normal’ – another sign that its argument on the importance of changing demographics is becoming mainstream.
But who knows how all this will end? Who even knows what will happen to oil prices? Will the promised US-Iran talks be the trigger for prices to fall back to $50/bbl, or lower? They could be, if markets turn away from today’s absurd consensus that insists on seeing shortages round every corner. If investors really do start opening their eyes, and thinking independently, there could be quite a lot of changes ahead.
Meantime however, as the chart shows, the divergence between the real world of chemical demand and the liquidity-driven financial markets is very clear. All the benchmark products are lower in price, highlighting how the only real ‘recovery’ has been in financial assets.
Benchmark price movements since the IeC Downturn Monitor began on 29 April 2011, with ICIS pricing comments this week are below:
PTA China, red, down 21%. “Slower-than-expected downstream polyester demand weighed down buying sentiment and spot prices”
Naphtha Europe, black, down 18%. “Market is oversupplied, suffering from slow domestic demand and sluggish exports to the US gasoline sector”
Brent crude oil, blue, down 13%.
HDPE USA export, yellow, down 10%. “Following the 2 force majeures, inventory tightness has made it difficult to find product for export”
Benzene Europe, green line, down 4%. ”Prices are at a seven-week low, largely as a result of falling crude, lower demand and a dip in US and Asian spot values”
US$: yen, orange, up 21%
S&P 500 stock market index, purple, up 24%