Contingency planning is essential in 2020 as “synchronised slowdown” continues

The IMF has now confirmed that the world economy has moved into the synchronised slowdown that I forecast here a year ago. Its analysis also confirms the importance of the issues highlighted then, including “rising trade barriers and increasing geopolitical tensions”, a sharp decline in manufacturing, contraction in the auto industry and structural forces such as the impact of ageing populations.

Capacity Utilisation (CU%) data from the American Chemistry Council has therefore once again proved to be the best leading indicator for the global economy. It has been far more reliable than stock markets, where valuations continue to be massively distorted by central bank stimulus. And unfortunately, the latest data shows no sign of any improvement as the chart confirms, with November’s CU% now back at November 2012’s level at 81.7%.

Of course, it remains very easy to ignore the warning signs. ‘Business as usual’ is always the most popular forecast, as we saw a year ago when the consensus assumed a sustainable economic recovery was finally underway. And it would be no great surprise if, in a year’s time, consensus opinion starts to claim that “nobody could have seen recession coming”.

This is why it seems likely that businesses will now start to divide into Winners and Losers. As the IMF note in their analysis, the current situation is “precarious”, with a number of potential downsides starting to crystallise. On a macro view, these include the growing supply chain risks created by Brexit, where the UK expects to leave the EU at the end of this month.

Anyone with experience of trade negotiations knows that these normally take years rather than months to complete. No Deal is therefore the most likely outcome in a year’s time at the end of the transition period.

This will have a major impact on industries with complex and highly integrated downstream value chains like autos, chemicals and aerospace. Contingency planning is therefore on the critical path for any company that currently relies on product flowing seamlessly and tariff-free across the UK-EU27 border.

Of course, potential Losers will continue to nurse the hope that the UK government might reverse its refusal to accept the 2-year extension offered by the EU. But anyone who followed the recent UK election campaign knows this is an unlikely outcome.

The chemical industry also has its own specific challenges to face, given the growing impact of US shale gas-based expansions in the polyethylene area. This is no great surprise, as I have been warning about the likely consequences of these supply-led expansions since they were first announced in 2014 . But unfortunately, the combination of stock market euphoria over the shale gas revolution and the Federal Reserve’s easy money policy meant that the core assumptions were never properly challenged.

Euphoria remained the rule even after the oil price collapse at the end of 2014 disproved the assumption that prices would always be above $100/bbl. And it continued despite President Trump’s election. As a self-confessed “tariff man”, his policies were always likely to upset the idea that plants could be sited half-way across the world from their markets.

Warning signs were also obvious around the assumption that China’s growth would remain at double-digit rates, creating an ongoing need for major imports. And more recently, concerns over climate change and plastic waste issues have created further question marks over the outlook for single-use plastic demand.

Incumbents are often slow to understand the likely impact of potentially disruptive developments on their businesses. Business discussions around the boardroom and water cooler can often take place in a parallel universe to those that happen outside the office with friends and family.

The upstream oil industry is currently providing a classic example of this phenomenon as it promotes the idea that despite mounting concerns over the role of fossil fuels in climate change, chemicals can somehow replace lost oil demand into transport. Yet as former Saudi Oil Minister Yamani warned back in 2000, “the Stone Age didn’t end for lack of stones, and the Oil Age will end long before the world runs out of oil”.

Unfortunately, therefore, it seems likely that 2020 will see today’s synchronised slowdown continuing to challenge consensus optimism. Contingency planning around recession risks should therefore be top of the agenda, particularly for companies with high debt levels.

But at the same time, better placed companies have a once in a generation opportunity to take advantage of the paradigm shifts now underway, as adoption rates accelerate up the typical S-curve. These Winners are likely to discover that their best days still lie ahead of them, given the range and scale of the new opportunities that are emerging.

Please click here to download my full 2019 Outlook (no registration necessary).

Will stock markets see a Minsky Moment in 2020?

Few investors now remember the days when price discovery was thought to be the key role of stock markets. Instead, we know that prices are really now set by central banks, on the model of the Politburo in the old Soviet Union.

How else can one explain the above chart? It shows the US S&P 500 Index has risen 50% over the past 5 years, even though US corporate profits have fallen 5% (using US Bureau of Economic Analysis data).

As in the old USSR, central banks have also abolished “bad news”.

All news is now good news, as any ‘bad news’ means the Federal Reserve will rush to provide more price support. It has been so successful that the Index hasn’t even suffered a 20% correction over the past decade, as my Chart of the Decade confirmed.

But does this mean that stock markets will never fall again?  That is the real question as we enter 2020.

On the positive side, we know that companies have also provided major support via buybacks.  Apple alone did $240bn of buybacks between 2014 – 2018. Companies spent $800bn in total in 2018, but cash now seems to be tighter with 2019 purchases down around 15% to $700bn.

We also know that President Trump believes a strong stock market is key to his re-election this year. His Trade Adviser, Peter Navarro, has already suggested 2020 will be another record:

“It’s going to be the roaring 2020s. ”Dow 32,000 is a conservative estimate of where we’ll be at the end of the year.”

Certainly investors seem to be very positive, as the above charts confirm.  Share prices for the FANGAM stocks – Facebook, Apple, Netflix, Google and Amazon stocks have soared to new heights:

  • Apple for example, was up 32% in Q4 and nearly doubled in 2019
  • On its own, it provided 14% of the S&P’s gain in the quarter, and 8.5% of the annual gain

This wonderful performance took place even though Apple’s net income has fallen for the past 4 quarters. It is also hard to argue that Microsoft or the other FANGAM companies are suddenly about to see supercharged growth.

So is there a negative side?  Maybe old-fashioned investors were simply wrong to believe stock markets’ key role as price discovery and the efficient allocation of capital?

If one wants to worry, one has to instead look to the insights of Hyman Minsky, who warned 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 to finance ever more speculative investments

His argument was that liquidity is not the same as solvency. Central banks can pump out trillions of dollars in stimulus, and make it ridiculously easy for companies to justify new investments. It is hard to argue with a CEO who claims:

“Why not borrow, as it’s not costing us anything with today’s interest rates“.

But what happens if the earnings from the new investments are too low to pay the interest due on the debt?

That is the risk we face today, given there is now a record $3tn of BBB grade debt – the lowest level of ‘investment grade’ debt. If some of these companies start to default, then confidence in the central banks’ ‘new paradigm’ will quickly disappear – and, with it, market liquidity

Investors will then 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.

China’s former central bank governor has already warned that it may be facing its own Minsky Moment. As investors finish celebrating their 2019 success, they might find it prudent to ponder whether the good times can really continue forever.

Chart of the Decade – the Fed’s support for the S&P 500 will end with a debt crisis

Each year, there has been only one possible candidate for Chart of the Year.  Last year it was the collapse of China’s shadow banking bubble; 2017 was Bitcoin’s stratospheric rise; 2016 the near-doubling in US 10-year interest rates; and 2015 the oil price fall.

This year, the ‘Chart of the Decade’ is in a league of its own. Produced by Goldman Sachs, it shows that the S&P 500 is in its longest-ever run without a 20% downturn.

The reason for this amazing performance is not hard to find.  It has been caused by the US Federal Reserve’s adoption of Ben Bernanke’s concept that:

“Higher stock prices will boost consumer wealth and help increase confidence“.

Set out in 2010, it replaced the previous policy set out by William McChesney Martin that their job was:

“To take away the punchbowl as the party gets going”.

“Don’t fight the Fed” is one of the best short-term investment principles, but the Fed’s success is quite extraordinary when one looks back over the past decade.  Each time the market has threatened to slide, they have rushed in with yet more support:

  • In QE1, the Fed pumped out $1.3tn of support for financial markets, in addition to reducing interest rates to near-zero
  • This free money mostly went straight into asset markets such as stocks, which weakened when the stimulus stopped
  • QE2 came to the rescue with another $600bn of support – but again, stocks then weakened
  • QE3 provided longer-term support, with $40bn/month then increasing to $85bn/month

President Trump’s tax cuts provided even further support when the Fed finally paused, as the Financial Times chart confirms, by encouraging a massive wave of share buybacks.

Remarkably, these buybacks came at a time when profits were actually falling as a percentage of GDP, as the third chart shows. Investors should really have been pulling out of shares, rather than buying more. But after so many years of Fed support, most asset managers had either forgotten how to read a Profit & Loss account and Balance Sheet – or had decided these were irrelevant to stock valuation.

Since September, we have been in a new Fed stimulus cycle. As I noted then, a $50bn hole had appeared in New York financial markets.  Regulators and consensus commentators combined to explain this was only due to temporary factors. But since then, the support has reached $376bn, and the Fed has announced it will happily supply another $500bn of support to cover possible year-end problems, probably taking the total close to $1tn since September.

Behind this panic is the IMF’s warning that the $8.1tn of Treasury bonds available as collateral for the repo market, are in fact “owned” by an average of 2.2 different banks at the same time. Understandably, bank CFOs are pulling back, and trying to establish if “their” Treasury bonds in fact belong to someone else.

Regulators should never have allowed this to happen.  They should also have focused long ago – as I suggested this time last year – on the implications of the decline in China’s shadow banking sector.  Just as I expected, China is now exporting deflation around the world, with its PPI falling since June.

China’s slowdown also means an end to the flow of Chinese cash that flooded into New York financial markets, which hedge funds have then leveraged into outsize profits in financial markets.

The Fed turned a blind eye to this, just as it allowed BBB corporate debt to expand at a record rate, as the chart from S&P confirms.   As we noted in June’s pH Report:

“US BBB grade debt, the lowest grade in which most funds are allowed to invest, is now more than $3tn, with 19% of this total ($579bn) in the very lowest BBB– grade. And this BBB– total jumps to $1tn if one includes financial sector debt. S&P also report that global BBB debt is now $7tn, with US companies accounting for 54% of the total.

“The problem is that BBB- debt becomes speculative debt if it is downgraded by just one notch to BB grade. And most investors are then forced by their mandate to sell their holding in a hurry, creating the potential for a vicious circle, as the most liquid bonds will inevitably be sold first. In turn, this creates the potential for a “waterfall effect” in the overall bond market – and to contagion in the stock market itself.”

The Fed’s focus on boosting the stock market is clearly going to end in a debt crisis.  But when warning of this, the consensus responds as in 2006-8, when I was warning of a global financial crash, “That’s impossible”.  And no doubt, once the debt crisis has occurred, it will again claim “nobody could have seen this coming”.

This is why the S&P 500 chart is my ‘chart of the decade’.

Global economy hits stall speed, whilst US S&P 500 sets new records

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.

Oil markets hold their ‘flag shape’ for the moment, as recession risks mount

Oil markets can’t quite make up their mind as to what they want to do, as the chart confirms. The are trapped in a major ‘flag shape’.

Every time they want to move sharply lower, the bulls jump in to buy on hopes of a major US-China trade deal and a strong economy. But when they want to make new highs, the bears start selling again.

Its been a long journey  for the flag, stretching back to the pre-Crisis peaks at nearly $150/bbl in the summer of 2008. And the bottom of the flag was made back in 2016, after the last collapse from 2014 $115/bbl peak.

Recent weeks have seen the bulls jump back in, when prices again threatened to break the flag’s floor below $60/bbl. And, of course, OPEC keeps making noises about further output cuts in an effort to talk prices higher.

But as the charts from the International Energy Agency’s latest monthly report confirm:

“The OPEC+ countries face a major challenge in 2020 as demand for their crude is expected to fall sharply.”

This is OPEC’s problem when it aims for higher prices than the market will bear. Other producers, inside and outside OPEC, always take advantage of the opportunity to sell more volume. And once they have spent the capital on drilling new wells, the only factor holding them back is the actual production cost.

Capital-intensive industries like oil have always had this problem. They raise capital from investors when prices are high – but high prices naturally choke off demand growth, and so the new wells come on stream just when the market is falling. Next year the IEA suggests will see 2.3mbd of new volume come on stream from the US, Canada, Brazil, Norway and Guyana as a result.

OPEC’s high prices have already impacted demand, as the IEA notes:

Sluggish refinery activity in the first three quarters has caused crude oil demand to fall in 2019 for the first time since 2009.”

OPEC has had a bit of a free pass until recently, though, in respect of the new volumes from the USA. As the chart shows, the shale drilling programme led to a major volume of “drilled but uncompleted wells”. In other words, producers drilled lots of wells, but the pipelines weren’t in place to then take the new oil to potential markets.

But now the situation is changing, particularly in the prolific Permian basin region, as Argus report:

“The Permian basin has been a juggernaut for US producers, with output quadrupling from under 1mbd in 2010 to more than 4.5mbd in October.  US midstream developers have responded with a wave of new long-haul pipelines to shuttle the torrent of supply to Houston, Corpus Christi and beyond.

“The 670kbd Cactus 2 and the 400kbd Epic line went into service in August moving Permian crude to the Corpus Christi area. Phillips 66’s 900kbd Gray Oak pipeline is expected to enter service this month, moving Permian basin crude to Corpus Christi, Texas, for export.”

As a result, some of that oil trapped in drilled but uncompleted wells is starting to come to market. So if OPEC wants to keep prices high, it will either have to cut output further, or hope that the world economy starts to pick up.

But the news on the economic front is not good, as everyone outside the financial world knows.  Central banks are still busy pumping out $bns to keep stock markets moving higher. But in the real world outside Wall Street, high oil prices, trade wars, Brexit uncertainty and many other factors are making recession almost a certainty.

As the chart shows, there is a high correlation between the level of oil prices and global GDP growth. Once oil takes ~3% of GDP, consumers start to cut back on other purchases. They have to drive to work and keep their homes warm in winter. And with inflation weak, their incomes aren’t rising to pay the extra costs.

The US sums up the general weakness.  The impact of President Trump’s tax cuts has long disappeared. And now concerns are refocusing on the debt that it has left behind. As the function of debt is to bring forward demand from the future, growth must now reduce.  US GDP growth was just 1.9% in Q3, and the latest Q4 forecast from the Atlanta Fed is just 0.3% .

Its still too early to forecast which way prices will go, when they finally break out of the flag shape. But their failure to break upwards in the summer, when the bulls were confidently forecasting war with Iran, suggests the balance of risks is now tilting to the downside.

Budgeting for paradigm shifts and a debt crisis

It is now 8 years since John Richardson and I published our 10-year forecast for 2021 in Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’. Remarkably, its core conclusions are very relevant today, as the summary confirms.

Unfortunately, as we feared, policymakers refused to junk their out-of-date models, despite the lesson of the 2008 financial crisis. Instead, they doubled down on their failed stimulus policies.

  • Yet nearly 1/3rd of the world’s High Income population are in the Perennials 55+ age group and are a replacement economy
  • As a result, and as we suggested in 2011, central bank policies have not, and cannot, produce sustainable growth or inflation

As a result, they have created record levels of government, corporate and individual debt – which can never be repaid. Even the IMF has now started to recognise the timebomb that has been created:

“We look at the potential impact of a material economic slowdown – one that is half as severe as the global financial crisis of 2007-08. Our conclusion is sobering: debt owed by firms unable to cover interest expenses with earnings, which we call corporate debt at risk, could rise to $19tn. That is almost 40% of total corporate debt in the economies we studied.”

Already we are starting to see the unwinding of some of the most extreme examples of the bubbles that have been created in asset prices:

And if the IMF are right, which is almost certain, we must expect major bankruptcies to take place over the next few years.  Over-leveraged businesses go bust very quickly when profits decline, as they can no longer pay their interest bills.

As with the run-up to the 2008 crisis, the signs of trouble are already building. The Fed has had to provide $200bn of support to overnight money markets in New York over the past 6 weeks, and is having to add another $60bn/month into next year.

Companies now face a binary choice as they finalise their Budgets for 2020-2022.

They can choose to ignore what is happening in the real world and continue to hope ‘business as usual’ will continue? Or they can start contingency planning by working through the implications of our forecasts for their Downside Scenario?

One key issue is that our 2021 predictions included paradigm shifts as well as economic forecasts. And as the chart above shows, the transitions associated with paradigm shifts are now accelerating:

  • It took decades for the telephone, electricity, autos and even the radio to reach most Americans
  • But it took only years for the microwave, computer, cellphone and internet to become mainstream

It is clear that a whole series of major paradigm shifts are now underway, as I noted 2 weeks ago:

  • Climate change is finally being taken seriously by legislators and many companies
  • This will lead to dramatic declines in the use of fossil fuels for both transport and petrochemicals
  • It highlights how sustainability is now the key issue for corporate strategy, replacing globalisation
  • Affordability is also moving up the agenda, and will become critical as the debt crisis starts to impact

The problem is that incumbents, as we have seen with central banks, are usually very slow to notice what is happening in the real world outside their office or factory.  The reason is simple – they forget what they have discussed with their friends and family once they go to work. Group-think instead takes over, and everyone goes blindly on believing their own propaganda until it is too late.

German car company VW was a classic example of a blinkered strategy. As top executives now recognise, it was only the “dieselgate” emissions disaster that enabled new management to introduce the Transform 2025 strategy based on a transition to Electric Vehicles.

Most companies don’t face the near-death challenge faced by VW in 2015. But they do face major challenges over the next 2-3 years, which will require them to implement major shifts in their strategy if they want to continue to grow revenue and profits in the future.

The good news is that these challenges can be turned into opportunities with hard work and imagination.  Please let me know if I can help you to achieve the necessary transformation.