London house prices slip as supply/demand balances change

London house prices are “falling at the fastest rate in almost a decade” according to major property lender, Nationwide.  And almost 40% of new-build sales were to bulk buyers at discounts of up to 30%, according of researchers, Molior.  As the CEO of builders Crest Nicholson told the Financial Times:

 “We did this sale because we knew we would otherwise have unsold built stock.”

They probably made a wise decision to take their profit and sell now.  There are currently 68,000 units under construction in London, and nearly half of them are unsold.  Slower moving builders will likely find themselves having to take losses in order to find a buyer.

London is a series of villages and the issues are different across the city:

Nine Elms, SW London.  This $15bn (US$20bn) transformation has been ‘an accident waiting to happen‘ for some time.  It plans to build 20000 new homes in 39 developments at prices of up to £2200/sq ft.  Yet 2/3rds of London buyers can only afford homes costing up to $450/sq ft – thus 43% of apartments for sale have already cut their price.

West End, Central London.  This is the top end of the market, and was one of the first areas to see a decline.  As buying agent Henry Pryor notes:

“Very few people want to buy or sell property in the few months leading up to our monumental political divorce from Europe next March, which is why 50% of homes on the market in Belgravia and Mayfair have been on the market for over a year. Yet there are people who have to sell, whether it be because of divorce, debt or death, so if you have money to spend I can’t remember a time since the credit crunch in 2007 when you could get a better deal.”

NW London.  Foreign buyers flooded into this area as financial services boomed.  Rising bonuses meant many didn’t need a mortgage and could afford to pay £1m – £2.5m in cash.  But now, many banks are activating contingency plans to move some of their highly paid staff out of London ahead of Brexit.  Thus Pryor reports buying a property recently for £1.7m, which had been on the market for £2.25m just 2 years ago.

W London.  Also popular with foreign buyers, even areas such as Kew (with its world-famous Royal Botanic Gardens) have seen a dramatic sales volume decline.  In Kew itself, volume is down 40% over the past 2 years.  And, of course, volume always leads prices – up or down.  Over half of the homes now on sale have cut prices by at least 5% – 10%, and the pace of decline seems to be rising.  One home has cut its offer price by 17.5% since March.

Outer London.  This is the one area bucking the trend, due to the support provided by the government’s ‘Help to Buy’ programme.  This provides state-backed loans for up to £600k with a deposit of just 5%.  As Molior comment, this is “the only game in town” for individual purchasers, given that prices in central London are out of reach for new buyers.

The key issue is highlighted in the charts above – affordability:

  • The first chart shows how prices were very cyclical till 2000, due to interest rate changes.  They doubled between 1983 – 1989, for example, and then almost halved by 1993.  In turn, the ratio of prices to average earnings fluctuated between 4x – 6x
  • But interest rates have been relatively low over the past 20 years, and new factors instead drove home prices
  • The second chart shows the impact in terms of first-time buyer affordability and mortgage payments.  Payments were 40% of take-home pay until 1998, but then rose steadily to above 100% during the Subprime Bubble.  After a brief downturn, the Quantitative Easing (QE) bubble then took them back over 100% in 2016

The paradigm shift was driven by policy changes after the 2000 dot-com crash.  As in the USA, the Bank of England decided to support house prices via lower interest rates to avoid a downturn, and then doubled down on the policy after the financial crash – despite the Governor’s warning in 2007 that:

“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”

  • The 2000 stock market collapse and subprime’s low interest rates led many to see property as safer than shares.  They created the buy-to-let trend and decided property would instead become their pension pot for the future
  • The 2008 financial crisis, and upheavals in the Middle East, Russia, and parts of the Eurozone led many foreign buyers to join the buying trend, seeing London property as a “safe place” in a more uncertain investment world
  • Asian buyers also flooded in to buy new property “off-plan”.  As I noted in 2015, agents were describing the Nine Elms development as: ” ‘Singapore-on-Thames’. Buying off-plan was the ultimate option play for a lot of the buyers [who are] Asian. You only need to put down 10% and then see how the market goes. A lot of buyers are effectively taking a financial position rather than buying a property”

But now all these factors are unraveling, leaving prices to be set by local supply/demand factors again.  Recent governments have taken away the tax incentives behind buy-to-let, and have raised taxes for foreign buyers.  As the top chart shows, this leave prices looking very exposed:

  • They averaged 4.8x earnings from 1971 – 2000, but have since averaged 8.7x and are currently 11.8x
  • Based on average London earnings of £39.5k, a return to the 4.8x ratio would leave prices at £190k
  • That compares with actual average prices of £468k today

And, of course, there is the issue of exchange rates.  Older house-owners will remember that the Bank of England would regularly have to raise interest rates to protect the value of the pound.  In 1992, they rose to 15% at the height of the ERM crisis.  But policy since then has been entirely in the other direction.

Nobody knows whether what will happen next to the value of the pound.  But if interest rates do become more volatile again, as in 1971-2000, cyclicality might also return to the London housing market.

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Time to recognise the economic impact of ageing populations

Is global economic growth really controlled by monetary policy and interest rates?  Can you create constant growth simply by adjusting government tax and spending policy?  Do we know enough about how the economy operates to be able to do this?  Or has something more fundamental been at work in recent decades, to create the extraordinary growth that we have seen until recently?

  • As the chart shows for US GDP, regular downturns used to occur every 4 or 5 years
  • Then something changed in the early 1980s, and recessions seemed to become a thing of the past
  • Inflation, which had been rampant, also began to slow with interest rates dropping from peaks of 15%+
  • For around 25 years, with just the exception of the 1st Gulf War, growth became almost constant

Why was this?  Was it because we became much cleverer and suddenly able to “do away with boom and bust” as one UK Finance Minister claimed?  Was it luck, that nothing much happened to upset the global economy?  Was it because the Chairman of the US Federal Reserve from 1986 – 2006, Alan Greenspan, was a towering genius?  Perhaps.

THE AVERAGE BABYBOOMER IS NOW 60 YEARS OLD 

Or was it because of the massive demographic change that took place in the Western world after World War 2, shown in the second chart?

  • 1921 – 1945.  Births in the G7 countries (US, Japan, Germany, France, UK, Italy, Canada) averaged 8.8m/year
  • 1946 – 1970.  Births averaged 10.1m/year, a 15% increase over 25 years
  • 1970 – 2016.  Births averaged only 8.5m/year, a 16% fall, with 2016 seeing just 8.13m born

Babies, as we all know, are important for many reasons.

Economically, these babies were born in the wealthy developed countries, responsible for 60% of global GDP.  So right from their birth, they were set to have an outsize impact on the economy:

  • Their first impact came as they moved into adulthood in the 1970s, causing Western inflation to soar
  • The economy simply couldn’t provide enough “stuff”, quickly enough, to satisfy their growing demand
  • US interest rates jumped by 75% in the 1970s to 7.3%, and doubled to average 10.6% in the 1980s
  • But then they began a sustained fall to today’s record low levels as supply/demand rebalanced

BOOMERS TURBOCHARGED GROWTH, BUT ARE NOW JOINING THE LOWER-SPENDING 55-PLUS COHORT

The key development was the arrival of the Boomers in the Wealth Creator 25-54 age group that drives economic growth.  Consumer spending is 60% – 70% of GDP in most developed economies.  And so both supply and demand began to increase exponentially.  In fact, the Boomers actually turbocharged supply and demand.

Breaking with all historical patterns, women stopped having large numbers of children and instead often returned to the workforce after having 1 or 2 children.  US fertility rates, for example, fell from 3.3 babies/woman in 1950 to just 2.0/babies/women in 1970 – below replacement level.    On average, US women have just 1.9 babies today.

It is hard to imagine today the extraordinary change that this created:

  • Until the 1970s, most women would routinely lose their jobs on getting married
  • As Wikipedia notes, this was “normal” in Western countries from the 19th century till the 1970s
  • But since 1950, life expectancy has increased by around 10 years to average over 75 years today
  • In turn, this meant that women no longer needed to stay at home having babies.
  • Instead, they fought for, and began to gain Equal Pay and Equal Opportunity at work

This turbocharged the economy by creating the phenomenon of the two-income family for the first time in history.

But today, the average G7 Boomer (born between 1946 – 1970) is now 60 years old, as the 3rd chart shows.  Since 2001, the oldest Boomers have been leaving the Wealth Creator generation:

  • In 2000, there were 65m US households headed by someone in the Wealth Creator 25-54 cohort, who spent an average of $62k ($2017).  There were only 36m households headed by someone in the lower-spending 55-plus cohort, who spent an average of $45k
  • In 2017, low fertility rates meant there were only 66m Wealth Creator households spending $64k each.  But increasing life expectancy meant the number in the 55-plus cohort had risen by 55%.  However, their average spend had only risen to $51k – even though many had only just left the Wealth Creators

CONCLUSION – THE CHOICE BETWEEN ‘DEBT JUBILEES’ AND DISORDERLY DEFAULT IS COMING CLOSE
Policymakers ignored the growing “demographic deficit” as growth slowed after 2000.  But their stimulus policies were instead essentially trying to achieve the impossible, by “printing babies”.  The result has been today’s record levels of global debt, as each new round of stimulus and tax cuts failed to recreate the Boomer-led economic SuperCycle.

As I warned back in January 2016 using the words of the OECD’s William White:

“It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something. The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.”

That recession is now coming close.  There is very little time left to recognise the impact of demographic changes, and to adopt policies that will minimise the risk of disorderly global defaults.

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Financial markets party as global trade wars begin

More people left poverty in the past 70 years than in the whole of history, thanks to the BabyBoomer-led economic SuperCycle.  World Bank and OECD data show that less than 10% of the world’s population now live below the extreme poverty line of $1.90/day, compared to 55% in 1950.

Globalisation has been a key element in enabling this progress, as countries and regions began to trade with each other.  But now global trade is starting to decline, as the chart from the authoritative Dutch World Trade Monitor shows:

  • After a good start to 2018, February saw trade fall 0.7% in February and 1.2% in March
  • The major slowdown was in Asia, particularly China, as its lending began to slow

And then on Friday, President Trump confirmed the opening of his long-planned trade wars:

  • He imposed 25% import tariffs on steel and 10% on aluminium from Canada, Mexico and the European Union
  • Similar tariffs were already in place on imports from China, Russia and other countries
  • America’s longest standing allies have since imposed their own sanctions in retaliation
  • The stage is now set for a developing global trade war as more countries join in

PRESIDENT TRUMP IS IMPLEMENTING THE POLICIES ON WHICH HE WAS ELECTED
None of this should have been a surprise, as it simply follows the agenda that President Trump set out in his Gettysburg speech just before the election.  His policy proposals then, which I featured here in depth in January 2017, were crystal clear about his objectives, as the slide shows:

  • Those policies marked in red are now being introduced
  • Only 2 of them – around China being a currency manipulator, and infrastructure – are still to be delivered
  • Yet companies, commentators and analysts have preferred to ignore the obvious

It was clear then, and is even clearer today, that Trump intends to abandon the policies followed by all post-War Republican and Democratic presidents including Eisenhower, Reagan and Clinton, and summarised in President Kennedy’s 1961 Inauguration Speech:

“To those old allies whose cultural and spiritual origins we share, we pledge the loyalty of faithful friends. United there is little we cannot do in a host of cooperative ventures. Divided there is little we can do–for we dare not meet a powerful challenge at odds and split asunder.”

As I noted after Trump’s own Inauguration Speech in January last year, he broke very explicitly with these policies:

“We assembled here today are issuing a new decree to be heard in every city in every foreign capital and in every hall of power. From this day forward, a new vision will govern our land. From this day forward, it’s going to be only America first, America first. Every decision on trade, on taxes, on immigration, on foreign affairs will be made to benefit American workers and American families.”

BAD NEWS HAS ALWAYS LED TO MORE STIMULUS IN THE PAST

Unsurprisingly, financial markets have chosen to ignore this rise in protectionism.  For them, bad news is always good news, as they expect the central banks to provide more stimulus via their money-printing policies.  As the left-hand chart shows of Prof Robert Shiller’s CAPE Index (Cyclically Adjusted Price/Earnings ratio) since 1881:

  • When Trump took office, the ratio was already at 28.5 – above the 1901 and 1966 peaks
  • Since then it has peaked at 33.3, above the 1929 peak
  • Only 2000 was higher at 44, when the end of the SuperCycle coincided with the Fed’s first liquidity programme to prevent any problems with the Y2K issue

The right-hand chart confirms the bubble nature of the rally:

  • It compares S&P 500 developments with the level of margin debt in the New York Stock Exchange
  • Until 1985, the Fed operated on the principle of “taking away the punchbowl as the party gets going
  • Since then, it has increasingly believed, as then Fed Chairman Ben Bernanke said in November 2010

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

As a result, the S&P 500 has risen along with margin debt, which peaked at $659bn in January ($2018).

FINANCIAL MARKETS HAVE AN UNPLEASANT “SURPRISE” AHEAD AS CHINA SLOWS
It is therefore no great surprise that financial markets have continued to ignore developments in the real world.

Yet a decline in world trade, and the rise in protectionism, will inevitably produce Winners and Losers.  This will be quite different from the SuperCycle, when the rise of globalisation created “win-win opportunities” for countries and regions:

  • Essentially the deal was that consumers in richer countries got cheaper, well-made, products
  • People in poorer countries gained paid employment for the first time in history by making these products

History also suggests President Trump will be proved wrong with his March suggestion that:  “Trade wars are good and easy to win”.  Like all wars, they are easy to start and increasingly difficult to end.

So far, financial markets have ignored these uncomfortable facts.  They still believe that any bad news will lead to even more central bank stimulus, and a further rise in margin debt.

But as I noted last week, China – not the Fed – was in fact the major source of stimulus lending.  Now its lending bubble is history, the party in financial markets is inevitably entering its end-game.

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China’s lending bubble is history

As China’s shadow banking is reined in, the impact on the global economy is already clear, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

China’s shadow banking sector has been a major source of speculative lending to the global economy. But 2018 has seen it entering its end-game, as our first chart shows, collapsing by 64% in renminbi terms in January to April from the same period last year (by $274bn in dollar terms).

The start of the year is usually a peak period for lending, with banks getting new quotas for the year.

The downturn was also noteworthy as it marked the end of China’s lending bubble, which began in 2009 after the financial crisis. Before then, China’s total social financing (TSF), which includes official and shadow lending, had averaged 2 times gross domestic product in the period from 2002 to 2008. But between 2009 and 2013, it jumped to 3.2 times GDP as China’s stimulus programme took off.

It is no accident, for example, that China’s Tier 1 cities boast some of the highest house price-to-earnings ratios in the world or, indeed, that Chinese buyers have dominated key areas of the global property market in recent years.

The picture began to change with the start of President Xi Jinping’s first term in 2013, as our second chart confirms. Shadow banking’s share of TSF has since fallen from nearly 50% to just 15% by April, almost back to the 8% level of 2002. TSF had already slowed to 2.4 times GDP in 2014 to 2017.

The start of Mr Xi’s second term has seen him in effect take charge of the economy through the mechanism of his central leading groups. He has also been able to place his supporters in key positions to help ensure alignment as the policy changes are rolled out.

This year’s lending data are therefore likely to set a precedent for the future, rather than being a one-off blip. Although some of the shadow lending was reabsorbed in the official sector, TSF actually fell 14% ($110bn) in the first four months of the year. Already the economy is noticing the impact. Auto sales, for example, which at the height of the stimulus programme grew more than 50% in 2009 and by a third in 2010, have seen just 3% growth so far this year.

The downturn also confirms the importance of Mr Xi’s decision to make “financial deleveraging” the first of his promised “three tough battles” to secure China’s goal of becoming a “moderately prosperous society” by 2020, as we discussed in February.

It maps on to the IMF’s warning in its latest Global Stability Financial Report that:

In China, regulators have taken a number of steps to reduce risks in the financial system. Despite these efforts, however, vulnerabilities remain elevated. The use of leverage and liquidity transformation in risky investment products remains widespread, with risks residing in opaque corners of the financial system.”

The problems relate to the close linkage between China’s Rmb250tn ($40tn) banking sector and the shadow banks, through its exposure to the Rmb75tn off-balance-sheet investment vehicles. The recent decision to create a new Banking and Insurance Regulatory Commission is another sign of the changes under way, as this will eliminate the previous opportunity for arbitrage created by the existence of separate standards in the banking and insurance industries for the same activity, such as leasing.

As the IMF’s chart below highlights, lightly regulated vehicles have played a critical role in China’s credit boom. Banks, for example, have been able to use the shadow sector to repackage high-risk credit investments as low-risk retail savings products, which are then made available in turn to consumers at the touch of their smartphone button. This development has heightened liquidity risks among the small and medium-sized banks, whose reliance on short-term non-deposit funding remains high. The IMF notes, for example, that “more than 80% of outstanding wealth management products are billed as low risk”.

Mr Xi clearly knows he faces a tough battle to rein-in leverage, given the creativity that has been shown by the banks in ramping up their lending over the past decade. The stimulus programme has also created its own supporters in the construction and related industries, as large amounts of cash have been washing around China’s property markets, and finding its way into overseas markets.

But Mr Xi is now China’s most powerful leader since Mao, and it would seem unwise to bet against him succeeding with his deleveraging objective, even if it does create short-term pain for the economy as shadow banking is brought back under control.

As Gabriel Wildau has reported, the official sector is already under pressure from Beijing to boost its capital base. Analysts are suggesting that $170bn of new capital may be required by the mid-sized banks, whilst Moody’s estimates the four megabanks may require more than double this amount by 2025 in terms of “special debt” to meet new Financial Stability Board rules.

Essentially, therefore, China’s lending bubble is now history and the tide of capital flows is reversing. It is therefore no surprise that global interest rates are now on the rise, with the US 10-year rate breaking through 3%. Investors and companies might be well advised to prepare for some big shocks ahead. As Warren Buffett once wisely remarked, it is “only when the tide goes out, do you discover who’s been swimming naked”.

Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.

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Oil prices flag recession risk as Iranian geopolitical tensions rise

Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same.  Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.

The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story.  So the chart above instead combines 5 “shock, horror”  stories, showing quarterly oil production since 2015:

  • Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015.  OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
  • Russia has also been much in the news since joining the OPEC output agreement in November 2016.  But in reality, it has done little.  Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
  • Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
  • Venezuela is an OPEC member, but its production decline began long before the OPEC deal.  The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
  • The USA, along with Iran, has been the big winner over the past 2 years.  Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!

But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April.  Not much “shock, horror” there over a 3 year period.  More a New Normal story of “Winners and Losers”.

So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday?  Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble.  The answer lies in the second chart from John Kemp at Reuters:

  • It shows combined speculative purchases in futures markets by hedge funds since 2013
  • These hit a low of around 200mbbls in January 2016 (2 days supply)
  • They then more than trebled to around 700mbbls by December 2016 (7 days supply)
  • After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)

Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently:  “Several of them had little or no experience or even a basic understanding of how the physical market works.”

This critical point is confirmed by Citi analyst Ed Morse:  “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.

Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:

“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).

OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION

The hedge funds have been the real winners from all the “shock, horror” stories.  These created the essential changes in “crowd behaviour”, from which they could profit.  But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:

  • Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
  • This level has been linked with a US recession on almost every occasion since 1970
  • The only exception was post-2009 when China and the Western central banks ramped up stimulus
  • The stimulus simply created a debt-financed bubble

The reason is simple.  People only have so much cash to spend.  If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy.  Chemical markets are already confirming that demand destruction is taking place.:

  • Companies have completely failed to pass through today’s high energy costs.  For example:
  • European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
  • They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)

Even worse news may be around the corner.  Last week saw President Trump decide to withdraw from the Iran deal.  His daughter also opened the new US embassy to Jerusalem.  Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.

As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities.  Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz.  It is just 21 miles wide (34km)  at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.

As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”.  Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets.  We must all learn to form our own judgments about the real risks that might lie ahead.

 

Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.

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Apple, Xiaomi squeeze smartphone mid-market as sales plateau

The global smartphone market has finally gone ex-growth as China’s slowdown continues.  In turn, the market is starting to polarise – with Apple pushing further up-market whilst Chinese brands such as Xiaomi focus on volume.  Samsung’s middle market positioning looks increasingly under threat:

  • The chart shows Q1 sales for Samsung, Apple, the 3 top Chinese brands and Others (Strategy Analytics data)
  • The 3 Chinese brands (Huawei, OPPO, Xiaomi) have collectively taken top position with 27% of the market
  • Samsung has slipped into 2nd place with 23%, whilst Apple is at 15%
  • Total volume at 345m was down 2% versus 2017 and back at 2015 levels, as Strategy Analytics note:

“Samsung is holding steady in its core markets of North America, Western Europe and South Korea, but the company is facing intense competitive pressure in China and India from rivals such as Xiaomi. Apple volume grew 3%.

“Huawei grew 14% despite headwinds in North America (whilst) Xiaomi doubled marketshare versus 2017 as its growth soared 125%. Xiaomi is expanding like wildfire across Asia, particularly in India.  OPPO has been hit hard by Xiaomi’s rapid retail expansion and Huawei’s much-improved Android device portfolio.

CHINA’S PREVIOUSLY HOT MARKET HAS GONE COLD

The key to Q1’s decline was the collapse in China’s market, where sales fell 19% to 91m, and were back at 2013 levels according to Canalys data.  And as the chart shows, the 4 main players are consolidating their position:

  • Huawei grew market share to 24% from 18%; OPPO grew from 17% to 19%
  • Vivo grew from 15% to 17%, whilst Xiaomi jumped 8% to 13%.  And as Canalys note:

“There is a sense of fatigue in the market. The level of competition has forced every vendor to imitate the others’ product portfolios and go-to-market strategies.  But the costs of marketing and channel management in a country as big as China are huge, and only vendors that have reached a certain size can cope.”

Xiaomi’s growth is due to its focus on the sub-RMB1000 level ($160).  Its recent launch of cheap up-market phones will put more pressure on competitors and further drive consolidation in the market.

SMARTPHONE MARKET’S POLARISATION CONFIRMS THE GLOBAL TREND

It is, of course, no accident that China’s downturn has ended global market growth.  Its vast stimulus programme after 2008’s financial crisis meant that it became the growth engine for the global economy.  But now President Xi’s resolve to make “deleveraging” one of his “3 tough challenges” is changing the rules of the game, again:

  • As the chart shows, the Boomer-led SuperCycle created a new and highly profitable mid-market
  • Before then, companies had competed on the basis of price or perceived value
  • But from the mid-1980s onwards, the mid-market became the most profitable sector
  • Now, with the Boomers retiring and stimulus programmes ended, we are going back to basics again
  • The vastly different strategies of Apple and Xiaomi highlight the new world ahead

Apple CEO, Tim Cook, has deliberately turned his back on the mid-market, positioning the new iPhone X at the $1000 price point, where it has consistently outsold the cheaper iPhone 8 and iPhone 8Plus. In turn, this led profits to jump 25%.  As a result, Apple is the clear leader in the high-end sector with its relatively niche products and high margins. As the Financial Times reports:

“iPhone unit sales of 52m were up only 3% by volume but the product’s revenues jumped 14%, as the iPhone X drove its average selling price up by $73 compared with a year ago, to $728.

Apple’s performance highlighted the new strategy:

  • Its China revenues rose 21% and the iPhone X was the top selling smartphone
  • It also benefits from the growth of the used-phone market, now around 10% of the total
  • Around a quarter of US consumers sold their old smartphone when upgrading last year
  • iPhones will likely hold their value well, making them more valuable when resold

Similarly, Xiaomi’s success in China highlighted the opportunity in the mass-market.  Its market share jumped to 13% as it aimed to make a net profit margin of just 5% on its $100 – $160 phones.

INVESTORS NEED TO WATCH FOR BANKRUPTCIES AS CONSOLIDATION REVS UP
The free money provided by the central banks since 2008 has had two key effects:

  • It has prolonged the reign of the mid-market as consumers have been able to borrow cheaply
  • It has allowed mid-market companies to borrow heavily and build up major debt

Now, both of these trends are reversing.  Consumer spending is increasingly being driven by income, rather than borrowing.  Companies are seeing interest rates rise on their debt: even worse, those who borrowed to take advantage of low US rates are seeing repayments rise as the US$ rises again.

Investors need to be very careful about where they place their bets for the future.  And companies need to check out their business partners’ strategies.  Falling volumes and higher interest/debt costs will lead to a wave of bankruptcies.

Most analysts are ignoring the changes underway in China.  As with subprime, they will soon argue that “nobody could have seen this coming”.  But in reality, there are always warning signs.  The global smartphone market has been the great success story of the stimulus era.  Its paradigm shift is highlighting the likely “surprises” that lie ahead.

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