The litmus test for the global economy

China’s property sector is at the epicentre of the crisis

A branch of Centaline Property Agency in Hong Kong © Bloomberg

Indebted Chinese property developers threaten a domino effect on western credit markets , as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Second-order impacts are starting to appear as a result of China’s lockdowns. These are having a big impact on the critical property sector, which makes up as much as 25 per cent of gross domestic product.

Housing sales fell almost 40 per cent in February and seem likely to be down again in March, while developer Evergrande cut prices to try and maintain its cash flow. This creates growing risk in the offshore dollar market, where property developers have been significant borrowers, with Fitch already warning of possible defaults. It is unclear whether local authorities can provide much support, as their dependence on revenue from land sales means their own position is weakening.

Rightly, the world’s attention has focused on the impact on public health of the coronavirus pandemic and the best ways of mitigating it. But as Martin Wolf highlights in the Financial Times, the virus is an economic emergency too, with the ability to plunge the world into a depression. Talk of the reforms made to the world’s banking systems since 2008 misses the point. The risk is now centred on the vast build-up of corporate debt since the global financial crisis, under the easy money policies of the world’s central banks.


China’s property sector is unfortunately the epicentre of this debt. As we noted in the FT in August: “Its tier 1 cities boast some of the highest house-price-to-earnings ratios in the world, while profits from property speculation allowed car sales to rise fourfold from 500,000 a month in 2008 to 2m a month in 2017.” Last month’s collapse of car sales back to 2005 levels of 244,000 confirms the damage that has been done.

Sales by China’s top 100 property developers plunged by 44 per cent in February, and Caixin reports that over 100 builders went bust in the January-February period, normally one of the busiest times for property sales. Equally worrying, as Caixin’s chart below illustrates, is that, although the largest developer, Evergrande, bucked the trend, this was only because it cut prices by 25 per cent in February and offered 22 per cent reductions this month.

There are few signs of a sustained upturn, with S&P reporting that housing starts were down 45 per cent across January-February. S&P adds that property sales could fall 20 per cent this year, if the effects of the lockdowns are still being felt in April, as seems likely.


The issue is that we are now starting to see second-order impacts of the lockdowns emerge, particularly in terms of consumer affordability and supply chain disruption:

  • The economic impact of the initial lockdowns was focused on two areas — companies and consumers. Companies were shut down, and consumers were quarantined
  • In turn, this led to a number of key impacts within and outside China
  • Within China, demand disappeared for a wide range of products as consumers were unable to leave their homes; supply also disappeared as companies shut down
  • And ‘out of sight’, critical logistic arrangements were being completely upended by quarantine measures, and the need to prioritise essential food/medical supplies

We can probably assume that truck drivers have now been released from emergency duties and from quarantine (if they travelled from infected areas across provincial borders). But we have no idea if their basic equipment — containers, specialist materials, etc — is in its normal place. We do know, however, from the shipping industry that its activity has been severely disrupted, with ships away from their usual moorings and many idled due to lack of work; containers and crew are equally disrupted.

It is safe to assume that most Chinese companies and consumers are short of cash and that consumers will cut back on all but essential spending, further depressing demand. This creates the risk of a vicious circle, whereby property sales remain depressed, reducing developer cash flow still further after most building activity came to a standstill during the lockdowns.

Fitch Ratings identified five Chinese corporations with a high risk of refinancing in a recent report, four of which are in the homebuilding sector, citing concerns about near-term capital market debt maturities and the unpredictability of the epidemic. A further sign of stress, as the Financial Times has reported, is that land sales are now running at less than a quarter of average levels.

Two key facts highlight our concerns:

  • Chinese developers ramped up their offshore dollar borrowing by 52 per cent to an all-time high of $75.2bn last year, according to Centaline Property Agency, as onshore funding became more difficult. And as S&P reported in November, before coronavirus hit: “For some developers, offshore yields to maturity have surged well beyond the mid-teens, reflecting low investor confidence.”
  • Chinese borrowers also tend to operate on a short-term basis, with an ICE BofA index of Chinese high-yield securities in dollars having 2.7 years to maturity, compared with 5.9 years for a similar US index.

We have warned here for some time that China’s property market has been ‘subprime on steroids’. Property sales have been buoyed by vast government stimulus programmes. And western investors have flocked to lend in the offshore dollar market, attracted by the high interest rates on offer compared to those in their domestic markets under central banks’ zero-interest rate policies.

The renminbi’s weakening beyond Rmb7 to the US dollar adds to the difficulties developers will face in servicing their dollar debts.

The potential for a domino impact on western credit markets from a coronavirus-related downturn in China’s property market should already be keeping regulators up at night.

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

“They may ring their bells now, before long they will be wringing their hands”

The wisdom of Sir Robert Walpole, the UK’s first premier, seems the only possible response to this weekend’s headline from the Wall Street Journal. How can a National Emergency ever be the basis for a major rise in stock markets?

Of course, we all know that stock markets have become addicted to stimulus. But the problem with stimulus is that the patient needs more and more of it, to keep markets moving higher:

But the headlines surrounding the National Emergency clearly did the job as far as the High-Frequency Traders were concerned. They still dominate equity and other major markets, and Friday afternoon was exactly the kind of bumper payday that they adore.

The only problem is that neither stock markets, nor even the Federal Reserve, can cure coronavirus. And if the pandemic continues as the experts expect:

  • Between 160 million and 214 million Americans will become infected
  • Between 2.4 million and 21 million people could require hospitalisation

Clearly, no hospital system in the world could cope with the higher end of this range, particularly if they all come at once. And although the US system is easily the most expensive in the world, its performance is relatively poor by comparison with other major Western nations.

One key issue, of course, is testing. Nobody can know the actual size of the problem until we know how many people are already affected. And yet, as the WSJ reports from the President’s speech on Friday:

“By early next week, Mr. Trump said, there would be a half-million additional tests available, with 5 million tests available within a month.”

By comparison, China already has the capacity to do 1.7 million tests a week, according to the World Health Organisation.

This, of course, is why the experts are talking about trying to ‘delay’ the pandemic, rather than ‘contain’ it, as the chart based on US Centers for Disease Control and Prevention analysis (interpreted by Vox) confirms.

The US lack of a proper social support system is also a major disadvantage. Around 34 million American workers have no access to paid sick leave, for example, and 27 million don’t have health insurance.  These people may well feel they have to keep working even if infected in order to pay the rent.

Hopefully, the new support package agreed on Friday night will help solve these problems. But who knows how long it will take to actually roll out the measures, and how many people will benefit?

The essence of populism, of course, is that it supplies simple answers to complex problems. And coronavirus is likely to prove a classic case of this weakness in action:

  • Experts suggest the virus will keep returning unless ‘herd immunity’ can be established
  • They estimate this means around 60% of the population therefore need to be infected

Data from China and Italy confirms that the main risk from coronavirus is to people over the age of 70, as the chart shows. The CDC also recommend that people with serious chronic medical conditions such as heart disease, diabetes and lung disease need to take special precautions.

But their voice is being drowned out. People are understandably frightened, and they need wise and well-informed leaders to give them clear messages. Leaders should be focused on aiming to manage the pandemic and on taking the obvious steps to protect those most vulnerable.  Unfortunately, the opposite is happening as former UK Finance Minister, Lord Darling  has noted:

“There is a striking lack of global cooperation in dealing with coronavirus”.

The issue is that effectively closing down large parts of the economy in response to coronavirus is a very high risk strategy:

  • Millions of businesses could well go bankrupt around the world, and tens of millions lose their jobs
  • And as watchdog the Institute of International Finance already warned on Thursday:

“Global growth is potentially approaching 1% this year (anything below 2.5% is essentially recession). The multitude of shocks in the system now risks a global “sudden stop”. Falling oil prices potentially accelerate mounting credit stress in the US. Vulnerable emerging markets are already seeing large outflows”.

Friday saw Wall Street celebrating its latest “fix” of easy money. But as Bloomberg also noted:

“For context, this was the S&P 500’s best day since Oct. 28, 2008. At the end of that day, the bottom was more than 4 months away, and there was a 29% fall before hitting the intraday low.”

We may well all come to regret, as we wring our hands in the summer, that the bells rang too soon.

 

 

Chain’s smartphone and auto sales tumble as coronavirus hits demand

China is the world’s largest market for smartphones and autos – responsible for c30% of global sales for both.  Yet as Reuters notes:

“Most western policymakers and journalists view the world economy through a framework that is 10-15 years out of date, failing to account fully for the enormous shift in activity towards China and the rest of Asia.”

The critical fact is that both markets are now about to go into a severe downturn as a result of the coronavirus epidemic. This is already having a major impact on domestic sales in China, and is starting to create major disruption to today’s globalised supply chains.

SMARTPHONES SALES HAVE BEEN IN DECLINE SINCE 2017

As the chart shows, global smartphone sales were down again in Q4.  2019 sales were 1.4bn, versus their 2017 peak of 1.5bn. And, of course, Q1 is going to be a terrible period for sales, given the coronavirus impacts.

China has been the world’s largest market since 2012, but sales were down 37% in January as consumers began to worry about the risks from the virus.  February will clearly be much worse, as a result of the major lockdowns in place.  As Strategy Analytics warn:

“The smartphone market will be adversely impacted by the slowing GDP growth and the plunging consumer spending. It will also impact global smartphone supply and manufacturing, because China makes 70% of all smartphones sold on the planet.”

Research firms IDC and Canalys are already forecasting that China’s market will be down 40% in Q1. But this is likely an under-estimate, given the impact of the lockdowns.  Most retail stores, including Apple’s, have been shut during February, after all. And as Chinese business paper Caixin reported:

“China’s capital might be officially back to work, but it would be hard to tell from walking around the normally congested city. Tourist sites and other popular destinations remain unusually free of sightseers, customers or pedestrians.”

Outside China, parts arriving in the West today came from factories that were still open before Lunar New Year.  But now, supply chain problems are about to become evident:

  • Port calls in China fell 30% last month, as ships worried about crews being quarantined
  • Los Angeles – the largest US gateway for seaborne China imports – saw volumes drop 25%
  • Things will now get worse, as shipping times of 4 – 6 weeks mean new supplies are reducing
  • And back in China, it seems workers are often frightened to return – Apple’s main supplier, Foxconn, is having to offer $1k bonuses to persuade new workers to join

And, of course, the recession is also seeing major paradigm shifts take place.

For example, used smartphones are now becoming a viable market in their own right for the first time.  207m were sold last year, up 18% from 2018, and IDC see the market growing to over 300m phones by 2023. As they note:

“In contrast to the recent declines in the new smartphone market, as well as the forecast for minimal growth in new shipments over the next few years, the used market for smartphones shows no signs of slowing down across all parts of the globe. Refurbished and used devices continue to provide cost-effective alternatives to both consumers and businesses that are looking to save money when purchasing a smartphone.”

CHINA’S AUTO MARKET IS IN CRISIS

China’s auto market also matters. It is easily the largest in the world, with peak sales in 2017 of 24.7m, versus 17.9m in the USA and 15.3m in Europe.  And without China’s four-fold stimulus-powered sales increase since 2008, the global market would have seen no growth at all.

But today, the used market has become key to auto sales growth, as the chart confirms.  Consensus opinion still believes that its new car sales would continue to grow until at least the end of the decade. But this conclusion fails to reflect the unique nature of China’s market:

  • Back in 2000, there were just 16m cars on the road – and the quality was so bad, they mostly fell apart within a few years. There were still only 65m cars in 2008, before stimulus began
  • As a result, used car sales hardly existed. Instead, as in most poor countries, local mechanics would strip out parts from abandoned cars and reuse them to keep others on the road
  • It was only when China’s “subprime on steroids” stimulus programme began in 2009, with shadow banks funding speculative house purchases, that Western companies introduced their technology
  • Even then, it took until 2014 for used sales to start motoring, and they have still not reached a 50:50 ratio with new cars. And the direction of travel is clear, as used sales are normally 2x-3x new in most countries

China’s used sales rose 8% in 2019, whilst new sales fell 9%. They may well equal new sales this year for the first time, given the collapse underway in new sales.

Thus the virtuous circle of the last decade is turning vicious.  China’s new car sales fell by 90% in February, and salary losses during the lockdowns make it unlikely that the crisis has left a backlog of pent-up demand to create a V-shaped recovery.

Similarly, used car sales are set to cannibalise new car sales in all the major markets. Lending standards are already tightening, making new cars simply unaffordable.

THE WORLD WILL SEE MAJOR CHANGE DURING THE RECESSION

People sometimes say they ‘can’t plan until they know what is happening’. But in reality, what they mean is that they have become used to doing tactical planning, based on the idea of ‘business as usual’.  Today, however, we all have to relearn how to plan for uncertainty.

The question now for investors and companies is to start contingency planning for what may happen next.  We have to ask the question – how quickly will used smartphones and cars cannibalise new sales over the next year? Will they take 10%, 20% or more?  And what will happen to prices and margins as a result?

As the saying goes – “to fail to plan, is to plan for failure.”

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’.