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.

$50bn hole appears in New York financial markets – Fed is “looking into it”

Most people would quickly notice if $50 went missing from their purse or wallet. They would certainly notice if $50k suddenly disappeared from their bank account. But a fortnight ago, it took the New York Federal Reserve more than a day to notice that $50bn was missing from the money markets it was supposed to regulate.

Worse was to come. By the end of last week, the NY Fed was being forced to offer up to $100bn/day of overnight money.  And it was also clear that the authorities still have no idea of what is going wrong.

This is perhaps not surprising when one remembers, as I charted here between 2007-8, that the Fed failed to notice the subprime crisis until Lehman went bankrupt in September 2008.

For the past 2 weeks, extraordinary things have been happening in a critical part of the world’s financial markets. And unfortunately, the NY Fed didn’t notice until after it had begun, as the Financial Times later reported:

  • First, on Monday 16th, the repo market suddenly began to trade higher – reaching a high of 7%
  • Then as the market opened at 7am on Tuesday, “Rates rocketed upward again, to 6% within a few minutes and then to a high of 10%. That was four times the rate the repo market was trading the week before. Typically, repo prices move around by a few basis points each day — a few hundredths of a percentage point.

Finally, someone at the Fed woke up – or perhaps, somebody woke them up – and they announced $75bn of support to try and stop rates moving even higher. Even that had its problems, as “technical difficulties” meant the lending was delayed.

As Reuters then reported next day, this cash wasn’t enough. The shortage “forced the Fed to make an emergency injection of more than $125bn …. its first major market intervention since the financial crisis more than a decade ago.”

Of course, as with the early signs of the subprime crisis, the Fed then went into “don’t frighten the children mode“.  We were told it was all due to corporations needing cash to pay their quarterly tax bills, and banks needing to pay for the Treasury bonds they had bought recently.

Really! Don’t companies pay their tax bills every quarter? And don’t banks normally pay for their bonds?  Was this why some large banks found themselves forced to pay 10% for overnight money, when they would normally have paid around 2%?  And in any case, isn’t repo a $2.2tn market – and so should be easily able to cope with both events?

Equally, if it was just a one-off problem, why did the NY Fed President next have to announce daily support of “at least $75bn through 10 October” as well as other measures? And why did the Fed have to scale this up to $100bn/day last Wednesday, after banks needed $92bn of overnight money?

Was it that corporations were suddenly paying much more tax than expected, or banks buying up the entire Treasury market? The explanation is laughable, and shows the degree of panic in regulatory circles, that their explanation isn’t even remotely plausible.

We can expect many such stories to be put around over the next few days and weeks. As readers will remember, we were told in March 2008 that Bear Stearns’ collapse was only a minor issue. As I noted here at the time, S&P even told us that it meant “the end of the subprime write downs was now in sight“.

I didn’t believe these supposedly calming voices then, and I don’t believe them now. Common sense tells us that something is seriously wrong with the financial system, if large borrowers have to pay 10% for overnight money in a $2.2tn market.

And what is even more worrying is that, just as with subprime, the regulators clearly don’t have a clue about the nature of the problem(s).

My own view, as I warned in the Financial Times last month, is that “China’s (August 5) devaluation could prove to be the trigger for an international debt crisis”.  Current developments in the repo market may be a sign that this is more likely than many people realise.  I hope I am wrong.

 

London house prices edge closer to a tumble

After the excitement of Wimbledon tennis and a cricket World Cup final, Londoners were back to their favourite conversation topic last week – house prices. But now the news has become bittersweet as the price decline starts to accelerate.

As the London Evening Standard headline confirms:

The London property slump has dramatically accelerated with prices falling at their fastest rate in a decade, official figures reveal… The latest “punishing” downward lurch means that more than £21k ($26k) was wiped from the value of the average London house over the period, according to the Land Registry… The number of sales is still in decline with just 5947 recorded in March, down from 7350 a year previously.”

‘Reversion to the mean’ is always the most reliable of investment guides, and the chart shows prices could have some way to fall before they reach this level – and, of course, prices often over-correct after the type of sharp rise that has been seen over the past 20 years:

  • Most people have to buy houses on a mortgage, where the ratio of price to income is the key factor
  • As the chart shows, prices and ratios have seen 2 distinct periods since 1971 (when records began)
  • Prices (inflation adjusted) have had an upward trend since 2000, with today’s 11% fall the worst
  • 1971-1999 saw more violent swings – eg between 1983-1993 they doubled and then halved
  • The average ratio since 2000 has been 9.3, which would bring prices down by a further 23%
  • The average ratio between 1971-1999 was 4.8, which would bring prices down by a further 60%

WHY DID PRICES RISE?
London prices have been boosted by 4 main factors since 1971:

Demographics.  Most fundamentally, the BabyBoomers (born between 1946-1970) began to move into their house-buying years. This dramatically increased demand (as I discussed last week), whilst supply was slow to respond due to planning restrictions etc.

In addition, women began to go back to work after having children, creating the phenomenon of 2-income families for the first time in history. The younger Boomers saw the benefit of this as affordability rose; those who followed them paid the price in terms of higher prices.

Buy to let. London became the capital of ‘Buy-to-let’. UK tenancy law changed in 1988 and by the mid-1990s, parents realised it would be cheaper and better to buy apartments for their student children, rather than paying high rents for shoddy lodgings. Others followed in the belief that property was “safer” than stock markets”.

Falling interest rates (they were 15% during the 1992 ERM crisis) made the mortgage payment very affordable – particularly with tax relief as well. But since 2017, tax relief has been reducing, and disappears next year. And today’s ageing UK population, where nearly 1 in 5 people are now aged 65+, means the Boomers no longer have spare cash to spend on buying property.

The global city.  After the financial crisis, London property appeared an oasis of calm as the Bank of England supported house prices by cutting interest rates to near-zero, dramatically boosting affordability. Everyone knew by then that “house prices only increased”, as memories of the 1970-1980s were forgotten, and so capital gains seemed assured.

This made London, along with other “global cities” such as New York, very attractive to Russians, Arabs, Asians and anyone else who was worried that their government might try to grab their money. Europeans also bought as the eurozone crisis developed. And then the success of the 2012 London Olympics made it the city where everyone wanted to live, especially as its financial sector was booming due to central bank stimulus programmes.

WHAT WILL HAPPEN NEXT?
The question now is whether these drivers will continue.  Brexit, of course, has already cast a shadow over the idea of the UK as an island of stability in a troubled world. And whilst the collapse of the currency since the referendum makes property more affordable for foreign buyers, it means that those who bought at the peak are nursing even larger losses.

And, of course, the fall in the actual volume of sales is another worrying sign. Volume usually leads price, up or down. And housing markets aren’t like stock markets, where you can usually trade very quickly if you want to sell. Instead you have to wait for a buyer to appear – and even then, the UK’s property laws make it possible for them to pull out until the very last moment.

All in all, it would therefore be surprising if prices didn’t continue falling, back to the average house price/earnings ratio of the past 20 years.  A temporary over-correction, where they went even lower, would also be normal after such a long period without a major fall.

Whether they go lower than this, and return to the 1971-99 ratio, probably depends on what happens with Brexit.  If those who believe it will open up a new ‘golden age’ for the UK economy are right, then  prices might well stabilise and could even rise again, after the initial disruption. But if it proves an economic disaster, then a return to the troubled period of the 1970s would be no surprise at all.

 

G7 births hit new record low, below Depression level in 1933

If a country doesn’t have any babies, then in time it won’t have an economy. But that’s not how the central banks see it.

For the past 20 years, through subprime and now their stimulus policies, they have believed they could effectively “print babies”.  Even today, they are still lining up to take global interest rates even further into negative territory.

But common sense tells us their policy cannot work:

  • New data shows 2018 births in the G7 richest Western countries were just 7.8m
  • This was the lowest level seen since records began in 1921
  • It was even lower than at the height of the Depression in 1933 when births dropped to 7.99m/year
  • By comparison during the 1946-70 BabyBoom, they averaged 10.1m/year and peaked at 10.6m

The chart above confirms the unique nature of the Western BabyBoom.  Births jumped by 15% versus the previous 25 years, and since then they have fallen by an average 17%. Every single country is now having fewer births than at the peak of the Boom:

  • US births were 3.79m last year, versus a peak of 4.29m in 1959
  • Japan had 0.92m versus 2.7m in 1949; Germany had 0.79m versus 1.36m in 1963

The BabyBoom mattered because the Boomers were part of the richest society the world has ever seen.  In 1950, the G7 were half of the global economy, and they were still 45% in 2000. The “extra babies” born during the Boom, effectively created a new G7 economy the size of Canada.

But since 1970, the West has not been replacing its population, as fertility rates have been below 2.1/babies per woman.  This matters, as the second chart shows for the USA, the world’s largest economy.

Consumer spending is 70% of GDP, and it peaks in the 25-54 Wealth Creator generation – when people are building their careers and often settle down and have children.  Spend then drops by over 40% by the age of 75.

This didn’t matter very much for the economy in the past, when most people died around pension age:

  • In 1950, for example, there were just 130m Westerners in the Perennials 55+ age group.  By comparison, there were 320m Wealth Creators and 360m under 25
  • But today, there are 390m Perennials compared to 515m Wealth Creators and just 350m under-25s

This means it is impossible to recreate the growth of the Boomer-led SuperCycle.

Does this matter? Not really.

Most of us would prefer to have the extra 15-20 years of life that we have gained since 1950.  But because policymakers have pretended they could print babies via their stimulus programmes, they were able to avoid difficult discussions with the electorate about the impact of the life expectancy bonus.

Now, this failure is catching up with them.  Perennials are, after all, effectively a replacement economy. They already own most of what they need, and their incomes decline as they move into retirement. So we need to adjust to this major change:

  • In 1950, it was normal for people to be born and educated, before working to 65 and then dying around pension age
  • Today, we need to add a new stage to this paradigm – where we retrain around the age of 55, probably into less physically demanding roles where we can utilise the experience we have gained
  • This would have tremendous benefits for individuals in terms of their physical and mental health and, of course, it would reduce the burden on today’s relatively fewer Wealth Creators
  • It is completely unfair, after all, for the Boomers to demand their children should have a lower standard of living, and instead support their parents in the Perennials cohort

There is, of course, one other fantasy peddled by the central banks as part of their argument that monetary policy can always create growth.

This is that the emerging economies have all now become middle class by Western standards, and so global growth is still going to power ahead. But as the third chart shows, this simply isn’t true:

  • It shows the world’s 10 largest economies (the circle size) ranked by fertility rate and median age
  • Only India still has a demographic dividend, with its fertility rate just above replacement levels
  • But India’s GDP/capita is only $2036: Brazil’s is just $8968 and China’s $9608
  • By comparison, the US is at $62606, Germany is at $48264 and France/UK are at $42600

Companies and voters have been completely fooled by these claims of a “rising middle class” in the emerging economies.  In reality, most people have to live on far less than the  official US “poverty level” of $20780 for a 3-person household.

In China, average disposable income in the major cities was just $5932 last year, and only $2209 in the poorer rural half of the country. Its great success has actually been to move 800m people out of extreme poverty (income below $1.90/day) since 1990.

Demographics don’t lie, and they clearly challenge the rose-tinted view of the central banks that further interest rate cuts will somehow return us to SuperCycle days.

Their real legacy has been to create record levels of debt, which can probably never be repaid.

From subprime to stimulus…and now social division

The blog has now been running for 12 years since the first post was written from Thailand at the end of June 2007. A lot has happened since then:

Sadly, although central banks and commentators have since begun to reference the impact of demographics on the economy, they refused to accept the fundamental issue – namely that economic growth is primarily driven by the needs of the Wealth Creator 25-54 age group:

  • Their numbers are reducing because Western fertility rates have been below replacement level (2.1 babies/woman) for nearly 50 years
  • Central bank attempts to effectively “print babies” via stimulus policies have therefore only increased debt to record levels

As a result, the world has become a much more complex and dangerous place. None of us can be sure what will happen over the next 12 months, as I noted last week.  But clearly, the risks are rising, as UK Justice minister, David Gauke, has highlighted:

“A willingness by politicians to say what they think the public want to hear, and a willingness by large parts of the public to believe what they are told by populist politicians, has led to a deterioration in our public discourse.  This has contributed to a growing distrust of our institutions – whether that be parliament, the civil service, the mainstream media or the judiciary.

“A dangerous gulf is emerging, between the people and the institutions that serve them. Such institutions – including the legal system and the judiciary – provide the kind of confidence and predictability that underpins our success as a society. 

“Rather than recognising the challenges of a fast-changing society require sometimes complex responses, that we live in a world of trade-offs, that easy answers are usually false answers, we have seen the rise of the simplifiers. 

“Those grappling with complex problems are not viewed as public servants but as engaged in a conspiracy to seek to frustrate the will of the public. They are ‘enemies of the people’.”

THANK YOU FOR YOUR SUPPORT OVER THE PAST 12 YEARS
It is a great privilege to write the blog, and to be able to meet many readers in workshops and conferences around the world. Thank you for all your support.