The chemical industry is the best leading indicator for the global economy. And my visit to Singapore last week confirmed that the downturn underway in the Asian market creates major risks for developed and emerging economies alike.
The problem is focused on China’s likely move into recession, now its stimulus policies are finally being unwound. And the result is shown in the above chart from The pH Report, updated to Friday:
- It confirms that the downturn began before oil prices peaked at the beginning of October, confirming that companies were responding to a downturn in end-user demand
- Since then, of course, the oil price has – rather dramatically – entered a bear market, with prices down by nearly a third
The question now is whether finance directors will choose to aggressively destock ahead of year-end results, to mitigate the volume decline with a decline in working capital. This would be a bold move given continuing geo-political uncertainty in the Middle East, and would also conflict with the more upbeat guidance that was given earlier with Q3 results.
But a review of ICIS news headlines over the past few days suggests they may have little choice. Inventories are described as “piling up” in a wide range of major products, including polyethylene – the biggest volume polymer. Indian producers are even offering “price protection” packages on polypropylene, to safeguard customers from losses if prices fall further.
Asian countries and their major partners (eg Argentina, S Africa, Turkey) were, of course, the first to be hit by China’s downturn. But Q3’s fall in German GDP shows the downturn has now spread to the Western economy that most benefited from China’s post-2008 stimulus bubble. As The Guardian noted:
“Goods exports make up 40% of German GDP – a much bigger proportion than for the next two biggest eurozone economies, France and Italy.”
OIL MARKETS CONFIRM THE RECESSION RISK
Of course, consensus opinion still believes that the US economy is sailing along, regardless of any problems elsewhere. But the chart of oil prices relative to recession tells a different story:
- The problem is that oil prices have been rising since 2016, with the summer proving the final blow-off peak. As always, this meant consumers had to cut back on discretionary spending as costs of transport and heating rose
- The cost of oil as a percentage of GDP reached 3.1% in Q3 – a level which has always led to recession in the past, with the exception of the post-2008 stimulus period when governments and central banks were pouring $tns of stimulus money into the global economy
- In turn, this means a downturn is now beginning in US end-user demand in critical areas such as housing, autos and electronics
Oil markets have therefore provided a classic example of the trading maxim for weak markets – “Buy on the rumour, sell on the news”.
- Prices had risen by 75% since June on supply shortage fears, following President Trump’s decision to exit the Iran nuclear deal on November 4
- As always, this created “apparent demand” as buyers in the US and around the world bought ahead to minimise the impact of higher prices
- But the higher prices also negated the benefit of the earlier tax cuts for his core supporters just ahead of the mid-term elections, causing Trump to undertake a policy u-turn
- He is now pushing Saudi Arabia and Russia to maintain production, and has announced 180-day exemptions for Iran’s 8 largest customers – China, India, S Korea, Japan, Italy, Greece, Taiwan and Turkey.
Understandably, oil traders have now decided that his “bark is worse than his bite“. And with the downturn spreading from Asia to the West, markets are now refocusing on supply/demand balances, with the International Energy Agency suggesting stocks will build by 2mb/d in H1 2019. In response, OPEC are reportedly discussing potential cuts of up to 1.4mb/d from December.
CHINA’S SHADOW BANKING COLLAPSE IS CREATING A NEW FINANCIAL CRISIS
Unfortunately, as in 2008, the collapse in oil prices is coinciding with the end of stimulus policies, particularly in China, as the chart of its shadow bank lending confirms. This has hit demand in two ways, as I discussed earlier this month in the Financial Times:
- Just 3 years ago, it was pumping out an average $140bn/month in mainly property-related lending *
- This created enormous demand for EM commodity exports
- It also boosted global property prices as wealthy Chinese rushed to get their money out of the country
- But during 2018, lending has collapsed by more than 80% to average just $23bn in October
China’s post-2008 stimulus programme was the growth engine for the global economy – with the efforts of the Western central banks very much a sideshow in comparison. It was more than half of the total $33tn lending to date. But now it is unwinding, prompting the Minsky Moment forecast a year ago by China’s central bank governor:
“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous.”
As I warned then:
“Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy. China’s lending bubble – particularly in property – is likely coming to an end. In turn, this will lead to a bumpy ride for the global economy.”
The bumps are getting bigger and bigger as we head into recession. Asia’s downturn is now spreading to the rest of the world, and is a major wake-up call for anyone still planning for “business as usual”.
* Lending has major seasonal peaks in Q1, so I use rolling 12 month averages to avoid distortions
“Nobody could ever have seen this coming” is the normal comment after sudden share price falls. And its been earning its money over the past week as “suddenly” share prices of some of the major “story stocks” on the US market have hit air pockets, as the chart shows:
- Facebook was the biggest “surprise”, falling 20% on Thursday to lose $120bn in value
- Twitter was another “surprise”, falling 21% on Friday to lose $7bn
- Netflix has also lost 15% over the past 16 days, losing $27bn
- Tesla has lost 20% over the past 6 weeks, losing $13bn
These are quite major falls for stocks which were supposed to be unstoppable in terms of their market advances.
Of course, their supporters could say it was just a healthy correction and a “buying opportunity”. And they might add that so far, other “story stocks” such as Alphabet, Apple and Amazon are still doing well. But others might say a paradigm shift is underway, and these sudden shocks are just the early warning that the central banks’ Quantitative Easing bubble is finally starting to burst.
They might have a point, looking at the second set of charts:
- Twitter stopped being a major growth story as long ago as 2015, since when its user growth has been relatively slow, even going negative in some quarters
- Facebook stopped showing major growth in active users 18 months ago – and in 2018, it has been flat in N America and losing subscribers in Europe, whilst Asia and the Rest of the World are also heading downwards
- Tesla, of course, has been a serial disappointment. Its founder, Elon Musk, was brutally honest when founding the company in 2003, saying it had a 10% chance of success. Since then, it has mostly failed to meet its production targets. It was supposed to be making 5000 Tesla 3 cars a week by the end of last year, but according to Bloomberg’s Model 3 tracker, it is currently producing only 2825/week. Around 0.5 million buyers have paid their $1k deposits and are still waiting for their car – and Tesla needs their cash if its not to run out of money
- Netflix is another “story stock” now seeing a downturn in subscriber growth. Yet at its peak it had a market value of $181bn, with net income for this quarter forecast by the company at just $307m. Like Tesla, it was valued at a higher value than comparable businesses such as Disney, which have had solid earnings streams for decades.
The common factor with all 4 stocks is that they have a great “narrative” or “story”. Elon Musk has held investors spellbound whilst he told them of unparalleled riches to come from his innovation. This seemed to be the same with Facebook until the furore arose over the data user scandal with Cambridge Analytica. Twitter and Netflix have also had a great “story”, which overcame the need to show real earnings even after years of investment.
THE LIQUIDITY BUBBLES ARE STARTING TO BURST AS CENTRAL BANK STIMULUS SLOWS
In other words, reality seems to be starting to intrude on the “story”, just as it did at the end of the dot-com bubble in 2000, and the US subprime bubble in 2008. The key, then as now, is the end of the stimulus policies that created the bubbles, as the 3rd set of charts shows:
- Slowly but surely, the US Federal Reserve is finally raising interest rates back to more normal levels
- And more importantly, China’s shadow bank lending is declining – H1 was down by $468bn versus 2017
Even the European Central Bank and the Bank of Japan have signalled they might finally be about to cut back on the combined $5.75tn of lending, often at negative rates, that they pumped into the markets between 2015 – March 2018.
The issue is simple. All bubbles need more and more air to be pumped into them to keep growing. Once the air stops being added, they start to burst. And for the moment, at least, Facebook, Twitter, Netflix and Tesla are all acting as the proverbial canary in the coal mine, warning that the great $33tn Quantitative Easing bubble may be starting to burst.
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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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2000 should have been the natural end of the BabyBoomer-led economic SuperCycle. The oldest Boomer (born in 1946) was about to leave the Wealth Creator 25 – 54 age group that drives consumer spending and hence economic growth. And since 1970, Boomer women’s fertility rates had been below replacement level (2.1 babies/woman). So relatively fewer young people were joining the Wealth Creator generation to replace the Boomers who were leaving.
But instead, central banks decided that demographics didn’t matter. They believed instead that monetary policy could effectively “print babies” and create sustainable demand. So instead of worrying about financial stability – their real role – they aimed to stimulate the economy by boosting financial asset prices – primarily shares and housing markets.
London’s housing market was a key target as the Bank of England’s Governor told Parliament in March 2007:
“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… 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.”
But instead, when the Subprime Bubble burst, policymakers did even more stimulus via Quantitative Easing (QE).
The chart of London house prices since 1971 (in £2017) therefore shows 3 distinct phases:
- 1971-1999. Prices were typically Cyclical – (1) up 51%, down 31%; (2) up 37%, down 15%; (3) up 109%, down 43%. But they averaged around 4.8x average London earnings
- 2000-2007. Central banks panicked after the dotcom crash and kept interest rates artificially low – creating the Subprime Bubble as prices rose in more or less a straight line, till they were up 196% from the previous trough
- 2008-2017. The market tried initially to return prices to reality, and they slipped 10%. But then central banks rushed to flood it with liquidity and created the QE Bubble, causing prices to soar 46%
Now, however, the Stimulus Bubble is ending and a “perfect storm” is developing as 3 key myths are exposed:
The end of the ‘London is a global city’ myth. The house price/earnings ratio averaged 4.8x between 1971-1999. But it then took off into the stratosphere to reach 11x today, as the myth grew that Londoners weren’t relevant to the housing market. Instead, it was said that London had become a “global city” where foreigners would set the price.
Chinese and Asian buyers boosted this myth as vast new apartment blocks were sold off-plan in the main Asian cities – often to buyers who never even visited their new “home”. But the myth ended last year when China introduced severe capital controls – capital outflows collapsed from $640bn in 2016 to just $60bn in 2017.
The scale of the this retreat is overwhelming as The Guardian reported recently:
“The total number of unsold luxury new-build homes, which are rarely advertised at less than £1m, has now hit a record high of 3,000 units, as the rich overseas investors they were built for turn their backs on the UK due to Brexit uncertainty and the hike in stamp duty on second homes….
“Henry Pryor, a property buying agent, says the London luxury new-build market is “already overstuffed but we’re just building more of them. We’re going to have loads of empty and part-built posh ghost towers. They were built as gambling chips for rich overseas investors, but they are no longer interested in the London casino and have moved on.””
The end of the buy-to-let mania. Parents of students going away to college began this trend in the mid-1990s, as they bought properties for their children to use, rather than rent from poor quality landlords. After the dotcom crash, many decided that “bricks and mortar” were a safer bet than shares, especially with the major tax breaks available.
Banks were delighted to lend against an asset that was supported by the Bank of England, finding it far more attractive than lending to a business that might go bust. And so parents held on to their investments after their children left college – further reducing the amount of housing available for young people to buy. But as The Telegraph reports:
“Buy-to-let investors now face tougher conditions. A weakening housing market, tough new legislation and the tightening of affordability checks by lenders are but a few problems causing landlords to run for the hills. According to the National Landlords Association, 20% of landlords plan to sell one or more of their properties in the next 12 months.”
Interest rates will never rise. Of course, the key to the Subprime and QE Bubbles was the Bank’s decision to collapse interest rates to stimulate the economy. Monthly payments became much more affordable – and ever-rising prices meant there was no longer any need to worry about repaying the capital.
But some people still couldn’t afford to buy even on this basis, and by 2007 around 30% of mortgages were “interest-only” with no capital repayment at all. These buyers should have been forced sellers when the Subprime Bubble burst; prices would then have returned to more normal levels. But instead, the Bank of England stepped in again, as the Financial Times has reported:
“During and after the 2008 financial crisis Britain’s mortgage lenders took a more tolerant approach to non-payers through the use of forbearance ….at the height of the housing market troubles in 2011 Bank of England research suggested that as many as 12% of all UK residential mortgages were in some form of forbearance. This helped prevent the downturn from developing into a 1990s-style crash, the Bank suggested.”
PRICES WOULD FALL 60% IF THE HOUSE PRICE/EARNINGS RATIO “REVERTS TO MEAN”
All “good things” come to an end, of course. And the London property bubble is probably no exception. Its 3 key drivers are now all reversing, and there seems little sign of any new factors that might help to keep the bubble inflating.
The risk is that interest rates continue to rise, forcing many owners to sell and bursting the Stimulus Bubble. UK 10-year rates have already trebled from their 0.5% low in Q3 2016. Most rates seem likely to go much higher now the 30-year downtrend has been broken, as I discussed last week.
Today’s high prices will also make it difficult for sellers to find local buyers, as the number of homes being bought/ sold each year has fallen 25% since the 2007 peak. Most young people cannot afford to buy. And if many people do decide to sell, potential buyers might panic, causing the slump to continue for many years – as happened before 2000.
Nobody knows how low prices might go, if they start to fall. But ‘reversion to mean’ is usually the best measure. If this happened, today’s average London home, selling at 4.8x earnings, would cost £193k – a 60% fall from 2017’s average price of £475k. This figure also highlights the risk that policymakers’ denial of demographic realities has created.
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“Average UK wages in 2022 could still be lower than in 2008”
UK Office for Budget Responsibility
While Western stock markets boom under the influence of central bank money-printing, wages for ordinary people are not doing so well. So it is no wonder that Populism is rising, as voters worry their children will be worse off than themselves at a similar age.
The chart above is the key to the story. It shows births in the G7 countries (Canada, France, Germany, Italy, Japan, UK, USA) since 1921. They are important as until recently, they represented around 50% of the global economy. Equally important is the fact that consumer spending represents 60% – 70% of total GDP in each country.
As the chart shows, the absolute number of consumers saw a massive boost during what became known as the BabyBoom after the end of World War 2:
- The US Boom lasted from 1946 – 1964, and saw a 52% increase in births versus the previous 18 years
- The Boom lasted longer in the other G7 countries, from 1946 – 1970, but was less intense
- In total, there were 33 million more G7 births in 1946 – 1970 versus the previous 25 years
- This was the equivalent of adding a new G7 country the size of Canada to the global economy
Today’s dominant economic theories were also developed during the BabyBoom period, as academics tried to understand the major changes that were taking place in the economy:
- Milton Friedman’s classic ‘A Monetary History of the United States’ was published in 1963, and led him to argue that “inflation is always and everywhere a monetary phenomenon”
- Franco Modigliani’s ‘The Life Cycle Hypothesis of Saving‘ was published in 1966, and argued that consumers deliberately balanced out their spending through their lives
Today’s problem is that although both theories appeared to fit the facts when written, they were wrong.
We cannot blame them, as nobody during the 1960s realised the extraordinary nature of the BabyBoom. The word “BabyBoom” was only invented after it had finished, in 1970, according to the Oxford English Dictionary.
Friedman had no way of knowing that the number of US babies had risen by such an extraordinary amount. As these babies grew up, they created major inflation as demand massively outgrew supply. But once they entered the Wealth Creator 25 – 54 age cohort in large numbers and began working, supply began to catch up – and inflation to fall.
Similarly, Modigliani had no way of knowing that people’s spending began to decline dramatically after the age 55, as average US life expectancy during the BabyBoom was only around 68 years.
But today, average US life expectancy is over 10 years higher. And as the second chart shows, the number of households in the 55+ age group is rocketing, up by 55% since 2000. At 56m, it is fast approaching the 66m households in the critical 25 – 54 Wealth Creator cohort, who dominate consumer spending:
- Each Wealth Creator household spent an average of $64k in 2017, versus just $51k for those aged 55+
- Even this $51k figure is flattered by the large number of Boomers moving out of the Wealth Creator cohort
- Someone aged 56 spends almost the same as when they were 55. But at 75+, they are spending 47% less
- Older people already own most of what they need, and their incomes decline as they approach retirement
Unfortunately, today’s central bankers still base policy on these theories, just as Keynes’ warned:
“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”.
The result is seen in the third chart from the Brookings Institute. It highlights how labour’s share of income has collapsed from 64% in 2000 to 57% today. The date is particularly significant, given that the oldest Boomers (born in 1946), reached 55 in 2001 and the average US Boomer became 55 in 2010.
- Fed Chairman Alan Greenspan tried to compensate for this paradigm shift from 2003 by boosting house prices – but this only led to the 2008 subprime crisis which nearly collapsed the global economy
- Since then, Fed Chairs Ben Bernanke and Janet Yellen have focused on boosting the stock market, as Bernanke noted 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.”
But fewer Americans own stocks than houses – only 54% versus 64% for homes. So “printing babies” cannot work.
The real issue is that the dramatic increase in life expectancy has created a paradigm change in our life cycle:
- It is no longer based on our being born, educated, working, retiring and then dying
- Instead, we have a new stage, where we are born, educated, work, and then retrain in our 50s/60s, before working again until we retire and then die
This transition would have been a difficult challenge to manage at the best of times. And having now gone in the wrong direction for the past 15 years, we are, as I warned last year, much closer to the point when it becomes:
“Obvious that the Fed could not possibly control the economic fortunes of 321m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted as a result. The path back to fiscal sanity will be very hard indeed.”
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“There isn’t anybody who knows what is going to happen in the next 12 months. We’ve never been here before. Things are out of control. I have never seen a situation like it.“
This comment from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing companies, investors and individuals as we look ahead to the 2018 – 2020 Budget period. None of us have ever seen a situation like today’s. Even worse, is the fact that risks are not just focused on the economy, or politics, or social issues. They are a varying mix of all of these. And because of today’s globalised world, they potentially affect every country, no matter how stable it might appear from inside its own borders.
This is why my Budget Outlook for 2018 – 2020 is titled ‘Budgeting for the Great Unknown’. We cannot know what will happen next. But this doesn’t mean we can’t try to identify the key risks and decide how best to try and manage them. The alternative, of doing nothing, would leave us at the mercy of the unknown, which is never a good place to be.
RISING INTEREST RATES COULD SPARK A DEBT CRISIS
Central banks assumed after 2008 that stimulus policies would quickly return the economy to the BabyBoomer-led economic SuperCycle of the previous 25 years. And when the first round of stimulus failed to produce the expected results, as was inevitable, they simply did more…and more…and more. The man who bought the first $1.25tn of mortgage debt for the US Federal Reserve (Fed) later described this failure under the heading “I’m sorry, America“:
“You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2”
• And the Fed was not alone, as the chart shows. Today, the world is burdened by over $30tn of central bank debt
• The Fed, European Central Bank, Bank of Japan and the Bank of England now appear to “own a fifth of their governments’ total debt”
• There also seems little chance that this debt can ever be repaid. The demand deficit caused by today’s ageing populations means that growth and inflation remain weak, as I discussed in the Financial Times last month
China is, of course, most at risk – as it was responsible for more than half of the lending bubble. This means the health of its banking sector is now tied to the property sector, just as happened with US subprime. Around one in five of all Chinese apartments have been bought for speculation, not to be lived in, and are unoccupied.
China’s central bank chief, Zhou Xiaochuan, has warned that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008. Similar risks face the main developed countries as they finally have to end their stimulus programmes:
• Who is now going to replace them as buyers of government debt?
• And who is going to buy these bonds at today’s prices, as the banks back away?
• $8tn of government and corporate bonds now have negative interest rates, which guarantee the buyer will lose money unless major deflation takes place – and major deflation would make it very difficult to repay the capital invested
There is only one strategy to manage this risk, and that is to avoid debt. Companies or individuals with too much debt will go bankrupt very quickly if and when a Minsky Moment takes place.
THE CHINA SLOWDOWN RISK IS LINKED TO THE PROPERTY LENDING BUBBLE
After 2008, it seemed everyone wanted to believe that China had suddenly become middle class by Western standards. And so they chose to ignore the mounting evidence of a housing bubble, as shown in the chart above.
Yet official data shows average incomes in China are still below Western poverty levels (US poverty level = $12060):
• In H1, disposable income for urban residents averaged just $5389/capita
• In the rural half of the country, disposable income averaged just $1930
• The difference between income and expenditure was based on the lending bubble
As a result, average house price/earnings ratios in cities such as Beijing and Shanghai are now more than 3x the ratios in cities such as New York – which are themselves wildly overpriced by historical standards.
Having now been reappointed for a further 5 years, it is clear that President Xi Jinping is focused on tackling this risk. The only way this can be done is to take the pain of an economic slowdown, whilst keeping a very close eye on default risks in the banking sector. As Xi said once again in his opening address to last week’s National Congress:
“Houses are built to be inhabited, not for speculation. China will accelerate establishing a system with supply from multiple parties, affordability from different channels, and make rental housing as important as home purchasing.”
China will therefore no longer be powering global growth, as it has done since 2008. Prudent companies and investors will therefore want to review their business models and portfolios to identify where these are dependent on China.
This may not be easy, as the link to end-user demand in China might well be further down the supply chain, or external via a second-order impact. For example, Company A may have no business with China and feel it is secure. But it may suddenly wake up one morning to find its own sales under attack, if company B loses business in China and crashes prices elsewhere to replace its lost volume.
PROTECTIONISM IS ON THE RISE AROUND THE WORLD
Trade policy is the third key risk, as the chart of harmful interventions from Global Trade Alert confirms.
These are now running at 3x the level of liberalising interventions since 2008, as Populist politicians convince their voters that the country is losing jobs due to “unfair” trade policies.
China has been hit most times, as its economy became “the manufacturing capital of the world” after it joined the World Trade Organisation in 2001. At the time, this was seen as being good news for consumers, as its low labour costs led to lower prices.
But today, the benefits of global trade are being forgotten – even though jobless levels are relatively low. What will happen if the global economy now moves into recession?
The UK’s Brexit decision highlights the danger of rising protectionism. Leading Brexiteer and former cabinet minister John Redwood writes an online diary which even campaigns against buying food from the rest of the European Union:
“There are many great English cheese (sic), so you don’t need to buy French.”
No family tries to grow all its own food, or to manufacture all the other items that it needs. And it used to be well understood that countries also benefited from specialising in areas where they were strong, and trading with those who were strong in other areas. But Populism ignores these obvious truths.
• President Trump has left the Trans-Pacific Partnership, which would have linked major Pacific Ocean economies
• He has also said he will probably pull out of the Paris Climate Change Agreement
• Now he has turned his attention to NAFTA, causing the head of the US Chamber of Commerce to warn:
“There are several poison pill proposals still on the table that could doom the entire deal,” Donohue said at an event hosted by the American Chamber of Commerce of Mexico, where he said the “existential threat” to NAFTA threatened regional security.
At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail. But what if they are wrong? It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.
Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.
POLITICAL CHAOS IS GROWING AS PEOPLE LOSE FAITH IN THE ELITES
The key issue underlying these risks is that voters no longer believe that the political elites are operating with their best interests at heart. The elites have failed to deliver on their promises, and many families now worry that their children’s lives will be more difficult than their own. This breaks a century of constant progress in Western countries, where each generation had better living standards and incomes. As the chart from ipsos mori confirms:
• Most people in the major economies feel their country is going in the wrong direction
• Adults in only 3 of the 10 major economies – China, India and Canada – feel things are going in the right direction
• Adults in the other 7 major economies feel they are going in the wrong direction, sometimes by large margins
• 59% of Americans, 62% of Japanese, 63% of Germans, 71% of French, 72% of British, 84% of Brazilians and 85% of Italians are unhappy
This suggests there is major potential for social unrest and political chaos if the elites don’t change direction. Fear of immigrants is rising in many countries, and causing a rise in Populism even in countries such as Germany.
“Business as usual” is always the most popular strategy, as it means companies and investors don’t have to face the need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.
At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. The threat from subprime was perfectly obvious from 2006 onwards, as I warned in the Financial Times and in ICIS Chemical Business, as was 2014’s oil price collapse. Today’s risks are similarly obvious, as the “Ring of Fire” map describes.
You may well have your own concerns about other potential major business risks. Nobel Prizewinner Richard Thaler, for example, worries that:
“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”
We can all hope that none of these scenarios will actually create major problems over the 2018 – 2020 period. But hope is not a strategy, and it is time to develop contingency plans. Time spent on these today could well be the best investment you will make. As always, please do contact me at firstname.lastname@example.org if I can help in any way.
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