China’s renminbi and the global ring of fire

China’s property bubble puts it at the epicentre of the ring of fire © Reuters 

China’s devaluation could be the trigger for an international debt crisis, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

August has often seen the start of major debt crises. The Latin American crisis began on August 12, 1982. The Asian crisis began with Thailand’s IMF rescue on August 11, 1997. The Russian crisis began on August 17, 1998.

We fear that the renminbi’s fall below Rmb7 per dollar on August 5 will act as just such a catalyst — this time, for the onset of a global debt crisis that has long been in the category of an accident waiting to happen.

The risk is summarised in the chart below from the Institute of International Finance, showing the seemingly inexorable rise in global debt over the past 20 years

Central banks came to believe that business cycles could be abolished by the use of stimulus, first through subprime and then through quantitative easing. This would encourage the return of the legendary “animal spirits” and allow the debt created to be wiped out by a combination of growth and inflation.

© Institute of International Finance

Unfortunately, as we have argued here before, this belief took no account of demographics or the impact of today’s ageing populations in slowing demand growth.

The baby boomers, who created the growth supercycle when they moved into the wealth creator 25-54 generation, have now joined the cohort of perennials aged 55 and above. They already own most of what they need. The focus on stimulus means that policymakers have failed to develop the new social/economic policies needed to maintain soundly-based growth in a world of increasing life expectancy and falling fertility. Instead, stimulus policies have created overcapacity and today’s record levels of debt.

As William White, a former chief economist of the Bank for International Settlements, warned at Davos in 2016: “It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something.” Presciently, he suggested that the trigger for the crisis could be a Chinese devaluation.

Central banks have created a debt-fuelled ‘ring of fire’ with multiple fault-lines

The risk, outlined in our second chart, is that central banks have created a debt-fuelled global “ring of fire”. China has undertaken around half of all global stimulus since 2008, in effect creating subprime on steroids. As we noted here last year, 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.

As the FT reported in April, investors have already been spooked by rising levels of dollar debt in China’s property sector. This debt is set to open the global ring of fire, as US president Donald Trump raises the stakes in his trade war. The president and his advisers seem to have chosen to ignore the very real risk of currency devaluation, as markets respond to the impact of tariffs on the economy:

  • China’s property bubble puts it at the epicentre of the ring of fire
  • This is now spreading out across Asia, impacting other Asian currencies and economies
  • The Bank of Japan is about to become the largest owner of Japanese stocks
  • The end of the property bubble is causing the end of the commodity bubble
  • In turn, this is impacting Australia, South Africa, Brazil, Russia and the Middle East
  • ECB stimulus means eurozone government bonds have negative interest rates
  • Banks cannot make a profit and savers have no income
  • President Trump’s China trade war risks connecting all the dots
  • The UK’s potential no-deal Brexit in October further threatens global supply chains

The issue is the risk of contagion from one market to another. Risks in individual silos can be bad enough, but if they spread across boundaries it quickly becomes hard to know who is holding the risk. As US Federal Reserve chairman Jay Powell warned in May while discussing potential problems in the market for collateralised loan obligations (CLO):

“Regulators, investors, and market participants around the world would benefit greatly from more information on who is bearing the ultimate risk associated with CLOs. We know that the US CLO market spans the globe . . . But right now, we mainly know where the CLOs are not — only $90bn of the $700bn in total CLOs are held by the largest US banks . . . In a downturn institutions anywhere could find themselves under pressure, especially those with inadequate loss-absorbing capacity or runnable short-term financing.”

The CLO market is just one part of the problem. As S&P Global reported recently, more than $3tn of US corporate debt is rated triple B, with $1tn rated triple B minus, the lowest level of investment grade. US companies account for 54 per cent of the world’s $7tn total triple B debt. The risk of contagion in any sell-off is clear, as many institutions would have to sell if recession forced rating agencies into downgrades, taking debt below investment grade.

In turn, this would add to the risks in US equity markets, which are already at extreme valuations. Pension funds would be most at risk as they have been major investors in corporate debt and in recent years have entered markets such as the Asian offshore US dollar market in their search for higher yields. A downturn in their returns would risk creating a vicious circle, forcing companies to increase their pension contributions just at the moment when their earnings are already under pressure as the trade war slows the global economy.

Mr Trump may come to regret his comment that “trade wars are good and easy to win”. We envisage a testing time ahead, particularly as only those over 60 have personal experience of even the “normal” business cycles seen before the boomer supercycle began.

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

BASF’s second profit warning highlights scale of the downturn now underway

The chemical industry is easily the best leading indicator for the global economy.  And thanks to Kevin Swift and his team at the American Chemistry Council, we already have data showing developments up to October, as the chart shows.

It confirms that consensus hopes for a “synchronised global recovery” at the beginning of the year have again proved wide of the mark.  Instead, just as I warned in April (Chemicals flag rising risk of synchronised global slowdown), the key  indicator – global chemical industry Capacity Utilisation % – has provided fair warning of the dangers ahead.

It peaked at 86.2%, in November 2017, and has fallen steadily since then. October’s data shows it back to June 2014 levels at 83.6%. And even more worryingly, it has now been falling every month since June. The last time we saw a sustained H2 decline was back in 2012, when the Fed felt forced to announce its QE3 stimulus programme in September.  And it can’t do that again this time.

The problem, as I found when warning of subprime risks in 2007-8 (The “Crystal Blog” foresaw the global financial crisis), is that many investors and executives prefer to adopt rose-tinted glasses when the data turns out to be too downbeat for their taste.  Whilst understandable, this is an incredibly dangerous attitude to take as it allows external risks to multiply, when timely action would allow them to be managed and mitigated.

It is thus critical that everyone in the industry, and those dependent on the global economy, take urgent action in response to BASF’s second profit warning, released late on Friday, given its forecast of a “considerable decrease of income” in 2018 of “15% – 20%”, after having previously warned of a “slight decline of up to 10%”.

I have long had enormous respect for BASF and its management. It is therefore deeply worrying that the company has had to issue an Adjustment of outlook for the fiscal year 2018 so late in the year, and less than 3 weeks after holding an upbeat Capital Markets Day at which it announced ambitious targets for improved earnings in the next few years.

The company statement also confirmed that whilst some problems were temporary, most of the issues are structural:

  • The impact of low water on the Rhine has proved greater than could have been earlier expected
  • But the continuing downturn in isocyanate margins has been ongoing for TDI since European contract prices peaked at €3450/t in May — since when they had fallen to €2400/t in October and €2050/t in November according to ICIS, who also reported on Friday that
    “Supply is still lengthy at year end in spite of difficulties at German sellers BASF and Covestro following low Rhine water levels”
  • The decline is therefore a very worrying insight into the state of consumer demand, given that TDI’s main applications are in furniture, bedding and carpet underlay as well as packaging applications.
  • Even more worrying is the statement that:
    “BASF’s business with the automotive industry has continued to decline since the third quarter of 2018; in particular, demand from customers in China slowed significantly. The trade conflict between the United States and China contributed to this slowdown.”

This confirms the warnings that I have been giving here since August when reviewing H1 auto sales (Trump’s auto trade war adds to US demographic and debt headwinds).

I noted then that President Trump’s auto trade tariffs were bad news for the US and global auto industry, given that markets had become dangerously dependent on China for their continued growth:

  • H1 sales in China had risen nearly 4x since 2007 from 3.1m to 11.8m this year
  • Sales in the other 6 major markets were almost unchanged at 23m versus 22.1m in 2007

Next year may well prove even more challenging if the current “truce” over German car exports to the USA breaks down,

INVESTORS HAVE WANTED TO BELIEVE THAT INTEREST RATES CAN DOMINATE DEMOGRAPHICS

The recent storms in financial markets are a clear sign that investors are finally waking up to reality, as Friday night’s chart from the Wall Street Journal confirms:

“In a sign of the breadth of the global selloff in stocks, Germany’s main stock index fell into a bear market Thursday, the latest benchmark to have tumbled 20% or more from its recent peak….Other markets already in bear territory are home to companies exposed to recent trade fights between the U.S. and China.

The problem, as I have argued since publishing ‘Boom, Gloom and the New Normal: how the Ageing Boomers are Changing Demand Patterns, again“, in 2011 with John Richardson, is that the economic SuperCycle created by the dramatic rise in the number of post-War BabyBoomers is now over.

I highlighted the key risks is my annual Budget Outlook in October, Budgeting for the end of “Business as Usual”.  I argued then that 2019 – 2021 Budgets needed to focus on the key risks to the business, and not simply assume that the external environment would continue to be stable.  Since then, others have made the same point, including the president of the Council on Foreign Relations, Richard Haas, who warned on Friday:

“In an instant Europe has gone from being the most stable region in the world to anything but. Paris is burning, the Merkel era is ending, Italy is playing a dangerous game of chicken with the EU, Russia is carving up Ukraine, and the UK is consumed by Brexit. History is resuming.

It is not too late to change course, and focus on the risks that are emerging.  Please at least read my Budget Outlook and consider how it might apply to your business or investments. And please, do it now.

 

You can also click here to download and review a copy of all my Budget Outlooks 2007 – 2018.

Global smartphone recession confirms consumer downturn


Q3 smartphone sales data show the global market in recession, as Strategy Analytics confirmed:

The global smartphone market has now declined for four consecutive quarters and is effectively in a recession.

The warning signs began in Q1, when the market plateaued for the first time, as discussed here in May:

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

The chart highlights the key issues:

  • Samsung’s market share has declined from a third in 2013 to a fifth today, as its mid-market positioning leaves it without a clear value proposition for consumers
  • China’s Top 3 players have meanwhile soared from just a 12% market share to 29% today, powered by their low-cost positioning
  • Apple’s market share has remained very stable, as it has focused on the top end of the market, prioritising price over volume
  • “Others”, also usually without a clear value proposition, have seen their share drop to just 36% from a peak of 46% in Q3 2016


China remains the world’s largest smartphone market, with 103 million phones sold in Q3. But its volume was down 8% compared to Q3 2017, as the stimulus programmes continue to slow. As the Counterpoint chart shows, the market is now consolidating around a few winners:

  • Huawei are emerging as the market leader with a 23% share
  • Vivo and Oppo remain key challengers at 21%
  • But “Others” have dropped to 13%, and Samsung has almost disappeared at just 1%

As Counterpoint note, the top 5 brands now hold 86% of the market:

“The Chinese smartphone market is saturated with accelerated market consolidation. The competition in 2018 is almost a zero-sum game for the top five players. It is challenging however, even for the leading brands to create clear product differentiation. In Q3, only Huawei and vivo managed to achieve positive YoY growth among the top 5 brands.”

Meanwhile, of course, Apple continue to dominate the premium segment after the launch of the new iPhones in September.

This divergence between low-cost and premium will no doubt spread across the rest of the global market as the downturn continues.  And the main growth is likely to be in the low-cost area.

India, for example, saw volume grew 5% versus Q3 2017.  But with average per capita income less than $2000, price is all-important.  Reliance Jio’s ultra-low pricing strategy has been critical in making bandwidth affordable, and there are now over 400 million smartphone users in the country.

But iPhone sales are actually falling, and will be down by a third to just 2 million this year.  Functional phones in the $150-$250 price segment are driving sales growth, via online sales.  Q4 is expected to see these grow 65% to reach 50 million, due to their 50%-60% discounts.


The smartphone market thus continues to confirm that the BabyBoomer-led SuperCycle is over. As the chart shows, this created a new and highly profitable mid-market from the mid-1980s:

  • Before then, companies had competed on the basis of price or perceived value
  • But from the mid-1980s onwards, the mid-market became the most profitable sector
  • Now, with the Boomers retiring and stimulus programmes ended, we are going back to basics again

Instead, the market is segmenting again on the basis of price or perceived value. Chinese players compete on price, while Apple focuses on profit and is moving up-market. this means that previously profitable market leaders such as Samsung are slowly disappearing along with the mid-market segment that they supplied.

These very different strategies highlight the new world ahead for consumer markets and those who supply them.

Financial crises and the five stages of loss

The Financial Times has kindly printed my letter as their lead letter, arguing that the rise of the populists emphasises the risk of continuing to deny the impact of today’s ageing populations on the economy.

Sir,  Martin Wolf’s sobering analysis of policymakers’ post-crisis decision to “go back to the past”, ( “Why so little has changed since the financial crash”, September 5), brings to mind the celebrated “Paradigm of Loss” model developed by Elizabeth Kübler-Ross. Originally designed to describe how people come to terms with loss and death, it has since been more widely applied, including to economic and financial market developments.

His description of the post-1918 period appears to be a classic example of the paradigm’s denial stage, with policymakers ignoring the economic impact of the earlier carnage. Young people are the prime source of future demand as they enter the wealth creator 25-54 age group, when people typically settle down, have children and develop their careers. The war cruelly destroyed the lives of millions of young men before they could realise this potential.

As the paradigm would suggest, this denial then led to anger, and the rise of fascism and communism. This proved so intense that the next stage, bargaining, was delayed until 1945, when the adoption of Keynes’s new thinking finally allowed the cycle to complete.

Today, we are again seeing a demand deficit created by demographic change. Thankfully, it is not due to war, but to the post-1945 increase in life expectancy and collapse in fertility rates. Inevitably, therefore, consumer spending — the motor of developed economies — is now slowing as we have an ageing population for the first time in history. Older people already own most of what they need, and their incomes decline as they retire.

Just as in 1918, this means we need new policies to create “a better future”, as Mr Wolf notes. In their absence, the rise of the populists suggests that we instead risk moving into a new anger phase. It is not yet too late for new thinking to emerge, but time is starting to run out.

Paul Hodges

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West faces “demographic deficit” as populations age

Rising life expectancy, and falling fertility rates, mean that a third of the Western population is now in the low spending 55-plus age group.  Given that consumer spending is around two-thirds of the economy in developed countries, the above charts provide critically important information on the prospects for economic growth.

They show official data for household spending in 3 of the major G7 economies in 2017 – the USA, Japan and the UK:

  • Each country reports on a slightly different basis in terms of age range and headings, but the basics are similar
  • US spending peaks in the 45 – 54 age group: Japanese spending peaks at age 55; UK spending peaks at age 50
  • After the age of 75, US spending falls 46% from its peak and UK spend falls 53%: after the age of 70, Japanese spending falls 34%

The data confirms the common sense conclusion that youthful populations create a potential demographic dividend in terms of economic growth.  Conversely, ageing populations have a demographic deficit and will see lower growth, as.older people already own most of what they need, and their incomes go down as they enter retirement.

The Western world has been, and still is, a classic case study for this demographic effect in action, as the second chart shows:

  • In 1950, only 16% of Westerners were in the New Old 55-plus age group; 39% were in the 25-54 age group that drives economic growth and wealth creation; and 45% were under 25 as the BabyBoom got underway
  • But by 2015, the percentage of New Olders had doubled to 31%, whilst the percentage of Wealth Creators was virtually unchanged at 41% and only 28% were under 25 (as fertility rates collapsed after 1970)

The Boomers were the largest and wealthiest generation that the world has ever seen, and as they joined the workforce they created an economic Super-Cycle. This was turbo-charged by the fact that, for the first time in history, Western women began to re-enter the workforce after childbirth:

  • In the US, for example, women’s participation rate nearly doubled from 34% in 1950 to a peak of 60% in 1999
  • And after the Equal Pay Act of 1963, their earnings rose to 62% of men’s by 1979 and to 81% by 2005 (since when it has flatlined)

But since 2001, the oldest Boomer, born in 1946, has been leaving the Wealth Creator age group.  By 2013, the average Boomer had left it.  And since 1970, Western fertility rates have been below replacement levels (2.1 babies/woman).  So the Western economy now faces a double squeeze:

  • The Boomers who created the SuperCycle are no longer making a major contribution to economic growth
  • The number of new Wealth Creators is now relatively smaller, due to the collapse of fertility rates

In the past, very few Boomers would have lived beyond retirement age, as the 3rd chart confirms based on UN Population Division data.  So, sadly, they would have been irrelevant in terms of economic growth.  But, wonderfully, this is no longer true today:

  • In 1950, average US life expectancy for men was just 66 years and 72 years for women.  UK men died at age 67, and women at age 72.  Japanese men died at age 61, and women at age 65
  • Today, US men are living an extra 11 years and women 9 years more.  UK men are living an extra 12 years and women 11 years more.  Japanese men are living an extra 19 years and women 22 years more
  • By 2030, the UN forecasts suggest US men will be living 20% longer than in 1950, and women 16% longer.  In the UK, men will be living 23% longer and women 18% longer.  In Japan, men will be living 35% longer, and women 37% longer

By 2030, 36% of the Western population will be New Olders, almost equal to the 37% who are Wealth Creators.

Clearly there is no going back to SuperCycle growth levels.  I will look at this critical issue in more detail next week.

 

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Older workers are looking for something more

The Financial Times has kindly printed my letter arguing that we need new policies to help people adapt to their extra decade or more life expectancy.

Sir, There is another angle to Janan Ganesh’s interesting exploration of whether “Liberals risk the charge of complacency” (February 20). This is the question of why the policy elite has failed to go beyond congratulating itself for the successes cited by Professor Steven Pinker in his new book, Enlightenment Now.

Increasing life expectancy is just one example of the policy vacuum that has developed following the vast improvements seen since the second world war. Globally, longevity has increased by 50% since 1950, giving the average person an extra 24 years of life, according to UN Population Division data. In the developed world, life expectancy no longer coincides with retirement age, but instead offers the potential for a decade or more of extra life.

Yet where are the policy changes that would help people to adapt to this unprecedented shift in expectations? Where are the retraining options for people in their fifties and sixties that would help employees take up new careers when they become bored with their existing roles, or physically unable to continue with them? Where are the social policies that would enable them to continue contributing to society? Where are the financial policies to incentivise them to pass on the skills and expertise they have developed to younger generations?

The issue is most acute in the developed world, where the proportion of older people in the 55-plus age range has doubled to 32% compared with 1950. As Mr Ganesh rightly points out, they are looking for something beyond simple economic comfort and the arrival of bus passes and fuel allowances. Liberals should perhaps not be so surprised that their failure to address this critical issue has left the door open for populists to fill the policy vacuum.

Paul Hodges

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