Oil markets are once again uneasily balanced between two completely different outcomes – and one again involves Iran.
Back in the summer of 2008, markets were dominated by the potential for an Israeli attack on Iranian nuclear facilities, as I summarised at the time:
“Nothing is certain in life, except death and taxes. But it is hard to see markets becoming less volatile until either an attack takes place, or a peaceful solution is confirmed. And with oil now around $150/bbl, two quite different outcomes seem possible:
• In the event of an Israeli attack, prices might well rise $50/bbl to reach $200/bbl, at least temporarily
• But if diplomacy works, they could easily fall $50/bbl to $100/bbl”
In the event, an attack was never launched and prices quickly fell back to $100/bbl – and then lower as the financial crisis began.
Today, Brent’s uneasy balance around $70/bbl reflects even more complex fears:
- One set of worries focuses on potential supply disruption from a war in the Middle East
- The other agonises over the US-China trade war and the rising risk of recession
It is, of course, possible that both fears could be realised if war did break out in the Gulf and oil prices then rose above $100/bbl.
The issue is highlighted in the Reuters chart on the left, which shows that Brent has moved from a contango of $1/bbl at the beginning of the year into a backwardation of nearly $4/bbl on the 6-month calendar spread. As they note:
“Backwardation is associated with periods of under-supply and falling inventories, while contango is associated with the opposite, so the current backwardation implies stocks are expected to fall sharply.”
But as the second Reuters chart confirms, traders are also aware that forecasts for oil demand are based on optimistic IMF forecasts for global growth. And recent hedge fund positioning confirms that caution may be starting to appear.
Traders are also aware of the key message from the above chart, which shows that periods when oil prices cost 3% of global GDP have almost always led to recession. The only exception was after the financial crisis when central banks were printing as much money as possible to boost liquidity.
The reason is that consumers only have a certain amount of discretionary income. If oil prices are low, then they have spare cash to buy the products and services that create economic growth. But if prices are high, their cash is instead spent on transport and heating/cooling costs, and so the economy slows.
“To govern is to choose” and President Trump therefore has some hard choices ahead:
- His trade war with China currently appeals to many voters, Democrat and Republican. But will that support continue as the costs bite? The New York Federal Reserve reported on Friday that the latest round of tariffs will cost the average American household $831/year
- Similarly, many voters favour taking a hard line with Iran. But average US gasoline prices are already $2.94/gal as the US driving season starts this weekend, and today’s high prices will particularly impact the President’s core blue collar and rural voters
History doesn’t repeat, but it often rhymes as the famous American writer, Mark Twain, noted. If the President now chooses to fight a trade war with China and a real war with Iran, then he risks losing popularity very quickly as the costs in terms of lives and cash become more apparent. Yet as we have seen since Lyndon Johnson’s time, this is usually something that politicians only learn after the event.
Investors and companies therefore have little to lose, and potentially much to gain, by accepting that we can only guess at how the two situations may play out. Developing a scenario approach that plans for all the possible outcomes – as in 2008 – is much the most prudent option.
There are few real surprises in life, and President Trump’s decision to launch a full-scale trade war with China wasn’t one of them. He had virtually promised to do this in his election campaign, as I noted here back in September 2015:
“The economic success of the BabyBoomer-led SuperCycle meant that politics as such took a back seat. People no longer needed to argue over “who got what” as there seemed to be plenty for everyone. But today, those happy days are receding into history – hence the growing arguments over inequality and relative income levels.
“Companies and investors have had little experience of how such debates can impact them in recent decades. They now need to move quickly up the learning curve. Political risk is becoming a major issue, as it was before the 1990s.”
Of course, I received major push-back for this view at the time, just as I did in 2007-8 when warning of a likely US subprime crisis. Most people found it very hard to believe that politics could trump economic logic, as one American commentator wrote in response to my analysis:
“I have a very, very, very difficult time imagining that populist movements could have significant traction in the U.S. Congress in passing legislation that would seriously affect companies and investors”.
But, sadly or not, depending on your political persuasion, my conclusion after the election result was known seems to have stood the test of time:
“You may, or may not, approve of President-elect Trump’s policies. You may, or may not, think that these policies are destined to fail. But they do confirm that the world is moving into a New Normal, which will inevitably create Winners and Losers.
“The Winners are likely to come from those who accept that President Trump will at least try to introduce the policies proposed by Candidate Trump. And the Losers will almost inevitably include those who continue to believe he represents “business as usual”.”
Now, of course, we will start to see these Winners and Losers appear, as there is little the Western central banks can do to counteract the economic cost for the global economy of a US-China trade war.
One sign of this was Uber’s miserable performance on its stock market debut – despite having been priced at the low end of the planned range, it still fell further on its opening, in line with my suggestion last month that Uber’s $91bn IPO marks the top for today’s debt-fuelled stock markets.
But there will be many more serious casualties over the next few months and years:
- NE Asian countries such as Japan and S Korea are part of global supply chains which send a wide range of components to China, where they are incorporated into finished goods for sale to the USA
- Germany and the major European countries have relied on sales to China to boost economic growth, as domestic demand has stagnated, and clearly this support is now going to weaken
- The mining industry and other suppliers of commodities will also be hit – Rio Tinto, for example, depends on China for 45% of its revenue, and on the USA for 15%
- The petrochemicals industry has been dependent on China for its growth since the 2008 financial crisis, as I noted last summer, US-China tariffs could lead to global Polyethylene price war
Back in 2011-12, John Richardson and I wrote ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’ to give our view of the likely consequences of the major demographic changes underway in the global economy.
Unfortunately, the politicians of the time took the seemingly easy route out of the crisis. They decided that printing money was so much easier than having a dialogue with the electorate about the implications of ageing populations, or the fact that Western fertility rates have been below replacement levels for the past 45 years. Our warning is now coming true:
“The transition to the New Normal will be a difficult time. The world will be less comfortable and less assured for many millions of Westerners. The wider population will find itself following the model of the ageing boomers, consuming less and saving more. Rather than expecting their assets to grow magically in value every year, they may find themselves struggling to pay-down debt left over from the credit binge.
“Companies will need to refocus their creativity and resources on real needs. This will require a renewed focus on basic research. Industry and public service, rather than finance, will need to become the destination of choice for talented people, if the challenges posed by the megatrends are to be solved. Politicians with real vision will need to explain to voters that they can no longer expect all their wants to be met via endless ‘fixes’ of increased debt.
“We could instead decide to ignore all of this potential unpleasantness.
“But doing nothing is not a solution. It will mean we miss the opportunity to create a new wave of global growth from the megatrends. And we will instead end up with even more uncomfortable outcomes.“
Thank goodness for backbench MPs and the European Union. Without their efforts, the UK would by now have left the EU without any trade deals, or ongoing relationship with it’s biggest export market. And as the Duke of Wellington said in another context, “It was a damn close-run thing”:
- In a historic vote, MPs decided by just 1 vote to force the government to ask for a longer extension
- The EU Council argued into the night on its response, but decided to give the UK “a second chance”
The problem was well expressed in a tweet by former Brexit Secretary, David Davis, on Friday morning:
His tweet completely ignored the views of all the main business organisations and trade unions, who had spent weeks trying to point out that issuing government statements and Guidance Notes was not the same as actually being prepared, as The Guardian noted:
“Frances O’Grady, the general secretary of the TUC, and Carolyn Fairbairn, the CBI’s director-general, wrote last month before the crunch EU summit in Brussels: “Our country is facing a national emergency. Decisions of recent days have caused the risk of No Deal to soar. Firms and communities across the UK are not ready for this outcome. The shock to our economy would be felt by generations to come.””
On Friday, confirming their lack of understanding of business needs – and against the advice of senior civil servants – ministers decided to completely stand down No Deal preparations. Yet as the independent Institute for Government have warned:
“Despite the delay, a No Deal exit is still very much on the table, either on 31 May or 31 October… Businesses and the public should not be left to read between the lines of individual departmental press notices.”
It is therefore critical that UK and EU27 businesses now take the opportunity of the extension to understand and prepare for the changes that will affect them if the UK does leave the EU. For all the talk of a new referendum, this is still the law of the land.
Our surveys at Ready for Brexit have consistently shown that 80% of small businesses weren’t ready for Brexit. Some had stockpiled some essential goods, but only around one fifth had actually thought through a detailed plan. As a result, many people have had sleepless nights in recent weeks as they realised the UK might well be leaving with No Deal.
Now that the UK has an extension, it is time to stop panicking and start preparing. None of us can afford to be complacent – No Deal remains the default position and businesses need to know how Brexit will affect them in key areas for their future:
- Customs, Tariffs and Regulations. No one has needed to fill out Customs Declarations for EU trade for 25 years. HMRC has warned that following Brexit, businesses may need to make 400 million Customs Declarations at an expected cost of £32.50 each. Compliance with Rules of Origin could easily cost more, if legal advice is needed. Companies need to identify how Customs and Regulatory requirements could impact their business and plan to put the correct procedures in place
- Supply Chains. Will your business be affected by interruptions in supply chains following Brexit? You need to audit your supply chain partners to identify potential weak links. It only takes one missing item to shut down a production line. And think about what may happen to your cash flow if forecast delays take place at the ports
- Sales Agreements. Do you have Material Change clauses in your commercial contracts? You need to check out key areas such as your ability to pass on the costs of tariffs, customs delays and exchange rate movements, as well as the impact of possible regulatory changes. Governing contract law also needs checking as the UK will no longer be a member of the EU
- Employment. You need to understand how the status of UK-employed EU citizens may change and check out the position of UK staff working temporarily or permanently in EU countries. Don’t forget basic areas such as whether professional qualifications obtained in the UK will still be valid in the EU after Brexit, and the possible need for international driving licences
We have all had a lucky escape in the past few days. But we can’t rely on our luck holding. Planning now for whatever may happen in the next few months may well save you months of heartache later on.
This is why, with some highly experienced colleagues, I helped set up Ready for Brexit. As I wrote here in June:
“We are particularly concerned that many small and medium-sized businesses (SMEs) – the backbone of the European economy – are failing to plan ahead for Brexit’s potential impact.”
We can all hope that politicians now step back, and work together to avoid the disaster of a No Deal at the end of May or October.
But hope is not a strategy – particularly when the future of your business may be at stake. If you need detailed help in the form of Brexit Checklists and planning tools, they are all there on the Ready for Brexit site.
More people left poverty in the past 70 years than in the whole of history, thanks to the BabyBoomer-led economic SuperCycle. World Bank and OECD data show that less than 10% of the world’s population now live below the extreme poverty line of $1.90/day, compared to 55% in 1950.
Globalisation has been a key element in enabling this progress, as countries and regions began to trade with each other. But now global trade is starting to decline, as the chart from the authoritative Dutch World Trade Monitor shows:
- After a good start to 2018, February saw trade fall 0.7% in February and 1.2% in March
- The major slowdown was in Asia, particularly China, as its lending began to slow
And then on Friday, President Trump confirmed the opening of his long-planned trade wars:
- He imposed 25% import tariffs on steel and 10% on aluminium from Canada, Mexico and the European Union
- Similar tariffs were already in place on imports from China, Russia and other countries
- America’s longest standing allies have since imposed their own sanctions in retaliation
- The stage is now set for a developing global trade war as more countries join in
PRESIDENT TRUMP IS IMPLEMENTING THE POLICIES ON WHICH HE WAS ELECTED
None of this should have been a surprise, as it simply follows the agenda that President Trump set out in his Gettysburg speech just before the election. His policy proposals then, which I featured here in depth in January 2017, were crystal clear about his objectives, as the slide shows:
- Those policies marked in red are now being introduced
- Only 2 of them – around China being a currency manipulator, and infrastructure – are still to be delivered
- Yet companies, commentators and analysts have preferred to ignore the obvious
It was clear then, and is even clearer today, that Trump intends to abandon the policies followed by all post-War Republican and Democratic presidents including Eisenhower, Reagan and Clinton, and summarised in President Kennedy’s 1961 Inauguration Speech:
“To those old allies whose cultural and spiritual origins we share, we pledge the loyalty of faithful friends. United there is little we cannot do in a host of cooperative ventures. Divided there is little we can do–for we dare not meet a powerful challenge at odds and split asunder.”
As I noted after Trump’s own Inauguration Speech in January last year, he broke very explicitly with these policies:
“We assembled here today are issuing a new decree to be heard in every city in every foreign capital and in every hall of power. From this day forward, a new vision will govern our land. From this day forward, it’s going to be only America first, America first. Every decision on trade, on taxes, on immigration, on foreign affairs will be made to benefit American workers and American families.”
BAD NEWS HAS ALWAYS LED TO MORE STIMULUS IN THE PAST
Unsurprisingly, financial markets have chosen to ignore this rise in protectionism. For them, bad news is always good news, as they expect the central banks to provide more stimulus via their money-printing policies. As the left-hand chart shows of Prof Robert Shiller’s CAPE Index (Cyclically Adjusted Price/Earnings ratio) since 1881:
- When Trump took office, the ratio was already at 28.5 – above the 1901 and 1966 peaks
- Since then it has peaked at 33.3, above the 1929 peak
- Only 2000 was higher at 44, when the end of the SuperCycle coincided with the Fed’s first liquidity programme to prevent any problems with the Y2K issue
The right-hand chart confirms the bubble nature of the rally:
- It compares S&P 500 developments with the level of margin debt in the New York Stock Exchange
- Until 1985, the Fed operated on the principle of “taking away the punchbowl as the party gets going“
- Since then, it has increasingly believed, as then Fed Chairman Ben Bernanke said in November 2010
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
As a result, the S&P 500 has risen along with margin debt, which peaked at $659bn in January ($2018).
FINANCIAL MARKETS HAVE AN UNPLEASANT “SURPRISE” AHEAD AS CHINA SLOWS
It is therefore no great surprise that financial markets have continued to ignore developments in the real world.
Yet a decline in world trade, and the rise in protectionism, will inevitably produce Winners and Losers. This will be quite different from the SuperCycle, when the rise of globalisation created “win-win opportunities” for countries and regions:
- Essentially the deal was that consumers in richer countries got cheaper, well-made, products
- People in poorer countries gained paid employment for the first time in history by making these products
History also suggests President Trump will be proved wrong with his March suggestion that: “Trade wars are good and easy to win”. Like all wars, they are easy to start and increasingly difficult to end.
So far, financial markets have ignored these uncomfortable facts. They still believe that any bad news will lead to even more central bank stimulus, and a further rise in margin debt.
But as I noted last week, China – not the Fed – was in fact the major source of stimulus lending. Now its lending bubble is history, the party in financial markets is inevitably entering its end-game.
The post Financial markets party as global trade wars begin appeared first on Chemicals & The Economy.
“Consensus wisdom” is a handy way of keeping up with events. Nobody likes to be the person who says “I don’t know” when the boss asks a question about something important. But unfortunately, “consensus wisdom” is often wrong, as Ipsos MORI confirm in their new ’Perils of Perception‘ survey, As the authors note:
“It highlights how wrong the public across 40 countries are about key global issues and features of the population in their country.”
The chart above highlights one of the key results, which has major implications for companies and investors:
It shows the actual percentage of wealth owned by the poorest 70% of the population in each country
It also shows people’s perception of the percentage owned by this poorest 70%
Only 3 countries have an accurate perception – the UK, Australia and Belgium
India is the most inaccurate, with a 29 point gap between perception and actual
Other major countries are nearly as bad – the US has a 21 point gap, Russia and China have a 17 point gap, Brazil and Germany have a 15 point gap
As Ipsos MORI note, the problem is that middle class people usually think:
“The rest of the population is more like them, than they really are….On average, just 15% of total wealth is owned by the bottom 70% across these countries – but the average guess is almost twice that at 29%. (My emphasis)
“Some countries are incredibly inaccurate: Indians think this group owns 39% of the country’s wealth when actually only 10% do. The US is also significantly out: Americans think the bottom 70% own 28% of the country’s wealth, when it’s actually a quarter of that at 7%.
The Ipsos data helps to explain why companies and investors are often wildly over-optimistic when planning new investments. This has become a major problem in the Emerging Markets (EMs), where many senior executives have assumed after visiting the chosen country that vast numbers of people are becoming “middle class”:
They stay in good hotels, company-chosen for safety and service, with other guests from similar backgrounds
Their local colleagues and partners are usually middle class and suffer from the over-optimism recorded by the polls
They rarely visit areas where most people live, as colleagues and the hotel often tell them these are “too dangerous”
The past few years of high profile stimulus policies has only added to the confusion.
Most visitors were immediately impressed to find an expensive new airport when they landed. They were similarly upbeat to find shopping malls filled with western luxury goods. Naturally, they assumed this meant the economy was booming. And, of course, the major international banks were happy to supply them with imaginative and glossy reports on the country’s potential, in the hope of winning lucrative project work.
In reality, however, they have been fooled. This appearance of “middle class living” was financed by debt, not wages:
Average GDP/capita in the world is just $10k according to the IMF
Wealthy G7 countries such as the US are at $56k, with the UK at $44k, Germany at $41k and France at $38k
The EMs are very much poorer, and will take decades to catch up, even if they continue to do well
Russia is the richest BRIC country at $9.2k, followed by Brazil at $8.7k, China at $8.1k and India at just $1600
The end result, unfortunately, is that many companies have effectively been wearing rose-tinted spectacles when making investment decisions. They now face a very difficult time as these plants all start to come online.
President-elect Donald Trump has made it clear he will impose tariff barriers to force US manufacturers to reshore production back to the US. In turn, many EMs will no doubt put up trade barriers to protect their own industry. Supply chains will be hit from two angles at once. Not only will imports from the EMs reduce, but exports to the EMs will also decline:
Ford’s decision this week to abandon its planned $1.6bn Mexican investment is a clear sign of what is to come
They were at least able to cancel. If it had already been built, it would probably now become a “white elephant”.
Unfortunately, this creates a further problem for “consensus wisdom”. Much of what appeared to be true during the SuperCycle is no longer correct. As I noted on Monday, economic criteria are no longer the key to future profitability.
The next 12 months are therefore likely to see more change than we have seen in the past 20 years. Companies and investors that fail to quickly realign their perceptions with reality will risk finding life very difficult indeed.