Every New Year starts with optimism about the global economy. But as Stanley Fischer, then vice chair of the US Federal Reserve, noted back in August 2014:
“Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back.”
Will 2018 be any different? Once again, the IMF and other forecasters have been lining up to tell us the long-awaited “synchronised global recovery” is now underway. But at the same, they say they are puzzled that the US$ is so weak. As the Financial Times headline asked:
“Has the US dollar stopped making sense?”
If the global economy was really getting stronger, then the US$ would normally be rising, not falling. So could it be that the economy is not, actually, seeing the promised recovery?
OIL/COMMODITY PRICE INVENTORY BUILD HAS FOOLED THE EXPERTS, AGAIN
It isn’t hard to discover why the experts have been fooled. Since June, we have been seeing the usual rise in “apparent demand” that always accompanies major commodity price rises. Oil, after all, has already risen by 60%.
Contrary to economic theory, companies down the value chains always build inventory in advance of potential price rises. Typically, this adds about 10% to real demand, equal to an extra month in the year. Then, when the rally ends, companies destock again and “apparent demand” weakens again.
The two charts above confirm that the rally had nothing to do with a rise in “real demand”:
Their buying has powered the rise in oil prices, based on the free cash being handed out by the central banks, particularly in Europe and Japan, as part of their stimulus programmes.
They weren’t only buying oil, of course. Most major commodities have also rallied. Oil was particularly dramatic, however, as the funds had held record short positions till June. Once they began to bet on a rally instead, prices had nowhere to go but up. 1.4bn barrels represents as astonishing 15 days of global oil demand, after all.
What has this to do with the US$, you might ask? The answer is simply that hedge funds, as the name implies, like to go long in one market whilst going short on another. And one of their favourite trades is going long (or short) on oil and commodities, whilst doing the opposite on the US$:
- Since June, they have been happily going long on commodities
- And as Reuters reports, they have also been opening major short positions on the dollar
The chart highlights the result, showing how the US$’s fall began just as oil/commodity prices began to rise.
COMPANIES HAVE NO CHOICE BUT TO BUILD INVENTORY WHEN COMMODITY PRICES RISE
This pattern has been going on for a long time. But I have met very few economists or central bankers who recognise it. They instead argue that markets are always efficient, as one professor told me recently:
“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”
But if you were a purchasing manager in the real world, you wouldn’t be sceptical at all. You would see prices rising for your key raw materials, and you would ask your CFO for some extra cash to build more inventory. You would know that a rising oil, or iron, or other commodity price will soon push up the prices for your products.
And your CFO would agree, as would the CFOs of all the companies that you supply down the value chain.
So for the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford. In turn, of course, this has made it appear that demand has suddenly begun to recover. At last, it seems, the “synchronised global recovery” has arrived.
Except, of course, that it hasn’t. The hedge funds didn’t buy 15 days-worth of oil to use it. They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.
THE RISE IN COMMODITY PRICES, AND “APPARENT DEMAND”, IS LIKELY COMING TO AN END
What happens next is, of course, the critical issue. As we suggested in this month’s pH Report:
“This phenomenon of customers buying forward in advance of oil-price rises goes back to the first Arab Oil Crisis in 1973 – 1974. And yet every time it happens, the industry persuades itself “this time is different”, and that consumers are indeed simply buying to fill real demand. With Brent prices having nearly reached our $75/bbl target, we fear reality will dawn once again when prices stop rising.”
Forecasting, as the humorist Mark Twain noted, “is difficult, particularly about the future”. But hedge funds aren’t known for being long-term players. And with refinery maintenance season coming up in March, when oil demand takes a seasonal dip, it would be no surprise if they start to sell off some of their 1.4bn barrels.
No doubt many will also go short again, whilst going long the US$, as they did up to June.
In turn, “apparent demand” will then go into a decline as companies destock all down the value chain, and the US$ will rally again. By Q3, current optimism over the “synchronised global recovery” will have disappeared. And Stanley Fischer’s insight will have been proved right, once again.
The post The global economy and the US$ – an alternative view appeared first on Chemicals & The Economy.
Corporate debt in the Emerging Markets highlights the impact of the Great Reckoning, with the US dollar and interest rates rising, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Corporate borrowers in Emerging Markets (EMs) are now facing higher debt service and capital repayment costs, due to the combined impact of dollar strength and rising benchmark US 10-year interest rates. In turn, this risks creating a vicious circle for growth. The latest data from the Bank for International Settlements (BIS) suggest the EMs’ dollar-denominated debt doubled to $3.2tn between 2009 and March 2016. As the IMF has warned:
“China urgently needs to tackle its corporate-debt problem before it becomes a major drag on growth.”
The BIS identified the underlying issue: “Massive capital flows from advanced economies have contributed to accommodative liquidity conditions in a number of Asian EMs. To the extent that this has led to a region-wide accumulation of imbalances, the eventual correction in one country would likely trigger investor retrenchment from its neighbours and test the region’s loss-absorbing capacity.”
We are probably still at a relatively early stage in the process, as the chart highlights for the four Bric economies.
China, with foreign currency borrowings of $1.2tn in Q3 last year seems most at risk initially, as more than half of its debt is thought to be US dollar-denominated. Pressure is already building as the renminbi has fallen by 7 per cent since last March, and domestic interest rates have risen by more than a fifth since Q3. The problems are likely to prove complex to unwind, given that the government has reached the end of the road with its initial response, which was to use its forex reserves to support the renminbi and reduce interest rate pressure. Its reserves have now fallen by a quarter to $3tn since their June 2014 peak, and are approaching the $2.6tn level which is thought to be the minimum required for day-to-day operation of the economy.
Since the New Year, it has therefore adopted a new strategy of further restricting capital outflows and hiking short-term interest rates to deter currency speculators. This highlights that its key issue is now the age-old challenge of managing the so-called ‘Impossible Trinity’, which says it is impossible to maintain a stable exchange rate, free capital movements and an independent monetary policy at the same time.
Unfortunately for Beijing, this challenge is being intensified by Donald Trump’s election victory, given his desire to label China a currency-manipulator – even though there is little evidence to support the accusation. Perception matters more than reality in today’s febrile political environment and clearly the government feels obliged to try and defend the Rmb7:$1 level, ahead of Trump’s January 20 inauguration. But the tools it is using, such as overnight interest rates of 60 per cent plus, as seen early this month, can’t be maintained forever. History suggests they normally only defer the inevitable by further slowing the economy.
India also seems to be moving into the firing line. Its currency is flashing warning signs, having fallen 3 per cent versus the dollar since November, while its domestic interest rates have risen by 3 per cent. The catalyst seems to have been the shock of premier Modi’s demonetisation programme. In theory, this should have led to lower interest rates, given that the amount of cash in circulation has fallen by more than half since November. So it may well be that markets are giving advance warning that investors may need to mark down growth prospects more dramatically, given the impact of the continuing cash shortages across the country.
Brazil and Russia have so far been less impacted by these developments. Brazil’s currency has fallen 3 per cent versus the dollar since October, and Russia’s interest rates have risen by 2 per cent since September. But Brazil’s interest rates have fallen back again after an initial rise, and Russia’s exchange rate has actually strengthened due to hopes that oil prices might stabilise following its agreement with OPEC to cut output.
Unfortunately, as the second chart confirms, the latest trends in chemical production suggest the problems are now set to intensify. As discussed in November, the chemical industry is the best leading indicator that we have for global and national economies. The data strongly suggests that a downturn is already underway in China, Russia and India, while Brazil remains close to recession. If confirmed, this will further weaken currencies. It may also create the potential for interest rates to push higher, as rising levels of default cause foreign lenders to worry about return of capital.
We also cannot ignore the potential for second-order impacts, which tend to become more significant as downturns deepen. In oil markets, for example, OPEC is relying on continued strong demand from India and China to help rebalance global supply and demand. If their demand disappoints, even-deeper output cuts would be required, and these would likely be extremely hard to achieve. The same dynamics also, of course, apply to other commodity markets where supply and inventories are already ahead of demand.
Developments in Bric currency and interest rate markets therefore need close attention in coming months, as they may well provide further evidence for our suggestion here in August that the Great Reckoning for stimulus policy failures is now underway.
Paul Hodges publishes The pH Report, providing investors and companies with insight on the impact of demographic changes on the economy.
Last year it was the oil price fall. This year, there is no doubt that the US dollar has taken centre stage, alongside the major rise underway in benchmark 10-year interest rates. As 2016′s Chart of the Year shows:
The US$ Index (black) has risen 12% since May against other major currencies (euro, yen, pound, Canadian dollar, Swiss franc, Swedish krona), and is now at its highest level since 2003
Benchmark 10-year US interest rates (red) have almost doubled from 1.4% in July to 2.6% today. They are back to 2013-4 levels, when the Fed proposed “tapering” its stimulus policy
Clearly something quite dramatic is now underway.
In currency markets, investors are voting with their feet. It is hard to see much upside in the European, Japanese or Canadian economies in the next 12 – 18 months. Europe is going to be gripped by the unfolding crisis over the future of the euro and the EU itself, as it moves through elections in The Netherlands, France, Germany and probably Italy. By March, the UK will be on the Brexit path, and will leave the EU within 2 years. Japan is equally unattractive following the failure of Abenomics, whilst Canada’s reliance on commodity exports makes it very vulnerable to the downturn underway in the BRICs (Brazil, Russia, India, China).
Investors are also waking up to the uncomfortable fact that much of today’s borrowed money can never be repaid. McKinsey estimated global debt at $199tn and 3x global GDP at the start of 2015, and the total is even higher today.
As I warned a year ago in “World faces wave of epic debt defaults” – central bank veteran), there is no easy route to rescheduling or forgiving all this debt. Importantly, central banks are now starting to lose control of interest rates. They can no longer overcome the fundamentals of supply and demand by printing vast amounts of stimulus money.
This is the Great Reckoning for the failure of stimulus policies in action.
THE RISES WILL CREATE “UNEXPECTED CONSEQUENCES” FOR COMPANIES AND INVESTORS
These moves are critically important in themselves as the dollar is the world’s reserve currency, and US interest rates are its “risk-free” rates. Unsurprisingly, interest rates are already now rising in all the other ‘Top 15′ major economies – China, Japan, Germany, UK, France, India, Italy, Brazil, Canada, S Korea, Russia, Australia, Spain, Mexico. Together, these countries total 80% of the global economy.
The rises are also starting to create unexpected “second order impacts”. For example, many companies in the emerging economies have large US$ loans, which appeared to offer a cheaper interest rate than in their home country. Suddenly, they are finding that the cost of repayment has begun to rise quite rapidly.
This happens in almost every financial crisis:
People become excited by the short-term cost of borrowing – “Its so cheap, just $xxx/month”
They totally forget about the cost of repaying the capital -”I never thought the dollar would get that strong”
There were $9tn of these loans last year, according to the Bank for International Settlements. Many were to weak companies who are likely to default if the dollar keeps rising along with US interest rates.
In turn, these defaults will also have unexpected consequences. Lenders will suffer losses, and will be less able to lend even to stronger companies. Higher borrowing costs will force consumers to cut back their spending. This risks creating a vicious circle as corporate interest costs rise whilst revenues fall.
China is the obvious “canary in the coalmine” signalling that major problems lie ahead.
The Wall Street Journal chart shows 10-year rates have risen despite central bank support
Its total debt is around $27tn, or 2.6x its GDP, due to housing bubble and other speculation
The central bank now has to sell its US Treasury holdings to support the domestic economy
In turn, of course, this pushes US rates higher, as rates move inversely to bond prices
China used to hold around 10% of US debt, and was the largest foreign holder. Japan holds similar amounts, and is also stepping back from purchases due to the growing exchange rate volatility.
Nobody else has the financial firepower to take their place. The only possible replacements – Saudi Arabia and the Gulf countries – have seen their incomes fall with the oil price, whilst their domestic spending has been rising. This means interest rates and the US$ are likely to carry on rising.
Higher rates will further weaken the US economy itself, particularly if President Trump launches his expected trade war. In the important auto market, GM has just announced production cutbacks next month due to falling sales, despite the industry having raised incentives by 21% to nearly $4k/car. GM’s inventories are now 25% higher than normal at 86 days versus 69 days a year ago. Housing starts fell 7% last month, as mortgage rates began to rise.
And then there is India, the world’s 7th largest economy and a leading oil importer. Its rates are now rising as shocked investors suddenly realise recession is a real possibility, if the currency reform problems are not quickly resolved.
These risks are serious enough. But they are very worrying today, due to the steep learning curve that lies ahead of all those who began work after the start of the Boomer-led SuperCycle in 1983.
They assume that “recessions” are rare and last only a few months as central banks always rescue the economy.
Only those who can remember before the SuperCycle know that markets and companies should have long ago taken fright as these risks began to develop
This is why the rise in the US$ Index and US 10-year exchange rates is 2016′s Chart of the Year.
Thank goodness for Janet Yellen, and China’s provincial governments. That was clearly investors’ thoughts, when they bid up chemical company share prices during Q1. For as the chart above shows, there was nothing in the fundamentals of supply and demand to suggest economic recovery was finally underway. Instead, the latest American Chemistry Council data shows that global capacity utilisation fell to 80.1% in March – a new low for the current cycle.
However, the US Federal Reserve’s sudden “discovery” in early Q1 that the US economy wasn’t recovering as expected – Q1 GDP was just 0.5% and inflation only 0.1% – led investors to assume interest rates were unlikely to rise during 2016 as the Fed had promised:
- Instead, they sold the US dollar and bought commodities such as oil
- This repeated the “store of value” trade that proved so profitable until mid-2014
- And China’s panicking provincial governments stoked the rally even further
- Their lending soared to otherwise-bankrupt companies, as they battled Beijing’s efforts to restructure the economy
Oil prices thus repeated the 50%+ rally seen this time last year, causing downstream companies to panic and restock heavily. This was very good news for chemical company profits, and for investors’ share/debt portfolios. But as my quarterly summary of company results shows below, company managements were more realistic about the outlook.
Some product areas, such as polyolefins, did very well. And US company earnings were boosted by the temporary rise in the cost advantage of their gas-based feedstock. But many companies reported customer resistance to rising prices, suggesting volume was being driven by the restocking phenomenon rather than underlying demand growth.
Those companies such as Arkema who have embarked on long-term portfolio transformation efforts may well prove to be the real Winners over time, once markets recover from their excitement over the dollar’s weakness.
Arkema. “Internal momentum sustained by transforming investments which continue to ramp up”
Asahi Kasei. “Decreased prices of petrochemical products”
Air Products. “Economic conditions in the quarter “challenging”, weak manufacturing environment”
Axiall. “Worsening conditions for chlorvinyls operations”
BASF. “Lower selling prices to customers as the decline in raw material prices filtered through”
Borealis. “Very strong margins in the polyolefins business”
Braskem. “Resin consumption in Brazil during the quarter declined 18% compared with the same period last year”
Chemours. “We realized over $40m of transformation plan savings”
Clariant. “Increasingly challenging economic environment”
Covestro. “Positive effect of lower raw material prices, which outweighed the impact of lower selling prices and volumes”
Dow. “Record Q1 for polyethylene sales, driven by demand from North America and Asia Pacific”
Eastman. “Drop in chemical intermediates”
Evonik. “All divisions posted falling revenue apart from Resource Efficiency”
ExxonMobil. “Capturing increased specialty and commodity product demand along with significant cost benefits from both gas and liquids cracking advantages at our integrated sites.”
Hexion. “Selling prices were lower because of declines in prices for oil-based feedstocks”
Honeywell. “We will be be cautious in our sales planning, plan costs and spending conservatively”
Huntsman. “Lower cost of goods sold”
Kronos. “Average Q1 sales prices for TiO2 declined by 14% year on year”
LG Chem. “Improved margins at its petrochemicals business”
Lanxess. “Improved margins offset the decline in sales”
LyondellBasell. “A challenging environment for the rest of the year on the back of further maintenances as well as repairs”
Mexichem. “Difficult industry conditions”
Mitsui. “Prospects for demand growth in the chemical industry remains unclear due to the volatility of naphtha prices and exchange rates”
MOL. “Strong petrochemical margins”
OMV. “Strong polyolefin margins and an improved contribution from the base chemicals business”
PKN Orlen. “Expects downstream margins to weaken due to lower cracks on diesel and petrochemical products”
Phillips 66. “Weaker margins impacted our financial results in the first quarter”
PPG. “Higher volumes and cost control measures”
PTT. “Shutdown of a cracker and lower refining spreads”
Petronas. “Moving forward, the outlook for 2016 remains soft”
Praxair. “Volume headwinds primarily in the energy, metals and manufacturing end-markets”
Reliance. “Strong polymers demand and higher volumes in the polyester chain”
Shell. “Lower base chemicals margins in the US and sales volumes”
Repsol. “Higher petrochemical sales volumes”
Sherwin Williams.”Higher volumes driven by agricultural coatings demand”
Solvay. “Growth in 2016 will be “back-ended” compared to the “strong” first half of 2015″
Trinseo. “Lower raw material costs, unfavourable exchange rates and lower European sales in polystyrene”
Tronox. “Believe Q1 marked the turning point in the long decline in TiO2 pigment selling prices”
Unipetrol. “Petrochemical business was significantly affected by the shutdown of the cracker unit”
Univar. “Lower demand from the oil and gas market”
Vopak. “Sound market fundamentals for storage demand and infrastructure services”
Wacker. ““Low price levels for semiconductor wafers and solar silicon”
Westlake. “Lower selling prices for most key product lines”
The last 10 days have seen turmoil in major currency markets:
- The Swiss National Bank gave up trying to devalue versus the euro, and the franc jumped 30% in minutes
- The European Central Bank (ECB) launched its €1tn Quantitative Easing (QE) programme, causing an immediate 3% fall in the euro’s value versus the dollar
These are major moves by any historical standard, and highlight how earlier ‘currency wars’ have broadened in scale.
Their origin was in 2009, when the US Federal Reserve launched its first QE programme. One of its key impacts (whether intentional or otherwise) was to devalue the US$ – thereby supporting export growth and the US economy. By 2011, after the Fed’s QE2 programme, the US$ Index was down 19% as the chart shows.
But then the Bank of Japan launched its own QE programme. And in October last year, when the US$ Index seemed likely to fall again, it launched its QE2 programme. Last Thursday, the ECB began its own QE programme, effectively joining the war on Japan’s side.
Japan and Europe have ageing populations and so cannot generate domestic growth. By weakening the currency, the ECB and Bank of Japan expect to compensate for this by generating growth in export markets. In turn, however, these competitive devaluations create major risks for the global economy, as the greatest central banker of modern times, Paul Volcker, has explained:
“Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. I think it gets dangerous when they lose sight of the basic function of the central bank. The key issue concerns what this “function” should be. The basic function of a central bank is to defend the value of the currency,” he insists, as his highly successful experience in the 1980s “taught him how limited a central banker’s powers really are”.
CHINA HAS ABANDONED STIMULUS FOR A ‘NEW NORMAL’ APPROACH
The problem is that currency wars are a zero-sum game. Today, Japan and the Eurozone are winning at the expense of the USA and Switzerland. Thus the US$ Index has broken out of a 30-year downtrend, and is at an 11-year high.
Effectively, though, this means that 2 of the world’s 4 largest economies are effectively waging a currency war against the largest economy, the USA, as well as against Switzerland. This cannot end well.
Within a few weeks, the Fed will find that the US recovery is suddenly weakening again:
- The collapse of the shale gas/oil bubble means US jobs growth will soon reverse, and housing starts slow
- US companies will lose market share in export markets as Japan and Europe become more competitive
- The rise in the value of the US$ will also help to ensure that the US slips into deflation.
- And so the Cycle of Deflation will likely move forward another stage, towards protectionism and tariffs
Of course, there is another way forward, which avoids this zero-sum game.
China’s new leadership realised 2 years ago that its previous policies had been a complete mistake. It has since adopted ‘New Normal’ policies, based on an acceptance that ageing populations inevitably lead to lower economic growth. As Zhou Xiaochuan, governor of the People’s Bank of China, told the World Economic Forum in Davos last week:
“If China’s economy slows down a bit, but meanwhile is more sustainable for the medium and long-term, I think that’s good news”
Unfortunately, very few of his peers seem to be listening to his common sense message.
WEEKLY MARKET ROUND-UP
The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 57%. “Current market fundamentals do not support any significant upturn on benzene pricing”
Brent crude oil, down 53%
Naphtha Europe, down 53%. “Buying appetite in downstream petrochemical markets is thin as polyethylene players wait for the February ethylene contract to settle”
PTA China, down 44%. ”Buyers were mostly purchasing on a need-to basis, adding that the market outlook remains uncertain”
¥:$, down 15%
HDPE US export, down 23%. “Most domestic export prices continued to slip on lower ethylene and energy market values”
S&P 500 stock market index, up 5%
The Great Unwinding of policymakers’ failed stimulus programmes is now clearly underway in the global economy. The headlines this week all focused on the latest International Monetary Fund (IMF) report:
“IMF says economic growth may never return to pre-crisis levels.”
And then, in response, the US Federal Reserve suddenly realised that the US economy was not as strong as it had hoped. As the Wall Street Journal headlined yesterday:
“Federal Reserve officials have become more concerned that weak overseas growth and a strengthening U.S. dollar will crimp the domestic economy and hold down inflation, an outlook that has made them more inclined to stick to low interest rates.”
This confirms the blog’s suggestion back in August, when it highlighted the start of the Great Unwinding:
“Recent speeches by the new Fed Chairman, Janet Yellen, have been equivocal at best, suggesting she is not clear about the best policy to adopt. There is also the fact that to some extent, events are moving out of central bank control”
Market action in the US Dow Jones Industrials Index confirms the volatility that is now developing:
- The Dow fell 1.4% on 1 October, before jumping 1.2% last Friday
- It then fell 1.6% on Tuesday this week, before jumping 1.6% on Wednesday
- Yesterday it fell 2%, leaving it down 3.6% since its peak at the time of the Alibaba float last month
Meanwhile Brent oil has fallen $24/bbl since its late June peak. And no, that isn’t a typo. Brent traded at $114/bbl between June 19 – June 23, and closed last night at $90/bbl. The US$ has been equally volatile:
- Against the Japanese yen it has risen from $1 : ¥101 in early August, to $1: ¥108 last night
- Against the euro it has risen from $1 : €0.71 in early May, to $1 :€0.79 last night
These are enormous moves in such as short space of time, and will be extremely destabilising for the global economy. Very soon, no doubt, the IMF will have to revise down its estimate for global growth for a 4th time this year.
THE OUTLOOK REMAINS VERY SCARY
The reason for this drama goes back to the legacy of the failed stimulus policies seen since 2008. They created a tidal wave of liquidity which destroyed the ability of markets to undertake their key role of price discovery:
- Markets completely lost touch with the reality of supply/demand as a result of this liquidity
- But now, supply and demand balances are starting to matter greatly as the stimulus policies come to an end.
The blog developed its original analysis of the Great Unwinding in 5 posts during August – September. Very clearly the risks that it then identified are now coming true.
In response to many requests, it has now combined these posts into a special Research Note. Please click here to download a copy. And do please feel free to circulate it to your colleagues and business partners for discussion.
Next week, the blog will also launch ‘The pH Report’. It aims to help companies and investors survive the Great Unwinding of central bank and government stimulus now underway.