Chemical industry data shows reflation remains hope, not reality

ACC Jul17Western central bankers are convinced reflation and economic growth are finally underway as a result of their $14tn stimulus programmes.  But the best leading indicator for the global economy – capacity utilisation (CU%) in the global chemical industry – is saying they are wrong.  The CU% has an 88% correlation with actual GDP growth, far better than any IMF or central bank forecast.

The chart shows June data from the American Chemistry Council, and confirms the CU% remains stuck at the 80% level, well below the 91% average between 1987 – 2008, and below the 82% average since then.  This is particularly concerning as H1 is seasonally the strongest part of the year – July/August are typically weak due to the holiday season, and then December is slow as firms de-stock before Christmas.

FMs Jul17

The interesting issue is why these historically low CU% have effectively been ignored by companies and investors. They are still pouring money into new capacity for which there is effectively no market – one example being the 4.5 million tonnes of new N American polyethylene capacity due online this year, as I discussed in March.

The reason is likely shown in the above chart of force majeures (FMs) – incidents when plants go suddenly offline, creating temporary shortages.  These are at record levels, with H1 2017 seeing 4x  the number of FMs in H1 2009.

In the past, most companies prided themselves on their operating record, having absorbed the message of the Quality movement that “there is no such thing as an accident”. Companies such as DuPont and ICI led the way in the 1980s with the introduction of Total Quality Management. They consciously put safety ahead of short-term profit and at the top of management agendas. As the Chartered Quality Institute notes:

“Total quality management is a management approach centred on quality, based on the participation of an organisation’s people and aiming at long-term success.”

  Today, however, the pressure for short-term financial success has become intense
  The average “investor” now only holds their shares for 8 months, according to World Bank data
 This time horizon is very different from that of the 1980s, when the average NYSE holding period was 33 months
  And it is a very long way from the 1960s average of 100 months

As a result, even some major companies appear to have changed their policy in this critical area, prioritising concepts such as “smart maintenance”. Such cutbacks in maintenance spend mean plants are more likely to break down, as managers take the risk of using equipment beyond its scheduled working life. Similarly, essential training is delayed, or reduced in length, to keep within a budget.

ICIS Insight editor Nigel Davies highlighted the key issue 2 years ago as the problems began to become more widespread around the world:

“The situation in Europe has exposed underlying trends and issues that will need to be addressed. Companies appear not to have sustained an adequate pace of maintenance capital expenditure. That has been for economic as well as structural (cost) reasons. Spending in high feedstock and energy cost Europe has certainly not been considered de rigeur….Having maintained plants to run at between 80% and 85% of capacity, suddenly pushing them hard does little good. Sometimes, they fail.”

The end-result has been to mask the growing problem of over-capacity, as plants fail to operate at their normal rates. This has supported profits in the short-term by making actual supply/demand balances far tighter than the nominal figures would suggest. But this trend cannot continue forever.

THE END OF CHINA’S STIMULUS WILL HIGHLIGHT TODAY’S EXCESS CAPACITY
Shadow Jul17The 3rd chart suggests its end is now fast approaching.  It shows developments in China’s shadow banking sector, which has been the real cause of the apparent “recovery” and reflation seen in recent months:

  Premier Li began a major stimulus programme a year ago, hoping to boost his Populist faction ahead of October’s 5-yearly National People’s Congress, which decides the new Politburo and Politburo Standing Committee (PSC)
  Populist Premier Wen did the same in 2011-2 – shadow lending rose six-fold to average $174bn/month
  But Wen’s tactic backfired and President Xi’s Princeling faction  won a majority in the 7-man PSC, although the Populist Li still had responsibility for the economy as Premier
  Li’s efforts have similarly run into the sand

As the 3-month average confirms (red line), Li’s stimulus programme saw shadow lending leap to $150bn/month. Unsurprisingly, as in 2011-2, commodity and asset prices rocketed around the world,funding ever-more speculative investments.  But in February, Xi effectively took control of the economy from Li and put his foot on the brakes.  Lending is already down to $25bn/month and may well go negative in H2, with Xi highlighting last week that:

“China’s development is standing at a new historical starting point, and … entered a new development stage”.

“Follow the money” is always a good option if one wants to survive the business cycle.  We can all hope that the IMF and other cheerleaders for the economy are finally about to be proved right.  But the CU% data suggests there is no hard evidence for their optimism.

There is also little reason to doubt Xi’s determination to finally start getting China’s vast debts under control, by cutting back on the wasteful stimulus policies of the Populists.  With China’s debt/GDP now over 300%, and the prospect of a US trade war looming, Xi simply has to act now – or risk financial meltdown during his second term of office.

Prudent investors are already planning for a difficult H2 and 2018.  Companies who have cut back on maintenance now need to quickly reverse course, before the potential collapse in profits makes this difficult to afford.

The Deng, Jiang model for China’s economic growth under Xi

China pollutionJan14

Major change is already underway in China, with potentially enormous implications for all of us.

  • Corruption is being stamped out via a policy of ‘shock and awe’
  • Similarly, wasteful lending is under attack in both the official and the so-called ‘shadow banking’ sectors
  • Thirdly, pollution is being tackled by literally ‘sending in the bulldozers‘ to destroy polluting factories under the eyes of TV cameras, and introducing quotas on car sales in the major cities

It is impossible to underestimate the scale of the changes now underway.  Just as under Deng and Jiang, they are being led from the top by a new leadership group headed by Xi himself.  Its key focus is on the “economy and ecology“, highlighting the economic and political crisis that developed during the “lost decade“.

Equally, as the blog has detailed this week, these challenges clearly mirror those faced by Jiang and Zhu in 1993, and by Deng and Zhao in the post-Mao period after 1977:

Politics
Today’s challenge is not to restore order after the chaos of the Gang of Four, or after Tiananmen Square.  Instead it is to head off an existential crisis over pollution, coupled with demographic decline.  The Party’s main think-tank, China’s Academy of Social Sciences, has thus headlined the “shrinking demographic dividend, overcapacity, choking pollution, risks from the property sector and local government debt as key threats to be tackled immediately.

Financial
Bankruptcy was the key economic challenge facing Deng in 1977.  Whilst as the World Bank noted, the major risk in 1993 was that ”China could have lost economic control and landed in a Latin American-style inflationary spiral”.

This time, as a major World Bank report with China’s National Reform and Development Commission has warned:

China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the ‘middle-income trap’.”

This comprehensive Report was issued to coincide with the 5-yearly Party conference in March 2012 and highlighted 5 key risks:

“The end of export market growth; wasteful infrastructure investment; the need to boost personal consumption via higher wages (which has the downside of reducing profit margins and job creation); managing the transition to a new economic model; and the threat of hitting ‘the middle income trap’ described by Nobel Prize winner Sir Arthur Lewis”

Xi and Li follow the Deng/Jiang model
In response, it is clear that the new leadership is closely following the successful strategies developed by Deng and Jiang in response to similar crises:

  • The return of ‘the man who knows what to do’.  Deng was brought back in 1977, having been purged 3 times, because he was the only person who could manage the situation.  Similarly he returned a second time with his Southern Tour in Q4 1992 to build Jiang’s powerbase.  This time it has been Jiang who returned.  He ensured the removal of the corrupt Bo Xilai, and forced through the leadership changes in November 2012 that meant 6 of the 7 current Politburo members are his men
  • The immediate assumption of control over the military.  The Bo Xilai affair highlighted the risk of military unrest – there were well-reported rumours of tanks moving in Beijing in March 2012.  Xi has followed Deng and Jiang in immediately taking control of the Central Military Commission by becoming its chairman
  • The use of the World Bank to develop a policy framework.  Again, Xi has followed Deng and Jiang in this, with no delay.  In fact, the World Bank began work even before Xi formally took power – highlighting his early awareness of the depth of the crisis that China faces
  • Focusing on the economic challenge immediately.  Deng had premier Zhao Ziyang, and Jiang had premier Zhu Rongji, both entirely focused on the economic issues.  Today, Li Keqiang is taking the same role.  Equally important is that Xi has followed Deng and Jiang in taking personal leadership of the issue via chairmanship of the new “Leading Group for Overall Reform”.  Without his active involvement, reform will inevitably be blocked by those who would lose out as a result
  • Willingness to take tough measures.  China’s new leadership have 10 years of power ahead of them.  Thus they are already sending in the bulldozers to destroy polluting factories over the heads of local government officials.  Whilst Xi’s appointee at the central bank, Zhou Xiaochuan, is taking power back from the regulators who have failed to control the shadow banking sector.  All this has clear parallels with Deng and Jiang’s ‘no nonsense approach’, and their appreciation that a sense of urgency is critical for success

What does this mean for the outside world?
The years after 1977 and 1993 were stormy periods in China’s history.  The period to 2020 is unlikely to be different, and there are no guarantees that the new leadership’s policies will succeed.  But it is already possible to identify some of the likely major impacts on the global economy:

  • Domino effect.  US-centric observers have wrongly assumed that the Federal Reserve’s taper has somehow begun to destabilise Asian economies such as India and Indonesia.  They will now have to rush to catch up, as it becomes clear that this is really early warning of China’s massive policy shift
  • Double-digit growth.   The imperative of political survival means the leadership have to continue to bulldoze polluting factories, and also clean up the one-sixth of China’s farmland currently contaminated with toxic waste. Therefore the days of double-digit economic growth will never return
  • Deflation.  Premier Li made clear last year that maintaining employment was his key priority.  We can therefore expect China to focus on maximising export sales during the transition, effectively exporting deflation – as volume rather than profit will be the priority.
  • Export Demand.  China’s main export focus will no longer be the cheap textiles and plastic products of the past.  Instead it will create jobs via an aggressive drive to sell affordable cars, relatively high-value chemicals and other  products into Asian and developing country markets, based on its vast new capacity.
  • Dollar strength.  China’s economic crisis will come as a shock to most of the financial community, as did the US subprime crisis.  We can therefore expect China’s currency to fall in value, and the US$ to rise, all other things being equal.  This, of course, will also help to boost China’s exports
  • Domestic Demand.  Similarly the focus of China’s domestic demand will change.  Sales of western luxury goods will continue to decline as the corruption campaigns continue.  Instead, the focus will be affordable necessities such as $50 refrigerators for the 90% of the population who earn less than $20/
  • Debt.  China’s record $1.3tn holding of US debt was built up as a form of vendor finance, to support US purchases of China’s products.  But this strategy is no longer relevant, so we may well see China slowly reduce its holdings as it will have more use for the cash at home – putting pressure on Western interest rates

Readers will no doubt have their own insights into the impact of these changes on their own businesses and personal lives.  But one thing is very clear.  China not only has to go down this path, as we described in chapter 6 of ‘Boom, Gloom and the New Normal’ in November 2011.  But its leaders now clearly recognise that they have to change policy with great urgency.

The blog always feared that the recent boom would turn out to be another of the ‘boom and bust’ cycles that have characterised the post-Mao period.  No sane person would ever want to go back to the days of the Great Leap forward and the Cultural Revolution.  It therefore hopes that Xi and Li will not only manage to overcome the current crisis, but also succeed in establishing a more sustainable future for the country.

Fragments from the G20

G-20.jpg3 years ago, many hoped the G20 group of the world’s wealthiest countries might work together to solve the global financial crisis.

Last week’s Cannes meeting ended that illusion.

Instead, its decision to abandon the Doha trade round, launched in 2001, made it clear we have passed the high-water mark of globalisation. This conclusion was reinforced by the fact that only a few of the news media even mentioned the topic.

Two key figures also set out their views on the way forward:

China’s premier Wen, signalled that its lending slowdown will continue: “I will especially stress that there will not be the slightest wavering in China’s property-tightening measures–our target is for prices to return to reasonable levels.” Prices have already begun to fall by 20-40% in the major cities, and clearly more falls are on the way.

Italy’s premier Berlusconi was still in denial, however, claiming the country’s problems with its debt mountain were “a passing fashion“, and noting that “the restaurants are full, the planes are fully booked, and the hotel resorts are fully booked as well“.

And that, as far as the blog can discover, was that.