The return of volatility is the key market risk for 2018

We are living in a strange world. As in 2007 – 2008, financial news continues to be euphoric, yet the general news is increasingly gloomy. As Nobel Prizewinner Richard Thaler, has warned, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” Both views can’t continue to exist alongside each other for ever. Whichever scenario comes out on top in 2018 will have major implications for investors and companies.

It therefore seems prudent to start building scenarios around some of the key risk areas – increased volatility in oil and interest rates, protectionism and the threat to free trade (including Brexit), and political disorder. One key issue is that the range of potential outcomes is widening.

Last year, for example, it was reasonable to use $50/bbl as a Base case forecast for oil prices, and then develop Upside and Downside cases using a $5/bbl swing either way. But today’s rising levels of uncertainty suggests such narrow ranges should instead be regarded as sensitivities rather than scenarios. In 2018, the risks to a $50/bbl Base case appear much larger:

  • On the Downside, US output is now rising very fast given today’s higher prices. The key issue with fracking is that the capital cost is paid up-front, and once the money has been spent, the focus is on variable cost – where most published data suggests actual operating cost is less than $10/bbl. US oil and product exports have already reached 7mbd, so it is not hard to see a situation where over-supplied energy markets cause prices to crash below $40/bbl at some point in 2018
  • On the Upside, instability is clearly rising in the Middle East. Saudi Arabia’s young Crown Prince, Mohammad bin Salman is already engaged in proxy wars with Iran in Yemen, Syria, Iraq and Lebanon. He has also arrested hundreds of leading Saudis, and fined them hundreds of billions of dollars in exchange for their release. If he proves to have over-extended himself, the resulting political confusion could impact the whole Middle East, and easily take prices above $75/bbl

Unfortunately, oil price volatility is not the only risk facing us in 2018. As the chart shows, the potential for a debt crisis triggered by rising interest rates cannot be ignored, given that the current $34tn total of central bank debt is approaching half of global GDP. Most media attention has been on the US Federal Reserve, which is finally moving to raise rates and “normalise” monetary policy. But the real action has been taking place in the emerging markets. 10-year benchmark bond rates have risen by a third in China over the past year to 4%, whilst rates are now at 6% in India, 7.5% in Russia and 10% in Brazil.

An “inflation surprise” could well prove the catalyst for such a reappraisal of market fundamentals. In the past, I have argued that deflation is the likely default outcome for the global economy, given its long-term demographic and demand deficits. But markets tend not to move in straight lines, and 2018 may well bring a temporary inflation spike, as China’s President Xi has clearly decided to tackle the country’s endemic pollution early in his second term. He has already shutdown thousands of polluting companies in many key industries such as steel, metal smelting, cement and coke.

His roadmap is the landmark ‘China 2030’ joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition:   “From policies that served it so well in the past to ones that address the very different challenges of a very different future”.

But, of course, transitions can be a dangerous time, as China’s central bank chief, Zhou Xiaochuan, highlighted at the 5-yearly Party Congress in October, when warning that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008 in the west.

Business as usual” is always the most popular strategy, as it means companies and investors don’t face a need to make major changes. But we all know that change is inevitable over time. And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.

At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“. But, of course, this is nonsense. What they actually mean is that “nobody wanted to see this coming“. Nobody wanted to be focusing on contingency plans when everybody else seemed to be laughing all the way to the bank.

I discuss these issues in more detail in my annual Outlook for 2018.  Please click here to download this, and click here to watch the video interview with ICB deputy editor, Will Beacham.

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Anti-pollution drive hits China’s role as global growth engine

China is no longer seeking ‘growth at any cost’, with global implications, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

A pedestrian covers up against pollution in Beijing © Bloomberg

China’s President Xi Jinping faced two existential threats to Communist party rule when he took office 5 years ago.

He focused on the first threat, from corruption, by appointing an anti-corruption tsar, Wang Qishan, who toured the country gathering evidence for trials as part of a high-profile national campaign.

More recently, Mr Xi has adopted the same tactic on an even broader scale to tackle the second threat, pollution. Joint inspection teams from the Ministry of Environmental Protection, the party’s anti-graft watchdog and its personnel arm have already punished 18,000 polluting companies with fines of $132m, and disciplined 12,000 officials.

The ICIS maps below confirm the broad nature of the inspections. They will have covered all 31 of China’s provinces by year-end, as well as the so-called “2+26” big cities in the heavily polluted Beijing-Tianjin-Hebei area.

The inspections’ importance was also underlined during October’s five-yearly People’s Congress, which added the words “high quality, more effective, more equitable, more sustainable” to the Party’s Constitution to describe the new direction for the economy, replacing Deng’s focus from 1977 on achieving growth at any cost.

It is hard to underestimate the likely short and longer-term impact of Mr Xi’s new policy. The Ministry has warned that the inspections are only “the first gunshot in the battle for the blue sky”, and will be followed by more severe crackdowns.

In essence, Mr Xi’s anti-pollution drive represents the end for China’s role as the manufacturing capital of the world.

The road-map for this paradigm shift was set out in March 2013 in the landmark China 2030 joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition “from policies that served it so well in the past to ones that address the very different challenges of a very different future”.

The report focused on the need for “improvement of the quality of growth”, based on development of “broader welfare and sustainability goals”.

However, little was achieved on the environmental front in Xi’s first term, as Premier Li Keqiang continued the Populist “growth at any cost” policies of his predecessors. According to the International Energy Agency’s recent report, Energy and Air Pollution, “Average life expectancy in China is reduced by almost 25 months because of poor air quality”.

But as discussed here in June, Mr Xi has now taken charge of economic policy. He is well aware that as incomes have increased, so China is following the west in becoming far more focused on ‘quality of life issues’. Land and water pollution will inevitably take longer to solve. So his immediate target is air pollution, principally the dangerously high levels of particulate matter, PM2.5, caused by China’s rapid industrialisation since joining the World Trade Organization in 2001.

As the state-owned China Daily has reported, the Beijing-Tianjin-Hebei region is the main focus of the new policy. Its high concentration of industrial and vehicle emissions is made worse in the winter by limited air circulation and the burning of coal, as heating requirements ramp up. The region has been told to reduce PM2.5 levels by at least 15% between October 2017 and March 2018. According to Reuters, companies in core sectors including steel, metal smelting, cement and coke have already been told to stagger production and reduce the use of trucks.


The chemicals industry, as always, is providing early insight into the potentially big disruption ahead for historical business and trade patterns:

  • Benzene is a classic early indicator of changing economic trends, as we highlighted for FT Data back in 2012. The chart above confirms its importance once again, showing how the reduction in its coal-based production has already led to a doubling of China’s imports in the January to October period versus previous years, with Northeast and Southeast Asian exporters (NEA/SEA) the main beneficiaries
  • But there is no “one size fits all” guide to the policy’s impact, as the right-hand panel for polypropylene (PP) confirms. China is now close to achieving self-sufficiency, as its own PP production has risen by a quarter over the same period, reducing imports by 9%. The crucial difference is that PP output is largely focused on modern refining/petrochemical complexes with relatively low levels of pollution

Investors and companies must therefore be prepared for further surprises over the critical winter months as China’s economy responds to the anti-pollution drive. The spring will probably bring more uncertainty, as Mr Xi accelerates China’s transition towards his concept of a more service-led “new normal” economy based on the mobile internet, and away from its historical dependence on heavy industry.This paradigm shift has two potential implications for the global economy.

One is that China will no longer need to maintain its vast stimulus programme, which has served as the engine of global recovery since 2008. Instead, we can expect to see sustainability rising up the global agenda, as Xi ramps up China’s transition away from the “policies that served it so well in the past”.

A second is that, as the chart below shows, China’s producer price index has been a good leading indicator for western inflation since 2008. Its recovery this year under the influence of the shutdowns suggests an “inflation surprise” may also await us in 2018.

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

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China’s central bank governor warns of ‘Minsky Moment’ risk

The world is coming to the end of probably the greatest financial bubble ever seen.  Since the financial crisis began in 2008, central banks in China, the USA, Europe, the UK and Japan have created over $30tn of debt.

China has created more than half of this debt as the chart shows, and its total debt is now around 260% of GDP.  Its actions are therefore far more important for global financial markets than anything done by the Western central banks – just as China’s initial stimulus was the original motor for the post-2008 “recovery”.

Historians are therefore likely to look back at last month’s National People’s Congress as a key turning point.

It is clear that although Premier Li retained his post, he has effectively been sidelined in terms of economic policy.  This is important as he was the architect of the stimulus policy.  Now, President Xi Jinping appears to have taken full charge of the economy, and it seems that a crackdown may be underway, as its central bank chief governor Zhou Xiaochuan has been explaining:

  • Zhou first raised the issue at the National Congress last month, warning of the risk of a “Minsky Moment” in the economy, where debt or currency pressures could park a sudden collapse in asset prices – as occurred in the US subprime crisis.  “If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment.  We should focus on preventing a dramatic adjustment.”
  • Then last week, he published a warning that “China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing. [China] should prevent both the “black swan” events and the “gray rhino” risks.”

We can be sure that Zhou was not speaking “off the cuff” or just in a personal capacity when he made these statements, as his comments have been carried on both the official Xinhua news agency and on the People’s Bank of China website.  As Bloomberg report, he went on to set out 10 key areas for action:

  • “China’s financial system faces domestic and overseas pressures; structural imbalance is a serious problem and regulations are frequently violated
  • Some state-owned enterprises face severe debt risks, the problem of “zombie companies” is being solved slowly, and some local governments are adding leverage
  • Financial institutions are not competitive and pricing of risk is weak; the financial system cannot soothe herd behaviors, asset bubbles and risks by itself
  • Some high-risk activities are creating market bubbles under the cover of “financial innovation”
  • More companies have been defaulting on bonds, and issuance has been slowing; credit risks are impacting the public’s and even foreigners’ confidence in China’s financial health
  • Some Internet companies that claim to help people access finance are actually Ponzi schemes; and some regulators are too close to the firms and people they are supposed to oversee
  • China’s financial regulation lags behind international standards and focuses too much on fostering certain industries; there’s a lack of clarity in what central and regional government should be responsible for, so some activities are not well regulated
  • China should increase direct financing as well as expand the bond market; reduce intervention in the equity market and reform the initial public offering system; pursue yuan internationalization and capital account convertibility
  • China should let the market play a decisive role in the allocation of financial resources, and reduce the distortion effect of any intervention
  • China should improve coordination among financial regulators”

Clearly, Xi’s reappointment as President means the end of “business as usual” for China, and for the support provided to the global economy by Li’s stimulus policies.  Xi’s own comments at the Congress confirm the change of direction, particularly his decision to abandon the idea of setting targets for GDP growth.  As the press conference following the Congress confirmed, the focus is now on the quality of growth:

“China’s main social contradiction has changed and its economic development is moving to a stage of high-quality growth from a high-rate of expansion of the GDP,” said Yang Weimin, deputy head of the Office of the Central Leading Group on Financial and Economic Affairs. “The biggest problem facing us now … is the inadequate quality of development.”

Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy.  China’s lending bubble – particularly in property, is likely coming to an end.  In turn, this will lead to a bumpy ride for the global economy.

 

Budgeting for the Great Unknown in 2018 – 2020

“There isn’t anybody who knows what is going to happen in the next 12 months.  We’ve never been here before.  Things are out of control.  I have never seen a situation like it.

This comment from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing companies, investors and individuals as we look ahead to the 2018 – 2020 Budget period.  None of us have ever seen a situation like today’s.  Even worse, is the fact that risks are not just focused on the economy, or politics, or social issues.  They are a varying mix of all of these.  And because of today’s globalised world, they potentially affect every country, no matter how stable it might appear from inside its own borders.

This is why my Budget Outlook for 2018 – 2020 is titled ‘Budgeting for the Great Unknown’.  We cannot know what will happen next.  But this doesn’t mean we can’t try to identify the key risks and decide how best to try and manage them.  The alternative, of doing nothing, would leave us at the mercy of the unknown, which is never a good place to be.

RISING INTEREST RATES COULD SPARK A DEBT CRISIS

Central banks assumed after 2008 that stimulus policies would quickly return the economy to the BabyBoomer-led economic SuperCycle of the previous 25 years.  And when the first round of stimulus failed to produce the expected results, as was inevitable, they simply did more…and more…and more.  The man who bought the first $1.25tn of mortgage debt for the US Federal Reserve (Fed) later described this failure under the heading “I’m sorry, America“:

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2

• And the Fed was not alone, as the chart shows.  Today, the world is burdened by over $30tn of central bank debt
• The Fed, European Central Bank, Bank of Japan and the Bank of England now appear to “own a fifth of their governments’ total debt
• There also seems little chance that this debt can ever be repaid.  The demand deficit caused by today’s ageing populations means that growth and inflation remain weak, as I discussed in the Financial Times last month

China is, of course, most at risk – as it was responsible for more than half of the lending bubble.  This means the health of its banking sector is now tied to the property sector, just as happened with US subprime. Around one in five of all Chinese apartments have been bought for speculation, not to be lived in, and are unoccupied.

China’s central bank chief, Zhou Xiaochuan, has warned that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008.  Similar risks face the main developed countries as they finally have to end their stimulus programmes:

• Who is now going to replace them as buyers of government debt?
• And who is going to buy these bonds at today’s prices, as the banks back away?
$8tn of government and corporate bonds now have negative interest rates, which guarantee the buyer will lose money unless major deflation takes place – and major deflation would make it very difficult to repay the capital invested

There is only one strategy to manage this risk, and that is to avoid debt.  Companies or individuals with too much debt will go bankrupt very quickly if and when a Minsky Moment takes place.

THE CHINA SLOWDOWN RISK IS LINKED TO THE PROPERTY LENDING BUBBLE

After 2008, it seemed everyone wanted to believe that China had suddenly become middle class by Western standards. And so they chose to ignore the mounting evidence of a housing bubble, as shown in the chart above.

Yet official data shows average incomes in China are still below Western poverty levels (US poverty level = $12060):

•  In H1, disposable income for urban residents averaged just $5389/capita
•  In the rural half of the country, disposable income averaged just $1930
•  The difference between income and expenditure was based on the lending bubble

As a result, average house price/earnings ratios in cities such as Beijing and Shanghai are now more than 3x the ratios in cities such as New York – which are themselves wildly overpriced by historical standards.

Having now been reappointed for a further 5 years, it is clear that President Xi Jinping is focused on tackling this risk.  The only way this can be done is to take the pain of an economic slowdown, whilst keeping a very close eye on default risks in the banking sector.  As Xi said once again in his opening address to last week’s National Congress:

“Houses are built to be inhabited, not for speculation. China will accelerate establishing a system with supply from multiple parties, affordability from different channels, and make rental housing as important as home purchasing.

China will therefore no longer be powering global growth, as it has done since 2008.  Prudent companies and investors will therefore want to review their business models and portfolios to identify where these are dependent on China.

This may not be easy, as the link to end-user demand in China might well be further down the supply chain, or external via a second-order impact.  For example, Company A may have no business with China and feel it is secure.  But it may suddenly wake up one morning to find its own sales under attack, if company B loses business in China and crashes prices elsewhere to replace its lost volume.

PROTECTIONISM IS ON THE RISE AROUND THE WORLD

Trade policy is the third key risk, as the chart of harmful interventions from Global Trade Alert confirms.

These are now running at 3x the level of liberalising interventions since 2008, as Populist politicians convince their voters that the country is losing jobs due to “unfair” trade policies.

China has been hit most times, as its economy became “the manufacturing capital of the world” after it joined the World Trade Organisation in 2001.  At the time, this was seen as being good news for consumers, as its low labour costs led to lower prices.

But today, the benefits of global trade are being forgotten – even though jobless levels are relatively low.  What will happen if the global economy now moves into recession?

The UK’s Brexit decision highlights the danger of rising protectionism. Leading Brexiteer and former cabinet minister John Redwood writes an online diary which even campaigns against buying food from the rest of the European Union:

There are many great English cheese (sic), so you don’t need to buy French.

No family tries to grow all its own food, or to manufacture all the other items that it needs.  And it used to be well understood that countries also benefited from specialising in areas where they were strong, and trading with those who were strong in other areas.  But Populism ignores these obvious truths.

•  President Trump has left the Trans-Pacific Partnership, which would have linked major Pacific Ocean economies
•  He has also said he will probably pull out of the Paris Climate Change Agreement
•  Now he has turned his attention to NAFTA, causing the head of the US Chamber of Commerce to warn:

“There are several poison pill proposals still on the table that could doom the entire deal,” Donohue said at an event hosted by the American Chamber of Commerce of Mexico, where he said the “existential threat” to NAFTA threatened regional security.

At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail.  But what if they are wrong?  It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.

Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.

POLITICAL CHAOS IS GROWING AS PEOPLE LOSE FAITH IN THE ELITES
The key issue underlying these risks is that voters no longer believe that the political elites are operating with their best interests at heart.  The elites have failed to deliver on their promises, and many families now worry that their children’s lives will be more difficult than their own.  This breaks a century of constant progress in Western countries, where each generation had better living standards and incomes.  As the chart from ipsos mori confirms:

•  Most people in the major economies feel their country is going in the wrong direction
•  Adults in only 3 of the 10 major economies – China, India and Canada – feel things are going in the right direction
•  Adults in the other 7 major economies feel they are going in the wrong direction, sometimes by large margins
•  59% of Americans, 62% of Japanese, 63% of Germans, 71% of French, 72% of British, 84% of Brazilians and 85% of Italians are unhappy

This suggests there is major potential for social unrest and political chaos if the elites don’t change direction.  Fear of immigrants is rising in many countries, and causing a rise in Populism even in countries such as Germany.

CONCLUSION
“Business as usual” is always the most popular strategy, as it means companies and investors don’t have to face the need to make major changes.  But we all know that change is inevitable over time.  And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.

At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“.  But, of course, this is nonsense.  What they actually mean is that “nobody wanted to see this coming“.  The threat from subprime was perfectly obvious from 2006 onwards, as I warned in the Financial Times and in ICIS Chemical Business, as was 2014’s oil price collapse. Today’s risks are similarly obvious, as the “Ring of Fire” map describes.

You may well have your own concerns about other potential major business risks. Nobel Prizewinner Richard Thaler, for example, worries that:

“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”

We can all hope that none of these scenarios will actually create major problems over the 2018 – 2020 period. But hope is not a strategy, and it is time to develop contingency plans.  Time spent on these today could well be the best investment you will make. As always, please do contact me at phodges@iec.eu.com if I can help in any way.

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President Xi focuses on pollution, not growth, as key Party Congress nears

Beijing pollution Feb14

Imagine living in the capital city of a major country, and suffering the level of pollution shown in the above photo on a regular basis.  We used the photo in chapter 6 of Boom, Gloom and the New Normal when we highlighted how pollution was inevitably going to move up the political agenda in China. Controversial at the time, it warned:

Recent growth in China and India has come at a price: Poor air quality, chronic water shortages and deforestation.”

By February 2014, the pressure to act was becoming almost overwhelming as:

“The problems have worsened, to the point where almost everyone now agrees that they are creating a major political problem. The new leadership simply has to solve this, if it wants to remain in office. Beijing and the 6 northern provinces have now been shrouded in smog for 6 days, and on Wednesday the US embassy reported that the levels of PM2.5, the small particles that pose the greatest risk to human health, were “beyond index” at 512.

Guangdong province, close to Hong Kong, had already moved to clean up.  But other provinces did little or nothing, as officials worried about the likely impact on jobs. A major part of the problem was that the economy is the Premier’s responsibility, and Premier Li has been more worried about maintaining growth via stimulus programmes.

This year, however, Xi finally lost patience ahead of next month’s 5-yearly People’s Congress – at which he will be renominated for another 5-year term.  Having signed China up to the Paris Agreement on climate change in December 2015, he seized control of the economic agenda, as I noted in the Financial Times:

Xi knows that reducing pollution, rather than maintaining economic growth, has become key to continued Communist Party rule.  The recent rapid elevation of Beijing’s mayor, Cai Qi, to become party chief for the city is further confirmation of the high priority now being given to tackling air pollution and stabilising house prices.

“Taken together, these policies represent a paradigm shift from those put in place 40 years ago by Deng Xiaoping after Mao’s death in 1976. This shift has critically important implications, as it means growth is no longer the main priority of China’s leadership. In turn, this means that stimulus programmes of the type unleashed in 2012, and on a more limited basis by Premier Li last year, are a thing of the past.”

Since then, the Beijing area, and surrounding provinces such as Hebei and Henan, have become a centre of the battle against pollution.  One key development has been the use of thousands of drones to spot, and measure air and water pollution, and then identify and photograph the culprits. As state-controlled Xinhua reported last week:

“A total of 599 companies, mainly construction materials, furniture, chemicals, packaging and printing, were relocated out of the capital, said the Beijing municipal commission of development and reform.  Beijing also closed 2,543 firms and ordered 2,315 firms to make changes. About 73% had pollution issues.

Similarly, a senior chemical industry executive told me last week:

“I was in/near Cangzhou the other day (another city on the list) where the government have created a large National Level Economic Zone including a dedicated chemical “park” to accommodate the companies that are being cleared out of Beijing and surrounds. This was an otherwise nondescript flatland whose only previous claim to fame was a Mao era collaboration with then Czechoslovakia to make tractors.

China lend Sept17

The war on pollution has another side to it, of course, as it marks the end of the “growth at any cost” economic model.

As a result, realism is finally returning to discussion about China’s real growth potential.  As last month’s IMF Report on China noted, GDP growth had only averaged 7.3% over the 5 years to 2016 because of stimulus: without this, growth would have been just 5.3%.  As a result, the IMF also highlighted an increasing risk of “a possible sharp decline in growth in the medium term”, as well as a need to boost domestic consumption by reducing savings.

This is a welcome development. Too many companies and analysts have indulged in wishful thinking, wanting to believe China had suddenly become middle-class by Western standards.  In reality, as the second chart shows, the growth surge was due to $20tn of stimulus lending via official and shadow banking channels.

At its peak, between 2009 – 2013, this lending reached 3.2x official GDP.  And GDP itself was probably also over-stated for internal political reasons, as Communist Party officials were routinely judged for promotion on their success in generating GDP growth.  Now the pendulum has swung the other way, as the Caixin business magazine has reported:

In a document jointly released by the Ministry of Environmental Protection and nine other ministry-level bodies, if a city does not achieve 60% of the emission reduction target, the city’s vice mayor will be held responsible.  If the city achieves less than 30% of its target, the mayor will be held responsible; and if the PM2.5 level ends up increasing instead of falling over the winter, the party secretary of the city will be held responsible.

“Possible punishment includes party disciplinary or administrative punishments, the document says.”

Large economies are like super-tankers, they take a long time to change course.  As I noted nearly 2 years ago, China is now attempting to move in a radically new direction, away from export-driven growth and infrastructure spending – and towards a New Normal economy based on the mobile internet:

“The winners are developing services-led businesses focused on China’s New Normal markets – such as those aimed at boosting living standards in the poverty-stricken rural areas, or for environmental clean-up. The losers will be those who cling to the hope that more stimulus is just around the corner, and that China’s Old Normal will somehow return.”

Those who have done well under the old regime, like the Party heads focused on job-creation and the opportunities that it created for large-scale corruption, will inevitably fight hard to preserve their way of life.  Next month’s Congress will therefore be critical in assessing just how much power Xi will have to pursue his reform policies in his second term.

As I noted a year ago, this Congress will settle key questions.  Will Premier Li gain a second term, and continue to be able to obstruct reform? Will anti-corruption tsar Wang maintain his position on the all-powerful Politburo Standing Committee, despite being over the nominal age limit?

The Congress is therefore likely to the most important meeting since 1997, when Jiang Zemin gained re-appointment for his second term as President and led China out of poverty via membership of the World Trade Organisation.  Now, as set out in the China 2030 Report (published when Xi became President), Xi has to led China in a new direction.

Otherwise, he will be unable to achieve his twin goals of

□   Making China a “moderately prosperous society” by 2021 (the centenary of the Chinese Communist Party)
□   Making it a “fully developed, rich and powerful nation” by 2049 (the centenary of the People’s Republic), and returned to its historical status as the Middle Kingdom via his ‘One Belt, One Road’ project.

 

 

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.