GU 8Nov14

It is now almost 3 months since I suggested the Great Unwinding was about to hit oil and chemical markets.  As the chart above shows, there has since been a major collapse in most of the markets in our benchmark portfolio.  Given their role as leading indicators for the global economy, this major downturn is extremely worrying:

  • 4 of the markets (oil, naphtha, PTA and benzene) are down more than 20%
  • The Japanese yen is down 12% (and is down 50% since Premier Abe took office 2 years ago)
  • US polyethylene export prices, of course, remain nominal due to major production problems restricting availability

But the largest market of all, the US S&P 500 (purple), is sailing on regardless.   It is still wearing rose-coloured glasses, as US Federal Reserve Governor, Charles Plosser, noted back in March:

“If central banks do not limit their interventionist strategies and focus on returning to more normal policy-making aimed at promoting price stability and long-term growth, then they will simply encourage the financial markets to ignore fundamentals and to focus, instead, on the next actions of the central bank.”

This, of course, is exactly what has been happening over the past decade.  Fed Chairman Alan Greenspan refused to allow financial markets to work through the fallout from the dotcom bubble in 2000.  Instead, he developed the concept of the ‘Greenspan put’,  which aimed to abolish market cycles.

Greenspan’s policy, which has been followed by his successors – Ben Bernanke and Janet Yellen – meant that global financial markets stopped acting as a leading indicator.  Thus the role of many analysts today is not to monitor the state of the real economy, but instead to focus on the central banks.

Today, however, this means they are looking in the wrong direction.  China’s new leadership knows that the previous policies created a lost decade .  So they are reversing course as fast as they can, and cutting lending in order to burst the property bubble.  Though analysts still hope for new stimulus, they remain disappointed.  As President Xi told the APEC Summit at the weekend:

The intensity of our endeavor to comprehensively deepen reform will determine whether we will successfully adapt ourselves to the new normal.”

China has been responsible for the ‘recovery’ in global growth since 2009, so its reverse course matters more than any action by the Fed, the Bank of Japan or the European Central Bank.  One day soon, Western stock markets will realise this.  But today, they still think all is well: Japan has promised to supply more cash, as has Mario Draghi in Europe.

This is a very dangerous situation, as it means there is a risk investors may panic when they finally realise what is happening in the real world outside Wall Street.  Reports from ICIS Pricing’s benzene and PTA/polyester editors highlight the growing impact of China’s new policies across Asia:

  • “Asian benzene prices slumped this week, and with some parties struggling to obtain credit from banks, European players said that this could see the Asian market increasingly start to reflect physical supply/demand fundamentals amid less speculative trading.”
  • “The majority of market participants are expecting conditions in the downstream polyester markets to remain weak till the end of the year, especially on the back of weak conditions on the global macroeconomic front.  In addition to an already weak market, supply in the domestic China markets was described as long, with high inventories adding downward pressure on spot prices.”

This might not matter if the S&P 500 was at a reasonable level.  But as I discussed on Friday, it is actually priced for perfection – at the 91st percentile of performance based on Robert Shiller’s CAPE Index.

It seems unlikely that chemical markets will stage a quick recovery.  Too many players failed to anticipate the downturn, and find themselves with high-priced inventory in a falling market.  The next few weeks will also be seasonally weak, as companies destock over the Christmas/New Year period, and for year-end tax reasons.

Equally, it is hard to see OPEC managing to agree significant production cutbacks in oil markets.  Saudi Arabia has played that game before in 1980 – 1985 and lost badly, as I discussed recently.  It will also risk losing its defence shield from the USA if prices go back to the $100/bbl levels, as its 1.3mb/d imports will become unnecessary.

It therefore seems likely that it is only a matter of time before Great Unwinding also starts to impact the S&P 500.

MONDAY AFTERNOON UPDATE
The Wall Street Journal today confirms my suggestion last week that “panic at the Bank of Japan” was behind the decision to increase Japan’s stimulus effort and further devalue the yen.  This, of course, is further evidence that the Cycle of Deflation is well underway:

“TOKYO—The main purpose of the Bank of Japan policy board meeting Oct. 31 was supposed to be updating economic forecasts, not making policy changes.  But as board members submitted their forecasts, an alarming pattern emerged, according to people familiar with the BOJ’s thinking. Members were marking down their price projections, with at least one seeing inflation slipping below a 1% annual rate for the fiscal year starting next April.  Japan was headed a step back toward the deflationary environment the central bank had pledged to eradicate—and worse, it would have to admit so publicly.

WEEKLY MARKET ROUND-UP
The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:

PTA China, down 27%. ”Polyester markets have been stable-to-soft, with slow sales faced at end-users’ facilities”
Naphtha Europe, down 26%. “Oversupply remains the predominant bearish factor in the northwest European naphtha market”
Benzene Europe, down 23%. “Spot numbers have gradually moved lower over the course of this week”
Brent crude oil, down 21%
¥:$, down 12%
HDPE US export, flat. “Traders said prices need to drop at least 10 cents/lb ($220/t) more to compete with China and Asian values but that producers are resisting such price cuts”
S&P 500 stock market index, up 4%