The End of “Business as Usual”
The Expert View
Featuring Paul Hodges
Published on: April 8th, 2019 • Duration: 30 minutesPaul Hodges, chairman of the pH Report, breaks down a unique set of economic data through the lens of the world’s third largest industry behind energy and agriculture — chemicals. Looking at the chemical capacity utilization, supply and demand dynamics, and activity in China, a pattern emerges. With an abnormal first quarter of 2019 and the benefit of near real-time information, Hodges holds that the data suggests the global economy could be set for a downturn. Filmed April 1, 2019 in London.
PAUL HODGES: Most of the data is pointing in the same direction, and it's not terribly optimistic. The chemicals is an obvious problem area, simply because you've got this major capacity build going on at the moment because of shale gas. I think that the role of stimulus is played out. I think that China will continue to deleverage.
So I'm Paul Hodges from the PH Report. And we look at the world and the world economy through the lens of the chemical industry. Why do we do that? Because the chemical industry is the third largest industry in the world after energy and agriculture. It gets into every corner of the world. Everything in the room which you'll be watching this interview is going to have chemicals in it. And the great thing is, we have very good, almost real time data on what's happening.
So our friends at the American Chemistry Council have data going back on production and capacity utilization since 1987. So 30 years of data, and we get that within around six to eight weeks of the end of the month. So whereas, if you look at IMF data, you're just looking at history. If you're like, we're looking at this is what's actually going on as of today.
We look, obviously, upstream, as we would call it, at the oil and feedstocks markets, so we understand what's happening in that area. But we also-- because the chemical industry is in the middle of the value chain, you have to be like Janus. You have to look up and down at the same time, otherwise one of these big boys catches you out.
And so we look downstream. And we particularly look at autos, at housing, and electronics, because those are the big three applications. And of course, they're pretty big for investors as well. So there's-- we see the relative balance between what's happening upstream, what's happening downstream, where is demand going, and then we see what's happening in the middle of that chain, because that's where we're getting our data from.
So our data matches on pretty well, it's worth saying, to IMF data. So changes in capacity utilization, which is our core, measurement, if you go back and plot that against history from the IMF, very, very good correlation. So what we're seeing at the moment-- and really, we've been seeing this since we did the interview in November-- is a pretty continuous downturn.
One would have hoped, when we talked in November, we were talking about the idea that things have definitely cooled off. Some of that was partly due to the oil price coming down. Some of that was due to end of year destocking. Some of that was due to worries about trade policy. Lots of different things, but you would normally expect the first quarter to be fairly strong.
And reasons for that are the first quarter-- this year, particularly-- was completely free of holidays. Easter was late, so there was nothing to interrupt you there. There was the usual Lunar New Year in China, but that always happens, so there's nothing unusual about that.
And normally what happens is, that in the beginning of the new year, people restock. They've got their stock down in December for year end purposes, year end tax purposes, now they restock again. And of course, they build stock because the construction season is coming along in the spring and people tend to buy more cars in that period, and electronics, and so on.
So everything in the first quarter was very positive. And one wouldn't normally be surprised to start seeing stock outs in the industry, particularly after a quiet period in the fourth quarter. And unfortunately, we haven't seen any of that. We've seen-- and this is worth thinking about for a moment-- we've seen a 25% rise in the oil price because of the OPEC Russia deal, but we haven't seen the normal destock build that goes along with that.
And just to explain, this is a bit counterintuitive. When the oil price goes up, people in the chemical industry know that the prices of chemicals is about to go up as well, because oil is so important, and so is gas. So they tend-- you know, we're sitting in April-- they will tend to say, oh look, price is going up. We need to buy in April because the price in May will be higher.
And now, then that should have happened, but it didn't. And this is the first time I can ever remember that not happening. And the only reason that one can come up with for that is because obviously, interest rates aren't high, so finance directors wouldn't be saying, oh no, no, we can't afford that. Can't do that, or anything. It can only be that end user demand is actually quite weak.
And so the sales team are actually saying, you know, we've got quite a stockpile already. We probably don't need to add to it. That's where we are at the moment. What we were talking about at the back end of last year, that the smartphone market has gone into recession for the first time. So clearly, that trend, which was very, very powerful over three or four years and followed on from previous trends, has now run its course, and there isn't actually anything else that we can see coming along.
And, you know, what we are seeing-- everyone would have noticed this year-- that orders from Apple and so on into China are weak. And we're getting adverse reports coming out about future market demand there. You know, when Apple said last year, oh, we're not going to publish our sales figures anymore, not usually because they're so good that people might get too excited. So something has clearly happened there, and that we've seen that since.
If you look at autos, we follow the top seven markets, which are sort of 70%, 80% of the total. And of those, only one was up in the first couple of months this year. So Brazil. All the others, China, the States, Europe, Russia, India, so on, and Japan, they were all down. Some of them not by very much, China down by quite a lot. But, you know, so there isn't anything out there that says, oh, well wait a minute. This means you might be at a turning point. For at the moment, most of the data is pointing in the same direction, and he's not terribly optimistic.
When we saw the lending numbers for January, it was understandable, I think, that a lot of people jumped to a conclusion that said, oh, stimulus is back. And it's absolutely no right-- or no doubt, that in-- if you look at what happened after 2008, if you looked at what happened after 2015, both times, Chinese government was panicking for certain reasons. So it was panicking because 24 million people are unemployed after the financial crisis, after Lunar New Year in February 2009.
Massive stimulus. Again, not quite panicking, but wanting to bolster the position because you had the Party Congress coming up and the reappointment of all the top officials, and you don't want any unrest or disturbance ahead of that in 2017. So-- and I think the markets were absolutely right at the time to say, well, you know, we're going to see a big increase in consumer spending and so on. So all of that went through.
We had a record level of lending. Not so much in February, but you take the first two months together-- and you have to do that because of Lunar New Year, otherwise comparisons are meaningless. But you do that. So yes, it was definitely a record level of spending. But we have also had auto sales, housing sales, and smartphone sales. And auto sales are down, and that continues after 2018, which was the first year that the Chinese auto market had been down since 1990.
So this is a big break going on here. And sales are down in the double digit numbers. Similarly in smartphones, sales are down in double digit numbers. In housing, we don't have such detailed data, but China Daily, the state-owned media, reported that Evergrande, which is one of the big three property developers, in January and February, saw its sales down 43%.
Now, and they weren't reporting that as an exception. They were reporting that as part of a downbeat thing about housing. So it really does look to us as if the consumer market has turned down here. Please don't get me wrong. We're not talking about the collapse or the implosion of the Chinese economy or anything like that. We're talking about a restructuring of the economy here I think that's going on. And one does have to distinguish between the wealthy-- the very wealthiest part of the city-- the very poor parts in the West where, you know, there's still 80 million people in China living below on an income of below poverty level below $2 a day. There's still 80 million. So we can focus on the skyscrapers in the Bund in Shanghai, but there is another side to the story. And I think that the Communist Party is trying to redress some of that balance. That's going on.
But the other thing is where has this lending gone then? And again, we're searching for answers a bit, but we do have data about industries like China Rail, where we know that their interest payments have been larger than their income since the data was published, since 2015.
We know that as part of the stimulus program this time around, it's more focused on infrastructure. And we can see, therefore, that if they already have a major $5 trillion renminbi debt, that this is going up. And probably, they're unable to meet interest payments going forward and therefore, they need support.
Similarly, one of the big areas of concern-- and we're not the only ones who have focused on this in the past, of course-- is the local government financing vehicles. And the issue here is that local governments tend to get their money from property sales. So the Communist Party owns all the government, owns all land.
And so if you want to make your numbers in the local region, you sell land to your friend, the developer, and he then pays you some money, which goes into your coffers and boosts GDP. He then builds some housing blocks. And again, you get some revenue from that. And so if housing market is slowing down, that's when local governments start to run out of cash to pay their bills. Particularly, these off balance sheet local government financing vehicles.
So it looks to us we may be wrong, but we've been looking at this a long time. Looks to us as though the stimulus money hasn't gone to spark new consumer spending, as one might have thought, as before, as markets seem to have assumed. It's actually gone to meet these headwinds that you get from debt.
Because after all, at the end of the day, what does debt do? Debt brings forward demand. I can either wait and save up and then buy it or I buy it today and pay it back afterwards. Either way, it's the same thing. I don't need two cars to drive at the same time.
And so it looks as though this is what's happening, that we're getting these headwinds coming through. Again, please be clear. I'm not saying the economy is imploding, or anything like that. I'm just saying there is this necessary restructuring, and it's very sensible for President Xi, in the second term, he wasn't in charge of the economy in the first term. It was Premier Li for doing the stimulus, and so on. Now he's got it.
So you have to do that at the start of your term. You don't want to be doing that in three or four years' time. You've inherited the position. You now deal with it. You take the pain and move on. And of course, President Trump is providing him with an ideal excuse, that we have to tighten our belts because we don't know what the Americans are going to do.
We see it in two areas. The more areas we can see it in, the better, really, of course. So we've seen the downturn take place over the second half of last year in chemical capacity utilization. And this isn't because there's been a massive amount of new head of demand. It's just that the demand is not being-- then, of course, we can talk to companies, Chinese companies, or Western companies, and get an anecdotal view from them, which is usually pretty reliable, too.
So there's that. But then if you look at some of the basic chemicals that are around, things like acetone, and so on, you can see. And we have data for these storage, and so on. And these are at record levels. So there is a consistent picture here, that within the basic chemical market, there is not a lot of strong demand, that production is ahead of demand, and that stocks are building.
If we were going to be consistent with our story, then one would have to see a downturn in Germany. Because obviously, the German economy has been heavily dependent on export sales to China, far more than anybody else. And yes, indeed, we are seeing that. And we've just seen fairly recent data, which all of the major economies, in terms of chemical production-- so Germany, France, Spain, so on-- are down, with just one exception, which we can come to in a moment. And they're continuing to go down.
And so what does that mean? Well, if Germany is the motor of the European economy, and if the motor was firing on all cylinders when stimulus was under way and China was going strongly, well, if the motor isn't going to fire so strongly, then when China starts to slow-- and that's what we're seeing. It's very hard because Asian populations, we know, across Europe, particularly Germany, median age of 46 or so. And Europe has not replaced its population since 1970. So we're coming up to 50 years.
So the number of people in what you might call the wealth creation, age group 25 to 54, where people will tend to start their careers, their salaries will move up. They'll very often settle down, perhaps have children. They'll buy houses. They'll buy cars, and so on. It's a relatively small number of people in that group.
And of course, we've got this older group, the perennials, if you like, who, unfortunately, from an economic point of view and from a central bank point of view, instead of getting their gold watch or their clock and retiring and dying next week on the golf course, as they should have done, they're actually living now for another 15 or 20 years. But they're not economically active.
And you look at spending across the world for people aged 65 to 75. By the time you get to 75, it's half the level of when you're 45 to 54 for very obvious reasons. So you've got these two big headwinds in Europe, as you do, of course, in Japan, where you have the problem of an older perennial generation that really isn't contributing very much and a relatively small wealth creator, 25 to 54.
So all of this is very consistent. What would have made the difference? Well, obviously China doing what it did made a fantastic difference. But if China is taking its foot off the accelerator, well, Europe is now going to have to face those issues. And I did say there was only one country that didn't, but the trend-- and that, of course, is the UK-- where everybody had feared that we might have fallen out of the European Union already. We've now got till April the 12th before we fall out. Maybe we won't. Who knows?
But almost every company that could has stockpiled. We talked a lot of people and every warehouse in the UK, every village hall, is stacked full of stuff. I mean, the car companies are right, unfortunately, in the middle of the storm because they've all decided to bring forward their summer shutdowns to this fortnite in order to avoid the worst effects if there was a no deal. Well, of course, there isn't a no deal, so they could have been running normally.
Now they'll be coming back, and if there is a no deal that starts on the 13th of April, they'll just be stuck. You know, this is not very clever. But anyway, if you build stockpiles at this extreme level, you can either assume the Brexit is going to be the most wonderful thing for the economy and will never see a downturn again. Or you say, well, it's going to be a pretty rough second and third quarter because they're going to unwind it all. I know where I put my money.
We tend to look at these things, and I suspect a lot of people do, in terms of, what's the trend going on here? Are we going up? Are we going flat? Or are we going down? And what is it that's going to come along? I mean, if you like, what we've done is we've talked about the why we might be going down and the what, in terms of how we see it, in terms of the end user industry, chemical industry, and so on.
So now you get onto the interesting question of how and when, which is where you can make or lose money. And I've been an oil trader in Houston, Texas. So I'm pretty keen on the how and when side of this rather, just the high level analysis. And so one's looking at indicators to see whether the downturn becomes exponential, if you like.
And the oil market seems to us to be playing that role at the moment. I'm not making any sort of great claim. I'm just saying we're in one of those moments where the oil market is clearly going in the wrong direction compared to supply/demand dynamics. Saudis cutting by 1.2 million barrels. The Russians are cutting a little bit now and again.
But of course, it's very cold in Siberia so you can't-- who would have thought it would be cold in Siberia? So the usual excuses for everybody else, but the Saudis, as usual, also, are picking up the slack. And they want the $70 a barrel price because they've got some very extravagant budget needs to restructure the economy. So that's what they want.
And the problem, of course, is that if the market now starts to fall away, if Chinese demand really does continue to slow, and if India continues to slow, well, what are you going to get? Those are your two main sources of growth for oil demand. We do know that Saudi is not the swing producer anymore. We know that the US is now the largest producer.
Russia is up there, too. I'm very happy to discuss it with anyone, but I don't believe that Russia will ever cut back, meaningfully. They've never done it in the past. They never do it. In the future, they might. Doesn't suit their strategy at all, but they'll talk a good talk. So you've actually got more and more oil coming out. Some of that has been delayed in the States, in terms of hitting the market, because of infrastructure. Shale came out so quickly that the pipelines and everything just couldn't get there in place. But they are coming in place.