Synchronised global slowdown led by China hits chemicals outlook

January 10, 2019

It’s not news that China’s economy is slowing. Weakness in the manufacturing sector in particular has been apparent for years, and now exacerbated by the US-China trade war. However, the magnitude of the decline comes as a surprise and piles on top of the growing heap of macro concerns.

A synchronised global economic slowdown is on the horizon for 2019, a reversal of the upswing seen in 2017 and 2018.

Technology giant Apple’s revenue shortfall warning on 3 January put the spotlight on China and triggered harrowing equity market declines around the world.

While markets rebounded sharply on 4 January on comments from US Federal Reserve chairman Jerome Powell, and some of the issues Apple cited were indeed company specific, there’s no question China macro weakness will have wide ranging implications across multiple industries, including the chemical sector.

“We see clear evidence that the sector is heading into a downturn. Key areas of demand such as autos, electronics and housing are all weakening. Similarly, companies have begun issuing profit warnings – always a warning sign in terms of a demand slowdown,” said Paul Hodges, chairman of consultancy International eChem.

CHINA PMI SHOWS CONTRACTION
On 2 January, The Caixin China General Manufacturing PMI (purchasing managers’ index) for December came in at 49.7 versus 50.2 in November, dipping into contraction territory for the first time since May 2017. And the new orders sub index fell below 50 for the first time since June 2016.

Any PMI reading above 50 indicates expansion in manufacturing activity while under 50 denotes contraction.

“In general, China’s manufacturing sector faced weakening domestic demand and subdued external demand in December… it is looking increasingly likely that the Chinese economy may come under greater downward pressure,” said Zhengsheng Zhong, director of macroeconomic analysis at CEBM Group.

Zhong cited the US-China trade tensions as having a continuing negative impact on manufacturing.

There is hope the US and China are making progress on trade talks, with the US delegation in Beijing wrapping up discussions on 9 January while the 90-day US-imposed 1 March deadline is fast approaching. US tariffs on a third round of $200bn in Chinese imports would rise from 10%, to 25%, if no deal is reached.

“China has been the key to the post-2008 recovery, both directly within China via its massive stimulus programme and indirectly via the demand this created outside China for all types of chemicals and plastics,” said Hodges from International eChem.

“But this demand was not based on incomes, which remain below poverty levels in the West on an average basis. So today’s unwinding of China’s stimulus and lending bubble is having a ripple effect across the entire global economy,” he added.

China’s manufacturing PMI figures have lagged those of the US and Eurozone for years. But the move below 50 is an important warning signal.

“China will likely experience another soft year. Production through November 2018 is off 2.2% from the same period in 2017,” said Kevin Swift, chief economist of the American Chemistry Council (ACC).

“Although the Caixin PMI turned contractionary, it was below 50 for much of 2012-2016. China’s a hard one to digest… There are a lot of structural issues and economic headwinds but when observers turn negative, the nation seems to surprise to the upside,” he added.

It is worth noting that the Chinese government is taking a series of steps to stimulate the economy, from lowering banking reserve requirements, reducing taxes and approving major infrastructure projects.

WALL STREET EARNINGS PROJECTIONS
You can fully expect China to be at the top of the agenda on chemical companies’ upcoming fourth quarter earnings conference calls – most certainly in the analyst Q&As.

Expect Wall Street analysts to ratchet down 2019 profit estimates on China weakness.

When Germany-based BASF, the world’s largest chemical company, sees weakness in China’s automotive market, as indicated in its 7 December earnings warning, this is going to cut a swath across the global chemical sector.

Current earnings estimates, which show profit gains for many companies in 2019 versus a strong 2018, are likely too high. Investors are sceptical on analyst projections, as many major US-based chemical companies are trading at severely depressed price/earnings (P/E) multiples.

However, Laurence Alexander, analyst at Jefferies & Co, calls the US chemical sector “cheap, even given [the] current macros”, estimating that stocks are trading 17% below warranted levels.

“In terms of absolute P/E, the current sector average of 13.4x compares with 10x-12x at cyclical troughs. P/Es typically trough 8 months before EPS (but only 3 months in 2008 and 2011…), and consensus EPS is typically cut by around 21% in that interval,” he noted.

SHARP SLOWDOWN IN US MANUFACTURING
Meanwhile, the US and Euzozone PMIs are also moving in the wrong direction.

Eurozone manufacturing activity slowed markedly all through 2018 while the US held up remarkably strong. That is, until the December PMI reading, which showed a sharp decline to 54.1 from 59.3 in November.

While US manufacturing activity is still firmly in expansion mode, the magnitude of the decline is troubling. The US is finally succumbing to the series of interest rate hikes as well as weakness abroad.

“This time last year, the talk was about synchronised growth. As the year progressed, it was apparent that was not occurring and there was an unraveling or desynchronisation. Right now, the US is the bright spot but that’s like saying we are the cleanest shirt in a pile of dirty laundry,” said the ACC’s Swift.

However, the economist points out the “disconnect between the financial markets and the real economy”.

“The four main indicators used by NBER (The National Bureau of Economic Research) and most business economists are still positive. Employment has picked up, wages are rising and inflation remains muted – a good position for us to be in,” said Swift.

The economist sees slower growth in the second half of 2019, even “a pronounced slowdown”, but no recession. He pegs the odds of a recession in 2019 at 25-35%.

The ACC is maintaining its forecast of US GDP growth of 2.6% in 2019, and US chemical volume growth of 3.6%, up from an estimated 3.1% in 2018, noted Martha Moore,

“The economic expansion is mature, but still has legs, at least in the US, so we’re still expecting good gains in chemicals this year, especially with new production coming online,” said Moore.

“We haven’t revised our outlook for US chemicals output in 2019, though a sharp slowdown in China could impact some exports to Asian supply chains. However, US chemical exports to China only represent around 9% of total chemical exports,” she added.

For key end markets, US light vehicle sales came in higher than expected for 2018 at 17.0m units. They are expected to ease in 2019 but stay at elevated levels. Housing should improve slightly but at a slow pace, Swift noted.

It’s key to keep track of business and consumer confidence, as an erosion of sentiment can become a self-fulfilling prophecy, he said.

“Certainly, trade policy is eroding confidence in business and offsetting the goodwill from the tax cuts a year ago. And the Q4 slump is equities is feeding into hampered confidence,” said Swift.

“Expansions don’t die of old age – they get pushed over the edge usually by policy missteps or some shock. We need to watch for the shock or black swan. Policy missteps include a more extensive and protracted trade war. But it seems the Fed is being flexible,” he added.

FED WHIPSAWS MARKETS
Arguably the greatest macro concern has been US Fed interest rate hikes and the impact on global markets. On 19 December, Fed chairman Powell signalled there would likely be two more quarter-point rate hikes in 2019, putting equity markets into a tailspin.

But on 4 January, after widespread financial carnage, Powell took on a more conciliatory tone, saying the Fed would be “patient” and that it is “listening very carefully” to the markets. That sparked a huge snapback in US and global financial markets.

Yet it’s unclear if rate hikes for 2019 are off the table entirely. If financial markets stabilise and employment and wage data continue to come in strong, at least one hike could be in the cards.

And the Fed continues to wind down its $4,000bn balance sheet to the tune of up to $50bn every month. While Powell noted in his 4 January walk-back that the Fed would be flexible in using all tools, including the balance sheet, to promote stability, it would likely take another sharp downturn in financial markets to shift the balance sheet to neutral.

The Fed shrinking its balance sheet as it’s doing today is known as quantitative tightening (QT) – the reversal of quantitative easing (QE). The impact of QT should be polar opposite of the easy money QE that inflated asset prices for almost a decade after the financial crisis of 2008-2009.

DEBT PROBLEM
Companies with high debt levels are feeling the pain disproportionately. Leveraged companies took the brunt of the beating in the severe market downturn in December and early January.

The ratcheting up of corporate debt levels since the financial crisis poses a risk to future profitability.

“The post-2008 stimulus programmes were originally supposed to be a “short, sharp shock” to unblock the plumbing in the financial system. But they then morphed into an ongoing policy tool, and debt levels have since risen most alarmingly,” said Hodges from International eChem.

“Debt simply brings forward demand from the future, and paying back this debt is likely to create major headwinds for demand for the next few years,” he added.

By Joseph Chang

Source: ICIS News