This Is Not Merely A Rough Patch



By John Richardson

IT was interesting to read late last week about how certain chemicals analysts still believe that the big slump in the sector’s share prices might merely be a rough patch, possibly just a correction.

In this same excellent piece from my colleague Nigel Davis, Citi US chemicals analyst PJ Jukevar talks about how “battled tested” chemicals companies” have learnt since 2008/2008 to put “value over volume”. In other words, capacity will again be quickly shut down to bring markets back into balance if we do end up in a protracted downturn.

There is also a lot of discussion about two classes of chemicals companies. This comprises those more exposed to the cycle because they make highly commoditised stuff where there is lots of competition, against products where there are fewer players and so more of an ability to exercise market discipline (plus more “value-added” differentiation).

This latter group might get through the rough patch relatively unscathed, argue some chemicals analysts.

Regular readers of the blog will hardly be surprised to discover that we don’t agree with any of this.

In our view it was Federal Reserve liquidity that was a substantial factor behind driving share prices, in general, higher during 2008/09. The chemicals sector rode on the back of this and also benefited from cost savings, the operating discipline Citi talks about – and China’s economic stimulus package.

Fed liquidity did not mean that on a global basis demand was back where it was before the crisis during the 2009/2010 recovery, even though emerging markets were booming.

The rise in share prices was substantially because investors - faced with record-low interest rates in the US - were chasing higher returns in equities, oil prices and other commodities. The oil price remains in demand destruction territory thanks to the speculators.

The signs are that the Fed might not be able to extend its ultra-loose liquidity policy much beyond keeping interest rates very-low for the next two years – because of resistance within the Fed.

Plus, of course, there is global aversion to risk – benefiting government bonds, gold etc at the expense other commodities and equities. There will be mini-recoveries in the appetite for risk, sure, over the next weeks and months, but this will not mean a return to a bull market.

The reason is the macro-economic problems. No matter where you turn they are mounting, evolving and together represent a once-in-a-generation shift to a New Normal.

Take the Eurozone and the bitter divisions over how to solve the crisis as just one example.

Germany’s Finance Minister Wolfgang Schauble has rejected International Monetary Fund (IMF) calls for a softening of the European austerity drive.

“Pursuit of debt reduction by deflation only – in a world whose savings rate is already at a record high – means the Euroland recession could well be prolonged and deepen into a recession next year,” Charles Dumas from Lombard Street Research told yesterday’s Australian Financial Review.

Two years on from the start of the Eurozone crisis, we still seem to be some way from broad agreement on how to solve the crisis. This does not bode well.

India has now raised interest rates 11 times since March of last year and food-price inflation has been above 9 per cent for five weeks in a row.

A new global food crisis - driven by fundamental changes in the demand and supply of food – threatens emerging-market growth in general. This raises questions about existing emerging-market growth models.

China continues to struggle with the harmful side effects of its stimulus package.

Attempts continue to cool inflation without preventing a collapse in property prices that would leave the country with a potentially destabilising non-performing loans crisis. As we discussed earlier this week, the latest attempt to rein in liquidity – a change in how bank-reserve requirements are calculated – has further reduced the ability of chemical traders and buyers to source credit.

China’s 12th Five-Year Plan (2011-2015) involves perhaps the biggest overhaul in economic policy for a generation. This looks likely to set the economic direction for the next decade or more, not just the next five years.

Policy changes are going to have a big, disruptive effect on chemicals demand.

Take the auto sector as one example.

Government policymakers are leaning towards more limits on the rise in car ownership in order to address China’s steeply rising dependence on imported oil, its traffic jams, air pollution and shortages of land in many areas for more road construction.

This is despite strong industry pressure to reinstate reduced sales taxes and subsidies for rural purchases. The incentives resulted in a 33% surge in sales in January-July 2010 over the same period in 2009. After the incentives were removed, January-July 2011 sales were up by just 5 per cent.

Individual cities, such as Beijing, have also introduced restrictions on new vehicle registrations in order to deal with chronic traffic congestion and dreadful air quality.

The government is considering raising minimum kilometres per litre, or miles per gallon, requirements for new vehicles – and introducing new subsidies to promote the production and sales of fuel-efficient and battery-powered cars.

For the numerous foreign and auto makers who are building-up capacity in China – perhaps on the assumption that the old growth model still applies – these are worrying times. Annual auto production capacity is expected to rise from 17 million vehicles in 2010 to 31 million vehicles by 2013, according to consultants JD Power & Associates.

All chemical companies fall into one category – those dependent on demand.

There are fewer producers of polyurethanes (PU) than say polyethylene (PE), and so the PU producers might be able to react more effectively in the short term to declines in demand.

But the scale of the global economic changes we are undergoing at the moment – as we enter the New Normal - are so great that nobody can possibly be immune.

And this is not merely a rough patch or a correction.



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