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Inflation anxiety is misplaced as upward price pressures are only temporary

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By John Richardson on 18-May-2021

By John Richardson

SOME PEOPLE are panicking about global inflation. But I believe that much of the upward pressures on producer and consumer prices are temporary as they are the result of supply chain disruptions which will eventually disappear.

I also believe that demographics in the West and China represent long-term deflationary pressures that are acting as counterbalances to the supply-chain problems.

As for petrochemicals supply, nobody obviously has a clue about how many more outages will occur after a record year for lost capacity. But the availability of feedstock from refineries seems likely to increase over the next few months as demand for transportation fuels picks up.

There is also plenty of new petrochemicals capacity due on-stream during the rest of 2021 and in 2022 to turn today’s petrochemicals inflation into deflation.

Most of this new capacity is in China. This I feel helps to explain why northeast Asian polyethylene (PE) and polypropylene (PP) margins are weak versus margins in northwest Europe and the US Gulf. The above slide illustrates this point using high-density PE (HDPE) margins as an example.

Petrochemicals are very good proxy for the overall economy and last year there was no downturn in petrochemicals demand – quite the opposite, in fact.

I think the jury is out over whether the global economy will be stronger, the same or worse post peak-pandemic than during the height of the pandemic.

My view is that is more likely the developed world plus China economies, which make up most of the global economy, will be about as strong this year as in 2020.

The pandemic crisis in the developing world ex-China is likely to get an awful lot worse before it gets better because of weak healthcare systems, lack of vaccines and a lack of funds and infrastructure to deliver and inject the vaccines. Developing world ex-China growth seems likely to be weaker in 2021 than last year.

I thus expect not much inflationary pressure from global demand.

All that policymakers might have to fear concerning inflation is fear itself. This by itself course represents a risk as they may overreact.

US April consumer prices no reason for alarm

Enough containers have now been produced to meet global demand, according to Drewry Consulting. The problem is instead that containers are in the wrong places because of pandemic-related disruptions to global trading patterns and port operations.

The coronavirus crisis in India may delay a rebalancing of the global container market because of cargoes being turned away from India. Indian nationals account for around 200,000 of the world’s 1.7m seafarers. Indian workers are being placed into quarantine.

But never underestimate the ability of the Chinese government to intervene in markets and fix problems that are threatening the country’s economy. This is said to explain why there are reports of reduced pressure on container space at several Chinese ports.

And if you look in detail at the “shock” 4.3% April rise in US consumer-price inflation (CPI) – the biggest increase in 13 years – it wasn’t that much of a shock:

  • This was a year-on-year increase. All year-on-year data comparisons in H1 this year are misleading. This is because the world was in the depths of a huge collapse in industrial production and demand during the first half of last year. Any year-on-year comparisons are as a result bound to look good as we have climbed off the bottom of the collapse.
  • Excluding food and energy, US inflation in April 2021 was just 3%, according to the Wall Street Journal. Oil prices in April 2021 were 272% higher than in April last year when prices briefly went negative. In April 2020, traders were paying buyers to take oil in storage off their hands.
  • Prices of used US autos jumped 10% in April 2021 from the previous month—accounting for over a third of the all-items increase, added the WSJ. This was partly attributed to the shortage of semiconductors that has reduced the production of new cars.

Lack of semiconductor production is another supply-chain problem. The microchips shortage is due to the pandemic and a fire at a Japanese plant that supplies the autos sector.

Some labour market problems can be fixed

Labour shortages are another problem. In the US, for instance, only 266,000 new jobs were created in April this year, far fewer than the 1m that had been expected.

This was partly attributed to the unintended consequences of US stimulus. Because the hourly payment for furlough schemes has been set at a national level, low-paid workers in poorer areas of America are earning more money by staying at home. This has led to shortages of bartenders, waiters and plastic processing plant operators etc.

But US stimulus payments may be adjusted to deal with these disincentives. Labour shortages are only affecting some parts of America and national wage growth is low.

A long-term ageing of the US truck workforce is, however, also a factor behind the extraordinary story of Texas truckers being offered $14,000 a week.

Once the US borders fully re-open, though, increased immigration should help to ease labour shortages. The Biden administration is more open to immigration than its predecessor.

Labour shortages are a problem in Australia because our international borders remain entirely shut. But the Federal Government is coming under increasing pressure to offer a clear pathway to re-opening the borders.

Governments here usually listen to popular opinion as federal elections take place every four years, and because of a finely balanced electoral system. It only takes a minor vote swing for one governing party to be replaced by another party.

As other international borders re-open, global labour-supply pressures should ease.

The long-term trends are deflationary

“Over the past few decades, [US] CPI figures have mostly been the results of a concatenation of ‘temporary’ trends in different sectors—the costs of education and healthcare rose nonstop, while the prices of many goods continuously fell,” wrote the WSJ in the same article I linked to above.

“It was different in the 1970s, when an idiosyncratic squeeze in the supply of oil fuelled an inflationary spiral that pushed all costs up,” added the newspaper.

The 1970s were also an era of rising working-age populations in the West because of the surge in 1950-1960s birth rates – the Babyboomer generation.

Inflationary pressures eased from the 1990s onwards because of the integration of eastern Europe and China into the global economy. Both regions supplied cheap finished goods to the West as they took advantage of their low labour costs.

Working-age populations are shrinking in the West because of the fall in birth rates. This is creating deflationary pressure. When you retire you are usually living on a reduced income and you have already bought most of the big things you need, such as housing.

China is also an ageing society. But this does not mean a long-term increase in the cost of finished goods because China is outsourcing low-value manufacturing to countries with youthful populations.  Youthful populations equal low labour costs.

Chinese outsourcing has a geopolitical dimension as many of the countries to which Chinese manufacturing has been moved are part of the Belt & Road Initiative (BRI).

And as I discussed earlier this week, China wants to secure more competitively priced raw materials, including petrochemicals, from resource rich BRI members.  The speed with which China’s population is ageing and the strain this is placing on the Chinese economy is adding urgency to the search for lower-cost raw materials.

A theoretical example of how this may link together is as follows: China imports advantageously priced oil from the Middle East and turns the oil into polyester fibres or fabrics. It then exports fibres or fabrics to Chinese-owned textile factories in Middle East countries with youthful populations. Iran could be an example as it has a median age of 32 compared with China’s 38.4.

China’s short-term deflationary potential

“But these are long-term trends which won’t do anything to help with today’s supply-chain problems,” you might say.

I disagree. The long-term trends are bubbling away in the background as counterbalances to supply-chain related inflationary pressures.

And as mentioned above, I wouldn’t be a surprise if Beijing has helped ease container-freight shortages by intervening in markets.

This might have been prompted by a moderate slowdown in the Chinese economy during Q1 versus Q4 2020. I believe the slowdown was partly the result of difficulties in finding enough container space and semiconductors to fully maintain China’s stellar H2 2020 export growth.

Iron ore prices have retreated from record highs because of signs that Chinese government officials are prepared to act on allegations of hoarding and price manipulation.

“China’s central government seems to be very concerned about this major input for its steel-intensive economy. I think what the pullback reflects is the government trying to rein in prices,” Tom Price, head of commodities strategy at Liberum, told the Financial Times.

Copper prices have also fallen from record highs as China reduces credit availability for commodity traders and end-users.

This year is a watershed year for Chinese petrochemicals capacity. There is enough capacity in the ground for a potential sharp fall in imports of PP, HDPE, styrene monomer (SM), paraxylene (PX) and ethylene glycols (EG) if China chooses to run its plants at high operating rates.

Given the extreme tightness in global petrochemicals markets, it would make sense for China to run its local capacity very hard in 2021 and 2022.

As for the extreme tightness in global petrochemicals markets, this in my view won’t last much longer.

Global petrochemicals supply set to lengthen

In late 2019 as variable cost PE margins turned negative in Asia, it seemed as if the long-awaited supply-driven downturn hard arrived.

But then came pandemic-related petrochemical supply disruptions as refinery run rates were cut on the collapse of transportation fuels demand, reducing the availability of feedstock. The rate cuts were accompanied by demand that was much stronger than anyone had  been expected – again because of the pandemic.

Then came the US winter storms in February this year. The storms at one stage took some 60% of US PE capacity and 80% of PP capacity offline. US plants are gradually returning to normal.

Bigger volume exports of US PE to Europe are expected to occur in a few weeks’ time. Right now, only small cargoes are moving to Europe, which is a major factor behind “island Europe” – only theoretical arbitrage for both PE and PP. The other factor is lack of container space.

But ICIS believes there is plenty of container space on the US-Europe route and freight rates seem very workable. Tight supply in the European PE market should ease over the next few months.

Europe has also been hit by a series of unplanned production outages which have resulted in a large number of force majeures this year, wrote ICIS news in this article. As of last week, 27 locations were affected by force majeures compared with 14 at the same time last year and seven in 2019.

Europe also has a large number of planned maintenances underway, which are taking further capacity offline. Some of these were delayed from 2020 by the pandemic.

Refinery operating rates are unlikely to return to anything like the old normal for a long time. Jet fuel demand will surely remain depressed for at least the rest of this year and well into 2022.

People are getting used to working at home. Companies are finding it cheaper to let employees work from their living rooms because corporate office space can be reduced. This means less commuting-related fuels demand.

Gasoline and diesel demand should, however, improve over the next few months if lockdowns continue to ease in the developed world.

Buyers of petrochemicals would notice falls in naphtha deltas over crude and the cost of refinery propylene. This would place some downward pressure on petrochemicals prices.

New petrochemicals capacity hitting the market in 2021-2022 will, though, in my view be the real game changer.

“China ethylene capacity is forecast to more than double between 2019 and 2025, which will outstrip demand growth, leading to depressed global operating rates,” said ICIS analyst James Wilson in the same ICIS article I linked to above.

To be precise, China’s ethylene capacity is expected to rise by 103% between those years to 54.2m tonnes/year. Propylene capacity is forecast to rise by 55% between 2019 and 2025 to 48.9m tonnes/year,

Chinese capacity additions  could push both global ethylene and propylene operating rates lower (see the chart at the beginning of this section). There could be a resumption of the supply-driven downturn that was halted by the pandemic.

Downstream in polyolefins, China’s HDPE capacity is scheduled to rise by 105% in 2019-2025 to 17.3m tonnes/year. Low-density PE capacity is forecast to increase by 26% to 3.9m tonnes/year.

Linear-low density PE capacity is expected to be 72% higher at 13.6m tonnes/year with PP capacity 61% higher at 44.9m tonnes/year.

The above numbers underline my longstanding argument that China is about to push us from a world of petrochemicals inflation to one of deflation.

Remember that deflation may also apply to SM, PX, EG and methanol.

You cannot have a recovery without a downturn first

There is a lot of misleading commentary about the global economy roaring back as pandemic restrictions ease. This is based on year-on-year comparisons of statistics such as industrial production.

Industrial production is obviously much higher on a year-on-basis in H1 this year because H1 2201 was an historic disaster for the global economy. This doesn’t mean we are the in the middle a boom. It instead  means we are off the bottom of a major slump.

As I discovered specifically with the Chinese economy, it made more sense to use quarter-on-quarter comparisons between Q4 2020 and Q1 2021. This told us that the incredibly strong growth momentum of Q4 last year hadn’t been fully maintained.

More broadly, here is the critical point to remember: you cannot have a recovery without a downturn first.

Last year, petrochemicals demand was very strong despite the pandemic. What applied to petrochemicals I believe also applied to the broader economy. Some downstream industries did extraordinarily well in the developed world  plus China. These included supermarkets, hygiene-product manufacturers and internet sales companies.

Consumption of durable goods also boomed as the cash-rich middle classes spent money on washing machines, TVs, game consoles, computers and carpets to relieve the boredom of lockdowns and equip their homes as offices.

There will be a cycle out of some goods and services into other goods and services if lockdowns continue to ease in the developed world. Demand in some industries will decline as others make gains, which suggests that there may be no net gains in total economic activity.

And despite all the extra government stimulus sloshing around economies, not all of this extra cash will be spent. An important article by The Economist, which is worth deep study, said that spending patterns would vary between different demographic and income groups. Attitudes towards government handouts were crucial, said the magazine.

A shocking deep statistical dive into global excess deaths, also by The Economist, indicated excess deaths from coronavirus in the developing world ex-China were way higher than official numbers. This was the result of weaknesses in data collection and reporting systems.

This suggests the economic damage in poorer countries is greater than originally estimated.

And unless or until “all of us are vaccinated, none of us our vaccinated,” said my doctor last week. Hear, hear. Poorer countries are a huge distance from being fully vaccinated, raising the potential for a lot more economic damage.

The supply of vaccines was not the only problem for the developing world ex-China, as the cost of delivering and injecting a vaccine was five times more than its procurement, said the New York Times.

I therefore feel there is no need to panic about booming demand adding to inflationary pressures. And for the reasons detailed above, there are no reasons to be too concerned about supply-chain driven inflationary pressures.

But might policymakers panic anyway? Possibly. The last thing we need is a premature increase in interest rates.