Global economic outlook out of sync

Headwinds are starting to throw the global economic upswing out of sync. After a meaningful uplift this year in US and European economies, especially on the manufacturing front, Europe is slowing down markedly while China is taking measures to stave off the negative impacts of US tariffs.

On 10 October, the US equity markets plunged, with the benchmark S&P 500 Index finishing down 3.3%. This included major declines in chemical stocks.

The big risks going forward are trade and interest rates, with US policies causing the waves.

The latest manufacturing Purchasing Managers’ Index (PMI) readings show continuing strength in the US, but a major slowdown in the eurozone. China’s manufacturing PMI as measured by the IHS Markit/Caixin index, having long lagged the US and Eurozone, is now at the neutral level.

US-CHINA TRADE WAR

In the latest China PMI report, new export orders declined at the quickest rate since February 2016 as the trade war with the US hit home.

The US-China trade war continues to escalate, with the third round of tariffs being implemented from both sides on 24 September. Chemicals, polymers and finished plastics are all impacted in the second and third rounds.

This latest US tariff round on $200bn in Chinese imports at a rate of 10% comes on top of 25% tariffs on a cumulative $50bn in imports in rounds one and two. Importantly, this rate jumps to 25% by 1 January 2019 unless there is some trade agreement.

Plus, US President Donald Trump has threatened tariffs on another $267bn in Chinese imports – essentially placing all imports from China under tariff.

China has likewise put 25% tariffs on $50bn in US imports in rounds one and two, and 5-10% on $60bn in imports in round three. It simply cannot match the US dollar for dollar, as it exports far more to the US than it imports, to the tune of around $375bn in 2017, according to the US Census Bureau.

For chemicals and finished plastics, the second round of tariffs impacted $2.0bn in US exports and $2.2bn in China exports. The third round ratchets this up to an additional $8.8bn in US exports and $13.2bn in China exports, according to the American Chemistry Council (ACC).

China’s finished plastics exports to the US are hit particularly hard, with $1.4bn worth in the second round, and another $5.6bn in the third round, the ACC noted.

The US is hit harder in bulk chemicals, with notable volumes of polyethylene (PE), styrene, polypropylene (PP), ethylene dichloride (EDC), monoethylene glycol (MEG), paraxylene (PX) and ethylbenzene coming under tariff, according to an ICIS analysis.

And the US has opened up trade battles on multiple fronts – with the EU, Canada, Mexico, Japan, South Korea, Turkey, Brazil and India.

One positive development has been an agreement to revise NAFTA with the new US-Mexico-Canada Agreement (USMCA). The US and South Korea have also agreed to revise their free trade agreement.

CHINA MITIGATION MOVES

Yet the headwinds from these battles are being felt worldwide, particularly in China, where financial markets and business confidence have plunged.

On 7 October, China’s central bank announced a plan to cut to its reserve requirement ratio – the amount of funds it requires banks to hold – by 1 percentage point by 15 October.

This move would spur lending to support economic growth, potentially injecting over $100bn of liquidity into the banking system.

However, this did little to inspire confidence in the short term, as the benchmark Shanghai Composite Index tumbled 3.7% on 8 October – the first day of trading after the Golden Week holidays. It is now down around 19% year to date.

In contrast, the US benchmark S&P 500 Index is up 3% this year, even after plummeting on 10 October. In late September, China also slightly eased air pollution reduction targets in a move to presumably provide relief to the industrial sector.

EUROPE CONFIDENCE FALLS

Europe is not immune to the US-China trade dispute, as many of its companies have manufacturing operations in the US that export to China. The EU is also battling with the US on trade, with the US threatening to impose tariffs on auto imports in particular.

The eurozone manufacturing PMI has steadily declined from a high of 60.6 in December 2017, to 53.2 in September 2018 – its weakest level since September 2016, although still in expansion territory above the 50 level.

Global trade concerns pushed business confidence down to a three-year low, and export-led slowdowns were evident in Germany, France, Spain, Italy and Austria.

IMF OUTLOOK

On 9 October, in its World Economic Outlook (WEO) report, the IMF slashed its global annual GDP growth forecast to 3.7% for 2018-2019 versus its previous 3.9% target from April. Global growth, while still solid, has likely plateaued, it said.

“There are clouds on the horizon. Growth has proven to be less balanced than hoped. Not only have some downside risks that the last WEO identified been realised, the likelihood of further negative shocks to our growth forecast has risen,” said Maurice Obstfeld, economic counsellor and director of research at the IMF.

The IMF took down its GDP forecasts for the US and China in particular for 2019 because of negative impacts from the trade war. It expects US GDP growth to fall from 2.9% in 2018, to 2.5% in 2019.

For China, GDP is projected to decline from 6.6% in 2018, to 6.2% in 2019. And after growing by 2.4% in 2017, eurozone GDP is estimated to slow to 2.0% in 2018 and 1.9% in 2019.

RATES, EMERGING MARKETS

In addition to global trade tensions, the rising interest rate – also led by the US – is the other major threat to economic growth.

Already the series of interest rate hikes by the US Federal Reserve has boosted the US dollar and drained liquidity from emerging markets in particular.

Argentina, Turkey, Brazil and South Africa have seen notable economic weakness and currency declines, although Brazil’s financial markets and currency have gotten a boost from right-wing and business-friendly candidate Jair Bolsonaro winning the first round of presidential elections.

“Amid the trade uncertainties, financial conditions are tightening for emerging-market and developing economies as they adjust to progressive interest rate hikes by the Federal Reserve and an impending end of asset purchases by the European Central Bank,” said Obstfeld from the IMF.

“Compared with 10 years ago, many of these economies have higher levels of corporate and sovereign debt, leaving them more vulnerable,” he added.

CRUDE PRESSURE

Also pressuring emerging markets is rising oil prices, as many countries such as China and India are major net importers.

With US sanctions on Iranian exports of crude oil set to kick in on 4 November, US President Trump has been imploring OPEC to boost production to get prices down as the US alone will not be able to make up the difference.

Meanwhile, Brent crude oil at around $83/bbl has surged to its highest level since late 2014.

US CHEMICAL STOCKS

While the US economy is “ripping” with robust manufacturing and services activity and record-low unemployment, the key housing and automotive sectors have been weak of late as higher interest rates start to bite.

And one would not be able to gauge the strength in the general manufacturing economy by looking at US chemical equity prices and valuations.

The sector has hit a rough patch since early September and is well off its highs of late January. This week, profit warnings by PPG and Trinseo triggered severe declines in their stock prices with Trinseo down over 21% on 10 October.

Shares of DowDuPont, the largest and most diverse company in the US chemical universe, are off by about 15% since September and 23% from their January high.

At around $59 as of 8 October, the stock trades for about 12.3x estimated 2019 earnings versus 15.6x for the S&P 500.

More severe valuation compression can be seen in commodity oriented chemical names, indicating that investors are discounting the risk of a major earnings downturn going forward.

For example, LyondellBasell at $98 trades at 8.7x estimated 2019 earnings while Westlake Chemical at $80 fetches a multiple of 9.2x.

But nowhere is investor scepticism more evident than in the titanium dioxide (TiO2) sector, where Chemours at $36 trades at just 5.6x estimated 2019 earnings, even as fluoroproducts and other chemicals make up a substantial and growing portion of the company.

Other purer play TiO2 companies Tronox and Venator trade at multiples of 6.6x and 5.5x, respectively. Interestingly, this beaten down sector was actually up on 10 October amid the overall market carnage.

On a fundamental basis, juiced by corporate and individual tax cuts and regulatory reforms implemented by the Trump administration, the US remains a beacon of strength in the world economy.

However, with other major economies and emerging markets faltering, this isolated strength will be harder to maintain.

The world economy is still very much interdependent on trade and financial systems, and the overall risks are rising.

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