INSIGHT: Global cauldron of concerns bubbles amid BASF profit warning

NEW YORK (ICIS)–A bevy of uncertainties, stemming from US Federal Reserve rate hikes, late economic cycle dynamics, the US-China trade war, Brexit, Italy’s budget crisis and the mass protests in France, are weighing on global business sentiment.

While US manufacturing activity continues to march ahead for now, growth in Europe and China is screeching to a halt, as evidenced by their respective purchasing manufacturing indexes (PMIs).

A profit warning from Germany-based BASF, the world’s largest chemical company, outlines the challenges ahead. Weakness in the overall automotive sector, and particularly in China, was one of the key factors in BASF’s outlook for underlying operating profit in 2018 plunging 15-20% year on year.

BASF had earlier projected a 10% decline in operating profit.

The company cited the US-China trade conflict as a contributing factor to the automotive slowdown.

Shares of BASF, already down to more than a 2.5-year low of €60.69 when the warning was announced on 7 December, fell another 3.8% to €58.40 by 10 December.

Granted, the company’s projected shortfall comes after a 32% profit gain in 2017 and includes company-specific factors related to low water levels on the Rhine river. But the extent of the decline underscores deteriorating market conditions.

Weakness in automotive was cited in a number of profit warnings and disappointments for US-based companies in the third quarter – from Trinseo, PolyOne, PPG and Axalta Coating Systems.

US ECONOMIC OUTLOOK
On a regional basis, we know economic growth is slowing markedly in Europe and China. So let’s take a closer look at the region with the strongest economic growth – the US. Here we’re sidestepping GDP and going with manufacturing and services PMIs.

Even with softening automotive as well as housing sectors, US manufacturing appears to be powering ahead. This strong growth has led to a tightening labour market and resulting wage gains, sparking inflation concerns.

The US Federal Reserve has responded with a series of interest rate hikes, although lately signalling it could slow things down, depending on the data.

One economist believes inflation and thus higher US interest rates are on their way.

“We have the tightest [US] labour market in history, the largest deficit in history and yet no inflation. What do we make of this and what is likely to happen? JPMorgan Chase CEO Jamie Dimon said the 10-year Treasury could be at 5% in the not too distant future. I would agree,” said Peter Tanous, founder and chairman of Lynx Investment Advisory.

The 10-year Treasury stands at around 2.9% today. Tanous said a 5% yield is possible in the next 2-4 years. This would have disastrous consequences for equity values as well as economic activity.

Tanous spoke on a panel at the SOCMA (Society of Chemical Manufacturers and Affiliates) Annual Meeting in New York on 10 December with author and economic policy advisor, Stephen Moore. Tanous and Moore, along with economist Arthur Laffer, were co-authors of the 2008 book “The End of Prosperity: How higher taxes will doom the economy – if we let it happen”.

Tanous points out that with an interest rate of 5%, the interest paid on US debt would be greater than the entire US defence budget of $720bn for 2019.

Also, the US economic and stock market cycles are long in the tooth in the midst of a trade war with China, he noted.

“We have had the longest bull market in history, and that doesn’t go on forever. Most importantly, the tariffs are potentially devastating,” said Tanous.

“And the stock market is not a coincident indicator but a leading indicator, looking 9-12 months ahead. It’s very confused,” he added, referring to the steep decline and wild swings since October.

MOORE’S BULLISH OUTLOOK
His co-author Moore, a proponent of US President Trump’s tax reform, author of the newly released book Trumponomics and currently a CNN economic analyst, has a completely different take on the US economy.

“I’m super bullish on the US economy… We are in an economic boom like no other in history. We have 7m more job openings than people to fill them. And now we have higher wages which is what we wanted… We are also producing more oil and gas than we consume, and that matters,” said Moore.

While corporate and individual tax cuts were important, the number one driving force for the US economy is deregulation, he noted.

“The deregulation effect is the biggest single thing – people know the government is not going to come after them,” said Moore.

However, he did agree with Tanous that the US budget deficit resulting from overspending is “definitely a problem”.

While US tax revenues in 2018 have been the highest in history, spending has outpaced this by far.

“We don’t have a revenue problem – we have a spending problem. Republicans have been worse than Democrats. Republicans wanted more for defence and Democrats wanted more for social. We got more of both and that’s inexcusable,” said Moore.

As for the US tax cuts, that along with the immediate expensing of capital expenditures – whether on “trucks, factories, machinery or computers” – acted like “a shot of performance enhancing drugs in the butt of the economy”, said Moore.

US FED POLICY
But strong US economic growth does not mean the Fed should keep raising rates, the economist said.

“Economic growth does not cause inflation, period – end of argument. If an economy produces more apples, what happens to the price of apples?” said Moore.

The US Fed has a “growth phobia” and is “chasing a boogeyman”. Commodity prices have fallen 10% in the past few months, he noted.

Tanous disagreed, saying the Fed had every rationale to raise rates as full employment does set the stage for inflation.

“With wages starting to rise along with certain commodities, I can understand why the Fed raised rates,” said Tanous.

However, with crude oil and other commodities having plunged in the past couple of months and the growth outlook dimming, he sees the possibility of one or no rate hikes in 2019, following a widely expected rate increase in December 2018.

US-CHINA TRADE OUTCOME
On tax reform, Moore called Trump a “master negotiator”, as he started with a goal to cut corporate taxes from 35%, to 15%. While the level ultimately ended up at 21%, had Trump started at the 20% recommended by advisors, the corporate tax rate would have ended up at 25%, he said.

As you’d expect, Moore is also positive on the outcome of US-China trade negotiations based on Trump’s track record.

“I never underestimate that man. Don’t listen to what he says – watch what he does. Watch the results,” said Moore.

The China situation is complicated and it’s far from clear how it will end, but it’s unlikely that Trump will back down. Within the 90-day window before more US tariffs kick in, China could come to the table on around the 80th day to make a deal, he noted.

Tanous, while largely bearish on the outlook for the US economy, is optimistic on a trade deal with China. He called the US-China trade relationship “the only one that really matters”.

Yet Trump’s tackling of difficult trade issues incurs huge risks with potentially devastating consequences for failure.

“With tariffs he is taking a chance. But I think he is going to win,” said Tanous.

Trade, along with immigration, are the the two key issues where Trump won over the working class electorate in the 2016 election. Thus he is not likely to back down on either front.

That was clear from Trump’s public argument with US House minority leader Nancy Pelosi and Senate minority leader Chuck Schumer in front of the press on 11 December as he threatened to shut down the government if he doesn’t get more funding to build a border wall with Mexico.

Expect the same type of stance on trade and intellectual property issues with China. In the meantime, with risks so elevated in such uncharted waters, investors are talking with their feet.

By Joseph Chang