Submitted by Andrew Zaitlin of Moneyball Economics
"People's confidence that the consumer can somehow offset this industrial recession that we've had is really being shaken to the core with the disappointing numbers from some of these major retailers"
- James Abate, CIO of Centre Funds.
Recessions Are Underway
China drove the recent economic boom, just as it is behind the recent malaise. A turnaround in Chinese demand would certainly change things but the current data does not look promising.
For China’s trade partners, it means recession today. Only Germany and the US look positioned to weather the storm. Expect the next macroeconomic leg down to start in January. Between now and then, data will continue to weaken incrementally. Expect urgent Central Bank intervention in Taiwan, Korea, Brazil, and Australia.
It’s Not a US Recession… Yet
The US economy may be only 30% dependent on exports, but a sudden drop still hurts. Especially when GDP is growing only 2%.
The domestic hit this year from the downturn in commodities is well known. Falling prices and production immediately led to lower capital expenditure (CAPEX) spending on pipelines, extraction equipment, and so on. That extended to basic industrial component suppliers like pumps and fasteners, among others.
US exports pulled down as global customers got whacked.
After rising 2% from 2013 to 2014, non-petroleum exports suddenly contracted: down -3.5% year-to-date through August.
- Metal Exports -$3B
- Machinery Exports -$8B
- Industrial Machinery -$3B or -5%
While direct exports to China have fallen only $2B, the remaining drop is still China-related. The bulk of the export drop comes from commodity producing countries. Mexico and Canada account for $20B of the export drop and finished-goods producing countries that export to China (EU) account for $10B.
Bottom line: You can’t strip out $34B from the US economy without significant blow-back. If oil and mining companies were the first to be hit, the second victim of China’s downturn has been industrial goods suppliers. The next wave will be operating expenditures (OPEX), in the form of temporary workers.
The US Response: Slower Production
Hats off to US producers for responding quickly. Businesses have dramatically curtailed factory expansion and spending on capital goods.
The swift response is also a warning sign: if demand remains sluggish, additional cuts will come quickly.
Capital goods spending has also dropped. Some of that comes from IT spending shifts (Windows 10 release has pushed out some IT spending, the Cloud is reducing hardware spending). Most of the drop is business retrenching in the face of an inventory overhang.
Unfortunately, US producers are still behind the curve. While inventory production has slowed, demand is slowing even faster. US non-petroleum exports are contracting faster. The result: inventory overhang.
US: Weak Exports, Sudden Downturn in Imports
Not only have exports fallen to the lowest level since 2012; per the latest Census Bureau trade data through August, the pace is accelerating. That extends to exports minus food, autos, and oil which shrank 2X the rate of the previous six months.
The worst is yet to come. For more recent data, we looked at the biggest ports on either US coastline: Los Angeles, Long Beach, New York, and Savannah. (The individual port data was distorted by the 1Q 2015 West Coast ports slowdown and subsequent re-routing of cargo shipments via East Coast ports. So we combined all ports to get a clear overview.)
No surprise, the export story remains grim. Volumes continue to contract although the pace is flat, but this data includes oil exports and we know that they contracted in 4Q 2014 and 1Q 2015. Adjusting for oil and cargo, exports have probably contracted at a more constant pace. This means that it is possible that we are approaching a bottom of sorts.
Big surprise, imports turned for the worse. September imports suddenly collapsed to 0% y/y. The China-facing ports of Long Beach (-2%) and LA (-9%) fared the worst. It’s the lowest level of shipments since 2009. Just a guess, but it fits the industrial slowdown story (not holiday shopping season related).
Semiconductors: No Bottom and Continued Manufacturing Softness
Back in August, Southbay Research noted that semiconductor companies were uniformly less bullish. Recent earnings calls have reinforced the less bullish picture, and no wonder: top-lines have begun to contract.
Semiconductor companies are preparing for no growth. Silicon wafers are the basic building blocks of semiconductors. After surging last year, volume demand has collapsed from 11% in 2014 to barely 2% this year. Expectations are for 1% growth next year.
The standard playbook says to start with CAPEX cuts. The top three semiconductor manufacturers announced CAPEX cuts in the last month:
- Intel lowered CAPEX a further $500M, bringing total CAPEX budgets down from $11B last year to $7B.
- Samsung cut CAPEX $2B or 20%.
- TSMC to cut CAPEX $3B or ~30%.
The reason: China demand is lower than expected. Last year was a boom time for semiconductor makers as the Chinese smartphone market continued to surge. In particular, a new cellular infrastructure roll-out boosted sales of higher end phones. However, actual demand was overstated. The desire to not miss out on a sale drove handset makers to over-order.
“[There was] an artificial peak in retrospect meaning there was a lot of inventory being built up by our customers who all thought they were going to get a higher share… we had many customers thinking they were going to get a bigger share out of that.” -Jon Olson, XLNX CFO
The result was that supply exceeded demand and inventories surged. As the CEO of TSMC put it, the sudden weakness was surprising. The smartphone supply chain spent the summer bleeding off excess inventory. But demand remains weak. The China smartphone market contracted in 2Q. TSMC now forecasts 0% semiconductor growth in 2016, down from the previous forecast of 3%, citing China as the reason for weakness.
“Most of our customers are pretty optimistic about their own business… but growth has just slowed at least for now. And I think when you are CEO of the company and you take a look at what’s going on out there, you are sort of trying to save a little bit of money right now and waiting to see what happens.” -Don Zerio, CFO LLTC
Indeed, recent semiconductor sales continue to contract, and that’s after we include the massive production ramping for the new iPhone release (heavy demand for chips).
Expect more cost cutting and the start of layoffs. Beyond cutting back expansion plans, some companies are selectively shutting down production lines. Adding to the pain of excess capacity, more capacity is coming online. We expect layoffs and consolidation to accelerate into 1Q 2016. This is a great time for Chinese companies looking to hire talented engineers.
Adjusting to Slower Chinese Demand
“It’s not like [our customers have] seen a significant decline in demand. It’s just they haven’t seen the increase that they had originally planned.” -Richard Clemmer, CEO NXPI
Global exporters and producers are in a recession. China’s iron ore imports epitomize the current situation as Chinese demand flattened. While technically that’s not a recession (demand quantity has not dropped), the impact feels the same (falling prices and profits) and the response is the same: cuts in OPEX and CAPEX.
How did this all start? It began in late 2013, when China popped its credit bubble. The chilling effect was seen across the entire Chinese economy, from iron ore to housing prices. Everything proceeded to downshift in late 2013 as credit tightened. Credit bubbles tend to behave in the same way: hot money bids up assets and popping the bubble leads to over selling.
China’s bubble and current blow-back have some unique qualities:
- Significant global impact from changes in Chinese marginal demand
- Over reliance on real estate
The origins of the bubble started with China setting course on returning to economic might by becoming a manufacturing powerhouse and having world-class infrastructure. Both objectives turned China into a capital intensive economy and a destination for global industrial suppliers (machinery, commodities, etc.). Loose monetary policy facilitated the growth.
A boom in asset prices followed. This was partially the natural outcome of real demand driven by an unprecedented boom in consumption for domestic development and exports. It was also partially the outcome of credit bubble hot money that bid up asset prices.
Trouble came from significant and extreme corporate gambling in real estate and commodities. Seeing ever-rising asset prices, Chinese companies saw an opportunity: using special access to cheap credit, they bought iron ore, copper, and real estate which they then used as collateral to buy more iron, copper, and real estate. Actual demand, together with this artificial demand, combined to create the impression that consumption was racing higher. A false high growth trajectory was established and then reality hit. First came monetary tightening. Then came the Chinese government’s 2014 infrastructure budget which called for no growth. Producers were hit hard but borrowers were hit even harder. In other words: a textbook popping of a credit bubble.
- Overvalued assets get oversold and fall in price (commodities and real estate)
- Discretionary spending gets squeezed (gambling in Macau)
- Liquidity squeeze
Commodities have been hit especially hard.
- Focus of corporate gambling: loss of big demand coupled with stockpile sell-off
- Factory production slowdown: unprofitable factories dependent on loans to stay afloat are suddenly facing liquidity crunch
- Sluggish infrastructure spending: slowdown in public sector projects and private sector real estate development
Inventory adjustments define global trade through 2016. The market is still trying to discover the true levels of sustainable demand.
- Today: Bleed inventory, push out expansion
- Tomorrow: Reduce production and capacity
The first step is dealing with excess capacity. Here’s that iron ore chart again. Demand was on a trajectory of 80M-90M tons, and capacity was expanding accordingly. Instead, demand has stopped at 70M tons. That’s 15%-20% excess capacity.
As China exports deflation, political reality takes over. The Chinese government talked a good game.
When the new government took over in early 2014, one of its first moves was to emphasize the need for a more market-driven economy. In May 2014, President Xi stressed the point: a “decisive” role of market forces to allocate resources. We never believed it for a moment.
Then reality hit. The normal market reaction to a manufacturing recession is to close factories, reduce capacity, and fire workers. But that’s politically impossible in China. Instead the government is saving companies and hoping to export its way to growth. The Chinese government could reignite demand through more infrastructure spending. That would create a bottom in prices. We’ll know in December when the 2016 budget gets released. Regardless of spending initiatives, monetary policy will be to weaken the yuan, provide easy credit, and support dumping of excess supply into global markets. This is all very deflationary for the US and EU.
What This All Means
In the near-term (4Q 2015-1Q 2016), bleed inventory. The sequence of events will be:
- Push out factory expansion plans (CAPEX to drop)
- Reduce production (cut back extra shifts, slow hiring)
Longer term (2016-2017), cope with excess factory capacity. The sequence of events will be:
- Stop factory expansion plans (severe CAPEX cuts)
- Reduce production (shutter production lines, fire workers)
Industrial layoffs have already started, but will begin in earnest in 1Q 2016. Companies have entered a wait-and-see mode which is a precursor to layoffs.
This is a bearish place to be. Industrial company dividends are not at risk yet, but growth is very much under pressure. For the next 3-4 months, consider ETFs which are short Asia or short US industry.
One risk to this strategy is that Asian stock markets may jump on various currency moves or Chinese stimulus. Another risk is that the current adjustments to lower demand start to wind down by 3Q 2016, which would create a temporary boost to industrial stock.
The overall theme is excess supply, and it has yet to finish playing out across the ecosystem.