By Andrew Zatlin at MoneyBall Economics
The industrial slowdown predicted by semiconductors is coming true.
“We are operating in an environment of sluggish global economic growth, deflationary raw material trends, and heightened geopolitical tensions. The demand picture in China has not yet resolved itself, and growth in Europe and North America remains modest. We will continue our focus on commercial discipline, operational excellence and productivity to manage through the current environment.” -Mark Rohr, Celanese (NYSE: CE) CEO
In other words:
- The low growth macro continues.
- A China slowdown is underway. Demand is still unclear four+ months into the year?
- Corporate belt-tightening is underway.
- Big surprise: no layoffs announced.
This is a zero growth environment. Celanese is a leading manufacturer of acetyl based chemicals. Everyone uses its products: automotive, consumer electronics, construction, industrial, food, pharmacy, and agriculture. Things are worse than they appear: CE’s 1Q 2016 topline still shrank after initiating significant price hikes.
Volume demand is just falling, which means payrolls are under threat.
Celanese began small job cuts in 4Q 2015. No layoffs were announced in the earnings release, but what Celanese meant by “commercial discipline” and “operational excellence” is that, under these conditions, hiring is not going to happen.
We are seeing a “Stagflation-Lite” scenario. Government policies have created inflation in healthcare (Obamacare), rents, and wages (minimum wage mandated hikes). The problem is that these are fairly inelastic in the near-term. Also, Fed policy is mostly irrelevant: it won’t change mandated wage hikes, for example. Having signaled hawkishness about potential inflation, the Fed may actually tolerate this inflation.
- First, market pressure for a rate hike has disappeared. Treasury Inflation-Protected Securities (TIPS) rates have fallen from 0.69 in January to 0.21 in April, the lowest in 16 months. With negative yields popping up everywhere else, Treasuries demand will remain strong.
- Second, global macroeconomic weakness may take priority. If the Fed wants stronger macro before raising rates, then semiconductors say that won’t happen in 2016.
Next for the US: The Semiconductor Signals
Inventories are dropping for the first time since the recession ended. No inventory re-stocking is underway. In 2H 2015, the drop was in both nominal and growth terms. Normally, inventories rebound after deep cuts, but not this time since producers are expecting sustained drops in end-user demand.
To gauge the degree and duration of the manufacturing slowdown, turn to semiconductors, which are the primary and early component in all things manufactured. That, plus other factors, make semiconductors an excellent leading indicator.
Here are the three stages of the semiconductor production cycle:
- Raw silicon production
- Semiconductor production
- Final semiconductor system (PC Boards)
Start with silicon wafers. Imagine a large ingot one meter in diameter that gets sliced into discs. That’s a silicon wafer. Semiconductors are built on top of these discs. From wafer production to end-user sale is a four to six month cycle, which is why silicon wafers correlate to inventories with a one to two quarter lead.
In fact, the latest data from Japan (the source of most silicon wafers) shows a slight uptick in production – very slight. It would indicate inventory contraction through 2Q but at a slower rate. A bottom of sorts may be forming, but 2H is still unclear.
PC Board demand echoes that slower production. Break open an iPhone or take out the voice box in that Barbie doll and what you’ll see is a green plastic sheet with lots of semi chips soldered in place. That’s a PC Board (PCB).
As the last step in the semi cycle, PCBs offer less forward visibility but even more accuracy about end-user demand. Every device using a semiconductor also uses a custom designed PCB. That custom, build-to-order nature of PCBs adds to their accuracy at predicting demand. Suppose we want to track popsicle sales. If silicon wafers are the lumber being sold to popsicle stick manufacturers, then PCBs are the popsicle sticks being dropped off at the ice cream factory.
The current PCB signal shows low/no US production growth.
Some Good News: EU Looking Up
Strictly on the basis of semiconductor billings, conditions are looking much better in Europe.
If the current trajectory continues, the EU may see some uptick in economic growth in the 2H, which makes sense in light of the massive public spending to absorb millions of migrants. The IMF recently estimated that the EU is spending 0.22% of the GDP to house, feed, and support migrants. Considering that EU GDP is 1.4%, that’s material.
Now the Bad News: Asia Getting Worse
As you can see, Asian demand for semiconductors continues to skid. That’s a bad sign for the 2Q and 3Q economies of Taiwan, Korea, and China, which depend on high-tech exports.
How long will it be before more stimulus is required in South Korea and Taiwan?
Yesterday, the Bank of Korea lowered its view of the GDP but took no action on rates. That’s the 10th month in a row of no action. Meanwhile, economic conditions continue to worsen at an accelerating pace, and semiconductor billings are projecting further pain.
Conversely, Taiwan cut rates last month for the third month in a row.
The difference between Korea’s and Taiwan’s bank moves comes from exposure to high-tech. Both countries face a similar collapse in exports. But where South Korea’s industry continues to expand, Taiwan’s industrial production has contracted y/y for each of the last six months.
Korea may be more diversified, but it’s hard to see its economy resisting the sizeable IT drop much longer.
Now on to China’s hard landing. Official macroeconomic data reported a solid 6.7% GDP, but accusations are already flying that the data is falsified and inflated. The Wall Street Journal showed how the official statistics don’t add up. Or, put differently, GDP is actually a lot slower than officials admit.
China is the major destination for Korean and Taiwanese exports, which continue to collapse. Thus it’s safe to say that the Chinese GDP is falling faster than officially acknowledged.
Give the people what they want. Expect more monetary stimulus:
- More toxic debt assumption
- More cheap consumer credit
- More Yuan devaluation
Remember when the Chinese government announced credit tightening? Having looked into the abyss, it has backed away and resumed loosening.
Interest rates have been cut three times in the last few months and a number of policies have been loosened. For example, luxury home credit restrictions were removed. Lending surged in 1Q to $771B. That’s a 20% jump. Injecting further stimulus, the People’s Bank of China (PBoC) continues to roll over bad corporate debt, which is helping to keep factories afloat.
A more controversial move is Yuan devaluation. The PBoC has denied vigorously that this is a goal, but in the last six months, the Yuan is ~20bps cheaper. Maybe after burning the shorts and burning up dollars to do so, the PBoC will relent again and devalue a bit more.
The Market is Set to Roll Over Again
The recent surge in the market is manufactured by central banks. The collapse in January reversed on the day that Janet Yellen called other Central Bankers in an emergency discussion.
But it’s gone too high, too fast, and it is completely disconnected from underlying earnings expectations. In fact, notice that so far in earnings season, results haven’t moved prices that much – a few percent, if that. Big money isn’t buying the Bullish run.
Some people say don’t fight the Fed, and they are mostly right. The Fed’s goal is to prop up the stock market. When the market collapsed, home buying dropped. It’s that 1:1. But when the Fed is the only buyer, that won’t last.
I continue to advise that you get defensive. Expect some slide in prices. Buy some short ETFs, especially transportation stocks. There was sector rotation into these stocks this week. Prices of railroads and trucking companies shot up, but these companies are facing major headwinds. It’s a bounce that will reverse.