Submerging Markets

Freedom Financial Archive | Originally posted Dec 20, 2022
  • When we look at the broad economy, manufacturing has had a huge reversal to the downside, and we are just starting to see this hit the emerging markets.
  • The November Global Manufacturing PMI fell lower by 0.6 to 48.5, which is still below the 50 threshold for the third month.
  • Productivity, output, and the yield curve corroborate the slowdown story.

Just once, I’d like to write you with happy news.

Alas, I bear grave tidings this holiday season.

Unfortunately, supply chain troubles have reached back to their source, Southeast Asia.

India itself is about to fall into recession.

And China isn’t going to save us.

World industrial output, manufacturing, and productivity are suffering as I write this, and will be in full-fledged crisis by the time you read this.

In any event, we hope you have a very Merry Christmas and a Happy New Year.

But first, sit down in your favorite chair by the fire, get a glass of egg nog, and let me regale you with the trials and tribulations of the world economy.

ASEAN Isn’t Growing Anymore

The only region that saw expansion was Asia Ex-Japan, Ex-China, otherwise known as the ASEAN region.

Here’s a map of the ASEAN (pronounced: AH see en) member states:

Credit: Wikipedia

It’s important to put the ASEAN growth in context as we see a steep drop from the highs.

As demand slows further from the OECD nations, the data will likely turn negative in December.

All of the leading indicators – new export orders, new orders, imports, inventory, expected orders – all moved into contraction two months ago, which is now hitting the headline numbers.

India is the Next Domino to Fall

India was the one of the strongest entities out there posting a strong bounce in September.

But we called this out as pent-up demand.

Our expectations were for a steep drop in October data, and the recent Indian data is showing an acceleration to the downside.

India’s lower-than-expected industrial production in October follows September’s one-off growth spurt that was driven by spending in the festive season. This slowdown supports our view that pent-up demand is now fading, and the near-term outlook faces increased headwinds from geopolitical conflicts, tightening financial conditions at home and abroad and slower export orders.

Industrial output contracted by 4% year-on-year in October, reversing September growth of 3.1%.  Both of which was much worse than expected.

  • The contraction was mainly driven by demand in manufactured good with the most prominent being in consumer goods.
  • The deeper fall in consumer goods output suggests the economy is starting to take a hit from slowing export orders.

We see this continuing through the remainder of 2022, which will weigh on the data set and setup for a broad global recession in 2023.

World Industrial Output, Manufacturing, and Inventories

Even though the ASEAN region is still showing expansion, it’s slowing considerably.

We expect a negative print in December that only worsens as we progress into Q1’23.

When we factor in varying “real” components, we’re already slowing down.

As you can see in the chart below, falling manufacturing PMI is due to both a decrease in activity components (-0.9pt to 46.7) and a more significant decline in price pressures components (-1.7pt to 53.7).

A very important leading indicator is new orders to inventories.  In the chart below, you can see we’re at the same level as October 2001.

When we look at OECD Leading Indicators, we’re already in contracting territory for October.

But when we cycle in announced November data and leading indicators, we have only slowed further with PMIs disappointing to the downside across the OECD nations.

In the below chart, the U.S. posted something well below 0 and one of the worst numbers since the Financial Crisis of 2008.

The OECD markets are huge consumers of goods, especially derived from the Emerging Market world.

This can come by way of intermediate goods or raw materials that go into the supply chain.

Many goods and raw materials will pass between Emerging Markets before it goes into finally assembly (normally in China, India, Japan, or South Korea) before it finally heads to the end destination.

When we look at general trade data, Japan, South Korea, and China have all turned much lower (some of them negative) as India slows further.

This has pulled global manufacturing to a 29-month low, with more downside on the horizon.

When we compare that to manufacturing production and the “output index” (an important leading indicator), you can see there is even more downside to economic growth in these key areas.

The Composite Output Index is also a crucial leading indicator for the direction of GDP growth. When you look at it compared on the chart below, the move into global GDP contraction (recession) is swift once the COI has turned negative.

The huge disconnect in delivery times and supply chains resulted in a huge surge in orders.

This has been described as a “bullwhip effect.”

The bullwhip effect is a supply chain phenomenon describing how small fluctuations in demand at the retail level can cause progressively larger fluctuations in demand at the wholesale, distributor, manufacturer and raw material supplier levels.

This resulted in a massive surge in orders that are now sitting in inventory, and severely hindering new orders across the supply chain.

It takes time for this to reach the beginning of the supply chain (in this case Emerging Markets), but the impact has finally shown up on their shores.

This is becoming more apparent as delivery times have now shortened for seven months in a row, driven by both fewer bottlenecks but also a slowdown in demand.

This has resulted in developed markets returning to pre-crisis levels for wait times.  (See below chart.)

We are also seeing global productivity levels falling, which is showing how slack in the output side.  Productivity growth has been negative for most of 2022, as is shown below.

These indicators help to indicate direction and severity of the slowdown, which is accelerating into year end with more downside coming in 2023.

When we look at the export levels, we can see a big shift downward in export levels as the composite index has turned negative.

The only thing keeping us positive on the “real export” side is the support from Emerging Market flows (the brown line on the right-side graph).

But we are starting to see these flows come to an end.

When we turn to recent leading indicators for trade data, we are seeing negative flows with imports leading the way down.

For exporting nations, a big pick up in imports is a positive signal because it means manufacturing will ramp internally, and those imports become exports for the global market.

Based on commentary from Maersk, FedEx, Amazon, Walmart, to name a few, we are seeing a hard pivot lower.

When we look at the U.S., we are moving to new seasonal lows given 2019 wasn’t a good year.

The chart below shows U.S. container port volumes. The purple line is 2022. You can see the sharp decline from August onward.

November 2022 had the greatest October-to-November decline since 2016 at 12% as volumes trend back to 2019 levels (the blue line).

Demand in the U.S. has weakened further when we consider PMI new orders, and what is waiting at the ports.

Global manufacturing PMI new orders project a steep drop in EPS growth (the navy-blue line) over the next 12 months, which is going to exacerbate the issues at the Emerging Market level.

The slowdown in trade is already being forecasted, but the depth is likely to remain much lower for longer given rising rates globally.

The below chart shows a bit of a “normalized” buying world as we head into 2024, and I think we are going to see underwhelming trade volume, given the backdrop of debt and other pricing pressures.

The Global Yield Curve and Dollar Flows

Central banks have been forced to raise rates to get in front of inflation and pull back on liquidity. It has sent the “World Yield Curve” inverted for the first time in over twenty years.

We are seeing something unprecedented when it comes to the pressure on the yield front.

This is happening during a time when there is a record amount of global debt in the market, and a large portion of it is priced in US Dollars.

Central banks have raised rates and actively stepped into the market to protect their currencies from devaluing further. This results in a big drop in foreign reserves because the central bank is selling USD or EUR to buy their local currency.

To refill the coffers, central banks have been liquidating their treasury holdings (navy-blue line in the below chart) to pull forward USD to replenish the drop in FX reserves.

We have to consider how an Emerging Market naturally brings in USD through trade using a widget moving from Vietnam to the US.

Here are the hypothetical steps:

  1. A U.S. company agrees to buy a widget from Vietnam. Since over 80% of international transaction take place in USD, it makes the transaction easier.
    • A. The Vietnamese company expanded operations and issued USD denominated debt for the expansion.
    • B. While they have to pay interest in USD, they also have to import the raw materials priced in USD.
    • C. They pay their labor in the unfortunately named Vietnamese Dong. No VD jokes, please. The proper code for Vietnamese Dong is VND.
  2. In a normal year, the US companies and other exports pay the Vietnamese company in USD, and they are able to cover interest expense as well as raw materials.
  3. As trade slows, the company is no longer taking in USD at the same rate. But they have already ordered raw materials and still have to pay interest expense in USD.
  4. Now the VND is weakening against the USD, it’s becoming more expensive to manager their interest expense.
  5. The Vietnamese company is forced to convert VND into USD in order to cover their imports and interest expense.
    • As other companies face the same struggle, they’re actually making the FX exchange worse.
  6. The Vietnamese Central Bank steps in to try to mitigate the cascading monetary issues, and they are forced to liquidate T-bills in order to manage the outflows.

As trade slows, it cascades in emerging markets from the simple company up to the government and central bank.

During COVID, every government issued a significant amount of fiscal support along side central bank monetary easing.

This has created a ton of slack in the market, which is making the above example much worse.

We can also look at it slightly differently by using a sale of Argentina soybeans to China as an example:

  1. An Argentina farmer agrees to sell soybeans to China.
  2. Over 80% of all transactions occur in USD, and the farmer ends up buying fertilizer and seed from the import markets in USD. This means that the Argentine farmer will want USD for the transaction.
    • To be sure, though an Argentinian farmer and a Chinese company are engaging in this transaction, they’ll use USD, not the Argentinian Peso (ARS) or Chinese yuan (CNY).
  3. The farmer receives his USD, but the price of seed and fertilizer has gone up putting pressure on margins and driving up the cost of his farm.
  4. The farmer borrows money to cover the cost of seed and fertilizer, which causes him to also raise the price of soybeans to customers.
  5. Global governments try to subsidize the rise in food costs but have limitations on the amount they can protect prices.
  6. Local governments get concerned about food availability and put gates up on exports keeping more product in the country. (Incidentally, India banned wheat exports earlier in the year.)
  7. But what happens to the farmer that just bought seed/fertilizer in USD at much higher prices but isn’t allowed to recoup cost in the international markets. He also is subsidized for his cost.
  8. The farmer is also not bringing USD into the country, which helps also support the local economy and banking system.

When we look at the number of reserves sitting on balance sheets (outside of China and Japan), you can see in the below chart a huge drown draft that is only going to get pressured further.

Global governments and central banks are dealing with these problems in real time as trade slows and natural accumulation of USD dries up.

By actively going into the market, they’re driving up the price of the dollar as investors bet against their markets and yields drive higher.

This limits their ability to borrow and drives up the cost because interest rates surge.

This is why you see a massive downshift in new borrowing as countries/companies can’t afford to borrow.

The adjustment complicates their ability to finance normal operations and roll debt.

As companies can no longer roll their debt, they have to cut capital expenditures (Capex) and labor to afford the principal repayment.

This stops the economic expansion in the country.

The below chart shows just how much global loan and bond issuance has slowed.

Agflation is Aggravation

Food inflation is a real problem for large parts of the world, especially the emerging markets, where over eighty cents of every dollar is spent on food.

Even as food prices move lower (the blue line in the below chart), they’re still at historic highs with a lot of staying power given the cost of fertilizer, energy, diesel, and other important input costs.

Food and Agriculture World Food Price index increased by just 0.3% year/year (the orange line) in November, slowest since August 2020 and well-off peak of 41% in May 2021.

The affordability index for fertilizer (chart below) also remains very low as more issues crop up along the availability of product and yield.

Farmers have been facing a worsening backdrop as their yields fall, and while this has driven up prices- they are unable to bring in the same level of value.

Global wheat yields have been heading in the wrong direction for years.

The chart below shows they’re below the levels that sparked the “Arab Spring,” “Peasant Uprising,” or “Wheat Wars,” whichever you want to call it.

The pressure is growing at multiple levels, and this hits Emerging Markets the hardest!

The issues expand into water and food issues as major concerns grow across all of them.

Water isn’t just an Emerging Market problem.

The developed world is facing a water crisis in key growing regions.

As the droughts increase, the yield at the farm level drops off and impacts the available amount of food that can flow into the market.

All of this drives up prices of food (mostly priced in USD) and hits the emerging market community.

Chinese Unemployment and Manufacturing

We also have to talk about the elephant in the room: China.

There is a ton of hopium cycling around the reopening of China, but when you look at all the data the issues have been building for years.

Even when China was “open,” they weren’t able to see a meaningful bump in local activity.

This was also when the world was still massively short, but any increase was short lived and met with a quick reversal.

Even when you look at 2019 (pre-COVID), the cracks were already forming in the Chinese juggernaut.

The PMI charts below prove China has been walking a tight rope for years.

Employment has been a huge issue for China as those working has dropped hard and been in contraction well before COVID.

We also have the new advent of near-shoring and on-shoring, which is pulling additional manufacturing out of China. Apple is the most recent.

From Trivium:

On Saturday, the WSJ reported that Apple is accelerating its plan to move production out of China, citing unnamed sources.

The reason: Apple is sick of supply chain disruptions in China.

ICYMI: In the past few months, Foxconn’s Zhengzhou factory – which manufactured about 85% of the iPhone Pro series at its peak – has been nothing short of chaos, largely caused by zero-COVID policy.

  • Phone production is facing serious delays.

That’s got Apple looking for alternatives. From Mac Daily News:

“[Apple] is telling suppliers to plan more actively for assembling Apple products elsewhere in Asia, particularly India and Vietnam.”

Employment has been a going concern, especially for the youngest cohort.

You can see how Europe and the US became worse during COVID, but the issues have been growing for China (the white line on the below chart) since 2019 and has only progressively gotten worse through 2021-22.

Between lockdowns and the real estate crisis, all 31 of China’s provinces ran deficits in their general budgets in the first half of 2022 (white bar in the below chart), with some 23 provinces recording deficits that were bigger than their full-year shortfalls in 2021 (orange bar), when measured as a percent of GDP.

The longer strict containment measures stay in place, the worse the situation will become.

This is already on the back of massive deficit spending that China embarked on over the last two years.

The sheer leverage backdrop makes any move down exponentially worse.

Unemployment, uncertain economic outlooks, slowing trade, and reduced manufacturing is resulting in people saving more and reducing their spending.

Income gains have suffered. Increases in real household income slowed to 3.2% year on year over the first three quarters of 2022, less than half the average pace of 6.7% in the five years before the pandemic. Meanwhile, savings rates are climbing again this year — a sign of economic anxiety that depresses consumer spending and growth.

A key leading indicator out of China’s PMI, New Orders, is already showing a pivot lower, as you can see in the below chart.

If you look throughout 2019, problems were already cropping up. COVID bottlenecks and stimulus were able to “cover” some of the issues.

But as the market returns to a normal state, the problems are coming back with vengeance.

It’s hitting all sides of the economy, from the manufacturing to the service side of business (below charts).

All of these key pieces are showing a steady down move in Chinese exports, which we believe is already negative and just going to get worse.

Just rounding out the major issues in China is the lack of credit growth.

Whenever exports have slowed, the China’s central bank, The People’s Bank of China (PBoC) and the Chinese Communist Party (CCP) have driven more debt and stimulus through the infrastructure world.

Unfortunately, saturated markets have erased spending.

Even though the supply of debt is available, there is no demand!

Many companies and consumers are saddled with massive leverage and falling asset prices.

Banks have been directed to lend, but their collateral is falling aggressively in value making their balance sheet weaker.

We have been saying from the beginning that the old Chinese playbook for stimulus was going to fall flat, and the below chart is a perfect example of its failure.

  • “China Nov credit growth slowed further. No evidence of more relaxed policies on the property market as mortgages weakened further. (“Sam on Twitter: “RT @PkZweifel: #China Nov credit growth slowed …”)
  • “Credit impulse remains little impacted, navigating slightly below its neutral level, yet sending a better signal than manufacturing surveys” (“Makrobilderbuch 2022-12-13 – by Qwertz238”)

On my Twitter feed, I wrote:

Even as China tries to pump in more credit, there is no demand for it. The PBoC and CCP are trying to increase stimulus by pushing additional spending through infrastructure and other formats. But try as they might, there is no end user demand keeping the money on the sidelines.

The uncertainty around the zero-Covid policy and slowing demand is going to keep companies from investing, borrowing, or hiring.

These are huge headwinds for the 2nd largest economy in the world that already has a leverage ratio of over 350% to GDP.

Investors and talking heads will try to tell you that the reopening will change everything, but the issues have been compounding for over a decade.

How many ghost cities can be built?

How much debt can you layer into the system?

The CCP has been playing the same hand since 2006, and now the house of cards is being blown down.

Real estate, manufacturing, and exports are the core drivers of the Chinese economy and each one is failing.

The endless cycle of stimulus and infrastructure spending is collapsing. I don’t see this reversing anytime soon.

Key bellwethers for trade weakened again and remain on a soft path, being led first by China and now India. It has reverberated back into key growth regions.

Emerging Markets have benefited from a relief rally on the belief that a Chinese reopening is going to save the day.

As yields rise, trade slows, and leverage bites, the economic issues are going to get more pronounced.

The Emerging Market world is the backend of the “bullwhip.”

It’s going to see the largest impact over the next few quarters.

We believe that EDZ – the emerging market bear index – is the best place to bet on a broad slowdown over the next few weeks.

You will be able to capture the slowdown in China as well as the broad Emerging Market index.

There was just another clash between India and China at the Line of Actual Control, which was the source of recent clash between the two countries resulting in deaths on both sides.

The cracks are expanding, and it’s prepared to swallow up the global economy.

OPPORTUNITY: BUY EDZ up to $16.50.


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