Primary Vision Insights – August 18th, 2021

By Mark Rossano

SUMMARY

• U.S. Completions Update • China Data Deep Dive • Quick Overview of Global PPI and Impacts on the U.S.

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• U.S. Completions Update

The frac spread count slowed down a bit the last two weeks, which is inline with what has happened in previous years towards the end of July. There is normally an adjustment as drilling and completion programs are updated for the second half push. This year was no different with many of the adjustments happening in the smallest basins. As we head into the end of Aug, activity will pick back up across the complex and push us up to about 250-255. The fall push will bring more activity into Appalachia with steady work in the Anadarko, Permian, TX-LA-SALT, Western Gulf, and Williston. The smaller basins will also see one off work as companies pick up assets to maintain steady production in these specific regions. Many of them will see 1 or 2 spreads get activated through the end of Aug or in Sept. When these crews get activated will be the difference of our estimates- if it is Aug- we will get to 250-255 but if it slips into Sept- we will hit those levels in the middle of next month. Regardless, the trend remains higher as NGL prices push to new 2021 highs, natural gas around $4, and WTI sitting around $69. The Haynesville is an area that will get some additional action as we head into the shoulder season and E&Ps prepare for the winter gas push.

Natural gas remains well below the 5-year average as the global demand for LNG grows supporting demand. Storage is always beholden to weather and if we have a warm winter- the dynamics could change, but right now- we are well positioned for elevated pricing. The growth of LNG provides an important outlet for natural gas, which was always the case but was discounted over the last few years. Now that we have had several heat waves and depressed production with robust LNG demand, the natural gas market is well positioned to maintain strong pricing. Now- NG doesn’t have to stay at $4 to support E&P activity. Everyone would also be happy with $3.25- especially when we look at the last few years that saw a lot of stress as NG prices plunged and differentials struggled making realized prices even worse.

NGL prices reached a new 2021 high with more support coming even as we head into the shoulder season. Propane has support from strong exports and the fall harvest, while ethane remains stable with elevated petchem and export demand. The underlying fundamentals have only improved over the last few weeks that will provide key drivers through the shoulder season. Plastic (and general petrochemical demand) demand remains strong as supply chain backlogs keep orders flowing and pricing robust. As South Korea brings back some refining capacity from maintenance, there will be some additional naphtha available but it won’t be enough to slow demand for LPG as the “pie” has gotten bigger. India LPG demand (among other Asian nations) remains well over 2019 levels and that won’t be changing any time soon.

• China Data Deep Dive

China data remained under pressure with exports/imports missing estimates and “normalizing” further when compared to previous months. The level of imports vs exports still points to underlying support for export growth year over year, but the pace of it is slowing quickly as many regions struggle with renewed COVID restrictions. The economic slowdown has hit key areas including trade, consumer, investment, and most recently- real estate. It has caused some concern at the Politburo level, which resulted in a meeting to address concerns. This is the first time we have seen the “Special Purpose Bonds” come back into the conversations from a point of using MORE of the funds set aside. The goal has been to allow for “rolling” maturities but not to expand the borrowing capacity. The PBoC has allocated about 3.5T RMB, but by the end of June only 1.01T has been utilized. The lack of viable projects is becoming a much bigger problem as previous SPBs and LGFVs funded projects that aren’t covering their principal and interest. This is pulling tax revenue away from local government to fund the debt, which has caused local governments to avoid issuing more local debt. As the Politburo panics, it could result in more “incentives” to push local governments to inject capital into the local economies but given borrowing standards it would just increase the net overhang. All this means is- the economic growth of the new debt would be BELOW the principal and interest causing the GDP/Debt calculation to get worse.

The meeting's readout reflected rising concern about the economic outlook: • “At present, the global epidemic continues to evolve, the external environment is becoming more complex and severe, and the domestic economic recovery is still unstable and unbalanced.” • To counter this downward pressure, Beijing plans to lean more heavily on fiscal policy.

Specifically, the government wants to: • Ensure that budgeted investment projects actually get underway • Speed up the issuance of local government bonds (SPBs) – and then put those funds to work • Some context: The central government allocated RMB 3.5 trillion for SPBs this year. But as of the end of June, local governments had issued only RMB 1.01 trillion of SPBs – a mere 27% of the annual quota.

While Beijing looks set to ramp up fiscal spending, they are going to hold the line on monetary policy. • The readout insisted monetary policy will remain “prudent” and focus on “ensuring that liquidity is properly ample.” • The readout also pointedly stated that the government will “strengthen the autonomy of our monetary policy.” • To us, that’s a clear indication that authorities won't let the actions of other central banks disrupt efforts to maintain normalized monetary policy at home. (We’re looking at you Fed). • The bottom line: The government is worried about the outlook for H2 – that means investors should be as well.

Key areas of the economy have worsened over time with a big focus this year to reign in housing prices across the country. The government has also cracked down on developers by limiting and evaluating mortgages, loans, and underlying investments more closely. They have done it under the guise of stopping corruption of government employees that was the “favorite” investing platform for officials. It is also a way to try to reduce pricing for underlying housing as the government promotes the shift from urban to rural settings.

The shift in available financing has also cut the amount of home sales broadly speaking with more pressure to come in the next 6 months. These are just other pressure points when we evaluate the underlying economic conditions of China. Bank lending to the real economy was weaker because of: • Less household lending – especially medium- and long-term loans (mainly mortgages), which fell 34.5% y/y on a net basis. • Weaker corporate demand for loans. Short-, medium- and long-term corporate loans fell 33.5% y/y. More pain is coming across the sector with a recently announced halt on two residential projects of Evergrande Group in Kunming because they are overdue about $32M in payments. The off-balance sheet debt and leverage ratios across the board remains a broad problem. On the back of Evergrande, about $860B of Chinese Dollar offshore debt is seeing a big increase in underlying stress. “A Bloomberg index of returns on this debt fell by 7% in July. Evergrande notes, which make up about 5% of the cohort, were the worst performers last month. But worries also dragged down other developer bonds, with some notes losing as much as 19%.”

Many of these struggling companies open up local provinces to additional growth given the governments also invest as well as backstopping some of the underlying debt. Provincial governments have seen their balance sheets stretched and limitations on new borrowing through the LGFV facilities has only made that worse. Hainan has been facing pressure from multiple angles, and rolling defaults on offshore debt isn’t helping their situation. The PBoC and CCP have stepped in but the land mines of off balance sheet debt and what bankruptcy proceedings will look like are spooking investors. Let’s just saw the debt waterfall is hard to build because assets are mysteriously claimed by shell corps and the government while debt holders are left with IOUs. The unknown will keep investors cautious and on the sidelines.

Another signal of weakening construction and additional pressure: China's major construction machinery firms sold 17,345 excavators in Jul, lowest since Mar 2020, down 9.24% y/y, said China Construction Machinery Association. Domestic sales fell 24.1% y/y, down for 4th straight month and overseas sales rose 75.6%. There are multiple points of slowdown, which again- puts pressure on the GDP target.

We have been discussing how thePBoC still remains steadfast in their limitation on available liquidity in the market, and the recent release of money supply supports the thesis. Aggregate financing remains well below 2020 levels, which has been the goal to take the excess liquidity out of the market that was put into circulation following the pandemic. But, they have gone further and continue to adjust money supply more than estimates as the debt levels remain well above PBoC targets. The question will be- how close to the target will they remain as economic pressure grows. China issued a GDP target of “above” 6.5%, but given current numbers are supportive of something below 6.5% (much closer to 5%). I know they can pull off some “magic” when assembling numbers, but with 8 months of the year behind us- it will be difficult to make headway. So you have to ask yourself- Is this why they are maintaining their “Zero COVID Tolerance?” There has been a lot of infighting within the Politburo regarding the need for such decisive shutdowns and restrictions given what we know about the delta variant.

As we said last month, there was only a small increase, but it would quickly be adjusted the following month to overcompensate for a slight increase. The amount of liquidity coming out of the market will also keep credit impulses at multi-year lows.

According to Caixin, "China’s total nonfinancial debt as a percentage of GDP has declined for the third straight quarter, the first time that’s happened since 2008". But that's not true, and the fact that this is starting to become a very regular claim in the Chinese and foreign press does not make it any less incorrect. According to the National Institution for Finance and Development, China's debt-to GDP ratio fell by 2.6 percentage points in the second quarter of this year. It fell by 4.7 percentage points since the end of last year, and by 5.8 percentage points from its high in September 2020. Can this be true? According to the debt data provided by the PBoC, total debt rose 2.3% in the second quarter (9.6% annualized), 5.9% in the first half (12.1% annualized), and 7.7% since September 2020 (10.4% annualized). GDP would have had to grow at the same pace as debt just to keep the leverage ratio constant, and worse, it would have had to grow much faster than debt for leverage to fall as claimed. The calculation is complicated, but for debt to have grown in line with PBoC data, and leverage to have fallen in line with NIFD claims, GDP would have had to grow by an annualized 14% since September 2020 and by an annualized 16% year to date (or by 14% since March). Clearly that didn't happen. So is NFID lying? No, it is just that they're using a model (a lagging 4-quarter model) that they don't fully understand. There is no absolutely correct way to measure debt to GDP because debt is a stock, and GDP is a flow, so we generally use approximations (typically outstanding debt divided by annual GDP) that are useful as long as they are unbiased and consistent. Because China uses year-on-year data, the implicit assumption behind their approximation is that changes were smooth in the past year. Of course, that is a wrong assumption after last year, which makes their model useless for comparing leverage ratios this year. The proof is that debt will probably grow more slowly during the rest of 2021, and GDP at roughly the same pace, but we will nonetheless discover that China's debt-to-GDP ratio, as the NFID calculates it, will rise over the rest of the year. PS: I have explained this to several journalists, but they all quickly gave up. I know the math is complicated, but common sense should tell us that without explosive growth in GDP, China's leverage could not have declined by 5 percentage points in the past six months while total debt grew by 6 percentage points.

As we talk about Chinese debt, we just had an update on underlying foreign reserves. They still remain well supplied on paper, but the uncertainty resides in “off-balance sheet” risk and how much collateral has been double counted. When it comes down to underlying reserves: “According to SAFE, China's reserves rose to $3.236 trillion at the end of last month, the highest level since December 2015. This, however, is a little deceptive. Since 2017 the PBoC hasn't directly intervened in the currency, but large Chinese banks have, to the tune of over $1 trillion and, presumably, those dollars/euros/ etc. are also available for use by the PBoC. Counting the two together, China has access to $4.2 trillion, which is more than its previous peak in 2014 of just under $4 trillion. With at least another $1.1 trillion at the CIC, the government has access to over $5.3 trillion of liquid foreign assets to cover $2.5 trillion in external debt as well as absorb potential outflows from foreign investors. Its external position is still in very good shape. China's strong external position has come about however by its absorption of foreign demand through the trade account and converting it into external savings. China currently absorbs foreign demand equal to over 0.7% of the rest of the world's GDP.”

The problem arises when we look at the quality of the investments- especially in the emerging market and frontier regions. China has aggressively invested across Africa along the “Belt and Road Initiate” to create a streamlined supply chain and vertically integrate as much as possible. But, many of these projects are in unstable regions with projects that are FAR below their low end revenue targets. Many of these investments aren’t covering principal- let alone interest. Many of the banks have internally taken write downs, which was another important reason for the RRR cut.

Credit impulses are important when we review how the Chinese economy has functioned over the last 10 years. Even with the RRR cut, which as we said was to help shore up bank balance sheets and less about stimulus. When we look at the RRR cut and credit impulses, we can see that the cash injection with the cut has been neutralized with the adjustments on PBoC liquidity. The shift of cash injection points provides a stabilizing factor and will keep credit impulses fairly flat here. On the other side, it also points to more pressure on global manufacturing- especially when we look at other Asian nations. We have renewed pressure across the supply chain as we approach peak demand as companies prepare for the holiday season.

There has been another round of port closures in China- most recently Ningbo, which is becoming a very similar problem to the Yantian closure. We have already seen a shift higher (again) in container rates with more problems brewing based on the length of closure. The port was shut because one vaccinated individual tested positive for COVID, which begs the question- why react so aggressively? As I mentioned earlier, there is a zero-tolerance view of COVID, which is under increasing scrutiny- but is this offering up a much bigger goal. Does this provide cover for an economy missing internal estimates? Is this to hide the fact the port can’t function due to shortage of containers? Are they trying to address internal inflation by withholding products? There are many rabbit holes that we can go down, but the most likely reason remains- poor political policy and port problems already. Either way- it will be another headache for a struggling supply chain.

Here is a snapshot of the most recent spike in container rates:

The shift in rates and closures within China is a huge issue when we consider how much trade originates from China. The U.S. is obviously the largest counterpart, but look at the other nations that round out the top: Hong Kong, Japan, South Korea, India, Germany… to name a few. So- not only does the U.S. get impacted directly (with $481B worth of trade from China) but also indirectly given the knock-on impacts from other trade partners. This opens up the U.S. to additional price increases and delays. For example, if the U.S. purchases a product from South Korea but some key components have to come from China- we will not only see delays originating in China but the blow down into areas such as SK.

• Quick Overview of Global PPI and Impacts on the U.S.

All of these leads to why inflation is still very much in the system- with more coming down the supply chain. Now we can pivot into underlying cost increases that keep topping estimates around the world. Japan and China were the most recent to see another big increase in PPI (Purchase Price Index) as costs head higher internally. As ports remain stressed (and others shuttered) it will keep costs elevated across the complex-especially given the interconnection of all countries.

The whole ASEAN region is facing production and manufacturing headwinds- ranging from cost to delivery delays. The delta variant was just added stress on a region that was already struggling under the weight of elevated costs. The slowdown has expanded into retail activity and the general movement of consumers. Not only is there concern around COVID, but wages remaining under pressure as local costs rise put retail sales/consumer activity muted. The fall out is broad when considering the local economy and what that means for the assembly lines/ manufacturing backdrop.

Some countries (India and China specifically) have tried to limit the amount of cost passed on to the local consumer. They have tried to push more into the international market through exports, but the pressure is growing on companies and costs are starting to get passed on. ““Firms are yet to pass on the increase in underlying input costs due to weak demand,” said Sameer Narang, chief economist at Bank of Baroda in Mumbai. “This will change as growth and consumer confidence revives.”

Data due Thursday will probably show consumer prices rose 5.7% last month, cooling from near 6.3% in June. Wholesale prices -- scheduled for release on Monday -- are likely to show factory-gate inflation at double digits for a fourth straight month.”

Some of the slowdown in the recent CPI prints provides an opportunity for companies to pass on some more costs, but it will keep inflation running ahead of Central Bank targets and keep Emerging Markets in a rate rising cycle. CPI and underlying inflation have been a big issue around the world forcing rates higher and putting pressure on local consumers. Brazil is just one of many examples of the inflationary pressure with even China seeing a creep higher even as the government tries to slow the spread of price increases.

The U.S. import prices fell below estimates while the export side moved well over estimates. Both showed growth month over month, and the import data is going to push higher again-especially based on the guidance we have gotten from companies discussion inflation and supply chain costs. Exports is showing that U.S. companies have been able to push through cost increases international and domestically better vs most countries.

The US (blue) doesn't usually diverge from the rest of the world (black) in terms of mark-ups firms charge on output over input prices. But there's big divergence now, as our massive fiscal stimulus and rapid vaccinations are giving US firms pricing power unmatched anywhere else. The situation in the U.S. and large stimulus checks have allowed for more prices to get passed through, but as government transfers fall and savings decline- the consumer will start pushing back on price increases. We have already started to see that in some durable goods, housing, and automobiles. This pressure will expand over the coming months as wages remain depressed vs rising prices.

Worker pay has been under pressure as we talked about last week in our deep dive. Here is just another chart showing exactly what we were describing. Wages have failed to keep track with inflation on a broad level with increases only happening at the lowest level. Places like Walmart have increased hourly earnings for the bottom quintile, but those are individuals that were already living paycheck to pay check or borrowing against future earnings. Even at these increases, workers are falling short of broad price increases keeping them in the same position even as hourly earnings shift higher. As companies trying to push prices higher, this will be the biggest hinderance to how high.

The shifts in pricing remain higher given small business backdrops:

Prices remain higher as CAPEX plans are cut and optimism wanes as general business conditions deteriorate. This backdrop will also put pressure on hiring over the next few months as companies increase current employee hours and limit some of the new hires.