Primary Vision Insights – June 8th, 2020

Primary Vision Insights – June 8th, 2020

By Mark Rossano


  • U.S. Production Levels and Frac Spread Counts
  • Gasoline Demand Levels- will remain impacted throughout the remainder of the year
  • Industrial Production Will Struggle for the Foreseeable Future
  • U.S. Unemployment hasn’t Bottomed as the Second Wave of Reductions Roll Through
  • Refined Product Gluts Accelerate Globally
  • OPEC+ Meeting and Production Levels- Extension of One Month Likely Even While Cheating Persists
  • European Economic Data Improves From Terrible to Bad
  • Weak Global Economic Data Will Weigh on Exports and Global Manufacturing
  • China National People’s Congress Review
  • U.S.-China Trade War Starting to Heat Up (or Cool Off into an Escalating Cold War)
  • The PLA Makes Moves Across the Asian Continent
  • U.S. Production Levels and Frac Spread Counts

The shift in frac fleets continues to shift into natural gas basins while oily regions saw a decline in total activity. Based on E&P commentary, we are at a bottom in the decline across oil basins and will start to see a slow increase across the key areas and counties. Shut-ins are already reversing in the Permian (Midland) and Bakken, and new activity will start to accelerate by the end of July-early August. The restart dates can adjust as OPEC+ keeps total oil supply a fluid target, which is made even more complicated by the slow restart of the global economy driving oil demand. “EOG Resources Inc., America’s largest shale-focused producer, plans to “accelerate” output in the second half after shutting in about a quarter of its crude in May, exploration chief Ken Boedeker told an RBC Capital Markets conference Tuesday. Permian producer Parsley Energy Inc. is also turning wells back on just weeks after closing the taps, and producers in the Bakken formation in North Dakota are also easing the rate of shut-ins.” “Bakken producers had shut in 475k b/d of output as of May 28, according to a presentation from the Bakken Restart Task Force. [from 510k barrels a day}.” The EIA supply adjustment factor reached 1M barrels a day last week, which implies U.S. oil production at about 10.4M barrels a day. We believe that 10.4-10.5M barrels a day of production will hold for the next few weeks as shut-ins reverse and U.S. companies reassess the new term landscape. Companies have started talking about bringing shut-ins back online in June, and between the Permian, Bakken, and EF there is about 500k barrels (some have already started- 100k in the bakken for example) will come back on through June. Between the recent shifts lower and shut-ins coming back, production will close out June closer to 10.7-10.8M in the near term. This will put renewed pressure on realized prices and more crude in storage as exports continue to be pressured lower at 2.5-2.7M barrels a day.

Even though the frac spread count rose, it will remain locked in a range as the U.S. faces headwinds across the oil supply chain. I believe we will sit in a range of 50-60 active spreads as fleets are moved into OK dry gas, Appalachia, and activity normalizes in the Permian and Eagle Ford. June and July will be range bound, but as we get to the back-half of July activity will be gradual increase into August. In the meantime, E&Ps will be managing decline curves by attempting to optimize output through shut-ins and workovers. Over $30 a barrel will see shut-ins reversing and current activity remain stable. The below crude curve is enough to support production of about 10.5M barrels a day but hedging at these levels would lock in cash losing positions. OPEC+ is watching the curve closely as the countries struggle to remain solvent- supporting the front month while keeping pressure (uncertainty) across the remaining curve helps to provide additional cash flow while prohibiting effective hedging in the U.S. Physical crude trading tightened in the market and was trading inside the official selling prices, but things have started to loosen up as the bid/ ask spread has widened to about $1.50 vs $.60. This is showing that purchases are slowing down- which isn’t surprising given the weak crack spreads globally and refined product storage levels.

WTI Cushing Crude Curve

There is a tropical storm brewing in the Gulf of Mexico that could strength into something bigger over the next few days. Hurricanes are always transitory events, but it could shut-in production few a few days if platforms are evacuated ahead of it. This is something to watch as it could send crude production down in the near term because depending on the trajectory 500k-1M barrels a day of Gulf flow could be impacted. This would recover quickly and depending on landing strength won’t have any lasting impact on refining/oil production. The shift in the front month has happened quickly and put additional pressure on refiners that are seeing margins squeezed even harder. This will keep utilization rates locked between 70%-75% as the feedstock costs shift higher and demand for refined products sits under pressure.

  • Gasoline Demand Levels- will remain impacted throughout the remainder of the year

During the Government shutdown, workers were complaining about being unable to pay bills, mortgages, credit cards, etc. This was all occurring at the same time we knew backpay was going to be issued- but it really came to light how people live paycheck to paycheck. Now we have 43M or so people that have issued claims for unemployment with over 20M on continuing claims, but these people will be quick to spend and go on vacation? I think there is a big disconnect in reality- there is going to be a mixture of fear of COVID but also concerns over future earnings.

Gasoline demand remains well off pass when compared to seasonally adjusted norms coming in about 29.4% below last year. It was up vs a week prior, but the numbers remain stuck closer to about 30% off of seasonal averages. The social unrest that remains within the U.S. will keep travel minimal- especially in and around urban areas. Many corporate offices are keeping work from home orders through at least the summer with some already pushing them out into 2021. The consumer remains a key factor when evaluating driving habits that will see a challenge across the globe.

The gasoline data remains problematic, but we did get some recoveries in durable and capital good orders, which outpaced expectations in April. Some of the slow delays were shifted to May (depending on location) so the data will remain lackluster but was still a positive data set in a wave economic data. New home sales also outpaced expectations, but due to delayed closings there was going to be a catch-up point. Now that many of the closings have started to catch-up, the data going forward will be a better gauge for new home sales. The process of buying a home has also gotten longer with new restrictions on open houses, but as more people look to leave urban areas there is some support for new home sales. May new home sales will be hit as pending home sales took a big leg lower as the process is now longer, but this should catch up throughout June. Between a shift in migration out of cities and record low mortgage rates, I expect this key data point to remain relatively strong even as unemployment rises and consumer spending falls. Personal consumption fell through a floor and will remain depressed as more layoffs are announced, and people look to save more money throughout the current uncertainty.

U.S. Personal Consumption Expenditures Nominal USD Month over Month (April 2020)

U.S Continuing Jobless Claims Came in Better vs Estimates Down to 21.052M

The inverse nature shouldn’t be surprising as people remain unemployed spending patterns will inherently adjust. This has been reflected in credit card, savings, and other data points. The prolonged problem will be the extended nature of the unemployment, and the competition will drive down accepted salaries leading the “under-employment” and depressed real income as cost of living does not go down. The slowdown in consumers will show up at the industrial level as people buy less “stuff,” which will keep pressure at the industrial level. The below chart helps highlight the depth of pain across the industrial complex. It appears that we have found some sort of bottom as key ISM data points have hit 2008 lows. The increase in ISM Supplier Deliveries remains a problem as it demonstrates the delays across the supply chain. It has luckily started to fall as the facilities are restocked across the supply chain, but it remains at highs not seen since 2018- and before that the 1970’s. The supply chain remains under pressure, but some of the pressure is easing. Not surprisingly- Industrial production had the biggest single drop in its 101 year history driven by factories forced to shutter/slow operations due to COVID. This will start to normalize over the coming months, but the headwinds for demand persist keeping industrial activity well off normal.

ISM Manufacturing/ Supplier Deliveries/ Ex-Supplier Deliveries/ Industrial production

  • Industrial Production Will Struggle for the Foreseeable Future

The reason why we feel confident in saying industrial production will remain weak and not just “snap back” to previous highs comes from the struggling U.S. Consumer- but also by evaluating China. Trivium has a method of tracking business activity, and even the released Chinese data is lackluster.

Here are our latest updates as of June 3:

  • The Trivium National Business Activity Index indicates that China’s economy is operating at 87.8% of typical output, showing no change from June 2.
  • The Trivium National Large Enterprise Activity Index indicates that China’s large enterprises are operating at 87.9% of typical output, showing no change from June 2.
  • The Trivium National SME Activity Index indicates that China’s small businesses are operating at 87.8% of typical output, up marginally from 87.7% on June 2.[1]

The numbers might look “positive” but when we consider China was operating at 99% (I know I know-entertain the view), these figures show even manipulated numbers can’t hide the slow recovery. China was facing COVID-19 as early as Dec, and after just over 6 months- have yet to see manufacturing normalize. This is driven by their trade partners also struggling through their own outbreaks, as well as the residual pain of decimated local consumer demand. The Chinese consumer is also struggling, which has led for low demand across all end markets. I have likened some of these activity indexes to the equivalent of having a car running in a driveway- you can prove its on, but is it doing anything productive? Many of these facilities are operational, but given reduced exports/ local demand/ residual supply chain problems- they are operating well off normal utilization rates.

During previous recessions, the U.S. records a surge of new patents and businesses as people are incentivized (pushed) to realize their dream or creation driven by losing their job or underemployment. This recession is not any different and will aid the recovery as other industries need to be expanded and potentially new ones created. Many jobs that were lost will never come back in that specific area (hospitality/retail- just to name a few), which means many of the unemployed workers will need to shift industries/careers. The below is a first step to a long-term recover.

ADP employment reported a better than expected number with only 2.76M job losses vs 9M and April revised from -20.236M to -19.557M. Hopefully, we are starting to see a slowdown in job losses, which should continue over the next month or two given the announcements of new layoffs. We are well beyond the peak point of job losses, but the pain will continue as companies continue to adjust for a slow recovery. The below charts highlight where the U.S sits in regards to previous recessions, and the slow grind back as economies struggle to reopen. The biggest headwind will be New Orders, which continues to struggle on the back of slow exports and domestic demand. New orders also highlight how future manufacturing will struggle as inventories remain high as logistic bottlenecks hurt previous orders and companies slow down purchases.

The new data came out 6/3 with data points falling either slightly below or above estimates.

US Durable Goods New Orders Industries MoM Remains at All Time Lows

The below list of negative data is now enough to push the market back to 284 handles from all time highs as of this writing.  “The services ISM report confirmed some green shoots in activity, rising to a better than expected 45.4. The bounce in business activity was particularly notable, jumping from 26 to 41, though the rise in orders was less robust (32.9 to 41.9.) Tellingly, however, the employment component barely budged, inching from 30 to 31.8. The biggest factor remains well below 50 on key aspects of new orders.

  • Index rises to 37 from 27 in April; Year ago 50.9
    • Fourth consecutive month of contraction
  • New Orders rise to 36.5 vs 26.4 in April
    • Third consecutive month of contraction

The shift higher in Non-manufacturing is a positive but is a bit misleading as some aspects that make up the number are elevated for all the wrong reasons. A key metric is the supplier deliveries data that is elevated due to all of the supply chain bottlenecks across the system. The data still points to a contraction but has started to contract at a slower pace.

  • U.S. Unemployment hasn’t Bottomed as the Second Wave of Reductions Roll Through

The data has improved from epic lows reached when States shut-down economies to minimize the spread of COVID-19, but things were just muddling along prior to COVID-19. Trade with China was already low, global trade in general was sluggish, international PMIs were in contraction, and key GDP growth levels were below 1% and negative in key areas. The U.S. entered 2020 with major headwinds with COVID a key accelerant. The below info graph helps drive home how many jobs are still at risk across multiple industries on a “first wave” and “second wave” basis. While we have seen, “peak” initial jobless claims- it will keep the continuing claims well about 15M+ for the next few months.

Another problem that isn’t truly captured in the unemployment data (but is in consumer spending) is the level at which layoffs are occurring. For the most part, severance and healthy unemployment benefits have bridged some of the gaps in employment. Instead of this being pushed into the market, many recently unemployed are using the payments to pad savings accounts due to the uncertainty in the market. It is also leading to the formation of new companies (reference to chart above on new business applications), but this will inherently lead to a slow down in consumer spending. The new businesses will be promoted in the “I” in GDP for investments, but many of these items will take time to work through the system. This leaves a gap in consumer spending as unemployment increases

“Close to 6 million jobs are potentially on the line, according to Bloomberg Economics. That includes higher-paid supervisors in sectors where frontline workers were hit first, such as restaurants and hotels. It also includes the knock on-effects to connected industries such as professional services, finance and real estate.” The expectation for May’s unemployment rate is 19.5%, which is the highest since the Great Depression. “With more than 40 million applications for jobless benefits under regular state programs filed since mid-March, layoffs continue to roll on despite parts of the economy stirring back to life—something that could face challenges amid protests and a heavy police response in a number of cities.” While unemployment is typically a lagging indicator, the sheer volume across all levels of management will have a lasting impact driving down real wages (Competition for jobs) and impact consumer spending across the complex. The lack of demand is not just a U.S. problem with issues across the globe- in terms of economic data and builds in crude/refined products.

  • Refined Product Gluts Accelerate Globally

In the US, Japan, Fujairah, the pace of inventories accelerated across all regions. Growth had started to slow down, but all regions saw a big uptick in both crude and distillate storage. The lack of jet fuel demand will push kerosene into the diesel and gasoline pool, which is another reason storage in distillate remains problematic. The last time we were at these levels was 2010, and the growth in storage was relatively gradual- but as you can see in the chart below the pace of builds is impressive and accelerated this past week. The growth was driven by falling demand, weak exports, and relatively stable production. Refiners face a significant problem as demand remains weak and crack spreads under pressure as feedstock prices (oil) remain elevated. Refiners have slowly increased runs to 71.8% (vs the normal 91.8% last year), but with storage filling quickly and crude prices rising- some additional run cuts will hit the market- specifically in PADD 3 and PADD 2.

DOE Distillate Demand- Heading to the Lows Reached in ’91-‘92

Exports will remain depressed as Europe receives imports from Asia, and disty cracks remains weak across the region keeping pressure on imports. Local refiners are struggling to make any money on products regardless of the process.

PJK International ARA Gasoil Inventories- Rising at a Steady Pace

Singapore Middle Distillate Rises to Seasonally Adjusted All Time Highs

The amount of disty sitting in storage across Asia and lack of demand is pushing more shipments into Europe, and the same can be seen with shipments from the Middle East even being turned away. Even as some floating crude storage starts to decline, there is still a plethora sitting around the world

International Enterprise Singapore Oil Products Singapore Stock Data- Near All Time Highs

While Singapore, Europe, and the U.S. sit at or near all time highs, each area faces growing difficulties with exports. Europe typically sends gasoline into the U.S. and Africa, but due to the glut in the U.S. shipments sit on the East Coast (PADD 1) for weeks or get redirected into the Caribbean/Lat Am. West Africa is another key spot for Europe flow, but due to no demand, full storage, crowded floating storage, and shipments from Asia flow is dropping below 2017 lows. The trend has been shifting lower over the last several months, and shows no sign of stopping as more exports come from India and South Korea. China saw a decline in exports in May as they backfilled their system, but now that storage has normalized June exports will resume. Storage in China has moved back up to all time highs.

In March, China put a hold on all crude purchases in May and attempted to defer/ cancel as many shipments as possible in April. This left China short shipments that they “solved” by essentially sweeping all available shipments which tightened the market.

Teapot refiners have maintained record runs at about 76%, but based on the builds growing and cap to exports- they will be reducing runs. The independent refiners were “supposed to” make room for the reactivation of SOE assets, but the difficulty of getting personnel onsite and tightness in the domestic market- they were allowed to run at record rates. As the State Owned Assets look to maintain a minimum of 70% utilization rate, it will come at the expense of teapot activity.

China Shandong Crude Stock Shandong Weekly- Back to The Highs After Dipping in April

Shandong Independent Refineries CDU & VDU Operating Rate at All-Time Highs

Run rates have increased in Southern China, but headwinds persist in Northern China due to resurgence of COVID as well as lingering demand impacts. The COVID-19 outbreak epicenter was Wuhan, and spread North and East more aggressively vs South- which has caused lasting issues on demand.

All of these issues culminate into a problem in the U.S. The product that the U.S. typically exports gets pushed back on the coast, and is helping to drive refined product storage to all time highs across the complex. Demand for product started to break-down in 2019, and only accelerated into the end of the year aided by an oversupply of LSFO and ULSFO driven by a decline in shipping, trucking, and a warm winter. The highlights above will send exports to seasonal lows, and keep U.S. storage moving higher.

DOE Total US Distillate Fuel Exports- Will Reach New Lows This Week

DOE Distillate Total Supply at 2010 Highs with Demand at a 21 Year Low

The question was asked: “Is everything as bad globally as it is in the U.S.? Are any places seeing meaningful draws and not net builds?” The short answers are- Yes, it is just as bad globally, and no- no one is seeing meaningful draws. The issues are persistent even with an OPEC+ agreement in place that is supposed to cut production by 9.7M barrels a day- with the target being missed (more on that later). As Japan reopens, there has been a shift higher in crude storage, refinery throughput, and refined product storage. This just highlights the struggling local demand. Fujairah is a key shipping location, and it started to record a slow drawdown in distillate- but that was quickly reversed. Shippers have announced broad cuts across their tonnage expectations and slashed voyages, which will strand ULSD and VLSFD in each location. Crude on the water finally started to reverse, but it has started to shift higher again as more crude goes into transit and the North Seas experiences more builds. The area has already gone from about 11.56M to 13.6M in the region due to new local loadings and U.S. crude sitting offshore.

  • OPEC+ Meeting and Production Levels- Extension of One Month Likely Even While Cheating Persists

Oil production levels remain above global demand with OPEC+ talking about extending the 9.7M barrels a day cut instead of reducing the it to only 7.7M barrels a day in July. The OPEC meeting was supposed to be moved to June 4th, but due to disagreements on length of time and cheating the meeting was postponed. It has now been kept at its earlier date of June 17-18th– so that all of the data will be available to understand production and allow for more compliance from Iraq and Nigeria. Saudi Arabia wants to extend the cut of 9.7M for an additional 3 months, while Russia only wanted to prolong the cut by 1 month. The other sticking point was the severe cheating happening in Iraq and Nigeria. Both countries are way above where they should be versus the agreed upon levels as shown below. Most of the countries were close to the target, while Nigeria/Iraq essentially only pulled back to the 5-year average. Saudi has said the meeting can still happen as long as Iraq “atones” for their non-compliance. It is also worth mentioning again- this only covers production- because exports were still elevated even though global demand has fallen. West Africa had a large surge in floating storage as Angola crude was sent to China, but Nigeria struggled to sell barrels and instead opted to keep it off the coast. The view was to give countries more time to become compliant, but even the new loading program from Nigeria in July is targeting 1.63M barrels a day, which still fails to meet the target. Iraq has always cheated, but it is the “worst kept secret” that Iran pushes barrels through Basrah and get payments directly from Iraq. Crude from the shared fields will carry the Iraq flag, but some of the oil will be earmarked for Iran. Even with these elevated understanding/allocations- Iraq is far away from even remotely getting close to the target amount. When OPEC+ first announced the agreement, I was the first to point out how it was a useless deal and would do little to adjust the massive imbalance in the market. The problems still remain in the market across the supply chain with gross oversupplies at both the refined product and oil level.

While OPEC+ makes a big deal about crude production, it is important to look at what refined production looks like and exports. Russia has increased production of gasoline and diesel over the last few weeks (especially diesel)- and have slated a significant amount for export. Refining assets are increasing in some of these OPEC+ nations as a way to offset some of the export declines.

Russian Output Percentage of Gasoline Volume WoW

Russian Output Percentage of Diesel Volume WoW

  • European Economic Data Improves From Terrible to Bad

Demand will struggle in other places around the world as economic data still highlights contraction across the globe. Economic data across Europe remains deep in contraction territory with new stimulus packages being announced recently by Germany and the ECB. Germany has said they will push about $146B into the economy in order to spur growth.

German economic stimulus package:

  • Temporary VAT cut from 19 to 16%
  • €300 bonus payment per child
  • Backstoping municipal tax losses by 50%
  • €25 billion credit lines for most hit business
  • Total package: €130 bln

The above data in Europe drives home the economic headwinds, but the bigger problem remains that 2019 wasn’t all that great and the area was heading into 2020 already on a weak footing. Germany had a surprise increase in unemployment, which spurred the government to action in order to pass a stimulus bill. The rest of the countries are relying on the EU recovery fund, but it has faced some stiff criticism because others will foot a bigger part of the bill while not receiving the same benefits. The below chart helps to highlight the net winners/losers for the deal. The northern countries for the most part will be supporting the southern regions, which can be argued has been the case since the EU began. Sweden has come out with significant reservation with the structure of the agreement and is a key component:  But on Saturday, the Netherlands, Austria, Denmark and Sweden pre-emptively rejected the notion of grants in a counterproposal — instead recommending the creation of an “emergency fund” financed by loans only.”[2] The frugal four have been drawing a line in the sand, and based on the chart below- you can see why there are reservations given the amount put in vs the benefit received. Sweden has come out again today- highlighting the issues with the way it will be financed. Finland has also come out to reject the EU recovery fund proposal in its current form and wants to reduce the share of grants. Another sticking point is the ruling between the Germany and the ECB. “The court ruled against the European Central Bank’s (ECB) public sector purchase programme (PSPP), launched in 2015. It did not argue that the ECB had improperly engaged in monetary financing, but rather that it had failed to apply a “proportionality” analysis, when assessing the impact of its policies, on a litany of conservative concerns: “public debt, personal savings, pension and retirement schemes, real estate prices and the keeping afloat of economically unviable companies”.”[3] The issue now arises as to what role the Bundesbank plays going forward as commentary is conflicting with one side saying they can no longer participate in the ECB asset purchase program, but on the other hand commentary around a “new structure” to allow Germany to partake. The situation is fluid within the region just as the ECB announced another program of spending. While the ECB plans to purchase 27B of Greek GBs under the PEPP fund while there is only 50B outstanding.

The debt levels are already being pushed to extremes with debt to GDP now over 100%- the ECB has been expanding its balance sheet more aggressively after Lagarde said she would do “whatever it takes” to get Europe through this point. There is already talk of another $500B QE program to help juice the one that already stands at about $750B. The expansion would ensure the ECB has enough fire power to backstop European countries, and it is viewed as a key way of supporting the EU Recovery Fund. Germany had been standing in the way of more action, but with the increase in unemployment, weak exports, and struggling industrial sector- it will be hard for the Bundesbank and Merkel to not green light more aggressive action within the EU.

The below chart is just a great graphic highlighting the weakness throughout all of the key Euro countries. Many of them were facing PMIs between 40-48 in 2019 with GDP languishing around .4%- so we weren’t coming into 2020 strong.

The weak economic data remains a key driver on why GDP estimates keep getting rolled back across the European Union. The new estimates below help to demonstrate how quickly things have deteriorated, even after countries began reopening. A common view in the U.S. is that reopening is going to lead to a wave of rehiring and industrial resumption, but when we look at Asia and Europe we are seeing the opposite. As I described earlier, reopening actually sees unemployment rise as companies adjust for the “new normal” and industries are very slow to get back on their feet. Even in China with manipulated numbers, activity still remains almost 13% off of pre-COVID levels. This all points to why many areas in Europe are facing gasoline demand still down 25-30% and distillate down 15%-20%. Based on the data, I don’t see these numbers adjusting meaningfully, which will result in more economic run cuts as refinery margins remain negative.

  • Weak Global Economic Data Will Weigh on Exports and Global Manufacturing

The graphic highlights the sluggish nature of key trade partners that remain deep in economic contraction. With so many trade partners struggling, it shouldn’t be a surprise to see slow recoveries even when a country reopens. The constant fear of second wave infections and lack of consumer spending is stifling local demand. This is impacting imports at the local level, but also exports from abroad as people are just demanding less “stuff.”

The problems facing the U.S. are vast even as some of the data has gone from terrible to just weak, and the below helps drive that home. Industrial production remains in recession territory as excess liquidity is pushed into stocks. The divergence remains drastic, and with the limited options for investment- liquidity is being pumped directly into the stock market.

Lets think of it differently: The options presented before you are:

  1. Savings Account
  2. Money Market Account
  3. CDs
  4. Treasures
  5. Bonds
  6. Stocks

Based on the fact all but 1 of those provides a real negative yield (factoring inflation), investors have no place to park capital besides stocks that put out about a positive 2% yield. Powell already directly said if you are a saver with no assets, you won’t benefit from quantitative easing. The bigger issue is- not only will you not benefit, but you will actually be damaged by not participating. Cost of living (housing, food, goods, child care, healthcare) are all going to remain elevated and supported by printing, while salaries are compressed and no new income is earned. The common phrase of TINA- There is No Alternative- has driven the recovery in stock prices as the U.S. stock market sits only about 4% from all time highs with the Nasdaq already back at all time highs. This all in the face of data points that rival the Great Depression.

  • China National People’s Congress Review

China kicked off their National People’s Congress last week with a bunch of new insights to be gleamed from what was said and more importantly “not said.” Omissions in the transcript have always been key for reading between the lines as to future actions. We will break this down into two fronts- 1) economic 2) geo-political.[4]

We wrote back in January how difficult monetary/fiscal policy was going to be given the leverage ratios and economic slowdown weighing down action. A key metric that was dropped was the GDP growth target of 6% as it was becoming less and less likely to be reached. In 2019, the number was more than “lofty,” but in the COVID-19 era was even less likely to be even remotely reached. The other key metric was the shift to increase the deficit to “more than” 3.6% as stimulus is guaranteed. The problem is- where and how can the stimulus be moved into the market given the extended banking system especially at the SMID capital banks. “Help banks, especially small and medium-sized banks, replenish their capital through multiple channels…and strengthen their ability to dispose of bad loans.” The amount of bad debt that sits on the balance sheets is the biggest issue facing the banking sector. The issue is worsened by the government allowing for delayed principal payments, and reduced levels of cash to secure balance sheets with RRR reductions.

The PBoC is going to have an adjustment made to the laws that govern them, which will just “officially” cover the actions they have already taken including- credit management/ financial consumer protection/ coordinating financial supervision/ macroprudential policy and assessment. These are actions already being taken, but the effectiveness varies as more banks are bailed out through asset transfers. The PBoC is the backer of all banks, and another interesting move was the allowance to issue PERP bonds (perpetual bonds- which never expire). “So far in 2020, Chinese banks have raised RMB 274 billion by issuing 10 perpetual bonds.” There was a point that only large banks could issue this type of debt, but not 10 commercial banks have been allowed to utilize the instrument. These are interesting because “The magic of perpetual bonds is that the central bank can swap them into central bank bills, meaning jittery investors can exchange them for the safest debt available.” So an investor can take these bonds- collect payments for as long as they feel “comfortable” and at any time convert to central bank bills. The banks are getting creative to raise capital in order to meet directives to write more loans across provinces. China recognizes that forced capital allocation also led to misappropriation of funds, especially when the main objective was purely GDP growth.

The PBoC and finance department have accelerated support by pushing stimulus in very direct measures. Premier Li Keqiang announced the change in his Government Work Report delivered this morning:

  • “I would like to point out that we have not set a specific target for economic growth this year.”
  •  “This is because our country will face some factors that are difficult to predict in its development due to the great uncertainty regarding the covid-19 [sic] pandemic and the world economic and trade environment.”
  • “We must be clear that efforts to stabilize employment, ensure living standards, eliminate poverty, and prevent and defuse risks must be underpinned by economic growth; so ensuring stable economic performance is of crucial significance.”

Some of the recent measures taken

  • The deficit-to-GDP ratio this year will be more than 3.6% – up from 2.8% last year and above expectations of 3-3.5%.
  • RMB 1 trillion in special bonds for COVID-19 will be issued – below expectations of RMB 2-3 trillion.
  • A further RMB 500 billion in tax and fee cuts for businesses are in the pipeline.
  • The quota for local government bonds will be RMB 3.75 trillion – up from RMB 2.15 trillion last year and in line with expectations of RMB 3-4 trillion.
  • “[H]elp banks, especially small and medium-sized banks, replenish their capital through multiple channels…and strengthen their ability to dispose of bad loans.”
  • On June 1, the PBoC and MoF launched an RMB 40 billion scheme to compensate banks for extending the maturities on loans to struggling borrowers.
    • The funds are designed to compensate banks for the opportunity cost of having their funds locked up longer.
    • The funds will be distributed through a special purpose vehicle that will enter into interest rate swap agreements with local banks.
    • Banks are entitled to receive 1% of the outstanding principal of loans whose maturity they have extended.
    • Given that banks have deferred principal repayments on about RMB 3.7 trillion worth of loans, RMB 40 billion yuan should be more than enough to compensate banks
    • The PBoC has set aside RMB 400 billion to purchase the loans.
    • Banks need to buy back the loans within a year at the same price at which they sold them.
    • The banks retain interest payments on the loans, but also bear the credit risk.
    • Only city and rural commercial banks, rural cooperatives, and private banks that make 40% of new loans to micro and small businesses between March and December can use the facility.

While this all sounds aggressive, it is short of what was done during the Financial Crisis of ’08-’09, and it fails to specifically target SMID capital banks. There is commentary around the importance of doing it, but many of the early capital pushes benefit large cap assets. SMID cap banks are prohibited from selling shares when value falls below book, and with many banks facing liquidity problems- there remains no clear way to get capital to the lowest level of lending. The commentary is all about the importance of supporting small businesses, but the early moves in support fail to trickle down to that level. I believe we will get more aggressive action targeted at small businesses, but the PBoC is trying to limit inflation risks as the currency has weakened.

The PBoC inherently backstops all banks given the way the structure works within China, but the unknown leverage ratios at the smaller one’s has caused landmines to be planted around the country. Back in 2018, the PBoC took an initiative to open branches in every province again, and to do a deep diagnostic on all bank balance sheets- you will be shocked to learn they weren’t happy with what was found. There was a litany of items with little or no corresponding collateral as liquidity was pushed into the market to build everything from meaningful factories down to ghost cities. The question becomes- how many ghost cities can you build before the debt underwritten brings the house of cards down? We are at that point because cities are now paying interest with tax revenue, because the bonds issued aren’t generating any revenue. The multiplier on this debt is about .8, which means for $1 spent you are only generating $.80 of value. This can continue as long as there is collateral, buyers of debt, and revenue from other areas to cover the cost. We can also call this a massive (second largest economy in the world) ponzi scheme, and typically a ponzi scheme only gets destroyed when capital dries up and redemptions can no longer be met- or robbing Peter to pay Paul.

  • U.S.-China Trade War Starting to Heat Up (or Cool Off into an Escalating Cold War)

The growing issues in China is also pushing them to get more aggressive on the international front with new clashes with India and the U.S. Let us start with the U.S-China trade war: For the category of energy products identified in Annex 6.1, no less than $18.5 billion above the corresponding 2017 baseline amount is purchased and imported 6-2 into China from the United States in calendar year 2020, and no less than $33.9 billion above the corresponding 2017 baseline amount is purchased and imported into China from the United States in calendar year 2021; The value of crude exports to China was $4.3bn in 2017, out of a total of $8.4bn in energy exports to that country that year. The below chart breaks out how it is derived by dollar value and NOT by quantity. China has canceled shipments in soybeans and has only taken several U.S. crude shipments. In the agreement, it states that China will make best efforts BUT the U.S. has to “help” China by being competitive on pricing. Well- how can we competitive on crude pricing when shipping inherently is the most expensive from the U.S. and the quality is sub-par vs West Africa and Brazil? Brazil has made sure to keep production elevated and has been sending more to China- backfilling anything lost from Angola cutting.

The deal is dead in the water and was never a deal to begin with as I wrote back on Jan 15th. Exports to China never recovered even after the deal was signed due to COVID-19 (which China already knew about and inserted Pandemic language into the agreement.) The issues are mounting between the U.S. and China over the trade deal, Hong Kong losing their differentiated status, Taiwan tension, 9-dash line aggression, and India-China clashes. Based on shipping data and new orders, the below trading metrics won’t be adjusting as shippers cut volumes and export volumes slow globally.

U.S. Exports to China- Remain at Record Lows as Tensions Flare

U.S. Imports from China- Have Recovered as Back Orders are Filled but New Orders Lag Sharply

Instead- China has been buying more crude from Saudi Arabia, which is displacing Russia and Iraq flows into the country. KSA has been looking to take back some market share lost specifically Iraq over the last few months, which is why the cheating is such a problem at this point with both KSA and Russia. Both countries want to protect flow into China, and Iraq pumping well over their allotment is making that difficult.

  • The PLA Makes Moves Across the Asian Continent

All of these economic backdrops are happening during a time of mounting tension across the Asian continent. The below was a directive from President Xi to the PLA (People’s Liberation Army).

4. Xi tells PLA to get ready[1]

On Tuesday, Xi sat down with the People’s Liberation Army delegation to the National People’s Congress.
Xi’s message: The world is an increasingly dangerous place (Xinhua).

  • “The epidemic has brought a profound impact on the global landscape and on China’s security and development as well.”

Xi told soldiers they need to up their game:

  • “He ordered the military to think about worst-case scenarios, scale up training and battle preparedness, promptly and effectively deal with all sorts of complex situations and resolutely safeguard national sovereignty, security and development interests.”

The PLA should feel loved: Even though government finances are tight, the central government will still increase defense spending by 6.6% this year (Monday’s Tip Sheet).

Xi told officers not to take the money for granted:

“Every penny must be well spent to produce maximum results.”

Get smart: Making the PLA a world-class military has been one of Xi’s top priorities since coming to power in late 2012. But the PLA has not seen substantial combat for over 40 years, and there are considerable doubts about just how it would fair in actual operations.

On Friday, the Party held a symposium to mark the 15th anniversary of the Anti-Secession Law.

Some context: Passed in 2005 under Hu Jintao, the law gives China’s military (PLA) a legal basis to use military action against Taiwan, should the island declare independence.

Friday’s meeting was a bit of a surprise: They did not hold a similar symposium for the fifth or 10th anniversary of the law in 2010 and 2015, respectively.

What that means: The PRC leadership feels the need to send a message to Taiwan.

That message: We still want peaceful reunification, according to National People’s Congress (NPC) chairman Li Zhanshu (

“As long as there is a slightest chance of a peaceful resolution, we will put in 100 times the effort.”

BUT. We will also crush you if you get any smart ideas (SCMP).

“If the possibility for peaceful reunification is lost, the People’s Liberation Army will…resolutely smash any separatist plots or actions,’ said Li Zuocheng, PLA top general and Central Military Commission member.”

Some context: Anti-mainland sentiment is at an all-time high on Taiwan in the wake of the NPC decision to introduce national security legislation in Hong Kong.

Here are our estimates as of June 1:

The Trivium National Business Activity Index indicates that China’s economy is operating at 87.7% of typical output, up marginally from 87.6% on May 31.

The Trivium National Large Enterprise Activity Index indicates that China’s large enterprises are operating at 87.8% of typical output, showing no change from May 31.

The Trivium National SME Activity Index indicates that China’s small businesses are operating at 87.6% of typical output, up marginally from 87.5% on May 31.

On Sunday, the National Bureau of Statistics (NBS) released its Purchasing Managers’ Index (PMI) for May.

The results were – to use a highly technical economic term – pretty meh.

The manufacturing PMI for May came in at 50.6, down slightly from 50.8 at the end of April.

President Xi is looking to deflect problems in the local economy, Hong Kong, COVID-19, and Taiwan by getting more aggressive and trying to tighten control.  The below breakdown was created in 2018 to provide more oversite within China and affiliates. Hong Kong was supposed to operate under “One Country Two Systems,” but that has ended with the new laws coming out of the recent Congress meeting. This has sparked new protests throughout Hong Kong, but the world has shown it is willing to let China get control of HK without much of a fight. There will be sanctions/ tariffs/ rhetoric but nothing meaningful and things that were going to happen anyway. Beijing ordered a new law to extend many of mainland China’s security practices to Hong Kong, creating broad powers to quash unrest.

Through Xi trying to tighten control in the National Supervisory Commission, it has expanded throughout the country after the proof of concept really rolled out in Xinjiang. The move has rolled down into other key areas in highly populated areas, but also in areas of interest across Kashmir/Jammu and Sikkim/Bhutan. I will focus on the China-Pakistan Economic Corridor first because it is where Pakistan, India, and China (3 nuclear powers) merge. The Indus Water Treaty signed in 1960 divided water usage and distribution between India and Pakistan. It has stood the test of time, but these things are starting to breakdown with President Modi looking to adjust water flow. China has a problem with this because they are actively building the below Corridor to connect China to Gwadar. China and India have fought over time in Ladakh at the LAC line. PLA troops are now positioned in territory recognized by India, now while this is a show of force- nothing will come from it at the moment. India and Pakistan have seen an escalation in Kashmir, and China moving assets into place is a show of force and commitment to Pakistan. But- this will accelerate as the water treaty gets pulled front and center.

The Line of Actual Control or LAC in the Region

Indus Water River System

Another highly contentious area remains the Doklam Plateau in Bhutan and the Sikkim Province in India. This is the cleanest way to get heavy machinery over the Himalayas as well as a choke point for India. China already has agreements and investment in Bangledash and connecting to the Bay of Bengal would help offset a key choke point for China- Strait of Malacca. China would be able to pick up:

  1. More farm land
    1. Move heavy machinery over the Himalayas
    1. Connect to another point that doesn’t require transit through the Strait of Malacca
    1. Pick up fertilizer and other assets to increase growing potential

Doklam Plateau- Placement of Military Assets

The above I think drives home just how strategic this area is, and how both sides have been building infrastructure- bridges, roads, rail, and airports in order to protect and support this critical region.

The reason I focus so much on food is because it is the weakest point for China with the world’s largest population (21%) and some of the lowest amount of arable land (12%). The below graphic shows the cutoff at the 15-inch line that renders about 60% of the country useless for farming (without significant water and fertilizer support). The other problem is most of the populace also lives on the areas best suited for growing food- limiting the total output of food for a growing populace. These are key attributes that must be addressed, and is getting harder as China becomes more belligerent with neighboring countries.

The below map of the Belt and Road Initiative shows the interconnective nature of China with some emerging markets. The goal was to create vertical integration and diversify supply chains to bring raw materials back to China from a plethora of sources. This would make China less reliant on the U.S. for key assets and help China shake the need for U.S. involvements. Connecting the “String of Pearls” with alternatives to the Strait of Malacca becomes apparent when you follow the blue line back into China directly.

In order to protect the Chinese coast while claiming fishing locations and oil/gas assets was the implementation of the 9-dash line across the South China Sea. I go through this in more depth in the youtube video ( and provided the following answer across the China direction: “To answer the question of the day- I go back to Tiananmen Square and the slow disintegration of relations that proceeded it. Nothing dies in a straight line- especially on a geopolitical front, but the damage was done and public support quickly turned away from the CCP. There have been peaks and valleys along the way, but the trend has been moving in the wrong direction since this pivotal event. Fast forward to today, and we can see how President Xi came in with a splash by ending the Japan-China tension (lifting ban on rare earth exports). He also wanted to push China into the center stage with Made in China 2025/ Belt and Road Initiative/ Attracting more Foreign Investment/ Investing in local infrastructure. But the expansion kept getting more aggressive in the worst way possible, and things started to sour with our “Pivot to Asia” shifting military resources and focusing on building more relationships in South East Asia. China began to get aggressive across the false 9-Dash Line by claiming islands/ fishing grounds/ oil and gas resources. When President Obama pressed the issue in the Rose Garden, President Xi claimed they were only for scientific purposes, but within 6 months they had air strips, advanced radar, satellite interlinks, all forms of missile protection, and military barricks. The goal was to push the U.S. Navy further away from the Chinese Coast, and protect their false claims of the 9-dash line that was unanimously defeated in UN arbitration. President Obama launched a review of stolen IP and overall damage through the IP Commission Reports- identifying the true economic cost and passing laws to protect U.S. assets. The stage has been set for a ramp in tensions- especially as it came out the terrible structure and debt loads created through the BRI. The documents were leaked out of Africa early last year. The depth of espionage was finally appreciated with the Huawei backdoors installed in all the hardware they created/support. In my opinion, a trade war/cold war was the next logical step in the process of mounting pressure against China. I fear the cold war is going to quickly escalate into a “hot war” as China starts to make moves against- Hong Kong, Taiwan, and India. This is just a quick summary of the progression of China-US on the world stage… Just remember- China will enforce a contract as long as it is in their favor- the moment that stops… so does the contract terms in their eyes.”