Swinging market conditions, political tensions and trade battles were top-of-mind for the economists and industry experts speaking at this year’s VMA Market Outlook Workshop, Aug. 8-9, 2019 in San Diego.
While presenters talked about some of the same pressures they have for years such as the lack of skilled labor, the need for infrastructure improvements in the U.S., the effects of new technologies and what’s happening with oil and gas prices, forecasting was more difficult this year because of uncertainty over basically everything right now.
Issues at the forefront
One speaker referred to what’s happening as “chaos.”
The global and U.S. economies are both going through one of the longest, slowest recoveries in history, which has created a few opportunities but also contributed to the uncertainty.
Yet there was good news: Several speakers said they see no recession in the immediate future—the indicators used to measure a downturn aren’t present or are behaving in unusual ways.
In a few U.S. markets that are valve end users, the outlook was mostly positive. Water/wastewater will see “explosive growth,” according to one speaker, and construction, midstream/downstream oil and gas, petrochemicals and mining are expected to see continued growth over the next two years.
But for much of the world and this nation, the situation is unsettled.
“The top three concerns for the economy right now are uncertainty, uncertainty and uncertainty,” which “was raised to a record high in 2019,” said David Teolis, assistant director, International Economics, General Motors Company.
HIGHER LOWS AND LOWER HIGHS
The world’s economies are currently in the longest expansion in modern times, according to Michael Halloran, senior research analyst at Baird. However, the growth occurring has been very slow.
The current period “has been a limited growth cycle in large part due to modern monetary policy. There are higher lows and lower highs,” he said. “The feds of the world are manipulating growth through interest rates, bond purchases and more, which is softening the downside, but also constraining growth on the upside,” he added. Given those conditions, “it’s not surprising that the low growth cycle has been so long.”
At the same time, Halloran also noted that: “This is the most chaos I’ve seen without a recession.”
In the past, knowing the fundamentals of markets and their trajectory guided Halloran in making intelligent projections on where stocks were going.
The situation is different right now, however. “Macro politics, macro-economics, and trade and monetary policy are driving stock performance more than they ever had,” he said. In the past, such factors aligned with the fundamentals, but “that is not happening at this point in time,” he said.
Halloran said global government stimulus activity, falling regulatory burdens and faster approvals are current tailwinds for economic growth. Worldwide, central bank policies continue to drive markets, and in the U.S. recent rate cuts have been made by the U.S. Federal Reserve.
However, not much room exists in the current picture to allow for inflation and greater profits because of commodity declines. “It’s easier for industrial companies to pass on price increases when commodities are rising—not so much when they are down year over year,” he said.
Conditions that bear watching include trade tensions with China, the strength of the U.S. dollar and slowing global growth, especially among emerging markets that are dependent on commodities sales to developed markets. Halloran believes that these factors, along with historically high government and consumer debt, will contribute to the risk of a recession in the next 24 months or so.
Meanwhile, trade and tariff disruptions remain front and center, and macroeconomic risks are causing indecision and delays into 2020, he said.
Halloran stressed that the Purchasing Managers Index, which he said is a good indicator of demand, “is still relatively optimistic, although it is contracting a bit.”
On the other hand, the yield curve for lending is currently inverted, which can be an indication of an upcoming recession. “It could be a false indicator based on geopolitical sentiment, but historically, if a yield curve is inverted, a recession could occur within about two years,” he said.
What to Do
To stay ahead of competitors, Halloran urged process control companies to focus on building revenues in recurring business, aftermarkets, services and software revenue streams. “As the low-growth world drags on, emphasis on higher-margin recurring aftermarket revenues is critical for growth and margin expansion,” he said.
Regarding the internet of things, although products and capabilities are increasingly common, the surrounding opportunities (e.g., integration, monitoring, software) remains a contested battleground. Halloran suggested that opportunities exist in layering on the connectivity. “Take that product and expertise and translate it to the next level of growth,” he said.
Other opportunities in this low-growth cycle include environmental, social and governance criteria and in energy efficiency. “Customers hesitant to make large investments in new processes generally are still willing to spend on the higher-certainty, albeit lower-return profiles associated with investments into energy efficiency projects and upgrades,” Halloran said.
- Municipal water/wastewater, U.S. residential/commercial construction, midstream/downstream oil & gas, chemical and mining industries will see continued growth in 2019 and 2020.
- Aerospace/defense and general industrial will remain the same as 2018, while auto and agriculture will go down, mostly because of trade issues. Power generation will continue a downward trajectory.
- Companies will not make as much money next year as they thought, and while some growth is expected, downward pressure from geopolitical factors will moderate that growth through 2019.
THE ONLY CERTAINTY IS UNCERTAINTY
David Teolis, assistant director, International Economics for General Motors Company, pulled no punches when he described the current economic situation. Globally, uncertainty is at a record high, he said.
The world is wondering how long the trade war will persist and if it will extend beyond China, he said. Also, global manufacturing activity is contracting and global central banks are moving into a monetary easing cycle. This is happening at the same time the pace of economic growth is expected to slow even more than the sub-3% Gross Domestic Product (GDP) growth the world has experienced for the last five years. The U.S. and Chinese economies, which together contribute roughly 40% of the global economy, are among those destined for less growth, according to Teolis.
Elections in Canada, the U.S. and Argentina, geopolitical events and technological changes have added to economic anxiety, Teolis said. These lead to delays in decision-making for companies and for consumers, which further limits the pace of economic growth.
He pointed out that inflation, or rather the lack of inflation, is a significant concern globally right now—the U.S. Federal Reserve, European Central Bank and Bank of Japan failed to bring inflation rates to their 2% targets. “Why is this important?” Teolis asked. Because “Targeted inflation is important to stabilize prices to help facilitate the allocation of resources.”
In historic business cycles, recovery is stimulated by pent-up demand after a recession has occurred, he explained. When people finally get a job, they want to spend. In the current situation, pent-up demand has been exhausted by the long period of slow growth, so cutting the Fed rate is not going to help spur spending and raise prices, he said.
Additionally, globalization has created increased competition, which puts downward pressure on prices, and many aging baby boomers worldwide are not buying as many consumer goods as in the past. Another factor is a phenomenon some are calling the “Amazon effect”—consumers and companies can go online to compare and buy at the lowest prices, which affects competition everywhere.
Teolis said that if price pressures remain low, central banks may need to get involved—if the pressures are only temporary, those banks shouldn’t get involved because adding stimulus now can overshoot goals for the future.
Today, monetary leaders are facing the question of whether exogenous sources of uncertainty such as the trade wars can be effectively addressed by easing monetary policy. If that’s not the case, such policy will be ineffective until the root causes of uncertainty are addressed, he said.
The Trade War
According to Teolis, President Trump looks at the trade imbalance as a battle China is losing. However, China’s influence in the global economy has been increasing since it joined the World Trade Organization in 2001, he said. One key forecasting institute predicts that China will surpass the U.S. by 2030 or sooner if the U.S. sinks into a recession.
Teolis noted that, since the trade war began, there has been a net reduction in the U.S. trade deficit with China of only $2.5 billion. “Has it been worth all the chaos and uncertainty?” he asked.
Because China imports fewer goods, that country has to fight back in a tariff war with other weapons such as ceasing to buy specific goods (e.g., Boeing planes and soybeans). It also can sell U.S. treasury holdings—China holds more than $1 trillion of U.S. bonds as part of its currency reserves. Liquidating them would push up U.S. Treasury bond yields. China also could allow its currency to weaken, offsetting, at least partially, the impact of higher U.S. tariffs.
“There has been a significant downgrade [in the outlook for the world economy] since January; forecasters have become more pessimistic,” he warned. “They are saying we’re heading back down below 3% [GDP globally]. Populism and protectionism persist in that kind of climate, and they constitute major risks to the global economy.”
- Risks exist for geopolitical (e.g., Iran and North Korea tensions) and geo-economic (e.g., Brexit, oil or other commodity price shocks, financial instability, currency war) events that could halt global growth.
- Financial market instability is threatened by the U.S. Federal Reserve and other major central banks shifting towards a dovish policy bias.
- The next year will see global growth slowdown.
ANATOMY OF A RECOVERY
At the time of the VMA Market Outlook Workshop, the economic recovery in this country had just broken the record for the longest expansion since World War II. Giacomo Rondina, associate professor of Economics for the University of California San Diego outlined for attendees the specifics of what’s happened and explained why this recovery has been different than some others.
GDP growth has been good, Rondina said, “but is just now catching up with the potential GDP.” The very lengthy expansion period has actually seen less overall growth than normally seen in a recovery. Rondina pointed out that the current expansion shows lower growth overall (20%) than the two other long expansions, Kennedy-Johnson (30%) and Bush-Clinton (35%)
Also, the usual drivers of expansions—residential investment and consumption of durable goods—have not been as important in this expansion as in previous ones, Rondina said. This time around, investment in intellectual property products such as software turned out to be a driver in growing the GDP.
Some other specifics include:
The Labor Market
Labor force participation has almost completely recovered to its pre-recession level. Unemployment is very low and the labor market is solid, but some features are troubling. For example, if more job vacancies exist than unemployed people, that is an indication of a mismatch of skills, Rondina said. Companies are looking for skill sets they can’t find. He also said that productivity is not growing during this recovery as much as it did in previous recoveries.
Interest rates continue to stay low, and Rondina didn’t expect any inflationary pressures. A concern he had is that very low interest rates going into any downturn might prevent the use of these rates to stimulate the economy if that stimulation is needed.
Household debt is falling, and government debt is rising, Rondina said. During the last recession, household debt as a percentage of GDP lingered around 100%, while government debt went from about 63% to 80%. During the current recovery, household debt has gone down steadily, while government debt has risen fast and now is more than 100% of GDP. Rondina said this migration of debt exposure from private to public is one of the unusual features of the current economy.
The current market has created some imbalances. For example, the stock market has been up, but stock prices are not justified by earnings, Rondina said. Real estate, however, is in line with its fundamentals.
Also, low overall inflation masks major changes in the relative prices of some necessary items. To illustrate this, Rondina looked back at a selection of U.S. consumer goods and services from the time frame 1998 to 2019. While the overall inflation rate during that period was 57.6%, some items, such as televisions, computer software and cell phone services, fell in price. However, other items, mainly services, rose far higher than general prices. For example, hospital services topped out at over 200% more expensive from beginning to end; college tuition was not far behind; and childcare rose over 100%. The implications of this may be felt in the workforce, Rondina pointed out. For example, if childcare takes too big a bite out of income, parents may not re-enter the workforce as quickly. If college is too expensive, students may not continue their studies to get degrees, with the result that they won’t acquire the skills needed for good jobs.
In addition, the higher costs of medical insurance and increased wages discourage companies from hiring.
Income inequality is another troubling imbalance that is not improving. People on the lower end of the income range experience not only lower income, but lower income growth than those with higher incomes, Rondina pointed out.
Should we expect a recession?
As with other speakers at this outlook, Rondina said economic indicators and conditions are out of alignment in some cases. “Some factors are normal; some are not,” he said.
Recessions are painful; they mean lost jobs and lower income, Rondina said. However, they historically have been temporary, whereas some of the imbalances and concerns presently facing the nation are likely to persist beyond the next recession.
For example, government debt is projected to continue increasing, which is less of a burden when the economy is growing and interest rates are low. During the next downturn and/or inflationary cycle, that debt could bring trouble, he said.
- A slowdown may start in 12 to 24 months.
- After it does, the economy is likely to make a downturn.
- Monetary and fiscal policy might not have room to maneuver when a recession hits.
Oil and Gas
PRODUCTION AND EXPORTS UP
John Spears, president of Spears and Associates, said the outlook for 2020 for oil and gas is fairly steady. Production will likely be up for the year but the slowing in the economy may lead to reduced investment and drilling, he said.
Oil Demand and Production
The forecast for demand worldwide for next year has been reduced from previous expectations because of the slower economic growth outlook.
On the production side, OPEC+ (the supercartel of OPEC and some non-OPEC countries) extended its agreement to restrict output until 2020 to limit inventory and maintain price. Meanwhile, the U.S. is expected to supply all the additional global demand for 2020.
According to the Organization for Economic Cooperation and Development, oil inventories are currently at their third-highest level as far as the number of barrels and second lowest level in terms of days’ worth of supply, Spears said.
In the U.S., the spot oil price will rise by 8% for the year while supply is expected to remain adequate. Historically, rising prices mean an increase in oil rig activity, Spears said.
The average output in 2020 is expected to be up by 7.5%, an increase that will be good for the pumps business and associated equipment, such as valves, Spears said.
Of the wells in the U.S., 85% are now horizontal, Spears said. The reach for those wells now averages about 8,000 feet. Despite this increasing lateral length, initial productivity—the first month’s output of a well—for shale oil and gas wells seems to have peaked in 2018. For U.S. oil and gas output to continue to grow, post-2020 drilling and completion must increase, Spears said. A key issue here is “parent-child” well interference, which is where multiple wells, typically three or four, are commonly drilled from a single well pad. In such situations, the fracking zones of the wells may touch each other—parent-child interference—resulting in decreased output per well, Spears explained.
In 2020, U.S. oil exports of both products and crude are expected to average 9.5 million barrels per day (bpd), a number that has been increasing year over year. “Our refineries are set up for heavy, sour oil,” Spears said, “but what is produced is light, which is better processed at foreign refineries.” In 2020, crude exports are expected to be 3.8 million bpd, up 25%, he said.
Gas production is forecast at 92.2 billion cubic feet per day (bcfd) in 2020, up 2%. The condition of pipeline infrastructure is a concern, as is well productivity, Spears said.
U.S. gas exports are forecast to reach 13.8 bcfd in 2020, up 6%. A significant development in this area is that the proportion of LNG gas has been rising since 2016, when the first terminal for exporting in the U.S. opened in Louisiana. For 2020, LNG is expected to be about 40% of the market.
Drilling, Construction and Equipment
In the U.S, 21,600 new wells are expected, Spears said, which is down by about 5%. Maintenance and capital expenditure budgets will likely remain steady.
About 10,000 miles of pipeline construction is expected in 2020, down about 10%.
Expenditures on surface equipment such as wellheads and Christmas trees is projected to drop 4% to $4.8 billion in the U.S. Rig equipment spending in 2020 is likely to run $5.7 billion, down 14%.
- The worldwide oil forecast for demand for 2020 is about 102.4 bpd up 1.4%. The average oil output in the U.S. for 2020 is expected to be up 1 million to 13.4 bpd, up 7.5%. The U.S. spot oil price is expected to average $64/barrel in 2020, up 8%.
- U.S. gas production is forecast at 92.2 bcfd in 2020, up 2%.
- Midstream investment will continue to be strong to handle record levels of U.S. oil/gas production and exports, including transmission pipelines and oil export terminals.
- Valve demand has a mixed outlook with U.S. upstream weaker; international upstream up from a cyclical low; and U.S. midstream holding steady.
PROFITS NOW, TROUBLE AHEAD?
Mark Eramo, vice president, global business development at IHS Markit, noted an extended upcycle in petrochemicals and said profitability has been good.
A combination of high crude prices and stable natural gas is attractive for North America’s gas-based chemical investments, he said.
“Globally, petrochemical producers have been making good money into 2018, but since 2019, it has slowed down around the world,” he said. While the U.S. has not yet felt the downturn as much as some other countries, several factors could change the scenario in the next year.
The last four or five years of strong performance profitability led to reinvestment in the sector, so a wave of new capacity is on the way at the same time as a slowdown in demand.
“This is a bad combination, a classic train wreck, as they say in the industry,” Eramo warned.
The General Picture
Because global trade is slowing down, there is pervasive evidence of weakness in Europe, particularly in Germany, and despite recent signs of strength, Japanese growth is slowing. In the near term, the downside risks to growth for China will be mitigated by that country’s own government’s stimulus, but for other large, emerging markets, there is no winning this trade war.
“The bottom line is: We are a long way from being out of danger with respect to the trade wars,” Eramo said, and a truce would neither help nor hurt the ongoing global slowdown, he pointed out.
Meanwhile, companies are increasingly being asked to assess business models and investments under different scenarios. For example, they are being asked: What is the impact of electric vehicles on future energy demand? How will pressure from investors and society for a lower-carbon, highly sustainable footprint impact investments in the future? How will the competition between natural gas and renewables play out? How will solutions to the plastics waste issue impact long-term demand growth for plastics, monomers and feedstocks?
These kinds of questions have created a need to test business strategies in different future environments, Eramo said.
Megatrends for the 2020s
A huge focus right now is on reducing the hydrocarbons used to get people around. Most of that emphasis is on improved energy efficiency, especially mileage per gallon in cars, trucks, shipping and aviation. These industries must become much more efficient to meet what’s expected of them, which is creating an issue of plateauing oil demand.
This could result in a movement of oil formerly slated for mobility going into the petrochemical industry, which will influence where plants are located, and how energy and refining companies allocate resources.
This is happening at the same time use of plastics is under the highest scrutiny, Eramo said. The plastic waste issue accelerated into the global consciousness during 2018 and is considered the most critical issue that will influence the industry during the decade of the 2020s, he said. Local communities and corporations are imposing bans on single-use plastic, and the United Nations World Environmental Day had plastics waste as a central theme in 2018. Since plastics account for about half the demand for petrochemicals, sustainability risk assessment is essential to long-term planning for this sector.
There also are significant changes underway in China that Eramo says require close monitoring and analysis. That country’s economy is transitioning to high-value manufacturing and services, and there is a change in the balance of chemical company ownership between the central government and the private sector. This leads to value-chain integration and a push to be self-sufficient and to develop specialty chemicals.
- The overall financial outlook is down from 2018. Slower economic growth and lower crude oil pricing are predicted for 2019/2020.
- A slowing economy and too much new capacity are of concern.
- The issue of plastics and sustainability will be a big influence on the petrochemical industry in the coming years.
- Steady demand will soften the outlook for ethylene and propylene. Chlor-alkali is expected to strengthen and paraxylene faces a situation of significant over-supply.
RENEWABLES/NATURAL GAS RULE
Britt Burt, vice president of global research for the power industry, Industrial Info Resources, presented a moderately optimistic outlook for the power sector for the next two years.
Demand growth in the U.S. and Canada has been fairly flat with the exception of Texas and in places where reserve margins are tightening such as the eastern seaboard. However, he doesn’t see tremendous growth anywhere.
Currently, there are just over 3,000 power projects with a value of about $1 trillion worldwide in which maintenance is taking place or construction has begun. Globally, about 35,367 power projects are planned, with many of those in Asia and South Asia where a large percentage of the investment in nuclear and coal-fired grassroots projects exists.
Meanwhile, the 6,890 North American projects currently on the radar are worth nearly $781 billion. Grassroot projects, which include new builds and brownfields, are worth more than $463 billion of that figure while 347 expansions and unit additions to existing power plants are worth almost $114 billion.
The grassroots and expansion projects kicking off between 2019 and 2021 are mostly in renewables—solar and wind—and some natural gas. New build renewables also include hydro and less traditional areas such as geothermal, landfill-gas-to-energy and biosolids.
For the long term (by the year 2040), solar power is expected to surpass every other type of power growth except natural gas. Increases in solar will most likely be in photovoltaic because concentrated solar project technology has not come down enough in price, Burt said.
Wind hasn’t expanded on its own and cannot yet compete with natural gas-fired facilities, especially since storage technology and cost have not come down to a level where it can offset the need for backup from traditional sources such as natural gas.
As a result, Burt believes the potential for more natural gas is still good. For the next five years, about 45% of new builds will be natural gas, he said. The rest will be wind and solar.
Most of the natural gas grassroots and expansion projects between 2019 and 2021 will be centered around developments where the Marcellus and Utica Shale fields exist in Ohio and Pennsylvania. This does not include repowering or fuel switching.
The types of equipment installed will include combined cycle with a slight uptick in single-shaft generators. This area is already growing in Europe and beginning to grow in North America. There also is some potential in reciprocal internal combustion engines (RICE) for peak loads.
“Some of the microgrid involves installing these reciprocating engines so there is potential for growth there,” Burt said.
For the existing fleet, expenditures will be for modernization and efficiency upgrades. Digitization is part of that effort, which applies to digitizing records but also controlling system upgrades and giving efficiency upgrades on hardware, SCADA systems and turbine controls.
Burt said there is no real potential for new generation of power in coal or nuclear. Any expenditures in those areas will be for modernization and life extension programs. For example, Ontario is modernizing its nuclear fleet so there is opportunity there.
Areas of opportunity also are showing up in onsite power generation at manufacturing facilities. Across the U.S., about 594 such units are operating about 10 GW of facilities. Burt believes there will continue to be growth because of the movement away from traditional power generation and toward more distributed generation. This, and microgrid facilities (sometimes in conjunction with the grid and sometimes operating independently) will continue to grow.
- Development of natural gas-fired generation will continue, driven by fuel price and availability. Don’t expect natural gas prices to go up, however, even taking exports into consideration.
- Increases in project opportunities in the industrial power generation sector will occur.
- Long-term potential exists for increases in project spending for expansion and modernization of the hydroelectric fleet.
- Development of microgrid (“off grid”) systems will increase.
Water and Wastewater
EXPLOSIVE GROWTH IN THE U.S.
After a construction downturn in 2016-2017, the water/wastewater market experienced significant growth in 2018 at 12-13%, according to Thomas Decker, Thomas Decker Consulting. Compared to 2018, construction for water projects was up 20% by mid-2019 and up 13.4% in wastewater.
Decker predicted this boom will continue and said double-digit growth is possible for 2019. In fact, the market probably won’t slow for a few years—it typically lags behind the overall U.S. economy by about 18 months, Decker said.
Pent-up demand was the reason for much of the growth, Decker said. Water/wastewater utilities have delayed projects needed to solve problems and increase capacity, but those can no longer be ignored. One of the reasons growth could happen is approval of more than $40 billion in construction bonds for improvements to infrastructure. Growth will continue because projects funded by the bonds start with engineering, design and planning, which takes a year or two, followed by the stage where construction begins.
In the U.S., water and wastewater utilities spent $113 billion in 2017—$45–$50 billion of which was for outside goods and services including capital and operating expenditures. Meanwhile, the estimated global spend for water and wastewater in 2017 was $700 billion.
Decker pointed out the balance in the industry is changing. In the last eight or nine years, spending was higher for wastewater than for water. As of 2018, the reverse is true with 57% of spending going to water and 43% going for wastewater, Decker said.
Because of all the building, engineering and contracting companies in the industry and equipment sellers all saw solid positive growth in 2018, Decker said. Competition for the work is fierce, especially in engineering and construction.
Decker cited the five top-ranked issues selected by respondents to the American Water Works Association annual survey:
- Renewal and replacement of aging infrastructure
- Financing for capital improvements
- Long-term supply availability
- Public understanding of the value of water systems and services
- Watershed/water source protection
The Environmental Protection Agency (EPA) highlighted similar issues in its most recent infrastructure needs survey and assessment. In wastewater, for example, needs are split almost evenly among five areas: conveyance replacement and refurbishment (19%); secondary wastewater treatment (19%), advanced wastewater treatment (18%), combined sewer overflow mitigation (17%) and new conveyance (17%).
On the water side, the needs were greatest in transmission and distribution (67%); followed by treatment (18%) and storage (10%).
Paying for Improvements
Financing is available for projects, Decker pointed out. Besides local funding, sources such as the Clean Water State Revolving Fund ($1.7 billion) and the Drinking Water State Revolving Fund ($1.2 billion) help to provide the needed money. Nine projects also have been funded under the Water Infrastructure Finance and Innovation Act—38 applications await decisions and 51 new letters of interest were filed in 2019.
On the local funding front, the municipal bond market was solid; interest rates had stabilized; and construction and materials costs increased less than 3% for the first half of 2019.
Trends to Watch
Urban migration, which affects this industry, continues to increase in many areas of the country, which today include much more than major cities. Population increases in so-called second-tier cities, such as Fresno and Bakersfield, CA, have placed stresses on utilities. In other places, urban areas are shrinking. The population of St. Louis is down 11% while Cleveland has lost 19% of its residents. With lower populations, these cities have lower flow rates, resulting in water/wastewater problems such as corrosion, flow stagnation and microbial growth.
Meanwhile, desalination is showing its highest investment growth ever with capital expenditures at more than $6 billion in 2019, Decker said. Currently, 20,000 desalination facilities are in operation worldwide, though only a few are in the U.S. One of the reasons for the increased focus in this area is that operating costs have fallen more than 50% in the last 30 years because of improved membrane technology.
In wastewater, reuse projects are receiving attention. More than a dozen states now have these projects. Arizona allows direct potable water reuse while Los Angeles and San Diego have committed billions of dollars for recycle/reuse projects and the Hampton Roads Sanitary District in Virginia has an initiative for no-discharge treatment. For that project, treated water, instead of being returned to surface water sources, is injected deep into the aquifer to replenish groundwater and reduce subsidence.
- Some contraction is possible in 2020-2021 because of the slowing U.S. economy, but the water/ wastewater market should continue to grow.
- In the U.S., double-digit growth is possible for 2019.
- The five-year global compound annual growth rate (CAGR) in water/wastewater is forecast to be 4.7%; it is expected to be even higher in the U.S.
DEALING WITH CENTRALISM
Scott Nelson, partner at EY in Shanghai, and Andrea Yue, managing director at EY in New York, closed out the 2020 Market Outlook by addressing the hot-button issue of China and the trade wars.
Yue noted that China’s current President Xi is a strong leader and that new regulations have been issued this last year that decree he could serve for an indefinite period. He is centralizing power and is focused on party and fundamental socialism.
Because of this, much emphasis is placed on state-owned enterprises, which are receiving preferential treatment, the speakers said. The government is also focusing on eliminating bribery and graft within the governing bodies. This has led to restructuring in which state and local authorities are merging into one. For example, the commerce department and finance department in some local cities may now be the same. While the resulting governing bodies will give investing companies local subsidies to attract business in their cities, they also are responsible for taxation and could impose fines for infractions.
Investing in China
Despite difficult times and trade tensions, the Chinese government is willing to give various incentives to companies doing business in China, the speakers said.
Because in the past private industry had a difficult time getting credit, the government is pushing hard to get small- and medium-sized banks to lend and finance smaller businesses. Another significant change occurring is that, in the past, a U.S. or other manufacturing company dealing in technology that came into China often had to transfer the knowledge of that technology to the Chinese. That’s not as true anymore.
The Chinese population’s emerging middle class, which is consuming more and demanding better and safer products, has resulted in an increase in environmental and safety laws. That has created a more level playing field for multinationals against Chinese-owned companies.
Nelson warned, however, that anyone doing business in China must “make sure you know what’s going on in your Chinese companies. You do not want problems with compliance. Always be in touch with your team there, and make sure you are reviewing things frequently.”
The Trade Wars
As a result of increasingly strong rhetoric from President Trump, it has become difficult for the Chinese government to negotiate and accept U.S. terms. Sentiment and messaging in China have evolved to a more hardened position of “No deal is fine” [meaning the Chinese are much more willing these days to walk away from negotiations].
However, because of the imbalance in trade, China can’t impose tariffs dollar-for-dollar with those the U.S. has issued. Because of this, China may retaliate with other actions.
According to Nelson, the most important of these actions for U.S. businesses could be to leave them out of the opportunity to benefit from reforms that increase access to foreign investors. This means U.S. companies would be at a disadvantage relative to competitors from Europe, Japan and other countries.
Also, anything coming into China from the U.S. is already facing increased regulatory and investigative pressures (e.g., an increase in health & safety inspections, tax audits, license approvals, etc.) as well as an increase in customs inspections.
Retaliation may also come in the form of curbs on outbound tourism. Many Chinese people go to the U.S., but they could be barred from doing so, which would have an effect on U.S. hospitality and other tourist-based industries.
Yue offered some workarounds for American multinationals that want to do business in China, including restructuring the supply chain to buy more of the materials needed for manufacturing from Chinese companies. She also suggested that, for materials destined for importation into the U.S., manufacturers could use the First Sale concept, meaning that the first sale would go to another, free-trade country before coming to the U.S.
- There are incentives for foreign investment, but it is NOT a level playing field with government-owned businesses.
- The sentiment from official China is hardening with respect to rhetoric and the trade war with the U.S.
- China’s Ministry of Commerce announced last May it will introduce an unreliable entity list “in reaction to” practices distorting the market. The list has not yet been issued but is expected in the near term.