China bubble ahead or beginning of a new economic boom cycle?

Optimism on China and other emerging markets is a major driver in shipping markets this year in all classes of tonnage as well as resumption of new building orders. WTO's Pascal Lamy revealed global trade is now expected to grow 13.5% this year. The future depends on successful trade rebalancing, a highly complex and political issue. China watchers like Michael Pettis and Andy Xie do not believe in the sustainability of the growth model.

Pettis and Xie feel that this system is resulting in increasing asset misallocation. The growth model is based on easy money from domestic financial repression that the government invests in infrastructure projects, SOE's and real estate. China keeps its currency pegged with the US Dollar at advantageous rates to promote exports by massive purchasing of US dollar assets rather than importing their trade surpluses domestically. Internal saving rates are held at very low levels.

Xie has argued that there is no rational pricing mechanism for real estate swapped by local government entities. Pettis is worried about future non-performing loans. He cannot see how the Chinese authorities can boost consumer growth from loss-making infrastructure projects:

"But governments do not cover losses. They channel money from households to cover losses. In other words if the Chinese railroad system turns out to be economically non-viable (i.e. the true economic cost of building it exceeds the economic benefits), households will be forced pay for the net reduction in national wealth. This of course reduces future household income and consumption – the surging of which is supposed to make all these infrastructure projects viable."

Xi Li, a Consultant at State Street Global Advisors, focused in a recent article on the real exchange rate (RER), which is nominal exchange rate (NER) adjusted for inflation rate and is more important in determining a country’s current account balance with another country. China's NER, largely fixed with the U.S. in the last few years, is provoking very high internal inflation. Bubbly housing prices are due to a combination of negative real interest rates, few investment options, and extremely low carry costs in terms of maintenance fees and zero property taxes.

This viewpoint dovetails with Andy Xie's observation that the global economy is like fried ice cream, where China and other emerging markets are swallowing the US stimulus. Fed easy money policies are putting them on fire with inflation. Li feels that these dynamics will eventually put China in a very precarious position. China will become even more dependent on investments and a current account surplus to grow its economy. It is increasingly cornering itself by reducing the RER of Yuan.

Given the fixation of the current debate on adjusting the NER between Yuan and USD, one day, the continuously exploding trade deficit, coupled with the likely persistent high unemployment rate in the U.S., means that the only outcome will be the threat of trade war, or trade war itself. The U.S., controlling final demand, may finally realize that this control gives it much stronger bargaining power, may end up as the relative winner. If China has trouble, the most commodity driven economies. None of this would be good for commodity shipping.

Pettis recently wrote a lengthy piece on the politics of Chinese adjustment. He notes four ways of boosting the household income share of national income and made a list of winners and losers as follows:

Winners and losers

1.) Raise the renminbi:

Winners:

Households as consumers, especially middle and lower middle classes

Service industries

Exporters

PBoC

Losers:

Exporters

PBoC

2.) Raise interest rates

Winners:

Households as savers, especially the middle and upper-middle classes

Service industries

Labor-intensive industries

Small and medium enterprises

Capital intensive industries

Real estate developers

Banks

Local governments

Speculators

PBoC

Losers:

Capital intensive industries

Real estate developers

Banks

Local governments

Speculators

PBoC

3.) Raise wages:

Winners:

Households as workers, especially lower middle classes and urban workers

Consumer and retail businesses

Capital intensive industries with domestic customers

Employers, especially low-income labor intensive companies

Losers:

Employers, especially low-income labor intensive companies

3.)Transfer state assets:

Winners:

Households, with the distribution depending on the form of privatization

Government, especially local officials

Losers:

Government, especially local officials

He notes that the trick for any of the first three adjustment measures (which are the necessary ones for a sustainable adjustment) is to adjust just fast enough so that the employment created by the rise in household consumption offsets the unemployment created by financial distress among the relevant losers. He stresses that Chinese adjustment must be slow because in the short term the negative consequences for employment can overwhelm the positive consequences.

Pettis feels that the pace of China’s adjustment will in large part depend on the pace of the external adjustment. Its trade surplus depends on the ability and willingness mainly of the US and trade-deficit Europe to absorb them. He does not think that the rest of the world is able (especially in the case of trade-deficit Europe) or willing to wait long enough to allow China a relatively easy adjustment.

Accordingly, Pettis interprets the China optimism of commentators like the Sydney Morning Herald's Michael Pascoe and the Financial Times's David Stevenson as the final stages of a bubble. Both Pascoe and Stevenson see a huge rising consumer market in China in the coming years as a major driver in world growth.

The shipping community seems to believe strongly in the robust growth school with Peter G's block vessel acquisition deals earlier this year, Navios's foray into tankers and Evergreen's new order of post-Panamax tonnage. From 10% of the world container vessel fleet in layup in 2009, pundits are now concerned about a future shortage of boxships in view of this massive new growth ahead. All this is all based on continued robust demand growth in China and other emerging markets.

The Eurozone pact with the Devil and its risks

Peripheral Eurozone countries effectively made a Faustian pact with the Devil foregoing their economic freedom in exchange rates and monetary policy tempted by easy credit and EU transfer money that resulted in consumption and real estate bubbles. The Euro was always a political tool to force European integration rather than sound economics. The EZ created structural distortions increasing divergences. Without an exit mechanism, "Abandon every hope, ye who enter here" as Dante would put it....

The Trilemma in international economics suggests that it is impossible to have all three of the following at the same time:

• A fixed exchange rate.
• Free capital movement (absence of capital controls).
• An independent monetary policy.

A flexible exchange rate and independent monetary policy are means to manage trade balances and promote growth, which is critical in an open market environment and free capital flows - something that EU periphery politicians sadly overlooked.

These hapless countries were reduced to the status of US state governments but without any equivalent of the US Federal redistribution system. EU members in the north like the UK, Denmark and Sweden prudently passed on these risks, preferring their independence. They were unjustly and ruthless maligned by the Brussels elite, but today time has proven the wisdom of their judgement.

Unlike sovereign governments, who can create monetary reserves through their central banks, the peripheral Eurozone members unwittingly exposed themselves to the risk of insolvency and bankruptcy with the illusion of a sovereign guarantee from Brussels that allowed them to rake up public debt in amounts and at rates that they would not normally be entitled. Once the bond vigilantes moved in and popped this illusion, credit spreads started to widen with restoration of proper risk pricing and crisis broke out.

The Brussels elite initially compounded the crisis with their very poor management, blaming the markets for their own shortcomings and policy failures. They were only bailed out with the tacit cooperation of the US, who winked at the unprecedented expansion of the IMF charter by facilitating  them with a financial backstop because the Americans feared the systemic risk. The ostensible mission of the IMF is to support individual countries in trouble, not a badly constructed and questionable currency union. This should have been the sole responsibility of the European Union, not other IMF members collectively.

The unsustainable trade imbalances that this currency union has created have in no way been addressed to date. It is virtually taboo in the EU even to raise the subject. The reason for the lack of demand-side adjustment is that much touted Europe’s internal market is not fully functioning, certainly not at the consumer level. As FT's Wolfgang Munchau points out, Germany entered the Eurozone at an uncompetitive exchange rate and embarked on a long period of wage moderation where it benefited from a real devaluation against other members.  Meanwhile southern European industry lost competitiveness and withered.  Consumption soared and real estate bubbles were fueled by the cheap credit until the bond vigilantes spoiled the party. A large part of the German trade surpluses are reflected in peripheral member deficits.

Over time, these intra-Eurozone imbalances will not only persist, but probably increase. This will make the economic adjustment for Spain, Portugal or Greece even more difficult than it already is. Those persistent imbalances, as well as the alarming build-up of debt, raise cause of concern about the long-term health of the Eurozone. Solvency is defined as the ability to finance debt in a sustainable way, and is affected both by the amount of debt, and future income through which the debt is repaid. Already several EZ members like Greece, Ireland and Portugal are bordering on insolvency.

For the Greek austerity plan, it hard to imagine a realistic estimate of a trajectory that foresees a stabilisation of the Greek debt-to-GDP ratio at tolerable levels. Optimists like Olli Rehn in his recent article 'Greek Renaissance' tend to pull the joker of some massive above-average growth forecasts for the future without explicitly stating where this growth is coming from. Normally in these IMF work-outs the growth comes from exports spurred by devaluation and structural changes. Even Swedish restructuring in the late 1990's resulted in currency devaluation. In Euro Hell, Brussels will not give Greece this option in defense of their sacred cow, the Euro.

The other side of the German exports to weak peripheral members and the resulting trade deficits is the mounting debt crisis. The austerity measures of 'infernal' devaluation is largely a Brussels concoction of untested crank economics that in practice downsizes GDP and deprives the failing country of tax base and income needed to repay and reduce its debt. Coupled with the 'pretend and extend' debt pyramiding of the IMF/ EU 'bailout' facility for insolvent borrowers, this risks bringing the whole Euro currency union down like the Tower of Babel. In the case of defaults, other weak EZ members will be liable for the backstop facility, pulling them under as well.

To guarantee the solvency of the Eurozone’s periphery would require not a few quarters of solid growth, but an entire decade. Where is this joker of massive above-average growth going to come from? Who is going to accept the trade deficit rebalancing?

Presently the Brussels elite seem very much in self denial. They remain unwilling to accept that one day a Eurozone state might either default, or, more likely, be forced to restructure its debt. Not only do they adamantly refuse to accept the principle, but also stubbornly insist on avoiding any institutional preparations for an orderly default of a Eurozone member or departure from the currency zone.

It is as if the Devil has possessed their minds in the hell (with no exit) that they have created with their currency union.... Is it a coincidence that the Faustian legend came from Germany? Can purgatory bring salvation?

Chemical war of attrition

The chemical sector experienced some revival earlier this year, but rates softened again during the summer and there remains a great deal of uncertainty yet about the time of a market upturn. Financially weaker operators like Eitzen and BLT continue their optimism, the more established major operators like Stolt and Odfjell remain cautious and see a longer market recovery period.

The chemical tanker sector was badly hit by the 2008 GFC. Cargo volume dropped dramatically in nearly all trades. Markets during 2009 were sustained mainly by US chemical feedstock exports to China, with tonnage swelling in the FE struggling for return cargo. This year after a stronger first quarter, the chemical tanker market saw a pullback. The transatlantic trades slowed, not helped by continued weak petroleum product markets. Reduced requirements for aromatics from China, which sustained the market in 2009, led to less demand for larger commodity parcels (above 5,000 tons) and with plenty of available vessel space as a result. The biofuel market withered with the US putting a 54 cent/gallon import tariff on most foreign ethanol supply and Brazilian ethanol production has been hurt from high sugar prices and heavy rains in 2009.

Stolt has been outperforming its peers with its solid contract base, diversified income from storage and other activities, and its sound financial position with moderate leverage. Stolt was very fortunate in its CAPEX obligations because delays at the SLS Shipyard allowed them to renegotiate price and delivery of their Dwt 44.000 coated newbuildings placed in 2005 for ME commodity chemical trading and they eventually secured full refunds for their Dwt 43.000 stainless orders. STJS cargo volume transported was up 7.6% from 1Q10 albeit freight rates remaining flat. Stolt finished its 2Q2010 with US$ 27.5 mio net profit. 　

Stolt's main competitor Odfjell finished its 2Q2010 with a net loss of US$ 64 mio, but much of this was due to their decision to enter the new Norwegian tonnage tax system at a total cost of USD 42 million. Time-charter results per day increased by 2% compared to first quarter. Odfjell is not running any cash losses, but its balance sheet is somewhat weaker than Stolt with higher bank leverage.

Stolt expects a continued weak market for the rest of 2010 and 2011. Odfjell reports falling cargo volume in 3Q2010 accompanied by weakness in outbound voyages from US and Europe. They see increased competition for cargoes.

Ailing Eitzen Chemical with the recent exit of its CEO Annette Malm Justad and failure of its much touted merger with BLT gained reprieve by selling off its 74.3% stake in Eitzen Bulk, which brought a total profit of US$ 60.7 mio for the 2Q2010. Total freight income in the quarter dropped from US$ 31.03 mio to US$ 29.03 mio as the ethylene market remained weak and there were a number of drydockings. Eitzen has had extensive loan restructuring with its senior lenders and has extended its covenant waivers for several years, but it is far more dependent on a quick market recovery than financially stronger competitors. All the more so because it has a weak contract base, more dependence on the spot market and clean petroleum products.

The most optimistic and aggressive chemical operator, Berlian Laju (BLT), was recently down graded by Fitch, who cut its rating on the tanker owner from “B” to “–B” with a negative outlook. It also dropped its tag on BLT’s $400m unsecured notes from “CC” to “CCC”. Its Indonesian management believes fervently in rapid return to bull market conditions and it maintains a very aggressive new building program. This is an unlimited growth mentality similar to that of Seaspan's Gerry Wang, but without the support of long term SOE charterers to underwrite the business. BLT derives less than 10% of its revenues from Indonesian business, although lately it has shown interest to diversify into Indonesian FPSO and more domestic tanker cabotage business.

The weight of the shipowner’s significant capital expenditure requirements led Fitch to concerns that it may breach certain covenants if current market conditions persist. BLT leveraged up its balance sheet in 2007 when it purchased Chembulk from AMA at the peak of the market boom with a sizeable markup from the price that AMA had acquired this Connecticut-based chemical tanker operator from its founder Doug MacShane just a few months earlier in the beginning of the year. Having paid a premium price, the company strained considerably to raise the cash to complete the deal with AMA, selling and leasing back existing vessels in its fleet as well taking on heavy bank debt.

Eitzen and BLT have smaller vessels than Stolt and Odfjell. Particularly, the Eitzen fleet is concentrated in Dwt 12.000 stainless units and also has a fleet of coated chemical tonnage. BLT has some larger stainless tonnage in the Dwt 20.000 range, but this has come from their acquisiton of Chembulk, left largely with the US management. Their Asian fleet are smaller units. Both companies have smaller contract books than Stolt and Odfjell.

The future depends on how the markets play out. A V-recovery and bull market would greatly benefit BLT due its very high operating and financial leverage. A prolonged slack market will benefit Stolt with its resources to pick up distressed opportunities. Clearly Stolt and Odfjell with their stronger balance sheets and customer bases have more staying power than Eitzen and BLT. Eitzen needs very much a quick market recovery before its lenders become restless again and BLT could face loan restructuring with its senior creditors or even worse, be forced to sell off its Chembulk acquisition to raise cash.  

Seaspan's China gambit

Seaspan is a non-operating containership owner with a very ambitious fleet expansion plan. They have been struggling since the 2008 GFC to finance their aggressive CAPEX program. Their business plan is highly dependent on continued Chinese export growth. The two top customers are Coscon and CSCL  (70% total revenue) both Chinese state owned enterprises.  90% of their contracted revenue is from China and Japan. The company is highly leveraged and has recently filed a shelf registration for a new share issue.

Seaspan is a vessel provider business model. It owns and operates container vessels with long term charters to major liner companies. It has no container logistical system of its own as do the major liner companies like Maersk, CSCL, MSC, CMA-CGM, Neptune Orient and Orient Overseas. It is largely an asset play backed by long term charter parties with substantial rate discounts and subject to earnings margin pressures over time from inflation, currency fluctuations and increased repair costs as the fleet ages.

It has a very impressive Board of Directors, including Graham Porter (Chairman of the Tiger Group), John Hsu (partner of Ajia Partners, one of Asia's largest privately-owned alternative investment firms), Peter Lorange (former President of IMD) and Peter Shaerf (managing director at AMA Capital Partners). Seaspan's CEO Gerry Wang appears to have very good personal contacts with the Chinese SOE's in shipping. He is always been extremely bullish on Chinese growth prospects.

The container sector was one of the most sharply hit by the sudden and deep economic slowdown in 2008 GFC. The major liner companies suffered heavy losses in 2009, with aggregate industry losses running into tens of billions of dollars. As an effect of industry wide losses, the liner companies heavily cut capacity, idling their own capacity and returned the chartered tonnage to non-operating owners. Normally, most liner companies own approximately 50% of their tonnage and charter in the remainder to cover their cargo volume projections.

These major operators made substantial adjustments in terms of order cancellations and deferrals of newbuilding deliveries well into 2011-2013. There was probably more speculative vessel ordering in the container sector than any other sector of the shipping market. A very large part of the orderbook are the large post Panamax size vessels for long haul routes.

The great attraction for non operating owners' investment has been the term charter cover from the liner companies. The current order book stands at 30% of the current fleet, down from about 55% at its peak in mid 2008. It is important to understand the current order book mix in terms of the owners.  The German KG market and asset providers in non-operating owners like Danaos Shipping and Seaspan constitute greater than 50% of the current order book, remaining is covered by the liner operators like Maersk, APL, and CMA CGM etc, who actually control the underlying commercial business with end-users in the sector.

Seaspan fared well in 2009 closing the year with record profits of US$ 145 mio as opposed to the losses of the two prior years: 2008 (US$ 199) mio and 2007 (US$ 10) mio. They reported no charterer default or renegotiation problems. This year for the 1 H, Seaspan is again in loss position, but due to sizeable changes in fair value of financial instruments resulting in a loss of $223.2 million for the six months ended June 30, 2010 compared to a gain of $92.5 million in 2009. The change in fair value loss for was due to decreases in the forward LIBOR curve and overall market changes in credit risk.

As of their annual report filed last March, Seaspan had contractual CAPEX obligations on an additional 26 containerships over the next 30 months over an in addition to the existing fleet of 42 vessel in operation. Whilst there have been rumors of possible new order cancellations, Seaspan so far has maintained its orderbook.  It appears that they are highly dependent on COSCO in chartering this new tonnage. The employment contracts with their two Chinese SOE charterers are subject Chinese law and dependent ultimately on the Chinese legal system for enforcement. Indeed, this year, they turned aggressive and also added one additional new acquisition chartered to United Arab Shipping Company for two years and Gerry Wang has made statements about opportunities to pick up units in the troubled German KG markets.

Considering the industry environment with the major liner companies cancelling orders and lately reletting larger post-Panamax tonnage, this represents a remarkable contrarian business strategy with backing from a BoD of major industry figures, who apparently believe strongly in a robust world economic recovery with shipping markets bouncing back to former levels in the near future, ostensibly driven by renewed Chinese export growth and internal infrastructure development as a return the pre-2008 GCF situation.

Financing this program has not been easy. The total purchase price of the 21 vessels was estimated to be approximately US$ 2.6 billion. The remaining five units were covered by leasing arrangements with Peony Leasing Limited, or Peony, an affiliate of Bank of Scotland plc and Lloyds Banking Group. As these units were contracted during the market boom, Seaspan faces a valuation problem with the decline in prices for new orders today. They have "gearing” covenants in their senior debt that prohibit them from incurring total borrowings in an amount greater than 65% of our total assets. Further they were blocked from drawing the remaining approximately US$ 267 million available under their US$ 1.3 billion Credit Agreement on which they were relying heavily to support their CAPEX program.

In May 2010, Seaspan issued 260,000 Series B Preferred Shares for US$ 26 million to Jaccar Holdings Limited, an investor related to Zhejiang Shipbuilding Co., Ltd. of China ("Zhejiang"). These preferred shares are perpetual and not convertible into common shares. They carry an annual dividend rate of 5% until June 30, 2012, 8% from July 1, 2012 to June 30, 2013 and 10% from July 1, 2013 thereafter and are redeemable by the Company at any time for US $26 million plus accrued and unpaid dividends. This appears to be a shipyard-extended credit facility for their reported two orders in this yard.

Compare this to established liner-owner operators like Neptune Orient Lines (NOL) and Orient Overseas (OOIL), integrated logistics players with proven container shipping capabilities available at attractive valuations. For example, OOIL's three principal business activities are segmented under International container transport and logistics services (OOCL, OOCL Logistics, and China Domestic), Ports and Terminals (Kaohsiung and Long Beach) and Property Investments (Wall Street Plaza in New York and Beijing Oriental Plaza in Beijing). OOIL’s container shipping operations is amongst the most cost effective in the container shipping industry with the Company consistently outperforming its peers with the highest profit margin among major container line operators.

OOIL has always had one of the most conservative and strongest balance sheets in the container shipping industry and has consistently kept the net gearing to the lowest. The company has no major issues in meeting its capital commitments and capital expenditure. At the end of FY 2009, OOIL had vessel capital commitments of US$ 712 mio and US$ 1.27 billion in free cash. It's capital gearing is 58%.

Seaspan's second quarter earnings conference presented a very rosy picture of a company with a low debt ratio, impressive built-in future growth revenue of US$ 7 billion and fantastic compound annual growth rate (CAGR) of 40%. Suffice this to be based entirely on their assumptions of a V-shaped world economic recovery and deeming their situation a few years ahead. . Their present leverage is very high and they would be not going through the trouble and expense of a shelf registration if they were not concerned about the need to raise equity to maintain their covenant obligations and cover their CAPEX needs. Indeed, one can presume it likely that this is an exercise to woo potential interest for a possible IPO offering.

The issue is whether peer companies like NOL and OOIL offer more value to investors because of their integrated logistics business models, their diversity of revenues sources, and their stronger balance sheets. All this is in the context of an uncertain environment in terms of economic recovery and rebalancing of trade flows. All these companies are dependent on continued emerging market growth in the Far East.

Is the Chinese eldorado that fuels shipping investments coming to an end?

This year has seen considerable new investment in large block speculative shipping deals. Peter Georgiopoulos did a US$ 886 mio deal in May to buyout the Metrostar fleet, and now a US$ 545 mio deal for 16 bulkers from Bourbon. Metrostar paid a record price of US$ 180 mio for five container vessels. The driver is anticipated economic recovery driven by Chinese export growth. Good times again as if the 2008 meltdown never happened. Yet already there are signs of a slowdown. Will China save the day?

Global growth since the 1980's has depended increasingly on monetary easing to induce asset inflation for stimulus, each dose of monetary stimulus resulting gradually in weaker recoveries with increasing joblessness. Wages in Western countries have remained fairly static and the government authorities have encouraged consumer lending to prime consumer spending with households becoming increasingly indebted. As an example, much of the growth in the US since the Dot.com meltdown of 2000 was due to easy money that fueled a real estate bubble and led to the subprime mortgage crisis and massive foreclosures. The housing market in the US remains moribund.

The Asian emerging market countries since their financial crisis in the late 1990's moved to a neo-mercantilism whereby they kept their currencies undervalued to generate large trade surpluses through aggressive export policies. They recycle the money into developed western countries keeping down their exchange rates and financing their trade partners' deficits. One of Ben Bernanke's major speeches a few years before he become FED chairman was characteristically entitled "The Global Saving Glut and the U.S. Current Account Deficit" as a sign the times.

Eerily reminiscent of the defunct Dot.com investment craze, China has become the rage with investors as an eldorado of unlimited growth potential. This optimism fueled interest for shipping issues on Wall Street, especially for dry cargo vessels to transport iron ore and coal for the steel production with the increased demand created by the real estate boom in coastal areas. Likewise investors went wild over the container sector where the only concerns of Seaspan (SSW) CEO Jerry Wang were whether Los Angeles could expand its port facilities to cope with the insatiable demand for Chinese goods.

Since the 2008 meltdown, there has been a modest recovery in both the US and EU but there remains a huge sovereign, corporate and household debt overhang in a balance sheet style recession. The most robust growth has been in emerging markets where there are much lower sovereign debt levels. The Chinese could finance their stimulus out of their trade surpluses, but there is growing evidence that the stimulus money has resulted in commodities inventory stocking as well as an over-heated housing market that is causing a serious real estate bubble.

Growth in the US seems to be slowing now that we are moving to the second half of the year. The EU has been confronted with serious sovereign debt problems in their weaker members of which Greece is now under a joint IMF-EU workout. Bad management of the Greek crisis and serious structural deficiencies in the Euro system resulted in contagion in other member countries, which led to a massive emergency EU bailout facility funded by member states and IMF participation. The ECB balance sheet is filled with toxic EU government securities.  It even suspended minimal ratings standards for Greece. The weaker PIIGS members are all under strict austerity programs. The UK, whilst in a somewhat better position free of the Euro albatross, has also voluntarily started an austerity program to address its fiscal and debt problems.

In this environment, Chinese capital surpluses are becoming harder to export. The weaker EU members were the second largest importer of these surpluses, but now austerity programs make this unsustainable. There is is already evidence of falling trade volume on western bound container trade lanes from the Far East. Meanwhile dry cargo freights as represented by the BDI have plummeted to levels not seen since the fall of 2008. The dry cargo pundits feel that the drop in dry bulk rates is only temporary due to Chinese contract renewal negotiations with producers. Likewise, container operators like Maersk, euphoric over recent transpacific rate increases, are projecting a surge in profits that match 2008 levels. External signs, however, are troubling.

What we see is that China has an increasingly volatile economy with large swings. The real estate is showing signs of decline. Non-performing loans are on the rise. Dependence on the US to export trade surpluses has risen since EU sovereign debt problems and austerity programs. The next tension is likely to be between the US and China on trade surpluses, especially if US unemployment remains at present levels. The last thing that China wants is to import the surpluses domestically because this would lead to currency appreciation and risk bankrupting the exporting companies.

All hopes at present are on another Chinese stimulus program to shore up the output gap. There appears a growing internal debate on how to manage their housing bubble and overheated economy, but the other major issue is the sustainability of the export model and how to deal with the shock from the EU and US taking measures to address defensively their large unemployment problems in a time span that is out of their control.

As FT's Walter Munchau put it:

The pessimists believe that a strong global recovery is unlikely given the persistence of financial stress, and the deleveraging of the private and public sectors across the industrialized world.

The optimists divide into two groups. There are those who have difficulties counting to zero, who cannot add up the global private, public, and foreign balances, which must equal zero by definition.

And then there are the rational optimists, whose expectations of resurgence in private sector demand must surely rest on the assumption of a return to even greater global imbalances than before the crisis, to which the eurozone will this time contribute actively. But this is surely not a sustainable position.

The pessimists would argue that global demand growth will not be sufficiently strong to support a selfsustained recovery in the eurozone. Even the rational optimists, who believe that this is possible, would probably conclude that these imbalances are not sustainable, and may trigger another financial crisis down the road. And if that is what you expect, you are not really an optimist.

What we know is that some of our societies are deeply over-leveraged, and that de-leveraging them means running trade surpluses, not deficits. That is not good for China nor the 'smart money' in shipping!

A prolonged, sluggish global recovery with high levels of unemployment in Western consumer economies and possibly a series of sovereign defaults of which the restructuring of the Greek public debt is high on the agenda would lead to renewed stress on the banking system, particularly in Europe. Overleveraged companies having already negotiated covenant extensions with their banks may be forced to sell assets at distressed prices that everyone has been trying to avoid the last few years.

We see a lot of 'smart money' in shipping assets. The new IPO's earlier this year like Baltic (BALT), Crude Carriers (CRU) and Scorpio (STNG) are all trading at discounts.  Albeit these companies have bought marked down assets and have low leverage, it is unlikely there will be appetite for further issues unless the discount is closed. It will be interesting to see what levels, Genco (GNK) obtains in raising equity and debt funding to close the 16-vessel Bourbon deal. Generally, Wall Street remains soft and shipping issues have generally never recovered to pre-2008 levels. Many of them are trading below US$ 10.

Is the container sector really out of the woods yet?

Investors have been euphoric over the rate increases in transpacific annual contracts. The container sector attracts keen investor interest due the long term employment with large liner companies like Maersk (OMX: MAERSKB) considered too big to fail. As a result, the sector has been plagued by huge order book overcapacity. The demand driver is the proverbial Chinese export machine. Yet container earnings may be peaking, given slowing US consumption, high retail inventory and Europe’s financial woes.

The global financial crisis hit Maersk and other liner operators very hard. They had aggressively ordered new tonnage as well as chartered in vessels from non-operating owners like Seaspan and Danaos , who had order books as large as their existing fleets. 

Maersk sank to a loss of US $1.02 bn in the historically low rate environment of 2009, overturning a profit of US $3.46 bn a year earlier. The liner operation fell to a $2.09 bn loss for the full-year as income from its containerships collapsed by nearly 30%. Aside from the container losses, Maersk also made a dreadful timing mistake in acquiring the Broström tanker fleet at top of the market prices shortly before the 2008 meltdown.

In this difficult environment, the liner companies fought back earlier this year by slow-steaming to try artificially to reinflate demand and reduce their losses from the dramatic drop in cargo volume. Industry consultants AXS Alphaliner estimate 78% and 53% the Asia-Europe and Transpacific routes strings are still running in slow steaming mode currently. Maersk also became a leader in cost cutting.

During 2010, the container shipping market was been positively affected by growing demand, primarily due to inventory restocking in the US and Europe and, to a lesser extent, growing consumer demand. Growth was seen mainly on the head haul routes and Intra Asia, which increased by 18% and 70%, respectively. Average rates in the first quarter were $2,863 per FFE, up by 18% compared to the same period of 2009 as a result of improved market conditions and higher bunker surcharges.

Maersk banked US $639 mio in the first quarter, overturning last year’s US $ 372 mio loss and smashing the US$ 225 mio consensus among analysts.

Citigroup analyst Ally Ma feels that the return to profitability for many lines may mark the beginning of renewed capacity woes as they begin taking delivery of deferred new building orders placed prior to the global financial crisis, against a backdrop of weakening demand. She reckons that the 3rd quarter rate hikes may indicate that container earnings are peaking, given slowing US consumption, high retail inventory and Europe’s financial woes.

Most new building deliveries to date are directly being employed in strings running on slow steaming effectively dampening the supply growth. The German KG market has for the past decade been a major asset provider to the container operators, owning the vessels and chartering out to the liner companies. KG participants are still facing insolvency issues and despite the recent market surge in charter rates, payments are insufficient to cover the payment of interest and principal in 2010 and 2011.

Non-Operating owners to continue facing financing issues as bank credit remains tight. Danaos Shipping (DAC) announced cancellation of three new buildings of 6,500 TEU which were ordered at Hanjin Heavy Industries and initially expected to be delivered in the first half of 2012. Seaspan (SSW) in a filing to the stock exchange stated funding shortfall for its remaining capex commitments and hinted at further cancellations on the cards.

The future of the container industry hinges on the quality of the economic recovery ahead. The US recovery seems to be slowing down and the EU is facing a serious sovereign debt crisis where austerity measures in Southern European countries are likely to dampen severely demand.

The temptation to buy speculatively container tonnage today has led to a rise in asset prices as each new deal brings new highs. Indicatively, Metrostar is said to have shelled out some US $180 mio to buy five 10-year-old 3,500-teu ships from German owner Claus-Peter Offen. This is double what the vessels might have fetched at the start of the year.

This is driven by the expectation that container rates will soon regain historic norms and present rates are closer to 50% of this level leaving room for improvement. Yet this counter-cyclical investment could prove self defeating in dealing with the overcapacity should the recover stall and we face a longer period of sluggish growth as opposed to the forecasts of politicians and pundits.

Peter G's big gamble

Peter Georgiopoulos has been aggressively scaling up his 3 publicly listed companies: Baltic (BALT), Genmar (GMR) and Genco (GNK) with massive block vessel acquisition deals. Whilst asset prices are down from boom year levels, bulk carrier prices have risen considerably off the meltdown lows. Bulk carrier freight rates have fallen sharply. Economists like Nouriel Roubini predict a weaker 2H 2010 and a sluggish recovery ahead, with potential public debt defaults ahead. Does Peter G's timing make sense?

Baltic was conceived in late 2009 as a pure dry cargo play based on opportunistic vessel purchases, spot employment and low leverage with a high dividend payout. Baltic's IPO was successful, but at a larger discount than anticipated. It was priced between US$ 13-14 but it is currently trading at US$ 9-10. It is a captive company of Genco (GNK) who manages the vessels and earns commissions on its fixtures and S+P transactions.

Genco (GNK) crashed in 2008 to US$ 6,50-7, but then made a modest recovery in 2009. Lately it has been under pressure, trading around US$ 14-15.

Genmar (GMR), the oldest Georgiopoulos company concentrating on tankers, is trading around US$ 5,40, which represent new lows for the year. In 2009, it underwent debt restructuring with its senior lenders, which it partially refinanced by a bond issue that cost more than originally anticipated. The successful US$ 200 mio equity raise for the Metrostar 7-vessel block deal was priced at US$ 6,75, only a modest discount. Investors are presently under water, but the increased equity strengthened the company balance sheet by lowering the leverage to 70% down from 75%.

The latest Platou market reports makes subdued projections for the drybulk sector that would indicate that Peter G's timing may not prove to be the best in making his bulker acquisitions. The tanker market is looking better, but Genmar remains with fairly high bank leverage. This would generate exceptional returns if the tanker markets continues to improve, but it also means further covenant violations with senior lenders in a poor market.

The investment thesis depends on China and emerging market growth. China slowdown in construction has sent dry bulk rates southwards lately. Supply-demand conditions and cyclicals are more favorable for the tanker sector but projected demand growth in crude oil transport is low in coming years.

Time will tell whether Peter G's was overly aggressive in his massive block deals of 2010. I think that analysts may have been overly optimistic on the timing. At least, the market has been pricing the shares differently from the analysts.  The next test will be the forthcoming equity raise for Genco to support the 16-vessel Bourbon block dry bulk acquisition deal.