Monday digest

Posted 3 July 2023

Overview: A glass half-full half year
The second quarter ended with positive sentiment towards global risk assets (Although UK assets have fared less well), a surprising turnaround given the black clouds that gathered back in March amid the  US regional bank crisis. Markets have responded well to more earnings positivity from analysts, but the biggest change has been in their reaction to valuations. Developed world equity indices have doubled up on rising underlying profit expectations with rises in the price-to-earnings multiples applied on top of those earnings. This sign of increased investor optimism may perhaps be lack of pessimism, a sense that the downside is protected, following the experience of renewed central bank support in the aftermath of the US banking crisis.

Somewhat contradictory, manufacturing sentiment (the outlook from businesses rather than the analysts covering them), has continued to show looming recession. This has been particularly evident in Europe, despite the easing of energy price pressures. Furthermore, June’s purchasing managers’ index (PMI) data saw the service side of the economy also gradually turning less positive and manufacturing more negative. Europe was notable for quite a sharp decline across the board, while China’s June reading is estimated to slide back to about 52.8 which would probably mean a World Composite PMI reading of about 52.7.

The European Central Bank (ECB) held its annual symposium in Singa, Portugal last week and leading central bankers from across the world spoke. The tone ranged from mild to bloody-clawed hawkishness, and convinced money markets to factor in more short-term rate rises. Bond yields duly reacted and moved higher, yet equities gave the event a ‘whatever’ shrug. Perhaps investors believe that the impacts of inflation may be less problematic for the financial and economic system than previously feared. Perhaps the central banks also think so. They certainly have not been as hawkish as their rhetoric.

The other intriguing aspect of the past quarter was the lack of corporate bankruptcies and default. In the US, following Silicon Valley Bank’s demise, investors were on the lookout for signs of default contagion. Although there were a few, most would say that it did not become a problem. In the UK, the same could have been said right up until the news concerning Thames Water. The 2021 Bulb bankruptcy was an example of how a utility company can be caught between costs, competition and price caps. Thames Water is potentially of a different magnitude. Perhaps most important will be the impacts on current equity holders, generally pension funds. In itself, the Thames Water situation is not likely to precipitate a crisis. Nevertheless, large debtors with problems are things we should watch closely, as much perhaps as hitherto deemed ultra-safe infrastructure investments.

The heat of June is forecast to give way to a cooler July in Europe. We hope the relative calm experienced by equity markets in June will carry on regardless of the weather.

Markets don’t listen to Wagner
After Yevgeny Prigozhin launched (and quickly retracted) his Wagner rebellion, global stocks and bonds did not budge. The biggest geopolitical event since the Ukraine war began was not even a blip for investors. This is understandable as far as equities go. Russian assets were removed from westerners’ investment universe as soon as Putin launched his invasion, and the remaining trade links between companies have been almost entirely dismantled since then. What is perhaps more surprising is that oil and gas markets were similarly unmoved.

This is a far cry from a year ago, when Russia’s military and political exploits felt like the dominant driver of global – and particularly European – energy prices. Brent crude nearly doubled in price during the build-up to Russia’s war, while Dutch TTF, the European natural gas futures index, more than doubled in just the last two weeks of February 2022. The spikes were even greater when Russia cut the European Union (EU) off from pipeline imports. Still, markets hate instability, and a Russian civil war could destabilise energy supplies again. And, while Europe is far less reliant on Russian gas than it was, it would be a big overstatement to say the continent is unaffected by Russia’s supply situation. 12.9% of the EU’s imports is no insignificant amount in absolute terms. Moreover, the fact that Russian supply is no longer going to the west does not mean it is unimportant for global energy markets. It is now clear that Russian oil and gas has made its way to Asia, whose imports from elsewhere have adjusted downward.

Saudi Arabia recently signalled it would further cut its oil production in response to weak global demand. This is believed to be in large part down to overproduction in Russia, as it tries to pump out supply for much-needed funding. With the ongoing slowdown in the global economy – and even looming recessions in many parts of the world – the biggest swing factor in energy markets is the lack of demand, rather than supply. This puts big suppliers like Russia in a much weaker position than they were a year ago.

Much has been written about perceived Putin weakness following the botched rebellion – backed up by Ukrainian peace discussions with a host of developing nations, including China. But we should not assume that either his grip on domestic power or desire to take Ukraine has been diminished by this. What all this does suggest, however, is that Russia can only afford to keep fighting for so long. That, together with Ukraine’s dwindling counteroffensive, increases the likelihood of a ceasefire in the medium term.

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