Monday digest
Posted 7 August 2023
Overview: Expecting the unexpected
Stock and bond markets started August with something of a wobble last week. When bond yields suddenly ticked up over the week, for reasons that were not immediately obvious, equity valuations reacted with a mild correction. Only after Friday’s US jobs data signalled a cooling of underlying inflation drivers from the tight labour markets did equity markets begin to relax again. The catalyst for bond yields rising (which means prices fell) was not immediately obvious. It may have been Fitch’s downgrade of the US long-term foreign currency credit rating to AA+ but, since US Treasuries are NOT issued in a foreign currency, this shouldn’t matter greatly. Also, the much more influential Standard & Poor’s has had its US rating at AA+ since 2011.
It is more likely that the price falls were simply due ‘more sellers than buyers’. The US Treasury surprised markets by selling substantially more new long-term bonds than expected, just as corporate borrowers have been shifting from high-cost short-term borrowing to longer-term financing (as we noted last week) and therefore – like the US government – also looked for more buyers of long-term bonds.
The bond sell-off may not have much further to go, but investors are still wary after the huge capital losses of 2022. Here in the UK, we are no stranger to bond price falls since last autumn’s mini-budget disaster. Last Thursday, the Bank of England’s Monetary Policy Committee (MPC) voted by a majority to raise rates by another 0.25% and reiterated that “further tightening in monetary policy would be required”. Although the MPC sees inflation as hard to shift, investors see the risks as no longer heavily skewed. Growth here and in Europe (extremely important for the UK) seem to be on a slower path than the US, especially recently. Although the UK government bond yield curve is inverted, UK (and Euro) bonds look cheaper than those in the US. All areas have seen some price falls but, when comparing bonds of similar maturity, UK Gilts and Euro government bonds have been relatively stable.
The previously-mentioned US non-farm payroll data of new jobs created over the month (being slightly weaker and below 200,000 new employees) helped alleviate some of the pressure on US yields. Nevertheless, we suspect the incentive to issue around the 10 year maturity because of the currently lower yield cost compared to short term debt could still have some further follow-through – pushing this maturity band’s yield up further. It’s not the end of the world, but equities could lose momentum. So, while we welcomed July’s upbeat investor sentiment, August so far has again demonstrated the fragility of optimism-driven valuations. We expect market fortunes to remain finely balanced and therefore sensitive to anything with the potential to sway investors one way or the other.
European energy update: safer but not safe
Europe has come an incredible way from a year ago. Last August, European natural gas prices peaked at around €340 per megawatt hour, but currently prices are under €30. Far from shortages, current industry talk is of weak demand and storage capacity being close to full. Prices for futures contracts point to a sharp oversupply, leading benchmark contract prices to fall 24% in July, according to Bloomberg.
However, due to recent problems with production in Norway, and lower-than-expected cargoes of liquified natural gas (LNG), there has been a sharp drop in Europe’s projected supply recently. That pushed back analyst predictions of the date when storage will hit 100% of capacity. Bloomberg went from mid-September to the end of October. A year ago, this would have been the kind of news that sent commodity markets rocketing and policymakers spinning, but this time the news was shrugged off by traders, with storage levels currently at 86%.
Traders are now much more focused on weak demand prospects than supply side concerns. Despite Eurozone growth pulling out of a dip in the last quarter, manufacturing output has proven weak on the continent, lowering energy demand. The near future also looks difficult, with business sentiment surveys weakening further and unexpectedly. Last week, Bloomberg lowered its forecast for European gas demand for the 2023-24 winter; they expect it to be 27 billion cubic metres below the 2016-2020 average, if the weather is within the normal range.
Should the weather stay within a normal range, Europe will start its gas drawdown from a strong position and have comfortably enough energy supplies to provide for a sluggish economy. Given there are no great harsh winter fears (indeed policymakers’ attention is currently on the punishingly hot summer in southern Europe) it therefore makes sense that futures pricing for gas has come down, which should help European consumers down the line. On the negative side, however, the continent is still vulnerable to events entirely beyond its control, and despite the pressing need for energy security and the close-to-full gas supplies, Europe’s gas storage capacity has not significantly improved over the last two years. If the supply-demand balance did unexpectedly shift, the storage situation could mean prices change rapidly.