Monday digest

Posted 4 December 2023

Overview: December brings a price shock reversal
Expectations are growing for Eurozone rate cuts in time for Easter. Speculation intensified followed the release of provisional European inflation data for November that surprised on the low side for the third month running. Overall consumer price inflation came in at 2.4% year-on-year in November, less than half the pace as recently as August. In the US, even though inflation is still between 3% and 4%, some central bankers are validating these ‘next move is down – earlier than thought’ expectations. US Federal Reserve (Fed) member Christopher Waller is noted for similar views to those of Fed Chair Jay Powell, so markets reacted quickly when he said diminishing inflation would naturally allow the Fed to cut rates. Clearly, it is no longer too soon to talk of cuts.

Looking at the changing inflation picture, by far the weakest area of pricing power is now in goods and energy. OPEC+ finally met last week via videoconference, and a cut of 900,000 barrels per day (bpd) was announced. An OPEC+ statement said Russia, the United Arab Emirates (UAE), Kuwait and Iraq made a “voluntary” pledge, while Saudi Arabia would continue its unilateral one million bpd cut until April 2024. Most of the OPEC+ problems are driven by potential global oversupply, with US shale gas extraction increasing and new oil fields opening in in Brazil (which has been invited to join OPEC+). Meanwhile, Saudi Arabia is trying to bring Iran back into the fold as well. Iran is talking about production rising to 4 million bpd next year, a level they’ve not approached in 20 years.

The fall back in energy prices might signal growth worries, but lower energy prices are at the same time a growth spur for the wider economy. The right price is one which stabilises the supply/demand balance, and we should be grateful we are in a period where prices are moving gradually and bearably. This suggests that while we may be experiencing weaker growth now, the likelihood is that costs will be cut naturally and we are in the final stages of a welcome return to normality.

UK inflation exceptionalism
The Bank of England (BoE) continues its expectation management programme. Last Tuesday, Jonathan Haskel, an external member of its Monetary Policy Committee (MPC), told a Warwick University crowd that rates will “have to be held higher and longer than many seem to be expecting”. This came after similar warnings in recent weeks from BoE Chief Economist Huw Pill and Governor Andrew Bailey. The BoE’s Deputy Governor Dave Ramsden warned last week that UK inflation is becoming more “home-grown”, and repeated the messaging that wage growth was driving UK-specific price pressures. That is why, despite the fallback in energy and other input prices globally, Britain’s inflation “is going to be really difficult to squeeze out of the system”.

The BoE and other economists worry Britain’s supply side problems may stem from a combination of pandemic hangovers and Brexit frictions that imposed extra costs on goods and labour relative to our largest trading partner just before the global economy entered an unprecedented period of supply bottlenecks. In this light, UK-specific inflation pressures are unsurprising – as is the BoE’s focus on wage growth from a structurally tighter labour market.

Tight labour markets would suggest interest rates indeed need to remain high. But one could actually argue this is a bigger problem for the US, where growth has stayed strong thanks to a seemingly unshakeable American consumer. In the UK, however, sentiment among both consumers and businesses remains dour. Indeed, despite the BoE’s laser focus on wage growth, for most of the last year headline wage growth figures have been below headline inflation – meaning cuts in real terms. The MPC knows the effect of longer-term rates (often tied to mortgages) on the fragile UK economy, and is likely trying to persuade where it cannot directly control. After all, expectation management is as much a part of monetary policy as interest rates.

Wind of change for renewables?
It has been a miserable year for investors in the renewable energy sector. Tighter oil supplies have pushed up the price of fossil fuels, increasing the short-term returns on oil and gas stocks. When you add in the tightest global monetary conditions in decades – which have hammered valuations for all long-duration assets – it is a recipe for disaster, since clean energy stocks are seen as longer-term investments. The S&P Global Clean Energy Index has fallen over 30% year-to-date. In fact, S&P’s Clean Energy Index achieved dizzying heights at the start of 2021, thanks to sharply rising energy costs and an expected political drive for the global green transition. But shifting macroeconomic factors pushed fossil fuel companies ahead, with clean stocks losing nearly 60% from the January 2021 peak.

Such a prolonged downturn has starved renewables of much-needed investment – particularly damaging for capital-intensive projects like building wind and solar farms. Project cancellations or modifications are happening everywhere you look across the industry (Vattenfall, Siemens Energy AG and Li-Cycle, to name three), with profitability and balance sheet concerns at the root of all of their announcements.

The solution – as energy analysts have argued for years – would be to properly align incentives so that short-term cyclical forces do not outweigh longer-term transitional needs. We have seen at least some progress on this front recently, and the green shoots of a cyclical recovery are also helping to shift the mood. These factors have helped change investor perceptions with the S&P Clean Index rising more than 7% in November. But cyclical moves can only do so much, particularly with markets and the underlying global economy in such a delicate position. For sentiment to swing back around fully, markets need to feel drive to longer-term structural change. The results of the UN COP28 summit will therefore be vital, but rumours that host nation United Arab Emirates plans to use the venue to promote deals for its national oil and gas companies are less than encouraging. Even if investors buy into the renewables story, it will make little difference if politicians are not willing to stand up and join in.


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