Monday digest

Posted 23 August 2021

Overview: Markets hit an ‘air pocket’
Investors would be forgiven to think last week’s downdraft in global stock markets was in reaction to the rapid unfolding of the tragic events in Kabul, Afghanistan. However, as long-time observers of risk asset markets will attest, stock markets do not show any empathy to human suffering. Indeed, the fact that global equity and commodity markets gave back most of August’s gains was more likely driven by the combination of bearish headlines about the COVID-19 Delta variant and economic data continuing to disappoint after June’s exceptionally strong figures. In the words of our economists, the recovery has hit an ‘air pocket’ – doubts over the further sustainability of the recovery are creeping in, while fiscal bridging support is being phased out without structural infrastructure programmes having started yet.

Overall, we believe supply chain difficulties are the major driver of the slowdown. COVID-19 has swung back to where it started: Asia. The regional lockdowns there may be partial, but they are hitting South-East Asian manufacturing and shipping yet again, as out-going deliveries should peak for the winter holiday season. With continued pressure on shipping prices, it may seem odd that European-wide consumer price inflation (CPI) data surprised by being lower than expected, and the UK offered a good example of what is happening in the wider world. July CPI was 2% year-on-year, well below the June reading of 2.5% and expectations of around 2.3%. Some of this can be ascribed to ‘base effects’, which implies the readings should decline after a sharp rise in price levels in the second quarter.

However, retail sales also tell a story of price rises eating into both spending power and consumer confidence. By volume, overall retail sales dropped back by about 2.5% from June, whereas consensus was for it to be unchanged. And the GfK consumer confidence indicator dropped back relative to the previous month, the first decline since January. Of course, the adjustment processes go in phases. So, under most scenarios, it is likely the supply disruption will probably be over before jobs are at risk. That is partly because employers have been reminded that finding workers is difficult, as UK jobs data continues to show. Indeed, part of the supply chain disruption is down to that very fact. The payroll data showed a strong July increase in employees of 182,000. Job vacancies have also been climbing.

Stock markets have hit an uncomfortable point. Growth expectations remain strong, but the growth timeline is being pushed out again. That means corporate earnings estimates for this year (and probably for next year) are under pressure, and analyst estimates will quite likely be pulled back. Relative to real yields in fixed interest bond markets, equity market valuations are not expensive. They could even be said to have become cheap. But when earnings expectations decline, this can change quickly, meaning equity markets could continue to have a bumpy ride.

Auto industry still looking for direction
The car industry is one of the most-watched sectors, due to its wide-ranging effects on all parts of the global economy, from manufacturing and technology to credit and consumer spending. In recent years, though, the world of autos has been incredibly hard to call. Changing emission standards, particularly in Europe, have had a big impact on manufacturers – not to mention the upheaval of the Volkswagen diesel emissions scandal some years ago. In the background is the move to greener technologies and the rapidly accelerating switch to electric cars. More recently, the global microchip shortage has seriously hampered supply – leading to some unprecedented price moves in the used car market.

Such factors have made car sales moves extremely unpredictable. Car sales have recently fallen disproportionately to wider consumer spending patterns. Global autos sales fell 2.5% in July, the third consecutive monthly drop. Rising fuel prices and lockdown restrictions this year may have impacted consumer demand. But those distortions aside, the autos sector will likely be an important indicator for the wider global economy in the months ahead. This is because the fate of carmakers is heavily intwined with both cyclical and structural changes. On the cyclical side, the pandemic has impacted both supply and demand, though the scale of that impact remains to be seen. On the structural side, cars are a central part of the move to a greener economy.

Governments and businesses around the world agree the autos sector must change, with a quick phasing out of fossil fuel-powered internal combustion engine (ICE) cars. That said, demand for fully electric vehicles is currently still not enough to support the whole industry. A big part of this is likely the uncertainty facing consumers. Technology is evolving rapidly, and consumers are aware that cheaper, and perhaps cleaner, options will be available soon, and are reluctant to buy in the meantime, and risk being stuck with the vehicle equivalent of Betamax. For manufacturers, the challenge is how to manage existing production of ICE while also investing heavily in electric. Stopping the former would lead to a loss in well-established streams of revenue. Not being quick enough on the latter means losing out to newer companies like Tesla (now the world’s largest autos company by market cap) in the long run. Juggling both at once is expensive in the short run.

These questions put downward pressure on demand, and that pressure will likely stay at least until policymakers give more clarity on regulation. A clearer outlook on the legal framework is essential for shoring up both supply and demand. Moreover, even if recent announcements on phasing out ICE cars gives more clarity than other polluting sectors have, the question remains how the sector will adjust to such a deep transition. Producers need to know what standards they should build to, and consumers need to know their purchases will not become obsolete in a few years’ time. The shorter-term supply issues should improve as we head into the end of the year – and there is enough underlying demand to see a boost. But the longer-term picture is still firmly in the distance.

‘Dirty’ metal gets an ESG reappraisal
The metals sector is hardly known for its stellar environmental reputation. The mining and refining processes are both extremely energy and resource-intensive, and the industry directly accounts for a significant chunk of global emissions. Looking at this direct carbon footprint, those engaged in ethical or environmental, social or governance (ESG) investing might be avoiding the industry altogether. That would be a mistake, though. According to Citi Research, the 16 main metals markets could be at the heart of the reduction in global emissions over the next 30 years. In its ‘rapid electrification scenario’, Citi estimates that the incremental tonne of metal produced through to 2050 could lower greenhouse gas emissions by 170 tonnes of carbon. The statistics are complicated and somewhat flawed, as Citi researchers readily admit. But they suggest metal production is not a straightforward ‘dirty’ industry. This is important from an investment perspective. To achieve the 2050 decarbonisation target laid out in the Paris Agreement, a big chunk of demand for metals is all but guaranteed. After all, one cannot make wind turbines, batteries, or electric cars without a whole host of metals.

So, how should investors come to terms with ‘dirty’ industries that are nonetheless essential to the green movement? There is no simple answer, but there are a few points worth making. First, any assessment of metal production’s real environmental impact needs a good estimate of how much demand is needed to achieve decarbonisation elsewhere. We can accept some amount of dirty production for the greater and greener good but want to ensure no more than the required amount is produced. This would mean avoiding those areas of metal production tied to further emitting industries. Second, accepting metals are needed does not mean accepting industry practices as they are. Reducing polluting practices in metal production is a crucial part of the green movement. Technological improvements are already happening in this respect, and we can expect more in the future.

Crucially, this is where investors can have a big impact. The dangers of ‘brown spinning’ – where companies sell-off their heaviest polluting parts to private equity groups that continue to emit out of the public eye – remains a particular worry for the metals industry. If ESG investors boycott heavy-emitting companies like steel producers, only for those to be bought by less environmentally-inclined private equity groups, production will continue just as dirty as ever. ESG investors rightfully want to put their money where it looks greenest, but making an impact through investment is about more than looks. Metal production is crucial in achieving reduced emissions, and with the right incentives, and investor engagement, it does not have to stay the way it is.

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