Monday digest

Posted 20 September 2021

Overview: September wobbles are unsurprising 
Halfway through September and the positive picture of the summer months has faded with the sun. To be fair, investment returns are only marginally down for the month, and investors are still sitting on healthy cushions for the year so far. However, economic growth momentum has hit an air pocket and talk of the ‘Roaring Twenties’ has subsided. A global shortage of labour, rising wages and healthy corporate investment plans may ring alarm bells with inflation hawks, but more level-headed economists attribute this to a confluence of indicators of persistent growth, not stagflation.

When the dust settles, it would seem the recent period of extraordinarily steep economic growth has most likely come to an end. What follows now is a transition phase during which both households and businesses must get used to standing on their own feet, as fiscal and monetary support issued by governments and central banks is gradually withdrawn. In this environment, every dark cloud on the economic horizon can be viewed as a portent of economic equilibrium collapsing like a house of cards, but the current state of the global  economy is most likely less fragile than it might appear. With strong demand for labour strengthening consumers’ purchasing power over, and the climate challenge mobilising public and private investment, hardly anyone suggests this cycle is already nearing the end.

That does not mean the summer’s ‘Goldilocks’ environment is set to return to capital markets. Corporate earnings expectations have recently moderated, while bond yields are likely to see further upwards pressures as price-driving supply bottlenecks persist, and with central banks inclined to reduce their yield-constraining support measures. This limits further upside for risk assets in 2021 over and beyond what has already been achieved. In the months ahead, much will hinge on the dynamics that define the interaction between bond yields and equity valuations. We continue to believe that at current depressed yield levels, equity valuations are not excessive even if they seem so in purely historical comparison terms. If, however, yields begin to rise more strongly than corporate earnings can outpace them, market conditions could become unnerving again. Investors may experience more of what we have seen so far in September, bumpy sidewards movement until the true likely upward trajectory of the economic recovery becomes clearer and more acceptable again.

Why energy prices matter so much right now
Despite the demand for cleaner assets, and especially for metal and mineral input to build the greener infrastructure, ‘dirtier’ commodities are faring extremely well in price terms at the moment. Brent crude, the international oil benchmark, is currently at $75 per barrel, having climbed consistently since the first half of 2020, and gas and energy prices have driven electricity prices to record levels in Europe as post-lockdown demand meets tight supply. With oil prices high and global activity recovering strongly, old energy companies look very profitable – yet, for the last few months, investors have not had much appetite for their shares. Until last week, that is. Despite a broad fall in UK equity prices, British energy companies saw their stock prices climb higher. This could be a sign of things to come. Over the last few years, environmental, social and governance (ESG)-focused investing has surged, with investors pouring enormous amounts of capital into green assets. That is easy enough to do when such assets happen to be some of the fastest growing – as we saw throughout the pandemic. Sticking to environmental principles is harder when oil and gas companies are so profitable, and available at bargain prices.

Higher oil prices and the potential for more investment in fossil fuel companies make for an uncomfortable situation ahead of COP26, where world leaders will lay out enhanced plans for achieving net-zero emissions. Policymakers will desperately want to avoid an energy supply shock, but will be equally keen on maintaining the progress made since the Paris Agreement. The global economy is not in bad shape, but growth is brittle and there are more than enough disruptions that could throw it off course. This is the ‘Catch-22’ as far as the green recovery is concerned. Policymakers want the world to quit its addiction to fossil fuels, but going ‘cold turkey’ presents a serious risk to living standards. Global supply problems have been ubiquitous in recent months, massively pushing up inflation. The sharp bout of inflation is a negative for consumers, businesses and the global economy – taking away spending power and confidence at a time when it is vitally needed.

Leaving oil in the ground is clearly good for the environment. But we are still far from the point where greener energy sources can meet the global economy’s needs. So, current energy supply is unlikely to be enough to meet current demand levels – putting upward pressure on prices. This will harm consumer and (particularly) business confidence, heading into what will likely be a difficult winter. There are even reports that energy shortages in Europe could be enough to force rolling blackouts. This would lead to even further supply constraints, increasing inflation pressures and lowering consumers’ purchasing power. In the end, much will be down to a factor nobody can influence, namely how harsh the winter will be. As we say, this is a negative environment overall, but a potentially positive one for energy companies. That could be enough to push some ESG investors back into energy stocks, which continue to post healthy returns despite their relative unpopularity. As for the energy giants themselves, capex will be held back until they are confident new productions will generate a high enough return with an acceptable level of planning certainty. If oil and gas prices keep rising, eventually that higher threshold will be met, and new fossil fuel projects will be implemented.

Rising energy prices is yet another supply-side shock, one that could be an even bigger dampener on growth. In the UK, inflation has already spiked on the back of widespread labour shortages. Now, households across are set to see their energy prices jump just ahead of winter, which is likely to leave many with substantially higher bills. Then there are the second-round effects of energy inflation, likely to push up prices across the board. This is a downside risk to the recovery, one that policymakers will desperately want to navigate safely. With lingering COVID uncertainties and the after-effects of Brexit still feeding through, consumer confidence could take a big hit. This is possibly even more so for businesses, which often do not have the benefit of capped energy prices and may be forced to raise prices and lose demand – after 18 months of uncertain conditions. The UK is a good example of these issues, but the structural rise in energy prices will have global effects. If the above situation plays out, it could mean a further increase in inequality and social unrest – despite governments now seemingly on board with public investment.

The green revolution brings many opportunities for positive change, but we need to be aware of the difficulties it could also create. In the short-term, rising energy prices pose a threat to the fragile global recovery. Structural pressures mean these problems could persist over the long term, dampening confidence and global growth potential – as well as potentially worsening global inequality. These topics will feature heavily at COP26 in November, which investors will be watching closely.