Monday digest

Posted 8 August 2022

Overview: Markets bet on a perfect landing
Bad news filled the airwaves last week. Faltering global growth, higher inflation forecasts and rising interest rates set a dour tone – capped off by a geopolitical crisis in Taiwan. UK investors were struck by the Bank of England’s dire warnings: a 13% inflation peak and a protracted recession are now in store for Britons, according to Governor Andrew Bailey. Predicted to last for five quarters, the looming UK recession is set to outlast the one following the global financial crisis in 2008/09.

Yet despite all that gloom, capital markets have been in surprisingly good spirits. Equities have rallied since the start of July, and bond yields have fallen. As a result, markets have more or less recovered all of their June losses. So, why are investors so unfazed by the current bad news? Judging from bond markets, the feeling is that we have reached peak global inflation. Oil prices have started falling and the actions of oil producers themselves point to a belief that current prices are unsustainable. Supply chain bottlenecks clogged by the pandemic are also improving, while consumer demand has clearly taken a hit from the cost-of-living crisis. The thought is that this will cause a reversal of central bank policy sooner than previously expected, with implied US rates peaking by the end of this year. Investors have essentially given central banks – particularly the US Federal Reserve (Fed) – a vote of confidence. Its policies are expected to prevent a dangerous wage-price spiral while maintaining the economy at a decent level. What’s more, middle-class consumers still have savings to fall back on, while jobs remain plentiful and businesses are more financially sound than in previous downturns. Recessions in most regions are expected to be shallow and brief, while the US might avoid one altogether.

Monetary policy works on a very long lag, meaning that tweaks to interest rates now will only have an effect a year or so down the line. But if bond markets are to be believed, inflation will already be largely under control by then – meaning further tightening would be overkill. Central bankers want to tame inflation right now, and the only way they can think to do that is by affecting consumer and business behaviour. They will hope that pessimism will stop employees pushing for higher wages, bringing down cost pressures. That is the best-case scenario, and the one markets are currently betting on. Such optimism in bond markets was the main reason for July’s uptick in equity prices – as falling yields made stocks comparatively more attractive. But that positivity is itself a little concerning, as it makes asset prices vulnerable to worse-than-expected news.

There are still many risks to the overall outlook, which are arguably not properly priced-in. Europe is particularly at risk, facing energy shortages and sharply higher costs this winter. This should bring consumer demand down further and eventually cool inflation, but that could take some time. The main source of Europe’s woes is gas supplies, which are very hard to adjust in the short-term, and are highly susceptible to Russia’s war in Ukraine. European businesses could be the hardest hit, as they have less sway over electoral outcomes and are therefore lower down on politician priority lists.

Markets nevertheless seem to think the inflation battle is already won, and there is a clear path to economic recovery. But none of that is certain, and there are many political obstacles that could get in the way. Governmental paralysis in Britain and Italy could prevent decisive policy action (Conservative MPs have already questioned the Bank of England’s independence in response to its dire forecasts), while US-China tensions over Taiwan are a serious and perhaps under-appreciated risk to global growth. Negative news flow, particularly around energy supplies, could severely dampen market sentiment from here.

Energy profits: here for a good time, not a long time
Oil and gas prices, buoyed by pandemic supply issues and then catapulted skyward by Russia’s invasion of Ukraine, have generated truly astonishing results for the world’s biggest energy companies. Centrica, the owner of British Gas, recently reported profit growth of 500% year-on-year for the first half of 2022. Meanwhile, Shell posted its best ever quarterly profits for Q2 and BP its highest profits in 14 years for the same period. All of this comes while Britons face eye-watering rises in energy and fuel costs. Naturally, the disparity has led to a great deal of negative media coverage.

These profits have naturally benefitted share prices. On a net total return basis, unsurprisingly, Energy is the best performing sector over the last year, by some distance. Bloomberg’s energy index is 28.4% up from a year ago. Utilities, the only other sector to post positive growth over that time, are up just 5.3% by comparison. These moves are made all the more impressive by the negative equity market backdrop in that time. The rise in ‘risk-free’ rates has dampened equity valuations across virtually all industries, and energy is no exception. In fact, on a forward price-to-earnings ratio, energy company valuations have come down more than any other sector. The fact that energy companies have posted the best returns while dropping to the lowest valuations is astonishing, and shows how sharp the recent energy price shock has been. But it also shows investors are much less optimistic about the long-term prospects for energy companies than current results might suggest. Some of this is down to the likely political response: the UK government has already announced a windfall tax on oil and gas companies, and the sharper the contrast between struggling households and booming energy giants gets, the more likely we are to see further taxes – and not just in the UK.

The deeper reason for falling energy valuations, though, are likely to be structural. Russia’s war and the ensuing sanctions delivered the biggest price shock to global energy markets since the 1970s OPEC embargo. Oil and gas supply lines between Russia and the West have been battered and may not ever recover, leading to a sharp squeeze in prices. But over the longer-term, prices are less about what goes where and more about the balance of aggregate supply and demand. That balance has not been fundamentally changed by Russia’s invasion. Russia has a short-term interest in squeezing its European customers – particularly Germany, which has been one of the hardest hit by constrained gas supplies – but has no interest in reducing its oil and gas production over the long term. It has already found many willing buyers in Asia, and will inevitably want to get back to full production and export volumes when it can. Then there is the demand side. The pandemic recovery saw a sharp burst of pent-up energy demand, but this has since cooled off significantly. With looming recession fears, this trend is set to continue. What’s more, the incredible rise in energy prices is already destroying end demand. Come winter, this is likely to mean intense energy saving efforts – with communal heating and power-cuts already being discussed in Germany.

The current price shock will also have implications for the future. Fossil fuel investment measures have been drawn up for the UK and US – which will increase supply some years into the future. More importantly, there is a clear political drive toward increasing renewable or even nuclear energy production. This is part of a much longer-term move away from oil and gas, and the cost-of-living crisis that is rooted in our fossil fuel dependency goes back, has significantly heightened the sense of urgency that already existed from the global warming CO2 side of things. Inevitably, this dampens the long-term outlook for oil and gas demand.

Fossil fuel producers are well aware of this. At their most recent meeting, OPEC+ countries agreed a minimal increase in production despite a seemingly huge price incentive to pump more. This suggests a recognition that current price levels are unsustainable in the face of rising interest rates and a slowing global economy. On the current trajectory, oil supply is likely to outstrip demand within the next four years. As producers see it, increasing production now will just make them more vulnerable to lower prices in the future. With this in mind, lowly valuations for booming energy companies are to be expected. Record oil and gas profits are here for a good time, but not a long time.