Monday digest
Posted 5 September 2022
Overview: Europe still waiting for policy action
Last week investor attention turned towards what looks like an increasingly bleak winter ahead. The delicate equilibrium we wrote about last week has clearly once again been disturbed. It hasn’t helped that while unacceptable cost shock pressures have hit households and businesses across Europe, very little concerted action has been announced in response. In the UK, all eyes are on the new incoming Prime Minister, while the European Union (EU) is held up by the complexity of the problem paired with the terrible structural slowness of policy makers making decisions. This leaves businesses and households feeling more vulnerable. The energy supply shortfall that needs to be overcome by lower demand is estimated to be around 10-15%, which at current price levels will be massively overshot and lead to an unnecessarily excessive economic and mental health burden to everyone across Europe. Governments will need to devise a policy framework that combines the incentivisation that the price mechanism provides with means of soft (incentivised) energy rationing that achieves the same supply-demand equilibrium, but without the hardship that excessive price signals would cause for households and businesses.
Turning to recent market action in more detail, the past few days have seen markets fall and daily volatility has picked up, but to a much lesser extent than during the falls of earlier in the year. The falls in equity markets have been accompanied by falls in government and corporate bonds, much as when happened at the beginning of 2022 and again in June. However, because of the reduced intraday volatility levels there is much less of a sense as back then that monetary liquidity is draining. Indeed, US retail investors that were heavy sellers of assets during that period appear to be either less important or less scared now.
Looking ahead, September can be the most difficult month of the year. Investors will therefore not be holding their breath for a reversal of August’s falls – even though past seasonality trends have not provided particularly helpful guidance during 2022. However, either way, we are not pessimistic, as one of the main sources of equity market weakness this year has been the rise in US bond yields. Last week, those yields bounced back up after the US Federal Reserve (Fed) said it remained more concerned about labour market tightness above anything else. August data published last Friday showed a rise of 315,000 non-farm payroll jobs, still well ahead of the average 185,000 jobs per month of the 2010-2019 decade. This is an ‘improvement’ over July’s 528,000 new jobs number, but indicates that the Fed is unlikely to pivot on near-term policy anytime soon. Despite the Fed’s inflation concerns, the apparent stability of the US in the face of trouble elsewhere led to a sharp rise in the value of the dollar, backed up by a general risk-off move by global investors, in turn lessening the price-push impact of import prices.
For Europe, energy prices remain the focal point. Russia (officially Gazprom) shut down the flow through the Nord Stream pipeline and blamed sanctions and Siemens for “maintenance” issues. The shutdown was extended to “indefinite” late on Friday, and it appears Russia is determined to increase the pressure on European nations with continued supply disruption holding prices high, while not shutting of the gas supply completely to retain the leverage over European politics.
Emerging markets enjoying their time in the sun
Emerging Markets (EMs) have fared quite well recently, relatively speaking at least. Traditionally, EMs are very cyclical – expanding in times of global growth and falling back during the global economy’s low points. But while the world is undeniably in a slowdown (which became only more apparent over the month) EMs have not suffered as one would usually expect. At first glance, high energy prices would be a likely explanation. EMs are often reliant on commodity exports, meaning that high prices for raw materials can deliver a big boost. But the flaw in this argument is that the energy crunch is primarily in the natural gas market, specifically around Europe. EMs as a whole do not have a great exposure to European gas prices, and are unlikely to benefit from the supply-side tightness there. Energy issues have lately not been reflected in oil and metals prices, for example, which both had a lacklustre August. By comparison, food exporters such as Brazil have done well, despite the apparent fallback in developed world consumer demand.
Granted, from a longer-term perspective, commodities are in a good position. Price pressures are significantly higher than before the pandemic, and those forces are unlikely to dissipate any time soon. Pessimists point to a looming global recession and structural shake-ups from Russia’s war on Ukraine, which could undermine demand for commodities and thereby damage EMs. But the structural backdrop is still supportive of commodity prices – particularly for metals. A prolonged period of commodity strength and a favourable outlook have allowed many EMs to improve their trade balances. Potentially weak commodity demand could undermine some of that improvement, but many EMs have the additional benefit of proactive monetary policy last year. Latin American countries in particular began aggressively tightening interest rates in late 2021, and now have a fair chance of avoiding recessions as it gives them room for easing much earlier than developed countries.
Despite the positives noted above, anxiety lingers for EM investors. EMs have certainly held up better than expected, but what this means for the future outlook is deeply uncertain. Ultimately, the key factor is how bad the global economy gets. For all of the doom and gloom lately, nominal growth has held up well across the world. And while we are certainly in a slowdown, there is no global recession yet, and hence no significant pullback in commodity demand. In fact, fiscal stimulus is forthcoming in the US, Europe, China and Brazil, which will bolster growth in the months ahead. This is likely to lead to further monetary tightening from major central banks in developed markets, as has already been signalled. That scenario will be the real test for EMs. We will see whether EM success is structural and genuine, or just a fluke. The worst could be yet to come for developing economies, but things are at least looking positively different for some EMs for now.