Monday digest

Posted 26 September 2022

Overview: Competing policy measures leave markets fearful
The last two weeks have been sobering for investors world-wide, with all major markets (including bond markets) falling between 5% and 10%. The summer rally, which many hoped meant the worst inflationary headwinds were behind us, faded after the late-August meeting of central bankers where they confirmed their resolve to continue on their monetary tightening course. Markets have also come to terms with politicians’ actions to counter rising economic headwinds at almost complete odds with decades of fiscal prudence. If that were not enough, a cornered Vladmir Putin cranked up his war rhetoric, increasing the likelihood of much longer-lasting geopolitical uncertainty. It is not surprising investors have felt uncertainty rising and are inclined to reduce their market risk exposures.

It appears this downcycle has not reached its trough yet. However, several elements of the downdraft headwinds have gone beyond their lows and point toward markets reaching the capitulation level sooner rather than later. The energy price shock is receding as the price of oil continues to fall, and is now trading a good 40% lower than at its peak. Meanwhile, fiscal countermeasures announced across wider European markets should soften the blow, for consumers and also businesses. Whether the aggressive fiscal counter-cyclical measures announced by the UK’s new Chancellor – the most generous consumer and business energy support subsidies across Europe and the largest package of tax cuts in 40 years – will arrest the UK’s current decline toward recession is questionable. We note this fiscal largesse also stands in stark contrast to the austerity that followed the Global Financial Crisis (GFC) and led to a decade of subdued growth. One consequence from it is all but certain though: the feared decline in corporate earnings, and thus the running dry of stock market ‘fuel’, should be smaller than previously feared.

Markets are right to accept that we are not out of the woods yet, but we think this latest bout of downdraft is getting us increasingly closer towards capitulation and (usually) the turning point. Against this backdrop, it is essential for investors to hold their nerve and not risk missing the onset of the recovery rally. History suggests that, once markets touch their lows, the rebound is sharp, powerful and often pre-loaded with the bulk of the returns of the next bull market. This time, being ‘in the market’ may prove even more crucial given higher interest rates and bond yields may well lead to overall lower average return levels during the next cycle.

Utility companies suffering an identity crisis
Germany is feeling Russia’s gas supply squeeze more than anywhere else, and Europe’s largest economy is set to ration heat and power this winter. Last Wednesday, the German government reached a deal to nationalise Uniper, its largest natural gas provider. Germany will buy the 56% share held by Finnish state-owned company Fortum for €500 million – leaving the government with a 98.5% stake. The fallout from Russia’s invasion of Ukraine is clearly a big driving factor – shaking up the structure of European and global energy markets, with an underlying trend towards renewable energy sources. Uniper came about from EON’s pooling of old coal and gas assets in 2016, which was itself a result of the German government’s strategic shift to wind and solar energy production. The underinvestment in traditional utilities left the sector vulnerable, a problem exposed by Russia’s halting of gas supplies.

These issues impact the way we think about utilities as investment assets. Traditionally, utilities are considered a defensive investment, providing a regular and dependable stream of profits without much volatility or opportunity for expansion. Price volatility and its debt implications change that picture. In Europe, dependence on expensive gas imports is much more pronounced, and reflected in lower valuations. This might also go some way to explaining the differing fortunes of utilities. Those generating energy from renewable sources have not seen their costs rise anything like those burning coal and gas, but they are all selling onto the same market, meaning profits for renewable generators skyrocket while others struggle. The shift makes it increasingly difficult to distinguish between straightforward utilities – the traditional middle-men – and upstream energy providers.

We are certainly entering a period of increased government intervention for the utilities sector. Ideally, this would come in the form of efficient regulation that keeps basic market mechanisms in place, rather than direct state involvement which tends to lead to inefficiencies down the line. Authorities have understood that utilities are a vital element in the energy transition, and therefore fears of the imposition of higher (windfall) taxes may not be as pronounced any more. That would make utilities once again the solid defensive equity sector that we are used to.

Recessions, bear market rallies and recoveries The relatively low levels of overall financial leverage compared to previous crises, and a stable financial system (in large part down to post-Global Financial Crisis reforms) reduce the likelihood that the current downturn becomes structural and long lasting. Household and business balance sheets are healthy, meaning there is room to withstand higher interest rates without a collapse in demand or a big credit crunch causing a general liquidity crisis. That will not stop a recession, but it can at least limit the fallout.

However, balance sheets can only withstand so much pressure, and the more aggressive central banks get, the more likely that corporate defaults will follow. The crucial question is how long will inflationary pressures last? The answer to that differs by region. The US is dealing with an internal labour market problem, which will hopefully be cooled by an aggressive Fed. Europe, meanwhile, is struggling with an intense energy shortage on top of its post-pandemic hangover. Investment in alternative energy sources and changes to the market structure will help in the long term, but they are unlikely to have an effect in the short-to-medium term.

Whatever the case, the investment backdrop after this crisis fades will be different to the last few decades. Since the 1980s, globalisation, deregulation and the continually falling cost of capital (and bond yields) have led to higher equity valuations and capital-led growth. These trends now appear to be in reverse. This will likely mean structurally lower valuations and hence lower aggregate returns over the coming cycle. On the other hand, it might also lead to greater investment in productivity and higher rewards for shrewd stock-pickers.

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