Tuesday digest
Posted 1 June 2021
Overview: May ends with a touch of Goldilocks
After a strong April, May was something of a mixed bag for investors, particularly when stock markets suffered a mid-month correction. However, by the end of the month, volatility had been eased rather counterintuitively by expectations of lower, not higher, growth.
So far, this year’s sporadic sell-off periods have all been driven by concerns that economic growth may return with such a vengeance that supply bottlenecks would cause inflationary pressures – in turn driving up bond yields or forcing central banks to prematurely withdraw the ‘punchbowl’ of ultra-low interest rates. But May ended with an easing of both concerns after the US Federal Reserve (Fed) reiterated it would neither be blind to the fragile nature of the post-pandemic recovery path nor to the overheating risks should conditions improve faster than anticipated.
Meanwhile, various survey data points suggested inflation expectations have not increased despite quite marked price rises for certain goods. Neither have wage rise expectations – which would allow higher price levels to persist and turn them into structural inflation. And on economic overheating fears, the Biden administration’s apparent willingness to settle for lower overall spending volumes, to expedite Congressional approval of fiscal stimulus packages, lowered near-term growth expectations, lowering the temperature there as well.
Big changes ahead for ‘Big Oil’
May was a tumultuous month for the oil giants. First came an International Energy Agency (IEA) report imploring oil companies to stop all new fossil fuel projects from this year – suggesting this was the only way the world could meet its net-zero carbon target by 2050. Then, ExxonMobil shareholders backed a long-shot activist campaign to install two environmentalists on its board. In a similar vein, Chevron shareholders defied its board members to vote in favour of cutting the company’s carbon footprint. Finally, Royal Dutch Shell lost a landmark legal case in the Netherlands, after a court ruled it must cut emissions faster and harder than it had planned.
Climate concerns are hardly new. But for all of the environmental initiatives pursued over the last few decades, energy companies have rarely had to face direct action over their emissions. Now, oil companies are facing intense pressure from international bodies, the legal system and their shareholders all at the same time. When it rains, it pours.
For now, investors are adopting a “wait and see” attitude. Even so, the ruling is more significant in what it symbolises than what it dictates. Human rights-based legal cases are increasingly being brought against polluting companies by pressure groups, and this is a high-profile case in which the strategy has worked. It could be a watershed moment for the energy industry, much like the first legal cases brought against big tobacco companies last century. At the very least, it will embolden climate activists – who are gaining in prominence in the financial world. On this front, we suspect ExxonMobil’s boardroom shake-up may prove even more significant.
It is increasingly accepted that the energy sector – and the real economy as a whole – are in a transition phase towards the goal of net zero CO2 emissions. Some big incumbents in the energy and utilities sectors will adapt and benefit from the evolution, but those that fail to adjust risk turning into ‘stranded assets’, which is not only a risk for investors, but also for financial stability at large. Investor engagement and activism will remain an important pillar in the process. These issues are not going away, and after such an eventful week for Big Oil, it feels like change is bubbling up to the surface.
Brazil and South Africa – a tale of two BRIC countries
As we come out of the pandemic, markets are expecting a boom in global trade and infrastructure building (which we are already seeing in the US). This places global inflation at the top of the agenda for the first time in years. Domestically, inflation has and will likely continue to make some problems for many emerging markets.
Of the BRICS countries, Brazil and South Africa are structurally very similar in terms of the composition of their respective economies. Both are heavily dependent on commodities and semi-manufactured goods, making them sensitive to the promises and pitfalls of the commodity cycle. Brazil’s primary commodities – including semi-precious and industrial metals, oil and food – make up 55% of its exports. Meanwhile, metals and minerals account for around 60% of South Africa’s exports.
That commodity reliance is helping both countries right now. Brazil and South Africa are no exception here, but a bout of inflation – together with strong global demand – should be a boon in the medium term. In South Africa, the global commodity boom has brought on a surge of export growth – bolstering investor sentiment and strengthening currency values. Since the beginning of the year, the Rand has clearly outperformed the Brazilian Real, even if the latter started gaining some ground over the last month.
As with many emerging market countries, virus concerns have dampened optimism. This is particularly true for Brazil, which has the world’s second highest official COVID death toll. Thankfully, in both Brazil and South Africa, case numbers and deaths have been on a continual downtrend since the winter and early spring peaks. Even more encouragingly, vaccination programmes in both countries are now well underway – greatly lessening the likelihood of a third wave. With falling virus cases and increasing vaccinations, both have been able to loosen restrictions – giving a much-needed boost to sentiment.
Positivity from international investors is creating a positive cycle. With restrictions easing and global growth looking supportive, money has flowed back into Brazil and South Africa – and that outside investment is itself boosting domestic growth expectations. This will be a big help for their governments in particular, as both have a similarly high debt-to-GDP ratio, and both have bond ratings just below investment grade.
While political stability seems to be improving in South Africa – thereby support the growth outlook – the same cannot be said for Brazil. At the weekend saw tens of thousands of people in more than 200 cities and towns marched in protest at president Bolsonaro’s handling of the pandemic. Brazil is now entering an election phase, and while the tide is turning against the right-wing populist Bolsonaro, the prospect of a ‘left’ leaning government – which may fail to put public finances on a more sustainable path – is not enticing for investors either.
The political difference is most likely why the Rand has performed 25% better than the Real in recent years. But in a world that is slowly recovering from the pandemic, and has high commodity prices, things look bright for both of the two smaller BRICS. However, their diverging paths illustrate once again how heterogenous emerging markets behave, with policy developments again playing a key role.