A reason to be bullish on US markets is the less detrimental impact the global energy crisis is having compared to Europe. Gasoline and broader energy prices in the US have started to fall quickly. That will be good for households and businesses. At the same time, jobs remain plentiful. Growth might surprise to the upside in H2. But in Europe, natural gas prices are at new highs, consumers are wilting under higher energy prices (and temperatures) and governments are struggling to push-back against the adverse distributional consequences of Russia’s war.
Is Goldilocks back?
What are investors to make of the current macro-economic data from the United States? In the last couple of weeks we have had reports from the showing negative GDP growth in Q2, a surprisingly strong gain in employment and a mildly better than expected consumer price inflation report for July, and a drop in producer prices in the same month. If it is true that growth is not as bad as the GDP data suggests and that inflation is starting to come down, then what is there not to like? On the one hand, market expectations of where interest rates are going have stabilised with the peak seen in Q1 2023. On the other hand, if growth is as robust at the labour market suggests, there is no recession and a sharp decline in corporate earnings should be avoided. Companies appear to be managing higher costs and pressure on margins, while there is no need to de-rate equity valuations given that bond yields are not rising anymore. Returns from both fixed income and equities are better as a result. The US is hot!
These points support continued dollar strength and, in local currency terms, better returns from US markets where yields are higher and fundamentals seemingly better than is the case in Europe. The Federal Reserve (Fed) is actively engaging with market expectations on rates in order to limit volatility, while the Administration has taken steps to address some of the underlying inflation pressures. For the moment I would expect US equities to continue to perform well. Seasonally, Q3 and Q4 tend to generate positive returns for indices like the S&P500 and we have a while to go before valuations get back into expensive territory again. Based on current 12-month forward earnings-per-share forecasts, the S&P500 is currently trading on a multiple of 17.6x compared to a 15-year average of 15.7x.
No easing of inflation concerns in Europe
The easing in the US inflation numbers is down to lower energy costs. In the producer prices report, energy costs fell 9% in July. In the consumer prices report, energy prices were down 4.6% on the month. Unfortunately, in the rest of the world, energy prices are not coming down. In Europe, the price of natural gas in the wholesale markets remains elevated. Given the role that gas plays as a direct source of energy to consumers and in terms of balancing supply and demand in electricity generation, this is unlikely to change soon. The cost of natural gas for delivery in one month is currently €204.50 per megawatt hour, and 162.50 for deliver in one year. This is five times what it was a year ago. The threat of Russia cutting gas supplies to Europe means less supply, higher prices and potential rationing of the use of gas over the coming winter. It’s been said a lot, but this would likely trigger a significant loss of output in Europe in 2023.
Energy markets are complex
The value chain is comprised of extraction, generation and distribution with the public and private sector having varying degrees of involvement depending on the country. The problem at the moment is that, despite the increased role of renewables in the generation of electricity, most countries still rely on natural gas to balance electricity supply and demand. Gas is a more flexible energy source and can be stored, thus plays the pivotal role in generating more electricity in peak periods of demand – in real time during the day but also seasonally during the winter. Generators, who are paying a high price for gas, set the price of electricity based on the marginal cost of generating additional units of power. There is a very high correlation between the price of natural gas and the price of electricity in wholesale markets. If that marginal additional supply of gas is at risk, electricity companies are prepared to pay higher prices today to secure the future delivery then can. Even then, there might not be enough, hence talk of rationing.
Some companies are fully integrated in the value chain
- from extraction of hydrocarbons, through refining and purification, to power generation and electricity and gas distribution. As higher wholesale gas prices have been driven up by the conflict, they have been able to increase electricity and gas prices to end-users. This is particularly the case in markets like the UK where most of the energy sector is in the hands of private companies. Hence, record profits, especially for integrated oil and gas and utility companies (revenue determined by the marginal price of electricity, profits determined by the difference between that marginal price and the average cost, in simple terms. So even if a power generator derives half of its output from lower cost renewable sources, it receives a price for electricity that is determined as if all its costs were derived from the use of gas). Elsewhere more regulated retail pricing or direct public ownership has cushioned the full impact of higher gas and oil prices on the consumer (at least a little). The political debate in the UK at the moment is essentially about what an appropriate level of subsidisation of energy prices for consumers would be and what form it could take (limit the retail price cap, direct payments to consumers, increased taxes on the profits of energy companies). So far, the government in limbo has not come up with any new solutions despite warnings of massive increases in retail energy prices over the winter.
The complexity of energy markets also reflects their interdependencies. Europe’s electricity and gas networks are linked, which allows greater flexibility to meet fluctuations in demand. In addition, Europe imports energy sources from the rest of the word, with Liquified Natural Gas being the most important in this respect. Higher LNG imports are part of the solution to the Russian problem. In an article in the Financial Times this week, Chris Giles set out the numerous ways in which Europe is dealing with the need to get away from the reliance on Russian supplies. Sadly, for the environment, this means a reprieve for coal as a source of electricity generation. But longer-term it means more efforts to improve energy efficiency, more liquified natural gas (LNG) imports from the middle east, a role for nuclear energy and more and more investment in renewables.
Inflation will always be an issue when supplies of the most important fuels for energy generation are subject to voluntary or involuntary supply disruptions (usually because of geo-political reasons). Gas will remain the swing fuel for energy generation and the challenge is to reduce the impact of that through increasing further the share of renewable energy sources and securing the balancing gas requirements from less politically volatile suppliers. Energy security has rightly become a key political issue but it will always be the case that some countries can never achieve complete energy independence because they just don’t have the natural resources. There will always be the reliance on trading but improvements in energy efficiency and storage will help cushion the economic impact of disruptions to trade. Stronger international trade agreements amongst friendly nations would also help.
Transitory no more
Inflation is not just about energy. Core inflation is high everywhere as costs have risen across goods and services. Underlying this trend are structural supply and demand issues – in commodities, food production, semi-conductors and labour markets. So inflation is not transitory, but it is linked, in many ways, to how the pandemic impacted the global economy. Droughts in western Europe will not help either, nor will the inability to transport things along the River Rhine. So we need to temper our enthusiasm around the potential peak in inflation in the US. Tightening monetary policy is a pretty blunt instrument but markets are probably too optimistic about the medium term outlook for rates. All of this makes inflation linked bonds remain attractive for the simple reason that returns are indexed to consumer prices. The global economy will eventually find solutions to the market inefficiencies that are causing inflation today, but that still means higher inflation in the next couple of years than was the case in the era before COVID.
I will be taking a break over the remainder of August, enjoying the heatwave in Cornwall and trying not to complain about the lack of staff in restaurants or the unavailability of items on the menu. I don’t expect time will be up for energy company profitability by the time I am back at the desk in September but I hope something can be done to ease the pain for consumers and businesses over the coming winter. In the meantime, enjoy the fact that we are currently not in a continued bear market.