Bedrock’s Newsletter for Friday 19th August, 2022



“Our need will be the real creator.”

Plato

Friday 19th August, 2022

Markets have continued their recent rally into the fortnight since we last wrote. Over the last two weeks, the S&P 500 has risen +3.4% (by Thursday close). Last week, the US blue-chip index sealed its fourth consecutive weekly gain – its best streak since late 2021 – and is on track to add a fifth. The techy Nasdaq Composite has had the best of the recent rally, climbing +22.7% from its 16 June low, compared to the S&P’s +17.8% from its nadir the following day. But this rally is impressively broad-based: 93% of S&P 500 stocks were trading this week above their 20-day moving average, up from just 2% in June, and 88% were above their 50-day average. Other major indices have shared some of the positive momentum, with the STOXX Europe 600 up +1.2% in the last two weeks (and +10.2% since its June low) and the Nikkei up +2.4%. The risk-on sentiment has extended beyond equity markets: US high yield spreads narrowed further over the last fortnight to stand at 424bps by Thursday’s close, having moved rapidly from over 600bps earlier in the year.
 
Propelling markets’ ebullient moves have been a smattering of well-received economic data releases, chiefly the US Consumer Price Index print on 10 August. This measured year-on-year inflation in July at 8.5%, down from 9.1% in June, while there was also no monthly rise from June to July. As such, it presented a friendlier picture than most analysts anticipated (consensus was for an 8.7% annual rise) and fed the view that US inflation may finally have peaked – which in turn would allow the Federal Reserve to ease off its rate hiking plans, helping risk assets. Statements from Fed Chair Powell at his 27 July press conference seemed to lend credence to this outlook, as did encouraging data from the New York Fed suggesting inflation expectations were falling. Prices on two-year Treasury notes – always sensitive to changing Fed rate policy – perked up in response. Meanwhile, corporate earnings season showed little damage to US companies – indeed, results from retailers Walmart and Home Depot this week underscored continuing consumer strength. With the S&P 500 now having retraced just over 50% of its losses this year, some market participants are calling the bottom – and the start of a new bull market.
 
We think this is premature. The momentum of recent stock-price gains has indeed been impressive. But they’ve come entirely from multiple expansion (rather than growth in underlying earnings) – and those multiples still make US stocks look pricy by their historical averages (at close on Thursday, the S&P 500’s forward P/E measured 18.9x). Although the S&P this week made contact with its 200-day moving average, it promptly dropped back below that average, whose slope remains downwards. Seductive – and welcome – though this rally has been, it has the makings of a temporary, bear-market rally. These are an all-too common phenomenon: the Global Financial Crisis, the 1973 bear market, the dot-com bust all had their fair share of them; the latter, in fact, saw 7 relief rallies of 20% or more, each followed by a new low. The economic outlook remains troubled and a softening in the coming months would most likely be reflected in corporate earnings. If this earnings season appeared largely positive – about three-quarters of companies beat forecasts – it should not be forgotten that many of these beats came off downward revisions, nor that this is a nominal-terms exercise and inflation may serve to keep earnings up (so investors should begin to focus more on operating margins). Nor do we buy the ‘Fed-pivot’ narrative that has set in in the last few weeks. Like most – surely all! – market participants, we welcome an indication that inflation may finally be starting to cool. But 8.5% remains a long way above the target 2% and Fed officials have lined up this week to underscore the central bank’s solid determination to crush inflation back down. We will need to see a more sustained string of prints pointing in the right direction before we look for a more dovish Fed to support markets – and we think the Fed’s new emphasis on a ‘data-led’ approach shows they are thinking the same way.
 
Declining fuel prices and the passing of a post-Omicron travel cost surge were key to the recent tempering of US headline inflation. A new spike in energy prices would push the number back up – and the risk of this is very high amidst a global energy crisis that represents the greatest threat to the world economy in the coming months. Europe is in the eye of the storm. European wholesale gas prices minted a new record of €241 per megawatt-hour on Thursday – a figure that more normally hovers around €25: a tenth of current levels! On top of the post-covid squeeze on global energy supply, the phasing out of imports from Russia in the wake of its invasion of Ukraine (having previously met 40% of Europe’s gas demand) may be the principal cause for the crunch – but a remarkable set of pressures are together conspiring to push prices higher. Overdue maintenance had already taken half of France’s 56 nuclear reactors – normally a major source of energy exported to France’s neighbours – offline, when searing temperatures meant river water could no longer be used to cool the reactors still running. The same heatwave choked off rainfall in Norway, drastically cutting reservoir levels and thus hydropower output; Norway may be more famed for North Sea oil and gas but it is a major electricity exporter to the UK, Germany, Denmark and the Netherlands. A similar want of water has seen the Rhine drop to levels too low for barges to deliver coal to German factories. And the heatwave caused winds to sag in many countries, throttling wind-power output. The crisis is by no means limited to Europe. Gas prices are again rising in the US as underground stocks have fallen 12% below average and reduced drilling and pipeline bottlenecks constrain supply. In China, another heatwave and lack of rain have cut hydropower supply, bringing a surge in coal demand. Meanwhile, Europe’s sudden pivot away from piped Russian gas is making it a new player in global Liquified Natural Gas (LNG) markets – and very unwelcome competition to the current three largest importers of LNG, China, Japan, and Korea. This week, the first ever cargo of LNG from Australia made its way to Europe. The US, normally Asia’s main supplier, has this year sent over 70% of its LNG exports to Europe, up from 34% last year.
 
The energy crunch will almost certainly spark recession in Europe this winter – and perhaps elsewhere, too. Already, energy-hungry businesses such as smelters have announced production halts as energy costs surge, and ZEW’s measure of German economic confidence is at its lowest since 2011. But we see some glimmers of optimism. European countries have moved with alacrity to secure alternative supply. In December, a first temporary floating LNG terminal will come online in Germany, with three more to follow in 2023; already it has replaced the majority of its Russian supply with LNG piped from the Netherlands. The Spanish government is in talks to build a gas pipeline to its northern neighbours within 9 months (Iberia has a large share of Europe’s LNG terminal capacity). The French regulator is temporarily bringing more nuclear reactors back online, while reports this week indicated Berlin will opt to keep its final three nuclear stations running for the time being. Germany is on track to achieve its target 20% reduction in gas demand and across the continent evidence is stacking up that European businesses are already switching away from gas and trimming energy demand. Renewable electricity generation capacity in Europe is forecast to rise 15% this year. Looking further ahead, the crisis’ lesson in energy security has brought a belated recognition that the clean energy transition is not merely ESG do-goodery but rather a move to secure the commanding heights of the 21st-century economy. Beijing has already grasped this and is expanding renewable capacity at a dizzying pace; China installed more wind capacity in 2020 than the entire world combined in 2019. The passage of the Inflation Reduction Act in the US since we last wrote, which includes $369bn in clean energy investment, suggests Washington, too, has recognised the strategic imperative. The European Union is preparing to relax regulations to allow mining of lithium, cobalt, graphite and other clean energy resources within Europe. But in the immediate term, a tough winter will have to be navigated.
 
Amidst this threatening economic outlook, with a stock market rally that looks difficult to sustain, we believe now is the time for investors to protect their equity portfolios – as well as to use the rally to consolidate and reposition. Meanwhile, the shifting rates outlook may soon offer an entry for adding more to duration. And looking further ahead in the cycle, the responses to a painful energy crisis should encourage investors to position to benefit – impactfully – from emerging changes in the global energy environment.


 

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