Tatton News Archive

News from Tatton Investment Management: Too hot, too cold

15 July 2022, 12:00am

Investors’ rough ride continued over the week. Markets are being buffeted by the ups and downs of economic data and the resultant changing expectations for central banks. We had unexpectedly positive UK economic growth during May, while the continued decline in oil and general commodity prices (resources and food) paints a picture of receding inflation pressures.

On the negative side, China very nearly slid into recession territory in the second quarter of the year with GDP growing at just 0.4% - the second worst reading in 30 years (second only to the Q1 COVID quarter of 2020). However, as we write in more detail in a separate article this week, these negative readings on top of the ongoing property crisis have finally forced the Chinese leadership towards decisive stimulus action, which markets see as a positive.

In the US it is a similar picture of hot and cold, just the other way around, as its oil and gas self-sufficiency has it far less exposed to the pressures of Russia’s Ukraine war. Indeed, the latest 9.1% inflation reading for June was evidence that the US economy is still running far too hot for comfort for the inflation fighting central bank, the US Fed. While markets initially reacted negatively to the news by increasing rate hike expectation for July from 0.75% to a whopping 1%, this reversed on Friday. This was perhaps due to the fact that much of the rise was driven by the now falling price of oil. Nevertheless, some form of recession in the US is now market consensus, although the relative equanimity of stock and bond market valuations tells us that expectations are for the period of negative growth to be relatively short and shallow.

All this drives the current US dollar strength against other currencies, where this week it regained parity against the Euro for the first time since the turn of the century. Japan also faces energy issues, although being further away from the conflict, it looks stronger than Europe in some ways. We talk about the investment opportunities created by the legacy of assassinated former Prime Minister Abe in an article below.

Due to its oil and gas self-sufficiency, the US does not face the same exposure to Russia’s invasion of Ukraine, which is at the heart of the US dollar’s strength. Indeed, for the Fed, although they can see that US demand is important for a weakened world, the inflation data shows continued signs that pressure is shifting from goods to services and not slowing down fast enough for their liking.

Both consumer and producer prices were above expectations. Overall year-on-year CPI, at 9.1%, is yet to peak and the leaking into service prices is concerning. As mentioned, this led to an acceleration of rate rise expectations which is typical in US hiking cycles, but even so, this is the fastest in 40 years. The peak in rates is still not seen as being reached until after the new year. Paradoxically therefore, investors are likely to welcome any indications that the FOMC members will move aggressively now, in order to convince people that inflation will not last and the expected recession therefore be even shorter and less painful. The next meeting and rate rise decision is on July 27th, with no further meeting until after the summer break on September 21st.
Our focus at Tatton this week was on Europe, because the price direction of natural gas and electricity here is up and therefore the exception to the global norm of the gradual decline mentioned above.

As Britain and southern Europe braces for an upcoming heatwave, the discussion in Europe is all about what happens when the weather gets cooler. Gas and electricity prices, inextricably linked, both spot and forward, ticked yet again higher this week than last week, albeit down from the highs of Tuesday.

All this continues to feed into fears for Europe’s businesses, especially the smaller ones that produce so much of the intermediate products which are the lifeblood of the economy. Worryingly, they are now additionally facing what looks like a classic credit crunch.
Supply chain financing and its variants was a hot topic back in early days of 2021. Greensill Capital went bust in March last year when its nefarious practices were exposed. The outcome of this and other similar episodes was that EU and UK regulators felt they had to adjust the regulation of securitised debt introduced in 2019 and put out consultation papers to introduce tougher standards.

The EU consultation will probably end by September but already many involved in the industry appear to be very concerned that the regulators will impose near-impossible restrictions on the arrangers.

This comes at a decidedly inopportune time. Mid and small-cap companies are paying inordinately high prices for electricity. The price to lock in supply across the winter is significantly higher still. Most are not on long-term fixed tariffs and will have to pay what the going spot rate is at the time. If a company’s input costs go up, financing costs go up because their financial viability becomes more stressed. This makes banks and credit investors reluctant to lend – even before the regulations get more difficult.

The consequence is that Europe and the UK’s SMEs may be facing a credit crunch. A crunch differs from more normal times in that the cost of raising debt or refinancing maturing debt is much higher than the traded level of existing debt. The chart below indicates the € 3-month yield trading level of a 5-year loan for a smallish investment-grade company in the secondary market (a 5-year tradeable loan that was issued some time ago). Investors would get a 2% running yield, up from 0.7%.

However, a friend of ours who is involved in Europe’s company primary (new issue) tells us that one A+ rated company reported that the current best bid for refinancing its loan has gone from 0.7% to over 4% (the annualised 3-month euro floating rate borrowing level).

There is no getting round it – Russia’s invasion of Ukraine is at the heart of Europe’s issues. The pandemic weakened public finances in a bailout of households and, to a lesser extent, businesses. As a result, governments have much less fiscal headroom to address such issues and businesses, even if they could, cannot face another bout of loans through the winter.
This is exemplified by Italy, where Mario Draghi’s government is tottering because he is worried about weakening the country’s fragile debt position through an even larger than already planned consumer and business support package. Meanwhile, the 5-Star party wants more support to be clearly on offer and it is easy to see why.

At the margin though, the outlook might be improving. The Canadians have released the serviced Nord Stream 1 turbines, the delay in delivery having caused the cut in gas supply, according to Russia. To defuse other tensions, Europe is decisively asking the Lithuanians to wave through supplies to the Kaliningrad Russian enclave and not wrongly applying the EU sanctions regime. Turkey (now officially being referred to as Turkiye) is enabling a face-to-face discussion between Ukraine and Russia which might allow grain exports through the Black Sea.

But sanctions on Russia are not going to be removed and the war will continue. Russia is inching towards full control of the Donbas region, but the fight is bloody and reminds of WWI tactics. No one knows if the Russian leadership will halt if they achieve control of the region. So, the risks will continue, and the costs mount.

Like the pandemic response, Europe needs another coordinated response to prevent serious harm coming to its economy. To maintain financial market stability, the ECB has focused on its anti-fragmentation tool to support the finances of countries like Italy, but the governments have to believe in it and be prepared to use it. To prevent the double whammy of a credit crunch, perhaps the ECB may actually need to step up purchases of securitised corporate (business) debt in the same way that the Fed bought mortgage-backed-securities in its quantitative easing program in 2020 and 2021.

Returning to the global picture, markets continue to worry that growth will have to be squeezed down further by central banks to get the genie of structural inflation back into the bottle. That worry is behind the fall in oil prices below $100pb. As mentioned metals are also down and so are food (soft) commodities. Perhaps paradoxically that is fundamentally good news, as it lowers input costs and thereby takes pressure off the central banks to destroy demand in order to bring down inflation.

But for electricity, the issue is not demand but supply, much like at the onset of the pandemic in spring 2020 when factories had to shut down while consumers’ demand remained. As the CEO of Shell said this week, in Europe, we may not be able to avert some form of near-term lockdown – aka power supply cuts. What we can do, as in the pandemic, is make sure our businesses do not pay all of the price for our solidarity with Ukraine.

For investors, this multi-facetted and regionally differing picture opens opportunities for a change of regional emphasis in their portfolios. However, the somewhat mono-causal risks to the pan-European economy also means that any improvement in the energy supply picture or more decisive policy action on the issue will likely result in a very fast reversal of asset prices. Abandoning what is, in valuation terms, still a highly attractive region is therefore at investors peril.