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Client Update - 8th October 2021

Such is the scale of the economic shock from COVID that the road back to economic normality will, necessarily, be a long one. Today’s global energy shortages and supply chain disruptions are the first of many aftershocks that we should expect in the years ahead. Indeed, it is sensible to expect a series of rolling supply shocks becoming almost the norm for world markets. The challenge for investors is all the greater, because of two other changes that will confront us, at much the same time. The first is the restructuring of the world’s energy infrastructure to meet today’s highly ambitious de-carbonisation targets – a task that arguably involves the biggest capital spending commitment since the reconstruction of Europe after World War II. The second is the unwinding of the massive leverage in the Chinese economy, after 20 years of exceptional growth.

The first energy squeeze of the green era, as the Economist describes it, is already a global phenomenon. A worldwide shortage of gas has driven power prices higher around the world. A hot summer in Asia and a strong post-COVID rebound in industrial production have lifted demand, while supply shortfalls from Russian gas pipelines have left European storage well below seasonal norms. Although Putin has promised action here, other natural phenomenon have caused issues - such as lower wind speeds in Europe and the UK, which have curtailed generating capacity (and highlighted the intermittency of some renewables). China is facing particular problems, with at least 20 provinces already rationing electricity to industries to meet President Xi Jinping’s targets for energy efficiency and pollution reduction. Across the world the energy squeeze is driving up factory input costs, squeezing consumer incomes and lifting already high global inflation rates.

For policymakers there is no immediate solution – yes, carbon-intensive energy should be more expensive but without alternatives, price increases will tend to lift inflation with little immediate impact on supply. Additional gas storage and battery capacity will help (we are investing in both of these, via alternative energy funds and through bonds issued to fund transmission and storage). In the short term though, expect today’s higher energy costs to be with us for some time yet. Fortunately, central banks have indicated that they will be more tolerant of inflation overshoots in their new policy guidelines – such forbearance could be needed sooner than many had hoped.

At the same time as the global energy squeeze risks higher inflation, China is facing a deflationary risk from the likely bankruptcy of its second largest property developer, Evergrande. The company is a vast enterprise with 123,000 employees and 3.8 million contractors, and accounts for 6.5% of all China’s property debt. Across the country, real estate represents at least 25% of the gross domestic product, with more than 75% of China’s wealth invested in housing - so contagion issues are very real. Evergrande though, is no Lehman’s - there is comparatively little international debt at risk, while Chinese banks can effectively be directed by the state to lend to and support the sector. New regulatory standards introduced last year are forcing much needed de-leveraging - this is a laudable goal but as any policymaker will tell you, embarking on the rapid deflation of asset bubbles normally comes with meaningful risks to the wider Chinese economy.

This is not the only area where Chinese regulation is evolving fast. Other sectors, including cyberspace, gaming, after-school tutoring and fan-based culture, are all feeling the hand of government policy. The speed and determination are disorientating for investors in China, but the building of an overarching regulatory framework, which is what Xi Jinping’s government really wants, will provide much needed clarity. As with the property sector, some of the goals are to be welcomed – but once again the speed and suddenness of implementation comes with many risks.

As always, we remain vigilant on your behalf. Please do have a good weekend.

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