Client Update - Friday 19th August 2022
The current macro-economic data from the United States has, when combined with more dovish comments from the US Federal Reserve (FED), driven a welcome recovery in investment markets. In the last couple of weeks, we have had reports showing negative GDP growth in Q2, a surprisingly strong gain in employment countered against 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 and, returns from equities are better as a result. Better news so far.
The 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. We have a while to go before valuations get back into expensive territory again.
The easing in the US inflation numbers is down to lower energy costs. In the producer prices report, energy costs fell 9% in July. Gasoline and broader energy prices in the US have started to fall quickly. However, in Europe, natural gas prices are at new highs, consumers are wilting under higher energy prices and Governments are struggling to push-back against the adverse distributional consequences of Russia’s war. The cost of natural gas for delivery in one month is currently €204.50 per megawatt hour, and €162.50 for delivery 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 has been said a lot, but this would likely trigger a significant loss of output in Europe in 2023.
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.
As higher wholesale gas prices have been driven up by the conflict in the Ukraine, power generators 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. 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).
It has been a welcome relief to see a more sustained recovery in investment markets over the past few weeks and whilst we are by no means back in positive territory for 2022, it gives us plenty of reason to be more positive for the rest of the year ahead. Please do have a good weekend.