The Tipping Point

13 October 2022

With central banks (finally) taking the measure of the inflationary risk and signalling continued rates hikes until price indices fall under control, nominal bonds yields are also moving up fast. Which is bringing them closer to the level at which investors could be tempted to make the “big switch” out of equities and back into fixed income with a potentially large stock market selloff as a consequence. But we are not there yet, and one can hope for a shorter-term relief rally – as the current gloominess may prove exaggerated.

Having only moved back into positive territory earlier this year, the German 10-year yield has now passed the 2% threshold. Its US counterpart is meanwhile even approaching 4%. There will come a point when nominal yields are high enough to attract investors back into fixed income markets. The precise tipping level is obviously difficult to predict, and probably lower in Europe than in the US. But what does seem clear is that we are currently witnessing the end of the TINA (“There Is No Alternative”) era.

The equity correction of 2022 is singular in that it has been accompanied by a similar down move in fixed income assets (making it difficult to shield portfolios from a negative performance by adequately diversifying between stocks and bonds). Even though the war in Ukraine is further escalating while we are confronted with a serious energy crisis in the meantime, no panic selling in the markets has occurred yet and we have not witnessed a level of fear near to what prevailed back in, say, 2008.

At that time, the survival of the financial system was at stake. Today, the most pressing issue for governments is to support companies and households that are seeing their energy bills explode. German and Dutch policymakers are capitalising on their countries’ relatively strong financial situation – having been more disciplined in their public spending since the Great Financial Crisis – to fork out tenths or even hundreds of billions (Germany) of euros nationally. This is causing tensions within the EU, with France and Italy bemoaning the lack of solidarity between member countries. For France, the energy problem is less acute thanks to its nuclear capacity – once all plants will be fully up and running again. But for Italy, the situation is really quite critical. And it cannot even follow the UK route, one of massive government debt-financed subsidies, since it does not have its own currency (to let devalue) or its own monetary authorities (to limit the yield spread widening through market interventions). In effect, sooner or later, the EU might well face another version of the 2010-2011 Greek tragedy.

From a central bank perspective, the inflation problem can be solved in one way only: by pushing demand (for goods and services, but also labour) down below supply. Which, of course, means breaking the economic cycle. By our analysis, equity markets are now pricing in a +/-15% decline in company profits – typical of an average recession. As such, if the recession induced by the ongoing monetary policy tightening proves relatively mild, in intensity as well as duration, stock markets might be close to their bottom. This on the condition, of course, that interest rates don’t rise too much anymore.

Supply chain improvements may also offer some support to equity markets over the coming weeks. Freight rates for containers are down ca. 60% year-to-date and shipping times from Asia to the US West Coast have now fallen from 120 days at their peak to nearer 40 days. This not only supports company margins, but also helps reduce their working capital needs.

Finally, and still looking for potential near-term positive developments, winter temperatures could force a form of military standstill in Ukraine, perhaps even opening the possibility of a negotiated solution to the conflict. Needless to say, equity markets would rally on the news of even just the initiation of such talks…

All in all, the actual situation remains very precarious (geopolitics, inflation, Covid-19, environment, income inequality to name a few) but our policy makers have at least come into action now. Moreover, a lot of bad news has already been discounted for in the actual stock market prices. Just cross the fingers now that interest rates don’t peak above the tipping point.

2-Year Oil Price Outlook: The Only Way Seems To Be Up

OPEC+ made headlines recently, announcing a 2 million barrels/days cut. Beyond the news release though, and the geopolitical ripples, the fact of the matter is that the cartel’s members have recently been unable to meet their quotas. In effect, what OPEC+ did at its early October meeting was to adjust these quotas to the current production realities.

Delving further into the supply-demand situation in fact paints a positive price outlook for oil over the next two years, in our opinion.

On the supply front, the problems well predate the Ukrainian conflict. For years, we have commented on the lack of investments in new oil projects – outside of the US shale industry. And even in shale oil, the low-hanging fruit (i.e. already drilled but not yet fracked wells) has now been tapped. New drilling for oil in some parts of the world remains possible, but it will require capital – which has not been that forthcoming in recent years – and much longer than 24 months to move into production.

On the demand front, the downside risk for oil is lesser than it would usually be in a recessionary environment. This has notably to do with electricity production needs. According to the US EIA (Energy Information Administration), 61% of global electricity still comes from fossil fuels. Of these, coal is (by far) the most intensive in CO2, meaning that greater reliance on coal-powered plants would make the 2030 emission reduction targets impossible to achieve. As for gas, it is becoming increasingly unavailable outside of the US, particularly looking out one year into the future when the currently full European reserves will have been used up. Indeed, the Nord Stream pipelines have been irremediably blown out of action, new LNG terminal buildings will take a couple of years to be completed, and the (less than 60) existing vessels worldwide that are equipped to serve as floating terminals have already all been contracted. Which means that, within the fossil fuel category, oil is the only source of electricity that could readily be increased.

The alternative is of course to expand usage of the remaining 39% of energy sources, of which 10% is nuclear and 29% renewables (16.7% hydro, 6.2% wind, 3.3% solar, 2.4% biomass and 0.3% geothermal). Nuclear can, however, readily be ruled out on our 2-year analysis horizon (beyond the coming back onto the grid of the French nuclear plants) given the decade-long lead time for a newbuild. Which leaves only renewables – alongside aforementioned oil.

It may sound somewhat paradoxical, but our outlook for a strong oil price even amid an economic downturn, and hence our view that investors stick to their energy holdings, should thus also serve to incentivise investments in renewables, making the longer-term necessary green transition possible. That is indeed probably the silver lining to the current energy woes.

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