The gravitational pull from energy and rates hit equities
Head of Equity Strategy
Summary: Equities have enjoyed the second longest rally since 1999 with a drawdown of less than 5%, but the forces unleashed from the global energy crunch are about to change that. Galloping energy prices, power prices, and natural gas are sending shock waves through the economy forcing factory to shut down, making the global supply situation even worse, and putting pressure on inflation forcing interest rates higher in the US and Europe. Equities are finally succumbing to the gravitational pull of higher energy prices and higher interest rates.
Yesterday was an interesting session as it was the first session since February and March that we could clearly see interest rate sensitivity become a market dynamic with Nasdaq 100 futures selling off following a positive start to session. The risk-off sentiment has continued today as the US 5-year yield has pushed above 1% for the first time since March last year impacting equity valuations of technology stocks. Listen to today’s Market Call podcast where Althea Spinozzi lays out her views on the current momentum in US interest rates.
Equities are not only hit from higher interest rates but also a galloping energy crunch globally which we have described in our two research notes For how long can equity markets ignore the energy shock and Q&A: Could the energy crisis derail the green transformation agenda?. Higher electricity prices (up 38% in Germany this month) and higher energy prices on natural gas, crude oil, and thermal coal are pushing up manufacturing costs for fertilizer plants, steel, aluminum, and in general building materials. At the same time consumer demand remains high in an oddly disrupted global supply chain due to Covid-19 which are causing freight rates to balloon and delivery times explode higher. Recently, both Nike and FedEx have reported margin pressures and we believe this will be the overwhelming theme during the Q3 earnings season that starts in two weeks’ time. Adding further pressure to the global economy, the energy crunch is forcing China to preserve energy causing factories to temporarily closing worsening the global supply situation.
We are currently working on modeling the effect of commodity prices on headline inflation in the US. Previous research suggests that the link was quite strong back in the 1970s and early 1980s but then disappeared until briefly during the period 2002-2008. The main question for equities is whether we are entering such a regime again with commodities pushing inflation higher, because if that is the case then equities will have to reflect that through lower equity valuations which are currently at record highs.
ESG focus meets reality of risk-reward in energy and mining
On 4 January 2021, we defined this year as the reflation year and recommended investors to get exposure to the commodity sector. This is still our view and the recent energy crunch is confirming us that the physical world is simply too small to support our green transformation ambitions and the demand created by historic fiscal and monetary stimulus in the wake of the pandemic. Back in early March, we flagged that black energy was sprinting ahead of green energy, and that investors should consider investing in the traditional energy sector.
As the long-term chart of the relative performance between the MSCI World Energy Sector and the MSCI World shows, the underperformance of the traditional energy sector is enormous and given the current trajectory for energy prices, there is a great risk-reward potential to get overweight the traditional energy sector. However, it requires the investor to put less emphasis on ESG and make a tactical bet.
The ESG trend, which we recently wrote about here, has together with many other factors created an environment where it is increasingly difficult for traditional oil & gas and mining companies to get financing for projects because it is not ESG compliant. But the irony of our green transformation is that we need a solid baseload on electricity which has to come from natural gas, and potentially nuclear power, and we need large amount of new metals to roll the necessary electrification of our transportation and housing sector. The problem is that our oil & gas and mining companies are spending record low levels of revenue on expanding production which under the current demand dynamics will lead to even higher prices in the future and with it a higher level of inflation.