Head of Equity Strategy
Summary: Crisis brings opportunities, and the energy crisis will accelerate the energy transformation in Europe.
Due to the high-dimensional complexity of nature and our growing civilisation, society is running from one existential crisis to another, illuminating our fragilities. Each new crisis is unique and our response to it catapults societies on to a new trajectory—this crisis is no different. Evidence is growing that this energy crisis will invigorate concepts such as self-reliance, accelerate the green transformation in Europe and create a potential renaissance for Africa. Most importantly it will accelerate deglobalisation as the world economy splits into two competing systems, with India as the biggest question mark.
The world is going through its biggest energy shock since the late 1970s with primary energy costs as a proportion of GDP rising 6.5 percent this year. It is impacting consumers hard and forcing them to cut down on consumption, but it is also forcing factories to curb production and EU politicians to draw up schemes to ration economic resources as the approaching winter puts more pressure on the already troubled energy sector. According to the International Energy Agency, the total primary energy supply to the global economy is 81 percent from coal, oil and natural gas with main source of growth coming from non-OECD countries.
As the world is still run on fossil fuels it is natural that the world has spun into a crisis as prices of these three energy sources have increased 350 percent since April 2020. The price increase is the most intense ever experienced in the modern economy and, unlike the 1970s the energy crisis, is total in the sense that it is hitting transportation, heating and electricity. The recently approved US climate and tax bill is paving a legal runway for the oil, gas and coal industry to continue for longer than was expected just two years ago, using a carbon pricing and capture scheme. This may also be one of the reasons why Berkshire Hathaway has increased its stake in Occidental Petroleum and got approval to take over the majority of shares. In our Q1 Outlook we wrote that the global energy sector had the best return expectation with expected returns of 10 percent per annum. Due to rising prices on energy companies this expected annualised return has now fallen to 9 percent, but this is still making the oil and gas industry attractive
The energy crisis will slowly ease as the world economy naturally adjusts to the shock and higher prices, but the adjustment will likely take many years. The challenge facing the world’s largest economies is that the elasticity on supply of fossil fuels is low and the green transformation is accelerating electrification—this will put enormous pressure on non-fossil energy sources. It almost seems like a fantasy, and so the oil and gas industry is needed to bridge the gap and prevent energy costs exploding. In order to keep energy costs down we need to see investments, but unfortunately the real capital expenditures are not really increasing at a sufficient enough speed; this is prolonging the adjustment and higher energy prices.
China has talked about self-reliance for many years and now Europe is talking from the same book on its energy and defence policies. Europe was already leading the green transformation and has the most energy-efficient economy in the world, but the energy crisis and the move to become independent of Russian oil and gas is still painful for the European continent. However, crisis brings opportunities, and the energy crisis will accelerate the energy transformation in Europe. It will likely make the continent the world leader in energy technology and lead to an enormous export success in the future. While the US conquered the world during the decades-long digitalisation, the return of the physical world will see a return of Europe relative to the US. In the next 10 years the European energy and defence sectors will be drastically transformed and will become much more competitive out of necessity. But in the short term the EU will limit market forces by capping prices, which insulate the consumer on prices, but also prolong the transition while increasing the financial risk for the government absorbing the energy costs.
The green transformation is dependent on energy storage, as it creates an energy mix that at times will produce a lot of excess electricity which has to be stored. One of the big potential technologies is Power-to-X, which converts excess electricity to hydrogen through electrolysis of water. Other technologies are batteries, fuel cells and vehicle-to-grid electric vehicles as load stabilisers of the grid. The table below shows our energy storage basket. It’s intended as an inspirational list of companies engaged in these different technologies, and not meant as an investment recommendation.
The global energy crisis is grabbing most of the headlines and is directly tied to the tough winter ahead for the global economy. But the real winter for the world is not the energy crisis, but the deglobalisation current which has intensified. The US government has recently restricted Nvidia on their sales of its most advanced AI chips to China as the US government worries they are being used for military applications. The decision followed the US CHIPS Act which is the biggest US industrial policy since WWII and is aimed at quickly increasing production of semiconductors in the US. While the US is charging ahead, we are seeing the same urgency in Europe on semiconductors.
China has subsequently invoked the “whole nation system” which has been used twice before, in its space programme and in biotechnology during the pandemic. This time China has decided that it has to muster more resources to become self-reliant on semiconductors. Meanwhile the US is expected to curb exports of semiconductor equipment to China, forcing China to build out the entire production chain of semiconductors.
While semiconductors are just one industry the signs are telling. The moves follow the trade wars from the Trump period—the war in Ukraine has painted the picture that the world is splitting into two value systems. Longer term it will drive energy and defence policies, and critical technologies such as semiconductors, and generally reshape global supply chains. Globalisation was the biggest driver behind low inflation over the past 30 years and was instrumental for emerging markets and their equity markets. Globalisation in reverse will cause turmoil for trade surplus countries, put upward pressure on inflation and threaten the USD as the reserve currency.
One underappreciated aspect of deglobalisation and Europe’s drive for energy independence is what it means for Africa. Europe’s drive to become resource independent of Russia means that Africa must fill the gap. That puts Europe in direct longer-term competition with China over resources on the continent and here lies the next geopolitical tension. In the middle of all of this is India: can the world’s most populous country strike a truly neutral position during deglobalisation or will the country be forced to make tough choices?
Based on the energy crisis, the green transformation, continued urbanisation and deglobalisation, we still prefer equity themes such as commodities, logistics, renewable energy, defence, India, energy storage and cyber security.
The estimated 6.5 percentage point rise in primary energy costs is a tax on economic growth and it sucks surplus out of the private sector in terms of less disposable income available for consumption and less operating profits for investments by companies. Consumer discretionary stocks have reacted to this pressure by underperforming relative to the global equity market. The most vulnerable part of the consumer sector is the European consumer discretionary sector dominated by French luxury and German carmakers. The list below highlights the 10 largest European consumer discretionary stocks.
A drop in consumption means an equal drop in production of consumer goods which means that trade surplus countries such as Germany, China, Japan and South Korea are the most vulnerable to a significant slowdown in consumption. All four countries are facing severe structural headwinds and their equity markets have reflected these challenges this year.
Our main thesis all along has been that the global equity market is facing a potential 33 percent maximum drawdown before equities reach the trough. The final leg down will likely be driven by a combination of higher interest rates for longer, profit margin compression as companies can no longer pass on rising input costs without severely hurting revenue, and likely a recession in the real economy as a function of the energy crisis. In many ways the next six months will feel like a long dark winter, but rest assured, spring always returns and the brightest days in global equities are still ahead of us.
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