“There are concerns that rising gas prices will put Europe's post-pandemic economic recovery at risk”
Henning Gloystein, Director of Energy Research – October 7, 2021
This quarterly’s title, “The Beginning of the End of Easy Money” is not just about easy money but also about how higher interest rates, and potentially more important, energy prices that may have dramatic impacts across all of our economy. In many economies around the world, we are already seeing central bankers increase interest rates, with Norway being the first G10 central bank to lift rates post-pandemic. Also, New Zealand, Poland, and South Korea (the first major Asian economy) have raised rates citing an economic recovery, coupled with higher energy prices as reasons to try and cool inflationary pressures.
Here is where, what may typically be seen as two separate and distinct animals, energy prices and interest rates, come together to produce ugly unexpected economic outcomes, primarily in the developing world (specifically India and China). China is already feeling the effects of this trend with the central government seeking to control energy usage to avoid widespread blackouts and mandatory factory shutdowns. This will undoubtedly have other unexpected knock-on effects. We are already seeing this effect with further strain on supply chains now being blamed on energy costs.
Much debate has recently centered on Fed policy. While both the European Central Bank (ECB) and Fed have noted the likelihood that a slowdown in future bond buying will happen this year or next, many are worried that an inflationary spiral has already begun. Germany (the engine of Europe) has seen inflation rates hit 3.9% year-over-year, the highest recorded rate in over 25 years. ECB and Fed watchers are currently split on whether price increases are transitory or are indicative of a more persistent inflationary environment. Regardless, it is safe to say that inflation is rising (yes, off of a very low-level), and energy prices and supply-chain bottlenecks are combining to signal an end to Covid-era low interest rates and ultra-accommodative monetary policy.
As mentioned above, both monetary policy (bond buying via various central banks around the globe will decrease) and interest rates are set to be less accommodative in the not-too-distant future. The Fed has signaled it may curtail bond-buying as early as next month. Curiously, it appears that many central bank governors are citing higher energy prices as one main reason for their change in sentiment. Unfortunately, it’s not quite that easy. Raising rates doesn’t mean that it will magically impact energy prices. Unless you crush the economy with much higher rates, energy will continue up.
Oil and gas prices are largely driven by supply and demand. The current economic recovery in virtually all developed markets is a strong demand indicator for oil and gas. Sadly, increasing interest rates doesn’t mean that energy production will increase. Increasing supply certainly will cool price increases, which OPEC has refused to do on numerous occasions. This is another reason why we currently see higher energy prices and their impact reverberating around the world. China has noted that current power rationing and factory shutdowns are due to soaring energy costs. While goals in the greening of energy consumption are noble, it is creating a dangerous imbalance worldwide within energy markets. From the illustration below, currently, China (remember this is where most “stuff” is made) has no other option than coal to produce electricity for their power plants.
Most notably China and India, the world’s “factory floor”, are currently undergoing an energy crisis of epic proportions that is largely unfollowed in western media. A report by Moody's Investors Service said: "China's electricity cuts will add to economic stresses, weighing on GDP growth for 2022. And the risks to GDP forecasts could be larger as disruptions to production and supply chains feed through." More than 70% of China's coal-fired power plants are loss-making because of high coal costs, Citi analysts said in a note on Friday.
This in turn, is prompting power rationing and many factories have to either slow or temporarily shut down as a result. Even state-run Chinese power companies are simply refusing to operate at a loss. With this scenario, we see no other result than higher prices through both supply constraints from less factory production and price increases due to higher input costs primarily from more expensive energy. Again, this is why we are witnessing the beginning of a potentially sharp inflationary loop spreading through the global economy.
China’s energy crisis may be a harbinger of things to come in other parts of the developed world. These problems are just more acute in developing economies like China and India due to their reliance on “cheap” fuel like coal. Even in the developed world, “Rolling Blackouts” have become the norm in California in times of high power usage. In China and in the US, policymakers are caught between goals (many say unrealistic ones) of drastically reducing emissions (less production) and sustained economic growth. The effects of this policy are being felt right now via higher energy costs.
For a manufacturing-based economy like China this is an unsustainable situation, as mentioned, they rely primarily on coal for energy production. It is our opinion that increased focus on renewable power, which are far more unreliable in providing power versus hydrocarbons, are increasing the fragility of our power supply. Currently, there is no reliable way to store wind or solar power at a large scale so overproduction cannot be saved and used later after sunset or winds subside. This is a real problem for which there currently are no viable solutions, except to continue to use fossil fuels or ramp up use of nuclear power.
In California, we primarily rely on natural gas to run our power plants. Contrary to Public Service Announcements (PSAs) we may have heard on the radio stating that California “relies on renewables for power generation” (I have heard this stated many times); California, in fact, does not primarily rely on “renewables” for power production. Above is a pie chart from Stanford University that clearly shows we still mostly use natural gas for electricity. A good development in the past couple decades has been our tilt away from coal-fired power plants to much cleaner natural gas. This has resulted in cleaner air, from which we all benefit.
What this means for both China and California (which in turn, means for the US at large) is the world still relies on fossil fuels, and their rapid price increases likely means higher inflation throughout the economy. One might ask, “well…what really can higher energy prices mean for the economy, apart from higher energy prices”? Let’s explore higher natural gas prices and the impacts on fertilizer and food production.
The primary input in many types of fertilizer is natural gas. As mentioned above, natural gas and all other hydrocarbons are sharply more expensive. A quote from Doomberg, “To keep the chemistry lesson as simple as possible, you need natural gas to produce ammonia and energy from fossil fuels to mine for phosphate. You need ammonia and phosphate to make fertilizer. You need fertilizer to grow food at scale. You need food to keep the peace. As you might expect, the price of fertilizer – already under pressure from gyrations in the natural gas sector globally – skyrocketed higher on the news that China is halting all phosphate exports. Farmers will either raise prices dramatically or go broke. Inevitably, we’ll see an unhealthy mix of both. Inflation in the food sector, already running hot, is set to go vertical. The combination of higher costs, lack of supply, labor shortages, and broken logistics has set in motion a crisis that can no longer be avoided. Prepare accordingly.” While we don’t know what the end-game of this inflation spike will look like, it seems quite possible that we will experience substantially higher food prices in the near future.
While we are not saying this is a “doomsday” scenario, we are saying there will be broad-based higher inflation (we are already seeing this everywhere we buy goods). In the US and most of the developed world (wealthier countries) we can absorb these higher prices, but in emerging markets (like China, India, and similar economies) these higher prices may contribute to serious problems, as they are less able to adjust inflationary pressures. Central banks are looking at these developments and already talking about tightening monetary policy as a result, in addition to their preexisting desire to return rates to a more “normal” level.
What will higher prices in both food and energy look like in the coming couple years and how will that impact the economy and investment portfolios? This is the real question. Already we have read about hedge funds exiting positions that expose them to both foreign supply constraints and substantially higher costs emanating from China. To some extent, in the long-term the “reshoring” of manufacturing will correct some global trade imbalances and inflation pressure, but in the short-term there will be pain across many sectors due to continued supply bottlenecks and higher prices. Logistical constraints are, in turn, helping to bring some manufacturing back to the US.
In the microchip space, both Intel and Taiwan Semiconductor (TSM) have announced huge investments in new manufacturing plants in Arizona in an effort to reduce their reliance on China. In the auto industry, companies like SK Innovation, Toyota, and Tesla have either announced or begun building large battery manufacturing plants in the US to domestically produce new electric vehicles. But, on balance, the US lost worldwide manufacturing dominance over a decade ago. We can only hope that the shakeup in coal prices puts a serious squeeze on Chinese manufacturing. As the US has already transitioned to cleaner burning natural gas and has a tremendous domestic supply of energy, shipping costs explode upward, and reliability of supply becomes more of an issue, the US should slowly regain ground against China in the manufacturing sector.
With the potential for higher inflation, higher interest rates, and a global supply chain that is experiencing constraints of almost epic proportions, where does one look to invest? We honestly think that there is still strong support in favor of the US economy, which should in turn continue to support equity markets. Corporate earnings are strong and companies are paying down debt, while simultaneously buying back their shares. Among the three prominent assets classes, stocks, bonds, and cash, it should be safe to say that cash and bonds will perform poorly especially on an inflation adjusted bases.
This leaves stocks, as mentioned in past quarterly newsletters, as the only game in town. Now, with this inflationary backdrop, which will in turn be a headwind to high-growth companies and emerging economies, companies more focused in internal demand factors with less exposure to international supply chains should continue to perform well. The US consumer has the healthiest household balance sheet in modern history with record amounts of cash, low unemployment, and (politics aside) the fact that we are coming out of the COVID crisis with more vaccine and treatment options, should bode well for consumer sentiment. These are all indicators that the US economy will continue to recover from the COVID induced recession.
While the problems mentioned earlier regarding energy, inflation, and interest rates are real, they will likely have a much greater effect on emerging market economies. This is why we remain constructive on the US and domestically focused stocks. Our domestic consumption-focused economy should continue to perform well even with the aforementioned headwinds. Obvious winners in this scenario should be financial stocks, energy and commodity producers, healthcare, and companies with real assets like many Real Estate Investment Trusts (REITS) that can pass on inflation increases to their tenants, and to some extent certain technology companies that can avoid supply chain landmines overseas. This, in our opinion, is still a good opportunity set even in light of the prospect of higher inflation and commodity prices.
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