The Big Chill

5 min read 15 Sep 22

Equity markets lost steam in August as central banks re-emphasised their commitment to tackling inflation, despite the risks to growth. Meanwhile, energy supply constraints have worsened in Europe following the loss of key Russian gas supplies. Gas prices have cooled in September, but remain stubbornly high. With the winter months fast approaching, can governments, businesses and consumers avoid the worst outcomes?  Investment Specialist, Kirsty Clark reviews recent market performance and comments on the deepening energy supply crisis in Europe.

The investor optimism that propelled share prices higher in July, quickly faded in the second half of August after central bankers, gathering at the annual Jackson Hole symposium, re-emphasised their commitment to price stability and the need for further policy tightening to tame inflation.

The MSCI AC World Index finished the month down 3.6% in US dollar terms as markets started to price in more hawkish central bank actions. Global value outperformed global growth, defensives outperformed cyclicals, and large caps pulled ahead of their small cap counterparts.

Source: Refinitiv DataStream, 31 August 2022. Total Returns in USD.
 

Emerging market equities managed to secure incremental gains, led by strong performance in India and Brazil, as developed market equities retreated in August. Asia ex-Japan and Japan (up in local currency terms) were also among the more resilient equity markets in August. The FTSE 250 Index of UK mid cap stocks was one of the weakest performers, with a plummeting pound and political uncertainty adding to the downward pressure on share prices. European equities also lagged the wider market as the ongoing energy crisis threatens to broaden its impact on companies and households. 

At a sector level, energy was the only sector to finish in positive territory, while technology (semiconductors and software) and healthcare lagged the wider market.

With expectations of further interest rate rises in the US, Europe and the UK, government bond yields rose. UK gilts and European sovereigns were particularly weak. Global high yield and investment grade corporates also fell in August. Emerging market bonds fared slightly better, but were still down in the month. 

Concerns of weakening demand and slowing growth continued to cool the commodities markets in August. Brent crude, gold and copper all finished the month down. However, European gas prices continued to trend upwards on the back of ongoing supply-side concerns, despite some relief at the end of the month following reports of European gas storage running close to end of October targets. In the foreign exchange markets, the US dollar strengthened against a basket of currencies, while sterling weakened to levels last seen at the onset of the COVID-19 pandemic (and in September slid further, reaching its lowest level since 1985[1]).

Authorities globally are grappling with the rising cost of energy. A number of factors have contributed to the rise in energy prices, including demand growth in the wake of the COVID-19 pandemic and Russia-related supply restrictions, along with unusual weather patterns across regions.

One of the key reasons energy prices have been skyrocketing, is due to electricity prices being set by gas prices. Gas prices in Europe have risen by over 220% year to date[2], cooling (from a near 400% spike in August) following the announcement of a raft of relief measures and faster-than-expected progress with hitting stockpiling targets.

Source: Bloomberg, 14 September 2022. Netherlands TTF (Title Transfer Facility) Natural Gas Forward Month Ahead, German Year Ahead Power Prices, both series in €/Mwh
 

With a potential energy crisis looming in Europe, authorities have taken a number of measures to help improve affordability and cushion the impact of rising prices.

In the UK, Prime Minister Liz Truss announced an estimated £150 billion energy package, funded through debt issuance, that will limit average annual household energy bills to £2,500 over the next two years from 1 October 2022[3]. This comes after a study by the University of York estimated that three quarters of UK households would be in fuel poverty by the new year[4] if no action was taken to curb the price hikes.

EU countries have adopted various approaches to help shield households and businesses. These were ratcheted up another notch at the beginning of September after Russia (indefinitely) shut down gas supplies to Germany via the Nord Stream 1 pipeline, exacerbating energy supply constraints in Europe.

In response, Germany has unveiled a third relief package, totalling €65 billion, which included a ‘brake’ on household electricity prices, to be financed via a levy on ‘windfall profits’ received by electricity suppliers who are not reliant on gas to generate power. The logic being that these companies are benefitting from higher electricity prices without having to bear the higher input costs. Other measures include one-off payments to pensioners and students, top-ups to child benefits, a carbon price freeze and subsidised public transport[5].

The country-level support measures also include liquidity backstops for energy producers who are having to bear the brunt of soaring gas prices. The UK, Germany, Finland, Sweden and Switzerland are among the countries that have announced plans to offer liquidity guarantees to wholesale energy producers that are being squeezed by rising gas prices[6]. It’s also been reported that Germany is considering taking a controlling stake in Uniper, one of the country’s largest energy producers, and is in talks with other large gas importers who are seeking aid[7][8].

Although this is a temporal liquidity issue, European energy companies are having to secure enormous amounts of capital to meet outsized margin calls on short positions taken in the futures market, to hedge financial risk in advance of the physical sale for electricity. Once the power is physically delivered the hedges are unwound, but in the near term it’s been estimated that European energy suppliers face capital calls in the region of €1 trillion[9].

In keeping with Germany’s announcement, in her recent State of the Union speech, European Commission president Ursula von der Leyen outlined a proposal to cap the revenues of low-cost energy producers that do not rely on gas to generate power (e.g. nuclear and renewable sources of energy generation). In addition, authorities are also seeking a ‘crisis contribution’ from the oil and gas majors. The expected €140 billion raised will be redistributed to help cushion companies and households from soaring energy prices and wider inflationary pressures.

While the escalating crisis has prompted EU member states to call for coordinated action at a supranational level, to tackle the enormity of the challenge facing the block as the northern hemisphere heads into the winter months, there are varying opinions on the best course of action. The EU-level proposals are still to be voted on by all member countries, so businesses and consumers will be sitting with the uncertainty for a little longer.

Prior to the closure of the Nord Stream 1 gas pipeline, Russia’s Gazprom had been incrementally reducing the amount of gas being supplied, while European countries were stockpiling reserves in advance of winter and trying to diversify energy suppliers to shore up future reserves – the US and Canada have increased deliveries of Liquified Natural Gas (LNG) to the EU, Norway is providing additional gas, a memorandum of understanding for increasing gas deliveries has been signed with Azerbaijan, and new deliveries are planned from Israel and Egypt. Yet, this comes at a cost with countries and regions competing to secure contracts as global demand outstrips finite supplies.

Meanwhile, European countries have been reopening or delaying the closure of coal-fired and nuclear power generation plants to plug some of the supply shortfall, while also investing in floating and onshore LNG gas terminals and pipelines (Germany currently has no existing facilities) – but this infrastructure takes time to be brought online.

The EU’s overall LNG import capacity is significant, enough to meet ca 40% of total gas demand, but access to the infrastructure is uneven across the bloc[10]. Despite the efforts, the indefinite closure of the Nord Stream 1 pipeline creates a near-term ‘crunch’ for Europe. A persistent gas supply shortfall means demand will likely have to adjust. We’ve seen some evidence of reduced demand in anticipation of further price hikes, but broad relief packages risk the unintended consequence of increasing energy use at a time Europe can ill afford it.  

Winter is coming, and the weather will play a key role in determining how countries will fare as the colder months descend. With healthy reserves, and a fair wind, rationing may be avoided, but should winter bring its most inhospitable conditions and demand remain robust, imposed blackouts may become a reality. A gloomy prospect for some, potentially severe hardship for others. Governments, businesses and households will be hoping for a mild winter ahead.

 

 

[1] Source: Bloomberg, 8 September 2022

[2] Source: Bloomberg, 12 September, 2022, Netherlands TTF (Title Transfer Facility) Natural Gas Forward Month Ahead.

[3] Source: Financial Times, 8 September 2022, https://www.ft.com/content/984129f9-a133-468b-bc38-e8c4ec7386d6

[4] Source: University of York research, 8 September 2022, More than half of UK households to be in fuel poverty by the new year, according to new report - News and events, University of York

[5] Source: https://www.euractiv.com/section/energy-environment/short_news/berlin-to-implement-electricity-windfall-levy-price-limit-with-or-without-eu/

[6] Source: https://www.euractiv.com/section/energy-environment/news/the-green-brief-eu-energy-crisis-is-becoming-systemic/

[7] Source: Bloomberg, 14 September 2022

[8] Source: Irish Times, 15 September 2022 https://www.irishtimes.com/business/2022/09/15/germany-working-on-historic-takeover-of-three-gas-companies/

[9] Source: Financial Times, 9 September 2022, https://www.ft.com/content/cbc6a717-da49-491a-9cda-adde6f0f410a

[10] Source: Council of the EU and the European Council, 8 September 2022, https://www.consilium.europa.eu/en/infographics/lng-infrastructure-in-the-eu/

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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