The lull before the storm?

18 August 2022

David Jane
Premier Miton Macro Thematic Multi Asset Team

We are in the quiet summer period for markets, post the first half earnings results. Market volumes are very low and many participants are away on holiday. When they return, what are the issues they will need to consider?

One will certainly be the ongoing difficulties in Europe’s energy markets. On every level these are self-inflicted. The heavy subsidies on renewables, incentivised subsidy farming at the expense of reliability. The forced closure of Germany’s nuclear fleet has eroded base load capacity and the apparent opposition of government to new gas exploration has left the region dependent on imported gas, which government have now undermined with sanctions. Even without the Ukraine situation, it should always have been obvious that the aggressive move away from fossil fuels before the technology and infrastructure were in place would lead to energy shortages. A classic case of seemingly well-meaning policy leading to bad outcomes. With energy scarce Europe, and this includes the UK, policy makers now face two very uncomfortable choices: rationing through price or rationing through favour.

The price mechanism will destroy demand, such that only the richest will be able to consume and even they will need to substitute away from other consumption. In the case of industry, only the highest margin businesses will be able to consume energy and even they will lose competitiveness. If price controls are put in place then a form of rationing via blackout will be needed as the issue will become lack of supply and who is favoured in those circumstance will be entirely political.

Either way, consumption is bound to suffer and Europe’s competitiveness versus economies with abundant energy will suffer. Russia, having diverted its gas to other customers is unlikely to favour Europe as a customer in the future. While a resolution in Ukraine will be positive in the near term, the structural issues in Europe’s energy supply will remain for years to come, until reliable alternative energy sources can be developed, such as nuclear.

Another issue is likely to be the outlook for inflation. This is also related to energy and the actions government take to mitigate the political fallout from their past interventions. In our opinion, these further interventions can only be more inflationary, none of the politically acceptable options can resolve a supply issue. However, inflation is likely to be falling in the second half of the year, at least in the US, as base effects kick in and falling basic material prices hit. At the same time, a weakening global economy will also reduce prices through destocking. The question is going to be how far inflation falls; the market seems optimistic in our view.

The level of economic weakness and the outlook for company earnings in the second half of 2022 and beyond will surely be an issue. While first half earnings were strong, this was largely a feature of the strength of energy sector profits. Other industries will need to take up the running going forward.

Then we come to the more left field issues, which abound. China’s obsession with zero covid, its ongoing property and banking issues, the potential for Taiwan to escalate, the US midterm elections, food shortages and the related instability in the emerging world. There are basically a huge number of issues that could rock markets going forward.

At the same time, we shouldn’t underestimate the power of momentum, given some of the known issues will no doubt resolve positively. The expectation of a Fed pivot, and therefore rates being cut sooner rather than later is potentially a powerful force. We should know by now that liquidity trumps every negative, and if the Fed moves from tightening to loosening markets, it will no doubt continue higher. We are concerned that the market has jumped the gun somewhat and is rallying before it has properly discounted the higher structural inflation and weaker profit outlook. Despite this, we remain alert to the possibility that it may simply move on to another phase of liquidity driven revaluation.

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