MarketMinder Europe 

MarketMinder Europe

MarketMinder Europe provides our perspective on current issues in financial markets, investing and economics. Our goal is to analyse key topics in an entertaining and easy to understand manner, helping you see the news of the day in a unique perspective.

Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.

The UK's Commodity Supply Chain Adapts

Seemingly every couple weeks, we see more news breaking that yet another global energy producer is ramping up oil and natural gas exports to Europe. Israel is the latest example, with its energy ministry announcing natural gas production is up bigtime year to date amidst plans to increase exports to the EU.[i] We have seen many such anecdotes involving non-Russian suppliers, including Azerbaijan, Qatar, the US and others, but data on how all of this is panning out has been a bit thin, in our view.[ii] Germany publishes monthly crude oil imports by country but not natural gas. The Netherlands publishes both, but the data are values (in euros), not volumes (in barrels or tonnes or the like), subjecting them to big skew from commodity price swings. So you can imagine our excitement on Wednesday, when the UK’s Office for National Statistics (ONS) posted a report detailing how the country has adapted to Russian sanctions. It is but one example, but we think knowing how the UK has replaced Russian commodity imports may help investors get a better sense of how supply chains are readjusting, perhaps easing uncertainty as we head into the winter.

The UK’s main commodity sanctions included a pledge to phase out all Russian crude oil imports by yearend, cease natural gas imports as soon after that as possible, and ban all iron and steel products.[iii] As the ONS notes, Russia accounted for 24.1% of the UK’s refined oil imports in 2021, 5.9% of its crude oil imports and 4.9% of its natural gas imports.[iv] Now, the UK also produces its own crude oil, refined petroleum and natural gas, so these percentages don’t represent Russia’s share of UK consumption, which was more like 8% of total oil and oil products, according to Business Secretary Kwasi Kwarteng’s March estimates.[v] Much of its natural gas imports are also re-exported to Continental Europe.[vi] But refined petroleum imports in particular play a key role in the UK, making Russia’s impending absence an important hole to fill.[vii] Unsurprisingly, UK businesses haven’t waited for the bans to take effect: Russian fuel imports fell to zero in June.[viii] Meanwhile, the UK imported more refined oil from the UAE, Saudi Arabia, Belgium, the Netherlands and India.[ix]

That last one is perhaps most of interest, in our view, given India hasn’t ceased buying Russian crude—actually, it has ramped up Russian imports bigtime and is reportedly refining Russian oil into petrol and diesel shipped globally.[x] We think it is entirely possible that the UK is now simply buying Russian crude that was refined in India, underscoring an important point about energy markets, in our view: They are fully global, and total global production is what ultimately matters most. Even if Russian petroleum products are taking a more circuitous route than usual, they are still contributing to global supply, which we think goes a long way toward explaining oil prices’ fall from their March peak.[xi]

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What to Consider in August’s Purchasing Managers’ Indexes

Has a global recession—a period of contracting economic output—begun? Financial commentators we follow asked that question Tuesday after S&P Global’s flash US Purchasing Managers’ Indexes (PMIs) for August showed declining output in most major economies.[i] In our view, that makes today ripe for a timely reminder: Regardless of what the global economy is doing this month, we think stocks generally look about 3 – 30 months out and have likely already digested whatever business surveys and output metrics will eventually confirm happened.

PMIs, unlike so-called hard data like retail sales and industrial production, aim to use survey responses to determine the economy’s general direction. They ask participants how business evolved across a range of categories including output, new business, employment, inventories, supplier deliveries, prices and others, then mash the responses into a number. Readings over 50 generally indicate expansion, with growth broader the farther above 50 it is. Similarly, under 50 normally means contraction, with lower readings implying widespread declines.

Exhibit 1 shows the flash results for August, which S&P says include about 85% of expected responses.[ii] The Manufacturing and Services columns show headline indexes—the aforementioned mashups. The Composite column aggregates Manufacturing and Services output only, hence its apparent divergence.

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On Europe and the UK's Energy Pain

Europe’s energy crisis has dominated headlines of financial publications we follow for nearly a year, with many arguing shortages will lead to recession (a broad decline in economic activity). The Continent’s hot and dry summer has further stoked energy supply concerns, as droughts impact increasingly in-demand electricity. We don’t dismiss the economic pain for households and businesses, but our focus is on the market impact. In our view, the widespread discussion of an energy-driven recession across Europe reveals how weak sentiment is—a sign of the low bar reality must clear to positively surprise, in our view.

It is easy to see why sentiment has sunk so far, in our opinion. Natural gas prices are surging in Europe, with hot weather boosting demand and Russia throttling supply in response to EU sanctions.[i] Russian gas flows through the Nord Stream 1 pipeline have been around 20% of contracted volumes since late July, straining Europe’s ability to generate power whilst filling storage for the winter.[ii] There have been repeat warnings amongst financial publications we follow that even this flow will cease fully, particularly during periods when Russia claims to be performing maintenance, including today’s announcement in which Russia’s state energy giant imposed a three-day shutdown order on the Nord Stream 1 pipeline for gas compressor repairs.[iii] Beyond this, the summer heat has impacted other energy sources: In France, high river water temperatures are interfering with nuclear reactor cooling. In the UK, energy regulator Ofgem will announce October’s energy price cap (which resets semiannually) on 26 August, and we have read some observers estimate the new cap will double today’s record levels—worsening UK households’ burden.[iv]

Politicians have responded in myriad ways, based on our review of the latest reports. The EU has asked member states to reduce gas demand voluntarily. Some governments have imposed new taxes, from the UK’s windfall tax on energy firms, which passed last month, to Germany’s levy on households to help utilities. Elected officials have also sought to provide relief. Italy approved a €17 billion aid package whilst the Netherlands cut energy taxes for 8 million households.[v] The contenders in the UK Conservative Party leadership contest are each reportedly preparing household assistance packages to introduce once they take office next month.[vi] France plans to re-nationalise power operator EDF—in which it already owns an 84% stake—in order to sell electricity below cost without getting pushback from minority shareholders.[vii] An example of that resistance: The government ordered EDF to sell nuclear power to its rivals at below-market prices, and EDF is now suing for having to take a loss.[viii]

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Britain's Sky-High Inflation Fosters Gloomy Forecasts

The UK notched a dubious milestone in July, becoming the first major country to record double-digit inflation (broadly rising prices across the economy) this year. The Consumer Price Index’s 10.1% y/y rate is the fastest since 1982, and the Office for National Statistics (ONS) estimates it is just the fourth trip over 10% in 70 years.[i] This is obviously not good news, not least because essential goods and services—food, petrol, household energy—fuelled much of the rise.[ii] But even excluding food and energy, core inflation accelerated to 6.2% y/y, driving commentators we follow to warn entrenched price hikes will hit consumer spending hard—and likely give UK stocks a nasty recession to price in.[iii] In our view, a UK recession is possible and could already be underway. But we see reasons to think reality has a higher likelihood of going better than analysts we follow foresee, not worse.

With that said, we think inflation is quite likely to accelerate from here due to the forthcoming rise in the default household energy tariff, which energy regulator Ofgem is due to announce next week and will take effect in October. Some researchers anticipate it will double the current ceiling in order to reduce the risk of more suppliers going bust if power is in short supply this winter. The Bank of England (BoE) projects the cap increase will cause inflation to pass 13% y/y in October—a forecast some commentators we follow warn is too optimistic.[iv] Labour market data released earlier this week showed real (meaning, inflation-adjusted) wages falling at the fastest rate in the dataset’s short history over the three months ending in June (-3.0% y/y), a figure that doesn’t account for either the forthcoming price cap hike or the fact that income tax bands currently aren’t indexed to inflation.[v] So we can understand why observers suggest the consumer spending outlook is bleak.

Yet there is some history of consumer spending growing despite falling real wages. Inflation-adjusted wages fell on a year-over-year basis in every month from November 2009 through September 2014—a long, dismal stretch of seemingly falling living standards. The peak-to-trough drop, using the seasonally adjusted monthly inflection points of April 2009 and June 2014, was a painful -6.0%.[vi] Yet from the end of Q1 2009 through Q2 2014, inflation-adjusted quarterly consumer spending rose 9.1%.[vii] There were some occasional quarterly contractions, but the UK didn’t slide into recession during this stretch. Lest you think spending rose only because people borrowed beyond their means, consumer credit actually fell by over £25 billion over this span.[viii] The much-discussed consumer borrowing boom came later, in the decade’s second half, by which time real wages were rising.[ix] We aren’t saying that period is a perfect analogue for now, but we think it shows falling real wages aren’t assured to sink spending.

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America’s Q2 Earnings in Focus

America’s Q2 earnings season is winding down, with the vast majority of S&P 500 companies having reported.[i] Given the US is 70% of developed world stock market capitalisation, we think its profit picture is worth reviewing for global investors.[ii] The results? Three-fourths of those reporting so far beat expectations, and revenues did much of the heavy lifting.[iii] Yet whilst Energy earnings soared, profits in the other 10 sectors combined fell, echoing the split amongst sector returns during this year’s stock market downturn.[iv] In our view, this is a good reminder that stocks look forward.

In US dollars, US and global stocks’ declines this year breached -20%, which is the traditional threshold for a bear market—an extended deep stock market decline, typically with a fundamental cause.[v] As Exhibit 1 shows, S&P 500 sector returns in US dollars from their early peak this year through the year’s low point to date on 16 June mostly seemed to preview how earnings turned out. Whilst S&P 500 earnings overall rose 6.7% y/y, much of that came from Energy earnings soaring 299.2%.[vi] Excluding Energy, they fell -3.7%.[vii] So whilst headline earnings growth was near its 7.1% annualised average historically, we think it masks some underlying weakness.[viii] Yet first-half sector returns appear to us to have largely captured the earnings dynamic below the surface, with only Energy positive through Q2.[ix] Markets anticipated high oil prices’ impact on Energy earnings well in advance of official reports, in our view.

Exhibit 1: S&P 500 Sector Returns, 3/1/2022 – 16/6/2022

Source: FactSet, as of 16/8/2022. S&P 500 sector total returns in US dollars, 3/1/2022 – 16/6/2022. Currency fluctuations between the US dollar and pound may result in higher or lower investment returns.

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The Puzzle in UK GDP

UK gross domestic product (GDP, a government-produced measure of economic output) came out Friday morning, and here are the facts: Output fell -0.1% q/q in Q2, according to the Office for National Statistics’ (ONS) first estimate, with the bulk of the decline seemingly coming from June’s -0.6% m/m drop.[i] In our experience, the logical interpretation would be that the flattish quarterly reading obscures a late-quarter slide, implying the economy has weakened significantly since spring and signalling bad times ahead. However, due to some calendar quirks that the ONS warned skewed monthly data pretty heavily, in this case we think the quarterly figure is probably more telling.[ii] We don’t think it is predictive, and in our view, stocks are likely looking ahead to the next 3 – 30 months rather than what happened in April through June. But we think putting these data in context can help investors better weigh economic fundamentals overall.

The calendar quirk in question is the Queen’s Platinum Jubilee, which pulled one bank holiday from May into June and added another to the calendar.[iii] This resulted in two fewer working days in June and an extra one in May, which the ONS warns threw off their seasonal adjustments. The official monthly GDP release states plainly that there will be a visible effect on both May and June data and concludes: “Caution should be taken when interpreting the seasonally adjusted movements involving May and June 2022.”[iv]

In our view, this should provide some relief about the fact that all major categories—services, heavy industry and construction—declined month-over-month.[v] We think most of that drop stems from having fewer working days in June than May. Similarly, the jump in entertainment services and restaurant spending probably stems from people having two additional days of leisure—days with big celebrations up and down the country to celebrate the Queen’s 70 years on the throne. We don’t view this boom as any more representative of the country’s underlying economic health than the drops in other categories of services and the manufacturing industry. We aren’t saying there is no core weakness. Businesses reported higher energy and input prices as headwinds in June, which may have contributed to falling output in the categories that rely on petrochemical feedstock.[vi] But with so much one-time skew, it is impossible to disentangle the two, in our view. We think July data could benefit from an easy comparison to June, so we probably won’t get a clearer read until August figures hit the wires—which won’t happen until mid-October.

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An Overlooked Reason Behind July’s Slowing US Inflation

Editors’ Note: Inflation remains a hot political topic, so please understand that our commentary is intentionally non-partisan and focused on the potential market implications only.

America’s July inflation report made headlines globally this week, with good reason: The US generates about one-fourth of global economic output and represents about two-thirds of the developed-world stock market, making developments in America key worldwide.[i] So when the report revealed that the inflation rate decelerated from June’s 9.1% y/y to 8.5% y/y, we noted much relief amongst financial commentators we follow.[ii] We also saw ample discussion of the deceleration’s causes, with much attention centering on falling petrol and jet fuel prices. Whilst those played a role, we see an additional, widely overlooked explanation, and we think understanding it can help investors set realistic expectations for a big chunk of the global stock market over the period ahead.

That explanation: a mathematical phenomenon called the base effect. The inflation rate, as a year-over-year calculation, measures the percentage change between prices in one month and that same month a year prior. The base is that year-ago price level, which is the denominator in the calculation. As we all learnt in primary school fraction lessons, a higher denominator can result in a smaller quotient—and vice versa. That is what happened in July.

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On the BoE’s Dreary Forecast

The Bank of England (BoE) announced its biggest interest rate hike since 1995 last Thursday, raising the Bank Rate from 1.25% to 1.75%—but that wasn’t the day’s biggest news, based on our reading of financial commentary.[i] Paired with that rate hike was the BoE’s August Monetary Policy Report, which included the bank’s updated economic forecast. That forecast: Consumer Price Index (CPI) inflation reaching 13% y/y when the household energy price cap resets higher in October and a recession (a period of contracting economic output) starting that quarter and lasting all of 2023.[ii] (CPI is a government-produced measure of goods and services prices across the broad economy.) Looming over all of this is a fierce political debate on the BoE’s mandate and independence, which has featured in this summer’s Conservative Party leadership contest.[iii] We see some potential medium-term risks for UK stocks here, but not the ones that might seem most intuitive. Let us discuss.

When last we left the BoE in May, its top-line forecast was for inflation at 11% y/y and a -0.25% gross domestic product (GDP, a government-produced measure of economic output) contraction in 2023.[iv] Now it says the most probable scenario is CPI hitting 13% this autumn and GDP falling -1.25% in 2023.[v] Our May coverage discussed the BoE’s methodology and inputs at length, so we won’t rehash that here, but suffice it to say they mostly extrapolate recent conditions forward, which we think is a big reason why forecasts often don’t pan out. (Which, in turn, appears to be part of the reason for the political kerfuffle over the BoE’s status, which we will turn to momentarily.)

The BoE could prove correct. Wage growth, whilst strong in nominal terms, has lagged inflation, and in our view, the patchwork quilt of tax credits and rebates hasn’t offset the headwinds of this spring’s tax hikes and spiking household energy costs.[vi] We can envisage a potential scenario where GDP grows steadily in nominal terms (meaning, not adjusted for inflation) but shows as contraction once the inflation adjustment kicks in. That would represent a fall in living standards and, yes, recession by most definitions. Plus, the yield curve, which is a graphical representation of a single bond issuer’s interest rates across the spectrum of maturities, spent the past two weeks ever-so-slightly inverted, and as we write, it is just barely positive.[vii] Couple that with slight falls in broad lending and money supply in June, and we see some indication conditions are tightening.[viii]

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Hidden Storylines in Eurozone Q2 GDP

One day after the US announced Q2 GDP (gross domestic product, a government-produced measure of economic output) results, it was the eurozone’s turn last Friday—and surprising many financial commentators we follow, its results were much better. Where the US contracted last quarter, eurozone GDP grew 0.7% q/q, smashing economists’ consensus expectations for a 0.1% q/q rise.[i] That generated a heap of headlines, a few sunny on the positive result whilst most warned the fun won’t last now that Russia has reduced natural gas flows into the region substantially.[ii] We can’t help but wonder what all the fuss is about on both sides, because in our view, headline eurozone GDP is next to meaningless. It is the sum of 19 individual member state GDPs, and we find there are too many offsets amongst them for the total to be of much use, especially to investors looking for economic clues. We think this quarter’s results are a prime example.

So far, only nine eurozone member states have reported.[iii] Their results range from a -1.4% q/q contraction (Latvia) to 1.1% growth (Spain).[iv] But in our experience, whenever investors look at Continental Europe, they are mainly eyeing four countries: Germany, France, Italy and Spain, the four largest economies.[v] Of these, commentators we follow typically portray Germany as the engine, France as a ride-along and Italy and Spain as the periphery. So, if Germany is struggling, that can colour the view of the whole and raise questions about whether other nations will soon follow.

This was one of the primary angles we encountered in the news coverage Friday, as German GDP was flat in Q2 (or, as Bloomberg pointed out, ever-so-slightly contractionary when you round to 2 digits versus 1).[vi] This follows 0.9% q/q growth in Q1, which the data show stemmed largely from post-Omicron reopening boosting the services sector, and an Omicron-related -1.4% Q4 contraction.[vii] Germany’s Federal Statistics Office doesn’t release a detailed breakdown in its first estimate, but the accompanying commentary said consumer spending rebounded whilst net trade (exports minus imports) detracted. Whether the latter involves rising imports (which subtract from GDP), another drop in exports or a combo thereof, we will have to wait and see.

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A Look at US GDP’s First-Half Dip—and Beyond

Q2 US Gross Domestic Product (GDP, a government-produced measure of domestic economic output) fell -0.9% annualised, its second consecutive quarterly decline after Q1’s -1.6% dip.[i] Because this is one traditional definition of recession (broad, extended period of economic contraction)—although not the official way America defines it—headlines we read feverishly debate whether this means one is now underway. And, with US GDP about a quarter of the world’s, they discuss what it augurs for the global economy.[ii] But in our view, that debate is too backward-looking for investors to mind it much. Months-old economic activity has little relevance for stocks, which we think have already dealt with the mild economic contraction and are looking ahead to what the next 3 to 30 months have in store relative to expectations.

Our research shows stocks move ahead of economic activity, and bear markets (typically prolonged, fundamentally driven declines exceeding -20%) often precede recessions as stocks discount the likely decline in investment and corporate earnings. We think this year’s shallow (to date) US and global bear market (when defined in US dollars) would be pretty consistent with a shallow recession.[iii] But whether or not one is underway is questionable. America’s National Bureau of Economic Research (NBER), which is the US’s official arbiter, doesn’t define a recession as two sequential GDP contractions. Rather, it defines it as a “significant decline in economic activity that is spread across the economy and lasts more than a few months.”[iv] Diving under the bonnet of Q2’s GDP report, we think there are reasons to question whether the US economy meets that threshold.

Exhibit 1 breaks out the US’s net trade (exports minus imports, light blue columns) and inventories (burgundy) by their contribution to headline growth (dark blue line). It also shows America’s government spending contribution (lavender) and three major GDP components: consumer spending (71% of GDP), business investment (15%) and residential investment (3%) in shades of green.[v]

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Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.

This article reflects the opinions, viewpoints and commentary of Fisher Investments MarketMinder editorial staff, which is subject to change at any time without notice. Market Information is provided for illustrative and informational purposes only. Nothing in this article constitutes investment advice or any recommendation to buy or sell any particular security or that a particular transaction or investment strategy is suitable for any specific person.

Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom. Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission.