ANTIPODES - SEPTEMBER 2022
A hot US inflation report as Europe seeks alternative energy support
By The Antipodes Investment Team
- A worse than expected US inflation print surprised the market. Antipodes believes that inflation will fall but remain elevated as it’s driven by supply side issues.
- Relative to inflation, US equity indices still look pricey.
- Antipodes believes the European energy situation is one of the most critical factors for global equity portfolios right now – the European winter will be a crucial period.
- Rather than follow the herd and seek out expensive green “concept stocks”, Antipodes has around 18% of its portfolio exposed to energy transition. Decarbonisation is the ultimate goal but there will be steps along the way, and gas has an important role to play in this transition.
US CPI and the sea of red
The highly anticipated US CPI was hotter than expected sending US markets into a tailspin. In the immediate aftermath the S&P 500 and Nasdaq saw their worst single day moves since June and March 2020, and every stock in the Nasdaq 100 closed down. The yield on the 2-year US Government bond hit 3.8% – the highest since October 2007.
These are relatively large moves given it’s no secret inflation, driven by supply side issues, is proving sticky and Fed has remained steadfastly hawkish. But it shows how desperate the market is to see a Fed pivot.
Despite the fall in energy prices, headline inflation continued to rise another 0.1% over the month (versus expectations for a small contraction) and is still 8.3% higher than a year ago. The real surprise, however, was core inflation – which excludes food and energy – which rose another 0.6% for the month.
Core inflation is 6.3% higher than a year ago – the highest core CPI print in 40 years. Goods inflation is slowing as economic activity slows but services, which accounts for around 75% of core inflation, continues to be strong. For example, wages are still rising at above trend levels and rents are still rising as higher mortgage rates, combined with an under-build in housing since the GFC, is supporting renting over home ownership. This is meaningful since rent accounts for over 40% of the core inflation basket.
The market is now pricing in an additional 185bp in rate hikes by the end of this year.
Today, the S&P is priced at 19x trailing earnings. But over the last 70 years, in previous periods when headline inflation has run at around 8.3%, the S&P has averaged just 12x trailing earnings.
We have long said that inflation will fall. But it’s where inflation settles that matters for equity market multiples, and as the recent print shows inflation can remain elevated due to supply side issues.
At the benchmark level, US equities look expensive and investors need to be selective about exposure in this market.
Now let’s turn to the other major issue facing global markets right now, Europe’s energy crisis.
Global superpowers battle over energy
Geopolitical tensions are now well and truly back at the forefront of investors’ minds as Russia threatens to cut all gas to Europe.
We knew Putin had a powerful card to play if he felt cornered by the West. Now the proposal from the G7, led by the US, to cap the price paid for Russian oil has triggered Putin to play that card. Russia has cut off all gas flow through the Nord Stream 1 pipeline, resulting in supply to Europe now falling below critical levels.
If Europe follows through on its additional proposal to cap the price of Russian gas, we expect all other Russian pipeline routes to be cut off.
Europe can’t have its cake and eat it too.
At the same time, higher demand for LNG from Japan, Korea and China to build their own storage in advance of winter is affecting Europe’s ability to plug this ever-growing gap in energy supply.
Consequently, European energy prices have ratcheted up. At around €500/MWh, German baseload power is 10x its historical norm. The European Commission has wasted no time proposing a maximum €180/MWh revenue cap on all non-gas power generation, which covers about 80% of power gen in Europe. This proposal will see revenue earned by non-gas power generators above the cap clawed-back by the government and distributed to support consumers, and gas generators may see a temporary levy on surplus profits. Policy makers estimate this could amount to around €140b in support to consumers and it provides greater certainty to generators around the ambiguity of a “windfall tax”. The plan also includes a proposed mandatory 5% reduction in peak electricity demand. The European Parliament is expected to finalise the proposal by the end of the month.
Supply and demand for energy in Europe remains very delicately balanced through winter 2022 – peak annual consumption – meaning adverse winter weather could have an outsized impact on energy availability.
We don’t think it’s all doom and gloom though:
- Gas storage levels in Europe have been building in advance of winter. Member states have reduced demand in line with the European Commission’s directive to get to 90% storage fill by November e.g. Germany gas storage facilities are at over 80% capacity.
- Alternative fuel sources are being sought e.g. fuel oil, and
- Rising energy prices have led to incremental demand destruction as non-profitable, low value add industries shutter capacity e.g. nitrogen fertiliser, aluminum.
As Europe fills the void of Russian gas, it will come with a price tag. We estimate 2 – 4% of GDP.
Given the extent to which the weather remains a key yet unpredictable variable, the range of outcomes is wide. On a 12 – 18-month view, Europe is building additional regasification terminals to increase LNG imports to feed the gas between member states, as well as using alternative energy sources were possible.
Exposure to European stocks may feel uncomfortable. But at 12x forward earnings the market is already pricing in a tough scenario around energy. Our European exposure is focused on multinationals – leading franchises that generate revenue and profits globally and aren’t dependent on just the European economy.
Stock in Focus: TotalEnergies (EPA: TTE)
Oil and gas major TotalEnergies generates around half its upstream profits from natural gas (predominantly LNG) with the other half from oil production.
In the short-term the company’s scale position in the global LNG trade (as a producer and merchant) will benefit from higher imported gas/LNG as the European bloc strives to plug the gap from Russian gas. The outlook for Total’s oil business also looks positive heading into the northern hemisphere winter, with gas to oil switching bolstering aggregate demand despite weakness in other areas of the economy.
Over the longer-term, however, the company is focusing on lower-carbon fuels, recognising the role of gas as a transition fuel in the coming decades. Approximately half of its capital expenditure will be allocated towards LNG, renewables and new molecules (hydrogen, biofuels). By the end of this decade TotalEnergies’ oil business is expected to shrink to 30% of sales versus 50% from gas, with the rest from electricity and biofuels.
The company is currently priced at 7x next year’s earnings assuming an oil price of $80/barrel.
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