Gareth Gettinby: Growth risks greatest in Europe as conflict threatens winter gas supply
2022 was always going to be a tough year for the markets. The need to raise interest rates to counter inflation is due to a variety of pressures, including supply chain bottlenecks, the opening of economies after pandemic shutdowns, the unwinding of the pent up demand and the high levels of savings set up when people had nothing to do.
The Russian-Ukrainian war has added a total energy shock to the global economy, further increasing inflation and adding to investor woes.
As a result, most of the assets were sold and left few hiding places for investors. Since mid-June, however, risky assets have staged a remarkable rally as prices for many commodities have fallen, reversing much of the earlier gains.
This apparent “recovery” raised hopes among investors that inflation would slow. Additionally, a large consensus underweight in equities led to short hedge compression. This has allowed stocks to recoup half of their year-to-date losses since mid-June.
Investors are now wondering if the United States is in a recession or not. Recently, there have been mixed signals. Real GDP has shrunk for two consecutive quarters – sometimes referred to as a “technical recession”.
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On the other hand, the US labor market continues to grow at a healthy pace. Activity data holds up as the US services sector surprised in July, driven by improving business sentiment and new orders data, belying the argument that the US is in recession and are not headed for an impending recession.
This gives the green light for the Fed to continue raising rates in large increments while continuing to fight inflation, rather than slowing the pace of its monetary tightening activity, which the markets are looking for.
Fears of a significant slowdown are strongest in Europe and the UK. The coming winter promises to be gloomy, especially for consumers, as the cost of living continues to fall. Rising energy costs will continue to capture a greater proportion of revenues, further eroding investor confidence.
While the prices of many basic products are lower than they were at the start of the Russian-Ukrainian conflict, it seems that French and German electricity prices are reaching new highs every day; electricity prices are about six times higher than a year ago.
With rising gas prices and Putin’s threat to cut off gas supply completely during the winter, it is necessary to reduce our energy consumption. Last month, EU countries agreed to voluntarily reduce their gas consumption by 15%.
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The Spanish government has regulations in place – mainly for businesses – that place limits on the use of air conditioning and heating. While we may be in for a tough winter as gas prices continue to soar, changes in our energy consumption habits are likely to be long-lasting.
Where do we go from here? Any sustained rally in risky assets will be in question. The most obvious factor is the current geopolitical events, and in my opinion, a lot will depend on Ukraine.
There are a lot of prices in assets, both in terms of higher interest rates and strong earnings expectations. If we saw something in Ukraine that allowed energy prices to fall and food supplies to unblock, inflationary pressures could ease, reducing the need for central bank action. Consumer and business uncertainty could therefore ease.
But without this positive result, the outlook for the next 12 months is bleak. It will take a recession to reset inflation and the rise in inflation expectations.
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The outlook for businesses remains challenging. In recent years, central bank and government policies have stimulated economies, resulting in strong corporate profitability. The second quarter of 2022 was no different; overall earnings were strong, although the energy sector provided a strong boost.
So far, companies have been able to pass spiraling costs onto buyers or absorb those costs themselves. This cannot continue indefinitely and there are signs that consumers are starting to resist higher prices.
Thus, margins will be further compressed if inflation remains high for longer. Finally, many companies that have refinanced their debt in the low interest rate environment over the past two years will find it difficult to refinance their debt again at attractive rates.
In a context of high inflation and tighter financial conditions, the risks weighing on growth remain and caution is called for. The United States should do better than Europe and quality companies should do better than those that are very sensitive to economic conditions.
Gareth Gettinby is an investment manager at Aegon Asset Management