18th October 2021

Market Update

While the summer months passed with little incident, the onset of autumn has brought with it a distinct chill, as several threats conspire to knock markets off the consistent recovery path that they have followed since the trough of the COVID recession. While previously noted that it would be unrealistic to expect equity markets in particular, to continue to deliver positive returns at such a phenomenal rate, we also recognise that such periods of greater volatility can be unnerving, particularly when accompanied by predictions of much steeper declines. There are also concerning issues of the day, namely the extraordinary squeeze in the market for natural gas and the potential for tighter monetary policy.

When energy price rises start to make headline news, it makes for uncomfortable reading. Economic recessions in the 1970s, early 1980s, early 1990s and even the financial crisis itself, were all associated to some degree with a rising oil price, even if the circumstances of each period were different. The first three examples resulted mainly from supply disruptions in the Middle East stemming from political unrest across the globe. The latter was more a function of very strong demand, notably from China as it grew rapidly, even if, the financial crisis was ultimately triggered by an unwinding of the leverage in the American property and financial sectors.

There are two separate issues to consider when it comes to the effect of energy prices. The most immediate is the fact that, in an unchanged income environment, higher prices divert spending power from other goods and services, and, indeed, from savings. It is a bit like a tax rise that has a dampening effect on overall activity. To some degree the world has been shielded from the worst effects of higher oil prices when they did prevail in recent decades, thanks to the fact that the energy intensity of the global economy has declined. This was a result of  improved fuel efficiency and a greater share of activity being driven by services. Furthermore, a growing share of electricity generation has been from renewable resources, such as wind and solar, as well as from cheap, abundant natural gas. The latter, while still being a source of carbon emissions, has been viewed as a suitable fuel for smoothing the transition to a less carbon-intensive world.

However, we are now discovering the downside of becoming more reliant on natural gas, as burgeoning demand from re-opening economies has run into supply constraints. Even if these constraints appear to be relatively cyclical, the dash for scarce resources to keep the lights on has resulted in an epic price squeeze, with the price of gas multiplying several times this year. Inventories, which were not fully replenished following last winter, are much lower than normal; current supplies from the United States were disrupted by Hurricane Ida; cargoes of liquefied natural gas usually bound for Europe have been diverted to higher bidders in Asia; and the UK, which has seen a bigger squeeze than anyone else, has suffered its own specific problems. All of this before we have reached the colder temperatures of winter, with natural gas being the main source of fuel for central heating boilers. One important lesson to arise from this episode, is that the transition to a cleaner energy world is unlikely to be straightforward. Disappointingly, we might well see backwards steps being taken as electricity generators switch to using oil and coal as less costly fuels. Even so, the underlying trend should remain towards carbon neutrality.

However, these energy price spikes pose a major conundrum for central banks, whose policy pronouncements will now take on even greater significance. The US Federal Reserve and the Bank of England have recently made it clear that tighter monetary policy is coming sooner rather than later, initially in the form of a running down of asset purchase programmes, to be followed later by higher interest rates. A handful of central banks, including those of Norway and New Zealand, have already taken the first steps in raising interest rates. These moves are currently characterised as a shift away from the emergency settings of the COVID crisis, which we might describe as taking the foot off the accelerator rather than slamming on the brakes.

However, rising energy prices will become a major factor in further boosting consumer price indices at a time when other supply chain experience disruptions – ranging from shortages of computer chips to a lack of container shipping capacity – resulting in prices being forced upwards. Worries will be compounded by labour shortages in several sectors of the economy. Brexit is partially to blame in the UK, but it is clear from the experiences of many other countries that there are widespread skills gaps, and that many employees have re-evaluated their lifestyle choices during COVID, with some exiting the labour market permanently.

While governments are happy to promote higher wages as a source of greater spending power, central bankers are eyeing the risk of the development of a wage/price spiral which leads to more persistent, higher inflation. For now, the majority of central banks continue to stick to the “transitory inflation” line, but the risk they face is that inflation expectations continue to rise and become stuck at higher levels. Should that persuade them to impose a more aggressive monetary policy response, then we face the prospect of reduced growth expectations.

The fact that this is all happening when Western economies appeared to be recovering from the worst effects of the Delta variant wave is, to say the least, disappointing. Although we never subscribed to a narrative of an extended period of unconstrained excess as we all celebrated still being alive, we were more confident that activity could remain at elevated levels as excess savings were released. While there is plenty of evidence of decent demand, the real problems are on the supply side of the economy. As long as these problems are temporary – and we believe that they generally are – then the ability of good quality companies to continue to generate strong returns in the long term should not be greatly compromised. Good companies still offer an opportunity for investors.

However, we cannot ignore the fact that short-term risks have risen, although much will depend on the willingness of central banks to tolerate a period of higher inflation, which will, in turn, depend upon the development of consumers’ expectations for future levels of inflation.

We continue to believe that investors who do not face immediate demands on their cash should remain fully invested for the longer term, whilst expecting the ride to remain volatile for the next few months.

If you have any questions regarding this update or your own financial planning needs,  please do not hesitate to get in touch on 0117 450 1300.