Market Commentary: Europe’s energy crunch | US inflation caught markets by surprise

16 September 2022
Stephanie Leung
CIO Office

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Watch Stephanie Leung, Co-CIO and Albert Kok, Deputy Country Manager, Malaysia discuss the latest global events and their potential impact on the markets and on our investment portfolios.

In this episode:

  1. Is Europe facing an energy crisis? [1:00]
  2. Could Europe be headed for a recession? [5:18]
  3. US August CPI numbers caught markets off guard[8:33]
  4. Why are bonds going the same way as equities? [17:20]


Albert | 00:01

Good evening and good afternoon to our different viewers all around the world. Welcome to our first live Market Commentary with StashAway here. This is where we talk about the latest developments in the market and we share our thoughts about them. So my name is Albert and I am the Deputy Country Manager in StashAway, Malaysia. We are joined today with Stephanie, who is our Co-Chief Investment Officer. And how are you today, Steph?

Stephanie | 00:30

I'm good. How are you?

Albert | 00:32

I'm good, too. Doing well. And it's been a very rocky, rocky ride for markets these past few weeks. And well, since this session is a live session, it's the first live session that we're doing. For those who are tuning in today, if you have any questions, please do post them in the chat box and we'll get back to you. Alright, so starting off for this live session, I want to zoom in on or focus on something that really took off or really held a lot of our attention at the start of the year. And that was about the Russia-Ukraine war. So besides the impact on humanity - lives were lost, there's also been a huge impact on the prices of various things that we do pay for. So things like energy, metals, food, which are inputs to various goods and services that we do consume. So we've seen prices like wheat, which are key exports out of Russia and Ukraine. We've seen prices of oil and fertiliser shoot up given the war itself. So this has had a big bearing on our daily lives and focusing more specifically on natural gas itself. There's, well talks, that there are concerns about a limited gas supply in Europe as a result of this war that's taking place in Russia and Ukraine. And so, you see some people are worried, some people are not worried, meaning those who are worried are saying that, okay, 40% of Europe's natural gas supply comes from Russia, so if this war deteriorates further, then there could be implications on energy demand and energy supply in Europe. On the other side, we also have people who are not so worried because they say, okay, gas storage levels in Europe are up to 83% of their total capacity, normally 80% is the minimum threshold. So given all these things that's been happening Steph, is this something to be worried about whether there could be an oncoming energy crunch in Europe itself?

Stephanie | 02:46 

Yeah, I think it's a very, very topical question. And obviously, the market has been paying a lot of attention to it. And if you read a news headline, you would see that Russia is threatening or there are signs that they will stop gas going through the pipelines into Germany. And this is aggregated by the fact that we're going into winter. So some of you may know or may not know about natural gas, LNG, is mostly used in Europe for heating in the winter. So there's a lot of talk about or concerns about, oh, Europeans will have no gas to go through winter. And that would create a lot of social problems, of course, and force politicians to reconsider their stance on the Russia-Ukraine war. Having said that, if we look at the data, as Albert correctly pointed out, what matters today is what kind of inventory level is present in different European countries. And interestingly, if we look at the inventory build up in the summer, it's actually been quite healthy. So despite all the headline news, gas has been flowing into Europe and as of today, Europe is actually at 83% of inventory and that is actually within the historical band of where the normal inventory should be. So, I mean, this year is not, I guess, particularly difficult compared to previous years. And actually the inventory level today is better than what we had last year in Europe. So barring an escalation of the Russia-Ukraine situation and then also a very, very cold winter, actually, Europe would have enough gas to get through the winter. And if you look at kind of also at one level lower in more detail, different countries actually have different exposures. So among the bigger countries, Germany, of course, has the most exposure to Russian gas. But France, UK or other more major economies actually have lower exposure in terms of Russian gas. So I guess when you look at the headlines, I mean, newspapers or the media like to just kind of put out all these very, very concerning headlines. But when you actually dig a little bit deeper, the facts are actually more supportive of a more normal situation.

Albert | 05:18

Yeah. Thanks, Steph. I'd like to build up on that point. You mentioned that winter is coming, right? So given sufficient supplies, there shouldn't be too much to worry about. But as what we've seen in the past few months also is that inflation in Europe has hit an all-time high. So it's at about around 9.1% reported in August itself. And if you look at Europe itself, it's heavily driven by energy spending, which accounts for roughly about 12% of Europe's GDP, compared to 5% of sales. So if winter does come and well, winter is coming, but if winter is coming and Russia actually limits the amount of gas supply to Europe, is that an issue? Could we see Europe enter a recession? Note that the latest GDP print coming out of Europe in the second quarter was about 3.9% and the forecasts are for it to be a bit lower going into the end of 2022 and to be growing at about 0.9% next year. So what are your thoughts on this, Steph, in terms of Europe entering a recession and also potentially higher interest rates coming out of it as a result of higher inflation?

Stephanie | 06:37

Yeah. So I guess even though we mentioned that, there has been an exaggeration of the gas supply issues. The major issue concerning Europe is indeed that the central bank needs to start hiking the interest rates. And in fact, I mean, we've seen the ECB hiking 75 basis points and that is both pressure from the rising inflation and also the fact that the Fed has been very, very aggressive in raising interest rates. In fact, I mean, this has been one of the fastest cycles where the Fed has raised interest rates. So then, I mean, the fact that the Fed has been acting so aggressively actually puts a lot of pressure on other central banks to act as well. And mostly, I mean, the ECB is hiking kind of in a more laggard manner, but it has to hike. The problem is that the US is actually in a much better economic situation than Europe in terms of economic growth and employment, etc., not to mention that the US is also independent in terms of energy production. So European policymakers in particular, the ECB, has a very, very tough job because they need to hike, but the economy is actually weakening. If you look at the Germany manufacturing PMI numbers, they have been weak for a number of months already and are actually in contraction territory. So what we're more concerned about is actually Europe going into recession and they will be going into recession ahead of a potential US recession and probably a deeper recession than what's going on in the US. So I think that is a major concern. And if you look at currencies, I mean the fact that the Euro has broken below parity actually reflects the market's concern on that as well.

Albert | 08:33

Yeah. So that's one of the big things too that we are seeing the Euro falling below $1 USD, which is a pretty huge matter given what's been happening there. So we've been talking about, you know, the various things, inflation, risk of recession in Europe and I want to shift gears a little bit towards the US because this week itself we had some pretty big news coming out of there. We had the inflation print for the US for the month of August coming in at about 8.3%. So this is the headline inflation whereas core inflation itself was up about 6.3%. So what's interesting about this is this all happened on the back of oil prices declining. And so we've seen at the same time, there's been a broad based increase in other goods out there, excluding oil itself. So when this data came out, I think it was on Wednesday itself, we had markets where they didn't really take this new piece of news very well. There was a big fall in markets. So what do you think? What are your thoughts on this, Steph? Could we see further rate hikes? We've seen predictions of 100 basis points potentially coming next week. So, yeah, happy to hear more about what you think about this?

Stephanie | 09:57

Yeah, I guess let's maybe take that question in several steps. So first of all, let's look at the data itself. So as Albert correctly mentioned, the headline number was actually quite stable from previous months, but it was the core inflation number that really caught people off guard. And if you look at what the market is concerned about is the month-on-month number on the core CPI. So in terms of the market's kind of expectation going into CPI number was that basically, inflation should peak sometime in 2023. And if you kind of put in different scenarios of the month-on-month number ranging from month-on-month growing at 0.1% to 0.2% or even to 0.4%, that would imply on a year-on-year basis that inflation should peak sometime in 2023 because of the higher base effect. However, the month-on-month number actually came in at 0.6%. So this actually blew past all the expectations. And if you do a projection of 0.6% month-on-month going forward for the next 12 months, you would actually not see inflation peaking in the very short term. So that was kind of the big mismatch between the market's expectation and the data that came out and what's causing all this very, very sticky core inflation? It's basically wages and also kind of other components, for example, housing. So I guess previously when we're looking at inflation, it was a lot of goods inflation because of COVID reopening and people kind of spending more money on buying goods. Now that's shifted to services, which actually puts pressure on wages, which is kind of the more sticky part of things. And this is what is driving the Fed to actually tighten because the Fed wants to tighten enough such that demand comes off and demands for not just goods but also for services will come off. More people will have to go to work, and that would kind of release the pressure on the labour side. And what Powell has made very, very clear is that the Fed is actually also data dependent. So the Fed's action is, depending on what the data says. And after the CPI print, actually the market inflation for the next Fed meeting had shot up instantly. And now we're pricing in, for example, a 30% to 40% chance of 100 basis points and for sure they will do 75 basis points. So what does this mean in terms of asset classes or markets? And of course, on that day, the S&P fell 4%, NASDAQ fell 5%. But I would also remind everyone to maybe zoom out a little bit. So if you kind of take a one week view, basically the market did nothing. It was a round trip because there was expectation going and building that the CPI may be a good number and it turned out that it wasn't what the market was looking for therefore the market fell again. And actually if you zoom out even longer on a 3-month time horizon, also the market didn't do anything and these equity markets kind of fell, in June there was a bottom and a rally back in July and the first half of August because of peaking inflation expectation. And now it's back to square one again. So where does it take us? Again, it's back to data. And I guess one month of data is too short to really say, oh, are we looking at peak inflation not coming in 2023 because the data can be quite volatile for a month-on-month basis and hence that is why the market is so nervous. That is why, for example, September and November are typically the most volatile parts of the year because a lot of important decisions are getting made. The Fed just came back from a 2 months break in terms of meetings, so you will see a lot of volatility. And I think the best thing to do is to just kind of maybe take a step back, don't look at it from a day to day basis but think about your long-term time horizons. Again, there's a few things that we've talked about kind of repeatedly, for example, understanding the risk, know that if the market falls, are you in the right risk buckets with your portfolios, stocks, and holdings and number two, understand if you have a long-term goal and you've set up like for example, a DCA or you like to set up a DCA to kind of reach your long-term goal, just stick to your goals. And I guess over the long term, as history has repeatedly shown, asset classes, markets, be it equities or bonds, tend to go up over the long term. So yeah it's, I guess it's a long answer to your question, but I guess these are interesting times, very, very sensitive times. The market is very, very nervous.

Albert | 15:03

We have a question that relates to what you just talked about here. So from one of the listeners, he asked "Given this hawkish stance that we're seeing from Jerome Powell on inflation, do we foresee another outcome of reoptimisation by StashAway to protect their portfolios for potential scenarios coming up?".

Stephanie | 15:25 

Yeah, so that is a great question. So the StashAway's reoptimisation is triggered by changes in the economic regimes and these regimes as a quick reminder are defined by growth and inflation numbers. And we monitor a range of economic data to determine where we are in the cycle. I guess as of today, the regimes are still in inflationary growth and particularly if you look at the US, I mean data is still quite strong. However, it's also kind of weakening. So it's on a deceleration path and at some point when the Fed tightens enough, the US growth numbers will start to deteriorate. And that is when a reoptimisation would be triggered either into a stagflation regime if inflation is still high or into a recession regime when inflation actually starts to fall with the slowing growth. Historically, stagflation regimes tend to be very, very short-lived because if you think about the Fed's action, the more they hike, the faster inflation and growth will start to come off. Because in a recession, it's very, very hard to get inflation because there's no demand for goods and services, people are out of their jobs etc. So that's why stagflation is actually a very, very short regime, which we expect to pass through, but could be quite transitory. But the reaction function is clearly that good news, a good economic news is actually bad news for markets because good GDP news or good growth data actually prompts the Fed to hike more and the market would then have to push back the expectation of when does the Fed start to reverse their monetary policy.

Albert | 17:20

Alright, I guess still staying on the topic about portfolios. We have a question here from Kartik, he's asking about bonds itself because our portfolios do have some bond positioning. We've seen bonds this year, they've suffered a major loss in portfolios despite them playing a role as a cushion inside them. So what are your thoughts on having bonds as a component in portfolios for StashAway?

Stephanie | 17:49

Yeah, so bonds historically have been a good protective asset most of the time, except for a very strong inflationary regime. And also the fact that, I mean, we're starting from a very, very low bond yield level. So this year, bonds have not been very good protective assets. In fact, I mean, bonds have gone down just as much as equities and bond volatilities have been very, very high. However, if you think about the Fed cycle, once they are successful in slowing growth, then the bond-equity relationship should revert to a negative correlation, meaning, when the Fed actually starts to tighten enough, the market starts to worry about a slowing economy. So in a slower economy, the Fed will start to actually loosen. And when the Fed loosens, the interest rate will start coming down. For bonds, when interest rates come down, bond prices would go up. So in that case, in a recession scenario, bonds will actually start to outperform equities again because during a recession, it's very hard for companies to make earnings. Some companies actually may not even survive. So for equity as an asset class as a whole, they won't perform very well in a recession. However, bonds will actually perform a lot better. So historically, what we've seen in the sequence of events, is that in a tightening cycle, both bonds and equities would suffer, but I mean, bonds should be the first asset class, especially the longer duration bonds, should be the first asset class to start to actually recover. So in that case, bonds would still be a good protective asset in a multi-asset balanced portfolio. And that is really dependent on, I guess, when the market will start to price in a turn in the monetary policy.

Albert | 19:51

Alright, so it seems like next week will be a big week potentially with rate hikes being announced. And I guess we have one of the questions here from escaladee89, so he's asking about, you know, what do you see are the prospects for the health care and clean/green energy sectors in the long run? So this is a little bit different. This is more specifically on the thematic portfolios that we offer here at StashAway.

Stephanie | 20:20

Yeah. So I mean, we have 4 thematic portfolios at StashAway and these are thematic portfolios because these are themes that we're quite excited about and optimistic about for the long term, long term meaning not just like 6 months or not even 5 years. It's kind of a 10-year time horizon or above. And if you think about the underlying thesis, for example, ESG or environmental, there is definitely a push for governments and I guess not just European governments, given the Russia-Ukraine war, but also globally. For example, the US just passed a climate bill. There's a push that globally governments and corporations should invest more in ESG and also climate-related investments in particular. So that is kind of what drives the underlying growth for the companies that helps to push ESG forward. And then also from an investor side, there's also a lot of push for big asset allocators to allocate to ESG-related investments as well. So you also have a demand for ESG investments. And then for health care, of course globally an ageing population is a big problem. And I think from the COVID experience, we've also seen that innovation in different kinds of medicine and also fields like biotechnology are advancing very, very quickly. And these are I mean, not just I guess not just one technology, but also a combination of different technologies. For example, I mean, AI is being used in drug research and that accelerates kind of the pace of a lot of different drug development and research, including the COVID vaccines very, very quickly. And that would for sure benefit the companies that are involved in these innovation areas. Hence health care is one growth area that we see sustainable growth. I guess also healthcare tends to be a bit more defensive within the equity space because if you think about it, it doesn't matter what kind of economic cycle we're in. We still need to see the doctors. We still need the vaccines, we still need all the supplements etc. So it is an area which is quite defensive even during a bear market. So I mean, those are two areas that we're quite excited about in the long term. And in fact, this year they have performed quite well.

Albert | 23:07

Alright, thanks Steph. So it seems like with all these thematic portfolios, the key is to have a pretty long-term time frame when you invest with them and also to know if those themes jive with your long-term beliefs or whether they could play out over time? Because the risk with all these themes is that we don't know. It may take time for adoption, some may fail, some may work or succeed along the way. So that is how you should think about thematic portfolios. We're coming to an end already because we are short of time. So that's really it. I know there's a couple more questions from people who are listening live, but we have to cut it short due to time constraints. So if you have further questions, please do write in to us and maybe for those who are interested next week itself, we are doing a webinar with BlackRock. So for those of you who may have heard or may not have heard, we launched the BlackRock portfolios very recently and so next week's session we will be doing one with BlackRock itself where they go through why every investor needs a broad market exposure portfolio. So that takes place on the 20th September at 7 pm Singapore Time. So if you are able to make it, we're happy to have you there, happy to hear from you if you have any questions for those sessions. But in terms of tonight's Live Market Commentary, our very first one, that is it for this evening. I really would like to thank everyone for dialling in tonight, for asking questions and I'd also like to thank Steph for taking the time to explain her thoughts on the various topics that we've just gone through, alright.

Stephanie | 24:53

Thank you, Albert for hosting and thank you, everyone, for dialling in. If you have any suggestions for us, please feel free to reach out to us via WhatsApp, email, or call us. So thank you and have a great night.

Albert | 25:05

Take care everybody. Goodnight.

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