Admittedly it is not an easy task to produce a set of market expectations for 2022. There are now more moving parts and unknowns than almost any time that I can think back too, and this makes gleaning a clear picture of what trends might dominate global markets rather difficult. I have been very vocal in radio and television interviews about my views on the energy market. Those views are of course wildly bullish, based on a variety of factors, the most important of which is the severe underinvestment in ‘dirty’ energy over the last decade. There is more to the market than just oil prices though, so in this weeks edition of the weekly game plan, we’ll look at some of the other factors that could influence markets over the coming months.
Energy
Let’s start with oil prices, since that’s mentioned in the introduction. We’ve seen over the last several years that there has been almost no investment into oil and gas exploration. So much emphasis has been placed on ESG and sustainable investing in renewable energy that almost no institutions want to be seen funding ‘dirty’ fossil fuel based energy projects. That’s great and all, that we are trying to move to a greener more sustainable future, and that is probably something that we desperately need to do faster rather than slower. However, with the craze (and almost hysteria) around ESG and sustainable investing we’ve lost sight of reality. Green energy production do not (at this stage) generate enough power to sustain the ever growing demand for energy that we are experiencing. That in itself should be a strong enough case for higher oil prices as supply and demand is essentially how price formation takes place, but it’s not the entire story.
In recent months we’ve seen this shortage of traditional fossil fuel based energy like oil, natural gas and coal lead to some extraordinary price increases for electricity in the northern hemisphere. This was spurred on a little bit by a colder than usual winter (which is not over yet). In a nutshell: underinvestment in traditional energy has led to a situation where we are either going to run out of energy, or are going to have to reinvest into the ‘dirty’ energies in order to make it through the two decades. Demand for energy might have been temporarily derailed, but overall it is only ever going to keep growing. The gruff dirty fact here is that green energy cannot (yet) sustain our current demand, not to mention what demand might be like in 5 or 10 years from now.
This leads me to believe that a number of different things will happen. The first is that we’re going to continue to see higher and higher energy prices, particularly that of oil, natural gas and coal. The second thing is that we’re probably going to see nuclear energy be painted green by the ESG brush. The nuclear space had experienced a lot of backlash after the Fukushima disaster as that awakened memories of Chernobyl. We’ve seen countries shutting down nuclear power stations all over the world, in fact Germany has shut down two power stations very, very recently, right in the middle of an energy shortage and the highest energy prices (in Europe) in history. When I say that I expect nuclear to be painted green, I think that we’re going to potentially reach a point where oil (and other fossil fuel) prices are so high that we have to start looking for alternatives (other than begging the Russians and Saudis to ramp up production). Thus, I think we are likely to see countries make the decision to either turn their nuclear reactors back on, or to build new ones.
Omicron and China
Another major driving force I think is probably still going to be COVID-19. I hate to say it but, almost every macro analyst you can get your hands on at this stage are all forecasting a very similar scenario. One in which the Omicron variant is less severe yet more viral. Thus it spreads very, very rapidly across the globe, but is far less severe and thus ushers in the end of the COVID-19 pandemic. This paves the way for a return to ‘normality’. This is a scenario that is admittedly highly likely, however what is concerning is that so many people out there is calling the same thing. Which makes me believe that when everyone is thinking the same thing… nobody is really thinking.
China is case in point; we’ve seen them release some economic data recently which shows that their economy is starting to stabilize. GDP growth rate for the whole year in 2021 was a solid 8.1 percent, so we’re approaching that ‘normal’ level of double digit growth and we are seeing manufacturing output increase. We see that the energy shortages that they had late last year due to some coal shortages is largely out of the way as they prioritized production of coal and focused that output locally in order to stabilize their electricity production. We’ve also seen that the vaccines do have some value in preventing serious illness. While it might not stop you from catching or spreading the virus, it may protect you from being severely, severely sick from it and that obviously is a good thing. However, the Chinese version of the vaccine is not as effective or efficient as the western version of the vaccine. Combine that with a zero-COVID policy and you have a situation where potentially the Chinese government could overreact to the Omicron variant and go into another nationwide (or large multi-regional) lockdown, which could again put severe constraints on manufacturing production and supply chains. That scenario would obviously set us back quite significantly and therefore is one of the bigger downside risks. If (or when) countries with zero-COVID policies don’t allow Omicron to spread through their population and try to ‘manage it’ very, very strictly by locking people down, obviously that will prolong the disastrous economic fallout that we have seen thus far.
In the case that does not happen, then yes, I agree, China is turning the corner and looking like it is going to be the first one out of the starting blocks in the race to ‘full economic normalcy’.
Inflation and consumer spending
This leads us to the next factor, which is inflation and how the Fed deals with it. In the past I’ve been in the camp of ‘inflation is not transitory and is here to stay’. Now I’m not really sure which camp I’m in anymore, as trying to forecast what is most likely to happen is challenging. On one side you have inflation that’s essentially being driven by the change in consumer spending behaviour, and on the other you have supply chain and manufacturing production constraints… both brought on by COVID-19 and the subsequent economic fallout caused by it.
To explain; we’ve seen that because of COVID-19 (and lockdowns) many people are working from home. Being stuck at home with nowhere to go has made people around the world spend less money on things that fall within the services economy, like going to restaurants, or having a haircut. Conversely, what they have been spending money on is goods. They have been buying cars, clothing and electronics. There was even a brief moment where spending on pet accessories went through the roof, because everybody was home and suddenly everybody’s doggo needed a needed a jersey and a pair of sunglasses.
We know that fads come and go… but now we’ve been in a situation where people have been stuck at home for two years and the fad has been ‘well if I can’t spend the stimulus money that I’m getting on services like going out to restaurants or traveling, I’m going to spend it on goods like cars and electronics’. This creates a shift in demand away from services and towards goods. Now combine that with supply chain difficulties and lockdowns, and ports being closed, and ships getting stuck in canals, and you have a situation where you have severe bottlenecks. Now you have higher than ever demand for goods, with production not managing to keep up because all the factories are closed and transportation is an issue. Obviously this is going to lead to inflation. But on the other side of the coin, in the services economy, you have a recession. Restaurants are going out of business, barber shops are closing down, beauty salons are empty. The entire service industry is being crushed while the manufacturing industry can hardly keep up.
So as we enter into a phase where the pandemic starts to ease up and we start to see less restrictions to our everyday freedoms and people can start traveling and going back to their normal lives; what I think we have to pay very close attention to is how do consumers spend their money? I think we see a sort of a ‘normalization’ in demand on both sides of the equation. But the question is really; how long does it take for that normalization to take place? Because, during that process we might see inflation in the price of services and within the services economy. I think wage inflation will be a part of this drive in higher prices for services as labour is a vital input in the service industry. There is a labour force that is less incentivized to find work and thus demand higher wages, plus a possible surge in demand for services. Therefore, two very powerful drivers of price, both pushing higher.
At the same time, we now have deflation in the price of goods. Everybody wanted goods because they couldn’t have services, now that services are back, goods will be out of favour. Also the bottlenecks and production constraints are now mostly a thing of the past, so suddenly the market is flooded with goods that there is no significantly less demand for. This will most certainly create a picture (from an economic data perspective) of a recession in manufacturing while the economy tries to rebalance itself.
I think the question is really around ow the Fed interprets this ‘rebalancing’ and how it deals with it. They’ve done a good job at communicating their intentions and the time frames involved to the market. They’ve also alluded to the fact that they have more tricks up their sleeve if required. That said, I do think that they might have painted themselves into a corner and soon will be framing ‘higher interest rates’ in, well probably the light it should be. Interest rates are higher because (although severely warped) the economy is strong. They key difference here will likely be that they will stop the current stimulus (let’s just call is QE) and start to deleverage their balance sheet on a much faster schedule than with prior QE programs.
In conclusion
I think we are in for a volatile year. Honestly I do not know exactly which way this market wants to go. There are signs of massive distribution over longer time frames, which could indicate that ‘smart money’ is leaving the market. But then there is also the great wildcard of the last decade… the fact that people don’t really care about valuations or sustainability, as long as stonks go up and they can buy the dip.
For now, I think the best course of action is to position for higher energy prices and a resurgence of the ‘goods economy’. Dare I say it… we could see the return of value stocks. It’s going to be an interesting year.
That’s all folks
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