What the hell is happening? July 2022
What the hell is happening? July 2022
Energy narrative is burning out. From inflation to recession. When pivot?
This is the third post in the WTHIH series. The previous one was sent May 23rd.
In the previous WTHIH (What the hell is happening), we talked about the Fed’s strategy to bring down inflation and inflation expectations, and that the stock market would pay the price.
“Drastic times call for drastic measures. The Fed aims to bring down inflation even if it brings down the economy with it. It doesn’t matter if monetary policy can’t influence supply-chain disruptions or the price of energy via geopolitical events.
The Fed’s mandate is for maximum employment and price stability - and they aren’t ready to fail on the latter.
We have been in a two month sell off where seemingly nothing is safe, and Fed officials are piling on the hawkish messages on top.”
Is the Fed winning?
U.S 10-year inflation expectations are down 50bps since May 23rd, showing progress in the fight against inflation.
The U.S 10-year yield also peaked on June 15th, moving down materially.
Commodities peaked June 10th and are down ~15% on the CRB Index.
More recession sensitive commodities have fared even worse, with Copper down 20% in the past month.
U.S Natural Gas peaked June 8th and has almost halved since then.
The narrative for Crude Oil was extremely strong, but that also peaked June 8th and is done ~25$ in the past month.
Who suffered the most?
The last bullish theme standing was that energy prices would move higher and higher, enriching energy companies even further but destroying the economy in the process.
Oil is down ~17% since then. Energy stocks took the worst beating while stocks labelled as growth and considered very risky are either up or neutral during this period.
From the previous WTHIH:
Always know what you own, and know it well. The spike in volatility is bound to shake out the weak hands causing them to dump their shares at lower and lower valuations.
Remember the second hypothesis from the previous WTHIH article? The result was that well run businesses cannot be hurt from a change in Fed policy. But price matters.
Why sell something at rock-bottom valuations just because the Fed is trying to control inflation by hurting the stock market? They are at rock bottom for a reason.
And that’s because they have already priced in this future expectation. I am not saying that the stock market is at rock bottom valuations (far from it), but you better believe some stocks are.
Investors that dumped their growth stocks at the bottom to buy energy at the peak (XLE is down 30% peak to trough) have compounded their mistake and find themselves in an even bigger hole. Now, as they don’t know their positions well enough, they will possibly dump the bottom again only to watch energy stocks move higher.
*Note: some energy stocks are so cheap you can hardly lose money at these levels considering the cash they are generating.
A few words on Europe… 🇪🇺 🇮🇹 🇩🇪
I mentioned above that the U.S 10-year yield peaked June 15th, the same day the Italian and the German 10-year yields peaked too.
That was the same day the ECB had an emergency meeting of the Governing Council to discuss about the spread between Italian and German sovereign bonds blowing up and how the ECB would act to fend off possible fragmentation risks.
“Based on this assessment, the Governing Council decided that it will apply flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism, a precondition for the ECB to be able to deliver on its price stability mandate.”
The issue here is that the ECB decided to end net asset purchases of sovereign bonds (i.e. QE) and has signalled rate hikes. The market digested this policy change as dangerous for Italy and its massive government debt load.
What would happen if Italy falls into a recession and/or has to refinance its maturing bonds at higher and higher rates? The Greek nightmare is still alive in the hearts of Europeans so it didn’t take long for spreads (Italy Vs Germany) to blow up - spreading capitalistic fear all around.
So what happened?
EU leaders realised things are getting ugly for the EU and that they had to move, fast. They took the train to Kiev in a relatively unplanned trip, producing the headline below 👇
That was the headline, but what was the actual message to Ukraine’s leader?
“This war is going to rip us apart. We cannot continue supporting you if you don’t show a willingness to negotiate with Russia and end this war, now. Our industry will die without Russian energy. Our financial markets will completely breakdown and the domino effect will be fatal for the European Union. The euro is down severely agains the dollar and procuring energy is doubly expensive for us. This cannot go on.”
Financial markets started to digest all these seemingly minor events, hence the response in sovereign bond markets.
The Dollar 💰
The dollar is undeterred to current developments and is still up there, as the problems in the Yen and the Euro are much larger vis-à-vis the dollar. The Dollar index is currently at 107, a 20-year high.
News regarding the Nord Stream 1 pipeline together with recession fears and Bundesbank comments on the currently envisaged ECB anti-fragmentation tool are just making a large Euro position unpalatable for many.
My thoughts:
But will the ECB hike?
I strongly believe the ECB cannot postpone its signalled rate hikes and will decide on the first one July 21st. Yes the European economy isn’t great at the moment and the EMU suffers from a number of structural issues, but now is not the time to be selling Euros..
Doing so would risk putting you in a corner as things get tougher for the US, uncertainty fades in Europe and the war in Ukraine moves to a ceasefire.
Actually, the Euro is down 30% since the “Whatever it takes” line by Draghi. Now it seems Bundesbank’s Nagel is not ready to allow the ECB to become another BoJ and subsidise a country’s budget deficit by printing infinite amounts of money.
That is bullish for the Euro — NOT bearish.
The Italians (and other heavily indebted EU countries) are in this mess overwhelmingly of their own doing, and they will have to balance their budgets one way or another.
I expect a prolonged period of political turmoil for Italy, Draghi out as Prime Minister and Italy ultimately conceding to the EU institutions agreeing to structural reforms in order to keep the ECB’s support and their economy alive.
Another Procrustes Bed? 🇬🇷
Greece was unlucky enough to be the first EU member to need a restructuring - and the EU was not ready to handle that. Because of this lack of infrastructure and experience, Greece suffered greatly in the process.
I do not expect the same tragedy for Italy, but I am certain they will still need to cut and cut until they balance their budget.
No man is an island entire of itself; every man is a piece of the continent, a part of the main; if a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as any manner of thy friends or of thine own were; any man's death diminishes me, because I am involved in mankind. And therefore never send to know for whom the bell tolls; it tolls for thee. -John Donne