Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett discusses his outlook for markets and UK assets, in particular, following the appointment of new Prime Minister Liz Truss while Niall Gallagher examines the causes, current path and possible outcomes of the European energy crisis.

07 September 2022

David Dowsett – Global Head of Investments

A lot has happened over the course of the summer season. The best way to summarise it is by looking at the path of short rates and short government bonds. Focusing on two-year government bonds in most of the main markets, we saw an initial yield peak in the middle of June and then saw a 100 basis points (bps) rally in short rates until the end of July. Over the course of August and the beginning of September, we saw this reverse and short-dated yields are now almost exactly where they were at the low in equity markets in the middle of June. The first reason for this sell-off can be attributed to the current energy situation – particularly in a European context – which is examined in great detail below. The second reason stems from the Jackson Hole meeting at the end of August, which sparked discussions among global central bankers about prioritising the inflation fight even at the cost of a growth recession, if necessary. A final factor which will continue to be a feature as we move through the autumn, in our view, is uncertainty about the fiscal policy response to the growth recession and particularly the energy crisis. In the very short-term, we will likely see a key focus on what happens in the UK over the course of the next week as the newly appointed Prime Minister, Liz Truss, announces her new policies.

Expansionary fiscal policy in the face of the energy crisis, higher inflation and high debt loads raises uncertainty for global government bonds and risk assets associated with that. We expect this to continue to be a focus as September progresses.

In the very short-term, a 75 basis point hike is expected by the European Central Bank this week. UK assets, particularly government bonds and sterling, have been under pressure over the past two weeks. With the currency going down and yields going up virtually every single day, while not cause for panic yet, there is certainly discomfort. The hurdles for the new economic team in the UK are very high and the market does not at present believe that Liz Truss and Kwasi Kwarteng are likely to present a coherent response.

Niall Gallagher – European Equities

We are currently at peak bearishness in terms of European equities, with the energy crisis high on everyone’s agenda. Gas prices in Europe have increased enormously; they are trading at about 15 times the five-year average up to 2021. Furthermore, they are completely disconnected from gas prices elsewhere, particularly the US. On an energy equivalent basis, gas prices are trading at several hundred dollars per barrel of oil equivalent and electricity is even higher. In the short term, Russia’s invasion of Ukraine has caused a gas shortage in Europe, which has become much more gas centric over the last 10 years as nuclear and coal have been phased out and as intermittent renewables have been added. However, we believe Europe would have encountered an energy crisis as part of the energy transition even if the Russia-Ukraine conflict had not occurred. Europe needs to dramatically reduce carbon emissions over the next 30 years but there has been a lack of understanding among policymakers about how to do this.

There are a number of things that could help Europe reach a firmer footing regarding the energy transition. In the short term, a resolution with Russia would allow us to import Russian gas again. This, however, is highly unlikely as European solidarity with Ukraine is not about to break. Additionally, the French nuclear fleet is currently about 50% underutilised with significant numbers of their assets closed for maintenance; those operating at full capacity would help. A mild winter with lots of wind would also reduce the burden. But even if all these occur, Europe would still need serious demand side measures to reduce gas use, particularly in Germany.

Medium term, Europe needs a much more diversified supply of gas and to take energy security much more seriously. National governments could consider opportunities for fracking and developing gas reserves. As it stands it is difficult to see the EU phasing out gas usage in the next 20 or 30 years and so long-term contracts with producers in the US and Qatar would provide a long-term supply. There also needs to be a lot more renewable investment, with bottlenecks such as issues with transmission grids in Germany removed. We also believe that the transition to net zero is unlikely to happen without significant investment in nuclear energy. There is some consensus in most of Europe that nuclear is the future. There are also longer-term solutions such as modular nuclear reactors that can be adapted and industrialised for use in electricity generation and we believe we will see investment in this area.

Applying these views to European equities we believe a very significant pick up in capital expenditure is required. This will concur in conjunction with the transition to net zero as there are many areas where we see significant investment and the current energy crisis will accelerate the focus on these, in our view. There needs to be more investment in energy networks for security of supply which will benefit the oil and gas companies, but also some of the industrial companies that are supplying those value chains. One of the most important measures that we can take to reduce our energy demand is to invest more in buildings. For example, insulating buildings will make a huge difference to reducing energy consumption.

The final aspect to the current crisis is that oil and gas holdings are benefiting from the much higher prices. The prices will remain elevated for some time, and these companies will generate significant cash flows. Obviously, to maintain their social licence to earn those kind of profits they will have to invest heavily, particularly in renewables, and we believe they are likely to do that in terms of expanding into more renewables and low carbon technology which will be part of the long-term solution.

Overall, Europe is in a difficult situation economically. However, we think it is well understood and well discounted and while certain areas are likely to take material earnings hits from either having to curtail activity or from the impact of much higher prices, there are areas that would benefit from much higher levels of capital expenditure which will be required to make the energy transition plausible.