Markets hit a bit of to and fro
20 August 2021
Investors would be forgiven to think that this week’s downdraft in global stock markets was in reaction to the rapid unfolding of the tragic events in Kabul, Afghanistan. However, as long-time observers of risk asset markets will attest, unless human tragedies are likely to have a discernible impact on the global economy, stock markets do not show any empathy to present or foreseeable human suffering.
The fact that global equity and commodity markets gave back this week most of what they had gained since the beginning of the month was driven by a combination of bearish headlines about the COVID-19 Delta variant and economic data continuing to disappoint after the exceptionally strong June figures. In the words of our economists, the economic recovery has hit an ‘air-pocket’ – doubts over the further sustainability of the recovery are creeping in, while fiscal bridging support is being phased out without structural fiscal infrastructure programmes having yet begun.
Overall though, we believe supply chain difficulties are the major driver of the slowdown. So it would be tempting to think the unfulfilled demand will remain just that, pent up until the supply comes along. The trouble is that everything is circular (which is really the point of classical economics); demand affects supply affects demand affects supply, and so on.
If workers in a car factory are stood down because there are no semiconductor chip deliveries, they will feel comfortable with a day’s lay-off, even a week. Beyond that, they will be increasingly uncomfortable about the ongoing security of their jobs and income.
If the chips are delivered at half the previous pace, and at twice the price, the car company may want to raise its prices. Demand was strong three months ago, but now workers are feeling less secure (especially their own) and not so ready to spend, especially if the cars are now more expensive.
Shocks and adjustments are basic economics (the supply-demand curves, originally applied to asset prices and the availability of loans by Maynard-Keynes). The conclusion that a sustained supply shock results in higher prices and less demand is unsurprising, so why are economists seemingly so surprised about the weakness now? It is probably because this is a supply shock which is of an unprecedented nature. Not the usual regional affair, but instead a global shock in a globalised world. It has continued for longer than most had bargained for, even if the virus’ public health impact has being much reduced by vaccinations. And now COVID-19 has swung back to where it started – Asia. The renewed regional lockdowns there may be partial but they are hitting South-East Asian manufacturing and shipping yet again, as out-going deliveries should peak for the winter holiday season.
Yesterday Bloomberg reported a partial shutdown at the world’s third-busiest port in China, which risks further disrupting global supply chains and maritime trade. Bloomberg suggests congestion is up about 60% at the ports of Xiamen and Shainghai/Ningbo in China. Shanghai, Zhejiang province to the south and Jiangsu to the north are all large manufacturing hubs, the Yangtze delta being a major gateway for goods to the rest of the world. Factories there produce auto parts, electronic modules and chemicals used in various industries.
With continued pressure on shipping prices, it may seem odd that the week’s European-wide consumer price inflation (CPI) data surprised by being lower than expected, and the UK is providing a good example of what is happening in the wider world. For example, July CPI was 2% year-on- year, well below the June reading of 2.5% and the expectations of around 2.3%. Some of the decline in the rate-of-change can be ascribed to the basic math of ‘base effects’, which implies the readings should decline after a sharp rise in price levels in the second quarter.
However, retail sales also tell a story of price rises eating into both spending power and consumer confidence. By volume, overall retail sales dropped back by about 2.5% from June, whereas consensus was for it to be unchanged. And the GfK consumer confidence indicator dropped back relative to the previous month, the first decline since January.
Of course, the adjustment processes go in phases. So, under most scenarios, it is likely the supply disruption will probably be over before jobs are actually at risk. That is partly because employers have been reminded that finding workers is difficult, as UK jobs data continues to show. Indeed, part of the supply chain disruption is down to that very fact. The payroll data showed a strong July increase in employees of 182,000. Job vacancies have also been climbing as the chart below shows:
But for stock markets, we have hit an uncomfortable point. Confidence over growth remains strong, but the timeline for when this growth happens is being pushed out again. That means corporate earnings estimates for this year (and probably for next year) are going to be under pressure. Analyst estimates have just been through the usual review process after the very strong first half results, but now it is quite likely they will be pulled back – with some of this again being driven by the base effect. Relative to where real yields in fixed interest bond markets are, equity market valuations are not expensive. They could even be said to have become cheap as earnings rose but yields came down over the past months. However, when earnings expectations decline, this can change quickly, meaning equity markets could have a bumpy ride, as we have seen this week.
The good news is that economic data also tells us the current demand adjustment to the supply disruptions should be just that: an adjustment, not a shock in itself. This week’s UK employment figures showing almost one million job vacancies in July also tell us that the discomfort of temporary supply shortage-induced lay-offs may be far more limited than usual, which should further reduce the risk of the economic cyclicality dynamics mentioned at the beginning. In other words, as long as the supply constraint dissipates reasonably soon, we should resume the upward path later, and with markets cheap enough to benefit.
The car industry is one of the most-watched sectors at Tatton. A bit like the property market, the goings on in the automotive sector have wide-ranging effects on all parts of the global economy, from manufacturing and technology to credit and consumer spending. This makes it an important sector from an investment perspective.
In recent years, though, the world of autos has been incredibly hard to call. Changing emission standards, particularly in Europe, have had a big impact on manufacturers – not to mention the upheaval of the Volkswagen diesel emissions scandal some years ago. In the background is the move to greener technologies and the rapidly accelerating switch to electric cars. More recently, the global microchip shortage has seriously hampered supply – leading to some unprecedented price moves in the used car market. This is before even considering the massive distortions caused by the pandemic.
Such factors have made car sales moves extremely unpredictable. But those distortions aside, the autos sector will likely be an important indicator for the wider global economy in the months ahead. This is because the fate of carmakers is heavily intwined with both cyclical and structural changes. On the cyclical side, the pandemic has impacted both supply and demand, though the scale of that impact remains to be seen. On the structural side, cars are a central part of the move to a greener economy.
Let’s take these in turn. In one sense, the pandemic has given a relative boost to car demand. With the virus still spreading around the world, people continue to avoid public transport and hence are much more likely to buy a car. This is particularly pronounced in China – the world’s largest autos market – while the figures in Europe show a much smaller effect.
On the other hand, car sales have recently fallen disproportionately to wider consumer spending patterns. Global autos sales fell 2.5% in July, the third consecutive monthly drop. This puts sales down 12.3% from their peak in April, and 11.4% lower than pre-pandemic levels. Rising fuel prices and lockdown restrictions this year may have impacted consumer demand.
The bigger impact, though, is clearly on the supply side. In the early stages, this was due to the shutting down of production. Now, the global microchip shortage is perhaps the biggest problem facing carmakers. Manufacturers are still struggling to get the required parts, and Toyota announced a 40% cut in production in September, equating to about 340,000 fewer cars being produced, while Volkswagen announced it would extend its summer break .
We tend to think of supply shortages as being inflationary, and therefore supportive for producers, but these supply problems highlight an important point: supply constraints not only push up prices, but also lower overall output, which therefore has a negative effect on real growth. Falls in car production, for example, have been more pronounced than falling sales. Output declined 11.5% in the first half of the year, while sales had a more modest 8.5% drop. Meaning that there has also been a significant fall in inventories across the US, Europe and Asia.
The supply imbalances have led to a broad uptick in autos inflation this year, despite weaker demand. This suggests the underlying demand for cars is still there, and consumers are just waiting for supply problems – and hence prices – to ease. As we recently pointed out, supply bottlenecks like the infamous chip shortage can have a profound effect on the global economy, but they are ultimately transitory. They will wash out over time, and we should expect both production and sales to increase when they do. As such, the troubles for carmakers could well just mean a delay in output rather than a slump.
The structural changes mentioned before are not so temporary, however. Governments and businesses around the world agree the autos sector has to change, with a quick phasing out of fossil fuel powered internal combustion engine (ICE) cars. For manufacturers, the challenge is how to manage existing production of ICE while also investing heavily in electric. Stopping the former would lead to a loss in well-established streams of revenue. Not being quick enough on the latter would mean losing out to newer companies (like Tesla, now the world’s largest autos company by market cap) in the long run. Juggling both at once is expensive in the short run.
Demand for fully electric vehicles is currently still not enough to support the whole industry. A big part of this is likely the uncertainty facing consumers. Technology is evolving rapidly, with little clarity on regulation, and consumers fear being stuck with the car equivalent of Betamax. People are aware that cheaper, and perhaps cleaner, options will be available in the years to come, and are reluctant to buy in the meantime.
There are significant uncertainties around the future of the autos sector. Part of the structural changes might well involve a secular shift to less driving altogether, and more autonomous vehicles are likely to become more important in the coming decade. Some reports even suggest that hydrogen-powered cars (ICE and fuel cell based) could overtake battery cars over the next few years.
These questions put downward pressure on demand, and that pressure will likely stay at least until policymakers give more clarity on regulation. A clearer outlook on the legal framework is essential for shoring up both supply and demand. Moreover, even if recent announcements on phasing out ICE cars gives more clarity than other polluting sectors have, the question remains how the sector will adjust to such a deep transition. Producers need to know what standards they should build to, and consumers need to know their purchases will not become obsolete in a few years’ time. The shorter-term supply issues should improve as we head into the end of the year – and there is enough underlying demand to see a boost. But the longer-term picture is still firmly in the distance.
Dirty metal gets an ESG reappraisal
The metals sector is hardly known for its environmental reputation. Activities like steel production are synonymous with towers of smoke from polluting factories. The mining and refining processes are both extremely energy and resource-intensive, and the industry directly accounts for a significant chunk of global emissions. Looking at this direct carbon footprint, those engaged in ethical or environmental, social or governance (ESG) investing might be avoiding the industry altogether.
That would be a mistake, though. Metal miners and refineries are crucial to the green revolution, both in terms of reducing their own emissions but more importantly, helping reductions across the global economy. After all, one cannot make wind turbines, batteries or electric cars without a whole host of metals. To achieve the 2050 decarbonisation target laid out in the Paris Agreement, a big chunk of demand for metals is all but guaranteed. Governments will therefore need metal production to keep going in the most sustainable way it can.
According to Citi Research, the 16 main metals markets could be at the heart of the reduction in global emissions over the next 30 years. In its ‘rapid electrification scenario’, Citi estimates that the incremental tonne of metal produced through to 2050 lowers green house gas emissions by 170 tonnes of carbon. It calculates this by forecasting the effects of green technology and subtracting the direct emissions from metal production – essentially working out the net emission reductions that metals allow, then subtracting the amount they directly produce.
Breaking down these figures, Citi forecasts that net emissions for individual metals markets will be net negative for each metal bar one over the next 30 years. Steel, being a huge direct emitter, is the only industry that does not come out as net carbon negative on its analysis.
As Citi point out, it is difficult to base any strong conclusions on this. Decarbonisation technologies will combine all of the major metals, technologies that would not be possible without a single one of them. To put it another way: Even if a wind turbine is 99% steel and 1% other metals, that does not mean steel accounts for 99% of the emission reductions from the turbine. After all, the turbine would not be possible without all the metals combined, regardless of relative weightings.
So, Citi also calculated the net effects of each metal industry by working out the value of its production growth over the next 30 years. On this basis, all metals – including the supposedly dirty steel and aluminium – drive a huge reduction in forecasted emissions. On this calculating method, steel turns is the biggest contributor to decarbonisation by some distance. This is purely because the steel industry is so big, accounting for most of the forecasted production growth.
These statistics are complicated and somewhat flawed, as Citi researchers readily admit. For example, the comparisons of total impact on emission reductions to direct pollution misses out all the other emissions that metals enable. But they suggest metal production is not a straightforward ‘dirty’ industry. This is important from an investment perspective. If an investor wants to use their capital to best bring about positive change, how do they deal with ‘dirty’ industries that are nonetheless essential to the green movement?
There is no simple answer, but there are a few points worth making. First, any assessment of metal production’s real environmental impact needs a good estimate of how much demand is needed to achieve decarbonisation elsewhere. We can accept some amount of dirty production for the greater and greener good, but we want to ensure no more than the required amount is produced. For investors, this would mean avoiding those areas of metal production tied to further emitting industries.
Second, accepting that metals are needed does not mean accepting industry practices as they are. Reduction of polluting practices in metal production is a crucial part of the green movement. Technological improvements are already happening in this respect, and we can be optimistic of more in the future. These could come from advances in recycling of battery materials or so-called ‘green hydrogen’ in steel refining.
Crucially, this is where investors can have a big impact. We have written before about the dangers of ‘brown spinning’ – where companies sell-off their heaviest polluting parts to private equity groups that continue to emit out of the public eye. This is a particular worry for the metals industry. If ESG investors boycott heavy-emitting companies like steel producers, only for those to be bought by less environmentally-inclined private equity groups, production will continue just as dirty as ever.
Greener improvements are possible in metal production, but these will not be pursued by opaque private owners interested in cutting costs. Given how important metal is for the decarbonisation agenda, it will need to be produced one way or another. ESG investors rightfully want to put their money where it looks greenest, but making an impact through investment is about more than looks. Those investors who engage with these companies stand more chance of influencing them toward cleaner production. Metal production is crucial in achieving reduced emissions in the future and is therefore here to stay – but with the right incentives it does not have to stay the way it is.
Please note:
Data used within the Personal Finance Compass is sourced from Bloomberg/FactSet and is only valid for the publication date of this document. The value of your investments can go down as well as up and you may get back less than you originally invested.