Daily Comment (September 9, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about the raging energy crisis in Europe. Next, we give an overview of stories that show that the world is still adapting to a new normal. We end the report with our thoughts on the latest central bank developments.

Russia’s Energy, Europe’s Problem: The risk of a deep European recession remains elevated as countries grapple with finding alternatives for Russian energy.

  • Some countries have ignored calls for price caps and cooperation as governments struggle to compensate for Russian energy loss. The latest threat from Moscow to halt shipments has made the situation worse. Vulnerable countries such as Germany and Austria admitted that they were reluctant to back the price caps due to their dependence on Russian energy. Germany attempted to reduce its reliance on Russia by securing gas-sharing agreements. However, neighboring Belgium, Luxembourg, the Netherlands, and Poland failed to sign off on the arrangement. The lack of coordination among countries undermines European unity and may cause fractures within the bloc.
  • The White House’s plan to supply Europe with gas angered U.S. lawmakers. The Energy Information Administration forecasts the natural-gas spot-price will be $9/MMBtu this winter. Although the cost is cheap for European buyers, it will drastically increase energy bills for U.S. households. Governors of northeastern states have informed the Biden administration that they would prefer that the U.S. keep its gas domestically as the country copes with elevated inflation. The rising politicization of gas shipments in the U.S. could exacerbate the energy crisis in Europe.
  • As energy markets brace for a supply crunch in the winter, financial instability remains a risk. An ECB review of bank vulnerabilities to a potential surge of company defaults is underway over concerns that gas stoppage could strain the financial system. Earlier this year, the central bank warned traders that it would not provide emergency funding to bail them out in a crisis. The lack of support threatens the financial system because utility companies reliant on energy futures will be desperate for cash to cover shorts and meet margin calls. As a result, exchanges are now demanding more collateral to protect against a possible default. Although a potential cap on prices could help relieve some of this pressure, the ECB and governments may still need to get involved in ensuring that financial institutions remain liquid. As a result, we think the chance of a financial crisis in Europe remains a distinct possibility if immediate action is not taken to address ongoing issues.

 A Whole New World: The post-pandemic world is still taking shape as countries work out the best pathway forward.

  • After 70 years on the throne, Queen Elizabeth II passed away on Thursday and will be succeeded by Prince Charles of Wales. The country will spend the next ten days mourning the death of its oldest and longest-serving monarch. Her death will likely delay the new government’s effort to implement its energy agenda.
    • Additionally, with the country distracted, the Truss administration might use the time to clean house. U.K. Treasury official Tom Scholars was sacked as the new Truss administration looks to refocus the finance ministry away from financial prudence and toward economic growth. The overhaul will likely pave the way for Truss to implement her new policies that lower taxes and push through her £150 billion energy plan.
  • Wheat prices jumped over concerns that Turkey and Russia might scrap their grain deal. Turkish President Tayyip Erdoğan and Russian President Vladimir Putin have criticized the arrangement as benefiting wealthy nations and not developing countries. The leaders have advocated that Russia should be allowed to export its grains. Although food sales have been exempted from sanctions, many shippers and bankers are reluctant to do business with Russia. As a result, the wheat export has benefited Ukraine at Russia’s expense. The deal is set for 120 days, and markets are sensitive to any news that the agreement could collapse.
  • Firms are forced to choose between the U.S. and China as politicians are determined to force a decoupling. On Thursday, Apple (AAPL, $154.46) faced scrutiny from republican lawmakers over its decision to use Chinese-made semiconductors for its new iPhone 14. The attack on Apple reflects the growing animosity among U.S. lawmakers toward companies doing business with China. This political pressure will dissuade many companies from setting up supply chains in rival countries and accelerate a push toward deglobalization.

Central Bank News: Stocks rallied, and bond prices dropped after the Fed Chair’s hawkish comments and the European Central Bank’s historic rate hike.

  • Stocks closed higher on Thursday despite hawkish Fed rhetoric. On Thursday, Federal Reserve Chair Jerome Powell reiterated the central bank’s intention to raise interest rates until inflation drops to the bank’s 2% His comments reaffirmed expectations that the Fed will raise rates to 3.25% at its next meeting. Surprisingly, equities rebounded following Powell’s perceivably bearish comments. The rally was related to short-covering as investors grew confident that the market had already priced in a 75 bps hike. So far, the market anticipates that the Fed will lift rates to 4.00% by the end of the year.
  • There was a sell-off in Eurozone bonds after the ECB raised rates by a record 75 bps. The rate hike pushed German two-year bond yields to 1.37%, its highest level since 2011. The spike in yields reflects European interest rate expectations, hence the market believes the ECB is far from finished. During Thursday’s press conference, ECB president Christine Lagarde acknowledged that the benchmark rate’s jump signaled to markets that the bank was committed to the inflation fight and hinted that another jumbo hike could happen at its next meeting.
    • The yield spread between the Italian and German 10-year bonds, a measure of European financial stress, narrowed after the rate hike. The decline in the yield gaps suggests that investors are confident that the bank is prepared to intervene in bond markets in an emergency.
  • In China, data from the People’s Bank of China showed that financial institutions are not lending. Although demand rebounded from a low in August, credit growth remains anemic as households are cautious about taking out new loans. This lack of credit circulation throughout the real economy, even with easy monetary policy, has added to concerns that the country is in the midst of a liquidity trap. If correct, this could mean that China will struggle to achieve robust GDP growth over the next few years.

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