Markets Weekly podcast – 30 May 2022

Julien Lafargue (JL): Welcome to a new edition of Barclays Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist here at Barclays Private Bank, and I will be your host today. As usual, we will first briefly discuss last week in the markets before welcoming today’s guest Damian Payiatakis, the Head of Sustainable and Impact Investing at Barclays Private Bank.

The energy transition is a topic that is relevant, whether or not you consider ESG when investing, and in Europe probably more so than anywhere else. The recent events have made this transition an absolute necessity and a priority, and so Damian will share his thoughts on the topic and where opportunities are.

But before that, let’s review the markets. Last week was the first positive week for global equities in two months, and if I recall, the last positive week happened when I was on this podcast, so hopefully my presence is a good sign for the week ahead.

But last week the rally was driven by a combination of factors. First, solid earnings reports, but also a bullish update, or outlook, from JP Morgan during their analysts’ meeting, as well as a somewhat dovish Fed, which talked about potentially pausing rate hikes in September. We also saw further progress in getting Shanghai back online as well as additional evidence of US disinflation through the PCE, which we’ll discuss in detail in a second.

We also saw some M&A activity and speculation, but probably most importantly, all that happened on the back of a very bearish investor sentiment. In terms of macroeconomic data, the markets’ main focus last week was on Friday’s PCE reading in the US. At 4.9% year-over-year, down from 5.2%, core inflation seems to have eased a bit in April, reinforcing our view that we may have passed peak inflation. This, however, won’t be enough for the US Federal Reserve to backtrack, but there is certainly less urgency to talk up interest rate hike expectations. In fact, we are starting to hear Fed officials talk about a potential pause in September.

This would be a significant positive for sentiment, but a lot will depend on the wage dynamics. Indeed, even if supply-chain constraints ease and good inflation cools down, the tight labour market could still push wages higher and this, in turn, could force the Fed to keep tightening to avoid a price-wage spiral that is very difficult to counteract.

So, on that front, this week’s job report, which will come on Friday, will be a very important catalyst. In particular, the average hourly earnings, which are expected to be up 5.2% year-over-year in May, a fraction below the 5.5% recorded last month.

Now, the other key element of the previous week was the series of updates we got from companies, and these were relatively mixed. On one hand, some high-profile misses have made the headlines and the Snap warning was particularly painful for investors. But the group that was in focus was the retailers. These are closely watched by investors, as they provide a sense of the health of the US consumer in these times of high inflation, but also very supportive labour market.

Many US retailers posted poor numbers. However, and it’s very important to make that distinction, top line was actually generally fine, so the consumer is still buying, and instead the weakness came from margins which disappointed as some retailers built significant inventories, which they will now have to work through. And we’re talking about anywhere between 10% to 35%, or even 40%, year-over-year increase in inventory.

So these, however, will likely last a few quarters and that is what weighs on investor sentiment. But some retailers, on the other hand, have much better managed the last three months. To name a few, Dollar General, Dollar Tree, Masseys, Nordstrom, Ralph Lauren all reassured investors, as they managed well their inventories and demand was still very, very strong.

So this environment may feel scary, but it’s also a great environment for active managers, as the dispersion you see between companies within and across sectors opens plenty of opportunity in the short term.

Now, moving on to the mid- and long-term, let’s transition to our guest segment. As I mentioned previously, we’re joined by Damian Payiatakis, the Head of Sustainable and Impact Investing at Barclays Private Bank in order to discuss the energy transition in Europe, a topic that will be at the centre of our Mid-year Outlook coming out in two weeks.

Six months ago, and following the United Nations COP26 gathering in Glasgow, global attention was clearly on tackling climate change and accelerating transition to lower carbon energy. However, looking back at the first half of this year, we faced increasing challenges from a macroeconomic perspective and these were further exacerbated by the war in Ukraine. And so the dynamics around energy have rapidly shifted.

Energy security and affordability are now key items in global and government discussions. Spot market prices for fossil fuel have rocketed to long-term highs, and as equity markets have rotated out of growth sectors companies with low-carbon solutions have been hit as well.

European governments have sought to address this issue as they also seek to manage inflation and employment in the wider economy.

So, Damian, let me start by asking you a very simple question. Will we be seeing more or less fossil fuel usage in the energy mix going forward?

Damian Payiatakis (DP): Thanks, Julien, and a pleasure to be here with everybody again. So, it’s really a question of time horizon. In the short term, certainly, I would say the next 12 to 18 months, we’re likely to see an increase in both more costly, and often dirtier, fuels in the energy mix. You can even see Germany moving back for a period into coal in order to meet its energy needs as it tries to avoid its dependence on Russian energy.

Medium to longer term, the recent policy packages from European governments that were launched are really seeking to accelerate that transition, so rather than move away from, it’s actually leaning into going into the alternative cleaner fuels that are available to Europe. And that’s what we reviewed, actually, in the May Market Perspectives, this idea of working with the drivers around the current situation and how, where there’s specific policy responses of the UK and EU governments, to see what insights we could gather around the transition.

And without covering that whole article again, I guess what we can look at, very simply, is from an EU perspective we’re going to see more focus on diversifying gas suppliers, very clearly, increasing gas storage facilities and also reserves in advance or in run-up to the next winter period.

Also, much more clearly a focus on building renewables faster. So, thinking about biomethane and thinking about the hydrogen accelerator they announced to increase hydrogen production, and sort of the hydrogen valleys they’re trying to create, as well as actually reducing some of the burden, from a regulation or administrative perspective, in terms of infrastructure and planning for solar and wind heat pumps.

And a couple of the other interesting things that we saw out of the EU was a real focus on energy efficiency almost as a first principle, the idea being that if we can reduce the demand for energy that obviously requires less of a supply. And the other thing that the EU did was build-in an idea for a financial impact on vulnerable households, thinking about how they could use temporary state and price regulation, and interestingly the potential windfall tax on energy company profits that we’ve now seen the UK actually build up.

Now, the UK didn’t have that originally and their main goal was around energy security actually, in the name of the policy in trying to increase the energy production to actually 95% of all energy produced from cleaner sources by 2030, so that’s only in eight years’ time. And in that sense a lot of the focus was accelerating some of the work going on, so offshore wind, increasing that by 25% in gigawatt terms.

Nuclear is coming more back, and our government is trying to suggest or push for nuclear to come back more into the scene. So, the Climate Committee had about 10 gigawatts of energy committed in the future energy mix. The government is suggesting they want to see up to 24%, although that was a very high level ambition without any real plans or targets behind it.

And then the other side of it, which is very interesting to see, is hydrogen again. So really quickly trying to accelerate the growth of hydrogen as a fuel source, or a fuel supply in that sense. Now, when you look at these and you look at the response that the European governments have had, I would say there’s a certain irony here. You know, if you’re looking at what they’re trying to do to accelerate the move to renewables and to cleaner energy sources, had they invested earlier, we wouldn’t be as impacted these days by price increases, by these energy security issues. So now I think what we’re seeing is governments trying to adjust to that.

But even beyond governments, it’s not simply about governmental support. It’s actually on the economic terms. If you look at it over the last decade, right? Onshore wind, the cost has decreased by about 56% while at the same time the capacity, so the actual energy that it produces, has increased by a third. We can see the same numbers for onshore wind, you know, about half as expensive as a decade ago, while the capacity of turbines has increased by about 150%.

And the same thing for solar as well. So, we see on an economic basis even more than the governmental support is trying to lean in and accelerate some of where the markets are headed as well, such that the levelised cost of energy is much lower in some places and even building new fossil fuel supplies. And so I think what we’re seeing, to the original question, is short-term adjustments to address the current energy issues and obviously the Russian dependence. And medium- to longer-term, trying to shift to address all three issues that you brought up, security, affordability, and the climate impact as well.

JL: There is one thing that you didn’t really mention in May’s article, which you just referred to, which was the UK’s decision to auction another round of licences for the North Sea. Maybe, can you spend a minute explaining to us how this will affect the UK energy markets going forward?

DP: Yeah, the UK’s energy security strategy, again it offered a plan to have a new “lease on life” for the North Sea. However, it’s hard to interpret that, you know, both for investors and consumers when we’re looking at how do the markets actually work, so let’s look at the real world process after that announcement.

You know, the reality is once a block is auctioned off, the UK doesn’t control or own any of that gas or oil in the North Sea. It’s the companies who purchase those blocks who do. And the reality is they sell to the global markets, to the highest bidder on the market. And so, you know, when you look at it a majority of the UK oil is exported, about 80% I think, so it doesn’t support domestic energy supply or prices. And even more interestingly, when you look at the underlying home countries of those who own the assets, who is it? It’s China, it’s the Middle East, it’s even Russia. So, again, geopolitically, they don’t really have a concern around the UK energy supply.

And it’s the same thing, actually, when you look at UK refineries, you know, which are set up to produce for a specific slate of feedstock, so the type of oil that you’re getting or input you’re getting, the UK or the North Sea doesn’t really produce this either, so they’re trying to run full speed and they’re buying on the global markets for a different type of feedstock to produce for local demand.

So I think if you’re not able to supply local needs either, through the leases, it certainly raises questions around the arguments for energy security or affordability, and, I think, moreover, for investors when you’re looking at these leases it can take decades to come on stream in some cases. Even in the short case, right, this is not a tap-on/tap-off situation, you know, eight to 10 years on, easy types of exploration production and getting a stream on.

So when you’re looking at that, you’re going to be questioning, you know, going back to our point around energy prices and renewables, the levelised cost continuing to decrease. Investors are going to be looking at that and companies are going to be looking and saying, is this worth our time even if those blocks go on? And I think, moreover, when we talk about what we’ve just seen in the UK I’ve alluded to, this windfall tax on energy companies that’s raised questions about the attractiveness of investing with the uncertainties around it.

JL: Well, that’s a very good point. So, again, the UK was making the headlines recently because of the UK’s windfall tax, so how do you see that playing out? What’s going to be the impact there?

DP: Unfortunately, the Chancellor didn’t quite align with our publication for the May Market Perspectives. So just after we went to press, the UK Chancellor, Rishi Sunak, announced an estimated £13 billion tax on energy companies and actually alluded, as well, to some of the energy suppliers for a potential something later on in the year. And as I said, unlike the UK, in the original energy strategy there was little focus on immediate support for consumers or to address reliance on that Russian fossil fuel. Well, then again, the UK only has about 4% of its imports from Russia so it’s easier to manage a much wider supply of providers.

So, I think it’s a combination. You know, we’ve seen increased political pressure and both the general inflation and increased fuel prices have continued to rise. Arguably, “Partygate” has caused the government to need to respond and, therefore, the idea to take action around this question of energy affordability. And the windfall tax allowed them to do that and, as well, quite frankly politically I think it allowed them to take on a policy that their opposition, that Labour, had put forward as well.

So the idea of being able to refund or provide tax breaks back to individuals was a move to be able to show that they are, or demonstrate that they were, doing something. Now, interestingly, there is also a “super deduction”. So, companies that are affected can actually offset up to 91% of the taxes paid against new investment. Now, that new investment, interestingly, is not always clear in terms of what it is, is it to renewables or actually into fossil fuels as well? And so there has been some criticism that making investments with this allowance can actually be detrimental to both the economic situation. These investments may not actually be viable after the tax, so not beneficial for the taxpayers or to the environment.

So, it’s a good question in terms of, well, what action will energy companies take, and what should investors be looking at. And when you looked at let’s say BP or Shell, you saw a dip on Thursday just after that announcement, but actually they rebounded quite quickly and, therefore, there’s a clear indication that investors are committed, and BP itself has said that it will continue to invest in the UK irrespective of this windfall tax.

JL: To conclude, I guess, I think the one last question I want to ask you is where can investors learn more about all that, because obviously this is a very important topic.

DP: Yes. So of course, the starting point is the Market Perspectives article that I’ve referenced at a couple of points today. We’ve actually separated it out. So, in two parts, in May we covered off the policy implications from the EU and the UK in terms of delving into understanding what those implications would be around some of these issues. And then, this month, the follow up is looking into more detail around four different energy sources, onshore wind, offshore wind, nuclear, and hydrogen for investors or readers to understand a little bit more what the implications might be for those specific sectors, both from a policy perspective and an investment outlook.

I think, moreover, our Mid-year Outlook is forthcoming and we have one specific session where we’ll be discussing this further with our sustainable portfolio management lead and with some of the internal and external experts that we have. So for our clients in the UK, in Monaco, and Geneva during the week commencing 13^th June, you can join us live, and our global audience, I think on 20^th June, will be covering this as well. I certainly hope it will be an enlightened discussion, positioning portfolios in light of the energy transition trends that we’ve been talking about now.

JL: Well, thank you very much, Damian. Obviously, the energy transition is a key topic at the moment and that’s why we’re going to make it a big part of our Mid-year Outlook, and more to come on that.

Now, before we conclude, a quick look at the week ahead. And we will get several high profile economic releases this week, starting with the Chinese PMI and followed by Europe’s May CPI, or inflation reading, that’s tomorrow. And as I mentioned previously, we’ll also get on Friday the US job report for the month of May.

In the UK it will be a slightly shorter week this week, with the Queen’s Platinum Jubilee leading to a long weekend from Thursday to Sunday, but we will be back on Monday. And until then, as always, we wish you all the very best in the trading week ahead.