Slowing Investments and Earnings Growth Hurt Investor Sentiment
Concerns about the sharp fall in capital investments and earnings growth in select sectors resulting from lower oil prices continue to cloud the global economic outlook. While the decline in fuel prices is revitalizing consumer spending across all the major countries, the energy and mining sectors have already started curtailing their capital outlays. The large energy sector companies reported earnings for the last quarter of 2014 that were weaker than expected, and some of them have announced plans to trim their workforce. Countries such as Russia that are significantly reliant on energy exports have already slipped into a recession. Confirming these subdued trends, the World Bank and the International Monetary Fund have lowered their global growth forecasts for the current year.
Nevertheless, there is strong evidence that lower fuel prices are lifting consumer confidence across most parts of the globe. U.S. consumer sentiment indicators are at their highest levels in several years, with further help from the strengthening labor market. Retail sales growth in the Euro-zone has accelerated recently while Japan continued to see marginal gains in retail sales during December. Domestic consumption growth has also improved in China, and has helped its economy to expand at a healthy pace during the last three months of 2014. Unless oil prices rebound sharply, the gains in consumer demand are expected to improve further in the coming months. Lower inflation should also give central banks more flexibility to reduce interest rates, as the Reserve Bank of India unexpectedly did in January.
Global equity markets saw a modest decline in January, as gains in Asia were more than offset by declines in North America, Latin America, as well as Europe. Global manufacturing output continued to expand during January, and the pace of growth improved from the previous month. The U.S., Euro-zone, Japan and the U.K. saw healthier output growth during the month. New order flows for the manufacturing sector were robust while global services activity also gained pace in January.
GLOBAL INDUSTRY SPOTLIGHT FOR THE MONTH: UTILITIES
Lower costs due to the fall in oil prices and the potential improvement in demand as economic growth recovers have lifted the outlook for the utilities sector in recent months. Investors have started acknowledging these positive trends and utility stocks were among the best performers in the U.S. last year. Nevertheless, demand growth could be more muted in the long term for conventional utilities as regulatory support continues to make non-conventional energy sources more attractive to consumers. In addition, tougher emission standards could force utilities to phase out older power plants over the next several years. While this could cut supplies and lift prices for a while, the additional capital costs to build new capacity could be considerable.
Investors have started looking at the utilities sector more favorably in recent months as the combination of lower fuel costs and the prospective rebound in demand make the sector attractive. Utilities were among the top performing sectors for U.S. investors in 2014, recovering from the relative underperformance during the previous two years. Similarly, in other parts of the world, the outlook is positive for utilities that use fossil fuels and where domestic economic growth is rebounding.
The drop in fuel prices is probably the most significant positive driver for utilities this year. The sharp increase in domestic energy production that drove natural gas prices lower have benefited U.S. electricity generators in recent years. With the fall in international oil prices, the cheer is now spreading to other parts of the globe as well. This is most significant in countries such as Japan, which now depends on imported liquefied natural gas (LNG) for nearly a third of its electricity generation. Contract prices for natural gas for shipment to Japan have dropped from around $18 per MMBTU during the first quarter of 2014 to $10 per MMBTU this month.
Part of the lower fuel costs would no doubt be passed on to consumers, as some of the European producers have already done, but the utilities could still see meaningful gains in margins. However, it is possible that such gains would accrue only slowly for some producers. Fixed price fuel contracts and other hedging instruments put in place before the oil price decline could keep costs high for some producers in the short term. On the demand side, stronger economic growth should favor utilities, especially in faster growing markets such as the U.S.
Long-term demand outlook is more uncertain as the active regulatory support for alternate fuels and non-conventional energy sources could hurt conventional electricity producers. Encouraged by government incentives, large corporations and industrial consumers are increasingly deploying roof-top solar panels and similar generating equipment. In Europe, several countries offer attractive incentives to households for installing solar panels. As a result, their dependence on the public grid for electricity is falling gradually. If this trend continues, as expected, utilities could see muted demand growth in the future. Increased demand from the growing popularity of electric cars, which was expected to benefit utilities, is likely to be less significant as lower gasoline prices could limit the cost advantage of such vehicles.
The share of coal fired plants in new projects has steadily declined in most developed countries, though they remain popular in emerging countries with sufficient coal reserves such as India. Tighter emission controls could force utilities to phase out older plants that use coal as fuel, especially in the U.S. and Europe, over the next several years. It is estimated that these plant closures in the U.S. could reduce aggregate generating capacity by around 5 percent. While the reduction in capacity could potentially lift electricity prices, capital costs and debt levels could rise as capacity is rebuilt.
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