The Reincarnation of Fossil Fuels?

As long-term readers will be aware, we never comment on them all. Having said that, a few of them deserve a few comments. This year, I will begin with the very first one – I will even make fossil fuels the overriding theme of the Absolute Return Letter this month. After all the song and dance in Glasgow only weeks ago, could our political leaders be shrewd (cynical) enough to kick the green can down the road? Absolutely! Inflation is mounting, and rising commodity prices carry some of the responsibility for that. Therefore, an easy fix would be to slow the pace of the green transition, but more on that later.

#3 does worry me a bit too. The risk is impossible to quantify at this stage but, as we all witnessed in early January 2021, when the mob takes on the elite, it doesn’t take much for things to get out of control. Thankfully, few died in the riots in Washington D.C., but the political wounds are still wide open, and another incident at the mid-term elections later this year – not necessarily identical to what happened on Capitol Hill – is probably more likely than I would like to think it is. If you think this is a storm in a teacup, I suggest you read these articles in The Guardian, The Times and The New York Times, all of which have been published in the last few days.

#4 deserves a mention too but, as I will make further comments on inflation later, I am going to skip that one. The last one I will comment on now is #10, which I am tempted to categorise under “wishful thinking”. Living longer is nearly everybody’s dream, and new medical technologies should indeed make it feasible. The harsh reality, on the other hand, is that life expectancies have started to decline in certain countries, at least amongst ordinary people, whereas the super-rich continue to live longer, as they can afford the new, revolutionary treatment forms.

#10 is a massive issue, though – far too big for a couple of paragraphs in this letter, so “why life expectancies are now falling” is a topic for another day; for now, suffice to say that unless our political leadership is willing to do something serious about the rising gap between rich and poor, I don’t see how life expectancies can suddenly be extended by 25 years, as suggested by Saxo Bank.

My not so outrageous ‘predictions’ for 2022

I should qualify what I am about to say by stressing that what is to follow is not so much a set of predictions, as it is a small collection of risk factors that I think would have a harmful impact on financial markets, should they materialise. In other words, I am not saying they definitely will happen, however, the probability of them happening is big enough that you should have a plan B in place – just in case.

With those words in mind, let me share my top three concerns for 2022:

1. Inflation turns out to be a far bigger problem than the transitory issue the Federal Reserve Bank want us to believe it is and, for that reason, the Fed – and possibly also other central banks around the world – will be forced to increase interest rates much more than most expect at present.

2. Partially because of the inflationary impact and partially because of a desire to return to more normal conditions, the Federal Reserve Bank turns off the liquidity tap which has been open since the Global Financial Crisis and wide open since COVID-19 first struck in early 2020. In return, ample liquidity has created an excessive appetite for risk taking but now, with the liquidity tap being turned off, fundamentals begin to matter again. US equities turn out to be significantly overvalued, and other equity markets fall in sympathy.

3. Unrest in China, caused either by a collapse of the financial system or by geopolitical problems following China’s invasion of Taiwan, turns into another ‘Lehman moment’ with financial markets all over the world shaken to the core.

#1 – Inflation

Let’s begin by reiterating my worries re inflation:

Inflation turns out to be a far bigger problem than the transitory issue the Federal Reserve Bank want us to believe it is and, for that reason, the Fed – and possibly also other central banks around the world – will be forced to increase interest rates much more than most expect at present.

I cannot resist reminding you of the second risk I brought to your attention in last year’s January letter:

1. The V-shaped economic recovery in 2021, which equity markets are taking for granted, fails to materialise. Either the COVID-19 vaccine doesn’t work as expected or rolling out the vaccination programme takes much longer than expected, turning 2021 into another year which can be largely written off.

2. The massive increase in global money supply, which has been part of governments’ response to the health crisis, begins to have a rather unpleasant impact on inflation which financial markets react negatively to.

3. For whatever reason (could be as a result of either (1) or (2) above), the runaway bull market in Big Tech finally punctures and retail investors who have dominated the buying of Big Tech for most of the past year panic, leading to a collapse of the (overvalued) US stock market. I think of this risk as a re-run of the collapse of Tokyo Stock Exchange, anno 1990.

That is precisely what happened towards the end of 2021, particularly in the US, where the monetary stimulus programme has been the most elaborate. Now, before I pat myself too firmly on my fragile shoulders, I should point out that, although I was spot on about the monetary stimulus programme creating unwarranted inflation, I haven’t been correct (so far) about it translating into difficult circumstances in financial markets.

As you can see in Exhibit 1 below, apart from various emerging markets, equities performed extraordinarily well in 2021. It is also worth noting that, although the general perception seems to be that US equities had another standout year when compared to other markets, in fact, US equities ‘only’ performed in line with other developed markets – at least the better performing of them.

Furthermore, if you conduct a multi-asset class review of 2021, as you can see in Exhibit 2, it is not only equities that performed well in 2021 – so did many commodities. WTI oil did particularly well, delivering an annual return of about +55%. Again, in this multi-asset class survey, Brazilian equities stood out as the worst performing risk asset worldwide, although I should point out that not all risk assets have been included in the survey conducted by Deutsche Bank.

Looking at Exhibits 1-2 and holding them against the economic facts of 2021, it is tempting to conclude that, in many risk markets around the world, and particularly in the US, the typical investor attitude has been extraordinarily laid back, almost criminally so – an attitude which I think might change in 2022, but more on that later. Let’s begin with inflation and why I suspect it may not be as transitory as the majority of investors seem to think it is.

US consumer price inflation in November (the number for December hasn’t been made public yet) came in at 6.8%, in line with expectations. Markets breathed a sigh of relief, as the number was down modestly when measured month-on-month (see Exhibit 3). Then, a few days later, the PPI report for November was released, and the number came in at a whopping 9.2%. Despite PPI being a robust leading indicator of CPI, financial markets chose to largely ignore the bad news.

I am concerned about US inflation in 2022 for lots of reasons – tight labour markets causing wage pressures, supply chain problems causing higher prices, a red hot property market causing not only property prices but also rental prices to rise, high shipping rates causing higher prices on imported goods, and so on. I could list the first 25 reasons why you should worry about inflation as we enter 2022, particularly in the US, but one stands out, and that is inflation expectations.

As is obvious when you look at Exhibits 4-5, inflation expectations are rising, both amongst households (Exhibit 4) and amongst firms (Exhibit 5) in the US. This is problematic because expectations drive behaviour, i.e. if they are rising, workers will demand higher salaries, and companies will raise their prices. We learnt that lesson many years ago.

When the Fed released the minutes from its December FOMC meeting, it was obvious that most FOMC members are seriously worried about the inflation outlook. The pace of tapering will be doubled from early 2022, and no less than ten FOMC members (out of 12) projected at least three policy rate hikes in 2022 with the remaining two members projecting four hikes this year – a far cry from September where none of the members projected such drastic action.

The average maturity of US mortgage loans is about 23 years with less than 10% of all outstanding US mortgages on adjustable rate terms (see Exhibit 6). As you can see, the percentage of US households on an adjustable rate mortgage continues to fall and is now a shade below 10% – only half the levels seen in the years before the Global Financial Crisis (the last hiking cycle), where the share of adjustable rate mortgages in the US was hovering around 20%. The implication of this is that a rise in the policy rate now will have a lower impact on US consumer spending than it did in the last hiking cycle.

In the UK, the central bankers’ job is even harder. In the past, almost all UK residential mortgages were adjustable rate mortgages, meaning that a BoE rate hike always had an instant impact on consumer spending in the UK. Although 20 or 30-year terms are not on offer in the UK, as you can see in Exhibit 7 below, a significant number of UK mortgage holders have in recent years locked in the mortgage rate for 5 years. This is noteworthy, because it means that the BoE could find that it may take a lot more to curtail UK consumer spending now than it did in the last hiking cycle.

In plain English, this means that it may be necessary to raise rates a great deal more than what nearly everybody is projecting at present. The implication is that financial markets may underestimate the number of hikes awaiting us, although that is, as I just pointed out, a bigger risk in the UK than it is in the US.

Finally, before moving on, I should point out that ARP+ subscribers will soon have the opportunity to learn more about what to and what not to invest in, in the inflationary regime that is upon us. If you subscribe to ARP+, make sure you listen to our winter webinar, scheduled for Wednesday the 12th of January at 15:00 GMT.

More insight, more advice, more in-depth.

#2 – Excessive risk appetite

Let’s move on to my second concern – a worry which is closely associated with the one just discussed:

Partially because of the inflationary impact and partially because of a desire to return to more normal conditions, the Federal Reserve Bank turns off the liquidity tap which has been open since the Global Financial Crisis and wide open since COVID-19 first struck in early 2020. In return, ample liquidity has created an excessive appetite for risk taking but now, with the liquidity tap being turned off, fundamentals begin to matter again. US equities turn out to be significantly overvalued, and other equity markets fall in sympathy.

As I have just argued, inflation could quite possibly prove stickier than the optimists maintain. Consequently, policy rates will have to be raised more than consensus expectations. Should you worry about that? Yes and no! What do I mean by that? Allow me to explain. I do not worry a great deal about policy rates being raised 1-2% more than expected, but I do worry about the Wicksell spread. The Wicksell spread is a measure of the difference between the cost of borrowing for the average corporate entity and the nominal growth rate of the economy. Under normal circumstances, when the Wicksell spread is hovering around 2, the system is well-balanced.

As you can see from Exhibit 8 below, the US Wicksell spread is extraordinarily negative at the moment – a feature which is highly reflationary, i.e. robust US economic growth over the next few months is virtually set in stone. And because the Wicksell spread is so negative at present, a few hikes of 25 bps will most likely make no difference whatsoever.

For argument’s sake, let’s assume the Fed will raise the policy rate ten times in this hiking cycle – each and every time by 25 basis point, i.e. by 2.5% in total. Would that be detrimental to economic growth? Not necessarily when viewed on its own, but it could affect something else which is likely to have a massive impact on the economy and on financial markets, and that is inflation expectations.

US equities have benefitted from extraordinarily benign liquidity conditions more recently – to the point where fundamentals hardly matter anymore. In return, the very benign liquidity conditions have affected investors’ expectations. These days, it is not hard to find investors who are convinced that the show currently on offer will never stop, and that only old farts like me think otherwise. We are saddled with an entire generation of investors – all those who only started investing after the big bear market around 1980 – who think bear markets are occasional downturns which will be swiftly addressed by the Fed, so that the show can continue.

All those callow people have either forgotten that ‘proper’ bear markets can last many years, as the one in the late 1970s and early 1980s did, or they have simply chosen to ignore that fact. The Fed have pumped trillions of dollars into a US economy, weakened by COVID-19 (you can read more about the vast extent of the US support programme here), and the result is there for everybody to see. Now, if the liquidity tap is about to be switched off, investors will start to focus on fundamentals again, and I think risk markets could be in trouble.

Before moving on, one final point worth mentioning is that large, negative Wicksell spreads always lead to a plethora of misallocated capital. When access to capital is plentiful, as it is now, borrowers tend to ignore the most important rule when investing in the real economy – make sure the investment in case is productivity-enhancing. When investors forget that, the party always ends in tears.

#3 – China

Let’s wrap things up by taking a look at my third major concern for 2022:

Unrest in China, caused either by a collapse of the financial system or by geopolitical problems following China’s invasion of Taiwan, turns into another ‘Lehman moment’ with financial markets all over the world shaken to the core.

Several issues could derail China in 2022. A hugely over-leveraged property sector, orchestrated by Evergrande, could take the entire financial system down, just like Lehman Brothers took the financial system down in 2008. Another worry of mine is that the Chinese decide to invade Taiwan. They have made no secret of the fact that they believe Taiwan should be part of China, and I think it is only a question of time before they make the next move.

It also concerns me that China refused to phase out coal anytime soon, when the topic was up for debate in Glasgow. After all, China is the world’s worst polluter, emitting more than twice the amount of CO2 when compared to the Americans. This could very well turn (much of) the rest of the world against it, causing all kinds of problems, which will inevitably slow down economic growth globally. At the top of my ‘worry tree’, three fundamental questions stand out, and it is imperative that we address them sooner rather than later:

1. Should we allow free trade with a country that has demonstrated a total disrespect for human rights?

2. Should we import goods from a country that has been awarded a significant competitive advantage because it doesn’t follow the same rules and regulations as we do, for example on emission standards?

3. Should we import various technologies from a country that has blatantly stolen the IP used in the production of those technologies?

How the West choose to respond to those three questions will to a significant degree determine whether you should invest in China or not. Only time can tell.

Final few words

So, with central bankers lining up an attack on inflation, and with the world at large not being able to afford much higher interest rates given how indebted it is, it is indeed possible, as Saxo Bank argue, that the green agenda is in for a rain check. The problem with that is that capex in the oil and gas industry has been cut back dramatically in recent years, as more and more have fallen out of love with fossil fuels. With lower capex in oil and gas, lower output always follows and, with that, the price almost always goes higher. Therefore, we are of the opinion that, unless fossil fuels are temporarily taken off the list of f-words, we could easily see the oil price at $150, before it eventually settles near $0.

Such a dramatic rise in the oil price won’t make the job any easier for central bankers, and there is one more twist to the story. Green factions in Germany, Austria and Luxembourg have hit out at new plans, recently made public by the EU, to classify nuclear power as a sustainable technology (source: Financial Times). If the Green move gains momentum, we will be many years away from switching off the last fossil fuel tap in Europe.

I have a great deal of sympathy for the work the Greens do, and for the results they have achieved, but somebody needs to tell them that a world without fossil fuels is at least 50 years away unless we are prepared to accept nuclear as an energy source, and that nuclear today is vastly different, and much safer, than it was in its infancy. Renewable energy forms alone simply cannot deliver anywhere near the amounts of energy which are required to spin all wheels every day.

Going back to the three risks I pointed out earlier, which one do I think is the most likely to unfold in 2022? Although I think problems of some sort in China is a more likely scenario than I would like to think it is, a combination of risks #1 and #2 take the prize. Inflation is stickier than we would like it to be and that, combined with the Fed switching off the liquidity tap, will force a return to fundamentals, which again will result in lower equity prices.

In summary, I would definitely expect equity returns in 2022 to fall short of what was achieved in 2021 with negative returns (in my book) being quite possible if not the most likely outcome this year. I say “not the most likely”, as I think the negative Wicksell spread will ensure robust economic growth in the first half of 2022, and that will support equity markets. That said, given where we are in the economic cycle, the easy days are now behind us, and you should prepare for plenty of volatility in the year ahead. Good luck with your investments!

Niels C. Jensen

6 January 2022

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