Category: Financial Markets Commentary

Monthly financial markets commentary from Sabino Investment Management, LLC

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Europe’s Pending Energy Crisis

On Wednesday, August 30, Russia halted all natural gas deliveries via the Nord Stream 1 pipeline.  Supposedly, this was a planned maintenance that will last 3 days.  Russia had been operating Nord Stream 1 at 20% of capacity, while waiting for the delivery of a repaired turbine from Canada.

One year ago, the Dutch TTF gas futures contract for October 2022 delivery was priced at 28.80 euros per 1 megawatt day.  On August 26, the contract hit a record high of 346.52 euros.  As of the August 31 close, the price stood at 239.91 euros, a drop of 30.8% in 5 days.  German and French electric futures prices have also hit all-time records.

German economic minister, Robert Habeck, said that companies have worked hard to reduce gas consumption in recent months by switching to alternative fuels like oil, making processes more efficient, and reducing output.  But some companies have “stopped production altogether” with businesses that have a large energy component being the most susceptible.  The Budel zinc smelter in the Netherlands will be placed on care and maintenance from September 1 “until further notice.”  Norsk Hydro also announced plans to shutter an aluminum smelter in Slovakia at the end of September.

The dire situation of European energy is now reflected in consumer confidence surveys.  German consumer confidence is at an all-time low of -36.5, whereas the normal range had been between 0 and 10 prior to 2020.  German producer prices increased 37.2% in July 2022 from a year earlier.  Excluding energy, German producer prices, increased 14.6% from the prior year.

Apparently, Russia and Ukraine were prepared to negotiate a peaceful settlement in April.  Prime Minister of the United Kingdom, Boris Johnson, went to Kiev that month.  According to Ukrainska Pravda, Johnson had two messages for President Zelensky:

    • Putin is a war criminal and should be pressured, not negotiated with, and
    • Even if Ukraine is ready to sign some agreements with Putin, the UK and US are not.

And so, the war in Ukraine continues.

China has increased its imports of Russian natural gas substantially this year.  During the first six months of 2022, China increased liquified natural gas (LNG) volumes by 28.7% compared to the prior year.  China also imports natural gas from Russia via the Power of Siberia pipeline and the volumes imported via the pipeline increased 63.4% during the first half of the year.  There are several reports of Chinese (formerly Russian) LNG cargoes being sold to Europe.  So, Europe is willing to buy Russian natural gas from China, transporting it on ships with LNG capabilities.  This is an expensive alternative to Nord Stream pipeline deliveries, but it does get around the economic sanctions imposed on Russia.

The profits from acting as an intermediary natural gas deliveries are very attractive.  News sources indicate that Sinopec has sold 45 cargoes of LNG to Europe year-to-date.  Profit estimates from reselling Russian LNG to Europe using China as an intermediary range from tens of millions of US$ to over $100 million for a single LNG cargo shipment.  ZeroHedge writes that the embargo on Russian energy has failed spectacularly, and: “Worse, while Europe could buy Russian LNG for price X, it instead has to pay 2X, 3X or more, just to virtue signal to the world that it won’t fund Putin’s regime, when in reality it is paying extra to both Xi and to Putin, who is collecting a premium price thanks to the overall market scarcity.”

Unless there is a break in the geopolitical situation, this coming winter in Europe will experience inadequate heat and food for its residents, as well as a dramatic decline in economic production.  There are likely to be many European business failures and bank insolvencies as well.  The repercussions are likely to be global in nature.

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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What’s Next?

US real (after inflation) GDP declined by 1.6% in the first quarter of 2022.  According to the Atlanta Federal Reserve Bank’s GDPNow model as of July 1, second quarter real GDP is forecast to decline a further 2.1%.  The Blue Chip Economic Indicators consensus forecast of economists for real GDP was a full 5% higher at the end of May than the latest forecast of the Atlanta Fed’s model.  There are likely to be substantial reassessments by economists and securities analysts during the next few months.

The current P/E ratio of the S&P 500 Index is at 19.3 based upon the last 12 months of reported earnings.  The P/E ratio of equities held in client portfolios is lower than the S&P 500 due to my value orientation.  The P/E ratios of some stocks are substantially lower than the rest of the stock market.  For example, US Steel (X) sells at 1.0X trailing 12 months earnings, or 1.5X forecast earnings.

Year-to-date, the total return of the S&P 500 is -19.1%.  Since the Fed is expected to raise interest rates further and there is a high probability that we are in a recession that will impact corporate profits, the S&P 500 Index is likely to decline further during coming months.

The potential catalyst(s) for a turnaround in the economy are difficult to identify.  Here are some current economic indicators:

    • The consumer price index (CPI) is currently 8.6% higher than a year ago, and it is expected to remain at an elevated level for the near future.
    • The University of Michigan’s consumer sentiment index hit a record low, as the high inflation rate is hurting household finances.
    • Real (after inflation) wage growth on a year-over-year basis is lower at -3.9%.
    • The market capitalization of US equity markets has declined by $13.6 trillion since its peak at the beginning of this year.
    • The interest rate on a 30-year fixed rate mortgage is now at 5.81%.
    • Corporate profit margins are at record high levels but are likely to be under pressure from higher wage and material costs and a recessionary environment.

Meanwhile in Europe, the antagonism between NATO countries and Russia may soon get worse.  Russia has already reduced Nord Stream 1 gas flows by 40% while citing technical issues.  Gazprom then announced that they have scheduled an “annual maintenance” for a period of ten days from July 11 to July 21, that will shut down gas deliveries.  This should serve as a painful reminder to the NATO/European Union countries that they rely on Russian energy exports.  Germany and Italy together account for almost half of the European Union’s gas imports from Russia.  France, Hungary, the Czech Republic, Poland, and Austria are also large natural gas importers.

Some European companies have already hit their breaking point.  Germany’s largest gas importer and power utility, Uniper, is now seeking a 9 billion euro bailout package from the German government.  Uniper’s share price has declined by about 75% since the beginning of the year.

For now, the European energy supply problems have benefited American companies that are able to liquify natural gas (LNG) and export it to Europe at higher prices.  However, the LNG infrastructure has limited capacity.  If Russia takes the next step and eliminates energy supplies to Europe, an economic depression for the European economy is inevitable and will have consequences for the American economy and financial system.

What’s the good news?  The market declines of 2008-2009 and 2020 created some great buying opportunities.  We may see a similar opportunity before the year is over.  In the meantime, we have a low allocation to equities, debt with high credit ratings and shorter maturities.  We have a large allocation to precious metals, which did well until mid-April.  I expect more investors to recognize the importance of including precious metals in their investment portfolios in the future.

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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Fed Talk vs. Investors

Since January 2021, the last 15 months has shown a dramatic increase in inflation due to a combination of deficit spending, monetization of government debt, and supply constraints.   READ MORE

 

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The New World Dis-Order

The economic sanctions against Russia are likely to have a bigger economic impact on Europe and the United States than Russia.  The potential changes are not yet reflected in the financial markets.

On February 28, the US Treasury Department announced that it would freeze Russian central bank assets that are held in the United States.  The US also imposed sanctions on the Russian Direct Investment Fund, which is a sovereign wealth fund.  European allies and Japan joined the US in implementing similar sanctions on Russian assets.  The scale and scope of the sanctions were unprecedented.  The EU Council’s sanctions included the 351 members of the Russian State Duma and an additional 27 individuals and entities.

On April 6, the US in coordination with G-7 countries and the European Union, announced additional sanctions that will ban all new investment in Russia, increase sanctions on financial institutions and state-owned enterprises in Russia, and sanction Russian government officials and their family members.

Prior to the invasion of Ukraine, on February 4, Russia and China agreed on 30-year natural gas deal via a new pipeline, which is expected to be in operation within 3 years.  The agreement had been in the planning stage for years, but it serves as a reminder that Russia has other markets to serve besides Europe for its natural gas.

It is naïve to think that one country’s actions against another country will not generate responses, including some countries that are not the target of the initial action.  In response to the economic sanctions, Russia has taken the following actions:

  • March 10 – Russia suspends fertilizer exports to “Not Friendly” countries. China warns the US against retaliation.
  • March 31 – Russia issues a decree that payments for natural gas should be in rubles. Kremlin spokesman Dmitry Peskov said that Russia “won’t engage in charity if Europe refuses to pay in the Russian currency.”
  • Pavel Zavalny, Chairman of the Energy Committee of the State Duma in Russia, said that European countries will “pay in hard currency, and this is gold for us” or they can pay in rubles. “Friendly countries” such as China or Turkey can pay with their national currencies or the ruble.
  • The Russian invasion effectively cut off Ukrainian exports of wheat. Russian exports of wheat are expected to decline this year.

The suspension of fertilizer exports to selected countries and limited exports of wheat prompted President Biden to acknowledge at a March 24 press conference in Belgium after NATO and G7 meetings, “Yes, we did talk about food shortages and it’s going to be real.”

According to reports on March 9, the White House requested phone calls with Saudi Crown Prince Mohammed bin Salman and the UAE’s Sheik Mohammed bin Zayed al Nahyan to discuss increasing exports of their oil to the United States.  However, both declined the requests to speak with President Biden.

On March 15, Dow Jones reported that Saudi Arabia is in active talks with China to price some of its oil exports to China in the yuan currency instead of US dollars.

The use of US dollars beyond our borders is enormous in size.  What is often called the “Eurodollar market” encompasses bank deposits, bonds, loans, imports, and derivatives outside of the US that must be settled in US dollars.  Michael Every of Rabobank estimated the size of the Eurodollar market at $57 trillion at the end of 2018.  For his explanation of the Eurodollar market, see The Eurodollar Market Is The Matrix Behind It All – Daniel’s blog (wordpress.com).

Paul Craig Roberts, economist and chairman of the Institute for Political Economy, offered his opinion on the sanctions and its impact on the US economy:

What the sanctions have done is to destroy the dollar-based world that allowed the Americans to impose the financing of their huge trade deficit, due largely to US corporations offshoring their production for the US market, on the rest of the world.  Russia, China, central and east Asia will now create their own methods of payment separate from the West.  This will destroy dollar hegemony and American power.

The obvious question is how far will the US dollar decline if a significant portion of international trade requires payment in currencies other than the US dollar?

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA