Financial Update from Brewin Dolphin - 22 September 2023

September 2023

The Weekly Round-up

Friday 22 September 2023

In his latest weekly round-up, Guy Foster, Chief Strategist, discusses the easing of the UK’s net-zero commitments and explains why it’s too early to declare that the Bank of England’s rate hiking cycle is over.

September is a critical month for markets. On average, it tends to be a weaker one, although there have been enough exceptions to this (the 9% gain for the MSCI World in September 2010 being an example) to dissuade most from trading on seasonality. When considering these kinds of historical relationships, the useful aphorism is that a six-foot tall investor can still drown crossing a stream that is five-feet deep “on average”.

With a week to go, this is proving to be a reasonably typical September in the sense that equity markets are faltering after gains throughout most of the year. Hopes for a broadening of the rally have not been met so far. Instead, leadership has changed, with energy taking on the mantle from technology-enabled companies. And with this baton change, the whole dynamics of the market have changed. Easing inflation and upward surprises for growth have been supportive for the market for most of the year, but higher energy prices complicate those stories. Energy price inflation eats into the incomes of households and businesses. Sometimes, for this reason, central banks might be tempted to ignore energy’s influence on inflation, but with their credibility in question, there seems to be good reason for them to err on the side of caution.

Understandably with such a dilemma, investors needed to divide their attention between the rising oil price and the plethora of central bank meetings taking place this week.

Net-zero, not yet

The outlook for energy prices has been tied up with the hot political topic this week – namely, prime minister Rishi Sunak’s easing of the UK’s net-zero commitments. The topic is highly emotive, but the commitment to ban the selling of new internal combustion engine cars from 2030 (excluding some plug-in hybrids) had been criticised for being uncosted and unachievable. Delaying the commitment to 2035 will make it more achievable. This can be seen as part of a pattern in which the public becomes increasingly disillusioned with net-zero initiatives. Like many political issues, there is widespread support for the cause of lower emissions (just as there are for better public services), but much less support for the policies that will achieve these aims (typically taxes, levies and restrictions).

Fatih Birol, executive director of the International Energy Agency (IEA), predicted that given the growth in electric vehicles, global oil consumption would peak before the year 2030. The IEA has already said that global demand for oil would need to decline to under 25 million barrels per day by 2050 to achieve “net zero”. For reference, current global oil demand is four times that, at just over 100 million barrels per day.

Energy shares

The exact amount by which oil supply and demand ultimately declines is impossible to know. But what is clear is that despite its strong stock performance over the last two months, the overall oil industry will need to contract. Energy stock valuations imply that they’re priced for a weak secular growth environment. Even after the recent multiple expansion, the energy global 12-month forward price to earnings (P/E) ratio trades at a 38% discount to the broad market. Global energy also offers a dividend yield of 4.21%, not including buybacks, well above the 2.54% yield the broad market offers.

A key attraction of energy in the current environment is that producers continue to exercise restraint, resisting the temptation to open up the taps in response to higher oil prices. On that front, the US oil and gas rig count remains well below what one might expect given the level of oil prices. In addition, the weighted average capex to sales ratio for the global listed energy sector remains low. Investing on the basis of the capital cycle means observing that rapidly expanding capex is a bad sign for future returns from many industries.

Modest valuations and good capital discipline are attractive, but the outlook for oil as a commodity will obviously have a big impact on energy shares. The Biden administration tapped the strategic petroleum reserve (SPR) during 2021 and 2022, which kept the price down, but as the SPR has dwindled it gives less scope to restrain price growth in the future. The price has been explicitly supported by OPEC+ (Organization of the Petroleum Exporting Countries) constraining production to support prices (and revenues). Ordinarily, if the US growth outlook weakens, we would expect to see Saudia Arabia coercing the rest of OPEC+ into cutting production to support profitability and prevent demand destruction. That may be less likely to happen in the current environment in which relations between Saudi Arabia and the US have become strained. Saudi Arabia has borne more than its fair share of production declines over the last year and so would naturally be looking to increase its own production to take back its rightful market share.

Late cycle is a dangerous time to hold energy shares. During this phase, they tend to go from leader to loser very rapidly as the economy shifts from overheating to slumping. However, recognising the improved capital discipline and the hedging qualities that energy exposure has, relative to more secularly growing companies, energy shares remain an important part of most portfolios.

The rise of energy prices is the latest complication for central banks.

US rates on hold

Coming into its September meeting, the US Federal Reserve kept rates on hold. This was no surprise, but what was more interesting was the Fed’s updated economic projections, which it releases once per quarter. The Fed kept the projection for one more rate hike, but Federal Open Market Committee (FOMC) members are now tightly clustered around two outcomes – either one more hike or stay on hold – which reflects a narrowing of possible paths.

The Fed raised its expectations for inflation in 2025. The increase was a small one and puts personal consumption expenditures (PCE) inflation at just 0.2% above the Fed’s 2% target. After missing its inflation target for so long, any increase will be encouraged by the hawks. As such, another rate hike this year is still on the table. And a hike, after skipping a meeting or two, would be consistent with the Fed’s desired gradualist approach to tightening.

Whether the Fed goes ahead with another hike or not this November or December should be entirely determined by the data. But that is much less important than what happens next year. On that front, the Fed revised up the projected Fed funds rate for both 2024 and 2025 by 50 basis points. This came on the back of upward growth revisions. The Fed sharply revised up expected GDP growth for this year from 1% to 2.1%, and for 2024 from 1.1% to 1.5%. This makes it seem like the growing chance of a soft economic landing is being reflected in Fed forecasts.

UK rates on hold

Heading into this week’s Bank of England (BoE) meeting, it was close to a coin flip in terms of whether the BoE would hike rates. It didn’t, with the majority voting to keep the base rate at 5.25%. There were several developments and considerations that led the Monetary Policy Committee (MPC) to go this way.

First, the labour market continues to show signs of weakening. Monthly jobs growth seems to have dropped to zero. Meanwhile, the forward-looking job market indicators, including the KPMG/REC survey and the ratio of job openings to unemployed, point to a continued loosening in UK labour market conditions. And probably most importantly, the August inflation report came in weaker than private sector economists and the Bank had expected when they released their projections last month.

House prices slumping

Unlike in the US, tight monetary policy is beginning to bite in the UK. This is understandable given that UK borrowers have short-term mortgages, which must be refinanced at prevailing interest rates after relatively short fixed-rate periods. US borrowers, by contrast, tend to have 30-year mortgages, which they can refinance on demand when rates fall. The rate-sensitive UK housing sector is therefore in the midst of a significant contraction. House prices are declining, and the Royal Institute of Chartered Surveyors (RICS) survey points to a further deterioration.

Despite yesterday’s pause, it’s not clear whether the BoE has finished hiking for the cycle. Like the US, the starting point for the debt-service ratio is low for households, as well as businesses. And even with the greater mortgage sensitivity, a lower proportion of UK households – roughly 30% – have mortgages these days, down from around 40% in the mid-1990s.

The rise in the global oil price will have an outsized impact on UK inflation given that the pound has been dropping, meaning UK consumers will have to shell out more at the pump for a given volume of petrol. In fact, the weakness in the pound will have an impact on import prices across the board.

Credibility threat

The Bank of England has been more behind the inflation curve than most other central banks and has arguably lost a bit of credibility. Last week, the BoE’s quarterly survey showed that public satisfaction with the Bank’s ability to control inflation had hit a new all-time low. After missing its inflation target by so much for so long, MPC members will be sensitive to upside surprises in growth or inflation. And it likely wouldn’t take much – the vote was close at yesterday’s meeting, with four of the nine MPC members favouring a hike. The BoE has already shown it is willing to change tack – in June, it hiked rates by 50 bps after previously deciding to slow the pace of rate hikes to 25 bps.

To conclude, the BoE’s actions yesterday are probably best interpreted as a hawkish pause. As with other central banks, whether it hikes again will be determined by the way the data evolves. On that front, the indicators are ambiguous. But as a minimum, it’s too early to declare that the BoE’s rate hiking cycle is over.

The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.