Bond yields remain at the epicentre of risk assets and a dominating factor for stocks. Last week we asked whether rising bond yields might endanger the so-called “reflation trade” and a few days later we saw a napalm run during which US Government 10-year yields surged through key levels causing global risk assets to take a tumble.
Yields are testing the market’s resolve, though speed, rather than the absolute level, was the catalyst, with technical factors the driving force, as stops were triggered through the 1.45% level. Australian Yield Curve control came back with a vengeance.
For certain sectors, yields are absolutely key. The ratio of US banks vs the SP500 has matched the path of US yields over the last decade. If yields falter here, banks outperformance will slow.
In the euro zone, the ratio of banks versus the broader food and beverage staples sector has also been tracking the German 2Y versus 10Y yield curve. Banks have been on a tear, but if this mini bond bust has now reached its short term targets then we should be more cautious on the banks.
So what is the state of play in the so-called reflation trade and what strategies should investors be considering now that bond yields are testing the market? In the Big Conversation we’ll run through 10 charts that highlight an opportunity within the global energy sector.
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The sentiment pendulum has swung a long way since last spring. The panic we saw last year has been replaced by extreme optimism over a long-awaited post-Covid recovery. The front-page of The Washington Post last week touted the US economy’s “best chance in years to break from era of subpar growth” as we emerge from the ravages of the pandemic. Since last fall’s vaccine announcements, investor’s mounting enthusiasm has propelled commodity prices and bond yields substantially higher. Ten-year Treasury yields are now up 49 bps from the start of the year and almost 100 bps off the August 2020 lows. Five-year yields surged last week to touch 0.8%.
Surging yields are a global phenomenon. Ten-year yields were up 30 bps in Australia (1.90%) and five bps in Japan (0.16%) which may seem like nothing, but it meant that 10 year Japanese JGB yields hit a five-year-high, breaking out of the yield curve control range.
So do global bond markets have an inflation problem? The U.S. is after all running unprecedented peacetime deficits, with a new $1.9 TN stimulus package scooting through Congress and a debt to GDP ratios at its highest post-war level.
This is coming at a time when Fed is already expanding its balance sheet at historically unprecedented rates.
The current stimulus package will almost certainly be followed by a major infrastructure program. Inflationary pressures appear to be mounting and broadening – food, energy, housing and beyond.
Inflationary bottlenecks are gathering a head of steam with the recent US ISM prices paid index back near the 40 year highs, with many respondents talking about extreme supply issues. Two weeks ago Kellogg’s announced that it couldn’t make Frosted Flakes fast enough, while last Wednesday the Biden administration met lawmakers to discuss the shortage in semiconductors and chips.
In less than a year we’ve gone from worries about vast oversupply to mounting concerns over scarcity in the global supply chain.
So what should investors do about all this?
If the reflation trade is for real, then it’s probably time to consider the laggards within this sector.
The energy complex in particular stands out as a big relative underperformer. The chart of the ratio of the European oil companies vs the broader European market is still well below the previous 30 year lows.
Even more striking is the performance of these European oil stocks relative to other reflationary plays such as European Resources, where the ratio of oil to miners is at the all-time lows. Its not quite so dramatic in the US, but its still extreme.
If true global reflation takes hold, then the energy sector should start to see its long-term relative underperformance begin to reverse, or if the reflation trade is a mirage of dollar weakness, positioning and short-term effects of Chinese demand, then the mining stocks would be extremely vulnerable to a pullback.
Even within the oil and gas majors, we could look at the European sector which has performed far worse relative to its own market than the US over the last couple of decades, primarily because of the influence of shale in the US. A sector neutral position would be for the European names to continue making up some ground, especially that which has been lost during the recent rebound in prices.
There are, however, many structural caveats. The bull case for energy increasingly depends on many things to come true at once. Sanctioned Iranian barrels must remain offline, US supply must remain constrained, and economies must rebound quickly. Above all, OPEC must keep cutting because global demand remains weak. Add to this the draw of alternative energy technologies which have significantly outperformed global equities as investors flock to the decarbonization theme, and it's leaving many traditional energy players stranded. BP, Shell, ENI and Repsol have lost billions in market cap over the past several months, while renewable energy stocks and technology companies focused on cleaner fuels have surged. There also risk the further price rises in oil could prompt a response from the steadily recovering shale patch and tests OPEC's discipline, prompting a response from its biggest producer. Over the years, Saudi Arabia has shown its willingness to shift policy and maximize output if compliance falls or if the perceived cost of cooperation exceed the perceived benefits.
But Saudi Arabia could easily swing in the opposite direction in response to low compliance. And given the relatively low level of Saudi production, the size of the upward swing could be quite substantial, as was the case in April 2020. That could easily abort a bull run in energy stocks. The only feature that matched shale's disruptive rise in the past 15 years, during which it more than doubled the US oil and gas production, sharply reducing dependance on foreign oil supplies, was the industry's unmatched knack for destroying investor's money as hundreds of billions of dollars were spent with little return. Wall Street reacted by dumping its stocks, making the sector one of the S&P 500 smallest and they're underweight is effectively a huge short position on the sector. When the oil crash struck last year, operators were forced to slash capital expenditure, sack tens of thousands of workers, idle rigs and cut production. Chesapeake Energy's Chapter 11 filing into bankruptcy was just the most high profile of scores of bankruptcies. There are now signs, however, that a turn may be coming for the fossil fuel companies. Current prices are in a sweet spot because existing OPEC production quotas are largely being adhered to by the member states. So long as OPEC and companies in the US shale patch maintain their relative discipline, the rewards to energy investors could be substantial.
But energy investors still have long memories. And an additional note of concern for reflationists is the geographical distribution of the trends. Looking at the performance of the Canadian dollar relative to the Aussie dollar, if we have true inflation, shouldn't this be reflected in a broad outperformance of many resource based currencies? The underperformance of the Canadian dollar versus the Aussie dollar suggest that the demand in international markets for commodities was driven by China, who initiated supply side policies in response to the pandemic. She hoovered up demand for copper when supplies were constrained and her stockpiles were low. China will eventually dump her goods, creating a new bout of deflationary pressure. Chinese policymakers were this week warning about the dangers of bubbles, suggesting tighter policy ahead. If the US was a true reflationary story, the commodity rich Canadian dollar should be doing better. Commodity inflation is an Asia bottleneck, whilst U.S. citizens prefer to spend their fiscal checks on the equity market rather than the real economy, according to a recent study by Deutsche Bank. The point here is that miners is doing well and the Aussie dollar doing well reflect transient Chinese demand rather than true global reflation. It may also reflect supply side bottlenecks.
But if we get through reflation, then the energy sector should start to close the gap against the regional markets and against other resource plays with the caveats of the regulatory and renewable issues that we've outlined before. If, however, reflation is a mirage, then mining stocks have a long way to fall. And if the reflation trade is still in play because of fiscal policy, then the bond market is a reminder that this massively indebted financial framework is vulnerable to rapidly rising bond yields. Recent price action suggests yields may be getting to levels where reflation starts to hurt the reflation narrative. And as mentioned, some of the underperformance in traditional energy is due to demand for renewables.
I talked to Refinitiv's Wayne Brian about the current trends in sources of renewable energy.
The performance of the renewable energy sector relative to global equities has been explosive over the last year, whereas the performance of traditional energy sectors has been extremely underwhelming. Are the actual trends in the use of renewable energy sufficient to justify this outperformance, and what sort of growth trends have we been seeing?
So, yeah, I mean, looking at renewable capacity and generation of total demand, in the UK, typically we can get to around 50 to 60 percent. Today is not a good day. We haven't got much wind, we haven't got much solar and we're actually using more gas and coal. But on a really good day, we can get to around 50 to 60 percent. If we get about 40 percent from wind, 10 percent from biomass, and obviously 10 percent from solar and we have a little bit of hydro that's negligible, really so quite good levels. In the US that's around 21 percent. That's forecast to double over the next 20 years to around 40 percent. And in the EU, interestingly, about 38 percent of our electricity was generated from renewables. But last year, for the first time ever, renewable generation actually out did fossil fuels, which is a positive thing. In the European market, so in the EU last year, we added another 9 percent of wind generation and 15 percent of solar. So interestingly in terms of China, they installed about 45 gigawatts of wind last year, which is around half of their total installed capacity, which in the current climate was very impressive. In the UK, sorry in the US, they're looking to add between 40 to 60 gigawatts over the next few years and interestingly, that's equivalent to half of their whole nuclear fleets output. So, yeah, we've seen some positive changes over the last 12 months. Overall, it was a good year.
Investments into renewable energy have been picking up on a global scale and this has been diverting capital away from traditional sectors.
And if you look at the EU, they're looking at between 700 to a trillion euros being invested over the next 10 years. Now that obviously feeds into the green deal, so a lot of political pressure from there. We've also seen some funds that are allowing people to reinvest in that area. So, yeah, there's a lot, there's a lot of support technologically as well with new innovations. So we're seeing a lot of investments in that area. For example, in terms of solar, Statkraft, which are the biggest renewable generator in Europe, they actually purchased the UK company called Solar Craft. Now they're about to invest three point five billion in developing new solar farms, also to help you with the PPA, the energy management, etc.. So, yeah, we see lots of big scale investment in that, and also don't forget hydrogen, there's a lot of moves now towards hydrogen. So we're seeing large investments in that, around 300 million globally. And interestingly, again, half of that is slated for Europe, where we're really making real big moves in terms of hydrogen using electrolysis with renewables to create electricity in a cleaner way. In the UK, we're going to have a hydrogen town over the next seven or eight years, the first town powered purely by hydrogen. So, yeah, a lot more investment is happening at the moment.
As the production of renewable energy picks up development of the energy networks, also has to keep pace to avoid distribution shocks, but is there enough investment in the network?
Not as robust as we need, as they need to be at the moment to cope with what's going to be a huge change in how we produce energy. So looking in the UK, for example, Ofgem have already said we're going to invest up to 40 billion to actually make our networks able to handle the high levels of renewables we're going to see over the next 10 years. Of that, 40 billion, National Grid have already taken 10 billion of that. And that's what they're going to be doing to upgrade our network. Similar stories in Europe as well. So that's one of the most important things actually, we do have a lot renewables, we've got a lot more coming on, but can we integrate into our networks? A lot of these networks and infrastructures are aging. So investment is needed to allow us to move into 2050 where we want to be net zero. So, yeah, a lot more needed on that front when you look at what's coming in, but, yeah, we're making positive strides.
Whilst the relative performance of the renewable energy sector has probably got ahead of itself, it is being driven by increased investment and production. But these are still long term projects. Traditional energy has been on the back foot, but if true reflation really takes hold, there is still room to breathe life into the old sector as well.
