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MR. MICHAEL CEMBALEST: Good afternoon, and welcome to the Thanksgiving Eye on the Market. In the October note last month, I wrote about how, in almost every post-war recession except for one of them, equity markets preceded the decline in profits and employment and GDP and things like that by several months and said, let’s focus on the ISM survey instead, because when that bottoms, it tends of coincide much more closely to the bottom of the equity markets.
So, in terms of thinking about when that can happen, we have some approaches to try to figure out when the ISM survey is going, and they’re crude, but the fit’s actually not bad, and using this approach, the ISM would bottom in the mid- to low-40s sometime in January, February of next year.
If that were the case, it’s not impossible that the lows we hit in mid-October would be the lows for the cycle, and almost everybody I talk to discounts that scenario entirely, although, you know, it would be consistent with market history. I think that there are more corrections ahead, and that something closer to 3300 would be pretty good value for long-term investors if we got there.
The big question to me, now, obviously is not how high inflation goes. It’s probably cresting. The question is how long will it stick around, and we’ve got a chart in this month’s piece that looks at all the episodes of rising inflation in developed countries, and once inflation spikes, it tends to stick around for a while, which is in stark contrast to the much more rapid decline in inflation that markets are pricing in, in both the U.S. and Europe.
Now, I know we’ve got some exogenous issues now with COVID and China and the Russia-Ukraine War. Even so, what’s priced in about the inflation decline is much more rapid than what we’ve seen historically. Anyway, more on all of this in our outlook for next year.
The purpose of this year’s note is an eye on the market on the three things that I’m thankful for, and my list this year is CH4, HR4346, and mRNA1273. I will of course explain.
So, number one, why am I thankful for CH4? Well, I’m referring, of course, to natural gas. Natural gas composition is mostly CH4 with little bits of ethane and propane and butane mixed in. Let’s look at what was going on in Europe about a month ago. 70 percent of the fertilizer capacity was shut down. 30 percent of its aluminum was shut down. Steel plants were closing in Germany, Spain, Poland and France. One of the biggest companies in Spain furloughed 85 percent of its workforce and steel producers. The cement companies were shutting down. 30 UK energy suppliers filed for bankruptcy. The French utility EDF was nationalized. We saw the lowest level of business expectations for energy intensive German companies since re-unification in 1990, and Germany and Italy were seeing the highest inflation rates in 32 and 40 years, respectively. Now, gas and electricity prices have declined a bunch in, in Europe since the summer peak, and there’s a bunch of initiatives underway to cap energy prices, reduce energy taxes and provide support to businesses. Eventually, obviously, those are all borne my taxpayers. So, some of this industrial production might come back online, but European gas and electricity prices are still two to three times higher than at the beginning of 2021. Gas prices are still six times U.S. levels, et cetera, so while Europe is set for this winter with plenty of gas storage, most countries are either at or above 90 percent of capacity, a lot of what Europe has done to prepare for the winter is also lowering its consumption due to higher energy prices, and that obviously has a lot of negative repercussions.
So, stepping back for a moment, if I’ve learned anything from the 12 years I worked on our energy paper with Vaclav [phonetic], it’s that these renewable transitions are going to take time, for technological reasons, political reasons, judicial reasons, behavioral, economic. We go into detail every year in the energy paper. In the meantime, I’m very thankful the U.S. has ample supplies of its own natural gas, and the latest world energy outlook from the IEA, they show global natural gas demand rising by 2030 and 2050, in the scenario that is attached to policies that countries are currently pursuing, rather than declining. And we’ll go into more detail next year.
But, there’s something that all of your probably understand now about wind and solar power. We’re going to need plenty of natural gas power, gas capacity, even as we build more wind and solar power. Wind and solar are very intermittent and there’s times during the year where there’s not enough renewable generation to meet the load demand. This is all pretty simple. As a result, you can’t disconnect a megawatt of natural gas every time you add a megawatt of wind and solar power. The actual amount you can disconnect is referred to as a capacity credit, and they’re computed, and they’re pretty intensive calculations. We do them. You have to take the hourly generation by type and demand loads in each ISO, which is the independent system operator. Bottom line, every time you add one megawatt of wind and solar power, in the major ISOs in the United States, you can only disconnect around 10 to 30 percent of that in terms of the natural gas that you can unplug because you need that back-up thermal capacity. And the cost of that back-up power is not included in anybody’s estimates, or in most estimates I see of levelized cost of wind and solar, which is why I think that levelized cost concept is kind of irrelevant.
What’s more relevant to me on this natural gas question is methane emissions and flaring, and we have a little bit of a discussion in here, progress is being made slowly. Most largely firms have plans to reduce methane emissions and flaring, but only about a quarter of the smaller firms do, and this is from a Dallas Fed survey from last December and so the, look, the industry leaders have begun a very important shift from quarterly desktop estimations of methane leakage to more accurate measurements using sensors on planes and things like that. Most of them have committed to eliminate flaring by 2025. There are some new Clean Air Act regulations. A lot of the states have adopted new regulations. There’s a European and U.S. partnership called the Oil and Gas Methane partnership, so the industry leaders are generally moving in the right direction here and, and hopefully through, through both the combination of self-preservation and legislation, the smaller companies will follow.
Okay, what’s the second thing that I’m thankful for. I mentioned HR4346. That is the semi-conductor bill. The U.S. is going to need a lot of semi-conductors in the future, particularly if the renewable transition is going to pick up speed through adoption of electric vehicles. The semi-conductor intensity of electric vehicles is roughly double that of traditional, internal combustion engine cars.
So, unfortunately, as we all know, semi-conductor capacity started migrating out of the United States rapidly in 1990, fell in half by 2000, and then fall in half again by 2020, so only around something like 12 percent of U.S., the United States accounts for only around 12 percent of global semi-conductor capacity. The U.S. has a large market share of global semi-conductor revenues, but that’s because it relies heavily on Taiwan for production because Taiwan’s got 50 percent share of high value added chip capacity and 60 percent of the foundry market. I don’t think I need to spell out why this might be a geopolitical risk for the United States.
So, I’m thankful for this semi-conductor bill that was passed. It gives support for U.S. semi-conductor companies. I think it helps offset some of the negative consequences of the latest policies restricting their ability to sell chips and equipment to China. Nvidia, for example, stock has been in freefall. They, 95, they sell 95 percent of the high end chips in China. And this bill has gotten some criticism as corporate welfare, and I understand that, but if your goal is to improve U.S. semi-conductor supply chains, some kind of government support is going to be needed to offset some of the negative impact of some of these new national security rules.
Now, this semi-conductor bill is just a start. It’s probably only 10 to 20 percent of what the U.S. would need to become substantially semi-conductor self-sufficient, so it’s just a drop in the bucket, 50, 60 billion, but it gets the ball rolling, and believe it or not, it was a bipartisan effort. In the last few years, we’ve had a lot of bills that passed with zero support. This is the first time in American history bills passed Congress without a single vote from the opposing party in the House or the Senate. The 2021 American Rescue Plan, the 2022 Inflation Reduction Act are examples of that, and when the Trump Tax Cut Act was passed, it was the most partisan bill in U.S. history at the time.
So, the CHIPS Bill got 17 GOP Senator, 24 GOP House members, and Mike Pompeo also supported it, so in the context of the world we lived in, we currently live in, it is definitely a bipartisan bill.
Just a couple of quick comments, too, the United States relies on Taiwan, and China relies on Taiwan to an entirely different level. 70 percent, China only produced 10 percent of its own chips. The other 90 percent comes from imports or foreign firms producing chips in China. Of that 90 percent, 70 percent share is Taiwan. So, Taiwan produces 10 percent of China’s chips in Nanjing and Shanghai, and then exports the remaining 60 percent from Taiwan. I can’t find anywhere in the world an example of one country that’s so reliant on another one for a high value import. For context, Europe was, before the Ukraine war, 20 percent, or 25 percent reliant on Russian energy. So, think about that, 70 percent reliance on Taiwan for semi-conductors by China. That’s a huge number, and most of the Chinese foundries are working on 14 to 30 nanometer chips. The global leaders like TSMA in Taiwan are already producing at five to seven nanometers, so if the U.S. is reliant on Taiwan from a semi-conductor perspective, China’s reliance on them is much, much, much greater.
The last thing I am thankful for this year are mRNA vaccines. Now, the news is not all good. The latest COVID variants are showing increased signs of resistance to treatments. The new booster, which is derived from both the original variant and BA5 only has a 12 to 15 percent uptake in the U.S. The U.S. ranks somewhere around 73rd in the world on booster shots, and vaccines no longer do a great job against infection and transmission. However, they do a great job at preventing hospitalization and mortality, particularly for people like me, who are, you know, 60 years old. I just turned 60, which I’m still getting used to.
Now, what the world really needs is nasal vaccine delivery mechanisms, which might do a better job at preventing transmission and infection because instead of, I mean, I think the vaccines now do a good job at preventing the infection from getting into your lungs, but it doesn’t prevent you from getting into your respiratory system, and that’s what a nasal delivery might be able to do. We also need pan-coronavirus vaccines that are not so variant specific, right? In other words, not just tuned into the, into the three-dimensional topological shape of one variant or another.
That said, I’m very thankful for these mRNA vaccines, including the Moderna versions that I received. They have saved a lot of lives in the U.S. and elsewhere, and we have a chart in here showing how much more lives they could have saved if the vaccination uptake were higher. There’s some charts in here that support all of that, but I consider all of this to be pretty straightforward stuff.
Now, as you might imagine, my thanksgiving list of natural gas, the CHIPS Bill and vaccines is a Venn diagram that doesn’t overlap with a lot of Americans in the United States, which is why I’m still working alone from my hidden, unnamed bunker. Anyway, Happy Thanksgiving to all of you, and thank you for listening to the podcast. Bye.
FEMALE VOICE: Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of JPMorgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.
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This podcast is intended for informational purposes only and is a communication on behalf of JPMorgan Institutional Investments, Inc. Views may not be suitable for all investors and are not intended as personal investment advice, or as solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information, which can be found at www.jpmorgan.com/disclaimer-eotm.
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