Russia/Ukraine update: Energy implications
The brief note covers the price Europe is now paying for allowing its energy reliance on Russia to reach extreme levels, and the implications for the durability of sanctions placed on Russia if Russia retaliates with energy sanctions on Europe.
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Kathryn Pasqualone: Welcome, everyone, and thank you for joining us. My name is Kathryn Pasqualone, and I'm a client advisor here at J.P. Morgan Asset Management within our North American Institutional Business. Today I'm joined by Michael Cembalest, Chairman of Market and Investment Strategy for JP Morgan Asset and Wealth Management, and Monica DiCenso, head of the Global Investment Opportunities Group within the J.P. Morgan Private Bank. As we know, last week Russia launched a full-scale invasion of the Ukraine. There's a lot to unpack here from a macroeconomic perspective, but first we would like to send our thoughts and prayers to the victims of this terrible tragedy and all of those suffering. For investors it poses a number of questions which we're going to try to tackle today. As many of you know, Michael released an Eye on the Market on this very topic. For the next 45 minutes or so, Michael and Monica are going to discuss their views on the evolving situation and the implications for investors. So with that, Michael and Monica, over to you.
Michael Cembalest: All right, thanks. It might be an hour rather than 45 minutes, but we'll try to wrap it up quickly. Thank you, everybody, for dialing in. A lot of people my age have parents that fled wars in Europe, so this all brings back some memories that are not great. And so I wanted to start just with a few minutes of history. I hope everybody listened to the disclaimer in the beginning that said these are the views of Michael Cembalest and nobody else at the firm, because you're about to hear some.
What is it that the Ukrainians are trying to flee here? Russia might be the most consistently authoritarian place on the planet over the last millennium. They were ruled by the Mongols from 1250 to around 1500, and then for the next 400 years or so, they were representative of the most you authoritarian rule in Europe. There was a brief lull for 20 or 40 years. And then you had 75 years of Soviet totalitarianism, which was arguably the most deep-rooted system of totalitarianism that the world had ever seen at that point.
So I just want to put context around what Russia has been for the last millennium and maybe some of the misreading of what has taken place in history.
What is Russia today? Let's go to the first slide just so that nobody is under any illusions. This is a chart that we put together a couple of years ago. And it looks at the rights of the individual versus the rights of the state, and it looks at things like due process, press freedom, religious freedom, corruption, military involvement in politics. Where is Russia on this chart? Right where you would expect them to be it he lower right in between Iran and China. So that is -- that's Russia. And there might have been a misreading of just how intent the Russians were on regaining control over the Ukraine. I just want to walk through some history here before we get started on some of the market stuff.
If you can go to the next page, in the late 1990s, there was a NATO enlargement. And just to put some context on it, it was the purple region on this map. And the sum of that land area is more than the land area of France and Italy and Germany combined. So that was a massive movement eastward. And it was not a unilaterally well-received one, even in the West. And if you can just skip ahead to -- go ahead to the next page. There's some history here that we can skip. The only thing I do want to point out is as recently as 2008 and again in 2013, NATO leaders were pushing NATO membership for Georgia and the Ukraine. But I do want to go to the next page, because it's part of the history that we have to try to understand, and we can't avoid. There were a lot of foreign policy experts, politicians and military officers in the late 1990s, including some of the most well-respected people that I've ever either known, met or read about in my life who wrote letters in opposition to this NATO expansion. And George Kennan, who was the architect of the postwar peace with the Soviets, said that the Russians would react quite adversely to this. And he thought it was a tragic mistake. It's odd to bring this up at a time that the Ukrainians are fighting bravely for their lives, but it is part of the history here, because if NATO was really going to dangle membership in front of the Ukraine, we can now arguably say, within this debate about liberalism versus realism in foreign policy, that maybe that should not have been done without sufficient guarantees to protect them in the accession process of joining.
Just so everybody understands, you know, I ran emerging markets for J.P. Morgan in the 1990s. We all kind of thought Boris Yeltsin was a bit of a joke. He was drunk in public and Russia was flat on its back. Look at these charts. Russia had no foreign exchange reserves after default, the current account had collapsed, the Ruble had collapsed. But apart from making smart important policy decisions is not just estimating your enemy in the present but understanding what they might be in the future. This is a very different Russia we're dealing with right now. It's very well-funded. And a lot of the sanctions may do some damage here, but Russia is a very different place than it was in the 1990s when NATO pushed the expansion right to Russia's doorstep. And so I'm speaking for myself and probably a lot of the people on the call here, I'm praying for the Ukraine. But it looks pretty dire when you look at the military balance between the two countries. They've had some success with some Turkish drones and some Stinger missiles and more help coming from Western Europe. But I think at this point I don't know why the base case wouldn't be that Russia forges ahead, despite sustaining massive casualties of their own, and eventually takes control politically of the Ukraine, I don't know how one could avoid that central scenario. As I mentioned, I'm praying that the outcome is something that's different than that.
Let's go -- now let's get into some of the issues here around the politics and around the markets and around energy. Let's go to the next page. You've all read about this. The sanctions checklist has been growing. We don't need to go into details here. I think there's lots of unknowns about how effective the limits on Russia central bank trading will be. There are debates about how effective the SWIFT network blockage is going to be. Notice in the first bullet point fight all the sanctions on the Russian banks, there are carve-outs for transactions related to energy and agricultural exports for all the obvious reasons. And, you know, it was interesting to see the Nord Stream pipeline project frozen for the time being. But I think that this is more likely to be a lasting legacy of the conflict than something that changes the nature of the conflict or its outcome.
Let's take a look at some other things that have been happening. And this was just a partial list on the next page. Some of these are kind of remarkable. Next page. Germany for the first time is supplying anti-aircraft and other weapons to another country. The same thing for Norway. The last time Norway supplied arms to another country it was 1939 when the Soviets invaded Finland. There are contributions from the Dutch and from the Belgians. Germany is closing airspace to Russian aircraft. BP the other day, then Shell, either just outright writing off or selling their stakes in Russian energy companies. I do think that there should be some questions about Daimler which has a relationship with the Russian vehicle company that produces vehicles for the Russian military. The Norwegian Sovereign Wealth Fund is dumping Russian assets. Even the Swiss are considering greater sanctions participation, which is a sign of how much this has galvanized opposition. But, again, all of these things are simply raising the price that the Russians are apparently already willing to pay. .
Monica DiCenso: I want to jump in there, Michael, real quick. We're going through this list. Is there anything that they can do, because it does feel like it's a lot of little things happening. Do you think there's something bigger that could happen that could change the outcome, the scary outcome, that you outlined earlier?
Michael Cembalest: It's not clear to me even an embargo on Russian energy exports would end up depriving the Russian government of the ability to conduct this war to the conclusion that they planned for. If you look at the amount of foreign exchange reserves that they have already amassed and if you look at a population that takes its life into its hands for protesting its government, and you look at the fact that China made plenty of loans to Russia in 2014, after the annexation of Crimea, we have no reason to believe they wouldn't do the same this time around. China would also look advantageously in all likelihood at the opportunity to buy discounted energy exports from China-- from Russia. It's not clear -- and again, and the ability of the Russian government to incur massive losses without having to worry too much about domestic reaction, it's not clear that any -- it's not clear to me that any constellation of things, other than NATO participation in defending the Ukraine, would be able to change the outcome that appears to be underway. But that’s-
Monica DiCenso: The reserve balance is part of the scary chart, showing how deep their pockets are. I mean, at this pace, how long can they last like this? You're saying years potentially?
Michael Cembalest: These kind of conflicts tend not to last for years. You know, they could end up in a Vietnamese type quagmire, or an Afghanistan-type quagmire; anything is possible. But that would simply raise the cost. And again, it does appear that at least the Russian leadership, at the highest level, is willing to pay a significantly high cost here. Look, there's lots of commentary out here that Putin massively underestimated the amount of sanctions and their breadth and their depth and the brave resistance on the part of the Ukrainians and the underperformance, apparently, on parts of the Russian military, but I don't know that that necessarily changes the outcome.
Let's go to this issue you mentioned on what can and can't be done, because it starts with energy, right? What have we been saying? For the last 12 years in our annual energy paper? Energy transitions are slow things, not fast things. We have these charts where we compare rapid adoption of smartphones and social media and all sorts of other stuff that get adapted immediately. We're sitting here, wind and solar power still represent, after 15 years of investment, something like 2 to 3% of global primary energy use, and roughly the same percentage of the global fleet is electric vehicles. Energy transitions take a lot of time. Let's jump ahead to the next slide so we can start to get into that.
This is a tough chart. You know, Europe basically has been advocating its own domestic production of oil and gas, in favor of renewables, and is now equally reliant on Russia as it is reliant on its own domestic production for oil and gas, with Germany, Italy and the Netherlands being the most exposed. There are just no magic bullets for substituting for Russian oil and gas. And I'll have a couple of charts that explain why. But this is a shocking chart. If the United States had this chart, I think there would be an enormous amount of political recrimination if the United States ever allowed itself to get into this kind of a vise where we had this degree of energy dependence on another country. Let's go to the next one.
And -- and just to break it down, of all the imports, Europe gets around 60% of them from Russia for natural gas, and around 30% for oil. So it's really, as you might have read, it's a gas issue for now.
Now, this is the cost the Europeans have paid so far, and we don't even have any explicit controls, tariffs or war-related sanctions on importation of Russian energy. The chart on the left is wholesale electricity prices. And the chart on the right is wholesale natural gas prices. These are remarkable changes in energy prices, the likes of which I've never seen before, in a developed country, in this magnitude in this short period of time. Now, there are –
Monica DiCenso: Anything Europe can do to extricate itself from this? It's a little scary, at least in the near term.
Michael Cembalest: Over a 10 to 15 year time frame, sure. Over a 10 to 15 month time frame, absolutely not. And some of the most ill-informed things I’ve ever read about energy are the things that talk about the ability to engage in rapid this transitions, and I don't know if this is going to happen, but somebody mentioned to me today that the Biden administration, in the State of the Union address, might actually announce the creation of a strategic gas reserve alongside the Strategic Petroleum Reserve. Imagine the about face of the Biden administration acknowledging the critical nature of natural gas. That would be remarkable.
Monica DiCenso: How much does the strategic oil reserve, or potentially, gas reserve, can even play in, because people always say, “Oh, we'll open up more reserves.” But does that really matter?
Michael Cembalest: Well, no—well, what they’re talking about— well, releasing the strategic petroleum reserve is a way, over the short term, of controlling the increase in gasoline prices. The acknowledgment that you need a strategic natural gas reserve is because for home heating and industrial production, you're highly reliant on natural gas. Now, there's some, in some corners, I've read LNG to the rescue, U.S. LNG exports. Not quite so simple. LNG exports, you can’t ship gas. You have to ship compressed gas, which means that you need very expensive liquefaction and regasification facilities on both sides of that trans-Atlantic trade. And shipping costs are expensive.
Now, let's look at the chart on the left. So the chart on the left shows that pipeline flows from Russia have been going down over the last few months. That's the blue line. The gold line is LNG imports into Europe are rising. The red dots are the U.S. So the U.S. is participating in the provision of more natural gas to Europe through LNG, which is helping, and allowing them to slightly reduce their exposure. But at what cost? LNG import prices in Europe have nothing to do with Henry Hub prices in the U.S. The chart on the right, the blue line is Henry Hub prices for natural gas in the U.S., that gold line is European natural gas prices, and the red line is European LNG imports. So in other words, our LNG and the LNG from Qatar and Algeria and Australia is imported at the marginal price for gas, which is where the European natural gas prices are. So the U.S. can help in terms of flows, but in cost terms, it doesn’t really solve anything for the Europeans.
And just to spend one more minute on this, the chart on the left shows why. I mean, when you look at where gas comes into Europe, Russia is an enormous chunk of that. Then the other brown slices are all the LNG regasification facilities that exist in Europe. But they take years to build. Each one is going to be either 1 to 1.5 billion dollars at least, and you can't just say let's shut down a third or a quarter or a half of that Russian buy and immediately rely on LNG, because the existing LNG facilities are operating at above 90% utilization rate as it is. So as a long-term plan to secure more supplies, it's potentially an answer, but it's very expensive, the cost is high, and you know that's still the big issue. Next.
And I -- I'm not going it dwell on this, but for everybody that says, well, isn't there something the Europeans could do about their energy reliance on Russia? Okay, here's the chart. This is European energy consumption. Most of it is for industrial production of glass, cement, bricks, ammonia, fertilizer, steel and things like that. And as you can see, they use a lot of oil and they use a lot of gas. It's very difficult to electrify industrial production, another topic that we've written about a lot in the energy paper each year. Then you can see a massive transport bar that's mostly oil. Europe is making more progress than the U.S. on electric vehicle penetration. But remember, EV as a percentage of sales can go up fast, but EV as percentage of the stock takes much longer to rise. And then you can see the other two bars, residential and commercial home heating uses lots of natural gas and oil as well. Those dotted things, that's the electricity grid. And Europe is making a lot of progress in decarbonizing the grid, which are those green segments with the white dots. But the lesson here is probably the single most important thing about energy that I'm always telling our clients, which is decarbonizing the grid is very different than decarbonizing overall energy use, when the grid only represents 20% of energy consumption. Right? So when you say what can the Europeans do? Well, whatever it is they do will require them to decarbonize home heating, transportation and industrial production, and that takes a really long time.
Monica DiCenso: Add it all up, you don't see a way for them to pivot in the near term to pull away from this dependence?
Michael Cembalest: Again, if they want to pivot away using natural gas, that would be reliance on LNG exporters at a much higher price, whether it's 3 times 4 times 5 times, I don't know, could be in that range, and if you’re talking about pivoting by increasing the pace of renewable energy, they're doing it on the grid, but there's very little evidence of a rapid transition taking place outside the grid. OK? Let's keep going.
So what happens next in oil markets? Well, Russia could divert a million barrels a day or so to China. The U.S. is talking about releasing some of the Strategic Petroleum Reserve. It looks like the French, Russians and U.K. negotiators are cooperating on one thing, which is reviving the nuclear agreement with Iran which would free up maybe a million barrels a day from an Iranian floating storage and maybe another few hundred thousand barrels a day of additional production by the end of the production year. But all things considered, I don't though how we get out of $100 to $125 dollar oil over the next three to six months. It would take a global recession to drive oil prices way below that level.
Monica DiCenso: Yeah, one—I guess one question on that. At 125, you don't think it's high enough to push us into a global recession. Is that maybe 150, 175, something like that?
Michael Cembalest: There’s are a lot of coefficients that people estimate in terms elasticity, growth and inflation, employment, changing oil prices, things like that. I do think it's above 125. I mean, they're very imprecise beasts, but I do think it's above 125.
Monica DiCenso: And then I guess on Putin for one second, in looking at all this, it feels like he has a lot of leverage, so maybe we can answer this later, but what is his end game here, because—keep going on Ukraine, but I guess I'm struggling with what's next and where this ends.
Michael Cembalest: You know, again, in 2008, NATO made a push for Georgia to join NATO. The Russians invaded Georgia and that was the end of it. I think we're seeing the same thing play out, which is the Russians are going to seek to end this conflict, when they have sufficiently destabilized the Ukraine into a state of misery and poverty and political weakness, that they are unable to creditably say that they would be joining NATO. If I'm trying to find a silver lining here, it would be so far that the performance of the Russian military has been such that I think it would be very difficult for them to contemplate a subsequent invasion of an actual NATO country. And I can imagine that the U.S. military is paying very close attention to the successes and failures of Russian equipment planning, cyber, and everything else.
So the problem is -- and this is different. I mean, this is different than where we were just three or four weeks ago; wars like this can exacerbate very tight conditions in energy and grain markets -- we'll get to the rest in a minute, but here's another chart that I've been showing people, the chart on left. It-- decarbonization is great, but if you push too hard on supply and not on demand, you're going to have a problem. The chart on demand shows the world has been pushing real hard on decarbonizing the available supplies of energy. That blue line is the capital spending by the world's largest public energy companies. Unfortunately, demand hasn't changed at all. So global primary energy fossil fuel use isn't changing, right? So in a lot of countries there's been a lot of decoupling on policies supply and balloon that aren't working so great now, and in this kind of environment, you get energy price spikes. And we also, for a variety of other reasons, headed into this year with declining inventories of wheat and corn. And so the Ukraine is a pretty substantial producer of both, and so we're going to end up with not just energy price inflation but inflation of agricultural products as well, which can feed into inflation in other intermediate goods.
From an investor's perspective, as 18 months ago, we were baffled by the perception that fossil fuels were essentially permanently stranded assets. And we didn't agree with the degree of outperformance of renewables, less traditional energy. And as you can see, starting about 18 months ago, almost coincident with our energy paper, when we wrote about this, it's moved pretty rapidly in the other direction, and that Mark Twain quote, “for better or for worse, reports of my death are greatly exaggerated” is pretty accurate here as it relating to the relationship between the world and fossil fuels. And here you can see how quickly the pricing of some of those relative equity baskets changed.
And here you can see agricultural prices skyrocketing, industrial metals prices skyrocketing. These are a little misleading because these are prices, and every year energy intensity goes down. So the amount of industrial metals per unit of growth is not what it was two decades ago. So this price spike is not as painful. Same thing with oil. Same thing with gasoline, right? So the energy intensity of the world isn't what it was, but still these are pretty big spikes that are going to hurt consumption, and in terms of non-energy-related and none food-related consumption, and hurt confidence as well.
So, here are some charts from our outlook. We are expecting these things to be improving. These are the supply chain charts. We expected these things to be improving by May or June. They're improving a little. So the chart on the left is delivery times in the manufacturing sector. We still believe over the next few months there is going to loosen up. There's been a lot of capital spending in semiconductors, in the auto space, and we think some of that is going to pay off. But these manufacturing delivery times are still big. And then as you can see on the right, those LA and Long Beach ports, the number of anchored containerships there is still very high. And I will -- I think it was on the last webcast I showed that of 350 ports in the United States, these rank 320 and 323 in terms of their productivity and efficiency. So what's going on here is not just a supply chain issue, but some very specific productivity issues, a lot of which relate to the lack of automation in these LA and Long Beach ports, which account for a third of all container ship imports into the United States.
Monica DiCenso: And how does that get alleviated? That takes time as well, right? So there’s no quick fix.
Michael Cembalest: It does. I mean, the quickest fix here, other than changing a lot of what we know about the state of California and its politics, the quickest fix here is a shift in consumption from goods to services. And we had that massive COVID surge of goods-related spending. As the Omicron wave subsides and in many parts of the United States, it's subsiding as rapidly, as quickly, as it went up, we're starting to see some evidence of spending shift from goods to services. We need to have that come through real hard and real past over the next two to three months to start alleviating some of these bottlenecks. We've got to keep moving.
All right, so rising input costs are challenging. The good news is rising input costs, whether they're energy or labor, tend not by themselves to cause recessions. And that's because revenues -- one person's costs are another person's revenues. And look at this chart. It's kind of remarkable how revenues and costs tend to move in tandem. So the bigger question is not are costs going up. The bigger question is, is there going to be a recession as a result of the war, changes in confidence, changes in spending and changes in inflation. So let's take a look.
Monica DiCenso: I keep getting asked again, will this make the Fed pause, then, for example, on their hikes, for example?
Michael Cembalest: I don't think so. Let's take a look.
Russia and the Ukraine just don't account for that much of U.S. imports and exports to affect the inflationary dynamics that are underway. And this is really the back drop that may be hurting the markets this year even more than the Russia/Ukraine conflict, is last Labor Day, the markets were pricing in zero Fed hikes. I've been doing this for a long time, and I don't remember a time when we went from the market pricing zero hikes to pricing seven hikes in, you know, five months. And so that's a big adjustment for the markets to make. And I don't know -- maybe at the low end they hike five times, but the -- we're starting to see the beginnings of a little bit of a wage price spiral. Let's spend more time looking at this inflation question, because it's critical in terms of whether or not the Fed can deliver a soft landing versus a hard landing. So next.
The history is not great. There have been five episodes where headline inflation went above 5%. And it took a recession every time to knock it down. A combination of Fed tightening and recession. Now, you know, I don't know that the hyperinflationary or stagflationary conditions of the '70s are relevant here. And so 1990 and 2010 are the most recent examples of this, of when you had headline inflation over 5% and you couldn't really get out of that spiral without a recession. The Fed has a shot this time at a soft landing. And let me explain why. So let's go to the next page.
This is the weirdest chart that I've seen over the last I think -- in a long, long, long time. Normally there's some relationship between goods inflation and services inflation. And during the bulk of the 2000s, goods inflation was way more depressed than services because of the United States let China into the World Trade Organization in 2001 and you have this massive flood of emerging market imports that depresses goods inflation. But look at the this spike. The goods inflation spike here that's pandemic-related is anomalous. You use your own adjective. I don't know how else to describe it other than anomalous. And it suggests that there's a big payback in the pipeline once some of the supply chain issues, whether it's used cars or anything like that, starts to loosen up. And so I think the Fed's got a shot here because of how strange this inflationary spike happens to be, and that resolution -- they're still going to have to hike. But I don't think they're going to have to, for instance, raise the policy rate above the rate of inflation this year, or early next year, in order to get control over this, because there's going to be some pay back from this blue goods inflation line coming down.
Monica DiCenso: Basically we have a skewing of some of the data because of the effect of the COVID, which is making things look a little funny?
Michael Cembalest: They look funny to me. And I think this pandemic related surge will hopefully start to resolve itself. And we're already, as I mentioned, when we look at the Chase data on spending, we're already starting to see a shift from goods to services. Let's go to the next page.
Here's why the Fed can't do nothing. Which is -- by the way, a lot of this data we're looking at was also hanging around last summer and the Fed were still saying they were going to do nothing, because they thought it was all transitory. Now it's not so transitory. Inflation is broadening a little bit to services. You're starting to see wages increase. The chart on this page is a composite of average hourly earnings and the employment cost index adjusted for -- normalized for certain things. It's the best chart I've seen in terms of capturing what wages are actually doing. And then we've also got some really bizarre increases, 8, 10, 12, 15%, in the rental market, because of very tight housing markets.
Monica DiCenso: Because you're coming off a low number from COVID, you think?
Michael Cembalest: It's partially that. It's partially for two years a lot of states and cities had foreclosure and eviction moratorium that distort the markets. We had massive amounts of fiscal stimulus at the same time. You had unemployment benefits in some certain places that exceeded people's prior incomes. A lot of things that happened during COVID that hadn't happened before and distorted some of these things. But they appeared to have caught fire a little bit from a kindling perspective, and that's why the Fed has to act. And that's why I think almost irrespective of what happen happens in the Ukraine, you're looking at at least five hikes this year, unless we end up in a shooting warn between NATO and the Russians. I don't think you can put a zero chance on it, but I think it's certainly clear that the NATO countries are trying as hard as they can to try to avoid that. In terms of the West supplying weapons to the Ukraine, let's not forget that the French supplied Exocet missiles to the Falklands to the war with the U.K. Sometimes people don't react to weapons sales the same way they do to people firing weapons at you. Next.
Monica DiCenso: One question on that, because you mentioned a potential for a shooting war; we hope not. How popular do you think this war is on the ground in Russia? And I don't know if we have a great way to gauge it, but like, you just wonder, at some point it becomes very unpopular and is enough pressure?
Michael Cembalest: You know, I don't know how to answer that question other than saying for the last 20 years, I've been hearing people in the State Department talk about how Iranian sanctions were going to change the vex on the ground in Iran, and they have not. It doesn't mean they weren't worth doing. But there’s been some interesting research, and I read about this once on Eye on the Market, on how the long history of sanctions against determined monarchist or authoritarian regimes doesn't work auctions the outlet for people to complain is they end up in jail or worse. So as we saw from the very first chart in this presentation, Russia doesn't really take kindly to people protesting, and so I don't know that it matters, is my short answer.
Now, the silver lining for the Fed is this -- inflation expectations have gone up in the short term, but they haven't anchored yet over the longer term. So the chart on the left shows how, in 1980, and then again in 1990, consumers were expecting over one year and five years inflation to be elevated. This time around there's a gap. Same thing, chart on the right, median expected inflation rates, much higher one year versus three year. So, the Fed has got a window here if they get some relief on the goods inflation, they'll have a chance here to get a soft landing, if longer term inflation expectations don't really solidify at much higher levels than they are now. So they've got a window, and I would like to see the Biden Administration focused a lot -- as much as they can on helping the Ukraine, but also as much as they possibly can on taking steps to resolve supply chain and labor market issues. We lost 1.5 to 2 million people out of the labor force who retired during COVID; more than trend, right? That's 1.5 to 2 million more than the trend. Very hard to get those people back into the labor force once they leave. There are still several million people that can't get childcare because of COVID, people who aren't working because they refuse to get vaccinated. So whatever the Biden Administration can do to resolve supply chain and labor bottlenecks is going to be really important for the Fed. And I can't say I've really seen a lot of credible policymaking on that front. Next.
And some of the models that we follow agree with the prior page, which is that both producer prices and consumer prices will probably be drifting down over the next few months. The producer prices on the left, you can see, are already starting to roll over. And we think that using models based on global business conditions, the CPI is going to follow. So as things stand right now, we still think that the Fed has got a shot here to hike five or six times, funds rate still negative, 10-year still negative in real terms. And they don't have to crush multiples. But if the Fed has to bring the policy rate above the rate of inflation, you know, you get another large contraction in equity multiples.
Monica DiCenso: And so your five times assumption is based on GPC prices coming down. So fast-forward three months, we're not seeing that?
Michael Cembalest: Five or six hikes this year. Yeah. Next.
Let's talk about the equity markets. It's a weird mix. There are certain parts of the equity markets that have really gotten shellacked, which are beginning to look interesting, and others only modestly adjusted. So here, the cyclicals have given up a lot of ground versus defensives. But, boy, it was a long ten-year climb up that mountain. So I wouldn't say that cyclicals are necessarily trading at depressed .deep value type levels here. And so this particular one hasn't moved that much. Next page.
Let's take a look at value versus growth. Similar story. Value has been recovering. There's two different ways to look at it here. But value has been recovering versus the broad market versus growth. But there's still a pretty long way to go here. Which means that the average growth stock hasn't really gotten -- you haven't really seen capitulation in the average tech, software, services, and parts of the healthcare sector to protect growth stock. Next page. Let's look at parts of the market that have been clobbered.
Some of the weakest links have been crumbling. Here you can look at the SPACs, IPOs, thin tech, renewable, clean tech. And I'm not surprised -- and for those of you who remember the piece we wrote a year ago now -- did you do the SPAC call with me?
Monica DiCenso: You know, we did the meme stock call together. I was just thinking--
Michael Cembalest: The meme-- I forget who I did the SPAC call with; my memory is gone. But I'm not surprised that the SPAC market ended up being the thing that pulled the plug on the broader pricing for crazy risk. I call it SPAC-cine hesitancy. That's how much we disliked this market and its adverse selection. And I think for this market cycle the SPAC prize goes to Nikola, which is the fuel cell truck that staged its demonstration with a truck that didn't have a fuel cell in it, it had a hidden extension cord and they pushed it down the hill. For me, that tells you a lot about what you need to know about companies going public via SPAC mergers. But anyway, a lot of these weak links have gotten clobbered. Next page.
The low margin stocks have finally come back to earth. The last couple of charts are giving me a little bit more comfort about averaging into risk over the next few months and weeks, because a lot of the stuff that was massively mispriced have adjusted. And—
Monica DiCenso: --because you see these huge corrections in some sectors, right? Overall S&P is down 9 to 10% to date. We started the year called S&P to be up high single digits. Do you still stand by that view? Like, that implies pretty meaningful upside for people.
Michael Cembalest: Yeah, and l do think that based on a certain constellation of events, where the West accepts the horrible facts on the ground in the Ukraine, we don't get explicit bans on Russian commodity courts, the Fed hikes five to six times, goods price inflation starts to roll over by mid-year, I could definitely see -- and I'll get to the reasons why in a minute, but I still think we can reach those levels. Let's look at another one. Look at this one.
This is a distribution of the draw downs, you know, which is a decline from peak levels, on the Nasdaq stocks. So the average Nasdaq stock is down 40 or 45% from its peak, and a huge chunk of them are down 50, 60, 70% from peak levels. So you know, you've got to be -- by the way, this is an argument that ETFs in down markets can do damage. It will be interesting to see how the active management community does here. But this is telling me that there is a lot of capitulation in parts of the market, and I think this is an important thing it look at. Next.
And, you know, this is another one of our capitulation charts. One of the weirdest things I've seen recently is this ARK Innovation ETF. When you looked at it, the actual holdings, like it was part innovation, part hope, part expectations, part Tinker Bell, parts lots of stuff, and that has now converged with an old economy basket. Look at what it has converged with. You could have invested in farm equipment, industrial REITs and a company that makes mops, cleaning supplies, and uniforms and been in the same place. But again, this is a good-
Monica DiCenso: Arguably a less exciting ride.
Michael Cembalest: Yes. I prefer the bottom one to the top one. But you know, there's a lot of evidence here that we're seeing more signs of capitulation, which is a helpful thing as investors start to look at the landscape here of a-- of a-- I don't want to say post-war environment, because I don't how it’s going to take to get to post-war, because of what’s taking place. Next.
Monica DiCenso: This sounds interesting -- do you think the rout in biotech made sense? It sold off, along with so much else that’s high-growth.
Michael Cembalest: Yeah. Well, we talked about biotech in the outlook this year. Biotech has gotten shellacked, and the-- it doesn't have more than 25 years of history, in terms of what we now think of as biotech. And it has underperformed in the broad market as much as it ever has. And what's interesting, this was less about fears of the reconciliation bill, which had some clauses in there about Medicaid and Medicare being able to renegotiate drug pricing, because that was going to phase in very slowly. Just a few companies by 2025, maybe a hundred, it would only be for drugs where there was no generic competition. And now it looks like the reconciliation bill is -- may not happen, or if it does happen it will be in an extremely abbreviated form. What really happened here was a whole bunch of things. The drug pipeline had dried up, too much speculation based on mRNA vaccines being applied to all sorts of other diseases, a really badly handled Alzheimer drug approval process by the FDA. And—but mostly it was just a weak pipeline. But I think you're getting paid a lot for the R&D that's been put in place to take some risk here. And so, for example, if you look at the chart on the right, you're now looking at cash flow yields that are at or equal to the tech companies. And the tech companies have amongst the best cash flow yields in the entire market. So I put this slide in simply because I know that some of our clients are going to ask us, well, where are the deep value opportunities, where are the things that I should look at if I wanted to deploy some risk over the next couple of months. And this is one interesting idea.
Monica DiCenso: I assume we're going to talk more about other parts of the market, but I assume you wouldn't say touch any of these beaten up areas in the emerging markets yet, or Russia or Ukraine or something like that.
Michael Cembalest: You know, as a matter of principle, it our clients want to talk to some of our traders about Russian assets, but I don't think -- I'm not going to do it. I don't care how cheap they get. Next.
Now, these are prewar levels, but the other bright spot is the capital spending data looks good. And look at the chart on the right. Right before the war started, we had some pretty good data in both the U.S. and Europe in terms of positive economic surprises. Some of those will get reversed but some of them won't. And so I still think that we could see some reasonable GDP growth numbers in the U.S. this year. Europe is going to be tougher because of just the massive energy price hit that we saw in those earlier charts.
Monica DiCenso: One quick one there, because this has been very U.S.-focused from an investment standpoint. You talked about the Fed. What do you think the ECB does? Can they make a move here, or—
Michael Cembalest: I don't know. They're in a tougher spot than the Fed. The latest inflation data that we're seeing in Europe are higher than we've seen in a really long time. Three years ago, the ECB would have been overjoyed to see a signs of pulse in inflation. Now it's not so easy. I think they're reaction function is whatever the Fed is divided by two. Next.
So I just want to wrap up. We're almost out of time. But there was something I did in 2014, where we looked at geopolitics. Geopolitics are usually not the drivers of equity markets three to six months out. So these are the postwar geopolitical events. And three to six months out, whatever the pre-conflict trend was, economically, is what kicked in. And so sometimes you had sell-offs, sometimes it came back. For example, the line goes down after 9/11, not because of 9/11, but because we were in the middle of the kind of tech collapse. The line goes down during the Vietnam War because of the Vietnam War and because of deficit spending and things like that. The exception was the Arab-Israeli War, where you had an economic trajectory that was rickety but stable, but then the spike in energy prices, the collapse of the gold standard, a thousand days of wage and price controls by the Nixon administration, and that geopolitical conflict really did lay the seeds for a pretty horrible seven to ten years, at least seven years after that. And that's when I remember first trying to understand. I was only ten, but when I first was trying to understand the basics of energy markets, because our parents could only go to the gas station on odd and even days. I remember hearing the phrase “energy independence.” Right? And Nixon used to talk about energy independence, in between his other various crimes. And I remember -- and 50 years later, we're here. So if the United States doesn't have a big recession, it's because we have finally achieved a level of energy independence that the country has been trying to get to for 50 years. Let's go to the next page.
Look at these charts. It's about. A long journey. But you know, finally these -- when these charts are above zero, we have an energy deficit, you can measure it in dollar terms or you can measure it in megajoules of equivalent energy terms across oil, gas and coal. And finally on both of these charts the United States is energy independent. And if the United States weren't energy independent, then I would be much more concerned about the implications of what's going on globally and the risks of tilting the U.S. into recession.
And so what's taking place in the world is another reminder of how important energy independence can be.
So let's wrap up. You know, the near-term equity market reaction is going to be I think negative for a little while. Most institutional and individual investors, we're not positioned for the combination of what we're getting, which is the biggest land war in Europe since World War II, and also the largest gap between jobs and workers as well. In other words, the available workers to fill job -- vacant jobs is the largest gap since World War II as well, which is a chart we didn't have room for. But you know, as usual, it's going to be very difficult to time the bottom, and if we don't end up with a global recession, I think it's going to be very difficult for somebody to take risk off here and add it back at the right lower level. And a lot of the growth premium, not all of it but a lot of the growth premium has been eliminated, particularly in the “YUC” companies, those young unprofitable companies. I think it's created an opportunity for the people that are not over their skis on risk to start to benefit from the repricing that's been taking place. As difficult and as painful as it is, the energy consequences for Europe, because of the policy decisions that they have taken, may result in eventual acceptance of the facts on the ground in the Ukraine, even as those tougher sanctions unrelated to oil and gas remain in place. And to reiterate the Fed, the Fed is going continue to tighten here, they have a difficult challenge ahead, but the unorthodox nature of the inflation spike, because of the pandemic should help. We think policy rates are still negative in real terms by the end of the year. We still think we'll get 3% real GDP this year, although the inflation number by the end of the year, which we thought would be below 3%, looks like it’s going to be above 3%. And I don't think we can back down to 2.5 until the end of 2023.
Monica DiCenso: A couple of quick things -- what is the biggest risk to this view that you're summarizing here, just for people to kind of take away?
Michael Cembalest: That the wage/price spiral in the United States really kicks into overdrive, irrespective of the eventual pay back from declining goods prices. I mean, that's the biggest risk to the U.S. And then obviously the consensus opinions over the last few months were wrong about the escalation in the Ukraine, almost at every step. I think a lot of people have seen by now that Putin has mentioned some kind of high alert for Russian's nuclear arsenal. And--
Monica DiCenso: Do you believe that's posturing, or is that—
Michael Cembalest: I don't know. It's hard to speculate. In wars, people make mistakes, right? When wars are happening, even during the darkest days of the United States conflicts with the old Soviet Union, there was the hot phone. There was the red phone that was designed to establish lines of communication, to make sure that certain red lines didn't get crossed. And I'm tempted to believe that those red lines are still functioning, which is how the Europeans and the U.S. have made these carve-outs on the sanctions, to continue to allow agricultural and energy exports out of Russia and the Ukraine. So-- but in shooting wars, things can happen. The United States has made military commitments all the way up to Russia's border in the Baltics, and I thought it was interesting recently; just as the Swedes and the Fins are now pulling more in favor of maybe joining NATO, the Russians have responded to the Finns and the Swedes, saying not so fast. So NATO has got some tough decisions it make about what kind of military commitments it will make and what kind of military commitments that it won't make. And during wars, mistakes can happen. And that's obviously a very, very bad scenario for humanity, in addition to a bad scenario for markets.
Monica DiCenso: One last one you that could probably be a call in and of itself, we talk about shooting wars, nuclear. How does cyber play in, because that makes this war different than the past, I think many people would argue.
Michael Cembalest: We'll see. There are lots of cyber, anticyber, and anti-anticyber activities going on, on all sides right now. I would watch the electricity grids in Western Europe for potential cyber activity. And, you know, I don't think -- I think when you look at Stuxnet and the other things that have taken place, you don't generally find out about them until 18 to 24 months later. So it's very hard for me to make an assessment of some of the cyber war that's taking place in real time.
Let me show one more slide, in case I haven't, you know, gone too far already. I'm only doing this because of how many questions I get everywhere I go. One day we may be discussing Taiwan, and in the same way that we're revisiting the history and the wisdom of NATO's embrace of the Ukraine without the intention of protecting it during that process, we may one day be reevaluating the wisdom of allowing China and accepting China into the World Trade Organization in the early 2000s. Here you see a chart on the Chinese incursions on Taiwanese air space. But that, Monica, is a discussion for another day.
Monica DiCenso: Would you say, is that our topic for next year? I hope not, in 12 months, that we're sitting here –
Michael Cembalest: I hope not as well. I want to echo—I want to close the call by echoing what Kathryn said in the very beginning, which, is, you know, God help the Ukraine. So thank you all very much for -- or God help Ukraine. I've been asked not to use the "the." I apologize for that, and I promise I will not do it again. The word "the" implies that it's simply an autonomous region of another country rather than it's own country. So god bless Ukraine. Thank you all for dialing into this call, and I look forward to talking to you again soon.
Monica DiCenso: Thank you. Kathryn, throw it back to you.
Kathryn Pasqualone: Great. Thanks, Monica and Michael, for your insights today, and thank you for joining us. If you have any questions regarding what was discussed, feel free to reach out to your J.P. Morgan representative. That now concludes our webcast. Have a good day, everyone.
Operator: Thank you for joining us. Prior to making financial investment decisions, you should speak with a qualified professional and your J.P. Morgan team. This concludes our webcast. You may now disconnect.