Topics: A revised map of the United States; investing in equities before a recession; Russia’s natural gas squeeze on Europe leads to another rescue program for Italy; the high cost of pariah status for the oil refining industry
Independence Days. Europe’s energy crisis, China’s commodity trade war with Australia and other examples of resource nationalism (India and Indonesia restrictions on exports of wheat, sugar and palm oil) all reinforce the following: reliance on food and energy imports creates supply, price, currency stability and national security risks. In the US, food and energy imports as a percentage of consumption are the lowest out of all manufactured goods categories, resulting in a degree of food and energy independence uncommon to other countries.
This prompted me to create a map of the United States in which each state is sized based on its production of food, energy and minerals. I used 2021 production values; had I used 2022 data, the results would be more amplified. The results: states in the Northeast, Southeast and Pacific Northwest shrink relative to mid-Western and mid-Atlantic states, and Texas. As the Biden administration evaluates options to reduce the highest US food and energy inflation in decades (overtures to Saudi Arabia and Venezuela for more oil; a ban on export of US refined products1; gas tax holiday; increase from 10% to 15% in summertime ethanol blends to boost gasoline supply but which has driven corn prices to all-time highs - see Appendix I and II), I think about this map a lot2.
The US is a “Republic” which ascribes electoral and legislative power to some states in this revised map that is in excess of their population shares. Their critical contributions to food and energy independence are often underappreciated by an increasingly urbanized society (see below on the energy disaster now facing Germany), so I generally believe that a Republic ends up in the “right” place. But I also know that it’s a difficult time to have that discussion. There are different kinds of independence; while US energy independence has finally been attained, other kinds of US independence are suddenly disappearing. They are outside the scope of this report; I will refer you instead to press articles on JP Morgan’s policies with respect to its employees and their reproductive rights and health3.
In any case, food and energy inflation and independence also bring to mind another chart below. The unwinding of the largest stimulus program in history has resulted in a repricing of “real world” vs “digital world” assets, with the former comprised of equities linked to the food, energy and mining products used to build the US state map. The repricing of “digital world” stocks has resulted in more reasonable growth stock valuations for the first time in a while, and is part of the “investing before a recession” topic we discuss next.
Digital world: ride sharing, digital payments, cybersecurity, cloud computing, big data, social media, fintech, metaverse, food delivery, online shopping, wearable tech, peer-to-peer video, gaming, commission-free trading, video streaming and crypto
Lessons learned on energy independence: Germany
Germany, aiming for 100% renewable power by 2035, is now pushing the G7 to rescind a commitment to halt financing of overseas fossil fuel projects. Instead, Germany wants the G7 to “acknowledge that publicly supported investment in the gas sector is necessary as a temporary response to the current energy crisis”. Why? For the first time since the war began, Russia is cutting gas supplies to Europe via the Nord Stream pipeline (see supporting chart below), leaving Germany with only 10 weeks of supply. The risks: damage to Germany’s industrial furnaces requiring 75% gas inputs, gas rationing to homes and businesses, an exodus of manufacturing jobs and a steeper recession. One vital choke point: the world’s largest integrated chemical complex run by BASF which sits at the beginning of many industrial supply chains, including ammonia for fertilizer. BASF Chief Executive Martin Brudermüller: “There is no short term solution to replace natural gas from Russia”.
A postscript: Eastern Europe, long wary of relying on Russian gas and ridiculed as paranoid by Germany, is moving forward with plans to source nuclear technology from the US. These countries might have sourced it from Germany had the country not sold its nuclear technology assets to Russia’s Rosatom during the Merkel administration.
Sources: Bloomberg, Wall Street Journal, Foreign Policy Magazine, JPMAM.
Investing in equities before a recession
I don’t know if there will be a recession in the US, but chances are rising so let’s assume there will be. In the last Eye on the Market, we discussed how equity markets usually bottom before recessions and how equity markets were already rising by the time the recession was underway (see table below which summarizes the results). If that’s the case, investors need to be on the lookout for signals that are not as stale as employment and GDP. Historically, PMI surveys have been the best leading indicators. We expect these surveys to continue falling, but will be watching closely for turning points.
Another equity market signal: in past cycles, equity markets did not bottom until long term Treasury yields were declining, or at least until they stopped rising. The first chart below shows 10 year Treasury yields; the vertical bars represent equity market bottoms. In the last three cycles, bond yields started falling well before the equity bottom. From 1950 to 1982 when rates were rising on a secular basis, Treasury rates hit their peak right at the equity bottom. So, while I’m not a technician, a sign that the PMI index has bottomed out and that Treasury yields have peaked would be a good sign for investors, even as economic data are still deteriorating.
Meanwhile, market signals on investor capitulation are mixed. As shown on the left, there has been a spike in the number of companies trading below the value of cash on their balance sheets. To be clear, companies that are destined for insolvency can trade below cash value for good reason (i.e., when the value of their non-cash assets are insufficient to repay liabilities). But as a measure of capitulation, this is a sign that investors have thrown in the towel on many of their ill-fated growth investments. In contrast, the chart on the right shows a survey of retail investor asset allocation preferences (which are still elevated) vs consumer sentiment (which has crashed). The growing gap between the two suggests that retail investors are still too optimistic.
I put more stock in the first chart (i.e., more capitulation) when combined with (a) data we discussed last time on how the average stock in the Russell 1000 Growth Index, the NASDAQ and the Russell 2000 Small Cap Index is down 40%-50% from peak levels, and (b) a sharp decline in hedge fund and risk parity fund leverage4.
On a related note, I read an article in the Atlantic on the “end of the Millennial lifestyle subsidy”. The article notes that millennials have effectively been subsidized by overly optimistic investors and that this subsidy is now ending. Let’s assume that a prototypical millennial wakes up in a Casper bed, exercises on a Peloton, takes an Uber to their WeWork office, spends time on Snap while waiting for DoorDash to bring an Impossible Meat burger for lunch and takes Lyft home for a Blue Apron dinner. In aggregate, these companies were supported by equity investors despite having aggregate $6 to $10 billion in free cash flow deficits since 20185. Many of these companies will have to become profitable to survive, which may involve higher prices to customers.
Russia’s natural gas squeeze on Europe indirectly leads to another rescue program for Italy
Inflation pressures are rising in Europe, in part since Russian supplies of natural gas to Europe are being cut again. For the first time since the war began, Russia cut gas flows to Europe through the Nord Stream pipeline: flows are down by 60% as Russia claims the need for turbine maintenance. Producer and consumer prices are now rising in Germany at the fastest rate since 1980, and markets expect European headline inflation to hit 9% later this year which is ~2% higher than current ECB forecasts. As a reminder, natural gas shortages affect both energy and food prices since natural gas accounts for 70%-90% of nitrogenous fertilizer costs. As the ECB raises policy rates and credit spreads widen, this creates problems for one the world’s most indebted countries: Italy.
I haven’t written about Italy for a while. Its default risk declined in 2012 when the ECB partially socialized Italy’s debt problem among other members of the Eurozone. Given Italy’s high sovereign debt, it needs low rates: as Gavekal Research has highlighted, every time Italy’s government bond yields drift above its economic growth rate (left chart), its debt ratio has gone up (right chart). Now yields are rising and growth is falling in Italy, threatening another surge in government debt.
However, it looks like yet another ECB rescue program is on the way. We expect an announcement in July; the ECB organized an emergency meeting when Italian 10 year yields hit 4% (~2.5% over Germany), which appears to be some kind of tolerance threshold. We expect the ECB to “sterilize” its purchases of Italian debt by soaking up money supply via European bank deposits, similar to the Fed’s repo program. As usual, the ECB hopes that the threat of intervention will be enough to drive Italian yields down without actually having to buy them. It should be obvious at this point that Italy is a permanent financial ward of the Eurozone, and that German savers who pay for this have effectively lost their economic independence.
Appendix I: US refining capacity, gasoline prices and the high cost of pariah status
Appendix II: energy/food independence and food price inflation
May contain references to dollar amounts which are not Australian dollars;
May contain financial information which is not prepared in accordance with Australian law or practices;
May not address risks associated with investment in foreign currency denominated investments; and
Does not address Australian tax issues.
Topics: An independence day map of the United States takes on additional resonance as Russia’s energy choke hold on Europe tightens, and results in another rescue program for Italy; investing in equity markets before a recession and the rising number
FEMALE VOICE: This podcast has been prepared exclusively for institutional, wholesale professional clients and qualified investors only as defined by local laws and regulations. Please read other important information, which can be found on the link at the end of the podcast episode.
MR. MICHAEL CEMBALEST: Good afternoon, everybody. This is the late June Eye on the Market podcast. This podcast accompanies the piece that we sent out this week called Independence Days. It covers a bunch of topics in here related to energy independence, what’s going on in Europe and Russia, and the broader topic of investing in equities before recession with some metrics on where we are in the cycle.
So first on this Independence Day question, there is a lot of resource nationalism going on in the world, and what does that refer to? China is having a commodity trade war with Australia. Countries like India and Indonesia are putting restrictions on exports of wheat, sugar, and palm oil. And then of course there’s all of the issues going on in Russia and Ukraine with respect to Russian decisions to halt exports of certain commodities and sanctions on the purchase of Russian commodity exports by other countries.
All of this reinforces something that a lot of people, myself included, have known for a long time, which is that relying on food and energy imports is a risky thing. It creates supply risks, price risks, currency stability risks, and national security risks. United States happens to be more food and energy-independent than most countries. Food and energy imports as a percentage of consumption are the lowest out of all the manufactured goods categories. In other words, the U.S. relies on imports as a greater percentage of consumption for most other things that get consumed.
So I wanted to visualize this, and so I created a revised map of the United States, in which each state is sized based on its production of food, energy, and minerals. And the results were familiar but still interesting to look at. The states in the Northeast, the Southeast, and the Pacific Northwest shrink relative to Midwestern states, Mid-Atlantic states, and Texas.
And I was looking and thinking about this map a lot as the Biden administration struggles to figure out options to reduce the highest level of food and energy inflation in decades, including things like overtures to Saudi Arabia and Venezuela to pump more oil, a possible ban on the export of refined products, gas tax holiday, increasing summertime ethanol blends, which helps boost the gasoline supply, but drives corn prices to all-time highs, things like that. And so you can see on the first page what this map looks like. And it’s interesting to look at.
Now the concept of independence is a broad one. The U.S., and this is mentioned a lot in Congress, the U.S. is a republic, which means that it ascribes electoral and legislative power to some states in this map that is well in excess of their share of the country’s population. And in many cases, their critical contributions to food and energy independence are often overlooked and underappreciated by an increasingly urbanized society. Around 85% of the people in the United States live in large cities. And because some of these food and energy contributions are so critical and difficult to replicate through imports, I’ve always generally believed that a republic, whether intentionally or not, ends up in the right kind of “fair place” with respect to these contributions and the relative legislative and electoral power. But I also know it’s a difficult time to have that discussion.
There’s different kinds of independence. And while U.S. energy independence has finally been attained after 50 years of trying, other kinds of independence are suddenly disappearing. They are outside the scope of what I can write about and should write about and I’m allowed to write about. But I will refer you instead to some press articles in the piece on J.P. Morgan’s policies with respect to its employees and their reproductive rights and health. And I will just say in my own personal view, I’m glad that the firm did what it did.
Getting back to the issues of the day on energy independence, take a look at what’s happening in Germany. Germany is a country aiming for 100% renewable power by 2035 and is pushing the G7 nations to rescind and walk back a commitment to halt the financing of fossil fuel projects. Instead, Germany wants the G7 to, and this is the quote from Germany, acknowledge that publicly supported investment in the gas sector is necessary as a temporary response to the current energy crisis.
Why is Germany, the architect of one of the most ambitious renewable transitions in the world, saying this? Well they are learning an energy independence lesson, and it’s a painful one. For the first time since the war began, Russia is cutting gas supplies to Europe via the Nord Stream pipeline and they’re cutting them by a lot. And this is leaving Germany with only ten weeks of supplies. And the risks to Germany are pretty substantial if these reductions are permanent. A lot of Germany’s industrial furnaces essentially require 75% gas inputs, without which they crack and break. Germany is facing the prospects of gas rationing to homes and businesses, an exodus of some of its hard-fought and hard-won manufacturing jobs, and a steeper recession.
So this question of energy independence is a critical one as we start thinking about Independence Day and the steps that different countries will need to take to become energy independent. And this is something I’ve written a lot this entire year and the last few years, which is making sure that policies to reduce the supply of fossil fuels are properly calibrated relative to policies that reduce the demand for fossil fuels so that one does not outstrip the other.
In any case, this food and energy independence issue brings to mind some of the other work that we did this week. The unwinding of the massive stimulus program ended up causing a repricing of real world assets versus digital world assets, where real world assets started finally going up, and those are assets linked to food, energy, and mining. And the digital world assets have dropped sharply and obviously those are all the things you’re familiar with, whether it’s ride-sharing, digital payments, cloud computing, Fintech, food delivery, wearable tech peer-to-peer video gaming, all that stuff. And that repricing in the digital world is pretty advanced and has resulted in more reasonable growth stock valuations for the first time in a very long time and as part of the whole investing before a recession topic that we get into as well in this week’s piece.
I don’t know if this is going to be a recession or not in the United States, but chances are rising, so let’s just assume there will be. In the last Eye on the Market, we discussed how equity markets usually bottom before recessions and how equity markets are usually rising by the time the recession is really in full swing and starts to get better. So if that’s the case, investors need to be on the lookout for certain signals that are not as stale as employment and GDP. We discuss some of those leading indicators in this piece. We’re closely watching the manufacturing PMI level of ten-year interest rates.
We have a chart in here showing the prior six cycles and how bond yields started falling before equities hit bottom. But there’s a table that shows that if you wait until the economy has bottomed out or improving before you start investing again, the opportunity cost is pretty substantial, anywhere from 20 to 40% in the equity market that tends to rally during that timeframe.
And one of my favorite capitulation measures is this chart that we have in here that looks at the number of stocks that are trading underwater. Now what does it mean for a stock to trade underwater? It’s when the value of the company trades below the value of its cash and short-term investments on its balance sheet. In other words, the cash on the balance sheet and short-term investments could be liquidated for more than the stock is trading at.
Now companies can still trade like that for a good reason if the value of their non-cash assets are not enough to repay their liabilities. But as a capitulation measure, it’s pretty good. And as we show in the chart here, the underwater stocks are now a higher percentage of the market that either in 2002 or in 2009. And so to me, we’re gathering up a growing list of capitulation measures that that suggests that sometime this summer, maybe one more leg down the market will be a very interesting time to start putting money back to work.
We have an interesting section in here as well on the end of the millennial lifestyle subsidy and talks about how a bunch of millennial-oriented companies were essentially financed by the markets despite having 6, $8 billion annual free cash-flow deficits in aggregate, and how a lot of these companies will now have to be profitable to survive, which is going to end up with DoorDash, WeWork, Lyft, Blue Apron, Uber, Peloton, impossible, all these companies are going to be under a lot of pressure, which means both layoffs and higher prices to consumers.
Let’s go back to energy for a second, because I want to talk about this rescue program for Italy. So as I mentioned earlier, Russia has cut the Nord Stream pipeline flows to Europe by 60%, which is enormous. Now Russia is claiming the need for turbine maintenance. Most of the Europeans that are close to this don’t believe that. Producer and consumer prices are rising in Germany now at the fastest rate since 1980, and headline inflation in Europe might hit 9% this year.
So as the ECB raises policy rates and as credit spreads widen in Europe, that creates problems obviously for one of the world’s most indebted countries, which is Italy. I haven’t written about Italy for a while. It was in real trouble in 2012, and that’s when Mario Draghi, in charge of the ECB, basically socialized Italy’s default risk amongst other members of the Eurozone. Given Italy’s very high level of debt, around 150% of GDP compared to roughly 100% in the United States, Italy needs very low rates. And every time Italy’s bond yields drift above its growth rate, its debt ratio goes up a lot.
But it looks like even though Draghi is not running the ECB anymore, his legacy remains. The ECB looks like it’s planning yet another rescue program for Italy. We expect an announcement sometime in July. And as usual, the ECB is hoping that the threat of intervention will be enough to drive Italian yields back down without them actually having to buy a ton of them. And it should be pretty obvious at this point that Italy is a permanent financial ward of the Eurozone, and the German savers who are paying for this have lost their economic independence.
The last topic I want to talk about today is this issue of gasoline prices, because the administration is really trying hard to figure out what to do about high gasoline prices. And a lot of this has to do with the high cost we’re all paying of having made the refining industry into pariahs, effectively. And I have some charts here. I generally never write, talk about anything unless there’s some data that can help me and my team and all of you visualize what’s going on. So please take a look here at page six in today’s piece, ‘cause it’s just mostly charts that will help you understand what’s going on.
So when COVID hit, there was a collapse in movement for all the obvious reasons. And some of the refiners that were already struggling either shut their doors or converted to biofuels instead. But now all of a sudden refined product consumption is back to pre-COVID levels in the United States, but refining capacity is not and has dropped by about a million barrels a day on a base of let’s say 19 million barrels a day. So something like a 5 or 6% decline, it doesn’t sound like much. But in a lot of industries, things happen on the margin. And if you’ve got a 5 or 6 or 7% decline in refining capacity and an increase in demand for that capacity, you can get price spikes.
So just, let’s review. The U.S. gasoline refinery shutdowns have increased in recent years, very high maintenance and repair costs, declining institutional investor interest in oil and gas, you can’t open your eyes every morning without seeing and feeling and experiencing more ESG-related pressure for people to bail on the refining industry. That’s also affecting the banks. There’s been declining bank lending to oil and gas. There’s broad community and political opposition to the refining industry. And as I mentioned, some of the refineries have shifted to biofuels, or at least are trying to. And once these refinery shutdowns take place, they’re extremely costly and almost impossible to reverse.
And so now where are we? Well, the refineries are operating at around 95% of capacity, very difficult in any industrial process to go above those levels. Russia is the second-largest exporter of refined product after the U.S. So sanctions and disruptions related to the war in Ukraine is affecting the global supply of refined products. And you put all these pieces together, and you get a pretty big spike in the crack spread, which basically refers to refined product prices, less the cost of the crude oil that’s used in the refining process to begin with.
And I don’t think there’s a lot of easy answers here other than the demand destruction that takes place as prices go up. In other words, there’s a gasoline price that that will result in its own demise, happened to 2008 and essentially becomes so expensive for people to drive or fly that they begin to curtail their activities.
But all the stuff that’s being discussed, whether it’s releasing the strategic petroleum reserve, bans on refined product exports are not straightforward in terms of the impact they would have on gasoline prices. And there’s an interesting little footnote we have in this week’s paper piece that describes why an export ban might not work if it’s a ban that’s applied to all refined products because of a surplus of diesel that the refiners would end up with that they might have nowhere to go with.
And then to conclude, we’ve got some charts in here on food price inflation. And just to tie all the pieces together, fertilizer costs are affected by natural gas, particularly nitrogenous fertilizer costs. So now we’re at all-time highs on corn prices because of this decision to increase the ethanol blends, higher natural gas prices, a 20% decline in Russian fertilizer exports, and things like that.
So it’s a really important time for us to understand and appreciate energy and food independence and to focus on the policies that could sustain that food and energy independence on a long-term basis rather than just a short-term basis. And that’s going to require a much more careful and thoughtful analysis about how the whole renewable transition is managed and how it unfolds. As for the other aspects of independence which are disappearing in the United States, I wish I could talk more about those, but I can’t. So I will thank you all for listening, and I look forward to talking to you next time. Have a great day, 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 J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market by contacting your J.P. Morgan representative. If you’d like to hear more, please explore episodes on iTunes or on our website.
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