· The global energy crunch is weighing on growth forecasts
· Inflation expectations finally surge higher
· Central banks expected to outline tapering schedule soon
At the time of writing this note, WTI and Brent Crude futures are up 77% and 70% this year respectively. This is despite global oil demand still falling short of 2019 levels. Natural gas futures prices have more than doubled during the same timeframe. The energy crunch that has swept across the globe has driven commodity prices to recent highs, contributing to the already persistent inflation concerns.
As the first economy to emerge from the initial Covid-19 economic shock, China and its manufacturing sector went into overdrive - stepping in to satisfy domestic and global demand. Demand for goods skyrocketed, and the country quickly ran into its coal and hydropower production ceiling. With its primary energy sources constrained, China imported record levels of liquid natural gas (LNG) to meet requirements. In 2021, with price levels already much higher, Europe’s demand began to increase. At its peak, the price of LNG landing in Europe was the equivalent of $200 a barrel in oil terms. This meant that dual fired capacity plants quickly switched to oil as a relatively cheaper primary energy source, driving up prices further. Scarcity and fears of higher prices in the future are leading to premiums being paid to secure energy.
As we approach winter, natural gas inventories in Europe are lower than they have been in a decade. Annual drawdowns have not exceeded current gas supply levels over the same 10-year period, so the probability that the continent reaches crisis point are low. But tight supply, especially in the Netherlands, Germany and Austria should keep energy prices elevated for the medium term.
The US is fortunate to have established a level of self-sufficiency in its energy production that has given it the flexibility that other countries don’t have. However, we still expect a negative impact on demand attributed directly to higher global energy prices. Along with supply chain disruptions in other areas, the energy crunch is set to contribute to a 1.5-2% drop in 2023 G3 growth expectations. US growth forecasts for the rest of 2021 have already been revised lower by economists.
Despite annual inflation rates remaining elevated near decade highs for the last five months, the market derived measures for inflation expectations had remained rooted for much of the second and third quarter. As a key input for price and wage setting for companies, inflation expectations are keenly watched by investors and central bankers. They can also be a measure for how credible investors think central bank’s inflation objectives are. This has all changed in the month of October, where there has been a surge in these measures. Breakeven rates, derived from Treasury Inflation Protected Securities (TIPS) in the US, have reached the highest levels on record for the data series. Five-year, five-year inflation swaps, which price expectations for inflation five years into the future, are also now at multi-year highs in the US, Europe and the UK.
Global Economic Data Highlights
Whilst the finger has been squarely pointed at supply as the main culprit for the current imbalances, it is important to remember the role that record levels of demand plays. The US, which is a largely consumer driven economy, has seen durable goods consumption skyrocket and remain elevated since the pandemic. Since goods producing companies plan for trend growth in demand, this will have caught them off guard – exacerbating shortages and leading to higher price levels in key goods. The consumption mix seems to be in the process of normalising, which should ease shortages and lower prices.
Recent economic data has pointed to a higher chance of accelerating US growth for the rest of the year, going against the stagflation narrative which has become consensus this month. Composite flash PMIs sequentially increased, consumer confidence was higher than expected and regional Fed manufacturing indexes are also showing strong bounces. This may come just in time for the Fed, who are expected to announce their asset purchase tapering schedule next week. Only a few months back, the first target interest rate hikes by the Fed were only expected in 2024. Such has been the change in investor expectations recently, that as many as 6 hikes are now expected by the end of 2024. Two hikes are expected by the end of 2022.