Coûts de l'ancien, croissance du nouveau
The cost of the energy transition, Russian military adventurism and post-COVID recovery has been inflation and recession. This is hitting new economy businesses that for so long held inflation down. Oh, how we long for those days when automation and moving online were believed to be key reasons why inflation stayed low for so long. Share prices have responded accordingly with energy up and tech, down. If this persists, it’s bad news for the global economy and the climate. Longer-term it can’t. The move away from fossil fuels is in motion, despite the backlash from old-economy believers. There will be a time to get long tech and short (old) energy again.
Energy up, tech down
The relative performance of US energy stocks compared to the overall market and specifically to “new economy” sectors has been remarkable this year. According to Bloomberg data, the energy sector has seen a price gain of 64% while the information technology (IT) and communications services sectors are down 32% and 44% respectively. The moves correspond to the economic situation. Energy prices are high and demand for the products of technology sectors is waning as overall growth slows. The current consensus forecast for earnings per share for the S&P500 energy sector for the next 12 months is $70, compared to just $34 a year ago. In contrast, the earnings per share (EPS) growth forecast for the communications services sectors is -10.5%. The current earnings season illustrates the divergence in fortunes. Energy sector earnings surprised to the upside while communications services surprised to the downside (+10% vs -4%). The last week or so has seen record quarterly profits announced by major energy companies on both sides of the Atlantic.
For equity investors with a long-duration, “new economy”, growth and ESG bias, this is frustrating. Being underweight energy has led to underperformance against benchmark equity indices. It has not fitted the narrative either. Listed energy companies still reflect global reliance on carbon-based sources of energy and the long-term view is that demand will decline as the world continues to decarbonise. Record energy sector profits are not because energy has become more of an intrinsic value-add, but because prices have been driven up by the combination of the post-COVID recovery in global GDP growth and the supply disruptions related to the Russian invasion of Ukraine and the subsequent sanctions. Despite billions being invested in renewable energy sources, there isn’t enough yet to challenge oil, gas and coal as the dominant sources. As long as global energy prices remain high, energy sector earnings will too.
Slower spending hits FAANGS
In contrast, new economy sectors have suffered in 2022. The recent set of earnings reports show some slowdown in digital advertising, cloud investing and general consumer IT demand, given the surge in spending that occurred during the pandemic. Business models are being challenged and even the biggest online retailers are not immune to slowing consumer demand. Corporate investment spending is also likely to be weaker in 2023 given the cost of financing. The listed companies that produce these goods and services have share prices that have been expensive, based on the assumption of superior and more stable earnings growth. That assumption is being challenged by the monetary squeeze and growth slowdown.
Energy prices are up massively, boosting energy sector earnings and share prices, without touching the multiple on the energy sector (9 x 12 month expected earnings). Any comparison of energy against other sectors reveals that it is the huge rise in energy sector earnings that explains most of the relative performance. True, earnings growth is slowing across the economy and both the IT and communications sectors are experiencing downward revisions to earnings. They have both de-rated by 9-10 points relative to their 2020 price earnings ratio highs. Hence the dramatic share price declines seen by some of the mega-cap stocks.
Need lower energy prices
Reversing the energy vs new economy trade requires a number of things to happen. The most important would be a decline in energy prices, undercutting economic rents in the sector, resulting in lower EPS than is currently the case. Lower energy prices need reduced economic growth (coming thanks to the central banks) but also some easing on the supply side, the most obvious of which would be an end to the war in Ukraine. However, even with that, a “normalisation” of natural gas supplies in Europe would be difficult without a huge change in political relations with Russia. More supply might come on stream over the coming year given the efforts western governments have been taking (fossil fuel and renewable based). The embryonic revolution in Iran could also result in some thawing of political relations and increased exports of crude oil from there. Putting much conviction on any of these things happening is difficult though. It would be great to see lower energy prices as that would also lessen the need for the “higher for longer” interest rate outlook.
Perhaps it will be the central banks that bring energy prices down as global GDP growth slows (thank the Federal Reserve and the European Central Bank for lower CO2 emissions?) However, that makes a recovery in new economy performance difficult as well in the short-term. But to me, there should not be too much pessimism about these sectors. Admittedly, certain companies became very overvalued and have business models that are being challenged and the short-term economic outlook is difficult. Yet the broader themes of increased digitalisation, cloud computing, automation and biotechnology remain ones that will deliver long-term earnings growth. The energy transition remains a vital force and that in itself will create demand for products and services that facilitate the shift to a net-zero carbon world. The other big themes of re-shoring, supply chain security and skill shortages also support investment in technology and automation. Excitement about progress in treating diseases like Alzheimer’s and cancer bodes well for the performance of the biotechnology sector in the years ahead. When energy prices fall, the prospects for growth will improve and these sectors will perform again.
Away, dirty fossil fuels
The current energy cycle is unique in the sense that it is seeing geopolitics and under-investment play a role on the supply side. There will be temporary investment spending to boost supply but the long-term should see capital diverted away from capital investment in oil, gas and coal and towards renewables. Prices might remain high for some time, but history tells us that the profits from traditional energy companies are highly cyclical and dependent on prices. So when prices do fall, so will profits. As we approach the COP27 meetings, the need to accelerate the energy transition and reduce reliance on hydrocarbons should be stressed at all levels. The future energy sector should be one with less variation in prices and company profits.
Lower cost electricity
Responsible investors have set out their stalls. They don’t want long-term exposure to oil and gas. They want to see energy companies transition. There may be some backlash to this approach, but the momentum towards decarbonisation is strong. Capital needs to flow to the renewables sector and that needs policy encouragement, with national pledges on emissions reductions backed up by incentives, subsidies and public investment. The economics support the transition. If we are moving to electricity powering more of economic activity then we want the cheapest sources of electricity generation. According to Bloomberg’s New Energy Finance services, recent estimates for the Levelised Cost of Electricity puts the average cost of generating a megawatt hour of electricity in the US at $43 for onshore wind against $128 for gas turbines. The differences are similar in Europe and Asia. Energy security and restricting further climate change needs the shift to renewable energy to happen more and more quickly.
Reverse the trade
I am not bullish on traditional energy but admit that prices are going to remain high for the foreseeable future. Energy company profits will remain high too. There is clearly a risk that there will be more of a political backlash against this with governments introducing windfall taxes. The headwinds are clear, and the economics are clear. One can make the argument that demand for fossil fuels will decline as a percentage of GDP over the next 20-30 years. The demand for computer chips, IT systems, mobile communications, software developers, internet applications and online services will rise as a percentage of global GDP.
Secular growth sectors and companies deliver earnings growth in a steady fashion. Energy delivers earnings in wildly cyclical fashion. Over the last 25 years, the variability of EPS has been way above that of other sectors. Is it conceivable that at some point in the next five years oil prices will be down to $50 per barrel and energy sector earnings will collapse as a result? It’s happened before. Tactically there may be a case for retaining exposure to traditional energy, but I find more economic value in the long-term in operations and products that contribute positively to productivity and economic growth than in activities that are contributing to inequality and climatic disaster. I want there to be an energy sector, but I want it to be clean, more equitable and less prone to geopolitical manipulation.
New economy, lower rates and inflation (yes please)
The old economy (fossil fuel energy) is largely responsible for the current inflation while the new economy helped keep inflation down over the last twenty years. The result is that price levels have risen well above central banks benchmarks and brining the rate of change in prices is the key policy challenge. The bullish interpretation of a week of central bank activity is that they all are saying that they need to take into account what has already been done in terms of interest rate increases and hinted that future rate increases might slowdown. Yet the US economy remains strong and the Fed the most hawkish. This means my positive Treasury view keeps getting knocked back, but I do think that a range of 4.0% to 4.5% on 10 years looks reasonable. For next year, longer duration should come back into fashion as real yields peak. Not only for bonds, but for secular growth stocks as well.
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