August 2022 Market Commentary

The month of August was, on the whole, rather subdued. As we forecasted, bullish momentum peaked with the upside move likely exacerbated by positive dealer gamma, better than feared Q3 earnings, and a relief rally led by businesses most prone to short-term interest rates.

However, at the Fed Reserve’s Jackson Hole meeting, Chairman Powell reiterated the mission critical focus on getting inflation to 2%, which shocked markets in a flash move to the downside. Those expecting an early pivot were probably taken aback by the unambiguity of the ‘Fedspeak’ we’ve so come to love. Regardless, we’ll briefly see how the rest of the world did and comment on the utility of the European gas prices, as well as our forecasts for the continent in the next few months. On the Utility of European Energy Prices It is with a lot of breathless coverage that many of us have become accustomed to looking at parabolic energy futures, particularly the one year forwards for LNG. However, we must remember that prices, and markets in general, are only a method of allocating resources to those most willing to pay. In times of peril, as in the case of a famished village, any food is rightfully given to the young and starving, and in any case, energy will most certainly go to heating homes this winter. In such a market failure, politics will be the very visible hand that allocates. One year German power prices in EUR per MWh. Prices are now down nearly 50% from peak. So what information can we parse? With forward prices now down significantly from their highs, it can certainly give us a hint as to the level of energy speculation alongside the long term pain coming for heavy industry. However, even if prices were to double or halve again, it would signal the same thing. There exists an infarction of supply and demand that remains unaddressed by spot markets. But while spot prices are by no means cheap, they also don’t spell doom. Looking at aggregative North Western European storages, 2022 seems to be an otherwise unremarkable year. Supposing that maximum storage remains at near 550 TWh, with winter consumption unchanged, the EU on the whole will not face the catastrophe that seems to percolate through the financial markets. Indeed, as futures must converge on spot prices, with supply expanding, we expect prices to generally trend downwards. This will be due to no small part played by diversion of LNG tankers from the global south to Europe. While the fates of individual countries will vary, perhaps in negative correlation to the sensibility of their past energy policies, we remain adamant that what has been signalled is nothing more than a market failure. In the meantime, expect more defaults from power suppliers. Inadequate hedging has long been the love of a Chapter 11 attorney’s family. UK inflation and energy price cap In the background of increasing food and energy prices, the UK’s CPI set a fresh 40-year high of 10.1% in July. At Goldman Sachs, economists are now predicting that should energy costs remain high in Q4, inflation will potentially reach 22% in January. As we’ve observed in the past, elevated levels can be partially attributed to surging Covid cases, the disruption of the global supply chain caused by Chinese lockdowns, and the Russian-Ukraine War. In the meantime, UK gas futures are not likely to meaningfully decline in the coming months, as Ofgem announced last Friday a rise in the energy price cap, from £1,971 to £3,549 annually in Q4 2022. This skyrocketing energy price cap impacts 85% of the population, implying that households may need to budget for a tough winter, with millions of families anticipated to fall into fuel poverty. With the bleak economic outlook and the prospect of an energy crisis, the sterling has dropped to its lowest level since May 2020. The pessimistic view of the UK economy has been reflected in the stock market, as the FTSE 100 closed lower this month amidst increasing concerns over the inflation in the UK and Eurozone. As many anticipated, both US treasury bond yields and the US dollar increased pushing the already struggling pound further downwards. A brief note on energy transition and what to watch out for with China In Europe we’re seeing a renewed push to get renewable energy online, building on the ‘Green Deal’ growth strategy, especially with the energy Crisis. In the US we’ve seen the Inflation Reduction Act (IRA) recently pass. The IRA according to President Joe Biden is the ‘largest investment ever in combating the existential crisis of climate change’ ($430bn). Signed into law on August 16 2022, it aims to supercharge clean technology development in the domestic US economy. $370bn will be spent on climate-focused spending, with the Act offering incentives to purchase electric vehicles, and energy-efficient appliances. Incentives for wind and solar generation, as well as electric vehicle purchases are included. What’s the catch? ‘Made In America’ - 40% of the critical metals in the battery (lithium, nickel, cobalt, and manganese) must come from the USA or a Free Trade Agreement partner, which rises to 80% in 2026. Let’s provide some context in regards to China and capacity. Benchmark Mineral Intelligence estimates that China currently has: 81% of the world’s battery cathode manufacturing capacity, 75% of the cobalt refining capacity, and 59% of its lithium capacity. The USA & Canada combined refine 3% and 3.5% of the world’s lithium and cobalt, and even less in regards to battery cathodes. Outside of this, China also has a de facto monopoly on rare earth element global production - 37.9% of global reserves, 58% of mining, and 87% of global production. These metals are essential components in infrastructure relating to decarbonisation, such as in generators for wind turbines, electric motors and batteries. As China’s position begins to be challenged, and global demand for rare earth elements increases, China has strengthened and fortified its position, taking a leading position in Africa with its Belt and Road initiative, with Africa possessing the largest mineral reserves in the world. China also subjects its rare earth element industry to the Export Control Law - a law allowing for export control, or as the state-run Global Times put it, a ‘tool of reprisal’ against the United States. Add on US sanctions on China in regards to chip exports - especially high-end processors used in supercomputer development, and the picture begins to look quite frosty if China takes this as a motive to begin adding pressure on the supply side. However, China is not without trouble in its goal to secure its position. The DRC is a country controlling >70% of the world’s cobalt supply, of which a majority is exported to China, Chinese-owned companies have been accused of opaque mining contracts, and the Congolese government has begun to be warier; having recently re-reviewed a 2008 $6bn infrastructure-for-minerals deal due to concerns that the deal was one-sided. Greenland turned out of the office a party supporting a Chinese-backed mining venture, and Peru’s Las Bambas mine (2% of global copper production) was shut down in 2022 March due to protests against the Chinese-owned MMG corporation. If de-globalisation follows through and we do see a divide between East and West, look out for further tariff wars, potential Chinese retaliations on the supply side, and a soft power war over countries exposed to rare earth elements. Don’t expect any amount of money in the short term to dislodge China’s position significantly, for the time it takes to reorganize supply chains, and open mines and manufacturing facilities take far too long. In the meantime, China has managed to circumnavigate tariffs in the space, an example of which are South East Asian states (Vietnam, Thailand, and Malaysia) where Chinese multinationals export solar cells and panels to the US, allowing for a continuation of its leading position through cheaper pricing. What do we see? It all boils down to how much the US wants to spend to compete with Chinese companies that have high subsidies, low taxes, low labor costs, and low environmental standards. Short term we expect Chinese firms in these areas to benefit from the global energy crisis and overall higher spending on the energy transition, and for US companies in the space to begin to gain domestic market share with the IRA act. Unless we can see a stabilisation of relations between the US and China, be cautious within this space as we continue to be shackled to the whims of Sino-American relations. Ernest, Taiga, Crystal, and Simon Belvedere Wealth Management

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