American investors are laser-focused on the Federal Reserve, and for good reason. The central bank is about to raise interest rates by another 0.75 percentage points, just as the quieter side of this tightening cycle, portfolio shrinkage, escalates. But that focus means other dangers don’t get the attention they deserve.
“While understanding the risk-free cost of capital is always central to investing, we fear that equity investors have become overly myopic,” said Lisa Shalett, chief investment officer at
Morgan Stanley Wealth Management
Volatility has picked up across currency and global bond markets, but the VIX, the US stock market volatility gauge, has been benign, Shalett says. She warns that myopia sets the stage for a fraught 2023.
A risk that deserves more attention here is the crises unfolding in Europe. The continent is facing an energy shortage that is fueling record inflation and pushing the economy into recession. As the European Central Bank raises interest rates to drive down prices, higher borrowing costs dampen demand and could provoke another debt crisis. According to Zoltan Poszar, global head of short-term interest rate strategy at Credit Suisse, about $1.9 trillion of German manufacturing output depends on the equivalent of just $27 billion of Russian energy input. Germany, Europe’s largest economy, has been particularly dependent on Russian energy.
As Alfonso Peccatiello, author of the Macro Compass newsletter, puts it, it’s a lot of embedded leverage.
What happens in a highly leveraged environment when the cost or availability of the leverage – in this case both interest rates and Russian energy – changes drastically? The system becomes unstable, says Peccatiello.
A common misconception, he adds, is that only certain European countries have excessive debt. In fact, he says, public and private debt in all major European nations easily exceeds 200% of gross domestic product – and that’s not counting contingent liabilities or government guarantees or public company liabilities, which can be substantial. Germany’s contingent liabilities exceed, for example 100% of GDP.
On Thursday, the European Central Bank delivered a three-quarter interest rate hike, following a half-point increase in July after nearly a decade of negative interest rates. ECB President Christine Lagarde warned that inflation is spreading beyond energy to a range of products and said the ECB is poised to raise interest rates aggressively over the next several meetings.
Energy inflation is already serious and is affecting economic growth. The average German household pays almost 13 times more for electricity now than in January 2020, or about $38,000 against $3,000 before Covid, says Peter Boockvar, Bleakley Financial Group’s chief investment officer.
Yes, there are price caps and subsidies, but the latter is a double-edged sword. Germany has said it will spend at least $65 billion to help some citizens afford energy and give tax breaks to energy-intensive companies. This will mark the third round of aid related to the energy crisis, bringing the total to around $100 billion at a time when consumer price inflation in Europe is running above 9% a year.
High prices can help cure high prices, but that effect is limited when it comes to essentials. Strategist at
say German natural gas consumption was 20% below its five-year average in March, allowing the government to stockpile gas for the winter at a faster pace than some analysts had expected. But Deutsche notes that August was a summer month with light demand; winter is a different story. If Germany continues not to receive Russian gas, and even if demand remains 15% below average this winter, the bank says supplies will be exhausted by March. A falling supply is likely to lead to rationing this winter.
Bleakley’s Boockvar says US investors may not understand how Europe’s problems could flow back here. The economies of the EU and the UK together are around 20 trillion dollars, not much smaller than the US economy of approx. 25 trillion dollars, and represents about a quarter of global GDP, he notes. Europe contributed about 25% of
(ticker: AAPL) earnings in 2021, with the region representing 20%-25% of S&P 500 revenue. In addition to potentially reduced demand due to high energy prices, US companies with heavy European exposure must contend with the strong dollar, which makes their products more expensive abroad and shrinks repatriated profits.
Europe’s problems can also lead to opportunities: while analysts such as Peccatiello recommend avoiding European investments, Shalett of Morgan Stanley is less pessimistic. European stocks have underperformed US stocks for most of the past 12 years, partly reflecting disappointing relative growth and less effective monetary and fiscal policies. In the past 12 months, Shalett says, Europe’s relative futures price/earnings multiple has crumbled due to a weak post-pandemic recovery and the effects of the war between Russia and Ukraine.
While recession in Europe seems inevitable, the ECB is likely to continue raising interest rates and a debt crisis is more than a distant possibility. Some of that bad news is discounted in the region’s stocks, Shalett says, meaning there are opportunities for patient investors. US assets, on the other hand, are becoming unattractive to foreign investors as currency hedging costs are high, inflation-adjusted interest rates are converging and the Fed’s bond purchases are slowing, she says.
Fed policy will remain top of mind for US investors. But tuning out other dynamics, especially in Europe, is unwise and can be expensive.
Write to Lisa Beilfuss at firstname.lastname@example.org