Can the US achieve its ambitious energy decarbonisation goal?

Jon Wallace, Fund Manager, Environmental Solutions, discussed how company management are thinking about inflation in the latest results season, going on to outline some challenges ahead for the US’s “borderline physically possible” clean energy targets.

 

As much as the prospect of lasting inflation and its implications continue to drive investment markets, so too is it occupying the minds of company management teams. This is a change I’ve noticed since the Q4 2020 reporting period, with companies in their Q1 2021 results now taking into account higher input costs as a result of higher raw material and intermediate goods prices, as well as the cost of key services such as logistics. On the whole, I’ve found that management teams anticipate supply chain de-bottlenecking into H2 2021, indicating no significant continuation of rising inflation, but they are being notably more careful to caveat guidance of the remainder of the year.

 

There are also some interesting second-order effects of an inflationary environment, including higher demand as customers seek to get orders in ahead of future price rises. This pull-forward in demand is placing increased pressure on the availability of products right through the value chain. It is telling that company management teams are flagging the possibility of their customers de-stocking later this year or early next year.

 

An exception to this pull-forward of demand is in the clean energy sector, where some pockets of price rises have not triggered a pick-up in order flow. That’s because demand in this sector is anticipating something that is likely to offset inflation pressures: the expectation that the Biden administration will need to use all its levers to meet the goal to decarbonise the US power grid within 14 years.

 

In expectation of changes to fast-track planning, tax regimes, and a possible new national clean energy standard, the rate of growth in US clean energy demand has ironically slowed in recent months. So there is much ground to cover if the US is to achieve a decarbonised power grid. To put that goal into context, the US currently adds about 2 percentage points of clean energy to its grid annually, and that needs to reach about 6-7 percentage points – which one CEO of a clean energy company described to us as “borderline physically possible”.

Beware the late stage of the credit cycle in China

Xuchen Zhang, Credit Analyst, Fixed Income, explains the signs that China is the late stages of a credit cycle, and why ‘fear of missing out’ has been replaced by ‘fear of exiting late’.

 

Corporate China is showing clear signs of being late in the credit cycle, which helps explain some recent ‘credit dramas’ in this country – as headlines about defaults in China hit our screen more than ever before.

 

For context, between 2014 and 2018, the Chinese onshore bond market increased by 300% in size and overtook Japan to become the world’s second largest bond market. Although there were some sporadic defaults during this period, they were few and limited in size. Investors were complacent, taking it for granted that companies would repay bond maturities. Companies became complacent as well, issuing shorter-maturity bonds for cheaper financing costs.

 

The onshore bond market in China had been functioning well – until the end of 2020 when two high profile local state-owned enterprises defaulted on their debts, despite being rated investment grade at the time. This event caused a rapid reversal of sentiment, going from ‘fear of missing out’, to ‘fear of exiting late’. For investors, it was a classic prisoner’s dilemma: once there comes a negative headline, selling before thinking is assumed to deliver a better outcome than thinking before selling; so, everyone ends up taking a loss. Violent price drops can be self-fulfilling, and contagious to other bonds as well. On the other side, weak companies, especially with tighter liquidity, then found themselves unable to refinance upcoming maturities at reasonable yields and ran into distress. In this atmosphere of heightened fear, market rumours flourished and became influential in moving bond prices.

 

The offshore USD bond market shares the panic-selling mechanism seen in Chinese credits. While credit risk varies from issuer to issuer, market risk has intensified significantly. In this late-stage environment of heightened correlation and volatility, it’s important to stay cautious and diversified, while keeping your eyes open for attractive entry points into credits that are solid, but sold off in tandem with weak ones. 

Cheap gold miners, scarce silver, and weak jobs numbers

Chris Mahoney, Fund Manager, Gold and Silver, comments on the impact of the last week’s unexpectedly low US non-farm payrolls figure, the relative value of gold miners and stress in the supply of silver.

 

There are several reasons for last week’s disappointing US jobs number, which showed the country’s jobs growth in April to be just over a third of that seen in March. It validates Federal Reserve (Fed) Chairman Jerome Powell’s very patient stance, his insistence on wanting to see the economic recovery that he is seeking materialise in actual data rather than tightening Fed policy pre-emptively based on forecasts. It is our view that he is going to remain about as dovish as he is now for some time to come, and this easy monetary policy makes for low real yields, and low real yields are supportive for gold and silver prices.

 

Turning to the gold mining sector, we saw a pullback in gold mining stocks from their highs in Q3 of last year, they bottomed in March, and then subsequently rallied. Even after the recent rally, gold mining stocks are still very cheap, in our view, currently trading at around 8-times price to cash flow whereas back in Q3 2020 they were trading at closer to 13 times

 

Silver is outperforming gold in Q2 2021 and YTD and we note the persistence of the dynamics that led to the stress in the physical market seen in January and February, the so-called ‘silver squeeze’. Last month the LBMA, the independent precious metals authority, produced a report in which it suggested that if the high demand for physical silver seen in January and February had been sustained, London’s stock of physical silver would have been exhausted in just a matter of weeks.

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