Quick market outlook

• Our reflation outlook for the US and Europe in 2022 is alive and well despite a recent decline in leading indicators. While many bottleneck measures are still elevated, we expect automobile semiconductor production to double by next summer compared to its recent pace; Eastbound freight rates highlighted in our September piece are finally dropping, along with a large decline in the Baltic Dry Index of shipping costs; we expect a return of ~2 mm people that left the US labor force by Q1 2022; and there are reports of falling backlogs and rising factory utilization rates in Asia as vaccination rates surpass 60% in Vietnam and Thailand, and surpass 70% in Malaysia and Taiwan
• US and European GDP should get a boost as supply shortages eventually dissipate and as inventory levels are rebuilt from very low levels relative to sales, which are still holding up well; US infrastructure and reconciliation bill spending will boost output as well
• Despite supply constraints, US and European firms have posted another quarter of high margins, earnings and sales vs expectations (see table below). Also, it looks like top US statutory corporate tax rates will not rise, and that changes will include higher taxes on foreign income, a 15% minimum book tax and a 1% stock buyback tax. The net impact looks like a 3%-4% earnings hit to the profitable US tech sector, and at most a 1.0%-1.5% earnings hit to all other sectors
• US labor shortages will persist, however, due to the US having one of the largest unvaccinated populations in the developed world, a COVID-driven surge in retirement, declining immigration etc. As shown below, wage-price spiral risks are rising as the Fed’s “inflation is transitory” stance seems more implausible each month. Margin pressure is rising for labor-intensive Consumer Discretionary and Staple firms; but most S&P 500 market cap labor intensity is lower (Tech, Healthcare, Internet, Energy, Utilities, Financials)
• China is the growth outlier, suffering a demand shortfall due to a combination of energy constraints, a regulatory purge, only modest easing of monetary and financial policy and among the strictest COVID protocols in the world

The Thing

“In all my years I never heard, seen, nor smelled an issue that was so dangerous it couldn't be talked about”

Stephen Hopkins, Governor of Rhode Island and signatory to the Declaration of Independence, 1776

Until this year, I had never run into a topic that I couldn’t write about. Anything affecting markets, economics or growth was fair game, and a lot of controversial topics show up in the Eye on the Market archives since its launch in 2003(see Appendix II). But now I have run into such a thing, and I still don’t think I can write about it. My guess is that you know exactly which topic I’m referring to.

Anyway, here’s a different topic that I can discuss. There are some strange things going on in energy markets; Massachusetts, California, Europe and China provide some cautionary tales below. Some of these events are the byproduct of a 40% decline in global investment in energy, materials and transport. Bottom line: if you reduce the supply of fossil fuels faster than you reduce the demand for them, you’ll end up with a combination of higher energy prices, energy dependence that can border on servitude, and inadequate supplies that can lead to power rationing of homes and businesses. The chart below shows energy dependence by region. As the US moves forward on its renewable energy journey, policymakers should also try to avoid losing the hard-fought energy independence that has taken 50 years to achieve.

Massachusetts: in the progressive enclaves of the Northeast, NIMBYism continues to kill decarbonization. Maine has followed New Hampshire in blocking a high voltage transmission line needed to bring hydropower from Quebec to Massachusetts, requiring New England’s ISO to expand its reliance on natural gas instead.

California has already experienced rolling blackouts due to power demand that exceeded planning targets, and that’s before the state decommissions 2,250 MW of nuclear power and 3,700 MW of natural gas fired power plants in the next couple of years. California has among the highest solar irradiance levels in the northern hemisphere, comparable to Southern Spain and Northern Africa; its offshore wind speeds are even higher than the Central Plains states; and its 1,800 MW of geothermal power represents 75% of US capacity, an indication of the state’s favorable geology. And yet California still imports power from adjacent states, although even this is now at risk as neighboring states shut down coal-fired plants whose generation was sold to California. The state plans to store excess renewable generation in utility scale batteries but this will take time, so the state approved the temporary use of four natural gas generators to alleviate the power shortage.

Europe is facing a long winter with natural gas supplies 10%-15% below normal for this time of year. At the same time, Russia is offering only a small amount of gas to Europe to alleviate the crunch, and has only offered 15%-20% of 2019 spot market volumes to Europe for the years 2022 and 2023. A few reasons: last year, Russia had an unseasonably cold winter and its winter looks to be starting early this year; Russia is having trouble filling its own domestic natural gas reserves; Russia spent $11 billion on Nord Stream 2 and is trying to maximize returns on it by pressuring Europe to approve it; and Russia made it clear in advance that it prefers long term take-or-pay contracts rather than selling in the spot market
China’s energy crisis is complex but is another example of fossil fuel supply falling faster than demand. Contributing factors: a surge in Chinese power demand in 2021 as the global economy rebounded; lower China hydropower output which increased demand for coal fired power; a slowdown in China coal production due to climate goals, safety concerns and a coal price cap, leading to power plants running down coal inventories way below normal levels; disruptions in Indonesian coal exports due to heavy rains and domestic prioritization; and price controls in China’s power sector which prevent utilities from recovering rising input costs

Meanwhile, for investors, the fundamentals of traditional energy companies look quite different than they have in many years. Capital spending has collapsed vs depreciation and cash flow, and the industry is earning record high free cash flow margins.

And with that I wish all of you, and in particular Rachel⁴, a Happy Thanksgiving.

Appendix I: The declining link between COVID infection and hospitalization/mortality

There’s a large COVID infection spike in Belgium, the Netherlands and Germany; for the latter two, reported infections hit their highest levels since the pandemic began. It’s early to make a final judgment, but high levels of European vaccination and improved health care protocols have sharply reduced the degree to which COVID infection results in hospitalization and mortality (see table; note that in the US, the mortality linkage to infection in the most recent wave is higher, reflecting more unvaccinated people). If that pattern remains, the latest infection spike will have less severe healthcare and economic consequences for Europe. The efficacy of vaccines in preventing COVID from inhabiting the respiratory system seems to fade over time, particularly vs the Delta variant; that’s why infections can occur even among vaccinated people. Even so, vaccine efficacy remains high in preventing pulmonary and neurological damage which puts people in the hospital (or worse).

There’s plenty of data from multiple sources showing how age-adjusted hospitalization and mortality rates are much higher among unvaccinated people; we have some on our COVID portal. Even so, Aaron Rodgers rejected the premise that the US is experiencing a pandemic of the unvaccinated in a recent interview, calling it “a total lie” before mentioning some nonsense about ivermectin and HCQ. If you want to listen to professional athletes, read Kareem Abdul-Jabbar’s article⁵ on what he thinks of Rodgers’ arguments instead.

¹ Surging European natural gas prices lead to industrial shutdowns: CF Industries announced closure of two UK ammonia/fertilizer plants and, more significantly, Yara announced a 40% cut to EU ammonia capacity. Yara/CF cuts are > 20% of European capacity and ~1-2% of global capacity

² An example: when EOG Resources announced intentions to expand production last February, its stock price fell sharply. In other words, rising fossil fuel prices may not substantially boost US oil & gas production in a world of intense pressure on investors and lenders to divest. Michael Shellenberger’s pieces on Substack cover these and other energy topics on a frequent basis

³ Our renewable energy forecasts are probably too optimistic. We assume that by 2035, 57% of US electricity generation is wind, solar and hydropower. But as we illustrate in the hyperlink above, this would require more rapid transmission grid growth that is completely at odds with history, particularly since Congress has not provided the electricity transmission industry with the same eminent domain protections that were once provided to natural gas pipelines (1930s), interstate highway development (1950s) and broadband (1990s).

⁴ Rachel, I know you read the footnotes, so thank you again for taking care of me while I recuperate from a tibial plateau (knee) fracture and torn meniscus that I suffered in a freak accident in late October. I will try not to do this again! I expect to be walking again in January sometime and back in my kayak to fish by April (I hope).

⁵ https://kareem.substack.com/p/aaron-rodgers-didnt-just-lie