Looming Winter Energy Crisis Sees Poor Q3 Performance

By Colin Vella, Head of Wealth Management at Jesmond Mizzi Financial Advisors

Despite a positive start, the third quarter of 2022 saw markets registering further losses as inflation remains high and concerns grow over a potential energy crisis in Europe this winter. Jesmond Mizzi Financial Advisors’ Head of Wealth Management Colin Vella untangles the latest market reaction and offers insight into what we can expect from the year’s end

After a very bad first half of the year, we saw markets rebound quite strongly in July before plummeting once again in September. How do you interpret this performance?

By September’s end the market had registered a new bottom, after that registered in June. This was mainly because hopes of a soft landing for the economy started to fade in September as it became clearer that controlling inflation was going to be more difficult than we hoped.

At the start of the year, we saw inflation shoot up, but consumer spending remained high, despite an increase in prices. People were still keen to go out and enjoy the summer after two years of restrictions and this allowed companies to pass on their increase in costs, and a little bit more, to consumers.

We saw demand continuing to increase, despite conditions which would have normally been accompanied by a drop in spending.

Round about mid-August however, with inflation still a cause for concern, we saw central banks signal that they would be pursuing further aggressive interest rate hikes, and this sent markets tumbling.

Summer nearing its end also meant that business confidence was down since economic activity tends to slow down in the winter. This, coupled with the fact that Europe is bracing itself for an energy crisis this winter, with all the inflationary pressure that will bring with it, further compounded the market’s outlook.

In fact, we can say September’s performance reflected how markets were feeling about the winter, which is why we saw such a big decline.

How would one estimate business sentiment, especially when talking about the market as a whole?

There are many indicators which gauge how businesses are feeling about the economy. One such index is the Purchasing Managers Index, which is a measure of the prevailing direction of economic trends.

A survey is carried out every month across different regions and a score is calculated. A score higher than 50 indicates that businesses are positive about the future, while a score below 50 suggests the opposite.

The global composite purchasing managers index for August, which includes both the manufacturing and services sectors, dropped to 45 – its lowest value since May 2020. What’s more is that we saw it drop to below 50 across the EU, as well as in the UK and US.

The likelihood is that the next five to six months will be the bottom of the decline we’re experiencing, with markets starting to rebound in the spring.

This doesn’t mean we’re guaranteed further declines in the winter however, and more opportunities will continue to be created. For instance, equities in companies which fell victim to the market shock that resulted from skyrocketing inflation and interest rate hikes, but whose profitability remains intact. These companies should be considered over all others at this time.

In July you pointed to three scenarios that could result in quick recovery: a sudden end to the war, inflation being brought under control or a solution to the energy crisis. The situation with respect to all three has improved somewhat over the past three months. Can we expect this to be reflected in the markets?

Not for the time being. When it comes to energy, while most European countries have secured alternative sources of fuel and the situation is looking better than it was a few weeks ago, there is still a lot that can go wrong. We saw OPEC announce a reduction in oil product at the beginning of October, which will likely see energy prices shoot up once again, so we are by no means out of the woods.

If the winter isn’t as bad as expected, we could see a healthy recovery, though volatility will remain.

As for inflation, while it has slowed its increase, it hasn’t been as quick as we hoped. For example, markets reacted badly to August’s inflation numbers in the US, because while a rate of 8.3% did represent a slowdown, it wasn’t as great as was being anticipated by the market.

If we turn to the war, Ukraine appears to have the momentum now, but this doesn’t necessarily mean the war is coming to an end. If anything, it could mark the start of further escalation.

Let’s turn to the UK. In September we also saw global markets react to the government’s so-called mini budget. Developments in the UK rarely move markets, so why did they in this case?  

The issue with the UK was that it announced several fiscal measures that weren’t intended to address a particular issue. The government announced tax cuts and other measures that would increase government debt considerably in order to stimulate growth, while at the same time, you have the Bank of England trying to slow down an economy in which unemployment is already low.

As BNP Paribas economist Paul Hollingsworth was quoted saying by the Financial Times, it’s a bit like having a country’s monetary policy pressing the brakes and its fiscal policy with its foot on the accelerator.

So, the budget led to interest rate levels rising because there was a mass sale of government bonds. This triggered further interest rate increases which in turn fuelled more bond sales, forcing the Bank of England to intervene.

The global concern is really that a significant economy took growth measures at a period of such high inflation. The fact that there was a global ripple effect is due both to the globalised nature of the world we live in, and also how markets are linked from a currency perspective.

The fact that the Dollar was at a historically high point when compared to the British Pound, while positive from a currency perspective, also makes the US less competitive because it becomes considerably more expensive for UK companies to do business in the US.

Which sectors performed best during Q3 and what changes, if any, should investors be making to their portfolio?

The trend was more or less similar. The sectors that were hit the hardest at the start of the year were the ones to see the biggest recoveries in July. You saw 10% increases in some cases, but it was all wiped off by September’s losses. You saw double-digit losses being registered across the real estate and communication services sectors, for example.

On the bond side, certain segments fared even worse, including the higher quality end of the fixed-income spectrum, such as US treasuries, as the yield curve inverted, and UK gilts following the “mini-budget market tantrum”.

We did see a slight decline in the energy sector since energy prices fell slightly after the first half of the year, but still outperforming the rest, and ending the quarter in positive territory.

As I said in July, it is an ideal time for investors to rebalance their portfolios in order to make the most of the opportunities being created. I would say that it is now an even better time to do this than it was three months ago given that several opportunities have been created.

One such opportunity has been the decline registered in the high-quality bond market. September alone registered a 4-6% decline, so there are more opportunities for investors to buy good quality bonds that they wouldn’t have considered nine months ago.

Bonds with a BBB rating or higher can now be yielding a decent income for example. You’re not going to be making a huge amount of money, but it will go a long way towards cushioning inflation.

It is also a good time to evaluate one’s portfolio and evaluate whether it has a lack of exposure towards certain sectors and asset classes.

This is especially true in the current market conditions, in which your typical balanced portfolio – or one with a higher bias towards fixed-income – could easily be performing worse than a broadly diversified equity portfolio.

It’s an atypical situation which reflects the knock-on effect of decades-high inflation, rising interest rates and fears of a recession looming ahead.

Ultimately, market volatility will continue to bring about opportunities and we now have the advantage of enough time having passed that we have more information to make better decisions.

Markets will recover before the economy, so it is important for investors to remain ahead of the curve to make the most of the present situation.

This interview does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA under the Investment Services Act and is a Member of the Malta Stock Exchange and a member of the Atlas Group. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]