“It never rains but it pours”. A strange saying and metrologically inappropriate at this time. But the gist is that misfortunes come at the same time. The recent heatwave in Europe is a good example.
At a time of higher oil and gas prices, the extreme heat may start to impact electricity generation. Solar is fine but hydro and nuclear power need water and rivers are running low. And those lower rivers are starting to impact trade.
Holidays are a great way to learn. Last week’s article by Rory Sutherland in the Spectator (usually one of my most interesting reads) highlighted a similar point. We should embrace what other nations get right and learn from them even if this is not in tune with a prevailing political or economic orthodoxy. Why are health outcomes better in a lot of our peer countries? Why is the West Coast rail operator down to offering one train an hour to Manchester?
As an aside: how do you measure inflation? When Avanti replaced Virgin as the West Coast franchise operator ticket prices seemed to go up, or at least attractive deals disappeared: an example of price inflation. But the service has deteriorated significantly; from my perspective this ‘inflation’ is much more than that implied by the change in price. It’s like putting up the price of a chocolate bar and simultaneously cutting its size.
Back to holidays. In my last European venture before Covid, my wife and I cycled down parts of the Mosel and Rhine in Germany. I would highly recommend it: relatively flat and with some great wines along the way. And I learnt a few things: the Germans are keen cyclists and like electric bikes (they seemed much earlier adopters than Brits), German spas require nudity, electronic financial payments are relatively backwards (we are streets ahead) and the river systems are used extensively to carry heavy goods over long distances. The present European drought has taken the Rhine waters to really low levels and is beginning to interrupt freight movements. With about 7% of German freight moved through inland waterways, particularly focused on coal, crude oil and chemicals, disruptions will only add to inflationary pressure and reduce economic activity. From what I have read the impact is not big – but it could take off 0.2% from German growth in H2 if conditions persist.
Growth concerns remain
So, what is the outlook for European growth? Well, the latest Gross Domestic Product (GDP) releases beat expectations. But I remain bearish. The energy crisis will test consumers and businesses as winter approaches, with the prospect of energy rationing being discussed. As inflation is expected to be close to 10% in September it is unlikely that the European Central Bank will be in a mood to halt rate rises. Again, the labour market is key but this strength may only encourage a more hawkish central bank. A resolution in the Ukraine war would be a big plus for economic activity but short of this, I think a European recession looks likely later in the year.
There was relief on the US inflation front last week as Consumer Price Index slowed to 8.5%, reflecting lower gasoline prices even though food prices continued to rise strongly. The core rate slowed, helped by a fall in airfares and second-hand vehicles although cost pressures in some services remain a concern. In the UK Q2 GDP showed a small contraction, mainly reflecting a downturn in services but business investment was more upbeat. Not a lot can be read into this at the moment and I still feel the real pain is yet to come.
Markets: real yields remain volatile
In markets long end real yields have been on a roller-coaster ride recently. Taking the UK as an example: from mid-May the yield on the 2073 index linked gilt has gone from -1.6% to -0.5%, before dropping to -1%; it ended last week at -0.8%. In price terms this means the bond has traded between £136 and £245. Interestingly, these moves in real yields have helped push up implied UK inflation despite more concerns about a global slowdown. In conventional markets, yields were up this week with 10-year US treasuries hitting 2.85% at the close. German yields nudged a bit higher towards 1% while UK gilts settled above 2.1%.
Credit markets remain subdued with liquidity low and new issuance activity limited. The big corporate story last week was the potential litigation around Zantac, which hit the share prices of several companies including GSK, Sanofi and Haleon. From a debt perspective, the news had more limited impact but it is a good reminder that a lot of ‘large cap’ issuers offer very little protection in the way of covenants or enhanced security. Events such as these are a good reminder of the need for diversity and to think twice about having large exposures to companies with strong point-in-time ratings (due to large market caps) given the lack of bondholder protections and narrow spreads on offer.
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