Recession may not automatically equal lower prices
The current narrative reads that we have high inflation and central banks are getting serious about tackling it. This will result in lower growth and with lower growth comes lower demand which will automatically bring down inflation. There is another, more worrying scenario that could play out, especially in Europe.
Winter energy crunch in Europe
With the European tourist season in full swing, things on the continent are ticking along nicely despite higher energy prices and a war not too far away. However, trouble is brewing. This week the International Energy Agency (IEA) chief warned that Europe should prepare immediately for a complete severance of Russian gas exports this winter.
Last year the IEA was one of the first to accuse Russia of manipulating gas supplies to Europe and has made the link between the lower volumes of gas out of Russia in the last couple of weeks and an ultimate intention, which is to potentially turn off the spigot altogether during winter. With lower volumes during the warm summer months it stops European countries stockpiling gas for the winter.
Whilst individual countries are taking measures to alleviate an energy crunch, such as firing up mothballed coal plants and attempting to reduce demand for energy, the IEA suggests there should be more and deeper demand measures taken by governments. Already Germany is preparing to trigger the second stage of a three-stage emergency gas plan, a move that may mean passing along higher prices to industry and households. The government may soon move to the “alarm” stage after deliveries from Russia were cut last week, after being at an “early warning” stage since 30th March. “Alarm” kicks in when there is a high risk of long-term supply shortages of gas.
Further supply disruption across the board?
Any disruption to energy supplies will have knock-on effects to almost every industry. We’ve already seen this year how higher prices of energy feeds into the price of almost all goods and services, and drives up wages. But what if the warnings from the IEA become a reality, what if there is no energy or drastically less energy? What if the industrial heartland of Europe needs to go to a 3-day working week in order to ensure the continent is warm in winter. This will undoubtedly lead to additional supply shortages not to mention the prospect of other industries being hit outside of manufacturing. Is it right to keep the lights on in hotels and keep ski resorts open when it’s a struggle to ensure that the populous is warm. We could therefore get recession and greater supply disruption all at the same time.
Governments to the rescue once again
This is a scenario that’s not beyond the realms of possibility if the IEA is to be believed. Public funds for affected businesses and households are likely to be forthcoming, much the same as the pandemic but we’ve seen what this does. It creates more demand at a time when supply is constrained, pushing up prices further.
Still no time to be adding risk
A looming energy crunch is no time to be adding risk to the funds, especially at a time of increasingly tight monetary policy from almost every central bank on the planet. We are likely to see companies squeezed by input costs and households squeezed by energy costs which is not a good combination for company profits. In short, highly levered companies are out, those with strong balance sheets are in, safety is key. We also keep the maturity of our underlying holdings short to reduce price volatility.