To Coin An Old English Expression…..It’s A Fair Cop.
Seeing as COP-28 has just come to an end after two weeks in Dubai, what if anything material/significant has emerged from the point-of-view of our planet? As reported in “Earth Action Global League”, there is a certain irony in the fact that the UAE is the world’s 7th largest oil producer while being the 5th largest emitter of CO2…..and yet it plans on increasing oil production by +25% by 2027. The timing could not have been worse for the UAE given revelations in the British press the UAE has been lying about its methane gas emissions for some ten years. The latter enabled them to avoid having to find justifications or alternatives to replace its GHG emissions.
So, how did the talks go? There were some 84,000 attendees (more than double that of COP-26 in Glasgow which previously held the record). To their credit, the UAE made the effort to widen the audience by including more diverse voices. The conference hosted an impressive youth delegate & gender programme. It also drew the country’s top oil executive (President Sultan Ahmed al-Jaber, the UAE’s climate envoy and COP-28 President). Sadly though, this rather backfired – he stated there is “no science out there supporting the phaseout of fossil fuels to achieve the global goal of limiting global warming to 1.5C”. He was then directly contradicted by UN Secretary-General Antonio Guterres who said the only way of getting to 1.5C was by complete elimination of burning fossil fuels.
Some of the positives to takeaway:
The first ever Youth Climate Champion – a ministerial position meant to bridge gaps between governments and other officials and young climate activists.
The first ever International Youth Climate Delegate Programme – a kind of bridging mechanism to enable 100 young people from around the world to enable them to participate in the negotiations.
The first ever Youth Stocktake to determine the level of youth inclusion in climate negotiations as well as amplifying youth voices in the future.
Several countries made efforts to include young people within the ranks. Apparently, this was visible everywhere and older members encouraged younger ones to take the lead during meetings only to intervene in crafting their messages more effectively.
Some of the negatives to emerge:
There were some 600 fossil fuel lobbyists as well as over 1,300 affiliates of fossil fuel companies. The big oil companies – who have been attending COP for years – upped their presence this year. Overall, it meant some of the most ambitious, environmental proposals were staved off.
The next summit will be hosted by Azerbaijan to mark COP-29. Azerbaijan is not part of OPEC but is a significant oil producer in OPEC+.
There was a disputed agreement on when fossil fuel production should cease. The original version used language such as “phase out” which over 100 countries had expressed support for. In the end, we were left with a watered-down version that instead used language such as “phase down”. Fossil fuels are still some 75% of the global energy mix – this agreement in Dubai leaves numerous loopholes for polluters to circumvent the objectives.
While a “Loss-and-Damage” fund was approved, only $700mn has been pledged which falls far short of the $400bn of damage caused by climate change every year. The UAE led the way by pledging $100mn (no surprise!). Germany, France, Italy and the UK pledged a further $159mn. The US and Canada could only drum up $27.5mn between them – despite being amongst the world’s largest polluters.
So, overall, it was another, major PR exercise with very limited outcomes to show for it! Unless there is an earth-shattering breakthrough in the transition to alternative energies, the goal of limiting global warming to 1.5C remains seriously in doubt with rising catastrophes ahead!
And 2024 & Markets…..What Can We Expect?
On Wednesday 13th, after close of business, the Fed announced rates would stay on hold in the 5.25% to 5.50% range. This was expected given the rate of easing we have witnessed in inflation. What wasn’t expected is that they pencilled in at least three cuts in 2024 assuming reductions of -0.25% each. This is less than what the market had been pricing but far more aggressive than what officials had first indicated. Markets had expected no change. Even before this surprise announcement, bond yields had been falling fast on the back of the Israel-Hamas war and then dovish statements from the Fed on rate cuts. After peaking at 5.02% in October, the US 10y Treasury had dropped 4.10% only last week.
Now, they are falling even faster. The US is not alone……we’re seeing this phenomenon across G7 sovereign bond markets. European inflation is falling even faster than US inflation:
So, why do this – what has the Fed seen that has led it to make such an announcement? Here are some ideas:
The Fed has led the market for quite some time with its rate policy – now perhaps it is letting markets lead it. Frankly, this sounds a bit lame to me. I can’t see the Fed suddenly pandering to markets.
It’s election year next year – and not just in the US but across many regions. There is an argument that if it really does cut rates at least three times by -0.25% each time, it is seen as being apolitical while the actual amount of the rate cut is not that material in total. Remember, Powell was lambasted by Trump during Trump’s end days in office – maybe Powell doesn’t want another confrontation of this nature.
It has somehow realised that it has overcooked things on the rate hiking front and that there’s room to correct it sooner rather than later. This has some merit – the effective hike in rates (Actual plus QT) is much more than markets give credit for. Perhaps even the Fed has not given it enough credit. The monetary tightening to date is anywhere between an another +1% to +3%. Effective rates are therefore more like 6.25% to 8.50%. they have not made any reference to any change in monetary tightening – the latter is therefore presumed to continue as already set out.
Certain sectors of the economy, e.g. housing, has seen a liquidity tightening. This doesn’t just come down to rates – it’s also about supply/demand. New house prices have fallen the most in 60 years and this has severely affected home-builders who are desperately seeking relief from higher rates. There is some merit in this argument but it doesn’t strike me as being strong enough. If you want to kickstart the housing sector, targeted reliefs are a better way than meddling with rates at a national level – the latter is a dangerous game to be playing.
There’s another reason which I think might be more compelling: by trying to talk market yields down (e.g. the US 10y is already sub 4%), they might be giving companies an opportunity to rollover maturing debt. In my previous weeklies, I have referred to the big reset that takes place starting April 2025 and peaks in Jan. 2027. If these loans reset at current rates, it would add 5% to interest costs and place huge strain on balance sheets. By contrast, the impact on 2024 is fairly manageable. The housing sector/mortgage market would receive a boost in the process (as mentioned in point 4 above).
The key question is whether rate cuts is just talk (which can be a cheap but very powerful tool) or whether its real. The inflation path will be key as will also prevailing financial conditions. The following considerations are worth noting:
The Fed is forecasting these cuts despite retaining an optimistic view of economic conditions – even though it did cite evidence economic growth has slowed since the very rapid rise in Q3 GDP. Nevertheless, the median GDP forecast for 2023 has been revised up to 2.6% (previously from 2.1%). For 2024, 2025 and 2026, it is little changed from before. The unemployment rate is set to rise only modestly to 4.1% (3.8% end of 2023).. Retail sales beat expectations: https://www.investing.com/news/economy/us-retail-sales-unexpectedly-rebound-in-november-weekly-jobless-claims-fall-3256727
One of the reasons the Fed is confident about cutting rates is the path of inflation. End-2023 core inflation is now forecast to be 3.2% (from 3.7%) and 2024 to 2.4% (from 2.6%). After that, the forecast is little changed. A full return to 2.0% is not expected until end-2026.
US Retail sales show no let-up in consumer appetite to buy. November saw an unexpected rise of +0.3% m/m to 4.1% y/y (Oct: -0.2% m/m). It underscores consumers’ resilience – on the back of a strong labour market – and casts doubts on financial market expectations of a rate cut as early as next March! Granted, the pace of growth in retail sales has slowed due to higher borrowing costs and prices but it remains high enough to ward off a recession. The rise was almost across the board. Online retail bounced +1.0% m/m (Oct: -0.3% m/m). There were some strong individual readings too e.g. sporting goods, hobby, musical instrument and book-stores surged +1.3% m/m, clothing +0.6% m/m and motor vehicles/parts +0.5% m/m.
Talk of a slowing global economy has been the main driver of falling energy prices – which in turn has led to a sharp drop in headline inflation. The IEA (International Energy Agency) warned of a mounting slowdown in oil demand and expects softening global oil demand in 2024. OPEC, by contrast, takes a very different view – despite recent cuts in production. The two have often clashed with OPEC remaining cautiously optimistic. It blamed “exaggerated concerns” about oil demand. While it agrees with IEA over 2023 average daily oil demand (2.46mbpd), it sees oil demand at 2.25mbpd – sharply higher than the IEA’s prediction of 1.1mbpd. If OPEC is right, oil prices will surge – and this could trigger a huge surge in headline inflation. At the moment, the decline seen in headline inflation across nations is not proportional to the drop in energy price inflation. That should be a concern to all.
As I have alluded a few times, China’s economy is slowly turning. Stimulus measures are trickling through and boosting demand while production starts to pick up. Property is still a drag – but this is the last bit of the chain and will come down to sentiment and confidence.
For most of Q1 2024, the Risk-On theme will remain well-supported. In such an environment, look to other regions and sectors that are typically unloved. The chart below compares valuations (courtesy: JPM) using Global Forward P/E Ratios. It’s a nice little summary of equity valuations as of 12th December using multiples. Look just how much cheaper Europe, UK, EM and China are. If you buy in to the Risk-On theme, these have to be of consideration.
The top 10 names in the S&P 500 (the main driver of US performance) are trading on around 27X Fwd P/E. The remaining 490 is trading on 17X Fwd P/E.
Europe (excluding UK) is on a discount to the US of some -30%! Only Consumer Staples, Healthcare and IT are trading on a premium to the US and just 5% at that. All other sectors are in discount territory ranging from -7% (Industrials) to nearly -30% (Discretionary and Energy).
The UK is a discount of almost -45% to the US! The IT sector is the only one on a premium of almost +20%. The rest are in discount territory of -5% (Health Care) to over -25% (Materials).
Japan has had a phenomenal run this year. What happens in 2024 will centre very much around its Yield Curve Control policy and the resulting impact on the Yen. The falling Yen has been importing inflation – the Government is under intense pressure from Corporates to put control this. One way would be via putting an end (or at least significantly relaxing) YCC. So far, the TOPIX has risen against the headwind of a falling Yen. Imagine now if investors become bullish on the Yen.
In EM, there are some significant opportunities in countries such as China, Korea, Mexico & South Africa (all of which are currently priced at below its 1996 averages). In local FX terms, the peak-to-trough drawdown in China stands at some -60% (MSCI China).
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