Economy & Markets Nov 15, 2021

Thanksgiving Eye on the Market: “The Thing”

Michael Cembalest Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management

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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. We will explain more next time, but supply chain issues in the US are not just due to COVID and a surge in goods spending. LA and Long Beach ports rank #328 and #333 in the world in the IHS/Markit Container Port Performance Index for reasons related to working hours, resistance to greater automation, labor costs, Customs Office weekend closures, etc.
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. Wage-price spiral risks are rising as the Fed’s “inflation is transitory” stance seems more implausible each month.
China is the growth outlier, suffering a demand shortfall due to 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. But now I have run into such a thing, and I still don’t think I can write about it. Origin stories have always been contentious, whether they’re related to religion, mythology or viruses.

Anyway, here’s a different topic that I can discuss. There are some strange things going on in energy markets, with coal, natural gas/LNG, oil, gasoline, electricity and steel prices surging in many parts of the world. Massachusetts, California, Europe and China provide some cautionary tales below.

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 was 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. Surging European natural gas prices have resulted in 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.

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. China’s most recent interventions (price controls and production increases) have now halved the price of coal. However: domestic coal prices are still up 60% for the year, and coal inventories at power plants and ports are still 20%-40% below normal as winter approaches.

Decarbonization would in theory eliminate some of these gyrations, so in the wake of COP26, by all means accelerate the transition to renewables. Policy and shareholder initiatives are having an impact on the supply side, that’s for sure: there has been a 30%-40% collapse in global investment in energy-intensive industries like oil & gas, metals, mining, steel, etc. But as the economic, chemical, logistical and political realities that govern the demand side of the energy transition become clearer¹, policymakers should be aware of the following:

If they reduce the supply of fossil fuels faster than they reduce demand for them, they run the risk of higher energy prices, energy dependence that can border on servitude and inadequate energy supplies that can lead to power rationing of homes and businesses.

The next chart shows energy dependence by region. Look more closely at the details for Europe in the second chart: Europe now imports around as much oil and gas from Russia as it produces for itself, and is desperate for more Russian gas this winter. How will this impact Europe’s response to a warning received from the US last week that Russia has concluded a lengthy troop build-up near the Ukraine and may be planning another invasion, or that Russia may also be preparing for intervention in Belarus²?

The US does not face this kind of economic and geopolitical trap, but mounting pressure on investors and lenders to starve the US oil & gas industry of capital could eventually change that³. As per our assumptions outlined in detail here, the US might need roughly the same amount of natural gas in 2035 as it uses today. If that’s right, the only remaining questions are whether this energy is produced in the US or imported from Canada, Qatar and Russia, and how that affects reliability of supply, price and national security.

Source: JPMAM. 2020. See accompanying paper for sources and assumptions.

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.

With that I wish all of you, and in particular Rachel⁴, a Happy Thanksgiving. See Appendix I for a brief comment on COVID, Europe and Aaron Rodgers.

Appendix I: COVID, Europe and Aaron Rodgers

There has been a large COVID infection spike in Belgium, the Netherlands and Germany. For the latter two countries, reported infections hit their highest levels since the pandemic began. It’s very early to make a final judgment, but high levels of European vaccination and improved health care protocols have sharply reduced the degree to which infection results in hospitalization and mortality (see table). 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 occur even among vaccinated people. Even so, vaccine efficacy remains high in preventing the kind of pulmonary and neurological damage which puts people in the hospital (or worse).

Vaccine efficacy rates are not 100%, that is clear. But there’s plenty of data showing how US hospitalization and mortality rates are much higher among unvaccinated people; we have some on our COVID portal. The same is true in Germany, which has one of the largest unvaccinated populations in Europe (31%, same as the US), and where the unvaccinated are driving the surge: in its main pulmonary clinic in Giessen, patients have tripled, half are on ventilators and every single one of them is unvaccinated.

Even so, Green Bay Packers QB Aaron Rodgers rejected the premise that the US is experiencing a pandemic of the unvaccinated in a widely publicized interview, calling it “a total lie” before mentioning that he’s taking ivermectin (see box). If you want to listen to professional athletes, read Kareem Abdul-Jabbar’s article⁵ on Rodgers instead.

What’s the story with ivermectin? It’s complicated

Simply dismissing ivermectin as a horse dewormer is not the right way to approach this. Ivermectin is a very effective drug for humans infected with certain parasites and its creators won the Nobel Prize in 2015. In the early stages of the COVID pandemic, ivermectin was among the thousands of compounds tested to see if it could stop the replication of the virus in vitro. It showed promise, so human trials began. Two meta-studies which aggregated results of individual trials found that the drug showed some promise. But during the peer review process, the wheels came off the ivermectin train: many studies were revealed to have design flaws, no control groups, biases, data errors and irregularities, and these tended to be the ones showing that ivermectin was effective vs COVID. The more robust studies generally did not find clear statistical evidence of its effectiveness. As a result, the FDA, WHO and European health agencies have advised against taking ivermectin unless it is being administered as part of an ongoing clinical trial.

Despite a lack of clinical evidence (like evidence supporting mRNA vaccines), some online groups advocate its use and in the US, ivermectin prescriptions are soaring. Good luck with that: when used for parasitic treatment, ivermectin is given as a one-time dose; the “ivermectin for COVID” crowd are often taking it twice a week even though there is no safety data on prolonged use. Some conspiratorial types argue that the drug industry is against ivermectin since it’s cheap; this argument doesn’t hold up since the steroid dexamethasone and the anticoagulant heparin are both inexpensive, and have been adopted for use against COVID after properly constructed clinical trials proved that they work.

One last clue about the ivermectin controversy: more than half of the people who believe ivermectin is effective have no plans to get vaccinated. I think that explains a lot as well.

Sources: “Fringe Doctors Promote Ivermectin for COVID Despite Lack of Evidence”, Scientific American, September 29, 2021; and “The Real Scandal About Ivermectin”, The Atlantic, October 23, 2021

¹We write about such realities every year in our annual energy paper: the complexity of displacing billions of prime mover engines and motors; lengthy economic payback periods for equipment switching, even after subsidies; the chemical realities of industrial energy use and related decarbonization challenges; NIMBYism and local policies impeding expansion and interconnection of electricity grids; levelized costs of renewable energy published by Lazard and the EIA that do not take storage, grid expansion and thermal backup power needs into account; and the preposterous expectations for geologic carbon sequestration.

² “US and Europe fear possible Russia invasion of Ukraine”, Politico.com, November 12, 2021

³An 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

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

Listen to the Podcast

The Thing

Transcript

FEMALE VOICE 1: This podcast has been prepared exclusively for institutional wholesale professional clients and qualified investors only as defined by local laws and regulations. Please read other important information which can be found on the link at the end of the podcast episode.

MR. MICHAEL CEMBALEST: Good afternoon and welcome to the Thanksgiving "Eye on the Market" podcast which I am recording from my basement. I will explain that later.

So our inflation outlook for the U.S. and Europe is alive and well. Some leading indicators have come down in large part because a lot of the bottleneck and supply chain issues. Some of those issues are still elevated but we're starting to see the horizon loosening up a little bit.

We expect semi-conductor production for automobiles specifically to double by next summer. Eastbound freight rates, which we've been talking about since September, are finally coming down.

A big decline in the Baltic Dry Index of shipping costs. We expect around 2 million people in the U.S. that had left the labor force to return to the labor force. Obviously smaller than the number of total people that left, but a meaningful bump.

And just as importantly, vaccination rates are now over 60 and 70 percent in Vietnam, Thailand, Malaysia, Indonesia, and we're starting to hear of falling backlogs and rising factory utilization rates in Asia as some of these vaccination rates rise. And specifically as they rise, increasingly based on the mRNA vaccines instead of the Chinese ones.

So as the supply shortages eventually dissipate, inventory levels will get rebuilt from low levels, and then early next year we should see a boost to U.S. and European GDP. I think that's one of the reasons why the markets over the last couple months have been looking through some of these supply chain shortages and instead focusing on what looks like a pretty decent reflationary environment early next year.

Despite some of the – all these supply constraints, the U.S. and European firms have posted another very good quarter of high margins, earnings, and sales relative to expectations.

And on top of that, it's hard to say because the reconciliation bill in the U.S. still is being negotiated, but it looks like the top statutory corporate tax rate will not rise and instead we'll see increases in taxes on foreign income, a 15 percent minimum book tax, and a small stock buyback tax.

If you bake all the numbers in, it looks like about a 3 to 4 percent earning hit for the tech sector which is pretty profitable and just the one to one and a half earnings for the other sectors. So bottom line is a lot smaller of a tax freight hit than it otherwise would have been.

Now, U.S. labor shortages on the other hand, unlike the good shortages, are going to persist. The U.S. has one of the largest unvaccinated populations in the developed world. Covid drove a big surge in retirement and we've had an immigration pause here that's pretty substantial over the last couple of years.

And as a result, if you look at the small business data, more companies are talking about raising prices of worker compensation in 30, 40 years. It doesn't tell you necessarily the magnitude but it tells you about the frequency with which it's happening.

So there are some mini-wage price spiral risks that are here as a challenge to the Fed. Their whole inflation transitory stance seems more and more implausible each month.

With respect to demand, which is holding up well in the West, China is the outlier. China has got a demand shortfall because of a combination of energy constraints, a regulatory purge, only a modest easing of monetary and fiscal policy and some very strict Covid protocols.

But the bottom line here is that we are seeing some visibility on the supply chain issues and we expect a bounce in everything early next year - wages, prices, nominal GDP, et cetera.

So the Thanksgiving Eye on the Market is usually when I talk about a topic that people can discuss over holiday dinners. The topic I wanted to write about, I can't write about.

Until this year I had -- I had never run into a topic I couldn't write about, and the firm has been very supportive of me writing about anything affecting markets, economics, growth; it was all fair game.

And there's a lot of controversial topics that show up in the Eye on the Market archives since we launched it in 2003. But for the first time, I've run into something that I don't think I can write about and my guess is that you know exactly what topic I'm referring to and what my particular opinion about that topic is.

Anyway, here's a different topic that's interesting that -- that I can discuss. There are some really strange things going on in energy markets. Massachusetts, California, Europe, China, all provide different cautionary tales.

And if there's a common denominator here, they are all the byproduct of a 30 to 40 percent decline in investment in energy, metals, mining, and other energy intensive industries.

And I think for everybody that's focused on the decarbonization process, if you reduce the supply of fossil fuels faster than you reduce the demand for them, you're going to just end up with a combination of higher energy prices, more energy dependence on other places, and inadequate domestic supplies that can sometimes lead to power rationing of homes and businesses.

And so I know there's this intense focus on pressuring banks and institutional investors to starve certain industries of capital. If that process goes faster than the process by which primary energy reduced -- consumption reduces reliance on oil and gas, you're going to end up with one leg moving faster than the other and you're going to end up with some issues.

We have a chart in here that shows energy dependence by region for the U.S., Europe, and China. The U.S. is much less energy dependent on the rest of the world than Europe and China are for sure, but that could change.

And we walk through some of the issues here in Massachusetts. NIMBY-ism continues to kill decarbonization. Northeastern liberals love decarbonization but not if it comes at the expense of high voltage direct current lines to bring hydro power in from Quebec.

California is having rolling blackouts from time to time even before this state decommissions a couple of gigawatts of nuclear and a couple of gigawatts of natural gas. Europe is facing a very long difficult winter. Natural gas supplies are 10 to 20 percent below normal and Russia is only offering a token amount of help to alleviate that crunch.

And then you've got the whole energy crisis complex. The energy crisis in China, which is complex, but which has to do a lot with its cutting both the supply of coal faster than they can decrease the demand for it.

So there's a chart in here, for example, showing how Europe imports around as much oil and gas from Russia as it produces for itself. The -- that is a very unenviable economic and geopolitical position to be in.

The U.S. of course doesn't face anything like that, but again, mounting pressure on investors and lenders to starve the U.S. oil and gas industry of capital, um, could change some of these independents -- energy independence's balances.

We did an analysis. I've been working on this for several years now and -- and there's a link here that goes into detail on the assumptions. The U.S. might actually need the same amount of natural gas in 2035 roughly as it uses today.

And if that's right, the only remaining questions are whether that energy is produced in the United States or imported from Qatar, Russia, Canada, and places like that and how it all impacts the reliability of supply and price and national security.

If you're surprised that our analysis concluded that the U.S. is going to have roughly the same natural gas reliance in 2035 as it does today, go ahead and take a look at the link where we show a deep dive on our assumptions.

There's a lot of work you have to do on something like this and we spell out our assumptions. If other people have very different views, I'd love to hear them. We lay out our forecast for wind and solar capacity growth which is in the 90th percentile of capacity additions since 1960.

We lay out transmission growth estimates, wind and solar capacity factors for large footprints, what do we think is going to happen with coal fired plants, nuclear power plants, hydro power. We have our estimates for electrification of passenger vehicles, light trucks and heavy trucks.

We even have some data in here on compressed natural gas penetration with trucks and buses. We talk about our expectations for trend primary energy and electricity use.

And we even get into one of a cutting-edge topic which is what's going to happen with all of the municipalities that are pressuring commercial and residential buildings to move away from electric baseboard heating and fossil fuel combustion for heating and to heat pumps, and so we make assumptions about heat pump adoption as well.

And then lastly, we have some data in here on electrification of industry. The bottom line is you have to lay out that entire complex of issues if you're going to make an assumption about what kind of natural gas reliance the U.S. is going to have in 2035. Based on our analysis, it doesn't look that different in the future than it looks right now.

If that's the case, you have to think very carefully about starving that industry of capital because again, all you'll do -- are going to do is drive prices up and increase United States' dependence on other parts of the world.

I concluded the piece with a brief discussion of what's happening in Europe right now. There's been a large Covid inspection -- infection spike in Belgium and Netherlands and Germany.

As a matter of fact, for Netherlands and Germany, the reported infections have hit their highest level since the pandemic began. It's a little early to make a final judgment but I'm going to take a glass half full view here.

The high levels of European vaccination and some improved health care protocols have sharply reduced the degree to which Covid infections have resulted in hospitalization and mortality over time. We have a table that shows those declining factors, both for Europe and the U.S.

If that pattern remains, the latest infection spike will be disruptive but have much less severe health care and economic consequences for Europe. And if I had to summarize, it looks like the efficacy of vaccines in preventing Covid from inhabiting your respiratory system fade over time which is why we're seeing some vaccinated people actually get infected, particularly versus the Delta variant.

But even so, the vaccine efficacy remains really high in preventing pulmonary and neurological damage which is what puts people in the hospital or worse.

So again, the vaccines look to have some fading effectiveness against a respiratory infection that registers you as having Covid, but is not resulting in the -- in those more negative outcomes in hospitalization and mortality.

And there's plenty of data from multiple forces showing how hospitalization and mortality rates are much higher among unvaccinated people. We actually have some of this on our Covid portal.

And so I was recuperating from surgery, which I'll talk about in a minute. And I watched this Aaron Rodgers interview where he rejected the premise that the U.S. is experiencing a pandemic of the unvaccinated. I think he called it a total lie before talking some nonsense about ivermectin.

Look. This is willful ignorance. The data is there if people just want to take a look at it. And if you want to listen to professional athletes on Covid, you should read Kareem Abdul-Jabbar's article on what he thinks of Rodgers' arguments and logic instead.

So with all of that, I wanted to wish all of you a Happy Thanksgiving, and in particular Rachel. Around three weeks ago, I had a freak accident while I was on a fishing expedition and got a tibial plateau fracture.

So I fractured my right knee and tore my meniscus. And so Rachel has been taking very good care of me for the last three weeks and will be doing so for the next eight. I expect to be walking again sometime in January and hopefully back in my kayak to fish again by April.

So Happy Thanksgiving, everybody, and I look forward to seeing many of you in the New Year.

FEMALE VOICE 1:

Michael Cembalest's "Eye on the Market" offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of JP Morgan Asset and Wealth Management.

Michael Cembalest is the chairman of market and investment strategy for JP Morgan Asset Management and is one of our most renowned and provocative speakers.

For more information, please subscribe to the Eye on the Market by contacting your JP Morgan representative. If you'd like to hear more, please explore episodes on iTunes or on our website.

This podcast is intended for informational purposes only and is a communication on behalf of JP Morgan Institutional Investments, Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation.

Outlooks and past performance are never guarantees of future results. This is not investment research.

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With respect to countries in Latin America, the distribution of this material may be restricted in certain jurisdictions. We may offer and/or sell to you securities or other financial instruments which may not be registered under, and are not the subject of a public offering under, the securities or other financial regulatory laws of your home country. Such securities or instruments are offered and/or sold to you on a private basis only. Any communication by us to you regarding such securities or instruments, including without limitation the delivery of a prospectus, term sheet or other offering document, is not intended by us as an offer to sell or a solicitation of an offer to buy any securities or instruments in any jurisdiction in which such an offer or a solicitation is unlawful. Furthermore, such securities or instruments may be subject to certain regulatory and/or contractual restrictions on subsequent transfer by you, and you are solely responsible for ascertaining and complying with such restrictions. To the extent this content makes reference to a fund, the Fund may not be publicly offered in any Latin American country, without previous registration of such fund’s securities in compliance with the laws of the corresponding jurisdiction. Public offering of any security, including the shares of the Fund, without previous registration at Brazilian Securities and Exchange Commission— CVM is completely prohibited. Some products or services contained in the materials might not be currently provided by the Brazilian and Mexican platforms.

JPMorgan Chase Bank, N.A. (JPMCBNA) (ABN 43 074 112 011/AFS Licence No: 238367) is regulated by the Australian Securities and Investment Commission and the Australian Prudential Regulation Authority. Material provided by JPMCBNA in Australia is to “wholesale clients” only. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Corporations Act 2001 (Cth). Please inform us if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

JPMS is a registered foreign company (overseas) (ARBN 109293610) incorporated in Delaware, U.S.A. Under Australian financial services licensing requirements, carrying on a financial services business in Australia requires a financial service provider, such as J.P. Morgan Securities LLC (JPMS), to hold an Australian Financial Services Licence (AFSL), unless an exemption applies. JPMS is exempt from the requirement to hold an AFSL under the Corporations Act 2001 (Cth) (Act) in respect of financial services it provides to you, and is regulated by the SEC, FINRA and CFTC under U.S. laws, which differ from Australian laws. Material provided by JPMS in Australia is to “wholesale clients” only. The information provided in this material is not intended to be, and must not be, distributed or passed on, directly or indirectly, to any other class of persons in Australia. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Act. Please inform us immediately if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

This material has not been prepared specifically for Australian investors. It:

May contain references to dollar amounts which are not Australian dollars;
May contain financial information which is not prepared in accordance with Australian law or practices;
May not address risks associated with investment in foreign currency denominated investments; and
Does not address Australian tax issues.

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