US investors are laser-focused on the Federal Reserve, and for good reason. The central bank is set to raise interest rates by another 0.75 of a percentage point, just as the quieter side of this tightening cycle, portfolio shrinkage, is escalating. But this focus means other risks don’t get the attention they deserve.
“While understanding the risk-free cost of capital is always central to investing, we fear that equity investors have become too myopic,” says Lisa Shalett, chief investment officer at
Volatility has increased in currency and global bond markets, but the VIX, the U.S. stock market volatility index, has been favorable, Shalett says. He warns that myopia is setting the stage for a crowded 2023.
One risk that deserves more attention here is the crises unfolding in Europe. The continent is facing an energy shortage that is causing record inflation and pushing the economy into recession. As the European Central Bank raises interest rates to lower prices, higher borrowing costs reduce demand and could trigger a new debt crisis. According to Zoltan Poszar, global head of short-term interest rate strategy at Credit Suisse, about $1.9 trillion of German manufacturing output is backed by the equivalent of just $27 billion of Russian energy. Germany, Europe’s largest economy, has become particularly dependent on Russian energy.
As Alfonso Peccatiello, author of the Macro Compass newsletter, says, that’s pretty much built-in leverage.
What happens in a highly leveraged environment when the cost or availability of leverage—in this case, both borrowing rates and Russian energy—changes dramatically? The system is becoming unstable, says Peccatiello.
A common misconception, he adds, is that only certain European countries have excessive debt. In fact, he says, the public and private debt of all major European nations easily exceeds 200% of gross domestic product—and that’s not counting contingent liabilities, government guarantees or liabilities of public companies, which can be significant. Germany’s contingent liabilities, for example, exceed 100% of GDP.
On Thursday, the European Central Bank raised interest rates by three quarters, following a half-point increase in July, following nearly a decade of negative rates. ECB President Christine Lagarde warned that inflation was spreading beyond energy to a range of products and said the ECB was poised to raise interest rates aggressively at the next meeting.
Energy inflation is already severe and affecting economic growth. The average German household is paying almost 13 times more for electricity now than in January 2020, or about $38,000 versus $3,000 before Covid, says Peter Boockvar, chief investment officer at Bleakley Financial Group.
Yes, there are price caps and subsidies, but the latter are a double-edged sword. Germany has said it will spend at least $65 billion to help some citizens afford energy and give tax breaks to energy-intensive businesses. This will mark the third round of support related to the energy crisis, bringing the total to around $100 billion, at a time when consumer price inflation in Europe exceeds 9% a year.
High prices can help cure high prices, but this effect is limited when it comes to basics. Strategists at
they say German gas consumption was 20% below the five-year average in March, allowing the government to stockpile gas for the winter at a faster pace than some analysts had expected. But Deutsche notes that August was a summer month with little demand. winter is a different story. If Germany continues not to receive Russian gas and even if demand remains 15% below average this winter, the bank says supplies will run out by March. Reduced supply will likely push rationing this winter.
Bleakley’s Boockvar says US investors may not appreciate how Europe’s problems could return here. The economies of the European Union and the United Kingdom combined are about $20 trillion, not much smaller than the US economy of about $25 trillion, and account for about a quarter of global GDP, he notes. Europe contributed about 25% of it
(point: AAPL) earnings in 2021, with the region accounting for 20%-25% of the S&P 500’s revenue. In addition to potentially reduced demand due to high energy prices, US companies with heavy European exposure must face the strong dollar, which makes their products more expensive abroad and shrinks the profits of repatriates.
Europe’s woes could also lead to opportunities: While analysts like Peccatiello recommend avoiding European investments, Morgan Stanley’s Shalett is less pessimistic. European stocks have underperformed US stocks for most of the past 12 years, partly reflecting disappointing relative growth and less effective monetary and fiscal policies. Over the past 12 months, Shalett says, Europe’s relative futures price/earnings multiple has collapsed, driven by a weak post-pandemic recovery and the fallout from the Russia-Ukraine war.
While a recession in Europe seems inevitable, the ECB is likely to keep interest rates elevated and a debt crisis is more than a remote possibility. Some of that bad news is priced into the region’s stocks, Shalett says, meaning there are opportunities for patient investors. U.S. assets, on the other hand, are becoming unattractive to foreign investors as currency hedging costs are high, inflation-adjusted interest rates are converging and the Fed’s bond purchases are winding down, he says.
Fed policy will remain a focus for US investors. But coordinating other forces, especially in Europe, is unwise and can be costly.
Write to Lisa Beilfuss at firstname.lastname@example.org