Domestic energy supply shortages in Europe and dependence on volatile global markets are contributing to record gas prices across the continent. In the US, the latest inflation data is further testing the US Federal Reserve’s hypothesis that inflationary pressures are transitory in nature.
COVID-19 – A brighter picture?
World daily new Covid-19 cases have continued to fall and are now at around 410 000 per day.
However, high levels of infection rates, while no longer translating to the same degree in deaths, continue to have an economic impact.
Evidence of this came in the US September payrolls report, based on data collected in mid-September when the Delta wave was near its peak. Job growth in leisure and hospitality businesses was particularly subdued.
Antiviral treatment – A potential game changer?
Late-stage clinical trials have shown that a leading US pharmaceutical company has developed an antiviral pill that could halve the risk of hospitalisation and death. The company has applied for emergency use authorisation from the US Food and Drug Administration. Treatment involves twice-daily pills, prescribed for five days to patients diagnosed with Covid-19.
Antiviral treatments have advantages over other treatments. They are simple, easy to administer, cheaper, and manufacturing is less complicated. In addition to vaccines, an antiviral treatment could transform Covid into a manageable disease, moving it from a ‘pandemic’ to an ‘endemic’ phase. There are also potential benefits for emerging economies whose vaccination rates are low.
Winter is coming
There are early signs of a new wave of infections in eastern Europe with caseloads starting to rise in countries where vaccination rates are low. There is clearly the potential for a new outbreak as the approach of winter in the northern hemisphere coincides with a rising risk of breakthrough infections as vaccine efficacy across the population wanes over time.
In countries with high vaccination rates, the fact that vaccines remain highly efficient against hospitalisation combined with boosters for vulnerable people should help contain any pressure on health systems. A return to tough restrictions therefore appears unlikely now.
Stagflation is a loose term that means different things to different people. A broad definition, however, would be a period of rising inflation and slowing growth because of higher energy prices.
Stagflation talk is getting louder (see exhibit 1) because natural gas prices have tripled in the last three months. The price of liquid natural gas (LNG) has soared from about USD 5 per metric million British thermal units (mmBtu) a year ago to more than USD 30 today, having briefly spiked above USD 50 last week.
Gas in the spotlight
In the past, oil prices were the dominant force in energy markets. However, natural gas, which until recently was mainly priced off oil contracts, has moved to the centre of the energy complex. A global squeeze in supplies has been driving prices higher (see exhibits 2 and 3). Europe is particularly dependent on the global market for gas.
Oil prices have been rising too: Brent crude oil reached its highest level in three years last week at USD 83 a barrel. So far, the Opec+ group has not been prepared to accelerate production. Under these circumstances, with demand for oil rebounding hard as economies reopen after the pandemic, prices are likely to remain high. Crude prices could also be affected by the shortage of gas as some sectors envisage replacing gas with oil where possible.
Gas demand differs from oil in that it is more seasonal with stronger demand in winter due to the central role gas plays in domestic heating.
Among the reasons for Europe’s current gas shortages are:
- Domestic European gas fields and storage facilities have been run down as the continent’s focus has shifted to renewable energy sources.
- In the global gas market, Europe now competes with Asia, where demand for LNG has risen by 50% over the last 10 years. Cold weather in China, the world’s biggest importer of LNG, raises prices in the global market.
- Russia supplies around 30% of Europe’s gas. The focus now is on whether Russia can meet Europe’s gas needs in the event of a cold winter. However, Russia-Europe export volumes may not return to pre-Covid levels until early-2022; firstly, Russian gas exports have increasingly shifted towards Asia; secondly, Russia’s domestic inventories are also low, leading to local stockpiling. Finally, certification of the Nord Stream 2 pipeline to Europe has been complicated by the delays in the formation of a new German government.
- Gas is seen as a bridge fuel during the energy transition. It produces around half the CO2 of coal when burnt. However, methane emissions from gas during extraction and transportation have arguably discouraged new investments, again restricting domestic supplies in Europe.
We are monitoring developments closely. As uncertainty persists around supplies, European high-yield credit markets are vulnerable, given their greater exposures to sectors that are sensitive to energy price changes.
US prices – Housing sector inflation picks up
US core inflation data was in line with market expectations in September, up by 0.2% month-on-month. That left the annual rate at 4%.
At first glance, this data supports the hypothesis that the surge in inflation in late spring/early summer would be ‘transitory’. Price pressures in used vehicles, hotels and transportation – all segments clearly connected to Covid-related supply chain stress and post-vaccine re-openings – were robust earlier in the year, but netted out at almost zero in September, in part due to the resurgence of Covid in late summer.
Instead, the main contributor to US core inflation was housing rents. Housing is by far the largest component in the core index (CPI) and a segment where inflation often persists month-to-month: Strength (or weakness) in one month’s data tends to be followed by further strength (or weakness).
The rebound in rental inflation is mainly seen in cities in the Midwest and south of the US, which is consistent with the notion of people looking for more space in relatively cheaper markets.
If rent inflation does continue to rise into 2022, it will increase the challenge the Federal Reserve faces in balancing the employment and inflation sides of its mandate.
Even allowing for the smaller weight of rents in the PCE (personal consumption expenditures index), the measure of inflation the Fed targets, sustained housing rental inflation at 5% or more is unlikely to be consistent with core PCE inflation slowing to 2.3% by end-2022, as forecast by the Fed three weeks ago.
Yet it also looks unlikely that the US will return to pre-pandemic labour market conditions by the end of next year. That would require new payrolls to average around 700 000 a month for the next 15 months in a row.
With the Fed’s forward guidance on the timing of the first rate rise requiring both ‘maximum employment’ and 2% inflation, there is set to be intense debate between the hawks and the doves at the Fed over the definition of ‘maximum’ employment. Which side wins will determine when the first rate increase happens.
US bond yields steady
Yields of the benchmark 10-year US Treasury note slipped back in the wake of the latest inflation data to around 1.54% after hitting a four-month high at the start of the week.
A USD 24 billion auction of long-dated 30-year government bonds met with strong demand. Indirect bidders, which include foreign buyers of US government debt, took up roughly 71% of the amount on offer, marking the highest percentage at a reopening of that maturity since July 2020.
This strong demand from overseas buyers may partly counter the effects of the Fed’s expected taper of its USD 120 billion a month in asset purchases in November.