5.6 billion down the drain
What's up with Stonks is a biweekly report that delves into the complex and often confusing world of the stonk market. Community Manager Verneri Pulkkinen helps you navigate the troubled waters of market movements and macroeconomic phenomena. Stay tuned for the hottest investment scene news, moderate amount of stock populism and understandable information about the stock market.
In this post, I’ll talk about the European energy market and the nationalization of Uniper. Fortum was hit with billions in losses, but at least it is no longer sinking with Uniper. Then I’ll offer a brief look at economic growth forecasts, which are currently plummeting. That’s not good news for the stock market.
Unfortunately, the next post will not be published until next Thursday.
First some news.
Stock markets came crashing down yesterday as the gleeful Fed hinted that it was ready to drive the economy into the dumpster to tackle inflation.
As expected, the Fed raised its funds rate by 75 basis points to 3.25%. What was not that expected was the Fed's strong signal of continued increases in the funds rate. The dot plot that shows the various board members' views on the level of the policy rate increased to 4.6% for next year. This is the median expectation. Already a third of members see the funds rate being as much as 5% next year. That would be something for the market to chew on. However, even the Fed's forecasting abilities are limited, but at least the enthusiasm for new hikes doesn't seem to subside anytime soon. This doesn’t offer much forecasting value, but the signal value is high.
The long term funds rate is seen at 2.5%.
Sweden's Riksbank, for its part, pushed the funds rate up by 1% in one go. According to the Swedish central bank, interest rate hikes will hit Swedish household consumption hard, because Swedes have a debt-to-income ratio of 200%. As the cost of borrowing rises, less money is left for inflation fueling consumption. For Sweden's bubbling housing market, the central bank now expects a fall of 18%. Note that Sweden's economic problems may be reflected in a slight grumble in Finland, as Sweden is an important market for many Finnish companies such as Nordea.
The environment of rising interest rates is quickly hitting speculators and debt gamblers in the face. One such leveraged sector that has slumbered at zero interest rates is real estate. The European real estate stock market index has plummeted by as much as 40% this year. In addition to the index, this graph shows the 10-year German bond rate, which acts as a gravity pulling down valuations.
Uniper is nationalized, Fortum suffers heavy losses
Natural gas prices (check the chart below) have fluctuated wildly in recent days. Putin is trying to escalate the war in Ukraine, while Europe is struggling to cut off Russian energy. Europe is trying to scavenge for liquid gas around the world. Fortunately, natural gas stocks are beginning to be full. If the winter is a cold one, Bloomberg estimates suggest that rationing - the temporary closure of energy-intensive industries - will be necessary. In any case, the doomsday prophecies don’t seem to be coming true, unless of course Russia plays with fire with the use of nuclear weapons, but that is a completely different scenario.
According to estimates reported by Bloomberg, European countries are shoveling up to €500 billion into alleviating the symptoms of the energy crisis. By far the largest amount comes from the UK, which has already earmarked almost €200 billion to alleviate the energy crisis. The alleviation includes energy tax bills, heating subsidies and measures to keep energy companies afloat.
Germany that enjoyed Russian gas for decades and was caught with pants down is ruthlessly using every means at its disposal to get out of the hole it has dug. Chancellor Scholz's government has been nationalizing the fossil energy sector and yesterday it was Uniper's turn in the nationalization queue. Fortum is/was the majority shareholder of Uniper. As I understand it, the core of Scholz's policy is not just casually nationalizing the energy sector, but in a crisis situation this path has been chosen, despite several objections.
Uniper is easily one of the most disastrous M&A adventures in Finnish corporate history. Fortum will receive €500 million from the German state for its stake in Uniper, for which it has paid around €7 billion. During the ownership, Fortum has received €900 million in dividends. Sonera's €4.3 billion acquisition of a network operator license in Germany in the early 2000s, which turned out to be worthless, is a clear runner-up. And now I don't even want to think about what will happen to the billions Fortum’s has invested in Russia...
The silver lining in burning shareholders' money is that Fortum is at least getting a €4 billion loan and a €4 billion loan guarantee from Uniper in the arrangement. At the same time, the steel chain that connects Fortum to the ship that’s sinking under the weight Uniper's billion losses is broken and the responsibility for keeping her afloat falls on the Germans.
Perhaps there is some merit in the fact that our big listed companies pay out a large part of their profits in dividends, capital allocation being what it is. The average dividend yield of Nasdaq Helsinki has been very high in the 2010s. Based on this evidence, it should be even higher.
Despite the turmoil of the energy crisis, earnings forecasts for euro equities continue to gallop upwards, as I have often highlighted. The 12-month EPS of the STOXX Europe 600 index continues to inflate in the forecasts. Even if stocks look cheap, it’s unclear what impact the energy crisis will have on earnings or stock pricing. Therefore, I would take the forecasts with a pinch of salt even though otherwise there’s a contrarian investor’s market in Europe.
Macro-forecasters at Deutsche Bank see the euro area economy contracting by more than 2% next year. Macro-forecasting is very difficult (impossible), but predicting a recession isn’t surprising in a situation where Europe's energy supply is falling and interest rate hikes are shaking up the debtors' deck.
Economic growth is slowing down, profits are not (just yet)
Let's continue to talk about forecasts and profits for the US, the center of the global economy. Economic forecasts are falling like autumn rain down the drainpipes. In the US, the GDP growth forecast has fallen to less than 1% in 2023.
There was a good point on Bloomberg about how, in most cases, when economic growth in the US falls below 1%, the country has already slipped into an official recession, which is almost ready to be declared.
Gross domestic product, which measures the size of the economy through output, is a scattergun of a measure, and its accuracy is updated over time. More recently in the US, another way of measuring the size of the economy through GDI, “gross domestic income”, has continued to grow. It’s very different from GDP, although in theory they should mirror each other. I won't go into the accounting here, which is a swamp on its own merit. However, it's good to remember the inaccuracy of the big macro indicators. If you take the average of these two measures, the economy will slow down, but it is too early to talk about a recession without a crystal ball for the US.
While several indicators such as strong employment speak in favor of growth, the corporate sector is full of anecdotal evidence of a slowdown. Car manufacturer Ford warned how its profitability wouldn’t be able to cope with the inflated costs. The conglomerate General Electric, which has been in trouble for years, warned about the availability of parts. The CEO of McDonald's has warned of recession in the US and Europe, while Starbucks will continue its ambitious expansion and sees consumer strength in opposite way. FedEx, which moves goods around the world and is on the pulse of the economy, warned of a recession and withdrew its guidance. However, the company has a history of blaming the global economy for its own problems.
At key economic junctures, it’s easy for an investor to find data points and news to support their view, whether they are an optimist or a pessimist.
A recession doesn’t automatically spell disaster for stocks and, especially in the short term, there is little correlation between the stock market and the economy. But in the long run, it will be difficult for listed companies to grow their earnings if the economy as a whole slumps. It’s difficult to paint a slightly deeper recession as a positive experience for the stock market.
This graph from Bloomberg shows how recessions have on average hurt results. In the 2000s, recessions have halved earnings, which is why investors are very cautious about recessions. The financial crisis and the bursting of the tech bubble weren’t gentle on equities, but they were also very extreme events. There are numerous recessions where results have fallen less dramatically by 10-20%.
However, we enter the current recession with a fairly high valuation. The P/E ratio of the S&P 500 is 19x. This can be justified by the strong return on capital of US companies and their hefty growth.
In the coming years, analysts expect earnings growth of 10% to continue, which can be seen as an almost institutionalized starting point for the forecasts. Earnings growth forecasts for the coming years have leveled off, but they haven’t turned down. This would suggest that current valuation levels aren’t sustainable and earnings forecasts won’t materialize if the economy now enters even a mild recession. If things end up going well and the economy and the earnings grow, stocks are happy. If a recession hits with high interest rates, then stocks won’t be the best place to have your money in.
The most interesting situation is when there aren’t many expectations loaded into equities. Then there can be negative surprises and the investor's capital is still reasonably safe. The current situation is difficult to describe as such.
Thank you for reading the post! Read analysis and make good stock picks!