The market has been filled with extremely bearish headlines -- Evergrande's (EGRNF) collapse, China's hard landing, the U.S.' debt ceiling expiration that's threatening a U.S. government shutdown, and the Fed's tapering plan. We can throw a few more in, but the market has been trying to digest everything that's thrown at it and yet ... it's ... holding up?
This is because, despite what the Fed keeps saying, it is still adding liquidity to the market; the Fed is still buying $120 billion per month of mortgage-backed securities and Treasury assets, and this is making its way back to the markets and asset prices. Until that stops, one can argue, the broader markets are supported, for now.
We know China has come close to "finding a solution" to the Evergrande debacle, as it has now persuaded state-owned enterprises and state-backed property developers to buy some of Evergrande's distressed assets and complete the housing projects to avoid collapse in the real estate market and defaults. Given that more than 60% of households' net worth is exposed to real estate, China would hardly let the market collapse.
But there is something more sinister brewing, not only in China, but around the world, a real energy shortage.
What does this mean? There is no one single thing that is causing this, but is a combination of the perfect-storm of factors. From the coal supply weakness mixed with strong power generation demand that is driving up gas prices and coal prices. U.S. liquefied natural gas exports are getting pulled away to China and Japan at a time when U.S. domestic shale gas producers are hoking back after having "promised cash returns to shareholders" -- not the most opportune time to be disciplined -- as they seem to be losing out. European gas prices were moving higher on lower wind generation this summer and now with stronger E.U. power demand, they are competing with Asian LNG for imports, causing U.K. and Dutch title-transfer facility prices to trade north of $26/per million British Thermal Units now -- the highest settlement to date.
There is also talk of Russia holding gas back to help give incentive to the start-up of Nordstream 2, but the truth is that even Russia does not have more gas to pump for now to make up for the shortfall during this time. Coal, which is the dirtiest form of fuel, is also now rallying and being used as an alternative to combat this shortfall.
Inflation is very apparent in the system -- including in house-price and rent inflation, food and consumer goods, and now utilities. The E.U. and U.S. gas producers tend to use the summer months to produce enough gas to store before winter starts. We have a shortage before winter has even begun. This is concerning, as factories in China and Europe are closing down due to unsustainable costs, which will lead to more shortages in auto chips, carbon, and all other things needed. This is one of the Fed's worst nightmares, as this inflation is supply shock led, not really demand led.
When demand is strong, but the infrastructure is just not at a scale to take the load, there is only one solution: Demand destruction. China has rolling blackouts and power outages in residential areas, and this winter could be hard for the E.U. if we have a harsh winter. Governments all around the world have been talking about the clean energy transition, but have not really invested into it. The system is massively short. Gas, coal, power, electricity prices are spiking across the board. This is one problem the Fed cannot just throw money at and print more as that will only make the problem worse: hyperinflation.
China is now forcing some of its high energy industries to cut back on production, which will lead to more supply shocks across the globe, but it will also mean less exports and growth. This is the demand shock that, perhaps, may be needed to keep the inflation in check. After the summer, the market was worried about growth slowing down. The 10- and 30-year bond yields are moving to old time highs and breaking their downtrends, which is worrying.
The market may be about to experience a real inflation scare and this is never positive for equities nor risk assets. One needs to keep an eye on the dollar as perhaps it is about to wake from its deep slumber and break above 93.5. For if it does, the central banks can print all they want, the only thing that can solve this situation is demand destruction. At least, that is, until the system has time for supply to catch up. Who knew economics 101 may finally come in handy, after all the traditional text books were thrown away over the last decade in favor of the Modern Magic (oops, I mean "Monetary") theory.