Asset allocators have been well-aware of Europe's relative cheapness and underperformance for years, so much so that each time a strategist's note cited a case to buy, shoulders were shrugged in disbelief of yet another stale story.
As much as Europe is dismissed, this disregard for the Continent was even greater toward the second half of last year due to Russia's invasion of Ukraine as European natural gas prices traded as high as 300 euros per megawatt hour (MWh). Doom-and-gloom shrieks resounded that Europe would be sent back to the Stone Age as it simply would not have gas for the coming winter and would be forced to shut down altogether. Analysts and media, especially the tabloids eager to get higher numbers, printed draconian headlines. To the mainstream, such headlines appear scary and they do indeed instill fear, which often is used by politicians to advance their ridiculous policies after getting the public to sign off on anything. This is not just a developing country phenomenon; this game is often played across the world, just on different scales.
Commodities always find a way to make money by finding any mispriced opportunity and capitalizing on it. That is the beauty of these markets, which are so opaque and unknown to the average investor, and it's why the bigger commodity trading houses make so much money.
As European Union gas prices made new highs and the Continent was convinced that Russian flows would be lost forever, the liquefied natural gas (LNG) industry came into full force and US gas prices started rallying from $2.50 per million BTU all the way to $10 per MMBtu. There was an arbitrage. Gas producers could send flows to Europe, which was demanding even higher premiums than the traditional Asian buyers. They seized the opportunity and sent flows such that more than 80% of European flows that were lost were made up by US LNG.
Lo and behold, EU gas prices fell to 60 euro per MWh, aided by a warmer-than-normal winter. However, it was not all about the weather. Europe stored about 80% of its inventories about two months before winter started. And we know commodities are all about whether we have them or not, and if we don't need them, prices can go negative in a short time. That is the biggest difference between an equity and a commodity -- there is no floor value as in the case of the former.
As natural gas prices retreated, traders soon realized that the doom-and-gloom scenarios for Europe were perhaps overdone. The short soon started to get covered, and since October the European stock index, SX5E, is up about 30%. This is despite the euro being up from being below parity, so in dollar terms the index is up about 40%-plus. We have pretty much made up decades of underperformance in about one quarter. Seems like a very aggressive move in a short period of time. But is Europe really out of the woods here?
At the height of the gas crisis and recession, the European Central Bank guaranteed price caps for businesses and households. This shielded the economy for the time being. But now as things subside, a study published by Allianz Trade that cited contract expirations and delayed wholesale pricing effects found that German industry is set to pay about 40% more for energy in 2023 than in 2021, before the energy crisis triggered by Russia's invasion of Ukraine, Reuters reports. There is still a price shock coming to European corporates. Price increases soon will hit corporate profits across Europe by 1% to 1.5% and lead to lower investment, which in Germany's case would amount to 25 billion euros ($27 billion), Allianz Trade estimated. Earnings are still going to decline, whether we have a mild or a harsh recession. Once we add the banking system and its issues into the mix, you can argue that the true risk premium should be higher for Europe and questions arise as to whether it can continue its export-driven economy model.
A lesson learned from 2022 has been that it never paid to be invested in a theme that became too one-sided, as the market often saw a violent move the other way. Such is the case for investing these days. We are moving through shorter cycles and more aggressively. It is more of a trader's market than an investor's one, but then again it just depends on how deep one's pockets are, and as seen in the case of Adani Group recently, there is always a limit.
