Global energy crunch; where the risks lie

Recent concerns surrounding the energy crunch in Europe and the risk that it spreads globally continue to cloud the economic outlook. Indeed, just last week the International Energy Agency published its most recent World Energy Outlook, highlighting the threats pressuring global energy markets due to the current supply/demand imbalance.

In order to analyze where the risks lie for equity investors, we decided to break down how energy intensive each sector is, and then assess the composition of each country’s equity benchmark to see how “at risk” their stock market would be to rising energy prices.

Before going into the results, there is an important caveat. Evaluating an investor’s sensitivity to rising energy costs is far more effective on a company-by-company basis, because individual factors such as cost structure, margins and hedges are critical. That said, we feel that our work can provide investors with a place to start evaluating their portfolios to gauge potential threats at a macro level, before drilling down to each stock’s unique exposures.

With that in mind, Bloomberg data allow us to rank each equity sector’s energy intensity (scaled to revenue to help remove any bias from the company’s size). Our results show that the most intensive include energy, utilities and materials, while those that are less exposed are financials, health care, technology and communication services.

From here, we can then look at the sector composition of various equity benchmarks to get a better sense of which countries may be more exposed to a worsening energy crisis compared to others. While emphasizing that it is more nuanced than just sector exposure alone, our rankings were derived using the assumption that surging energy prices would be a tailwind for the sector; in contrast, the remaining two energy intensive sectors mentioned above — utilities and materials — are most at risk from negative headwinds.

Anecdotally, this aligns with what recent news stories are portraying. A number of power operators have gone bankrupt across the United Kingdom and Eastern Europe, while fertilizer, steel, zinc and aluminum producers in Europe and China are emerging as early casualties from this latest energy crunch.

Looking at net energy intensive risk exposure (energy sector weights less the sum of utilities and materials weights), we can immediately see that the balance of risk for the vast majority of countries is tilted to the downside. Stock markets that look to be most at risk include South Africa, Saudi Arabia, Australia, Brazil, Mexico and Germany. Interestingly, petrostates such as Saudi Arabia and Mexico are included in this group, which shows just how much a country’s stock market can deviate from its economy.

For example, in the case of Saudi Arabia, despite being home to the world’s largest oil company, the composition of the country’s MSCI index is such that any potential tailwind to Saudi Arabian Oil Co. (Aramco) is dwarfed by the share of chemical producers and cement companies that risk being more exposed to rising energy costs. In the case of Mexico, its energy weighting is zero, given Pemex is state owned, meaning publicmarket investors do not get any potential benefit here.

On the other hand, investors looking for countries with the lowest net risk should look towards Russia and Norway first — as the only two that have a positive net score in our analysis (that is, a larger energy share relative to utilities and materials) — followed by India, the United States, France and Canada as “relative” winners given their “less negative” scores.

Like the inclusion of Saudi Arabia and Mexico in our high-risk group, it was interesting to see India screen relatively well. Again, it is important to realize that the stock market is not the economy. Despite being known as an energy-dependent nation, the composition of India’s stock market gives it a lower risk than what its broader economy faces.

Ultimately, this is just one approach to measure potential winners and losers from an energy crunch. At the end of the day, price action is what’s most important for investors. Interestingly, when we went back and looked at comparable environments to what we are seeing currently — a sharp rise in energy prices alongside a slowdown in GDP growth — the stock market performance in the U.S. deviated a bit from what we would expect to see.

Unsurprisingly, equity markets tend to underperform in periods where energy prices are surging and GDP growth is slowing. This is shown in the performance of the S&P 500. Since 1990, its return has amounted to -0.6 per cent, on average, over a three-month window in this environment. Note that this is meaningfully less than the 2.3 per cent gain that typically occurs. We attribute this dynamic to a less favourable backdrop for corporate profits.

Notably, slowing GDP growth implies weaker topline results and rising energy prices likely mean input costs are also rising. In addition, cyclicals are usually weak in these periods. We can particularly see this in the performance of financials (-6.9 per cent), consumer discretionary (-2.4 per cent) and industrials (-1.8 per cent). Conversely, defensive sectors — such as real estate (3.6 per cent), utilities (two per cent) and health care (0.3 per cent) — all hold in comparatively well.

On the surface, these results aren’t surprising, given that cyclical sectors have earnings trends that are more exposed to the macro environment. But, given the energy intensity rankings (by sector) we presented earlier, this data doesn’t necessarily align. This is a good example of the difference between “theory” and “practice.”

For example, based on our list, we would expect utilities (No. 2 of 11 on energy intensity) and real estate (No. 4) to lag when energy prices are soaring. But this was not the case when we ran the performance data, at least not in the context of a growth slowdown. To us, this suggests that these sectors respond more to the GDP environment (whether growth is accelerating or decelerating) than they do the price environment.

The last takeaway is probably the most obvious: the energy sector, by far, is the best performer when energy prices soar and growth slows. Indeed, in these periods, the sector returns +8.4 per cent, on average, over a threemonth horizon. Thus, in contrast to the overall equity market, the sector massively outperforms (by 6.7 percentage points) in this environment.

In conclusion, while we believe investors ought to look at the sensitivity of their portfolio to a potential energy crunch on a company by company basis, we can make some broad statements. First, this is usually not a favourable environment for stocks, so either reducing overall equity exposure or adding hedges is likely prudent. Second, as a general rule, cyclical sectors underperform defensives.