Summary: In today's equity update we take a look at Yara's Q4 results which show that the high fertilizer prices are beginning to hurt demand from the agriculture sector and lower fertilizer use mean less yield and higher food prices which was also recently warned about by Tesco's chairman. The more we look at the economy and all its supply driven constraints the more it looks like the 1970s are coming back to haunt central banks and financial markets. We take a look at equity returns during the 1970s and it is unfortunately grim reading for today's equity investors. Companies can navigate inflation but investors will have few places to hide and it is about time to get exposure to those pockets of the market.
From energy crisis to food crisis
Yara International has reported Q4 results this morning and it is not good reading. Urea prices (key input for fertilizer production) were up on average three times in Q4 compared to a year ago and Yara is unable to realize prices on par with this growth reflected in its Q4 revenue of $5bn vs est. $5.5bn. Yara is not passing on the full increase in input prices because it would kill demand. Deliveries are down in Europe, Africa, and Asia, while Americas are still seeing positive growth, but delivery declines are due to higher prices.
The higher urea and ammonia prices are directly linked to the higher natural gas prices which are haunting Europe and Asia, which was the reason for our Q1 Outlook focus on the energy crisis. Our Head of Commodity Strategy, Ole S. Hansen, has commented on the galloping food prices and the problems in fertilizer production in his recent note High energy costs risk aggravating food price rises. Recently, Russia has announced a two months export ban on ammonium nitrate to secure the country’s own supplies, but the ban can aggravate the situation in many other countries. Two days ago, Tesco’s chairman John Allan said that the worst is yet to come in terms of food inflation, which will disproportionately hit lower income families, as the full effect on food prices from higher fertilizer prices will not be felt until later into this year’s harvest season.
As we wrote in our Q1 Outlook, the world has underinvested in energy for too long and we have taken energy supplies for granted, and how now we are paying the price. The green transformation, ESG, and lack of oil and gas investments will drive a long-term energy cycle with marginal higher energy prices to restore incentives and ROIC in traditional energy assets to spur more investment and supply. This transition will create upward cost pressure on all businesses as energy is the foundation of all modern activity. It will also lead to a 1970s style replay in the 2020s.
The 1970s were not fun for equities
The energy crisis in Europe has already begun a cycle of policy intervention with price controls in France and the UK, and in Denmark the government is contemplating subsidies for low income families. These are also signs that the 1970s are coming back. The next two obvious battlefields for politicians will be soaring food prices and higher interest rates. Both forces will hurt the lower 50% of the income distribution and disrupt voter patterns. Politicians will do what they do best, create short-term panic solutions reacting to the negative forces instead of implementing long-term solutions that aims to solve the structural issues in the economy.
The interesting thing about the current regime is that it is the supply side of our economy that is driving the inflation pressures and as such the interest rate will do little to tame inflation unless interest rates are put to levels that kill demand growth; in other words putting the economy into recession to alleviate pressures on ressources.
Given the many parallels back to the 1970s it is worth having a look at what it could mean for equities. The two charts below show inflation adjusted logarithmic return in earnings per share and total return (the MSCI USA Total Return Index starts on 31 Dec 1969). We have marked the 1970s in grey to see what happened to earnings and shareholder return during that decade. Corporate earnings had remarkable ability to grow faster than inflation but also growing faster than the long-term trend growth in real earnings (the blue line increases faster than the orange during the 1970s). In other words, companies have an extraordinarily ability to pass on inflation and even come ahead through innovation and productivity gains.
However, if we look at the total return for US equities adjusted for inflation the 1970s were ugly years with the real rate of return being -31.8% or -3.8% annualized. How could equities be so bad an investment when the underlying performance of companies were so strong? The simple answer is expectations at the beginning for the 1970s, which are reflected in P/E ratios, which gradually came down during the decade leading to a substantial contraction in valuations eroding the underlying business performance. A combination of higher operating volatility, lower ROIC through higher reinvestment rates to drive revenue growth, and higher discount rate (to battle inflation) all pushed equity valuations down. Do all of these things sound familiar?
Inflation components at the expense of growth stocks
As we have argued many times over the past year commodities are likely in a supercycle and commodities are one of those sectors that deliver positive inflation adjusted returns during supply-driven inflation periods because they are the primary cause of inflation. Investors have shown this year what they believe will protect portfolios against inflation and is expressed clearly in year-to-date performance across our theme baskets. The commodity sector, travel (due to scarcity driven pricing power), defence, emerging market equities, financial trading, and mega caps. The key word underlying these themes are pricing power and supply, and we believe retail investors should quickly balance equity portfolios between these themes and growth pockets.