What energy rationing could mean for fixed income: Adam Whiteley, Insight Investment

by | Aug 15, 2022

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Written by Adam Whiteley, Head of Global Credit, Insight Investment

Germany is at the forefront of industrial activity in Europe and thus, relies heavily on energy sources including oil and gas. As such, the sectors that will experience the biggest challenges from the EU discussions of potentially rationing energy supply will naturally be energy intensive industries such as chemical, automobile and key manufacturing sectors.

As Germany produces nearly none of its own gas, these sectors will naturally suffer from inflated prices and decreasing gas supplies to Germany (now down c. 20 per cent).

The sectors that will likely see a benefit from energy rationing are those who provide alternative sources of energy such as oil and gas replacements and renewables. Currently, there are debates around if renewables sources can fill the oil and gas supply gap as presently, there are not enough renewable energy sources to supply the nation, the suffering industries in Germany and elsewhere. As a result, Germany my need to rethink its plan to exit nuclear power by the end of the year as the Russia/Ukraine crisis may require Germany to revert to the use of nuclear energy and domestic legacy coal plants.

Europe is an open economy with large exports across the globe. Consequently the supply chain challenges that arose from the Covid-19 pandemic further exacerbated by this crisis.

As fixed income investors, we would be more inclined to invest in those sectors/companies who have a greater chance of direct or indirect support from the state. Beyond this, we look to invest in companies who have resilient balance sheets and flexible business models where valuations already provide compensation from volatility and geopolitical tensions.

Assessing risk

Forecasting politics is notoriously difficult because decisions and actions made by government officials are not always rational. At Insight Investment, we assess these risks by conducting a detailed scenario analysis looking at various potential headwinds and outcomes and then deciding if valuations compensate for some if not all these scenarios.

From a macroeconomic perspective, markets have already priced in a lot of the downside risk. We have also seen a dramatic cheapening of assets particularly in Europe which has begun to create attractive investment opportunities for patient investors. For context, European credit markets are not far off the levels we have seen at the peak of the pandemic

Energy flow is Russia’s key leverage against Europe and the world, but Russia will of course need to maintain a regular flow of foreign money to remain afloat. However, keeping these inflows at a lower level allows for political cracks within Europe to emerge and slows the pace that Europe can build up their energy storage, in turn giving Russia greater leverage in the winter when energy supply is really required. We assess the risks and likelihood of Russia potentially turning off energy supply through stress testing the downside risk of the companies we invest in, whilst also assessing the flexibility in their balance sheets to ensure resiliency.

What it means for fixed income

The investment climate today is one of elevated volatility and increased risk, which creates an environment of substantial threat but also opportunities. As an active manager, our role is to identify both market inefficiencies and attractive valuations against various backdrops. Within the current investment landscape, we are finding attractive opportunities in the chemical sector, as well as with the relative value of European assets compared to US assets as European assets currently have a greater cyclical premium.

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