Stock market monitor

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A long-term lens. Corporate earnings may come under pressure in the near term as central banks raise interest rates to control inflation, and as energy prices remain high. Yet at BlackRock Fundamental Equities we see long-term opportunities among those companies that can offer solutions to the current crises. As Q4 begins, we see:

• Opportunity in companies contributing to automation and the net-zero transition
• A stock-picker’s market as divergences grow across companies and regions
• The importance of company resilience amid high energy prices and looming recession

Company earnings have been resilient in developed markets this year– as the chart below shows – but they weren’t enough to prop up equity prices. Rising inflation, higher interest rates and economic growth fears have weighed on valuations.

This is a negative market environment. But long-term investors can take advantage of market volatility and what we see as attractive valuations. We also believe stock pickers can capitalize on valuation divergences across companies and regions – as well as identify those businesses helping to provide solutions to higher prices.

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Capturing the capex

Supply-side reform is needed to tackle inflation, in our view. This means spending on renewable energy projects to address high energy costs. It also means companies may have to spend to strengthen supply chains and address rising labour costs. Indeed, the chart below shows the recent uptick in capital expenditures (capex). Companies that help other companies keep costs down are set to benefit if inflation stays higher for longer, in our view. This includes those involved in automation, electrification and the transition to a low-carbon future.

Automation

In many major economies, the labour participation rate remains below pre-COVID levels. This puts workers in a strong position to negotiate wages that can keep pace with inflation, resulting in “sticky” labour cost increases for companies. At the same time, companies are seeking to bring production back “home” to avoid supply chain disruption, caused by pandemic shutdowns and geopolitical tensions. We see opportunity in companies that can provide automation and efficiency solutions. See our Q3 Stock Market Monitor for a spotlight on automation.

Electrification and the energy transition

Global governments are spending big to achieve a dual objective: tackle the current energy crisis and reach net-zero targets. This spending includes the U.S. Inflation Reduction Act and the EU’s €1 trillion “green deal.” Wind turbine makers have said this provides their customers with much-needed long-term clarity when making investment decisions. As renewable energy projects ramp up, we expect to see greater demand for semiconductors and raw materials such as copper. See our report on “Building the energy transition.”

Europe, the euro and energy prices

We find many of the companies that are best positioned to benefit from the trends outlined above are based in Europe. Yet the near-term economic prospects for the region are challenging. The euro has plunged in value versus the U.S. dollar as spiralling energy prices – a result of Europe’s reliance on Russian gas – stall economic growth. We believe these macro shifts create opportunities for stock pickers. As we explain in “Three reasons to consider European stocks” many European companies that enable automation, electrification and the shift to renewables are now available at a discount to global peers.

Assessing the energy impact on European companies

Europe relies on natural gas for one-quarter of its energy needs, and 40% of this gas came from Russia until the Russian invasion of Ukraine, according to Eurostat in 2020. This source of supply has plummeted as the Russian state-owned company Gazprom slowed and then halted flows of gas through the Nord Stream 1 pipeline. European countries have managed to top-up their storage levels – but even full storage tanks may only fulfil three months of gas needs, according to Aurora Energy Research.

Beware the gas guzzlers

The simplest way to mitigate the potential impact of gas shortages on portfolios is to be cognizant of the companies with high energy bills as a percentage of income – especially where the energy isn’t provided by renewable sources.

Some chemical companies have said they may have to cut production because the process is so gas intensive. Other processes such as brick, glass and cement making are highly energy intensive and the plants can’t easily switch from gas to other forms of energy.

Large companies might be able to ride out a period of short gas supply by hedging the cost of energy – this means they pay a lower price than the “spot” market price which moves daily. The ability to pass higher costs on to customers is also key. This pricing power comes with strong market share and a robust end market. A chemical company may be able to pass energy costs to automakers with healthy profit margins and high demand.

Smaller companies may not have the same sophisticated hedging techniques or pricing power. We have to be especially careful when companies that may seem attractive because they are “defensive” – they have historically generated cash despite slow economic growth – have a significant, unhedged exposure to gas prices. For example, a medium-sized brewing company might expect alcohol sales to hold up during a recession, but if energy costs are unhedged then it’s hard for investors to be confident on near-term earnings.

Location, location, location

Many companies based in Europe have globally diversified operations, shielding them from the impact of a gas crisis on the continent. Among companies that have most activities in Europe, we expect those with greater access to Nordic energy supplies to fare better. It’s also important to understand the supply chain of each company – the regions it runs through and the energy risk at each stage. A wind turbine manufacturer may have secure, renewable forms of energy to power production. But the steel that is used to make the turbines might be produced using large amounts of gas.

Strategic risk

Europe has enough energy stored away to get through winter, according to our analysis. But storage is a temporary solution while Russian gas remains mostly cut off. If high prices don’t bring gas demand down to sustainable levels, then some rationing may be required in 2023. In that event, we expect the most strategically important industries will be allowed to operate at full pace. This might include renewable energy producers, aerospace companies with large military contracts and healthcare companies.

As active stock pickers, we factor these energy-crisis considerations into our individual company analysis. The companies that we have most confidence in are resilient to medium-term energy shortages and play into the long-term themes of energy efficiency and sustainability.

There is no guarantee that a positive investment outcome will be achieved.

David Vos, industrials analyst at BlackRock Fundamental Equities, contributed to this report 

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