Russian gas – Full shutdown ahead of rescue plan.
Late on Friday, Gazprom announced that gas flows towards Europe via NordStream 1 won’t resume post maintenance due to an unexpected oil leak. The move came following G-7 leaders announcement of a cap for Russian oil, and ahead of a key European emergency meeting for energy security (scheduled for Friday), when cap to gas prices may be discussed.
The announcement brings us a step closer to the well anticipated “full shutdown” of Russian gas ahead of winter, which the market saw in summer as the key bear scenario. While the development is negative, we think Europe is much better equipped to deal with this situation than a couple of months ago. Italy and Germany, the two most exposed countries, have now storage full for 80-90% of capacity. Russian flows are important, but they were running at 20% of capacity anyways. So the actual reduction vs status quo is smaller than perceived. Finally, all countries are already doing some form of demand destruction. Germany has reduced gas consumption by c.15%, Italy by 3-4%. According to our calculations, current demand destruction trends allow for a reasonable storage depletion through winter even in case of a protracted 0 flow from Russia. The 2022/23 winter is the one that really matters for energy security, as medium term needs get more covered as countries invest in alternatives to Russian gas.
We thus see the physical situation as more challenging, but not desperate since countries had done some preparation work. Fiscal policy is also coming to the rescue, alleviating the impact on companies and households. The key Friday summit will shed more light on fiscal / support initiatives over the winter and further initiatives to try and limit energy dependence from Russia.
US data – Fewer jobs and lower prices.
US Employment data on Friday show the US macro conditions are softening but at a very slow pace. Labour markets thus failed to give a very hawkish signal, as opposed to July when job gains boomed. The print leaves the door open to both a 50 or a 75bp hike in September, but rises odds of a smaller hike slightly. August CPI on September 13 becomes the key print for the upcoming Fed meeting.
Nonfarm payrolls came at 315K, close to consensus of 298K and down from 526K in July. The unemployment rate rose to 3.7%, higher than consensus at 3.5% and average hourly earnings rose 0.3%, below consensus of 0.4%. Although growth in jobs is still higher than pre-pandemic times, where the trend was c.230k per month, the Fed may take this moderation slightly dovishly. Market reaction to the data was a tightening in rates and a steepening of the curve, driven by the short end of the curve drifting lower.
ISM data last week also point to a slight relaxation in inflationary pressures, with prices paid down 8 points since July. Commodity prices (ex gas) and supply chain dynamics also point to reduced inflationary pressures, paving the way for a second monthly drop in US inflation next week.
EU Inflation – No relief means hawkish ECB.
Inflation in Europe continues to rise, as a consequence of surging gas prices. The ECB will have no choice but raising the depo rate by 75bp this week, and maintain a very hawkish rhetoric.
Headline inflation in the Eurozone rose by 0.2pp in August, to 9.1%, slightly above consensus of 9.0% and 8.9% in July. Core inflation climbed to 4.3%, from 4.0% in July, above the consensus, 4.1%. Energy inflation eased, by 1.3pp to 38.3%, but still remains elevated. Elsewhere, inflation in food, alcohol and tobacco increased to 10.6%, from 9.8% in July, and likely will soon hit 12%. In the core, goods inflation jumped by 0.5pp to 5.0%, while services inflation increased by 0.1pp, to 3.8%.
Inflation data last week confirmed our view that the ECB will have to drastically increase their inflation projections in the September meeting, which in turn will force the ECB to maintain a hawkish stance beyond September: Market pricing currently sees YoY inflation to continuously rise to 9.7% December. Our view of a 75bp hike for the September meeting now seems to be fully priced in and we believe the ECB will hike irrespective of the source of inflation to preserve wage spirals and inflation expectations, even if it’s driven by energy supply. The market-implied policy rate for the ECB is now close to 1.6% for year-end, and peaks closer to 2.2% in summer 2023.
China – Lockdowns ahead of Party Congress.
Following another Covid outbreak last week, Chengdu, China’s 4th largest city with a population of 21 million, is subject to new restrictions with mass testing and negative tests needed to leave the city. The Chinese city entered lockdown after 157 new cases were reported. This represents the largest lockdown since Shanghai’s restrictions. Whilst the lockdown will probably not have a Shanghai-style setback, we think there is risk of a widespread impact on sentiment that amplifies the damage beyond the direct hit to activity.
The growth outlook for the second half of 2022 was already looking challenging, in part due to lockdowns motivated by China’s Covid Zero stance. Still, the policy has been specifically introduced ahead of the Communist Party Congress, scheduled for October 16th, as current leadership made zero covid a key target to deliver by then. All lockdowns introduced so far are strict but short-lived, suggesting potential for a deep relaxation after the Congress is over.
Algebris Investments’ Global Credit Team
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