In this quarter’s CIO View, we examine the hawkish turn in UK monetary policy and highlight developments in the green revolution.

• Market review: NASDAQ catches AI excitement
• Sticky inflation revives hawkish mood
• Green revolution: what can heat pumps do for 99% of industry?

With reporting from Aaron Cox on behalf of the CIO Office.

Markets in brief

Against the backdrop of another tumultuous quarter in markets, investors could be forgiven for adopting the adage “sell in May and go away”. While further fallout from the mini crisis in the US banking sector was contained, the inflation dilemma remained front and centre for central banks. However, despite a darkening economic mood, a narrow group of US mega-cap tech names, led by Nvidia, surged to new highs on excitement about the potential for AI to underpin a technology revolution – albeit one with rigorous caveats about AI’s potential risks.

• Hawkish mood returns with inflation stickier than central bank forecasts

Inflation was once again a dominant feature of the quarter. In June, the Bank of England (BoE) surprised the market with a hawkish 0.5% interest rate rise, lifting the bank rate to 5%. This came after a CPI print of 8.7%, with core inflation reaching a level of 7.1%, its highest rate since 1992.

With the Bank of England determined to get on the front foot, the bank rate is now expected to reach 6% by the end of 2023. Policy makers in Europe and the US grappled with a similar problem, with inflation remaining stickier than expected earlier in the year. After 10 consecutive hikes, the Federal Reserve paused its policy, leaving rates unchanged at 5%-5.25%. It framed the moves as a “hawkish pause” signalling that further tightening was imminent. The ECB, meanwhile, increased rates in two 0.25% increments to a level of 4.0%. With inflation rates in the US (4.0%) and Euro Area (6.1%) moderating faster than UK, the BoE has come under fire for appearing behind the curve. As the chart below shows, the BoE has been forced to into a sharper tightening cycle than it has indicated at any point until the most recent more hawkish rise.

^{Source: FT https://on.ft.com/3Xndat5}

So why has inflation been so sticky?

Commodity prices have eased, as have many of the supply bottlenecks that initially spurred the rise in prices. As such, the core drivers of inflation have changed, with labour market tightness, robust economic activity (retail demand, for example) and “greedflation” – i.e. the unfair use of pricing power by companies to sustain margins – each thought to play a role.

Andrew Bailey, the BoE’s governor, called for restraint in pay demands on concerns about an entrenched wage-price spiral. Meanwhile, the IMF recently claimed that some companies in Europe were opportunistically juicing profits through unfair price rises, which were in turn dragging up wages. The UK government has sought to ease this sort of behaviour in the UK mooting price caps.

However, the evidence of price gouging appears mixed at best. At times of high inflation, it seems natural for both employees and companies to protect their respective interests – which is why inflation is so difficult to contain. Indeed, rising wages puts pressure on margins, prompting companies to increase prices to protect margins, which spurs demands for higher wages.

Higher interest rates will eventually break this pattern, as it increases costs for both corporates and consumers, leading to a drop in demand, with consequences in terms of profit margins and jobs. Indeed, we have already seen signs this starting to play out, with weakening manufacturing data in the US, for example, and the UK property sector seeing the first annual price fall in over a decade. For many homeowners, interest rates are at the highest level they have ever experience and such is the concern about the impact of hight interest rates on mortgage delinquencies, the UK government has negotiated a 12-month delay on property repossessions with banks.

Similarly, rising interest rates have exposed weaknesses in the balance sheets of corporations that have resulted from misjudged capital decisions during the era of low interest rates. Silicon Valley Bank was a notable example last quarter, Thames Water this quarter. It is certainly a period during which to remain vigilant as investors and to remain laser focused on balance sheet strength.

Interest rate rises can take months to work through the economic machinery, and it is important that central banks retain credibility as they seek to control inflation expectations, which feed through to purchasing behaviour and wage demand, as well as expectations backed into bond markets. With the UK’s inflation cycle running behind the US and Europe, the Bank of England’s credibility has been challenged this quarter, hence the strengthening of its resolve and its firmer stance. Monetary policy is indeed a blunt and deeply unequal tool, affecting those most financially vulnerable first.

• Electrify everything – dispelling the myths around industrial heating

Turning now to the green revolution. The quarter produced some eye-catching statistics about the electrification of…well, almost everything needing power.

The International Energy Agency (IEA) forecast solar power investment alone will eclipse investment in oil for the first time, with $1.7trillion expected to be spent on clean technologies overall¹. As we reported earlier this year, clean energy investment broke through the $1trillion barrier for the first-time last year.

Analysis from Michael Liebreich, a founder of BloombergNEF, suggests that 90% of this figure was split roughly 50-50 between renewable energy and electric vehicles. Solar and wind barely existed as industries at the start of the century. Today, they account for about 15% of global electricity supply.

Indeed, solar is now the fastest-growing energy technology ever. At a growth rate of c.20% p.a. total installed capacity could move from one to six terawatts soon after 2030 – exceeding the combined capacity of gas, coal, nuclear and hydro². At that pace, 80 terawatts of installed solar capacity is achievable by 2050, which according to estimates from Professor Andrew Blakers of Australian National University would provide 130,000 of an estimated 200,000-terawatt hours of power for a global population of 10 billion people³, with the gap plugged by other low-carbon sources: wind, hydro, geothermal, nuclear etc. This would not only cut carbon, but also the marginal cost of energy, which would have profound impact on the global economy.

EV uptake ramps up

Like solar, the growth rate of electric vehicles (EVs) has often massively exceeded forecasts. The IEA’s Global EV Outlook 2023 – a report released during the quarter – is a case in point. It expects EVs to make up 18% of new sales this year, rising to 23% by 2025 and 36% by 2030. However, as noted by Hannah Richie of Our World in Data⁴, the IEA’s 2022 report had EV’s down for 13% of new sales by 2025 and 21% by 2030, significantly below this year’s figures. But it’s easy to see why forecasting the explosive growth of EVs has been so difficult: in 2020 EVs accounted for just 4% of new car sales, climbing and 9% in 2021. It will be double that this year. EVs are certainly on an extraordinary trajectory

Industrial heating – electrify everything?

While trends in solar and electric vehicles are incredibly encouraging, the green revolutionary potential of heat pumps particularly caught our eye this quarter. BloombergNEF’s Michael Liebreich produced a highly thought-provoking blog outlining the potential for heat pumps as a mainstay for general spatial heating, but also as a key source of industrial scale energy in developed economies, with greater efficacy per joule of input than green hydrogen. Put simply, heat pumps can provide energy of a higher quality than hydrogen in many situations; for example, providing heat for three homes to every one heated by hydrogen.

Unsurprisingly heat pumps are rapidly becoming a key source of space heating and now account for 10% of space heating demand globally. Europe is a standout region, experiencing 36% compound growth over the past two years.

Innovation, which is rapidly improving the efficacy of pumps, has been a further driving force behind growth and, indeed, the potential applications of heat pumps. Megawatt-scale heat pumps can upgrade heat from local rivers to 70 centigrade, solving a major issue with district heating. Home systems can similarly generate heat from water as low as 10 centigrade. Ground source pumps are excellent for heating tower blocks, with limited thermal loss and far greater efficiency than conventional gas fired systems.

The industrial potential of this technology is particularly exciting. Until relatively recently the dominant view in the media and indeed the industrial sector has been that renewable sources of heating will only be able to tackle a relatively small amount of the heating required by industry – a view often used as a reason (or excuse) for the continuation of fossil fuels.

Research from the Potsdam Institute shows that 78% of Europe’s industrial energy demand could be electrified using existing technology, with this figure rising to 99% if you include technology at lower stages of development. About half of industrial heating requirements are below 200 centigrade, which can be met by heat pumps run from clean electricity which save over half the energy used by conventional gas boilers. For higher temperature heating (300-400 centigrade), the temperatures often considered not achievable using electric heating, there are a host of solutions coming on board – infrared, induction, microwave and radio wave – that can deliver well over that requirement.

These solutions may not be suitable everywhere in the world, especially in some developing countries where the infrastructure isn’t available to support them. Even in Europe, the grid isn’t ready for the level of rollout required to meet potential industrial demand. However, Liebreich’s analysis debunks some myths around heat pumps, which typically put hydrogen ahead of heat pumps as the best option for industrial heating needs. Liebreich’s enthusiasm is well captured in this quote: “We are constantly told that there are no silver bullets in the fight against emissions; the closest thing we have is a heat pump.”

Conclusion

The economic backdrop for the second half of the year looks challenging. Central banks remain steadfast in their commitments to bringing inflation down, even if this involves periods of recession. Indeed, some sectors already appear to be heading in that direction – manufacturing in the US, for example – and we are seeing bifurcation in terms of economic cycles and policies between the US, Europe and UK, with the latter now likely to see a more protracted period of monetary tightening. China’s underwhelming economic reopening has added further complexity to the backdrop and investors will be watching policy makers there for potential stimulus.

Outside of the US technology complex, markets have become more cautious. Risk off sentiment is more prevalent in fixed income markets, with a deeper focus on balance sheet and asset quality when companies refinance debt. Yields in government bond markets are at levels not seen for many years, which certainly sharpens investors’ minds in terms of the compensation they might expect for risk.

At a time of uncertainty, we could expect to see further bouts of volatility across asset markets, some of it irrational. This can be unsettling but also a source of opportunity. The recent devaluation of green infrastructure companies is a compelling example of how sentiment can become detached from fundamentals, for example, with companies trading at large discounts to underlying net asset values.

While the interest rate tightening cycle has been more protracted than many expected at the start of the year, markets will continue to look keenly to economic indicators for early signs of potential shifts in the current monetary policy stance. In the meantime, we continue to redouble our own work on the quality of investments we hold on your behalf, carefully assessing the balance of short-term risks and long-term opportunities, within our well-established responsible and sustainable framework.

We wish you well for the summer months.

Source

1. https://on.ft.com/3WFtkhd
2. https://theconversation.com/despairing-about-climate-change-these-4-charts-on-the-unstoppable-growth-of-solar-may-change-your-mind-204901
3. https://theconversation.com/despairing-about-climate-change-these-4-charts-on-the-unstoppable-growth-of-solar-may-change-your-mind-204901
4. https://www.sustainabilitybynumbers.com/p/ev-iea-projections