Who is sanctioning who - The current EU energy crisis

“None of you seem to understand. I’m not locked in here with you. You’re locked in here with me!” - from the Watchmen comic

This quote from the Watchmen seems to fit the current European energy crisis. Everyone thought that sanctions would bring the Russian economy to its knees, yet the tables seemed to have turned with Russia turning off its natural gas to Europe. Gas is flowing to the rest of the world, but not to the EU. It is Europe who is suffering from sanctions. 

The policy failure of 2022 is not inflation, but the inability to anticipate the potential for reverse energy sanctions on the developed world. Energy sanctions trump broad economic sanctions for those countries that not energy independent.

There is no question the Russian economy is suffering, yet the trade balance is in surplus and cash is still flowing to Russia. Germany is seeing the balance of trade reverse, and the rest of the EU with the UK is now having to deal with subsidies to bail-out households, industries, and energy companies. Central banks need to plan for financial emergencies for power and energy companies as margins increase and liquidity is found to be in short supply. 

While governments are developing tactics to address energy logistics, the strategy issues of longer-term energy policies are only beginning. A fundamental role of a good functioning government is to ensure cheap and uninterrupted power for citizens. It is not a right, but is a responsibility for governments to ensure the system can provide power. An economic system failure increases dramatically without a good energy policy which focuses on reliability and cheapness. Green may be good, but reliability is critical. 

Policy uncertainty between world, EU, and US growing

Economic policy uncertainty provides a good measure on what the economic risk environment looks like for investors beyond classic volatility measures. A high uncertainty reading should negatively impact global investment. Capital will not be deployed in new projects if the policy future is unclear. 

There is a growing uncertainty gap between developed countries outside the US and the US. Given geopolitical risks (the war in Ukraine), the ongoing energy crisis, and economic sanctions, policy choices and decisions are in a state of flux. New global investments will be curtailed and the slowdown in the global economy will deepen. The US uncertainty picture is stable but subject to high volatility. Nee investment is not likely to support a growth story.

When in a slowdown, take sector beta risk off the table.

 Looking at the current beta for each major US market sector shows the relative risk across the market, (66-day moving average, current value). Given the current economic expectation of a slowdown to a recession, the portfolio structure is clear. Buy low beta consumer staples, utilities, and health care, (XLP, XLU, and XLV) and sell communication services, technology, and consumer durables, (XLC, XLK, and XLY). If the portfolio exposure is dollar neutral, it would have a short beta tilt. 

This long/short portfolio is consistent with what has been historically a defensive portfolio during a market slowdown, see:

 

Sector rotation based on the business cycle - It can work

Sector rotation across the business cycle - relative and absolute performance.

All these sectors have fallen since Chairman Powell's Jackson Hole comments, but the higher beta sectors have seen greater declines in return.

 

Sector rotation based on the business cycle - It can work

 

We are facing business cycle changes with the current slowdown and the policy switch to monetary tightening. Given the rise in inflation, bonds are not the same diversification solution, so other alternatives haver to be reviewed. Sector rotation is a viable alternative, but you need to know where you are at in the business cycle. However, using the concept of macro momentum is a helpful start.

The leading economic indicator index can be used to breakdown the economic environment into four regimes: expansion, slowdown, recession, and recovery. The LEI can be either above or below trend and be either expanding or contracting. If time is divided into these four regimes, market sector performance can be scored to provide conditional returns for different business cycle regimes. See "Sector business cycle analysis" from State Street Global Advisors.  Their research finds clear distinctions across the business cycle. 

In a recession, buy consumer staples, health care, and utilities and sell real estate, technology, and communication services. In a slowdown, hold consumer staples, health care, and industrials, and exit from consumer discretionary, materials, and real estate. The hit rate for excess returns in any month may be between 50-60% for buys but the overall excess performance can be significant.

The real work is forming a portfolio that will be workable and have controlled risk. The variation from portfolio construction may be high; however, the concept of trading against the trends in the business cycle is sound and offer a simple way of playing macro momentum.