The Energy Crisis in Europe Is Getting Worse

“Prices have a job to do, prices must be free to tell the truth.”

— Alfred Marget (1899-1962)

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Saturday, October 8th, Ulm.

I am spending a few days with family in my hometown. Next, I’ll be heading to Central America.

A few days ago, I had a conversation with a close friend about capitalism. We have totally different political views, but in our discussion I realized once more, that often a lot of it just comes down to the definition of words. While I fully champion capitalism in its pure and most comprehensive form, he thinks that capitalism is the source of most of our problems, benefiting a few at the expense of the majority. While he pointed to a number of things that are currently done to “safe the capitalist system”, I tried to explain that all of these measures are exactly the opposite of true capitalism. Unfortunately, I think that most people nowadays simply connect capitalism with bail-outs and other government interventions that benefit “the rich”, without thinking more deeply about what capitalism actually means and what it implies.

In a nutshell, capitalism is based on the recognition that in order to cooperatively work together in a society, individuals must have property rights. First, they must have property in their own bodies and stemming from that they can then homestead or acquire physical things and voluntarily exchange them with other individuals. This is all there is to it and most people would agree that this is the proper — and in my opinion, the only moral — way to interact.

Extending this concept to the political hemisphere, this means that individuals own all means of production. Hence, individuals are the ones who are in control and therefore make the decisions about production and trade. This is the point, where most people divert from a principled approach and start to come up with all kinds of various reasons and examples where they think the state has to intervene into the peaceful market process and thereby distorting the prices.

However, for capitalism to work properly, the free price mechanism is essential. It is the key future in a capitalist economy and without it, chaos and misallocation of resources ensues.

In his brilliant book ‘Interventionism’, Ludwig von Mises painstakingly points out, how every market intervention has to lead to some market dislocation, which in turn requires other interventions to fix the unwanted outcomes. Once these interventions are undertaken, there is no way back — except to repeal them — and therefore it must lead to a consistently increasing amount of interventions. Consequently, the result will be an inherently unstable economy.

Thus, in a capitalist world there should be little government intervention into the market.

And — in a perfect capitalist world, there would be no intervention at all, or in other words, no institutionalized violence against private property — hence, there wouldn’t be a state.

I didn’t convince my friend of this consistent framework — at least not yet.

But even though we still disagree on many issues, at least we were able to have a constructive conversation and more clearly see the others point of view.

This month’s newsletter will be shorter than usual. I will just cover the basic key indicator rundown and explain how to look at the MSCI ACWI index.

Here are the topics:

• Market Analysis:
  • Key Indicator Rundown
  • The MSCI ACWI Index as a Key Market Indicator
    • Index Breakdown
    • Index Performance

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Market Analysis

The main topic in Europe is the unfolding energy crisis, which seems to be getting worse even as oil and gas prices have been slightly declining. The problem is that an abrupt price spike is one thing, but the major troubles start occurring, when prices keep at an elevated level and the consequences slowly but surely make their way through the economy and problems occur to show up everywhere. In addition, the EU members have adapted different intervention strategies, to fight the looming winter crisis. Seeking Alpha reports:

Germany has already conducted a series of government bailouts and rescue loans for energy firms, but the need to source alternative supplies is racking up losses to the tune of hundreds of millions of euros per day. Controlling stakes and further capital injections seem like the only way out of the bind, with an outright nationalization of key energy assets even on the table. “Things are complex, we are working it through very carefully,” declared German Economy Minister Robert Habeck.

As discussed in the introduction, all of these interventions are detrimental for a functioning market economy.

Furthermore, we have seen that the Bank of England saw itself suddenly forced to suddenly pivot from its tightening policy and massively intervene into the Gilts market, to avoid a disaster (Gilt is the name for the UK bonds). The problem is that pension funds, which are quite substantial in the UK, have due to the long low-interest rate policy — again a result from market intervention — started to take on leverage in order to be able to pay out the required amounts. Since they hold a high amount of long-term Gilts as collateral against their debts, a significant fall of the Gilts valuation has resulted in subsequent margin calls. In order to avoid a bankruptcy disaster, the BoE had to intervene and buy Gilts in order to stop the rates to rise even higher.

The strong decline in the Pound after the new prime minister, Elizabeth Truss, announced plans to substantially reduce taxes, which likely is going to put the British government deficit in an even more dreadful situation, has also not helped in the situation.

Some analysts speculate, whether this is the first crack in the tightening cycle, that might initiate other major central banks — potentially even including the Fed — to reverse courses as well. We will see…

Key Indicator Rundown

• The Treasury market is in turmoil. Rates spiking to levels not imaginable a year ago and has been a rather substantial inversion across the whole yield curve for a substantial period of time by now. The 10-Year Treasury Yield even topped 4% towards the end of September and is currently standing at 3.88% at the time of writing.
  The current target rate is 3%-3.25%. Forecasts predict that there might be two more rate hikes this year, bringing the Fed Funds Rate up to 4.4% at the end of 2022.
• Meanwhile, Inflation is still at staggeringly high levels. In the US, the year over year inflation has declined a little bit to 8.3%, but the print was still much higher than was expected. In the Eurozone it seems that a local height has not been reached yet. In August the inflation rate jumped up to 10%. This is the first time that there has been a double-digit inflation print in the Eurozone area.
• The dollar index has been shooting up like a rocket. It has been all the way up to 114, levels that have’t been seen since early 2002. This puts an extreme pressure on other economies, especially emerging markets and countries with substantial debt loads that are US dollar denominated.
• After a recovery over the past two months, the Stock market saw new lows. The S&P 500 and the MSCI ACWI both broke their June lows. Below, I will elaborate a bit more about the MSCI ACWI.
• Both, the CAPE Ratio and the Buffet Indicator have been declining, mostly due to the fall in the stock prices.
• Market volatility has been going up. The VIX, which is generally seen as a fear-gauge, has also been trading substantially above its historic average and stood above the 30 mark at the end of the month.
• The energy crisis in Europe is getting more severe. Despite the fact that both oil and natural gas have substantially declined in September, it seems that more and more problems are surfacing, as companies and individuals face difficulties in paying their energy bills.
• The Gold price keeps declining amidst the consistently high inflation prints coming out. Partially, this is also due to the strength of the US dollar: In many other currencies, the gold price has actually been quite stable over the previous months, or even increased.
• Bitcoin also declined in September. It seems to have found its trading range between $18,000 and $23,000. The correlation of the daily price movements with the stock market are still very high. Interestingly, while stocks have made new lows for the year, Bitcoin has not fallen below its June lows. Historically, trading in such a range for an extended period of time has always resulted in either a significant outbreak, or a significant decline. Both are equally likely in my perspective.

The MSCI ACWI Index as a Key Market Indicator

Last month I explained why I look at the S&P 500 as a market indicator. This month, I want to look and compare it to one of its main international counterparts.

As some readers of this newsletter might have noticed by looking at the key indicator table that I provide, that these two indicators do have a high correlation and seemingly do almost the same movements. Hence, here I describe why that is and why I still think that looking at both is a prudent procedure in global stock market analysis.

Morgan Stanley Capital International (MSCI) is a finance company that maintains several indices related to equities, fixed income and real estate. The All Countries World Index (ACWI) is its flagship global equity index. It consists of large- and mid-cap stocks spread out across 23 developed and 24 emerging markets. It is therefore designed to represent the performance of the global stock market.

Thus, this index is interesting for investors, who a) want to invest in stocks and b) seek diversification across the globe.

It is however crucial to know, how the index is constructed, since there are many nuances when it comes to the allocation of such an index. Moreover, many people investing in indices often just look at the name of the index and are not aware what is actually ‘under the hood’ so to speak.

Index Breakdown

In total, there are 2,900 equities that are included in the index. The largest constituent is Apple, with a market cap of $2,236 billion, whereas the smallest included stock has a market cap of $0.79 billion.

• The average is $17.8 billion.
• The median is $4.9 billion.
• The index covers approximately 85% of the investable global equity market.

First, let’s take a look at the geographic allocation of the index:

At first glance it might seem puzzling, why does an index that has the objective to represent the global stock market have such a high allocation to the US? Why is it not more evenly distributed among the countries?

The reason is, that the total market capitalization of the American stock market dwarfs all other countries.

Here is a chart, which shows the top 10 countries measured by the total size of their stock markets:

Considering this, the MSCI is actually quite precisely representing the global stock market geographically. At least in terms of total market capitalization.

It is debatable whether this is a good approach for designing an index with the goal of global diversification, but this is a question how the framework of such an index is conceptualized.

The important aspect of it is that investors must be aware that the performance of the index is strongly tilted towards what’s happening in the US. Let’s take an imaginary example: If all stocks around the world would rise by 5%, except all American stocks, which would fall by 5%, the index would still be down (by 1.2% if my math is right).

Next, let’s look at the distribution among the sectors:

As can be seen, the Information Technology sector takes the largest share in the allocation, followed by Financials, Health Care and Consumer Discretionary (11.58%). This comes as no surprise and is approximately in line with what you would see when looking at the distribution in the S&P 500.

Let’s further break it down and look at the 10 largest individual constituents and their overall weighting in the index:

It becomes obvious, that except TSMC all top 10 companies are US companies, which are also the leading companies in the S&P 500. However, the top 10 constituents only account for about 15% of the total allocation, which means that the index is arguably much more spread out in comparison to the S&P 500 (in which the top 5 make up about 20% already).

Therefore, I would argue that — despite its strong overlap with the US stock market — it can provide a better gauge about the global stock market environment, as compared to just looking at the S&P 500 as the key index.

Moreover, from an investment perspective, investing in an ETF tracking the MSCI ACWI also should give a slightly better diversification, since it includes 2,900 both large- and mid-sized companies spread across the globe, compared to just 500 large stocks in the US only.

Index Performance

The following chart compares the returns of the iShares MSCI ACWI ETF with the SPX ETF that tracks the S&P 500:

The chart shows how the S&P 500 has largely outperformed the MSCI ACWI index over the last decade. Starting in 2011, there is a significant divergence between the two lines and especially after the ‘Covid-shock’, the upward movement of the S&P 500 has been much steeper than that of the MSCI ACWI. Thus, while the ACWI tracking ETF has returned 64.4% since March 2008, investors who invested in the SPX throughout the same time frame have seen almost three times more gains (183.1%).

While there is a huge divergence in returns over this long time frame, it is also visible that directionally the up and down movements of both indices are pretty much the same. Hence, while they are highly correlated, the results might still differ a lot over a given period of time.

Given the above analysis about the equity allocation of the ACWI index, it should not be surprising that there is a strong correlation. Furthermore, the reason why the S&P 500 return exceeded the MSCI so substantially, is due to the fact that the US stock market in general has had a comparatively strong performance — especially in the period following the Covid-19 panic.

As for the future performance of both indices I am really not sure. In general, I think that the US stock market is far more overpriced than others and we should see some mean reversion kind of trend between the two indices.

On the other hand, given the current market environment, with overwhelming sovereign debt burdens and the way central banks are meddling with the outcomes, I suspect that we might see even more divergence. In the August issue, I wrote extensively about the US Dollar Milkshake Theory. Considering all options that are currently on the table, I think it is indeed likely that even more capital is searching to be stored in US assets, which are perceived as a more safe haven, as sovereigns struggle to deal with their debt burdens amidst high inflation. Given that the Japanese Yen and the Euro are in a far more precarious situation, it makes sense that USD denominated assets keep outperforming over the next months.

I definitely will keep following both of them as events unfold and keep readers of this newsletter updated along the way.

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Best regards,

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Disclaimer: The content of this newsletter is for informational and educational purposes only. It contains my personal views and opinions, which are not to be taken as direct investment advise. All investments have risks and you should do your own due diligence before making any investment decision. If you require individualized advice, to review your unique situation and make a tailored advice for you, then contact a certified financial planner or other dedicated professionals.

This newsletter was first published on Substack, where I write it on a monthly basis. Thanks for reading Ataraxia Financial Newsletter! Subscribe for free to receive new posts and support my work.