Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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The parallel worlds of green transformation
Peter Garnry
Chief Investment Strategist
Summary: Politicians are all in on the green transformation and central banks support green bonds. As a result the green transformation does not lack available capital to be deployed, but the industry has been faced with terrible stock returns over the past year. It is almost as if the green transformation lives in different worlds. There is the world of what we want to achieve and then the harsh reality of higher interest rates, higher material costs, and higher grid system costs from more renewable energy, and there is no other stock represent the downfall of green transformation stocks than Orsted.
Key points in this equity note:
- Green transformation related theme baskets are the worst performing theme baskets over the past year despite strong political and capital commitment from the financial industry.
- Orsted has gone from being part of the bubble stocks cluster peaking in early 2022 at excessive valuation to a premium that is getting closer to the European utility sector as offshore wind projects are faced with multiple headwinds.
- While the talk of energy crisis has disappeared this year German baseload electricity is still 140% the long-term average from before the pandemic highlighting that Europe still has a big energy problem.
Green transformation baskets are the worst momentum
The past year has marked a period of first panic in technology stocks as the Fed unleashed its aggressive rate hikes before optimism and exuberance took over catapulting technology stocks back into positive gains. As recession fears increasingly looked wrong and the AI hype accelerated so did returns in technology stocks, so much in fact, that semiconductors is our best performing theme basket this year.
If we look at the past year, which is the classic definition of momentum used in equities, then the best performing themes are defence (due to the war in Ukraine), construction (delivering on backlog and infrastructure spending), luxury (bet on China’s consumer) and travel (post pandemic growth). Despite massive political capital, funds flowing into alternative investment funds for the green transformation, and retail investors liking the ESG agenda, our three energy baskets (renewable energy, energy storage, and green transformation) have been part of the worst performing baskets.
So despite the commitment from governments and capital being made available for green investments, the returns across many green transformation stocks have been bad. The power point slides and hopes of the green transformation have certainly met a harsh reality in financial markets. If investors continue to bid down prices of green energy stocks then it will at one point begin to reduce available supply of capital because capital is always seeking the highest risk-adjusted returns.
Will Orsted’s complexity weigh on valuation?
There is no stock like Orsted that represent the downfall of the green transformation since early 2022. At its peak, Orsted was the largest stocks in many of the leading clean energy funds, and as our valuation chart below shows, its 2-year forward EV/EBITDA valuation hit 22.1x in January 2022 compared to 8.4x for the European utility sector. In other words, Orsted peaked at the same time as many bubble stocks peaked illustrated by Cathie Wood’s Ark Innovation ETF.
Since then Orsted has disappointed the market in terms of profitability as its EBITDA margin has declined from 24.6% in FY19 to 14% in the latest 12 months. Rising interest rates, higher material costs, and higher volatility in electricity prices have all contributed to the headwinds for Orsted, and as a result Orsted’s equity valuation has come back closer to the utility sector in Europe. When you observe the historical development in Orsted’s equity valuation is interesting to observe its volatility compared to the overall utility sector. This sector is significantly regulated and constrained making it typically a very predictable sector in terms of returns and growth, but the narrative around the green transformation, and especially offshore wind farms, catapulted Orsted to be valued like a technology company.
Our view is that the operating model of Orsted is quite complex and the timing of cash flows has a high degree of volatility. In addition, the operating model is constrained by many factors (as mentioned above) and with renewable energy, including offshore, becoming more expensive due to expensive storage needed over time to balance the grid, our view is that Orsted should not have a significant premium to the rest of the utility sector.
Energy crisis in the short and long run
In one our recent equity notes Can European equities continue to ignore the bad news? we discussed the fact that Germany’s economic model is broken and that the industrial giant of Europe looks once again to become the sick man of Europe. A big part of the explanation is the energy crisis in Europe. It was a hot topic during the second half of 2022 with galloping natural gas prices as the ramifications of the war in Ukraine, and subsequent sanctions against Russia, played out across energy markets. Since the word energy crisis has been used less and less as German baseload electricity prices have fallen on average by around 60% from 2022 levels. However, this year’s German baseload electricity prices are still around 140% higher than the long-term average from 2009-2020 signalling a structural break from the past.
In the short-term (this winter and the next), depending on the weather, a severe energy crisis could come back to haunt Europe which in itself could be bad for European equities. Longer term the green transformation poses challenges for the input costs of Europe’s industry and inflation. As transportation, heating, and digitialization (data centers) will significantly increase electricity consumption over the years (something we have written extensively about in previous equity notes) the need for baseload electricity is important. Solar and wind can only meaningfully contribute over a certain threshold of overall electricity production if storage is added, but energy storage is expensive and thus over system costs go up with more renewable energy over a certain point.
Europe will need a lot of baseload electricity and the only viable options are coal, natural gas, and nuclear power. As coal is no go due to green ambitions, natural gas and nuclear power will play a significant role and especially natural gas. There is a real risk in Europe that electricity demand could grow faster than supply due to electrification keeping electricity prices high and thus putting a floor under inflation.
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