Responsible investors have the ability to call companies to account. The cost of living crisis is good reason to do that. Higher food and energy prices are a symptom of, amongst other things, unsustainable features of the global economic infrastructure. Addressing them needs policies but also activist investors taking into account business models, technologies and corporate behaviour as they deploy capital. What is going on today is creating negative social outcomes and companies can be and are complicit in that. The agenda towards more sustainable practices and the funding of technologies that can deliver better social and environmental outcomes has to be accelerated.
The cost of living crisis is essentially a crisis of falling real incomes. Prices are rising faster than wages. Specifically, prices of essential goods – food and energy namely – have been rising quicker than anything else. One aspect of the crisis is that poorer households tend to spend a greater percentage of their income on essentials. Thus the worst of the cost of living crisis falls disproportionately on the poorest in society. The crisis is a symptom of economic imbalances and in turn has significant repercussions for the macro outlook, for politics and for investing.
We know by now the story about rising energy prices being a combination of recovery in demand after the pandemic, falling relative capital investment in fossil fuel extraction and the disruptions caused by the war in Ukraine. There have been significant increases in energy commodity prices with the spot price of Brent crude oil rising from $50 per barrel in June 2020 to over $110 in the aftermath of the Russian invasion. It is close to $90 per barrel today. Natural gas prices have risen similarly. The current price for December delivery natural gas in Europe is at a record high, representing a more than 1100% increase over the last two years.
Massive increases in retail cost of energy
These prices have fed through to higher prices for consumers, in both the business and household sectors. Any popular news outlet today is full of stories about how much ordinary people are paying for their home heating and electricity and for gasoline, and how worse it could get over the coming winter. And of course, this is all feeding through into higher headline rates of inflation with the risk that other costs respond in kind – which is happening. The result is a monetary tightening cycle globally that is likely to drive many developed economies into recession.
So the cost of living crisis is embedded in the cyclical outlook for major economies. Inflation higher, interest rates higher, real incomes lower and, ultimately, aggregate demand slows, and unemployment rises. Markets have struggled with this for some time having to price in simultaneously higher inflation and lower growth. Hence, the flattening of yield curves in the bond market and the year-to-date underperformance of growth stocks in the equity market.
Margins under pressure for some businesses
There is more to think about related to the cost of living crisis than inflation and interest rates. Costs for all businesses are rising and this will put pressure on profit margins, especially in very competitive sectors and those most vulnerable to slower consumer spending. Taking financial data from Bloomberg, the average profit margin on companies in the S&P500 Energy sector rose from -0.2% in Q2 2021 to an estimated 11.3% in Q2 2022. For consumer discretionary companies, the average margin has fallen from 7.1% to 6.7%. We should not forget that the more general impact of the COVID pandemic on supply chains has also contributed to higher inflation and higher costs for raw materials, intermediate goods and labour. Higher inflation and slower real demand remain the key concerns for a view on equities. If inflation does peak soon, then markets can probably sustain levels above the lows reached in June, but what happens with inflation in the next two to three months is important.
Social and political implications
Quite aside from the financial aspect, with a redistribution of profitability from consumers of energy to producers, there are political and social considerations. Income inequality is worsened by a sharp increase in the cost of living and that is having political consequences. In the UK there has been a sharp increase in days lost to industrial strike action as workers demand higher wage settlements. More brutally, in Sri Lanka the government has been overturned by people protesting against higher food and energy prices. As governments recognise popular anger there is a risk of policy mistakes – such as the promises of large tax cuts being made by the two contenders for the leadership of the UK Conservative Party (and the next Prime Minister). There is a risk of civil unrest in Europe this winter as even higher energy prices hit pocketbooks.
How to treat the energy sector?
The crisis is sharpening ideological divides and nowhere more vividly than in discussions around the energy sector. Even the most die-hard capitalists must feel some level of discomfort when oil companies report huge profits, significant executive pay awards and increased distributions to shareholders when more and more households are at risk of falling into poverty. The increase in profits in the oil and gas sector is almost entirely due to the rise in global oil prices, creating windfall profits that could never have been generated by increased operational efficiency. Of course, these profits do generate more tax revenues for governments, but effective tax rates could still be higher. There is a political debate over whether to tax these companies more in order to subsidise retail energy costs or provide a greater level of benefits, or to increase investment in renewable energy. The financial sector saw increased regulation after the financial crisis in 2008, including curbs on bonuses. The risks of a similar political backlash on energy companies is tangible. Just this week, Antonio Guterres, Secretary General of the United Nations, called on all governments to tax the “obscene” profits of energy companies. A narrow constituency of shareholders and energy company executives are reaping the benefits of higher energy prices while the majority suffer hits to their living standards, and we are missing the opportunity to shift away from energy that is creating the climate crisis.
All of this increases the urgency of accelerating the energy transition. It is clearly sub-optimal to have so much power concentrated in the hands of a relatively few companies and countries that happen to control the extraction and distribution of fossil fuels. Would Russia be able to sustain its military operations in Ukraine if it did not keep receiving revenue from oil and gas? Would several emerging economies be on the brink of default if there were cleaner and cheaper sources of energy available? It remains a pipe dream but a decentralised, renewable global energy system would be unquestionably better for businesses, households, the environment, security and the planet. Europe has baked again this summer and now we are facing drought conditions in the UK. Even if climate change was not happening, getting away from a socially and politically distorted energy system would still be desirable.
Eating and heating
It's not all about energy either. Food price inflation has accelerated. The pandemic created shortages of agricultural workers and inputs to the production process. According to World Bank data, wheat prices have been steadily rising for the last five years and accelerated in February as Russia invaded Ukraine. The United Nations Global Food Price index has risen 70% since Q2 2020. Shortages and higher prices in retail food outlets have become common place in developed economies. Driving a combustion engine car, buying the weekly groceries and running the heating or air conditioning at home have all become much more expensive. For those in low paying jobs or unable to gain inflation matching wage increases, it means significant losses in real living standards.
Rate increases accentuate the crisis for some
Of course, rising interest rates does not help either. The relatively aggressive front-loading of rate hikes by the Fed and the Bank of England will add to interest costs for those households and businesses. The UK is traditionally more sensitive to hikes in the bank rate and the prevalence of buy-now-pay-later credit facilities and more general consumer debt mean a significant increase in delinquencies. Again, through these channels, the less well-off are likely to suffer the most from higher interest rates. The only silver lining is that we are closer to the end of the rate cycle than the beginning, at least in the US and UK.
Not much relief
The cost of living crisis is not going to be solved quickly. There is some relief from lower global commodity prices but there are still concerns around supplies of things like fertilizers and wheat. Nominal wages are going up, but will lag behind price increases for a while yet. Using average weekly earnings data from the US and the core CPI index, real wages have fallen around 1.5% from their peak last September – and this is an average, so in lower income groups the decline will be even more marked. Using headline inflation it is much worse, with real wages down a massive 5.5% compared to May 2020 just as the global economy was beginning to emerge from lockdown. It’s the same story in many other countries and positive real wage growth looks some way off. Thus the politics around the cost-of-living crisis will remain hot. If unemployment rises then things get even more politically charged which is an issue for politicians seeking election in the next couple of years (US Presidential election and UK elections in 2024).
Responsible investing in a cost of living crisis
Many of the themes that contribute to the cost of living crisis have relevance for investors. As we strive more and more to invest in sustainable businesses, all aspects of ESG should be considered. Through the social prism we need to look at how companies balance their need to protect margins and earnings growth with their broader social responsibilities and whether or not their business models are at risk. Pricing policies in sensitive sectors like food retailing, utilities and energy should be under scrutiny. Executive and employee pay policies need to be sensitive to the broader pressures facing people. Risks of a governance backlash, brand dilution or loss of market share need to be assessed on the basis of whether companies are displaying signs of “greed” relative to a more sustainable long-term approach. There are economic gains to be realised from breaking down oligopolistic markets though government policy but also through investors using their influence over the long-term cost of capital.
Impact strategies that focus on social outcomes are becoming more widespread. Several of the United Nations Sustainable Development Goals are relevant to designing portfolios that invest in companies that will help contribute to reducing hunger, providing cheap and clean energy, and making healthcare more affordable and accessible. There is also the need to invest in energy and food production that is more sustainable, does not lead to deforestation and soil erosion, and can avoid the fragilities of the supply chains that have been highlighted over recent years.
To misquote Karl Marx, football is the opium of the masses, and boy do we need it now. After the stunning success of the Lionesses last weekend, the English Premier League returns. I have to concede that City and Liverpool are again likely to be the front runners. For Manchester United, hope springs eternal and from the fact that there is a new coach and several new players (not to mention the disposal of some tarnished assets). Sport won’t do anything to pay the weekly bills, but it can bring excitement, entertainment and glory to a lucky few. Sit back and let the games begin!
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