The state of the energy market is having a profound effect on the UK corporate sector. Few companies remain unaffected by rising energy prices, with some significant beneficiaries and others facing higher input costs and tighter margins. For Shires Income, it has become an increasingly important factor in our analysis of companies.

There has been some divergence in energy markets in recent months: the war in Ukraine continues to constrain supply, but recession fears have also started to weigh on markets. We believe this may have lulled some investors into believing the crisis may be nearing an end. In reality, energy prices remain elevated and are likely to be the catalyst for a global synchronised recession over the course of the next 12 months.

The impact of the energy market on equities has been profound. Many companies are facing higher costs, at a time when margins were already being squeezed. Energy companies have benefited, particularly those exposed to gas. Utilities are also benefiting from higher power prices, while companies involved in the energy transition have become more important as governments seek to create energy security.

On the other side, consumer companies have been hit hard. Consumers are facing higher energy bills and have become more cautious as a potential recession looms. That has had a clear impact on consumer demand. There are also companies facing second order effects – higher inflation has pushed central banks to raise rates, which has hurt companies with higher debt. It has also prompted a notable rotation from growth to value by investors.

What happens next?

Governments across Europe have put in place measures to shield consumers from the worst impact of rising energy prices. Even with these defences in place, households have been forced to draw down on any savings buffer they built up during the pandemic. It is also affecting sentiment in the corporate sector. Expectations for new orders have declined and manufacturing has been hit.

It is difficult to see this uncertain backdrop changing significantly. Certainly, Europe has been successful in building up its gas inventories, and, in some places, in curbing demand. This is a better starting point, though there are still risks that prices could spike higher and rationing might be needed, particularly if it is a very cold winter. Prices are likely to settle higher than historic norms.

This should create an ongoing tailwind for the energy sector. Energy companies are already generating strong cash flow, which is allowing them to pay down debt. They have generally been disciplined on capital expenditure and returning cash to shareholders. With the floor under commodity prices higher, we still have a relatively high energy sector weighting in Shires Income.

These companies also have a longer-term tailwind from the move into clean energy trading and renewables, where many have significant investments. This doesn’t get a lot of credit from investors today, but is likely to become increasingly important over time. In a tight, disrupted energy market, energy trading becomes increasingly valuable.

Renewables

Renewables are also likely to be longer-term beneficiaries from the energy crisis. The recent events have brought home to governments the need to transition away from conventional fuels, both from an environmental and energy security perspective. There is a good understanding between companies and governments that they need to earn a competitive rate of return to provide infrastructure and clean energy supply. Therefore, renewable companies such as SSE and National Grid have a potentially good pathway of growth.

That said, there are interesting opportunities elsewhere. Good quality retailers with strong balance sheets should emerge from this difficult period with greater market share. Valuations remain very low. In contrast, industrials facing a sharp slowdown in demand and the expiry of their energy hedges at the end of the year should be avoided.

Inflation and interest rates

The shift from a low inflation, low interest rate world, to a high inflation, high interest rate world has been a significant change over the past 12 months. This has prompted a rotation from growth into value and into certain sectors, such as financials.

We have to assume that inflation will continue to weigh on markets. Against this backdrop, we prefer to own quality companies with pricing power. Pressure on margins is likely to increase, as energy costs rise and wage demands increase. We have started to see the ‘quality’ factor find favour with investors as recession fears have emerged. Companies that are resilient and able to protect their margins during a downturn have found favour with investors.

The energy crisis presents a challenge to all investors, affecting margins across all sectors. With little imminent resolution to the crisis, it is an important factor in our decision-making at Shires Income today. The portfolio is positioned to help ensure that our investors are less vulnerable to the crisis and its secondary effects.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

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