Chateauneuf-du-Pape: Appellation Deep Dive; & My MBS Outlook for '23

Today, rather than talking about a specific bottle, we will discuss an entire appellation… and a legendary one as well. And when we get tired of talking grape varieties (as if this is even a possibility) we will take refuge in the magical world of MBS, with my 2023 outlook being the focus of our discussion.

Today we are diving into a fascinating region in France which illustrates all three founding factors for success in winemaking: Terroir, terroir, terroir. This story has it all: Catholic Church intrigue, prehistoric rivers that left us sacred rocks known as galets roules, a complicated relationship between the French crown and the papacy, Aliens, & Lady GaGa…

Well, ok, Lady Gaga is not part of this story, but I had to get your attention somehow. Now, I am sure that you think that the Aliens are not part of this story either. And you would be so wrong. So stay with me.

If there is one French wine that every wine enthusiast should taste, it is definitely Chateauneuf-du-Pape. And that is going to be the topic of today’s article.. Lets start with an obvious question:

Where is Chateauneuf du Pape?

Chateauneuf-du-Pape is a wine area in?Rhone Valley near Avignon that is well-known throughout the country for its outstanding wines: Appellation d'Origine Contr?lée Chateauneuf-du-Pape AOC is one of the most renowned names in the southern Rhone Valley, with vineyards surrounding Chateauneuf-du-Pape and the nearby villages of Bédarrides, Courthézon, and Sorgues, located between Avignon and Orange (curiously, this is the only known area on the planet legally banning UFO flights (while permitting them to land). See, and you thought that I was lying about the aliens in this story.?The vineyards occupy slightly more than 3,200 hectares and produce more than 110,000 hectoliters of wine annually. This region of the southern Rhone produces more wine than the entire northern Rhone.

History

The history of this region is amazing and could be the subject of a dissertation in its own right… Chateauneuf-du-Pape means "Papa's New Castle" in French. This is from a 70-year era when the pope transferred his residence from Rome to Avignon. The popes were avid wine drinkers, initially preferring Burgundy wines over lesser local wines. But soon the C?te du Rh?ne winemaking experience developed. In the 13th century, Chateauneuf, with its 1,000 residents, began to prosper and establish vines (approximately 300 hectares).

Pope Clement V established the vineyards in 1308 but passed away in the Rhone Valley a few years later. He was undoubtedly the first winemaker in Chateauneuf. Wines from the northern Rhone Valley were served at the nomination ceremony of the second pope of Avignon (John XXII). Thus, the region got its name from the "pope's wine"—"Vin du Pape."

Terroir

The appellation Chateauneuf-du-Pape runs from the Rhone's eastern shore in Orange in the northwest to the Morgue near Avignon in the southeast. In the northern part of the appellation, the altitude above sea level reaches 120 meters. The classification encompasses 3,200 hectares of land with at least three distinct soil types or terroirs.?

Chateauneuf-du-Pape's unique terroir is derived from a layer of stones known as?galets roulés?(pebble rock). The rocks are usually quartzite and the remains of Alpine glaciers that have been smoothed over millennia by the Rhone. The stone stores heat throughout the day and releases it at night, which helps speed up grape ripening. Stones can also act as a barrier to keep moisture in the soil during the hot summer months.?

Summers at Chateauneuf-du-Pape are short, hot, and mainly clear, while winters are cold, windy, and partially cloudy. The Grenache grape is known as the King of Rhone and is the main ingredient in most?Chateauneuf-du-Pape. Winemakers that are lucky to be located on La Crau (plateau) have the best terroir and consequently the best Grenache grape. They do not need to add any other grapes and maximize the % of grenache used in their wines. And thus, the story of?Chateauneuf-du-Pape wines is that of scarcity of the right terroir to produce this ultimate grenache.

And the scarcity is at the heart of my MBS outlook for 2023...so let’s switch gears for a moment.. I promise you – we will return to finish this bottle..

The magical world of MBS

Today,?I want to step back and assess the overall health of the "mortgage patient". With less than 4 weeks before the "expiration" of 2022, we feel that a more?holistic view?is in order. With this holistic view comes a set of projections that may be mildly controversial. Oh well...?C’est la via.?

Let’s start on the?geopolitical front. The year 2022 has been marked by the disgraceful action of the Russian ruling elite to invade Ukraine under an absurdly?false pretense?of Ukraine becoming the?NATO launchpad?for the future attacks on Russian territory. Since both Russia and Ukraine are important players in the?commodity space, the war between the two resulted in a considerable?price volatility?and inflation in the energy and food markets.

While we do not expect that the next year will bring a complete?resolution?to this conflict,?Putin?will do what he does best: he will put this conflict on the?back-burner, while activating the propaganda machine to convince his supporters at home (as well as?Marine Le Pan?abroad) that his mission has indeed been accomplished. He will skillfully use his puppet governments in?LPR,?DPR,?and other territories, annexed from Ukraine, to occasionally?escalate the conflict?in order to keep Ukraine in?perpetual dependency?vis-a-vis Russia.?

Yet, the transition to this "simmering" will have a?positive?impact on commodity prices, slowing down the?inflationary trend, while reducing volatility in this space. Thus, we expect that the European situation in 2023 is likely to be slightly more?deflationary, while contributing to the overall decline in volatility.

Speaking of?volatility, it has clearly been on the?high?side. In fact, I struggle to recall time periods when volatility was higher for a longer time period. While, historically, interest rate volatility had occasionally been?extremely elevated, it remained higher than current levels only for brief periods. One of the biggest contributors to the 2022 volatility landscape has been the?QE->QT?transition, supplemented with?uncertainty?with respect to the?terminal?Fed fund rates.

I feel that the terminal rate will be reached by late spring of next year, with volatility beginning to?decline?well before that. To be sure, since we do expect that the Fed could actually start lowering the rates as early as October 2023 (since we expect that the economy will be in?recession), volatility is likely to?spike?again.

Overall, we are likely to see the vol surface drifting lower next year. Add to this my?previous argument?of declining volatility in the?commodity space, and one gets a reasonably positive feeling on this front. Needless to say, lower volatility?benefits?the option-adjusted spreads of MBS, as well as the?liquidity?in the MBS market.

MBS supply is another factor that is likely to be "kind" to mortgages in 2023. This year, the overall net supply is likely to be around?$535 billion, with a risk to the upside, if the recent rally persists. The next year will offer a?dramatically different picture, with the overall supply level falling just?below $200 billion. To be sure, this is the?organic?portion of net supply.

Since we expect that the Fed portfolio will produce ~$17.75 billion?in monthly run-offs, the Fed will, effectively, create?~$178 billion?of additional supply (assuming that they will begin reinvesting the paid downs again in Nov and Dec of next year), resulting in a total MBS supply of just over?$375 billion. Clearly, the?Fed?could increase this number in the event they decide to?sell?mortgages, but given our?recessionary outlook, we do not expect the Fed to resort to this course of action.

Who will be the buyers of that $375 billion? Firstly, we must say that we are turning much more positive on banks (as prospective MBS buyers), as we expect a?mild decrease in loan demand, correlated with a moderate increase in deposits. Thus, we have “upgraded” our expectations of bank appetite to?$130 billion.

In fact, if the curve steepens meaningfully into?recession, deposits that were “lost” to money market alternatives, will return into banks' hands, making depository institutions more likely to step into the MBS space. Similarly,?recessionary fears?could curtail loan growth more than we forecast, thus enabling banks to absorb as much as?$175 billion?of MBS.

Foreign investors?are likely to add?$70 billion, while the?REITs?may be good for?$15 billion?(which is highly dependent on their price/book ratios). This leaves?$160 billion?to money managers, which is not a completely unrealistic assumption since thus far, in 2022, they have already added close to?$460 billion?in MBS.

Additionally, a?recession?scenario bodes well for additional fund inflows since equities are likely to underperform, increasing the likelihood of MM participation.

Well, now we definitely deserve another glass …

The Grapes of Chateauneuf-du-Pape

While grenache is the dominant grape,?Chateauneuf-du-Pape permits 13 different types of grapes where Grenache is always the base in the blend.?Other red grape varieties include:?Cinsault, Counoise, Mourvèdre, Muscardin, Syrah, Terret noir, and Vaccarèse.

Chateauneuf-du-Pape red wines are commonly described as earthy with a lively taste and traces of resin and leather. Wines are robust and tannic in their youth, yet they keep their deep spice with age. Wines usually show scents of garriga, a dried herb popular in Provence. Red wines from Chateauneuf-du-Pape often have higher tannin levels and must be aged for a longer period of time before they are drinkable.

The entire wine-consuming world knows red?Chateauneuf-du-Pape, and deservingly so. I will say that white Chateauneuf-du-Pape are among the best ones on the planet. They are made from Grenache blanc, Bourboulenc, Clairette blanche, Picardan, Roussanne, and Picpoul. Grenache Blanc and Roussanne contribute vivacity and richness to the Chateauneuf-du-Pape white wines, while Bourboulenc, Clairette blanche, and Picpoul offer acidity, flowery, and mineral notes.

These wines range in style from mineral to fatty and flavorful, with almonds, carom, anise, fennel, honeysuckle, and peach among the flavors and aromas. Some domains also make Roussanne, a wine that is aged in an oak barrel. The majority of white wines are made to be enjoyed young. Some white Chateauneuf-du-Pape is made to age, and after 7-8 years, it has a piquant exotic or orange peel aroma.

Chateauneuf-du-Pape winemaking styles

Wines from Chateauneuf-du-Pape commonly have a high alcohol content, typically 13-15% and must have a minimum alcohol content of 12.5% without chaptalization to comply with the appellation rules. The region's winemaking focuses on balancing high sugar levels in grapes with tannins and phenols, which are prevalent in red Chateauneuf-du-Pape. Grape clusters are rarely removed after harvesting and before fermentation.

To obtain the characteristic dark color of Chateauneuf wine, fermentation temperatures are kept high, and the skin is frequently pumped and punctured to raise the level of tannins and extract color. Since the 1970s, some estates have experimented with carbon dioxide maceration in response to market trends favoring lighter, fruitier wines that can be consumed earlier.

Low yields are regarded as critical to Chateauneuf-du-Pape's performance, as the primary grape varietals have a tendency to create fine and soft wines in large amounts. AOC regulations limit output to 368 gallons per acre, which is less than half of the Bordeaux maximum.?

Since the principal Grenache grape is prone to oxidation in porous wooden barrels, the traditional method of using cask oak in Chateauneuf-du-Pape is not widely practiced. Grenache is vinified in big cement tanks, whilst other grape varietals are vinified in large old barrels known as?foudres, which do not impart the same "oak" qualities as smaller oak barrels.

With 300 domaines in Chateauneuf-du-Pape, there is a never-ending debate as to who are the top winemakers in this space, I will share my personal favorites with you:

1. Chateau de Beaucastel

2.?Chateau Rayas

3. Domaine du Vieux Telegraphe

4.?Clos des Papes

5. Domaine de la Janasse

6.?Domaine Bois de Boursan

7.?Domaine de Marcoux

8.?Domaine Charvin

9.?Chateau La Nerthe

10.?Domaine Guiraud

While I know that I am missing some very good producers, above are just my personal favorites…

Thanks and take care..

Kirill A Krylov, CFA, PhD