Analysis: As the war in Ukraine drags on, the European economy succumbs to the crisis

  • Recession almost certain
  • Germany and Italy among the hardest hit
  • Consumers’ wallets depleted by record inflation
  • A strong labor market raises hopes of a short recession
  • Energy transition can build long-term resilience

FRANKFURT, Aug 23 (Reuters) – It was supposed to be Europe’s star year.

A post-pandemic spending euphoria, backed by abundant government spending, was expected to stimulate the economy and help weary households regain a sense of normalcy after two terrible years.

But all that changed on February 24 with Russia’s invasion of Ukraine. Normality has disappeared and the crisis has become permanent.

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A recession is now almost certain, inflation is approaching double digits, and a winter with impending energy shortages is fast approaching.

Although gloomy, this outlook is likely to worsen further before any significant improvement through 2023.

“Crisis is the new normal,” says Alexandre Bompard, the managing director of retailer Carrefour (CARR.PA). “What we’ve been used to over the past decades – low inflation, international trade – is over,” he told investors.

The change is dramatic. A year ago, most forecasters predicted economic growth of almost 5% for 2022. Now, a winter recession is becoming the reference case.

The recent rise in euro area inflation has been dramatic in historical context

Households and businesses are both suffering as the fallout from the war – high food and energy prices – is now exacerbated by devastating drought and low river levels that limit transport.

At 9%, inflation in the eurozone is at levels not seen in half a century and it is sapping purchasing power with excess cash being used for gasoline, natural gas and basic foods.

Retail sales are already plummeting, months before the start of the heating season, and shoppers are reducing their purchases. In June, retail sales volumes were down nearly 4% year-on-year, driven by a 9% drop in Germany.

Consumers are turning to discount chains and switching from high-end products to discount brands. They also started skipping some purchases.

“Life is getting more expensive and consumers are reluctant to consume,” Robert Gentz, co-CEO of German retailer Zalando, told reporters.

So far, companies have held up well thanks to superb pricing power due to persistent supply constraints. But energy-intensive sectors are already suffering.

Almost half of Europe’s aluminum and zinc smelting capacity is already offline, while much of the fertilizer production, which relies on natural gas, has been shut down.

Tourism has been the rare bright spot with people looking to spend some of the accumulated savings and enjoy their first carefree summer since 2019.

But even the travel industry is crippled by capacity and labor shortages, as workers laid off during the pandemic were reluctant to return.

Key airports, such as Frankfurt and London Heathrow, were forced to limit flights simply because they lacked staff to process passengers. At Schiphol in Amsterdam, waiting times could reach four or five hours this summer.

Airlines couldn’t cope either. Germany’s Lufthansa (LHAG.DE) had to issue an apology to customers for the chaos, admitting it was unlikely to subside any time soon.

THE RECESSION HAS BEEN

This pain is likely to intensify, especially if Russia further reduces its gas exports.

“The gas shock today is much bigger; it’s almost double the shock we had in the 1970s with oil,” said Caroline Bain of Capital Economics. “We have seen a 10 to 11 fold increase in the spot price of natural gas in Europe over the last two years.”

While the EU has unveiled plans to accelerate its transition to renewables and wean the bloc off Russian gas by 2027, making it more resilient in the long term, supply shortages are forcing it to seek a reduction in 15% of its gas consumption this year. Read more

But energy independence has a cost.

For ordinary people, this will mean colder homes and offices in the short term. Germany, for example, wants public spaces to be heated to only 19 degrees Celsius this winter, compared to around 22 degrees previously.

Later, this will mean higher energy costs and therefore inflation, as the bloc has to give up its largest and cheapest energy supplies.

For companies, this will result in a drop in production, which further eats away at growth, particularly in industry.

Wholesale gas prices in Germany, the bloc’s biggest economy, have quintupled in a year, but consumers are protected by long-term contracts, so the impact so far has been much less.

Yet they will have to pay a government-imposed tax and once contracts are renewed, prices will soar, suggesting the impact will only come with a delay, putting persistent upward pressure on inflation.

This is why many, if not most, economists consider Germany and Italy to be the no. 1 and no. 4 economies heavily dependent on gas, soon entering recession.

If a recession in the United States is also likely, its origin will be quite different.

SILVER LINING

Faced with a scorching labor market and rapid wage growth, the US Federal Reserve quickly raised interest rates and made it clear that it was willing to risk even a recession to rein in price growth.

On the other hand, the European Central Bank has only raised its rates once, to return to zero, and will only act with caution, aware that the increase in the cost of borrowing for countries in the very indebted countries, such as Italy, Spain and Greece, could fuel concerns about their ability to continue to pay their debts.

But Europe will enter recession with some strengths.

Employment is at an all-time high and businesses have been grappling with growing labor shortages for years.

This suggests that companies will want to retain their workers, especially as they head into recession at relatively healthy margins.

This could then support purchasing power, indicating a relatively shallow recession with only a slight increase in what is now record unemployment.

“We are seeing acute labor shortages, historically low unemployment and a high number of vacancies,” ECB board member Isabel Schnabel told Reuters. “This probably implies that even if we enter a recession, companies may be quite reluctant to lay off workers on a large scale.”

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Reporting by Balazs Koranyi Additional reporting by Silvia Aloisi and Christopher Steitz Editing by Tomasz Janowski

Our standards: The Thomson Reuters Trust Principles.

Mary I. Bruner