Energy shock fuels recession in Europe
The European Central Bank raised rates by 75 basis points, maintaining its focus on inflation.
Preparing for a deep recession in Europe
We believe that the energy crisis will cause a deep recession in Europe. And the ECB wants controlling inflation without recognizing the costs.
1) The energy shock shapes Europe’s outlook
The energy crisis is clouding the outlook. Europe now spends nearly 12% of its GDP on energy, more than double the US level.
2) Geopolitical tensions
Gas supplies from Russia have been drastically reduced, causing prices to spike. Storage has been built, but winter weather is still a risk. The demand for gas must fall even further.
Our view already factors in natural gas rationing, and we see the energy crisis pushing Europe into a deeper recession than the US by the end of the year.
3) The ECB has not yet signaled the growth-inflation trade-off
We see the ECB ending its bullish cycle earlier than expected as it wakes up to this reality, including the risks of fragmentation.
Here is our view on the market:
We believe that the risks of recession in Europe are not fully priced into equity markets.
We are cautious on a tactical horizon. We are underweight European equities and most other developed market equities, and we are not looking to buy the downside.
We prefer fixed income assets in Europe to equities.
The energy crisis will lead to a recession in Europe, as we have argued since March. The crisis has since worsened as Russia cut off gas supplies. Moreover, the European Central Bank (ECB) does not recognize that it will further crush activity in an attempt to combat high inflation, in our view. We believe that the ECB will realize this reality sooner than expected by the markets, but not before it inevitably faces a severe recession. We remain underweight equities and favor high quality credit.
Europe’s energy crisis
Notes: The graph shows the cost of oil, gas and coal consumption in the European Union and the United States as a percentage of GDP. We use regional energy prices and divide by GDP in US dollars. Data for 2022 is based on the latest IMF GDP forecasts and the year-to-date average of daily commodity prices.
Europe’s efforts to wean itself off Russian energy have sparked a price spike that has amplified as Russia cuts its gas supplies. The European Union now spends nearly 12% of its GDP on energy, making the crisis worse than the oil shocks of the 1970s. See the orange line in the graph. This is not the case for the United States, a net exporter of energy (yellow line). It is hard to see any relief for Europe in the next two years, with rationing on the horizon, in our view. Winter can lead to increased demand, reducing inventory. Countries are rushing to cushion the pressure, especially on households. Germany plans to collect excess profits from energy suppliers and cap prices. EU energy ministers have called for similar policies. The UK has a major plan to pay energy suppliers the difference between a new capped price and the price they could have charged.
Eurozone policies are much smaller than UK or Covid-19 policies. This reinforces why the energy shock will lead to a prolonged multi-quarter recession in Europe, in our view. The ECB is ready to make matters worse: Like the Federal Reserve, the ECB has failed to recognize the damage it needs to do to growth to fight this inflation, even after hitting a record 0.75% in the week last. The ECB is responding more to the policy of energy-induced headline inflation, we believe. Its new modest growth forecast for next year is already out of date as it does not take into account recent events such as Russia’s gas supply cutoff. We believe the ECB’s bearish scenario of a -0.9% contraction is more likely. In our view, the euro’s decline to a 20-year low against the US dollar reflects deteriorating growth and terms of trade due to higher energy prices.
View of the European Central Bank
The ECB will also have to deal with the risks of fragmentation – and perhaps put into practice its anti-fragmentation tool for peripheral debt spreads. Italy’s economic fundamentals have deteriorated in this shock, with it shifting to a current account deficit amid its heavy debt load. This is more likely to fuel volatility in Italian bonds, although the upcoming elections will likely result in a centre-right government that will not be very hostile to the EU.
We believe the ECB will maintain its aggressive rate hikes until the end of 2022, but then stop once it sees the economy take a hit. In our view, year-end rates will likely remain somewhat below current market rate expectations.
View of the Bank of England
Unlike others, the Bank of England (BoE) has made it clear that bringing inflation back to its target would require a deep recession. UK budget plans would not change that, in our view. The measures are just another example of governments’ response to high inflation policy. Subsidies could slow headline inflation and cushion the blow of short-term recession. But they can’t resolve the imbalance of weak supply versus demand – and in fact, block the fall in demand needed to reduce inflation. Limiting the hit to real household income reduces the drag on growth that the BoE expected. This implies that the BoE will continue to raise rates to bring demand back in line with supply, but not as much as markets expect, in our view.
Our bottom line
European equities are not priced for the deep recession we expect. Excluding commodities, European earnings growth estimates are overly optimistic, in our view. We remain underweight European equities and equities from more developed markets. We favor Investment Grade credit because the yields better offset the risk of default. We are neutral on European government bonds and have a slight overweight on UK gilts, with a preference for short-term bonds due to market prices in a too hawkish rate path.
Volatility persists across all markets, highlighting the new regime of heightened macro volatility. The ECB raised rates to a record 0.75% and lowered its growth forecast last week. Yet the ECB’s new growth forecasts still do not reflect the deep recession we expect from the energy shock and rising rates. We see the ECB raising rates until the end of the year, then stopping when the economic toll of the energy shock and rate hikes becomes clear.
This week, the focus is on whether core US inflation is slowing further or remaining at elevated levels. Consensus sees core CPI holding fairly steady, driven higher by housing costs, even as headline inflation likely cools on lower gas prices. The Bank of England policy meeting previously set for September 15 has been postponed following the death of Queen Elizabeth.