There are long-term investing opportunities aligned with policymakers’ priorities in energy transition, food security and defense.
War-time economics is complex, and Europe’s economy seems to be short circuiting. A perilous energy crisis has pushed inflation to record levels, is squeezing households, and threatens to worsen in the cold winter months ahead.
Import prices are soaring. Consumer confidence is the weakest it’s been since the European Union (EU) started tracking it. Business sentiment is weakening. The European Central Bank (ECB) is trying to do what it can. Governments are looking to crisis-management strategies: price caps, excess profits taxes and rationing.
Avoiding recession will be difficult. Yet profound disruption also brings investing opportunities.
Can Europe avoid a recession?
Whether or not Europe can steer clear of recession lies in how the energy crisis is managed.
The war in Ukraine and sanctions against Russia have upended Europe’s energy supplies. Russia was the continent’s traditional source for a quarter of its oil and almost 40% of its natural gas. Households and businesses need gas for heating, cooking and powering electricity. But transporting gas now is tricky, and high demand relative to limited supply has sent prices out of control.
European natural gas, even with a recent move lower, is still trading more than 60% higher* than a year ago. The EU succeeded over the summer in refilling its stockpiles of liquified natural gas (LNG), mostly from the United States, hoping to avoid rationing this winter. (Storage currently stands at average levels, meaning close to 90%.)
The real challenge will come in 2023.
Russia continues to limit the flow of natural gas to the continent—most recently through the closure of the Nord Stream 1 pipeline—and has given no indication of when the supply will resume. Despite higher LNG shipments from elsewhere, storage levels for winter 2023 are likely well short of what will be needed. Moreover, a colder than expected winter this year could draw heavily on reserves and exacerbate the shortage.
Russian natural gas exports to Europe plummeting
This chart shows the 7-day average of Russian natural gas exports to Europe in millions of cubic meters per day from January 2019 to September 2022. In January 2019, the level is about 500 million cubic meters per day, made up of 170 million of Russian exports via Ukraine, 100 million via Yamal (Poland), 160 million via Nord Stream 1, and 60 million through liquefied natural gas (LNG). This then transitions to circa 400 in July 2019, as Nord Stream 1 annual maintenance takes its export contribution to zero. We see a series high of around 550 million at the end of 2019, largely due to a jump in exports via Ukraine to 230 million cubic meters. This then drops sharply to approximately 330 million in early 2020, as exports via Ukraine, Yamal and LNG fell. This then jumps to 490 million in late 2020 following another sharp decline in July due to the Nord Stream 1 maintenance. Since then, Russian exports to Europe have fallen quite consistently. Noticeably, there is a drop to around 200 million in January 2022, followed by a rise to around 350 million in early 2022 before a dramatic fall to just 61 million cubic meters at the end of the series. This final contribution is made up of no flows via Nord Stream 1, 43 million via Ukraine, and 18 million via LNG. Alt text: This stacked area chart shows the 7-day average of Russian natural gas exports to Europe in millions of cubic meters per day from January 2019 to September 2022.
Storage levels have improved
This chart shows the European natural gas storage levels as a percentage of capacity from January 2021 to September 2022, with an estimate for capacity in October 2022. Capacity in January 2021 is at 72%, from where it falls to 30% in April 2021. There is then a steady rise through the summer to 77% in October 2021. Levels then drop through the winter to a series low of 25% in March 2022. Since then, capacity has risen to current levels of 89% at the end of the series.
The war represents a large “terms of trade” shock to the eurozone economy, in which import prices have surged disproportionately to export prices. Such large price fluctuations this winter could worsen the war’s economic fallout across the region.
Energy exporters, including the United States and Canada, should benefit. They will almost certainly be satisfying Europe’s energy needs for many years as Europe pivots away from Russian imports.
Europe is suffering a terms of trade shock as import prices surge relative to export prices
This chart shows terms of trade balance in the United States, Canada and Europe from December 2019 to August 2022, indexed at 100 on December 2019. Initially, the United States remains fairly flat, while Canada faces a negative shock down to 91 by May 2020, and the Eurozone rises to 106 in the same month. From there, Canada rises sharply over the next two years to a high of 120 before dipping to 117 at the end of the series (July 2022). The U.S. terms of trade steadily increases to finish at 108 in August 2022. And the eurozone gradually declines from highs of 106 in May 2020 to 89 in June 2022 to end the series.
The nearly 7% decline in the eurozone’s terms of trade since the start of the war could, in isolation, wipe away about one-third to a half of the GDP growth that would have occurred in 2022 and 2023 had the war not broken out. Risks to this projection are also skewed to the downside, particularly if the energy situation proves disorderly and disrupts European industrial sectors, particularly in Germany, where growth is more reliant on manufacturing and trade.
The challenges of monetary policy
Such a terms of trade shock pushes inflation higher, squeezes incomes and hurts a country’s reserves and external debt. Such conditions make designing policy solutions all the more challenging.
Higher energy prices have to be paid for by corporations passing on the costs to customers and governments potentially providing subsidies, caps or stimulus to help people pay the bills. But with risks skewed toward a worsening crisis, price caps and subsidies could prove insufficient. Rationing that stamps out demand may be needed to build sufficient energy supplies for next year.
At the same time, the ECB, like the Federal Reserve, is expected to continue to tighten policy in order to have a fighting chance at price stability. Yet because the eurozone is a monetary union, there is more at risk as the ECB goes on the offensive. As credit conditions tighten, the more indebted nations, including Italy, will feel the effects more acutely than wealthier member states such as Germany.
The danger is that ECB policy will fail to transmit across all members effectively and will fragment the single market. The spread between Italian and German government debt (an indication of funding stresses in the periphery versus central Europe) is hovering around its highest levels since the depths of the COVID-19 crisis.
Emerging investment opportunities in Europe
Some investment strategies can thrive in a downturn.
The euro has depreciated meaningfully, falling 12% versus the U.S. dollar year-to-date and below parity for the first time in two decades. For example, Europe is suddenly “cheap” for American tourists. Indeed, the number of tourists visiting Europe this past summer soared to pre-pandemic levels.
Europe is now cheap for those with dollars
The euro has depreciated meaningfully and increased risks to growth
This chart shows the real effective exchange rate (REER) of the euro divided by the REER of the dollar from January 1993 to August 2022. A high figure suggests the euro is stronger relative to the dollar, while a low number denotes a stronger dollar. The series starts at 1.0, before dipping below 0.9 in January 1994 and bouncing higher again above 1.0 in July 1995. From here, there is a sharp decline to 0.6 in June 2001, followed by a strong period to a series high of 1.08 in April 2008. The EUR/USD REER then bounces between 0.9 and 1.0 until May 2014, where the series fall sharply to 0.7 by January 2016. Then, there is a move slightly higher to 0.8 in January 2021 before a sharp decline to 0.61 in August 2022.
A cheap euro should buffet Europe’s economy from the war shock in the short run, set the stage for faster growth in export sectors over the medium term, and eventually help to adjust Europe’s economy.
Given that currencies tend to “overshoot” when external shocks inflict damage on economies, now could be an opportune moment for U.S. dollar–based investors to pick up euros at historically depressed levels, or to consider investments in European real assets, such as real estate and infrastructure.
At the same time, the stresses related to the current crisis and COVID-19 aftershocks have made it difficult for many Europe-based companies to maintain their profits and service their debts. Loan defaults are already on the rise. A window appears to be opening for investors with expertise in special situations to acquire at a discount and restructure troubled credit and real estate assets. Such strategies can also generate yield in portfolios and returns with an opportunity for downside protection.
And investing opportunities aligned with policymakers’ priorities—around themes such as the energy transition, food security and defense—could offer long-term investors growth at a time when it is scarce.
We can help
For a thoughtful analysis of how such strategies might fit into your portfolio and best align with your family’s goals, reach out to your J.P. Morgan team.
*As of October 6, 2022.
