Investment Strategy

Is Europe on the brink of recession?

Jul 22, 2022

An ongoing energy shortage, policy tightening that threatens the union, and multiple political upheavals are creating a perfect storm for the continent.


Madison Faller, Global Market Strategist 

Matthew Landon, Global Investment Strategist

 

Our Top Market Takeaways for July 22, 2022

Markets in a minute

Another hawk joins the flock

 

Markets seemed to find some footing this week, but it wasn’t all smooth sailing.

Heading into Friday, both global equities and commodities rallied. Bond yields rose, particularly in Europe. Notably, the dollar weakened from 20-year highs relative to a basket of other currencies.

But earnings so far have been underwhelming, and SNAP was the latest to disappoint on Thursday. The stock fell more than -30% in after-hours trading. Concerns over advertising and a wider economic slowdown also weighed on tech names like Meta and Alphabet. Friday morning is bringing choppy waters.

The trickle of news surrounding layoffs and hiring pauses in the U.S. continued. Ford, Microsoft, and Apple also all announced plans to hit the brakes on hiring, or eliminate jobs all together. Still, all three companies look to close the week with gains.

U.S. homebuilder sentiment was dismal, and existing homes sales fell to a two-year low—hinting at the growth deceleration to come. Even so, a basket of homebuilder stocks was up almost 5% heading into Friday.  

Perhaps the only constant of the last several years is COVID. The White House released news that President Biden tested positive for the virus yesterday.

But this week, our attention was forced to Europe, where the European Central Bank (ECB) showed that they too are intent on cracking inflation. Yesterday, the ECB raised rates by 50 bps—its first hike since 2011, its largest since 2000, and officially ending negative interest rate policy that’s been in place since 2014. The hike comes at a trying time for the continent. In today’s note, we explore the challenges that have the European economy on the brink of recession.

Spotlight

Europe’s perfect storm

 
From a perilous energy crisis, to policy tasked with both tackling rampant inflation and supporting indebted nations, to unforeseen elections, Europe is facing a perfect storm of uncertainty. How do we make sense of it all?
 

Dilemma 1: An energy crisis that just keeps getting worse

While this week’s scorching heatwave may make cooler temperatures seem far away, we dare not forget winter is coming. The war in Ukraine and knock-on sanctions have upended energy supplies in Europe—the continent has traditionally imported a quarter of its oil and almost 40% of its natural gas from Russia. That said, it’s the geopolitical wrangling around the latter that stands to bring Europe to its knees.

We need gas for heating our homes, cooking and powering electricity. But, transporting gas is tricky during this war. It can be funnelled through pipelines, but Russia has been squeezing supply. Europe typically receives over a third of its gas through the Nord Stream 1 pipeline, which connects Russia to Germany. Despite resuming pipeline flows yesterday after maintenance closure earlier this month, it’s estimated the pipeline is only operating at 30-40% capacity. Meanwhile, Russia hasn’t upped gas channelled through other pipelines via Ukraine to compensate for the shortfall.

This chart shows the 7-day average of Russian natural gas exports to Europe in millions cubic meters per day from January 2019 to July 2022. In January 2019, the level is circa 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 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, Russia exports to Europe have fallen quite consistently. Noticeably, there is a sharp drop to around 200 million in January 2022, followed by a rise to around 350 million in early 2022 before a dramatic fall to less than 130 million cubic meters at the end of the series. This final contribution is made up of 62 million cubic meters via Nord Stream 1, 42 million via Ukraine, and 23 million via LNG.
Gas can also be shipped—through cooling it to the point it becomes a liquid (so-called liquified natural gas, or LNG). But LNG has to be regasified once it reaches its destination—a problem given some countries like Germany don’t have the necessary facilities. Overall, steps have been taken and proposals have been made to reduce consumption and find alternative sources for Russian gas (through both traditional sources like coal and renewable sources like wind and solar), but still fall well short of solving for the risk of an imminent cut-off of Russian supplies.
This chart shows the gas sources that the International Energy Agency (IEA) has proposed to replace Russian gas imports to Europe this year, measured in billions cubic meters. Of the 150bn cubic meters of gas imported from Russia, the IEA proposes that 85bn cubic meters can be replaced by alternative sources. These sources are: • Other piped gas and LNG: 30bn cubic meters • Coal: 22bn cubic meters • Heat pumps, energy efficiency, and turning down the thermostat: 14bn cubic meters • Nuclear and biomass: 13bn cubic meters • New renewables: 6bn cubic meters

Countries are working to stockpile gas reserves ahead of winter, and it’s possible tanks are successfully refilled to 80% of their capacity to get through it. Yet, some countries are more vulnerable (Germany, Italy) than others (United Kingdom, Sweden)—a dynamic that could lead to political squabbling over how best to send gas where it’s needed most. 

Dilemma 2: An ECB really on the move

With the energy crisis ongoing, commodity prices have pushed inflation across the Eurozone to records. The cost of living crisis is very real, despite still healthy balance sheets and pandemic-era savings on hand. Like the Fed, the ECB needs to tighten policy to have a fighting chance at price stability. Its 50bps hike yesterday ends an era of negative interest rates in the largest economy to ever try them.

Yet, given the euro area is a monetary union, more is at risk as the ECB goes on the offensive. As credit conditions tighten, more indebted nations like Italy can feel the effects more acutely than wealthier member states like Germany. The danger is that this fragments the single market, and ECB policy fails to transmit across all members in the same fashion. With that in mind, the ECB further unveiled an “anti-fragmentation” tool at yesterday’s meeting to combat that risk. TBD how effective it is (if ever used), details are still lacking, and markets are certainly questioning it—the spread between Italian and German government bond yields spiked higher, and are already at their highest levels since the COVID crisis. That said, it’s clear policymakers are serious about containing the risks.

This chart shows the spread between the 10-year Italian BTP yield and the 10-year German Bund yield from January 2013 to July 2022. The series begins at 2.8% and rises for the first three months to reach a series high of 3.5% on March 28, 2013. From here, the spread tightens over the next few years to 0.9% in March 2015. The series rises from here and then falls again before a sharp increase in spreads in May 2018 from 1.1% to 2.7%. Throughout 2018, spreads continue to move higher to 3.3% by November 2018, before declining back to 1.3% a year later. Spreads spiked to 2.7% at the onset of the pandemic and then fell back to a series low of 0.9% in February 2021. Since then, the spread between 10-year Italian BTP and German Bund yields has risen consistently and sharply to current levels at 2.4%.

Dilemma 3: Political battles on the home front

The risk of fragmentation grows further given snap elections are now inevitable in Italy. Prime Minister Mario Draghi (who you may remember as the “whatever it takes” former ECB President) officially resigned yesterday after attempts at salvaging a coalition government went up in smoke. Elections are likely to take place later this fall, and the new leader will be tasked with finding stability in the face of blistering inflation. Reforms are necessary, but agreement to get there will be tough.

Political uncertainty also reigns in the United Kingdom, where Prime Minister Boris Johnson was also essentially forced to resign the other week. The search for his replacement is contentious. The current level of weakness in the pound versus the dollar has only been seen twice in the last 50 years.

Investment takeaways

Near-term challenges, long-term opportunities

 

European assets have been under tremendous pressure, but have still managed to outperform the United States. so far this year. In local currency terms, the Stoxx Europe 600 is down “only” -11% year-to-date vs. the S&P 500’s -16%, thanks in large part to the region’s greater weighting to value-oriented companies and commodities. 

But, factoring in currency moves changes the story. The euro is reflecting a lot of the region’s weakness (even briefly trading one-for-one with the dollar last week for the first time since 2000)—a dynamic that reverses the region’s outperformance above (in U.S. dollar terms, European stocks are down over -20%) and may be partially behind all those anecdotes of Americans looking to move to Europe this summer.

That said, bad news could get a lot worse, and we prefer to focus on the long-term story when it comes to investing in Europe. The European investment landscape is undergoing an evolution, and new areas of opportunity are emerging. Broad markets could remain troubled for longer, but thematic opportunities aligned with policymaker priorities—such as around food and energy security, defense and infrastructure—could offer investors compelling growth when it is scarce.

Your J.P. Morgan team is here to help you think through these dynamics in the context of your portfolio.

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Our Top Market Takeaways for July 22, 2022.

All market and economic data as of July 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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