Europe: Ukraine Invasion — A Year On

24 February 2023

The end of China’s lockdown, signs global inflation is peaking, and the slower pace of US interest rate hikes have led investors to embrace the prospect of an economic “soft landing”. Financial market optimism has been particularly evident in Europe. Indeed, collapsing natural gas prices have led to a 10% rally in the Euro’s value, and have boosted equity prices 30% since October.

As Europe’s economic outlook remains clouded by events in Ukraine, the one-year anniversary of Russia’s invasion provides a good occasion to assess whether such optimism is warranted at this stage. To be sure, recent European business and consumer surveys point to “green shoots” of recovery. However, the following Chart illustrates this has not yet been translated into improved economic performance. Indeed, 2022 ended on a weak note: industrial production and retail sales declined 1.7% and 2.8% YOY respectively in December. And, Eurozone GDP advanced a meagre 0.1% during Q4 2022.

Investors must address several key questions. Will upbeat sentiment be reflected in improving Eurozone (EZ) economic performance, e.g. will Europe avoid recession? Will European GDP growth outpace the United States in 2023/24? When will Eurozone and US inflation return to the 2% target? What are the implications for ECB and Fed policy? Will the Euro’s rebound continue?

Energy Transition: Another Challenging Year Ahead

President Putin’s weaponisation of energy policy has required Europe to reduce/eliminate its dependence on Russian fossil fuels. Of course, a transition of this scale potentially poses a major economic headwind. Where is Europe in this process? The first achievement is that oil’s share of the European Union’s energy bill has declined sharply, while the role of natural gas (especially liquid NG) has risen. Indeed, in value terms Europe now imports almost as much NG as oil. While both are fossil fuels, NG’s CO2 emissions are much lower (Chart above). (It’s worth noting, however, the shift has been less significant in volume terms, as the relative price of NG to oil rose sharply in 2022).

So far, remarkably, Europe’s efforts to reduce its dependence on Russian fossil fuels has not resulted in an economic recession, as the EU has successfully found alternative energy sources. Reflecting Europe’s surprising economic resilience, the region’s overall energy imports (in volume terms) not only did not decline in 2022, but rose slightly returning to pre-Covid levels (Chart above).

On a geographical basis, Europe’s ability to diversify its oil suppliers has been impressive. Russia’s share of EU oil imports declined form 25% in 2021 to 14% by Q3 2022 (following Chart). Meanwhile, Saudi Arabia, and the USA (now Europe’s second largest petrol supplier) helped fill the gap. Europe has also found numerous new petroleum suppliers, most noteably Angola. Overall, while EU oil import volumes rose 8% last year, purchases from Russia declined 6%.

Arguably, the transition in natural gas has been even more impressive, as finding alternative suppliers is logistically more complicated. Again, Russia’s share declined from 39% in 2021 to 15% by Q3 2022. In volume terms, purchases of Russian NG declined 48% through Q3 2022. The USA and Norway played the largest role in filling the gap, along with the United Kingdom. Angola and Azerbaijan also increased sales substantially. Qatar, USA, and others sharply increased LNG supplies. The US is Europe’s biggest LNG partner: the US now provides the EU more NG than Russia.

However, as impressive as these achievements have been, there’s still a long way to go. Indeed, the growth headwind posed by this energy transition may last through 2024 at least. And, the next six months may be especially challenging. First of all, the EU has established ambitious goals. Seaborn imports of Russian oil and petroleum products will be banned by this February (with exceptions for landlocked countries). And, the EU aims to eliminate its dependence on Russian natural gas by mid-2024. Russia’s decision to halt NG exports to the EU last Autumn has accelerated the process.

The impact is already evident. High-frequency data from Bruegel indicate imports of Russian NG have collapsed in recent months (Chart above). Indeed, Russia’s share of EU NG imports declined below 10% by the end of 2022 (Chart below). In the period ahead, identifying alternative sources may become more difficult, and building needed NG infrastructure will take time. In the interim, natural gas prices are likely to rise. Likewise, as Europe seeks new sources of oil, the price of petroleum may increase (and the Brent/Ural spread to widen).

Germany is an important example, as Russian NG imports ended last Autumn (next Chart). Higher imports from the Netherlands, Norway, and elsewhere prevented a complete collapse. Nevertheless, total German NG import volumes declined 60% YOY in December (compared to a 44% fall in 2022 overall).

Generous government packages have cushioned the impact of higher energy prices for households and businesses. However, budgetary constraints soon may require this support to become more limited and focused (on most vulnerable groups). Indeed, there’s some evidence that government assistance is limiting the incentive to cut power consumption: the performance varies widely across countries (next Chart).

Fortunately, Europe enters this challenging period with a large inventory of Natural Gas, which will help smooth the transition away from Russian supply in coming months (Bruegel’s Chart below).

Post-Covid Recovery: Europe Lags Behind

Assessing the post-Covid economic performance provides insights into the outlook for the period ahead. The Chart above illustrates the US recovery has been much stronger than in Europe. Moreover, significant differences exist within the EU. The Scandinavian economies have outperformed, perhaps reflecting less economic “scarring” from the pandemic. At the other extreme, output in the United Kingdom and Spain has not yet recovered to pre-Covid levels. Germany has also been a weak link.

America’s more robust recovery in consumer spending has fueled US outperformance (Chart above). Differing approaches to supporting households during the pandemic, perhaps, accounts for the difference. In Europe, furlough schemes limited the rise in unemployment. In the USA, meanwhile, generous unemployment compensation has provided consumers with lots of cash to spend. Within Europe, consumer spending was again weakest in the UK, Spain, and Germany.

On the other hand, the undervalued Euro has allowed European exports to fare better than US competitors. Germany, again, has underperformed other EU neighbours. Meanwhile, UK exports remain below pre-Covid levels, despite an undervalued currency — who said Brexit isn’t leading to UK economic underperformance.

What does this tell us about the period ahead? Despite slowing growth, the US economy should outpace Europe in H1 2023, as Europe enters an intense phase of its energy transition. Declining real incomes will curb consumer spending in both regions. Europe should still benefit from an undervalued Euro. But, I expect Europe to outperform the USA in H2 2023 and into next year. The key driver will be differences in the outlook for inflation and monetary policy — topics to which I will now turn.

Inflation: Wages Are Key to Persistence

To be sure, Europe confronts a challenging inflation environment. In recent months, while US inflation has peaked, Eurozone (EZ) price growth has continued to accelerate. And, European inflation now exceeds that in the USA. For instance, US PCE inflation has eased from 7% to 5% during H2 2022; meanwhile, Eurozone inflation stands at 8.6% (having peaked only in October at 10.6%). Similarly, US core PCE inflation has cooled to 4.4% (from 5.2%) in recent months. Meanwhile, EZ underlying price growth has accelerated to 5.3% (from 4%).

Does this suggest that Europe will face a more persistent inflation problem than the USA? Probably not. Ultimately, wage growth is the key driver of underlying prices. Despite tightening labour markets, so far European compensation has not accelerated as much as in the USA (Chart above). The UK’s situation is even more challenging.

In recent months, the USA has benefited from slowing goods price increases, which have cooled to only 1.3% in January. However, as compensation represents the largest cost for service industries, out-sized US pay awards have led to accelerating inflation in this key sector (representing 80% of US GDP), up from 6.2% to 7.6% since June 2022. Reflecting more modest wage growth, European service sector inflation remains lower (Chart above). Furthermore, as in the USA, Eurozone inflation should benefit from slowing price increases in both the goods and energy areas in the period ahead. To be sure, the EZ inflation environment remains troublesome, but more modest pay gains suggests inflation may recede towards the 2% target by the end of 2024. In the USA, meanwhile, core inflation may prove stickier: remaining in the 2.5%-3% range even at the end of next year.

Strategic Implications

  • Of course, Europe’s outlook will remain clouded by events in Ukraine. The EU’s energy transition has been impressive, but the next six months could be particularly challenging. The US has played a key role in reducing Europe’s reliance on Russian fossil fuels. Oil and NG prices may rise as Europe seeks new suppliers of energy.
  • Europe’s economy will flirt with recession in H1 2023, and will continue to lag the USA. However, I expect EU GDP to outperform beginning in H2 2023 and into 2024. In both areas, tepid GDP gains will remain below long-term potential growth rates. Germany and the UK will continue to be weak links. Scandinavia should outperform, reflecting less Covid scarring and lower dependence on Russian energy.
  • The EZ inflation environment remains difficult. Reflecting more modest wage growth, however, European price growth will return to target range earlier than the USA.
  • The Fed’s terminal interest rate will exceed the ECB’s. In both cases, interest rates will remain higher for longer than the market expects (Chart above).
  • The Euro’s rally may stall in H1 2023, reflecting weak near-term EU economic prospects. However, the US dollar should weaken further in late 2023 and into 2024, as I expect the US economy to slip into a mild recession towards the end of this year.