European Markets: Intact or In Tatters?

12 May 2022

In my 2022 Strategy blog entitled “Avoiding Stagflation?” (published 1 December 2021), I suggested global financial market volatility was poised to rise, and equity and bond returns would be negative. On a relative basis, however, I made the case for an outperformance of European markets. Much has happened during the past six months: inflation and interest rates are rising sharply, the war in Ukraine threatens a broader European conflict (and, perhaps, a World War), and Russia’s invasion has focused attention on Europe’s dependence on Russian energy.

During the financial market correction of the past 6 to 12 months, however, European markets have outperformed global equities, and have roughly kept pace with the S&P500. With a further deterioration in global economic fundamentals likely, and market sentiment negative (especially regarding Europe’s prospects), this is a good opportunity to review whether the case for European outperformance remains intact……or is it in tatters!

Inflation: Rising Everywhere, But Europe Better than USA

To be sure, European inflation has increased sharply: “core” CPI has risen to 3.5% from 2.3% at the beginning of the year (and from less than 1% a year ago). And, the 7.5% advance in headline inflation is the highest in nearly half a century! Nevertheless, prospects in Europe are better than in the USA. First of all, US core and headline inflation is not only higher than in the Eurozone, but the acceleration has been sharper and more broad-based. Indeed, the Chart above illustrates US price pressures are greater for both goods and services, as well as food. On the other hand, European energy prices have risen far more than the large gain in the USA — a situation that’s not likely to change soon.

Likewise, European labour market conditions have improved dramatically. Employment is higher and unemployment and the jobless rate are both lower than pre-pandemic levels. Indeed, all three measures are the healthiest in nearly three decades. And, unlike the USA, the labour force participation rate is at an all-time high. From an inflation perspective, most importantly, European wage pressures have not picked up yet, despite tighter labour markets. This is in distinct contrast to the USA, where a classic wage-price spiral is emerging, especially as inflationary expectations have deteriorated in recent months.

So, the case for a relatively better European inflation outlook remains intact. Indeed, I expect Eurozone CPI advances to peak during the summer, and begin declining during H2 2022.

Monetary Policy and Equity Market Derating

In my 2022 Strategy outlook, I suggested the US S&P 500 P/E ratio would decline as US interest rates (especially real rates) increased. Indeed, so far this year valuations have derated from 21X to 18X forward earnings projections. The logic is straightforward: discounting future earnings with a higher interest rate deflates valuations. In addition, the Chart above illustrates the US Equity Risk Premium (e.g. the gap between equity yields — the inverse of the P/E ratio — and US bond yields) is narrower than in many years. This suggests US equity valuations are now very expensive relative to fixed-income alternatives; thereby, leaving stocks vulnerable as the US Federal Reserve tightens monetary conditions.

However, this is not true in Europe. The Chart above illustrates the Equity Risk Premium remains high, which offers stocks a degree of protection as bond yields rise. As interest rates increase, therefore, the valuation case for European equity market outperformance remains intact. In addition, as European inflation risks are more modest, Eurozone bond yields should rise less than in the USA. Indeed, the gap between US and Eurobund yields has widened 30bp year-to-date. To be sure, the ECB will likely begin tightening monetary policy this summer. But, markets are projecting that Euribor rates will peak near 1.75% compared to over 3% in the USA.

Economic Outperformance: Europe’s Case Weakens

My case for European market outperformance also relied on the prospect for stronger 2022/23 GDP compared to the USA. This now seems less likely. Indeed, supply chain disruptions, higher Covid cases (hopefully now past), and the impact of the war in Ukraine (to be discussed later) have been taking a toll on European manufacturing activity during the past year. With Covid restrictions easing, fortunately, rebounding service and consumer sectors appear to have helped cushion the impact (Chart above).

As always, the economic outlook will depend greatly on consumer spending. In both the US and Europe, rising inflation will reduce real household incomes, and consumer outlays are likely to be sharply curtailed in the year ahead. Correctly, I had hoped Europe’s elevated savings rate would cushion the pain. However, Europe’s savings rate is now back in line with its long-term average, although it remains well above the USA’s level. Therefore, European households will be less able to offset troubles in the region’s manufacturing sector. As a result, Europe’s GDP growth is not likely to outpace the USA in the period ahead.

Germany: Growth Engine Now the Weak Link?

A key feature of Europe’s economic landscape recently has been the relative weakness of Germany. Indeed, Germany’s recovery from the pandemic has lagged the rest of the region (Chart above). As an exporting powerhouse, Germany has been adversely impacted by supply chain bottlenecks. And, while Germany’s Covid performance compares favourably to many other countries, the most recent Delta-wave impeded Germany’s rebound earlier this year. Moreover, the Chart above indicates German economic performance lags those countries with the best Covid track records, e.g Denmark, et al (see the Chart below).

While Covid risks are hopefully receding, Germany remains particularly exposed both to supply chain issues and Europe’s attempts to reduce its dependency on Russian energy sources (next section). Indeed, in its recent World Economic Outlook, the IMF sliced its 2022 German GDP forecast by 2.5% (compared to its October 2021 projections) — twice the forecast reduction for the overall global economy.

Reducing Russian Energy Dependence: Who’s At Risk?

Despite the successful imposition of broad-based sanctions, Russia recorded an unprecedented $60 billion current account surplus in Q1 2022 (Chart above). Thwarting Russia’s ambitions in Ukraine, therefore, will require Europe reduce, and eventually eliminate, its dependence on imported Russian energy. From an investment perspective, we must assess how painful the transition will be, and which countries will bear the heaviest burden.

The Chart below indicates that Eastern Europe, Finland, Austria, and the Baltic countries are the most vulnerable to curtailment of Russian energy supplies. Scandinavia, the Iberian peninsula, and France are better positioned. Germany relies on Russia for about 30% of its energy supply. But, as the region’s largest importer of Russian energy (in Euro amounts), weaning Germany off Russian energy is critical to curbing financial flows to Russia.

Coal: Germany, Turkey, Czech, Eastern Europe at Risk

What are the prospects of reducing Europe’s consumption of Russian energy? First of all, the EU has now committed to eliminating Russian coal imports by August 2022. How difficult will this be? In recent years, coal’s share in European energy consumption has been declining sharply; now representing only 10% of the region’s energy supply. Usage varies widely by country. The black rock accounts for 41% and 32% of the energy needs of Poland and Czech respectively, and 15% in Germany. At the other extreme, France, Spain, and the United Kingdom barely consume any coal.

However, as EU coal production has declined, dependency on Russia has increased (Chart above). But, Germany and Poland alone account for over 50% of all coal imports from Russia. Replacing Russian coal, therefore, neither will be particularly difficult, nor cause major disruptions in the global market. Ample spare capacity exists in Indonesia, Australia, South Africa, and Colombia: all would love to regain lost market share in Europe. Likewise, the EU could also increase coal production temporarily; indeed, the decline in European coal output in the past two years exceeds the region’s imports from Russia.

Oil: Challenging, But Sources Well Diversified

To a certain extent, oil (not natural gas) represents Europe’s biggest challenge to meeting its climate goals and reducing its dependency on foreign supplies. Indeed, oil accounts for 71% of EU energy imports (natural gas 17%), and represents 38% of the region’s overall energy consumption (natural gas 24%).

The Chart above indicates Russia is the region’s largest foreign supplier: nearly 3X imports from Norway. The level of vulnerability, however, differs widely across EU Member States (next Table). Again, Finland, Hungary, Slovakia (and other Eastern European nations), Benelux, and the Baltic states (especially Lithuania) are most at risk. Likewise, Scandinavia, Iberia, France, the UK, and USA are better positioned. Given the size of the German economy, its sccounts for roughly 25% of European imports of Russian oil. And, Russia represents roughly 33% of German oil imports: compared to 25% for the EU overall. Meanwhile, Russia’s dependence on Europe is also worth noting: exports to the region represent 50% of sales abroad and 25% overall Russian oil production.

How difficult would it be to eliminate Russian oil imports by the end of 2022, as the EU Commission has proposed? For some countries, very tough. However, the earlier Chart illustrates that Europe’s sources of petroleum supplies are quite diversified. Can other partners make up the lost Russian supplies? The US Energy Information Agency (EIA) estimates OPEC countries have over 3 million barrels per day of spare production capacity, which exceeds Europe’s purchases from Russia. In addition, production in Venezuela and Iran is well below peak levels. And, US output remains 1.5mbd below pre-pandemc levels. So yes, replacing Russian exports would be possible. And, while oil markets are tight, the impact on global prices may be less than feared, especially as global demand may weaken in H2 2022 as worldwide GDP growth slows (although the Brent-Ural spread will widen further).

Natural Gas: Now the Hard Part

Natural gas is the most difficult piece of the puzzle. To be sure, natural gas accounts for less energy consumption than oil: 24% versus 38%. And, Europe imports twice as much petroleum than natural gas. However, the region’s sources of natural gas supplies are less diversified than oil, and Russia plays a larger role: 40% market share compared to oil’s 25% (Chart above). Likewise, Russia is more dependent on Europe for natural gas than petroleum: NG exports to the EU represent 72% of total sales abroad (49% for oil).

The earlier Table illustrates that the Baltic nations, Eastern Europe, and Austria are particularly vulnerable. While Germany may not be quite as dependent, 60% of its NG comes from Russia. And, Germany is the region’s largest importer of Russian NG (in Euro amounts), accounting for 25% of the area’s purchases (Italy ranks second).

In addition, European NG inventories are now extremely low. Restocking may require large-scale Russian imports over the summer.

What are the options in reducing/eliminating the 155 billion cubic metres (bcm) of imported Russian gas? NG delivered by pipeline accounts for roughly 85% of EU imports. Conceivably, pipeline imports from Algeria, Libya, Azerbaijan, and Iran could rise, but these would be marginal gains. Norway is already the region’s second largest supplier, but capacity constraints may limit its potential to dramatically increase supplies.

Therefore, much rests on increasing supplies of liquid natural gas (LNG), which amounted to about 80bcm (15bcm from Russia) in 2021. Fortunately, the Chart above indicates LNG imports have risen in 2022. Increased exports from the USA, which have advanced sharply in recent years, are largely responsible (next Chart). The USA (already Europe’s largest supplier) has pledged to increase LNG supplies to Europe by 15bcm this year, and by 50bcm in 2030. Qatar, Europe’s second largest LNG supplier, has great potential, as do several African nations and Trinidad. At present, Europe imports no LNG from Australia, the world’s largest exporter.

However, there are numerous constraints on rapidly increasing EU LNG imports. Severe infrastructure difficiencies will take 2-3 years of investment to fully remedy. Also, LNG contracts are long-term. Suppliers may be reluctant to divert sales to Europe from reliable Asian customers, especially as EU climate goals involve a reduction in NG consumption over the long term.

As alternative near-term supply options are limited, eliminating European NG imports from Russia will likely require efforts to curb demand, including slower GDP growth, rationing, etc.

Reducing Russian Dependence: Economic Costs

Recently, both the EU Commission and the International Energy Agency (IEA) published roadmaps to reduce Europe’s reliance on Russian energy. The former aims to cut EU NG imports from Russia by two-thirds by the end of 2022, and eliminate Russian imports by 2030. The IEA plan wants to reduce NG imports by over 50% this year without threatening EU climate goals.

Both plans share many features, aiming to slice NG imports by 100bcm by the end of 2022. Both combine measures to cut energy demand, and to shift towards alternative energy sources. How feasible are they? On the supply side, both rely heavily on boosting LNG imports by 50bcm, which seems challenging. New suppliers of NG delivered by pipelines, however, could quite feasibly add 10bcm. Delaying planned decommissioning of nuclear sites, especially in Germany, could add 15bcm. Temporarily utilising additional coal and oil, especially in electricity production, could save another 25bcm. Likewise, while increasing renewable usage is the long-term answer, this source could save 5bcm even in 2022.

On the demand side, simply reducing thermostats by 1 degree Celcius could save 10-15bcm. Again, improving energy efficiency in industry, homes, and construction is a long-term aim, the plans suggest these measure could save 5-10bcm this year.

With the exception of the ambitious LNG target, these plans appear feasible. The near-term economic consequences do not appear catastrophic, nor should the EU’s climate targets be unduly threatened (e.g. cutting emissions 55% by 2030 and achieving net-zero by 2050). Indeed, eliminating Russian fossil fuel imports should accelerate investment in the energy transition, and may make achievement of the climate goals more likely. Recent estimates of the economic costs of eliminating Russian energy imports range from 0.2% to 5% (in part depending on the length of the transition period). Indeed, this suggests huge uncertainty, but the near-term consequences could be less than the Covid pandemic or the Global Financial Crisis. Longer-term, the transition away to a net-zero economy will boost, not reduce, GDP growth.

Strategic Considerations

  • I remain very cautious on equity markets. But, while the case for European outperformance has weakened, I still expect Eurozone returns to outpace global indices (for both stocks and bonds).
  • As the US Federal Reserve will remain more aggressive than the ECB, the US dollar should strengthen further (until the US economy cools later this year).
  • The ECB will tighten monetary conditions this Summer, but will proceed cautiously until the consequences of the Ukrainian war are more evident.
  • To be sure, transitioning from Russian energy sources will have near-term economic consequences. However, as these costs appear manageable, sanctioning Russian energy should proceed in coming months.
  • The risk of recession in 2022/23 is at least 25%, but I am hopeful this will be avoided, as Eurozone inflation peaks in H2 2022.
  • Despite slowing global growth, energy prices may rise further, especially for natural gas and LNG.