Energy War and European Markets
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Bottom line: Europe's policymakers are shifting to accelerating support for households and (to a lesser degree) businesses in the face of the ever-clearer gas and electricity price shock (here).This is coming alongside a more medium-term aim to decrease the impact of Russian gas on European gas/electricity prices alongside the objective of moving away from Russia gas dependency. The immediate support will likely lessen the risk of severe recession in Europe, while we also feel that money markets are overdone in the scale of ECB monetary policy tightening discounted by early 2023.
Market Implications: Market expectations that the ECB will lift the deposit rate to 2% by early 2023 look overdone, as a EZ recession will reduce underlying inflation pressures; labor market flexibility avoids a EZ wage inflation problem and the Euro will likely avoid a downward spiral as fiscal support tempers deep recession fears. EZ equity market will likely not underperform the U.S. materially, as an EZ recession will likely be small to modest rather than large. EZ equity losses are still likely though, both as a recession is not fully discounted and the U.S. equity market remains vulnerable to losses.
Figure 1: EZ Gas Price Rollercoaster (TTF EUR MWH)
Source: Bloomberg/Continuum Economics
A number of developments have occurred in the last few days in the Energy War in Europe. Key points include
- Russia shutting Nordstream One.Russia announced that a “leak” meant that Nordstream 1 to Germany would be closed indefinitely, which has prompted a renewed jump in European gas prices (Figure 1) after last week's plunge on higher than expected inventory levels and hopes that the EU would provide emergency relief. It is worth noting that the flows through the Ukraine gas pipeline to Europe are reported to have increased over the weekend, so this is not a complete cut off from Russia.
- G7 oil price cap or Putin tactics? G7 finance ministers agreed to move forward on an oil price cap on Friday, which is seen by some as a trigger for Russia's Nordstream decision.However, it remains unlikely that China, India and Asia buyers will agree to the price cap, while Russia is already discounting oil prices. If anything, the G7 willingness to exempt the planned penal EU seaborne insurance ban (provided that the cap is not exceeded) actually reduces pressure on Russia oil export volumes. In reality, the Nordstream 1 decision is also likely to be a tactical reaction to higher than expected European gas inventory builds and the desire to try break German and EU cohesion before the winter. This would suggest Nordstream 1 could remain symbolically closed while gas flows through other pipelines remains close to recent restrained levels through the autumn.
- Emergency EU energy ministers meet on September 9.Reports suggest a lot of different proposals (here) are being considered by EU energy ministers including EU wide plan to reduce demand for gas and electricity; a Spain style wholesale gas and electricity price cap; a Greece proposal to split renewable and fossil fuel sourced electricity prices; restricting wholesale gas and electricity market functioning; windfall taxes on power producers; reduced carbon emission prices to ease electricity prices and support for distressed power distributors – action already taken in Sweden over the weekend. (The UK has a separate announcement possibly later this week, which we will review in a separate article later this week).
- A template: Demand reduction, plus a German style windfall tax and borrowing for fiscal support short-term. Internal high level EU political agreement on the most favoured proposal has not yet been reached, though the majority accept the principle that more household/business support is needed and electricity and gas prices need to come down. Favoured proposals could have to wait for EU Von der Leyen's state of the union speech on September 14 and will most likely require an emergency EU heads of state meeting to reach final agreement. However, the German coalition announcements over the weekend could provide a template. The €65bln package includes windfall taxes on power producers and energy companies alongside borrowing to pay for a package of fiscal transfers for households and businesses. This does not stop medium-term measures to break the link between wholesale gas and electricity prices, but provides breathing space until EU policymakers can implement changes to the gas and electricity market and also reset EU energy supply – EU households also use gas for winter home heating.
Market Implications
This all matters for European financial markets, as concerns about a recession have grown with the surge in gas and electricity prices set to hit EU and UK businesses – the UK is still inter-linked with the European gas and electricity markets (here). While economists have been cutting growth forecasts including ourselves (here), European central banks are worried that existing inflation pressures will be amplified and made more persistent by apparent 2nd round inflation risks.Hence the increased hawkishness from central banks that has prompted a jump higher in government bond yields over the past 2 months (Figure 2), which has been greater in the EZ and UK than the U.S. – the rethink on Fed Funds has played a part, but a renewed inflation shock in EZ/UK has also contributed. Even so, we feel that the market is too aggressive on ECB rate hike thoughts and we look for 50bps at the September 8 meeting (here), while we also continue to feel that fears of a 4% UK policy rate by early 2023 are overdone as higher energy prices will slow underlying inflation through a recession (we shall be releasing a preview of the September BoE meeting by mid-week).2yr yields could now well be overdone in Italy and UK, though 10yr yields need soothing from Italian and UK fiscal credibility in the next few months. In the UK case, financial markets are worried about incoming PM Truss fiscal plans and the impact on the deficit and debt trajectories. German government bond yields are about right given the end of the negative interest rate era.
Figure 2: German/Italian/UK and U.S. 2 and 10yr Government Bond Yield Changes since 30 June 2022 (%)
Source: Datastream/Continuum Economics
European equity markets have lagged the bounce in the U.S. equity in July and August, but this is modest rather than material (Figure 3) and 2022 and 2023 earnings outlook in Germany and UK are not yet consistent with a technical recession view. Thus, further downside could be seen, as German and UK recessions arrive. However, this will likely not translate into material underperformance versus the U.S. before end 2022, as the U.S. equity market is not discounting the recession that we see late 2022/early 2023 and the U.S. equity market is vulnerable to earnings expectations being downgraded – the S&P500 12mth forward P/E ratio is also only in a normal band, while European equity markets are now cheap. We see the S&P500 down to 3750 by end 2022 (here).
Figure 3: German/UK and U.S. Equity Market (30/06/22 = 100)
Source: Datastream/Continuum Economics
Finally, the EUR has intermittently been weak against the USD when European gas prices have jumped, as the relative recession risk is seen to increase in Europe relative to the U.S.However, EUR/USD over the last 2 months has also been impacted by the upward adjustment in Fed Funds expectations towards 4%.Additionally, on a broader trade weighted exchange rate basis the EUR is not so weak (here). We can see further USD strength versus the EUR in the next 1-2 months, but then the USD reversing and ending the year around 2% weaker than current levels versus the EUR. By end 2022 data will likely show that the EZ recession is modest rather than large, while tightening U.S. financial conditions will be tipping U.S. data into recession territory and ending Fed tightening.