European Union: Cohesion amid adversity

T

he conflict appears likely to push stubborn inflation even higher and dent growth in many countries around the globe, but it could affect Europe more than most.

The biggest impacts, in our view, are likely to take the form of commodity prices being greatly elevated for longer, and supply chains – which had shown tentative signs of improvement earlier in the year – facing new stresses, given that Russia is a major provider of essential metals and agricultural resources.

We estimate the conflict could drive US inflation measured by the Consumer Price Index to 8.5%, up from the 7.5% previously pencilled in. An even longer period of higher inflation would increase the risk of inflation expectations becoming stuck at a higher level.

We also estimate tentatively that a scenario of moderately elevated commodity prices and depressed demand due to the conflict could subtract 0.2% to 0.5% from global growth, bringing his US growth estimate down to 3.1% for 2022.

Europe is particularly vulnerable to these disruptions because it imports close to 40% of its natural gas and 25% of its oil from Russia, though the level of dependence varies from country to country.

With the caveat that estimates are highly changeable given the fluidity of the situation, we assess the potential impact on European growth to be on the order of 0.7% of GDP, bringing his GDP growth forecast for 2022 down to three percent—still above the historical average. The region ended 2021 with particularly strong momentum, some of which is likely to spill over into spring and summer economic activity. But a higher inflation outlook is likely to hurt household wallets in Europe eventually, despite government support. To a lesser extent, a reduction in European exports to Russia, which represented 0.6% of regional GDP in late 2021, would also weigh on growth.

A worst case scenario, which is less likely in our view, would be for Russia to entirely shut off its energy taps to Europe. This would have a larger impact, with global growth likely taking a one percentage point hit and European growth falling by as much as two percentage points, in our view.

Europe could cope with these new circumstances for a time by tapping regional and national strategic reserves, importing more natural gas, and possibly imposing mild measures to cap demand such as limiting some industrial gas uses. Most EU members should then be able to make it to next winter without severe shortages.

Living without Russian gas for a longer period of time could prove challenging, as long-term supply contracts often limit the flexibility of producers to redirect large volumes of gas to new buyers. Some suppliers outside of Russia are also already producing and exporting at full capacity.

An extreme disruption in the supply of energy would increase the risk of a recession in Europe.

For central banks, the higher inflation outlook is problematic. They now need to balance the risk of higher inflation against the risk of lower growth.

We believe most should recognise that the geopolitical situation warrants caution, and may slow the pace of policy normalisation, including rate hikes, over the next few months. The dilemma could be most acute for the European Central Bank (ECB).

We now expect the ECB to postpone the announcement of the end of its Asset Purchase Programme by six months, to September, and to increase interest rates only in 2023 instead of later this year.

In the face of this adversity, profound transformations are taking place in the regional bloc. Regional cohesiveness has increased, and attitudes towards fiscal rectitude are relaxing.

The war has brought member countries closer together. The decision by German Chancellor Olaf Scholz to approve the export of lethal weapons to a conflict zone for the first time since World War II is a notable development which could enable more coordination at the EU level. The threat of external aggression may also shift the balance towards a greater tolerance for decision making at the EU level rather than at the national level.

The war also appears to be reducing the appeal of euro-sceptic political parties, both from the extreme right and extreme left, which have at times cited Putin as a role model. This reduces the risk of an anti-EU government being elected in France or Italy – French elections will take place in April –, and likely channels the political winds more firmly towards the centre.

Importantly, we think Germany abandoning its long-held preference for reining in fiscal deficits should diminish tensions within the bloc, where limiting national deficits to three percent of GDP has been a thorny issue for years. German Finance Minister Christian Linder is now advocating for increased defence spending representing 2.7% of his country’s GDP, with further increases possible thereafter. A more constructive tone from Germany, long a fiscal hawk, suggests a review of EU fiscal policy—a key topic under discussion this year – could result in a more accommodative stance on what constitutes an acceptable level of budget deficit, as opposed to a fiscal policy straightjacket.

The transition towards cleaner and greener energy policies, a key regional focus, may well stall in the short term as a result of the conflict. On the one hand, Germany’s advocacy for a more rapid build-up of renewable capacity as an investment in “freedom” from Russian energy dependence – and, by extension, Russian influence – as well as its decision to bring forward its goal of 100 percent green power to 2035 from 2040 represent a strategy likely to be copied by other countries.

On the other hand, coal-burning power plants could be revived and the closure of German nuclear plants might be postponed as short-term measures to reduce dependence on Russian energy. Nonetheless, the decarbonisation push remains an area where Europe stands out relative to other regions, given it is home to numerous leading global companies that should be well positioned to benefit from the pickup in green spending this decade.

Despite a more complicated outlook for the region as a result of the war, and inevitable volatility in the short to medium term, we continue to suggest holding a modest Overweight position in European equities.

So far in 2022, the MSCI Europe ex UK Index is down more than 11 percent in local currency terms, leaving it trading on 14x its 12-month forward earnings, a steeper-than-average discount to the U.S. on a sector-neutral basis. This low valuation suggests the severity of the situation and the upcoming downgrade in growth forecasts have largely been discounted in the price.

In addition, we think recent developments in the region – including increased cohesion as expressed by the EU’s swift action on sanctions, Germany’s foreign and fiscal policy U-turns as well as its possibly more lenient approach to EU fiscal rules, and decreased concerns that anti-EU political forces could prevail in a large country – all point to reduced tensions within the bloc. We think the changes lower the risk of a potential EU breakup, and increase the likelihood of more fiscal support for the regional economy. These profound transformations could contribute, in time, to reducing the valuation discount historically attributed to the region.