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Investing

Investing in Europe as recession threatens and war continues

There are long-term investing opportunities aligned with policymakers’ priorities in energy transition, food security and defense.


War-time economics is complex, and Europe’s economy seems to be short circuiting. A perilous energy crisis has pushed inflation to record levels, is squeezing households, and threatens to worsen in the cold winter months ahead.

Import prices are soaring. Consumer confidence is the weakest it’s been since the European Union (EU) started tracking it. Business sentiment is weakening. The European Central Bank (ECB) is trying to do what it can. Governments are looking to crisis-management strategies: price caps, excess profits taxes and rationing.

Avoiding recession will be difficult. Yet profound disruption also brings investing opportunities.

Can Europe avoid a recession?

Whether or not Europe can steer clear of recession lies in how the energy crisis is managed.

The war in Ukraine and sanctions against Russia have upended Europe’s energy supplies. Russia was the continent’s traditional source for a quarter of its oil and almost 40% of its natural gas. Households and businesses need gas for heating, cooking and powering electricity. But transporting gas now is tricky, and high demand relative to limited supply has sent prices out of control.

European natural gas, even with a recent move lower, is still trading more than 60% higher* than a year ago. The EU succeeded over the summer in refilling its stockpiles of liquified natural gas (LNG), mostly from the United States, hoping to avoid rationing this winter. (Storage currently stands at average levels, meaning close to 90%.)

The real challenge will come in 2023.

Russia continues to limit the flow of natural gas to the continent—most recently through the closure of the Nord Stream 1 pipeline—and has given no indication of when the supply will resume. Despite higher LNG shipments from elsewhere, storage levels for winter 2023 are likely well short of what will be needed. Moreover, a colder than expected winter this year could draw heavily on reserves and exacerbate the shortage.

Sources: Bloomberg Finance L.P., EIA, CREA, JPMAM. Excludes pipelines to and through Turkey. Annual LNG data amortized daily until 2022. Data as of September 10, 2022.

Sources: Bloomberg Finance L.P., Gas Infrastructure Europe. Data as of September 30, 2022.

The war represents a large “terms of trade” shock to the eurozone economy, in which import prices have surged disproportionately to export prices. Such large price fluctuations this winter could worsen the war’s economic fallout across the region.

Energy exporters, including the United States and Canada, should benefit. They will almost certainly be satisfying Europe’s energy needs for many years as Europe pivots away from Russian imports.

Europe is suffering  a terms of trade shock as import prices surge relative to export prices

Sources: Statistical Office of the European Communities, Haver Analytics. Data as of June 30, 2022.

The nearly 7% decline in the eurozone’s terms of trade since the start of the war could, in isolation, wipe away about one-third to a half of the GDP growth that would have occurred in 2022 and 2023 had the war not broken out. Risks to this projection are also skewed to the downside, particularly if the energy situation proves disorderly and disrupts European industrial sectors, particularly in Germany, where growth is more reliant on manufacturing and trade.

The challenges of monetary policy

Such a terms of trade shock pushes inflation higher, squeezes incomes and hurts a country’s reserves and external debt. Such conditions make designing policy solutions all the more challenging.

Higher energy prices have to be paid for by corporations passing on the costs to customers and governments potentially providing subsidies, caps or stimulus to help people pay the bills. But with risks skewed toward a worsening crisis, price caps and subsidies could prove insufficient. Rationing that stamps out demand may be needed to build sufficient energy supplies for next year. 

At the same time, the ECB, like the Federal Reserve, is expected to continue to tighten policy in order to have a fighting chance at price stability. Yet because the eurozone is a monetary union, there is more at risk as the ECB goes on the offensive. As credit conditions tighten, the more indebted nations, including Italy, will feel the effects more acutely than wealthier member states such as Germany.

The danger is that ECB policy will fail to transmit across all members effectively and will fragment the single market. The spread between Italian and German government debt (an indication of funding stresses in the periphery versus central Europe) is hovering around its highest levels since the depths of the COVID-19 crisis.

Emerging investment opportunities in Europe

Some investment strategies can thrive in a downturn.

The euro has depreciated meaningfully, falling 12% versus the U.S. dollar year-to-date and below parity for the first time in two decades. For example, Europe is suddenly “cheap” for American tourists. Indeed, the number of tourists visiting Europe this past summer soared to pre-pandemic levels.

Europe is now cheap for those with dollars

Sources: Bruegel, Haver Analytics. Data as of August 31, 2022.

A cheap euro should buffet Europe’s economy from the war shock in the short run, set the stage for faster growth in export sectors over the medium term, and eventually help to adjust Europe’s economy.

Given that currencies tend to “overshoot” when external shocks inflict damage on economies, now could be an opportune moment for U.S. dollar–based investors to pick up euros at historically depressed levels, or to consider investments in European real assets, such as real estate and infrastructure.

At the same time, the stresses related to the current crisis and COVID-19 aftershocks have made it difficult for many Europe-based companies to maintain their profits and service their debts. Loan defaults are already on the rise. A window appears to be opening for investors with expertise in special situations to acquire at a discount and restructure troubled credit and real estate assets. Such strategies can also generate yield in portfolios and returns with an opportunity for downside protection.   

And investing opportunities aligned with policymakers’ priorities—around themes such as the energy transition, food security and defense—could offer long-term investors growth at a time when it is scarce.

We can help

For a thoughtful analysis of how such strategies might fit into your portfolio and best align with your family’s goals, reach out to your J.P. Morgan team.

*As of October 6, 2022.

 

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