Is Europe on the brink of recession?
An ongoing energy shortage, policy tightening that threatens the union, and multiple political upheavals are creating a perfect storm for the continent.
Our Top Market Takeaways for July 22, 2022
Markets in a Minute: Another hawk joins the flock
Markets seemed to find some footing this week, but it wasn’t all smooth sailing.
Heading into Friday, both global equities and commodities rallied. Bond yields rose, particularly in Europe. Notably, the dollar weakened from 20-year highs relative to a basket of other currencies.
But earnings so far have been underwhelming, and Snapchat (SNAP) was the latest to disappoint on Thursday. The stock fell more than -30% in after-hours trading. Concerns over advertising and a wider economic slowdown also weighed on tech names like Meta and Alphabet. Friday morning is bringing choppy waters.
The trickle of news surrounding layoffs and hiring pauses in the U.S. continued. Ford, Microsoft, and Apple also all announced plans to hit the brakes on hiring or eliminate jobs all together. Still, all three companies look to close the week with gains.
U.S. homebuilder sentiment was dismal, and existing homes sales fell to a two-year low, hinting at the growth deceleration to come. Even so, a basket of homebuilder stocks was up almost 5% heading into Friday.
Perhaps the only constant of the last several years is COVID. The White House released news that President Biden tested positive for the virus yesterday.
But this week, our attention was focused on Europe, where the European Central Bank (ECB) showed that they too are intent on cracking inflation. Yesterday, the ECB raised rates by 50 bps—its first hike since 2011, its largest since 2000, and officially ending negative interest rate policy that’s been in place since 2014. The hike comes at a trying time for the continent. In today’s note, we explore the challenges that have the European economy on the brink of recession.
Spotlight: Europe’s perfect storm
From a perilous energy crisis, to policy tasked with both tackling rampant inflation and supporting indebted nations, to unforeseen elections, Europe is facing a perfect storm of uncertainty. How do we make sense of it all?
Dilemma 1: An energy crisis that just keeps getting worse
While this week’s scorching heatwave may make cooler temperatures seem far away, we dare not forget winter is coming. The war in Ukraine and knock-on sanctions have upended energy supplies in Europe—the continent has traditionally imported a quarter of its oil and almost 40% of its natural gas from Russia. That said, it’s the geopolitical wrangling around the latter that stands to bring Europe to its knees.
They need gas for heating their homes, cooking, and powering electricity. But, transporting gas is tricky during this war. It can be funnelled through pipelines, but Russia has been squeezing supply. Europe typically receives over a third of its gas through the Nord Stream 1 pipeline, which connects Russia to Germany. Despite resuming pipeline flows yesterday after maintenance closure earlier this month, it’s estimated the pipeline is only operating at 30-40% capacity. Meanwhile, Russia hasn’t upped gas channelled through other pipelines via Ukraine to compensate for the shortfall.
Gas can also be shipped—through cooling it to the point it becomes a liquid (so-called liquified natural gas, or LNG). But LNG has to be regasified once it reaches its destination—a problem given some countries like Germany don’t have the necessary facilities. Overall, steps have been taken and proposals have been made to reduce consumption and find alternative sources for Russian gas (through both traditional sources like coal and renewable sources like wind and solar), but still fall well short of solving for the risk of an imminent cut-off of Russian supplies.
Countries are working to stockpile gas reserves ahead of winter, and it’s possible tanks are successfully refilled to 80% of their capacity to get through it. Yet, some countries are more vulnerable (Germany, Italy) than others (UK, Sweden)—a dynamic that could lead to political squabbling over how best to send gas where it’s needed most.
Dilemma 2: An ECB really on the move
With the energy crisis ongoing, commodity prices have pushed inflation across the Eurozone to records. The cost of living crisis is very real, despite still healthy balance sheets and pandemic-era savings on hand. Like the Fed, the ECB needs to tighten policy to have a fighting chance at price stability. Its 50bps hike yesterday ends an era of negative interest rates in the largest economy to ever try them.
Yet, given the euro area is a monetary union, more is at risk as the ECB goes on the offensive. As credit conditions tighten, more indebted nations like Italy can feel the effects more acutely than wealthier member states like Germany. The danger is that this fragments the single market, and ECB policy fails to transmit across all members in the same fashion. With that in mind, the ECB further unveiled an “anti-fragmentation” tool at yesterday’s meeting to combat that risk. TBD how effective it is (if ever used), details are still lacking, and markets are certainly questioning it—the spread between Italian and German government bond yields spiked higher, and are already at their highest levels since the COVID crisis. That said, it’s clear policymakers are serious about containing the risks.
Dilemma 3: Political battles on the home front
The risk of fragmentation grows further given snap elections are now inevitable in Italy. Prime Minister Mario Draghi (who you may remember as the “whatever it takes” former ECB President) officially resigned yesterday after attempts at salvaging a coalition government went up in smoke. Elections are likely to take place later this fall, and the new leader will be tasked with finding stability in the face of blistering inflation. Reforms are necessary, but agreement to get there will be tough.
Political uncertainty also reigns in the UK, where Prime Minister Boris Johnson was also essentially forced to resign the other week. The search for his replacement is contentious. The current level of weakness in the pound versus the dollar has only been seen twice in the last 50 years.
Investment takeaways: Near-term challenges, long-term opportunities
European assets have been under tremendous pressure, but have still managed to outperform the U.S. so far this year. In local currency terms, the Stoxx Europe 600 is down “only” -11% year-to-date vs. the S&P 500’s -16%, thanks in large part to the region’s greater weighting to value-oriented companies and commodities.
But, factoring in currency moves changes the story. The euro is reflecting a lot of the region’s weakness (even briefly trading one-for-one with the dollar last week for the first time since 2000)—a dynamic that reverses the region’s outperformance above (in U.S. dollar terms, European stocks are down over -20%) and may be partially behind all those anecdotes of Americans looking to move to Europe this summer.
That said, bad news could get a lot worse, and we prefer to focus on the long-term story when it comes to investing in Europe. The European investment landscape is undergoing an evolution, and new areas of opportunity are emerging. Broad markets could remain troubled for longer, but thematic opportunities aligned with policymaker priorities—such as around food and energy security, defence, and infrastructure—could offer investors compelling growth when it is scarce.
Your J.P. Morgan team is here to help you think through these dynamics in the context of your portfolio.