Brewin Dolphin: Putin keeps Europe guessing on gas

Brewin Dolphin: Putin keeps Europe guessing on gas

Brewin Dolphin: Putin keeps Europe guessing on gas

As heatwaves hit many parts of Europe, it is hard to envision the scenario of a freezing winter with an insufficient supply of gas and prohibitive costs to heat up homes and offices.

Before the war in Ukraine, the scenario of a complete gas shutoff from Russia to Europe was unfathomable. However, this is a tail risk that is garnering increasing caution from authorities, economists, and financial markets.

In June 2022, the International Energy Agency (IEA) warned that Europe needs to prepare for a total halt in Russian gas and widespread curtailment in gas usage would be necessary. It is a nightmare scenario and leaves Europe in an extremely vulnerable position, economically, politically and socially.

The asymmetric growth outlook in Europe is a key reason why we have turned more negative on the region’s assets. Recession risks seem far more acute in Europe, and this is reflected in the euro and dollar exchange rate that has reached parity.

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The direct economic consequence of this potential energy crunch is dire, likely involving rationing of gas usage, shutdown in industrial facilities and significantly higher gas prices. Needless to say, this could potentially send the region into a deep recession, as supply capacity is severely reduced and high inflation destroys demand.

We are clearly not there yet, and it is not the base case for us or many other investors. It is impossible to predict what will happen and there is clear evidence Russia intends to keep Europe on tenterhooks by restricting or selectively cutting flows from time to time. Whichever way you look at it, gas prices will stay high for the foreseeable future as flows from Nord Stream One have been cut to just 40%.

It is prudent to have a higher risk premium when investing in European assets considering the rising probability of the developments mentioned above. There is evidence that the reaction to the potential energy crunch is depressing activity already: Germany is incentivising industries to use less energy which is bound to hit production, from cars to machinery to equipment.

Manufacturing and industrial production are important economic engines for the country, and recent data on new orders and activity levels are both in contraction. The agreement reached by EU nations to target cutting gas usage by 15% (in an emergency situation) through next winter gives a flavour of what may yet be to come. Going forward, differing reliance on Russian gas by different member states is likely to cause division and most likely a reduction in economic output.

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The eurozone typically enjoys a generous trade (and current account) surplus, driven by Germany as an exporting powerhouse. Germany has not reported a trade deficit since 1991, well except in May 2022 when it posted a foreign trade deficit of 1 billion euros.

The evaporation of a vast and persistent German trade surplus is a significant development that I believe is not receiving enough headlines.

A key reason is the 27.8% increase in import bills from higher prices for energy, food and other commodities. Furthermore, the slump in the euro versus the US dollar has exacerbated the cost of imported goods in dollars. On the other side of the equation, German export volumes have been weak as its major trading partner China, had its own economic challenges. When the euro weakens it tends to boost net exports, but not at a time when the impact from imported inflation is far worse and global growth faces a downturn.

The impact of rampant inflation is reverberating across monetary policy and politics, which refocuses investors to the fragmentation risk inherent in the eurozone. The European Central Bank finally ended an era of negative interest rates at its July meeting, but it is still severely lagging other major central banks in tightening policy. Markets are now expecting more jumbo rate hikes by the ECB given its hawkish tilt in July. The ECB has unveiled the Transmission Protection Instrument aimed at preventing a disorderly widening in peripheral spreads. It remains to be seen how much faith the markets have in the effectiveness or credibility of it.

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Politically, high inflation is causing division and may fuel instability, which is another reason to stay cautious on the region. Italy is one of the most reliant countries on Russian gas and households are severely impacted by higher gas prices.

While Draghi’s government has announced support for households, one of the coalition parties, Five-Star, feels this is not enough and hence has withdrawn support for the government. That triggered Draghi’s resignation as he lost unanimous support and a snap election will be held on September 25. Although Italy has courted political instability on many occasions, Draghi is widely seen as a source of stability and a safe pair of hands, which is especially relevant in the current economic environment given his stellar track record at the ECB.

Overall, gas supply shortages and high energy prices remain the biggest headwinds for Europe. The risk of outright supply shortages could become devastating – the tail risks of which could spell trouble ahead for economies, policy, politics and therefore, financial markets.

Janet Mui, head of market analysis at Brewin Dolphin

This content was originally published here.

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