Could Europe's energy crisis raise contagion risk?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we consider whether the new energy crisis will have economic repercussions beyond Europe and potentially echo the recession of the late 1970s.

 

Need to know •    The energy shock seems to be geographically asymmetric for now, with Europe bearing the brunt •    Yet, if elevated energy prices become structural, growth could be significantly affected •    An earnings contraction is priced in across European markets, but the potential for contagion to the rest of the world is not

 

A foreseeable consequence of the Russian attack on Ukraine was an increase in commodity prices. Is this energy crisis going to drive the economy into a recession echoing the late 1970s?

 

Eurocentric crisis

Firstly, the energy shock seems to be geographically asymmetric. Chart 1 represents the historical energy bill as a percentage of GDP for the US and Europe. The latest data point is estimated using the 1 month forward prices specific to each region while the historical figures are based on annual prices.

At first glance, Europe appears to be at a significant competitive disadvantage compared to the US given the spike in gas prices across Europe on the back of the conflict. Given current prices, Europe could suffer from an energy shock at least similar in size to the energy crisis in the late 1970s and this could be exacerbated by a devaluating euro, representing around 8 to 10% of GDP.

Even though current prices are high, they may fluctuate based on seasonality (winter is ending) or depending on the solutions brought forward by the European Union to replace Russian gas. In any case, this energy crisis would appear to be Eurocentric rather than global.

 

Chart 1. Historical energy bill as a % of GDP

Source: Bloomberg, LOIM. Note, spot prices have been used for the latest data point.

 

Growth at risk?

Secondly, if elevated energy prices become structural, growth could be significantly affected. Indeed, in 1979, a 100% increase in energy prices caused a recession. Chart 2 represents the simulated medium-term impact of a permanent 100% increase in energy prices over a quarter from a one and two year forward perspective.

If the shock is temporary (one year), durable consumption will be the main casualty. The average consumer will give up his or her non-essential purchases to fund their essential needs (such as gas and food). This in turn could cause a 3% drop in GDP and 4% drop in profits.

However, if the shock is structural (two years) we could face a more typical recession. Accompanying a sharp drop in durable consumption, would be investments. Companies would suffer from the double effect of lower earnings/lower demand and higher energy expenses. Consequently, GDP and profits could lose 7%. A Eurozone fiscal response package of EUR700 billion would be needed to offset these losses.

 

Chart 2. Simulated medium-term impact of an ongoing 100% increase in energy prices over a quarter

Source: Bloomberg, LOIM. Based on US data 1976-2019, estimated from the orthogonal responses of an Impulse Response Function.

 

Earnings: a warning signal

Finally, the market appears to be pricing in an earnings contraction in Europe. Chart 3 represents the estimated expected earnings growth across major indices in 2022. What is clear from this chart is that European markets have already been discounted owing to the energy price shock, while other regions (apart from EM) still seem to be unaffected.

This may be a warning signal that markets are underestimating the second-round effect of a Chinese and European slowdown. It could also be interpreted as a sign that the shock will remain confined to Europe and will not propagate to other regions.

Bottom line: the risk now is that a potential consumption shock hits economies beyond Europe. At present this is just a risk, not a core scenario, but its odds are rising by the day.

 

Chart 3. 2022 Estimated expected earnings growth across major indices

Source: Bloomberg, LOIM. Estimated from a 2-period Gordon and Shapiro model.

 

Simply put, the energy shock is Eurocentric and already seems to be priced in across European markets. However, investors should not underestimate contagion risk elsewhere.

 

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Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

The macro news flow has brought the broader economic picture back to the forefront. The US inflation report brought more evidence of still elevated inflation. Inflation coming from goods remains high, notably compared to historical averages.

However, the month-over-month variations in February were lower than in January: a positive sign, consistent with what leading surveys have hinting towards. However, shelter costs and energy have been stronger contributors of late, making a solid case for the Federal Reserve (Fed) to hike rates next week.

The real earnings growth published last week probably cast a different light on the sustainability of the growth situation: growth is still in negative territory here and has been so for six quarters. For now, the inflation argument will prevail as the “transient” inflation card has been played too many times of late.

In Europe, the European Central Bank (ECB) meeting brought an important message to investors: between the uncertain growth consequences of the current situation and the certainty of rising inflation, the ECB went for the latter. In its statement, it made inflation its primary concern, confirming it is set on an inflation warpath. It still sees inflation as temporary, with an eventual normalisation, but is willing to set its course towards normalisation. This attitude paves the way for major central banks during the first half of the year.

In China, inflation remains low (0.9%) while producer price indices have entered a period of moderation from their highs: back in October 2021, PPI was rising by 13% on a yearly basis, while today this number is sub-9%. Money mass shows the delayed impact of the public stimulation of the Chinese economy (M1 rose by 4.7% last month versus -1.9% the month before). China remains in a difficult macro situation: the potential slowdown from Europe is not good news there.

Factoring in these new data points, our nowcasting indicators currently point to:

• Solid growth worldwide, with stronger momentum in the Eurozone, while China lags. The Eurozone indicator does not show signs of slowing activity yet, while the Chinese situation remains difficult.
• Inflation surprises should remain an essential factor for 2022 with the energy crisis falling on our shores. The European inflation indicator has recently shown an uptick and the US inflation report has also pushed our nowcasting indicator up.
• Monetary policy is set to remain on the hawkish side, except in China. The ECB’s reaction last week was nothing but a sign that between inflation and growth, central banks are likely to focus on the former rather than the latter.

 

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

World Monetary Policy Nowcaster: Long-Term(left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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