Figure 1. Timeline of Events Exacerbating Europe’s Energy Crisis
Gazprom’s move to reduce gas deliveries to Europe to 40% on June 15 was a regime change. It marked a new Russian strategy to stress the eurozone economically. But despite all the pressure on Europe, the region has proven resilient, although at a severe economic cost. Two symptoms of that cost are a radically smaller eurozone current account surplus and a diminished value of the euro. European growth expectations have also significantly declined. The most recent Bloomberg economic survey for the eurozone expects little growth for the region in 2023.
Europe’s high-starting dependency on Russian natural gas means that the process to switch energy sources will take time. The complications are numerous. Consumers face an elongated cost-of-living crisis and battered confidence. Governments are offsetting the damage with fiscal spending (see Figure 2), but they cannot forestall the negative impact indefinitely. Greece, for example, has already allocated almost 4% of GDP (gross domestic product) to energy offsets. Climate events are also exacerbating the gas shortage, as low water levels imperil transport of coal—itself a stopgap measure—while high water temperatures curtail nuclear electricity generation in France.
Figure 2. Eurozone Nations Are Spending to Cushion the Energy Shock to Consumers and Businesses
High natural gas prices are also challenging business models in Europe, dampening production of energy-intensive industries like nitrogen fertilizers and aluminum. To stave off a full energy shortage, Europe is conserving energy and filling up natural gas storage tanks, but filling those tanks comes with an economic cost of reduced production from gas-dependent industries. The race to reformat energy supply also pressures Europe into more complicated relations with energy-exporting countries like Algeria, Angola, and Azerbaijan.
The policy response is playing catchup with these developments. ECB (European Central Bank) officials are signaling more aggressive rate hikes over the next year as they fret about long-term damage to inflation expectations. Rumors in the press suggest the ECB is considering quantitative tightening (i.e., reducing bond purchases) a policy move that the markets considered unlikely until recently. The EU recently announced an emergency intervention in power markets, the details of which are forthcoming but likely involve a reshaping of the region’s electricity markets. Europe is headed into a crucial period both for the conflict in Ukraine—where both sides are looking to achieve military breakout—and for the energy shortage in Europe, where the region’s leaders are looking to break through to the other side of the coming winter intact.
Investment Implications
Although valuations of European companies may seem compelling at this point, risks of further deterioration in fundamentals as costs rise, and demand declines, and the lack of any catalyst that may signal a resolution to the conflict in Ukraine or energy supplies in Europe suggest a continued investment underweight of the region.
As always, we remain attuned to the challenges facing global investment markets but view U.S.-focused businesses with less exposure to the difficulties facing European companies more favorably. Within that framework, hawkish Federal Reserve policy and high inflation in the U.S. have prompted a defensive outlook where an "up-in-quality" bias in high-quality, fixed-income portfolios may be an effective response to current market conditions.
Meanwhile, our outlook on the U.S. energy sector remains positive, as the financial conditions of these companies remains strong. As a result, we believe that spreads for energy-related companies should continue to compress versus their benchmark indexes. Thus, we are overweight energy-related companies, particularly the exploration and production sector.
More Market Insights and Resources for Investors
The ECB Steps Up Its Battle Against "Fragmentation"
Fixed Income: Finding Opportunities in the Quality and Maturity Curves
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