04/10/2022

Jeremy Batstone-Carr, European Strategist, Raymond James Investment Services Ltd*

Key Takeaways

Europe’s energy crisis has dominated investor sentiment and determined political initiatives and exacerbated regional inflationary pressures and growth slowdown.

Apparent acts of sabotage on the Nord Stream gas pipelines have refocused attention on Europe’s lack of energy security, whilst ensuring that the Ukraine conflict remains front of mind.

Commission plans to manage energy costs carries the risk that suppliers may not invest in additional capacity and do little completely to protect households from rising energy bills.

Political disunity threatens to fracture regional cohesion. The Italian election result being merely the highest profile indication of popular discontent.

The ECB has embarked on a rate hiking programme in an effort to contain regional inflationary pressure, whilst standing ready to utilise its new anti-fragmentation tool were peripheral sovereign bond yields to rise too sharply, too fast.

September has historically been the most difficult month of the year for financial assets, and 2022 has proved no exception. The month in Europe has been “bookended” by a severe energy crisis which, with winter just around the corner, may yet serve as the catalyst for both political and economic instability.

Profoundly aware of the pressures facing regional unity, Commission President Ms Ursula von der Leyen has given a forceful speech emphasising the importance of togetherness in the face of myriad challenges. “The months ahead of us will not be easy”, the President warned, “Be it for families who are struggling to make ends meet or businesses that are facing tough choices about their future”. With regard to Russia’s invasion of Ukraine, Ms von der Leyen stated, “This is not only a war unleashed by Russia against Ukraine. This is a war on our energy, a war on our economy, a war on our values and a war on our future”. As metacrises go, that sounds like the full works.

Ms von der Leyen’s speech was heavy on regional values but much lighter on specifics. This prompted one commentator to observe that what the EU is promising is not simply a semi-war/planned economy, from energy and environmental awareness upwards, but muscular liberal-democratic mercantilism from the top down. Well said! The problem is that Europe does not yet have the muscular clout to enable it to brandish its flash sheriff’s star with authority.

Indeed, what was proposed amidst the lectern thumping would likely have been considered the very opposite of what passed for democracy just a few years ago. Governments should impose a ceiling on energy producers’ revenues and add a windfall tax on the profits entitled a “solidarity contribution”. The plan, very obviously, is to try and manage energy costs in a high inflation environment sufficient to distribute additional money to those who most need it. The risk is, of course, that the plan discourages oil and gas companies from investing against a backdrop of already profoundly curtailed capital expenditure in the dash for “green” credibility.

Importantly, such a windfall tax is merely a proposal, not a compulsion. Admittedly, the proposal comes from the highest levels of the administration, but it still requires ratification by all EU members. According to Mr Laurent Ruseckas, executive director of S&P Global, the proposals are extremely complex in practicality and impossible to work through in time for winter, even if there were a political consensus behind them.

Politically speaking, the successful functioning of the EU has been constructed on two pillars. The first is German growth (the regional engine room), and the second is a combination of low-cost debt, highly supportive regional budgeting and a TARGET 2 regional bank clearing system aimed at ensuring that the region’s weaker economies can survive without being forced into politically (and socially) unacceptable reforms.

The present-day reality reveals that the sharp slowdown in the global economy, coupled with a profound energy crisis, threatens both regional industrial activity and standards of living. This, in turn, limits the scope and desire for multilateral economic support whilst simultaneously increasing the desire for political self-determination at home. Nowhere is this more apparent than in Italy.

Irrespective of pledges made on the campaign trail by the victorious right-of-centre coalition, yields on Italian debt have edged higher. Whilst the spread between Italian government bond yields and core (German) counterparts has risen, implying that investors are seeking a risk premium for Italian bonds, they have not blown out to the levels of the past, at least not yet. That being said, Italy’s indebtedness is very high at around 150% of GDP, while its maturity profile is also unfavourable (35% of outstanding debt will fall due for repayment in 2024 and 50% within five years). Without the latent support in the form of the, as yet unutilised, European Central Bank’s newly minted anti-fragmentation Transmission Protection Instrument yields would likely have blown out even further than is currently the case.

Elsewhere, both Poland and the Czech Republic have made clear their objection to plans to cap the price of Russian energy, a proposal which seems unlikely to be enforced. Beyond this, much-needed disbursements from the regional Recovery Fund are increasingly being made conditional on adherence with Ms von der Leyen’s “European values”, a list of essentially political requirements aimed at subjugating regional nation states to an unelected cadre in Brussels. This is not popular. Poland’s governing Party secretary-general has recently warned that “without a clear change in the actions of Brussels, we will have no choice but to pull out all the cannons in our arsenal and open fire”.

In response to these and other threats, the Commission may have to announce a second regional Recovery Fund, much larger in size than the current €800bn Fund. This, in turn, may ultimately require the regional central bank already raising key interest rates and actively looking to shrink the size of its balance sheet to recommence its earlier quantitative easing programme. It is this expectation that seems likely to limit the scope for regional sovereign bond yields to rise too far beyond prevailing levels. The region’s stock markets, with a clear cyclical bias, are thought unlikely to perform until evidence of an economic upturn starts to emerge, that or the US dollar starts to depreciate on the foreign exchanges.