Energy crisis in Europe

The recession in the central scenario

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Pending a decline in inflation in early 2023, growth prospects are clearly on the downside.

In July, the cyclical indicators in Europe and the United States accentuated their decline to the point of approaching or crossing, in some cases, the threshold for entering recession. The deterioration affects the business climate, household confidence, consumer spending, activity in the real estate sector and world trade. So much for the past.

Looking ahead, the downside risks are stacking on top of each other: Russia is fanning the energy crisis as much as possible, which is making the inflationary spurt worse; access to credit becomes more difficult; businesses realize they have too much inventory relative to anticipated demand. On the positive side, labor markets are resilient, but for how long? Let’s not look for support from economic policy, the priority is to fight inflation, even if it means sacrificing a share of growth. Monetary policies are being tightened at a speed rarely equaled in the past. There are some targeted fiscal measures in response to the energy shock, but fiscal policies are neutral at best. Under these conditions, no region is in a position to pull the others out of the rut. China is struggling with its real estate crisis, the United States is in technical recession and on the verge of a real recession, Europe remains the most fragile zone. The question is not whether there will be energy shortages this winter, but how severe.

If it is customary to consider the economic cycle as the alternation between phases of expansion and recession, the passage from one to the other is rarely instantaneous. The pandemic is the perfect counterexample. Overnight, the global economy came to a halt, activity collapsed, and then a few months later, aided by powerful stimulus policies, the global economy surged forward at a breakneck pace. In an ordinary cycle, neither the fall nor the rebound can be seen so clearly. Thus, the outbreak of the war in Ukraine accentuated the downside risks to activity, but for several months there remained doubts about their materialization. This doubt is no longer permitted.

Now, the Fed and the ECB are careful not to pre-announce the extent of their next move, but remain clear on the direction: to continue tightening their monetary policy until there are signs of moderation in the economy. ‘inflation.

There is no longer any doubt about the will of the Russian government to exploit the energy crisis to weaken and divide the European countries. Who can believe that maintenance problems of the installations explain the intermittence of Russian gas deliveries? Since mid-June, flows passing through Nord Stream have been reduced to 40% of normal, then to zero, restored to 40%, before being cut back to 20%. Europeans are diversifying their supplies, filling storage facilities at a good pace, encouraging efforts to reduce their demand, in the hope that this avoids rationing. It’s a race against time in anticipation of winter 2022-2023. Eventually, Putin will lose all leverage over Europe in the energy field, but in the meantime, he is using it to the fullest. The shock of uncertainty, far from diminishing, continued to intensify. This is to the detriment of the conditions of activity.

There is also no longer any doubt that central banks are ready to sacrifice economic growth, if necessary, to reduce the risk of inflation. To this end, they are continuing to raise their key rates at an accelerated rate, with the exception of China and Japan. The global policy rate (a weighted average of each country’s policy rates) was raised by 7bp per month in the first quarter, 19bp per month in the second quarter, 36bp in July, for a total of around 120bp since the start of the year. It is doubtful that these actions quickly moderate inflation, which is mainly the result of a supply shock. They aim to prevent inflation expectations from going off the rails. Now, the Fed and the ECB are careful not to pre-announce the extent of their next move, but remain clear on the direction: to continue tightening their monetary policy until there are signs of moderation in the economy. ‘inflation.

Finally, there is no longer any doubt as to the repercussions of all this on working conditions. In July, all the cyclical indicators continued to fall, and moreover, at an accentuated pace. First of all, this concerns companies. For the first time since the 2020 lockdown, the business climate has fallen into “recession territory” in several countries, including Germany. Companies have finished product inventories that are too high in relation to future demand, which will lead to further production cuts (positive counterpoint: this should moderate price pressures). Secondly, household morale has shattered its recent record lows. With an inflation shock that persists and punctures real incomes (despite partial compensation via targeted and transitional budgetary measures), spending intentions are reduced. Employment conditions remain solid but we see signs of fragility, for example in the United States a rise in jobless claims. Third, banks have become much more cautious. In the euro zone, the latest Bank Lending Survey signals a tightening of credit standards for all categories of loans. In the United States, demand for housing, which depends heavily on the cost of credit, is collapsing. Finally, we can add a rise in political (United Kingdom, Italy) and geopolitical (US-China tensions) risks.

Taken together, these elements lead to lower global growth prospects for the second half of 2022 and the start of 2023. The United States was in a “technical recession” in the first half, but the contraction in domestic demand is still to come. In China, despite the rebound in activity following the lifting of health restrictions, the purge of the real estate bubble is in full swing to the point that the authorities have admitted that their growth target was out of reach. This is not without consequences for emerging countries, already weakened by the sharp rise in US rates and the dollar. In Europe, even if efforts to reduce dependence on Russia bear fruit, the winter months are unlikely to pass without any friction in the energy markets. Our base case is now a recession over the next few quarters. The German economy is most at risk because its industrial base cannot operate efficiently if energy production is reduced, intermittent or too expensive. Under these conditions, we can expect inflation to begin a potentially rapid decline in early 2023, giving central banks the opportunity to stop their rate hike cycle, which would subsequently ease financial conditions. . Compared to this central scenario, the balance of risks still tilts downwards; the reasons are not lacking: massive shortage of gas, resumption of the pandemic, debt crisis…

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