Can the eurozone head off a recession?

The eurozone economy is facing one of the greatest tests since the single currency was created almost a quarter of a century ago. The threat comes from an interlinking set of challenges: a shortfall of energy supplies, the highest inflation levels in the eurozone’s history and the fastest ever rate rises by the region’s central bank.

Any one of these factors alone would represent a significant headwind for the region’s economy. The combination of the three has left economists divided on whether the eurozone is facing a period of economic stagnation or an outright contraction.

Against this backdrop, the main questions for CFOs are how abrupt will the slowdown be, and which nations or sectors will suffer most? Finally, how far can government rescue packages ease the pain?

Energy price surge

At the heart of Europe’s challenge has been a looming energy shortage. Supplies of gas from Russia – which used to account for about 40% of the flow to Europe – have been cut back to less than a fifth of capacity. The resulting surge in energy prices represents a considerable headwind for growth, argues Andrew Kenningham, chief Europe economist at Capital Economics.

‘It seems reasonable to assume the effects will be of a similar magnitude, or bigger, than the oil shocks of the 1970s, in which oil prices first rose three-fold and then doubled again,’ he argues, based on title transfer facility (TTF) price averages of €200/MWh between now and the year end. ‘This is sobering given that GDP contracted by between 0.2% and 3.8% in the larger economies after the oil shocks of 1974 and 1979.’

Surging gas prices have also been a major contributor to inflation, sending household energy prices up around 50% over the past 18 months. Consumer price inflation, which had already been boosted by the Covid-19 pandemic, has hit a new high for the 11th consecutive month as energy prices continue to rise, bolstering calls for the European Central Bank (ECB) to continue aggressive interest rate rises when it meets next month.

Consumer prices in the eurozone rose 10% in the year to September, accelerating from 9.1% in August, which was already the highest level in the euro’s 23-year history. The price rises also outstripped the 9.7% expected by economists polled by Reuters. Such rapid price rises impose an ‘enormous burden’ on eurozone citizens, in the words of Germany’s central bank president, Joachim Nagel, and is curbing their spending power. It is also a multiple of the ECB’s 2% target.

This flows into the third drag on the region’s growth: rapid monetary tightening. In September, the ECB raised rates by 75 basis points, the largest step at a single meeting in the institution’s history. And financial markets are bracing for considerably more tightening to come, with the deposit rate rising from 0.75% at present to a peak of around 2.5% by next spring.

Rate rises of this magnitude can be expected to have a chilling effect broadly across the region – for both consumers and industry. Capital Economics is forecasting that the cost of servicing household debt will quadruple as a share of income next year, from around 0.5% to 2% for 2023.

‘That will leave much less disposable income to spend on discretionary goods and services,’ says Jack Allen-Reynolds, a senior European economist. Add in falling real incomes – as wages fail to keep pace with inflation – and Capital Economics expects real household incomes to fall by 2.5% in 2022, which would be the largest drop since the eurozone was established. While more defensive industries, such as healthcare and consumer staples, tend to cope relatively well under such conditions, weaker consumer confidence is a greater concern for more cyclical industries, such as apparel, luxury goods, and leisure.

The second major effect of rising borrowing costs is to reduce the willingness of firms to invest, a drag on the revenue outlook for producers of capital goods. This already appears to be happening. ‘Eurozone non-financial companies’ demand for loans to fund fixed investment has declined in recent quarters and is consistent with machinery and equipment investment grinding to a halt,’ explains Allen-Reynolds. Technology companies are also likely to be hit. Since their valuations are often based on more distant profits, rising rates typically dent their share price more than other parts of the market – increasing the challenge of raising capital.

While rate rises will impact the region as a whole and most sectors, the drag from the energy crisis looks set to hurt some nations and sectors more than others. Germany, for example, is among the most vulnerable for several reason. First, energy-hungry industry accounts for a larger share of economic activity compared with its neighbours, at about 23% of gross value added for Germany versus 14% for France.

Alternative options

An economy’s ability to cope with the reduction in Russian gas also depends on its flexibility in switching to alternative energy sources – both for industry and electric generation – or to source gas from elsewhere. Again, Germany looks among the most exposed. While Berlin has been investing heavily in floating liquified natural gas terminals – enabling it to import gas globally – these will only come online over the coming year or so. That leaves Germany playing catchup with Spain, France, Italy and the Netherlands, which already have LNG terminals. The Netherlands, which has its own natural gas fields, looks relatively well placed, as does France, which produces 70% of its electricity from nuclear power.

From an industrial perspective, the pain from high gas prices is likely to be most acute in a series of directly affected sectors. For example, Germany’s chemical industry alone accounts for close to 14% of the nation’s consumption, with base metals, minerals and food each representing around 4%.

Fiscal support

But grim as the outlook might look, governments around the region are seeking to provide support to both industry and consumers. Germany has already announced fiscal aid equivalent to around €65bn, or around 2% of GDP, to bolster the economy, with specific measures to support specific parts of the nation’s industrial base. While this is far smaller than the 15% of GDP package deployed during the Covid-19 pandemic, the traditionally frugal nation could loosen the purse strings further if conditions continue to deteriorate.

Elsewhere in Europe, fiscal packages have also been unveiled in France, Italy and Spain. If governments continue to ramp up these efforts, it remains possible that the eurozone could still suffer only a modest slowdown – despite the formidable headwinds facing the economy at the moment.