Capital Ideas^TM

Summary: Energy remains a key factor in Europe’s shorter-term economic and stock market performance, and while the region remains on the brink of recession, there are signs the downturn may not be as deep as feared in the immediate aftermath of Russia’s invasion of Ukraine.

Key to this is that European industry has been substituting other energy sources for Russian oil and gas, reducing the need for significant cuts in output or energy demand destruction, which could mean a less dramatic hit to GDP.

A milder recession could ultimately unlock the value in European equities, possibly triggering a move to higher valuations if central banks stop their policy tightening in 2023. In the short term, however, consensus estimates for the Continent’s gross domestic product (GDP) and earnings per share (EPS) growth are still too high, which means European markets will struggle to make headway.

Debate around the prospects for Europe’s economies and financial markets has largely focused on energy supply, or rather the lack of it, in the wake of the Russia/Ukraine conflict. But a detailed breakdown of European gas demand as 2022 has progressed shows the response to the situation from industry is greater than expected.

In short, a reduction in demand for gas so far (around 15% over the first eight months of 2022 and an estimated 25% in Q3¹) has largely come from substitution in heavy industry rather than genuine demand destruction (a permanent downward shift induced by a prolonged period of high prices or constrained supply). This substitution effect has further to run, which means demand destruction will likely be lower than feared, perhaps considerably so, and that should translate into a less dramatic hit to European GDP than the market expected.

To caveat this, there are many factors influencing gas demand and it is impossible to isolate them completely. But the current disconnect between demand and industrial production is striking and supports the argument for less damage to GDP; while industrial demand for gas has declined throughout 2022, production has - unusually - not followed suit.

Within industry, the biggest gas users are the refining, chemicals, and metals/minerals sectors, which typically account for 60%-65% of demand². Since the energy crisis, however, they have been substituting other energy sources for natural gas. Companies have turned to fuel oil, propane, naphtha or diesel rather than gas – and their processes either already allow for this or can be modified easily.

One driver of this substitution has been price. Before the Russia/Ukraine conflict-induced price spike, EU gas was broadly cheaper (and cleaner) than other oil-derived products. Since gas prices remain higher than pre-crisis levels (despite recent falls), these competing products look more cost-effective. There appears to be no real cost disadvantage; rather a material gas saving – and this seems to have been overlooked by the market.

Looking into 2023, these developments imply gas demand will be substantially lower, which could help offset the impact of the continuing Russia/Ukraine conflict. While still early days, current trends imply heating demand will be lower (perhaps 5%-10% if current savings rates hold in normal weather) and industrial demand 10% less (at current run rates). Demand for gas used in power generation could also be 15%-25% lower, assuming normalising conditions in French nuclear (which is not certain) and EU hydro (which is weather dependent). France is currently dealing with reduced output from its nuclear power plants, with a series of strikes delaying planned maintenance work. Nuclear power generation has been falling throughout the year due to technical issues and around half the country’s plants are currently closed.

All in all, this implies gas demand could fall a further 10-15% in 2023 on top of what is likely to be a 10-15% reduction in 2022. Combined savings of these amounts are material and would help to balance the market.

As a counterpoint, the International Energy Agency (IEA) has warned Europe could face a major shortage of natural gas during the key summer period for refilling its storage sites in 2023³, highlighting the need to reduce consumption further amid the current crisis. The report shows gas storage sites in the EU are now 95% full – putting them 5% above the five-year average level – but cautions the cushion provided by these levels, as well as recent lower gas prices and unusually mild temperatures, should not lead to overly optimistic conclusions.

While the demand picture is looking more positive, the IEA says a full cessation of Russian pipeline gas supplies to the EU and a recovery of Chinese liquified natural gas (LNG) imports to 2021 levels could be challenging. China’s lower LNG imports over the first 10 months of this year have been a key factor behind higher availability for Europe, which has helped compensate for the drop in gas from Russia. But if China’s LNG imports recover to 2021 levels, it would account for over 85% of the expected increase in global LNG supply⁴.

In the early stages of the Russia/Ukraine conflict, analysts (including the IMF) estimated the loss of Russian energy might depress eurozone GDP by 2%-3%⁵. Now, despite higher prices and increasing disruption to supply (notably explosions in the Nord Stream pipelines), the macroeconomic impact looks more modest.

Taking a broader perspective, an intense squeeze on real incomes in Europe has depressed consumer confidence but households have run down savings rates to prop up consumption. Survey data have weakened through autumn and the latest manufacturing and services Purchasing Managers’ Index (PMI) figures⁶ are signalling recession stretching into 2023. With industry proving more resilient to the energy shock, however, and continuing support from governments to households and companies, recession in Europe should be milder and shorter in comparison with the global financial crisis (where eurozone real GDP contracted by 4.5% in 2009⁷) and the pandemic downturn (where it fell 6.5% in 2020⁸). I currently expect eurozone GDP to decline by around 1% in 2023.

A less severe recession could ultimately unlock the value in European equities. Since the European debt crisis in the early 2010s, there has been a marked divergence in the relative valuations of US and European markets. In the US, the implied equity risk premium (the expected return on equities less the expected return on bonds) has moved lower; in Europe, they have remained higher, with a particular spike in the premium for German and Italian equities since the outbreak of the conflict in Ukraine.

In the face of continuing uncertainty around this situation, energy prices, and their impact on economies, there is a danger that European equities remain a value trap (where something looks attractively cheap but the price continues to fall). But there are three further conditions that might help trigger a re-rating, where shares move up to higher valuations.

First, a clear peak in headline CPI inflation rates that would enable the European Central Bank (ECB) and Bank of England (BoE) to stop policy tightening. This is unlikely over the next few months, however, as higher energy prices are still feeding through to consumer prices, which will encourage both to continue on their current path. But if inflation peaks in early 2023, I would expect both central banks to stop hiking, with policy interest rates well below current market expectations that suggest the ECB should stop at around 2%, and the BoE at around 4%.

Second, the impending recession is likely to depress European earnings, with a likely earnings-per-share contraction of 10%-15% in 2023, and equity markets are not yet fully factoring in such an outcome. But once earnings expectations have adjusted, there will be greater scope for European equities to re-rate. Finally, alongside domestic factors, we also need to see a clear signal from the US Federal Reserve (Fed) that it is halting its tightening cycle. Given current momentum in US inflation and the recent tone of Fed officials, this once again looks unlikely in the short term.