European Union: Cohesion amid adversity

Frédérique Carrier - RBC Wealth Management

By Frédérique Carrier, Head of Investment Strategy in the British Isles and Asia at RBC Wealth Management

The Russian invasion of Ukraine puts lives and livelihoods at risk. It may also have consequences for the global economy. We focus on how it could impact Europe’s recovery and look at some of the profound policy changes taking place in the EU as a result of the war, with an eye to positioning European equity investments.

Higher inflation, lower growth

The conflict appears likely to push stubborn inflation even higher and dent growth in many countries around the globe, but it could affect Europe more than most.

The biggest impacts, in our view, are likely to take the form of commodity prices being greatly elevated for longer, and supply chains – which had shown tentative signs of improvement earlier in the year – facing new stresses, given that Russia is a major provider of essential metals and agricultural resources.

We estimate the conflict could drive U.S. inflation measured by the Consumer Price Index to 8.5 percent, up from the 7.5 percent previously penciled in. An even longer period of higher inflation would increase the risk of inflation expectations becoming stuck at a higher level.

We also estimate tentatively that a scenario of moderately elevated commodity prices and depressed demand due to the conflict could subtract 0.2 percent to 0.5 percent from global growth, bringing his U.S. growth estimate down to 3.1 percent for 2022.

Europe is particularly vulnerable to these disruptions because it imports close to 40 percent of its natural gas and 25 percent of its oil from Russia, though the level of dependence varies from country to country.

With the caveat that estimates are highly changeable given the fluidity of the situation, we assess the potential impact on European growth to be on the order of 0.7 percent of GDP, bringing his GDP growth forecast for 2022 down to three percent—still above the historical average. The region ended 2021 with particularly strong momentum, some of which is likely to spill over into spring and summer economic activity. But a higher inflation outlook is likely to hurt household wallets in Europe eventually, despite government support. To a lesser extent, a reduction in European exports to Russia, which represented 0.6 percent of regional GDP in late 2021, would also weigh on growth.

Europe faces the potential loss of Russian energy supplies

A worst case scenario, which is less likely in our view, would be for Russia to entirely shut off its energy taps to Europe. This would have a larger impact, with global growth likely taking a one percentage point hit and European growth falling by as much as two percentage points, in our view.

Europe could cope with these new circumstances for a time by tapping regional and national strategic reserves, importing more natural gas, and possibly imposing mild measures to cap demand such as limiting some industrial gas uses. Most EU members should then be able to make it to next winter without severe shortages.

Living without Russian gas for a longer period of time could prove challenging, as long-term supply contracts often limit the flexibility of producers to redirect large volumes of gas to new buyers. Some suppliers outside of Russia are also already producing and exporting at full capacity.

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