An extreme disruption in the supply of energy would increase the risk of a recession in Europe.
Central banks face a policy quandary
For central banks, the higher inflation outlook is problematic. They now need to balance the risk of higher inflation against the risk of lower growth.
We believe most should recognise that the geopolitical situation warrants caution, and may slow the pace of policy normalisation, including rate hikes, over the next few months. The dilemma could be most acute for the European Central Bank (ECB).
We now expect the ECB to postpone the announcement of the end of its Asset Purchase Programme by six months, to September, and to increase interest rates only in 2023 instead of later this year.
Profound transformations in the EU
In the face of this adversity, profound transformations are taking place in the regional bloc. Regional cohesiveness has increased, and attitudes towards fiscal rectitude are relaxing.
The war has brought member countries closer together. The decision by German Chancellor Olaf Scholz to approve the export of lethal weapons to a conflict zone for the first time since World War II is a notable development which could enable more coordination at the EU level. The threat of external aggression may also shift the balance towards a greater tolerance for decision making at the EU level rather than at the national level.
The war also appears to be reducing the appeal of euro-skeptic political parties, both from the extreme right and extreme left, which have at times cited Putin as a role model. This reduces the risk of an anti-EU government being elected in France or Italy – French elections will take place in April –, and likely channels the political winds more firmly towards the centre.
Importantly, we think Germany abandoning its long-held preference for reining in fiscal deficits should diminish tensions within the bloc, where limiting national deficits to three percent of GDP has been a thorny issue for years. German Finance Minister Christian Linder is now advocating for increased defense spending representing 2.7 percent of his country’s GDP, with further increases possible thereafter. A more constructive tone from Germany, long a fiscal hawk, suggests a review of EU fiscal policy—a key topic under discussion this year – could result in a more accommodative stance on what constitutes an acceptable level of budget deficit, as opposed to a fiscal policy straightjacket.
The green transition in a holding pattern
The transition towards cleaner and greener energy policies, a key regional focus, may well stall in the short term as a result of the conflict. On the one hand, Germany’s advocacy for a more rapid build-up of renewable capacity as an investment in “freedom” from Russian energy dependence – and, by extension, Russian influence – as well as its decision to bring forward its goal of 100 percent green power to 2035 from 2040 represent a strategy likely to be copied by other countries. On the other hand, coal-burning power plants could be revived and the closure of German nuclear plants might be postponed as short-term measures to reduce dependence on Russian energy. Nonetheless, the decarbonisation push remains an area where Europe stands out relative to other regions, given it is home to numerous leading global companies that should be well positioned to benefit from the pickup in green spending this decade.
Maintaining our regional Overweight
Despite a more complicated outlook for the region as a result of the war, and inevitable volatility in the short to medium term, we continue to suggest holding a modest Overweight position in European equities. So far in 2022, the MSCI Europe ex UK Index is down more than 11 percent in local currency terms, leaving it trading on 14x its 12-month forward earnings, a steeper-than-average discount to the U.S. on a sector-neutral basis. This low valuation suggests the severity of the situation and the upcoming downgrade in growth forecasts have largely been discounted in the price.
In addition, we think recent developments in the region – including increased cohesion as expressed by the EU’s swift action on sanctions, Germany’s foreign and fiscal policy U-turns as well as its possibly more lenient approach to EU fiscal rules, and decreased concerns that anti-EU political forces could prevail in a large country – all point to reduced tensions within the bloc. We think the changes lower the risk of a potential EU breakup, and increase the likelihood of more fiscal support for the regional economy. These profound transformations could contribute, in time, to reducing the valuation discount historically attributed to the region.
