The risk of a recession in Europe

A key question on investors’ mind at the moment is whether the current war in Ukraine would lead to a recession.  While investors are becoming incrementally more worried about this possibility, an outright recession is not on the cards yet, and will very much dependent on the duration of the conflict itself.

Outside of Russia, which is probably already in a depression, the biggest risk of a recession is in Europe.  The European economy is currently being challenged by higher energy prices and tighter lending conditions in the wake of the Ukrainian invasion, due to higher reliance on Russian energy, economic ties, and geographic proximity.  Moreover, in view that Europe is a huge consumer of products and services produced by companies based in the US and Asia, this could have an impact on other regions as well.

Should a blanket ban on energy imports from Russia in all major consuming countries, not merely the US, come to pass, it would severely reduce and disrupt energy supply on a global scale, making a recession more likely.  However, that scenario doesn’t seem likely in the near term as the German Chancellor has currently outright rejected the idea of a ban on Russian energy imports to Europe due to the economic harm it would inflict on its economy.  Additionally, there seems to be no indication that Russia intends to cut off energy exports – which make up over a third of their gross domestic product (GDP).

Encouragingly, economic data in Europe shows that the economy strengthened in February before the war, rebounding from the omicron-driven slowdown.  More recently the European Central Bank (ECB) revised lower its forecast for Europe’s GDP growth this year from 4.2%, to a still very respectable 3.7% due to the war.  Their forecast came with two  downside scenarios – the “adverse scenario” estimating a 2.5% GDP growth, and the “severe scenario”, pushing GDP growth down to 2.3%.

These scenarios are both still well above the negative rate of change that would define a recession.  In the worst-case scenario, the ECB still sees above-average growth for Europe this year, which is notable for a central bank whose policy has anticipated economic weakness in the past decade.

Meanwhile, Europe is considering a joint bond to finance higher energy and defense spending as it seeks to reduce its dependence on Russian energy imports by two-thirds within the next nine months, i.e. by next winter.  While the severe cost of the tight commodity markets pose a near-term risk to growth, the massive government spending needed to undertake this dramatic transition in Europe is likely to act as a tailwind to growth over a much longer term than the next few years.

In the current environment, it is hard to have a lot of confidence in how and when the war and related impact is going to resolve, for better or worse, in the near-term or longer-term.  In these circumstances, we have positioned our portfolios more towards commodity and defensive sectors in Europe at the expense of cyclical and financial companies, in view of the inevitable slowdown ahead.  At the same time, we have maintained a degree of cyclicality through high quality companies, primarily in the US, that have strong pricing power, as they should have more ability to raise prices to offset higher input costs than other stocks.  

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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