Europe’s economic vulnerabilities could lead to closer political union
As Vladimir Putin’s forces step up their violent assault on the starving civilians of Ukraine’s cities, European commentators are looking backwards as well as forwards. A war of this intensity, causing senseless destruction of both human and infrastructure targets, was never expected again. Preventing just such a recurrence was the key reason for formation of the European Coal and Steel Community in 1951, an early incarnation of today’s European Union.
That nascent trade bloc, spearheaded by French foreign minister Robert Schuman, was built to make another European war “not only unthinkable but materially impossible”. Even President Putin, today accused by US leader Joe Biden of war crimes, once talked of a free trade area “from Lisbon to Vladivostok” before his failure to subjugate Ukraine economically and politically led him to invade his neighbour. Investors are now asking whether Russian aggression has put paid to the modern European dream, or whether it can mark the resurgence of a more resilient continent, expanding beyond the realm of economic co-operation.
Worrying times
“Europe is clearly facing its worst import price crisis since 1973. This will deflate real incomes,” says economist and family office adviser James Bevan, formerly investment boss at Santander and CCLA, referring to the “uneven real shocks” of Covid and war, which have unsettled the single currency bloc.
“The euro today is at its most vulnerable. To bring inflation back towards its target, the European Central Bank would need to create recession,” he says.
For many, Europe’s entry into an economically bleak, inflationary cycle, resembles the 1970s, when turmoil in the Middle East led to Saudi Arabian energy minister Sheikh Yamani quadrupling the price of oil. Supermarket and petrol station staff around Europe were left adjusting till prices on a daily basis, such was the inflation shock which followed, leading to a deep and damaging recession. Today’s rampant inflation on the forecourt and in the grocery store seems eerily familiar.
An already fragile European economy is being hit hard by a combination of spiralling energy prices - caused by restrictions on Russian oil and gas supplies – and the shutdown of Ukraine’s grain exports by Moscow’s attack on the country’s Black Sea ports. “The EU economy is poorly placed to withstand the challenges of a sharp economic slowdown and accelerating inflation,” believes Mr Bevan.
After the EU’s announcement of an €800bn recovery plan at the height of the Covid pandemic to make the continent “greener, more digital and more resilient”, initial enthusiasm for a brighter new era for Europe’s bond and equity markets was soon tempered by harsher realities.
Closer political ties
Many expect the rebirth of a politically stronger but economically weaker entity, once the disproportionate exposure to Russian fossil fuels is addressed by the continent’s authorities. The really grave danger, believes Sharmila Whelan, deputy chief economist at emerging market specialists Aletheia Capital, is that the energy price shocks are accommodated rather than contained, with resulting inflation biting deep into real incomes, corporate profits, discretionary consumer spending and corporate investment.
Yet the combination of these multi-directional ill winds, with their potentially disastrous damage of any economic growth, could well provide the unity which Europe badly needs. “Europe's economic woes and the war itself are likely to politically unify the region further as member countries become increasingly dependent on EU funding and move ever closer to a fully-fledged fiscal union,” says Ms Whelan.
Most EU watchers are highly sceptical of the Commission’s commitment to reduce dependence on Russian gas by two-thirds before the end of 2022. Yet they believe this will kick-start a broader trend around greener energy, which will be a pre-requisite of longer-term growth.
“While a greener Europe may prove to be positive down the road, it requires long-term investment,” says Francois Savary, chief investment officer at wealth advisers Prime Partners. “The problem is we have this crisis coming today and it shows us we are not yet able to be more independent in terms of energy sources. We have a transition period. Renewable energy is exactly what you want to see in Europe and it will eventually provide major support for the independence of Europe in economic activity.”
Germany’s U-turn
Commentators believe the future of Europe’s political and economic strength as a power bloc hinged on Germany’s actions during several days in the war’s early stages. “We saw an 180 degree change in how Germany sees itself,” says Arnab Das, global market strategist at Invesco, citing the instant €100bn defence commitment which Berlin made, as a previously pacifist country united behind chancellor Olaf Scholz. Following on from a parade of “amazing” German leaders who have shaped the continent’s history, “Scholz has also stepped up to the plate”.
It is unlikely that the definitive path set by Germany will ever be rolled back after any eventual peace settlement between Ukraine and Russia, believes Mr Das. “Even if the peace talks are successful, the EU will be distancing itself from dirty Russian energy, through its green transformation,” he says.
“There was a lightbulb moment in the war, when Germany cancelled the Nordstream-2 pipeline, even though it was going to hurt them economically,” adds author and digital democracy campaigner Kyle Taylor. “It was a crucial point when Germans decided they foresee their future more in the European rather than the Russian sphere of influence.”
This show of unity and direction means that countries to the east have been further motivated to seek economic and political protection within the European family of nations, accounting for EU membership applications from Ukraine, Georgia and Moldova. Unfortunately for our trio of hopefuls, initiation is no longer straightforward. Joining the EU requires commitment to the single currency and the EU has learned from bitter experience with Greece that misaligned economies put huge pressure on the eurozone.
The only way in which the EU could expand to receive the three aspirants – all of which currently have land occupied either by Russian troops or Russian-backed militias – would be through fostering a much tighter union, embracing fiscal as well as monetary authority. This would in effect make the EU a single country, or some say, an empire, with voluntary membership. “The political will to move to this position looks a long way off,” concludes Mr Bevan. “But extraordinary things can happen in times of extreme geopolitical stress.”
While the emergence of a stronger, more resilient EU should not be written off, most commentators see the struggle for economic and philosophical supremacy between the US and China to be the defining debate for at least another decade. “Europe does not look to have the commitment and cohesion to challenge, and no other bloc looks set to emerge to provide a genuine alternative,” ventures Mr Bevan. “Shorter-term arrangements and expediency may become the order of the day for countries seeking to achieve co-operation and symbiotic mutually advantageous growth.”
This notion of more flexible alliances rather than definitive empires or power blocs emerging also finds favour among other commentators. “Many people in Russia study or travel abroad and are not convinced by the Putin regime. They are agreeing more to a compromise with the West than China, but you need a change of regime and to see Putin go in order to achieve this,” says Prime Partners’ Mr Savary. “Most of the population in Russia lives at the border of Europe, not in Asia. There is a strong possibility that after this crisis, Russia will end up closer to Europe than to China.”
Asset allocation implications
The energy price shock, coupled with lack of supply of agricultural commodities in the region encompassing Ukraine and Russia, is leading wealth managers to reduce exposure of clients to European equities and increase US assets. “Because of Europe’s geographical dependency on energy sources, there will be a much bigger impact here in the short-term than in the US. Europe needs to diversify its source of energy supply,” says Mr Savary of Prime Partners.
“The growth rate in Europe will fall more than in the US.” He also recommends some allocation to real assets to protect purchasing power in this time of rampant inflation.
While the €800bn “recovery plan” commitment from Brussels sounds significant on paper, it can in fact be viewed as modest, relative to the significant challenges the bloc faces. These include differences and divergences between member states, which have never been properly addressed. Sustained, non-inflationary European growth therefore looks unlikely.
This means the European Central Bank will continue to prop up the financial system, believes family office adviser Mr Bevan, who suggests equity investors must take a more selective stance moving forward. The companies they focus on must be able to generate long-term value not just in a regional setting, but a global competitive marketplace.
The backdrop suggests an intrinsic vulnerability for equity markets during 2022, with earnings growth and positive re-ratings not expected until 2023, provided inflation can be brought under control. “Stocks linked to oil, banking and IT look the most likely winners, with relative valuations in small and mid-cap sectors providing the most fertile grounds for stockpickers,” says Mr Bevan.
