Last month, we described how the European Central Bank (ECB) pivoted to a more hawkish stance at its February meeting. At the time, we outlined how the bank would update its economic projections and reassess its outlook in March. Now, instead, a single development is likely to dominate discussions when the ECB’s Governing Council meets on 10 March: Russia’s invasion of Ukraine.
The Conflict in Ukraine Will Weigh on Activity and Raise Inflation – a Dilemma for the ECB
The economic impact of Russia’s invasion constitutes a clear negative supply shock for the euro area that creates a dilemma for policymakers. On the one hand, higher energy prices will hit economic activity, reduce confidence and damage trade and financial links. On the other hand, the conflict will raise inflation for firms and households.
ECB President Lagarde’s statement last Friday, 25 February, that “the ECB is closely monitoring the evolving situation” makes clear that the bank is keeping its options open. We expect it to maintain its dovish stance on 10 March, with a gradual tapering in asset purchases as announced last December.
Recent events also offer the ECB an opportunity to regain control of the inflation narrative: higher-than-expected inflation outturns are clearly due to an external shock outside of its control. All else equal, sustained higher energy prices will slow the pace of monetary policy normalisation in the eurozone, with a 2022 rate hike now unlikely.
Our Base Case Scenario Foresees a Delayed, but not a Derailed, Euro Area Recovery
Our base case scenario assumes that gas from long term contracts with Russia continues to flow, as it did throughout the Cold War. Additional supply from the U.S. and Norway can cap further price rises, possibly helped by mild weather and the end of winter in western Europe. This scenario, the blue line in Figure 1, sees euro area GDP (gross domestic product) grow by 3.7% in 2022, 0.5 percentage points below our 4.2% projection before Russia invaded.
Figure 1
Euro Area GDP Projections (Index, Q4 2019 = 100)
PGIM Fixed Income
Despite higher energy prices, however, momentum in the eurozone economy remains strong. Deeper budget deficits can therefore lead support to households and firms, with accommodative monetary policy as a facilitator. The corresponding increase in national budget deficits could plausibly lie in a range of 1 to 3 percentage points (pp) of GDP. Centrally-issued European Union (EU) debt, first conceived during the pandemic, would probably support member states’ deficits. And appetite for a more radical overhaul of the bloc’s Stability and Growth Pact, away from austerity, is likely to grow among its members.
Beyond the immediate support to households and firms, additional outlays could encompass investments first tabled to address climate change. These would include spending on alternative gas supplies, accelerating the conversion to renewable energy and slowing down the phase-out of nuclear power. As demonstrated by German chancellor Olaf Scholz’s €100 billion initiative unveiled on Monday, defence spending is expected to rise as well.
Politically, the conflict in Ukraine has reinforced the eurozone’s recent direction of travel: accelerating the transition to a green economy, further integrating member states’ economies, and reinforcing its so-called “open strategic autonomy” – the ability to rely on the euro bloc’s own resources while working with external partners, such as the U.S., when needed.
Recent elections in Germany and Italy have demonstrated a shift away from the nationalist, anti-EU sentiment that was popular only a few years ago. In France, Russia’s invasion has strengthened President Macron’s position ahead of presidential elections in April, at the expense of candidates seen to be friendly towards President Putin. As a result, the European Union has a much stronger centre of gravity now, compared to its situation before the pandemic.
A Worst-Case Scenario: Long-Term Disruption to Gas Supplies
Further escalation of the war and long-term disruption to gas supplies are plausible risks to our base case scenario. They could materialise due to a further tightening of sanctions, physical damage to pipelines, payment system problems or the wilful interruption of supply by Russia. Russia supplies around one-third of Europe’s energy imports, a gap that would be difficult to plug in short order.1 Such a shortfall could meaningfully affect energy-dependent, industry-heavy economies that rely on Russian gas, like Germany and Italy.
Provisional calculations based on ECB research suggest that a 10% reduction in gas supplies to the euro area would reduce gross value2 added by 0.7%, not including amplification effects on economic confidence and supply chains. Back-of-the-envelope calculations suggest that a total shutdown of Russian gas supplies to Europe might reduce euro area GDP by as much as 5 percentage points (the red line in Figure 1) – an effect 10 times larger than our base case.
Even these conservative estimates of the effect of long-term disruption on European growth are large, in line with the Global Financial Crisis (2008). Should our worst-case scenario materialise, we expect that GDP growth would fall to –1% in 2022, similar to what happened during the euro sovereign debt crisis (2012).
Asymmetric Risks to the Euro Area
Disrupted Russian gas supplies would have an asymmetric impact across the eurozone. Austria, Slovakia and Italy would feel the effects of a stoppage first, because they rely on Ukraine as their main transit corridor for Russian gas. Later on, Germany and Italy’s industry-oriented, energy-intensive economies would be hardest hit, due to their greater reliance on Russian energy than, for example, France. The Netherlands and Germany export significant volumes of high-tech manufacturing equipment to Russia, which export bans would reduce.
An asymmetric shock may disproportionately weigh on growth in economies such as Italy and make their debt unsustainable. That danger may make the ECB more cautious in normalising monetary policy, to prevent peripheral sovereign bond spreads from widening. But traditional monetary hawks such as Austria, the Netherlands and Germany are relatively susceptible to the supply shock we described as well. Their acquiescence could remove a further obstacle for the ECB to adopt a dovish stance for longer.
If the situation were to deteriorate, we could see the continuation of open-ended asset purchases, a so-called “lower for ever” scenario for interest rates and active interventions by the ECB to stop a widening in the bond spreads of peripheral eurozone members. Even the creation of a permanent central fiscal authority for the Euro area could conceivably be an option.
Conclusion
In our base case scenario, the crisis in Ukraine will reduce euro area growth from 4.2% to 3.7% in 2022, delaying but not definitively derailing the recovery. Euro area budget deficits will widen further, possibly by 1 to 3 percentage points as a share of GDP, and monetary policy is expected to remain lower for longer, with no rate hike in 2022.
In our worst-case scenario, long-term disruption of Russian gas supplies could reduce the euro area’s GDP growth by as much as 5 pp in 2022, to -1% for 2022. The conflict in Ukraine will affect some euro members, such as Italy, more than others. Such fragmentation could lead to an even more dovish stance by the ECB and greater fiscal integration across the euro area.
Recent geopolitical developments have introduced new uncertainties to a market that was already challenged by rising inflation and a global wave of central bank tightening. While previous geopolitical shocks have typically been short-lived, the situation between Russia and Ukraine could have more profound near-term implications for financial markets. And perhaps more importantly, recast the balance of power between the East and West. Have markets accurately discounted the risks or is the potential for military mishaps, stagflation, and a hard landing underestimated?
Join PGIM Fixed Income's Chief Investment Strategist and Head of Global Bonds, Robert Tipp, CFA, and Global Investment Strategist, Guillermo Felices, PhD, for our webcast as we address these important questions and more.
1See McWilliams, Sgaravatti, Tagliapietra, Zachmann (2022), “Preparing for the first winter without Russian gas”, Bruegel blog post 28 February 2022.
2Gross Value Added is a close proxy for GDP, which removes product subsidies and product taxes from GDP.
This material reflects the views of the author as of March 1, 2022 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income. We do not guarantee the accuracy of such sources or information. This outlook, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and our views are subject to change. Past performance is not a guarantee or a reliable indicator of future results.
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. Clients seeking information regarding their particular investment needs should contact their financial professional. These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. All investments involve risk, including the possible loss of capital. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or an y investment management services and should not be used as the basis for any investment decision. No risk management technique can guarantee the mitigation or elimination of risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.
Conflicts of Interest: PGIM Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. PGIM Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. PGIM Fixed Income and its affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. PGIM Fixed Income’s personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to PGIM Fixed Income’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of PGIM Fixed Income’s Form ADV.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In South Africa, PGIM, Inc. is an authorised financial services provider – FSP number 49012. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you of that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 - Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2022 PFI and its related entities.
2022-1655