Europe’s Unfolding Crises Could Impact U.S. Stocks. Here’s How.

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U.S. investors are laser-focused on the Federal Reserve, and for good reason. The central bank is about to lift interest rates by another 0.75 of a percentage point, just as the quieter side of this tightening cycle, portfolio shrinkage, escalates. But that focus means other dangers aren’t getting the attention they deserve.

“While understanding the risk-free cost of capital is always central to investing, we fear equity investors have become overly myopic,” says Lisa Shalett, chief investment officer at

Morgan Stanley Wealth Management
.

Volatility has ticked up across currency and global bond markets, but the VIX, the U.S. stock market’s volatility gauge, has been benign, says Shalett. She warns that nearsightedness is setting the stage for a fraught 2023.

One risk that deserves more attention here are the crises unfolding in Europe. The continent is facing an energy shortage that is spurring record inflation and pushing the economy into recession. As the European Central Bank raises rates to pull down prices, higher borrowing costs dampen demand and could provoke another debt crisis. According to Zoltan Poszar, global head of short-term interest-rate strategy at Credit Suisse, roughly $1.9 trillion of German manufacturing output relies on the equivalent of just $27 billion of Russian energy input. Germany, Europe’s biggest economy, has been particularly reliant on Russian energy.

As Alfonso Peccatiello, author of the Macro Compass newsletter, puts it, that is quite some embedded leverage.

What happens in a highly leveraged environment when the cost or availability of the leverage—in this case, both borrowing rates and Russian energy—changes drastically? The system becomes unstable, Peccatiello says.

A common misconception, he adds, is that only certain European countries have excessive debt. In fact, he says, the public and private debt of all major European nations easily exceeds 200% of gross domestic product—and that doesn’t count contingent liabilities, or government guarantees, or liabilities of public corporations, which can be substantial. Germany’s contingent liabilities, for example, exceed 100% of GDP.

On Thursday, the European Central Bank delivered a three-quarter-point rate hike, following a half-point increase in July, after nearly a decade of negative interest rates. ECB President Christine Lagarde warned that inflation is spreading beyond energy to a range of products, and said the ECB is ready to boost rates aggressively over the next several meetings.

Energy inflation already is severe, and is affecting economic growth. The average German household is paying nearly 13 times more for power now than in January 2020, or about $38,000 versus $3,000 before Covid, says Peter Boockvar, Bleakley Financial Group’s chief investment officer.

Yes, there are price caps and subsidies, but the latter are a double-edged sword. Germany has said it will spend at least $65 billion to help some citizens afford energy and give tax breaks to energy-intensive businesses. This would mark the third round of support related to the energy crisis, bringing the total to about $100 billion, at a time when consumer price inflation in Europe is running above 9% a year.

High prices can help cure high prices, but that effect is limited when it comes to essentials. Strategists at

Deutsche Bank

say that German natural gas consumption was 20% below its five-year average in March, allowing the government to stockpile gas for the winter at a faster pace than some analysts had anticipated. But Deutsche notes that August was a summer month with light demand; winter is a different story. If Germany continues to receive no Russian gas and even if demand stays 15% below average this winter, the bank says supplies will be depleted by March. Diminishing supply likely would prompt rationing this winter.

Bleakley’s Boockvar says that U.S. investors might not appreciate how Europe’s problems could flow back here. The economies of the European Union and the U.K. combined are about $20 trillion, not much less than the roughly $25 trillion U.S. economy, and represent about a quarter of global GDP, he observes. Europe contributed about 25% of

Apple
’s
(ticker: AAPL) earnings in 2021, with the region representing 20%-25% of S&P 500 revenue. In addition to potentially reduced demand due to high energy prices, U.S. companies with heavy European exposure must contend with the strong dollar, which is making their products more expensive abroad and shrinking repatriated profits.

Europe’s woes could lead to opportunities, too: While analysts such as Peccatiello recommend avoiding European investments, Shalett of Morgan Stanley is less pessimistic. European stocks have underperformed U.S. shares for most of the past 12 years, in part reflecting disappointing relative growth and less effective monetary and fiscal policies. In the past 12 months, Shalett says, Europe’s relative forward price/earnings multiple has crumbled, due to a weak post-pandemic recovery and effects of the Russia-Ukraine war.

While recession in Europe seems inevitable, the ECB is likely to keep hiking rates, and a debt crisis is more than a remote possibility. Some of this bad news is discounted in the region’s stocks, Shalett says, meaning there are opportunities for patient investors. U.S. assets, on the other hand, are becoming unattractive for foreign investors as currency-hedging costs are high, inflation-adjusted rates converge, and the Fed’s bond purchases wane, she says.

Fed policy will remain top of mind for U.S. investors. But tuning out other dynamics, especially in Europe, is unwise, and could be costly.

Write to Lisa Beilfuss at [email protected]