Europe Is Heading For “Deep Recession”, Deindustrialization

With natural gas prices over $100 more per megawatt hour than they were a year ago, the Western European economies are heading to the Middle Ages.

Forests are being cut for firewood as Russia retaliates with its own Ukraine war sanctions by shutting off the trickle of natural gas it was still piping into Europe.

Germany, watching companies suffer high electricity bills (Arcelor Mittal is closing two steel mills there), is finally talking about decoupling from China. The energy crisis is making them nervous. They want to make it harder for manufacturers to outsource now that their energy bill is at an all-time high.

This no longer looks like a short-term crisis.

Stories from Western Europe are like stories one once heard in countries like Bolivia. High inflation and resource rations imposed by the state.

Corporate investment goes where money goes farthest. It used to be taxes and labor and environmental costs they looked at. Now European companies will add electricity to the mix. None of this bodes well for European businesses.

For this reason, new UK Prime Minister Liz Truss has given up listening to the climate lobby and said the country would end its fracking ban. Britain is in the same boat as the EU. Brexit didn’t shield it from Europe’s policy errors.

Germany is signing long-term contracts for U.S. LNG to save itself, though it will have to find a place to put it all. For this reason, they will have to build new terminals to handle those shipments quickly.

But these actions should have been done years ago, or at least set in place before the Russian sanctions were announced. Europe had no Ace up its sleeves.

“We now expect a deeper prolonged recession and more persistent elevated inflation due to the impact of higher energy prices, a more decisive European Central Bank tightening cycle and weaker…demand,” says Barclays Capital economists led by Silvia Ardagna.

The European Central Bank raised its main lending rate 75 basis points to 1.25% last week. That’s still historically low. But the EU economy has been so used to near-zero rates that liquidity will start to dry up as capital costs rise. All the margin traders will think twice about buying securities on leverage, among other things.

Vanguard’s FTSE Europe (VGK
) is not a buy. This looks like the classic dead cat bounce.

Europe’s Recession: How Bad Will It Be?

Barclays forecasts a eurozone recession in the fourth quarter that will persist until the second quarter of 2023, with a 1.7% contraction in real GDP.

Some countries will be worse off than others.

Barclays revised their growth rates down in Germany (2023: -2.3%), Italy (-2.1%), France (-1.2%) and Spain (-1.6%).

Germany will be the worst due to its high reliance on Russian gas and bottlenecks in transporting gas within Europe. Most piped gas is from Russia.

Italy is the second worse performer because it is highly dependent on natural gas to generate electricity, using it for about 50% of power generation. These factors mean Germany and Italy are more likely to face physical shortages while the energy crisis represents more of a price shock for France and Spain, Barclays economists wrote on Friday.

Inflation in Europe should peak at 9.3% in the fourth quarter. Barclays says that domestic drivers of medium-term inflation now look weaker than they did in June as demand slows and real incomes fall flat.

Europeans will be spending a lot on fuel.

Natural gas prices are up by around $170 per megawatt hour over the last 12 months. In the U.S., we measure natural gas price by British thermal unit. Prices closed at $8.81 per million BTU on Friday for the nearby futures contract while EU natural gas is around $50 per million BTU.

Despite these inflationary headwinds, the ECB is seen raising rates by 75 basis points in October to fight inflation.

Europe and Russia’s Energy Decoupling

In the past five years, the European Union consumed on average 400 billion cubic meters (bcm) of natural gas a year, of which roughly 100bcm was consumed by households, and 167bcm was used by industry. Another 133bcm was used as an intermediate input in the energy sector.

Before the Russia-Ukraine war, the EU sourced almost half of its natural gas imports from Russia, and so when Russia cuts its gas exports to Europe in retaliation for sanctions, the only thing to do is ration and scramble for alternatives. Why these leaders did not think of this before is for another source to debate.

Barclays calculates that Russia is exporting only around 25% of its average yearly amount to Europe (based on five-year averages), and will suspend shipments from the Nord Stream pipeline connecting Russia to Germany.

Europe has been able to substitute large quantities of Russian gas with more costly LNG from other producers, but they have also had to cut gas consumption.

According to the European Commission, Europe needs to reduce gas consumption by around 15% (or around 60bcm) of its annual consumption if they break up with Russia. This calculation, however, still assumes Russia sells some natural gas to Europe.

Of this 60bcm of savings, based on an IMF paper published on July 19, 2022, Barclays estimates that roughly 16bcm will be the real shortfall, but that assumes the rest of the 60bcm can be made up by renewables. Considering Green Party-obsessed Germany is now burning coal again, solar and wind are unlikely to save them.

Barclays says that Europe can fill most of that gap (minus the 16bcm) if it adds nuclear and coal to its renewable energy matrix. Any mandates to reduce energy consumption will hurt the economy as much as high electric bills.

Eventually, the European business class and general population will pressure leaders to change course. As that pressure is accompanied by more announcements of layoffs and factory shutdowns (imagine BMW stopping their EV assembly lines because charging a car is too costly, as are the energy-intensive materials to make it — like steel), then that’s probably as good a time as any to call the bottom in this crisis.

Natural gas prices in Europe are falling for several reasons — including commodities investors cashing in after a huge price run-up. This is good news for Europe.

Protests are just getting started. So are the layoffs and shutdowns at high-paying jobs. Those prices will have to fall even more.

Barclays says they expect a U-shaped recovery by the second half of next year. That means the FTSE Europe may anticipate that around March.

Until then…thoughts and prayers.