Europe faces increasingly severe stagflationary risks due to its energy crisis and markets are going to test the credibility of the regions central banks. Brace for a stress test in European assets.
It has been a hot summer for risk assets, but the outlook ahead is considerably bleaker, especially in the broader Europe, which is facing the risk of an acute stagflationary shock this winter.
The prolonged conflict in Russia-Ukraine, alongside an extreme drought this summer has pushed electricity costs sharply higher and we believe these costs are likely to remain elevated through the winter, generating a new inflationary impulse and causing a meaningful drag on growth. Real incomes and real interest rates are both firmly negative, political uncertainty is high and the risk of a test of central bank credibility in Europe and the UK is rising.
In our framework, a principal component of an inflationary environment is higher baseline volatility as the market prices a wider distribution of central bank driven policy outcomes . The further behind the curve, the more this risk premium builds as policy makers eventually pivot. Initially, the convexity is heavily skewed toward higher rates and then, as the cycle matures, volatility remains high but the distribution becomes more two sided.
A typical cycle (at least for the last 30 years) assumes that inflation is a demand side issue. While you can get rolling positive demand shocks (Trump tax cuts are one example), this is rare and so the likelihood of new inflationary impulses driven by demand is low and so inflation risk premium should fall over time.
This is not the case for supply shocks, as we are currently experiencing, as supply shocks can compound Furthermore, central bank policy is less effective to deal with supply shocks. In essence, supply shocks open up a whole different distribution of inflation risk premium and with that rates and curve shape.
This is a growing risk now in Europe as we head into the winter. The prolonged grinding war in Ukraine has given no room for any diplomatic resolution and countries are rapidly trying to rebuild gas inventory for the winter. Electricity costs are up between 50-70% in the last month across the curve and worryingly long term power costs (1y ahead) have also increased exponentially. This has been compounded by low water supply in the Rhine and elsewhere.
German Wholesale Power EUR/MWH - 1 year fwd
The impact on CPI will be immediate, with JP Morgan estimating an 83% surge in natural gas prices to consumers this October in the UK, which should hold the CPI above 10% through to the spring. For broader Europe, energy and electricity prices at these levels, alongside low water levels, present clear downside risks to manufacturing over the winter (we have already seen high intensity smelting plants shut). This assumes a normal winter, a cold winter would create conditions for a true energy and societal crisis.
There are signs that the prolonged inflation shock in Europe and the UK is feeding through into wages, with increases in negotiated pay (unionized pay) broadening across the continent. However, even with these wage increases, real wages continue to fall.
The 3.6 standard deviation move higher in UK rates last week is evidence of this dynamic and this situation is not unique to the UK. From our perspective, the risk that the market tests the resolution of central banks in September is rising, with both the BoE and ECB looking significantly behind the curve again relative to inflation. In this scenario, we would expect meaningful new lows in EUR and GBP in a volatile fashion, which would push central banks to respond creating 30-50bps upside in front end rates, which we expect would flatten the curve by another 20-40bps in 2s10s.