Europe: On the Brink of a Global Re-Positioning

In this week’s note, I draw on Franklin Templeton’s strengths as a truly global asset manager to survey how war, sanctions and other factors are changing Europe’s future. Europe has challenges aplenty, but to borrow the German phrase, a Zeitenwende (changing of the times, or colloquially “a turning point”) is arriving. I believe this change offers opportunity and growth. European dynamism may still be an oxymoron to many, but Europe’s ability to adapt is equally underestimated.

Recent History Has Not Created Optimism for Europe’s Future

Europe’s litany of challenges is well known. Politically, the European Union (EU) is an unusual project as the mix of nationalities, ethnicities and cultures gathered under a political tent offer limited capabilities of common security or defense, much less common destiny. Economically, Europe is mostly wealthy and more egalitarian than the United States, but hardly its rival in flexibility or innovation. Historically, Europe’s economy is more outward looking but also more dependent on imports—above all for raw materials and energy.

War and sanctions have laid bare Europe’s dependency on Russian energy imports. Most importantly, natural gas. Nearly 40% of Europe’s natural gas imports flow via pipeline from Russia.[1] Those supplies cannot be quickly offset by imports of liquified natural gas (LNG) or alternative energy sources, including any delays of nuclear power decommissioning. Critical infrastructure, such as intra-regional gas distribution and power generation, has been built for decades with Russian supplies in mind.

There is no magic switch to instantly shift from Russian gas to something else. Modern economies are built with paramount emphasis on efficiency and cost, not redundancy. That lesson is now twice learned—once during the global supply chain disruptions stemming from COVID-19 and most recently via war and sanctions.

Do Not Count Out Europe’s Resilience

Yet, it would be wrong to assume that Europe is resigning itself to the status quo. Shortly after Russia’s invasion, Germany refused to certify the opening of Nord Stream 2, a recently completed major addition of pipeline to offer Russian natural gas supply via the Baltic Sea. That decision reversed a quarter century of German policy, including the personal efforts of former Chancellor Gerhard Schr?der, who was directly involved in the promotion, development and financing of Nord Stream 2.

Moreover, it is the stated aim of the EU and the new German government to reduce gas imports from Russia by two thirds by the end of this year.[2] That will be a massive undertaking, requiring large LNG imports from Qatar, the United States and Nigeria, among others.[3] It will also require politically difficult reductions in household and business energy use, partly offset by windfall taxes on utilities to subsidize low-income consumers otherwise struggling under the higher cost of energy. Politically, it will require uncommon flexibility on the part of key political constituents—including the Green Party in the current German coalition government—to accept delays in closing nuclear power facilities.

Sacrifice, in other words, is the order of the day.

In other circumstances, the divisions of Europe would make the task insurmountable. But Putin’s invasion of Ukraine has resulted in an unexpected response: a more united Europe. Those who have long warned of Putin’s authoritarian and imperial ambitions may wonder why it took so long, but a moment of common purpose in Europe has arrived.

The Near Term May Still Be Challenging

In the short run, the risks to Europe are considerable. Should war, sabotage or Russian counter-sanctions interrupt Europe’s natural gas supplies, its economy could possibly stumble into recession. The European Central Bank (ECB) estimates suggest that in a worse-case scenario, Europe’s economy could shrink by 2-3% if gas supplies from Russia were cut off.[4]

The reverberations of a European recession would be felt worldwide via slowing growth, falling corporate earnings, and higher risk premia. Given all the uncertainties about how the conflict in Ukraine may play out, that is not a scenario that investors should easily dismiss.

But equally, the Zeitenwende offers opportunity. The construction of new LNG terminals (Germany is on the verge of approving two of them) and their related distribution networks, as well as the possibility of transporting hydrogen from Norway to the Netherlands and onward elsewhere in Europe are massive infrastructure projects. Wind and solar investments are also slated for further expansion, as are ongoing efforts to electrify Europe’s auto fleet and expand charging networks. Industrials, alternative energy, and utilities—Europe’s once-stodgy sectors—are suddenly looking like the foundations for a new future.

Here, too, challenges loom. Sourcing minerals previously supplied by Russia, for example nickel, aluminum, or copper, will become more expensive. Over the next half year, supply shortages could even hinder production in key sectors, such as autos (particularly electric vehicles). Yet, long-term investors ought to see such bottlenecks as short-run impediments along a secular transition to more diversified, modern, and dynamic European energy and industrial sectors.

The diversification of Europe’s energy sources and modernization of its distribution are enormous undertakings and will have the by-product of invigorating Europe’s engineering and industrial sectors, which have always been the backbone of its economic strength. Investors would be wise to look beyond the near-term challenges confronting Europe and focus on the long-term opportunities for growth.??

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[1] Source: BP – Statistical Review of World Energy 2021, US Energy Information Administration, Statista.

[2] Source: European Commission: Joint European action for more affordable, secure energy (europa.eu)

[3] Source: BP – Statistical Review of World Energy 2021, US Energy Information Administration, Statista.

[4] Source: European Central Bank. Growth and inflation projections for the euro area. There is no assurance that any estimate, forecast or projection will be realized.?