European unity tested, as ECB raises rates, and Draghi resigns...

This year is shaping up to, quite possibly, be the most trialing period in the European Union’s history. The continent is plagued by several trials and tribulations that may lead to GDP contractions in upcoming quarters. For market participants navigating European markets looking to identify bearish/bullish scenarios, a deep understanding of all headwinds is essential in order to accurately capitulate on any trends that may arise as a result.

Energy crisis tests EU unity

Most recently, the European Commission’s bid to unify member countries behind the ‘Save gas for a safe winter’ energy conservation operation has, thus far, been unsuccessful. In a rare turn of events, Southern European countries, i.e., Portugal and Spain, criticized the conservation target of a 15% reduction in gas consumption as being simply too high!

The efforts primarily aim to alleviate pressures for Northern European countries (i.e., Germany), as indicated by insinuations from Spain’s energy minister Teresa Ribera, stating that “Unlike other countries, we Spaniards have not lived beyond our means from an energy point of view”.

Furthermore, Hungary—long considered a fringe regime within the EU—announced last week an energy emergency and prohibited any exports to other EU states. In any case, despite the initial resistance to the ‘Save gas for a safe winter’ initiative, under EU rules, the proposal must be approved by either 55% of EU countries, or by any number of countries that collectively represent 65% of the union’s total population. The emergency meeting for voting is poised to take place next week, with the outcome highly anticipated by investors.

As of now, Russia has restarted gas supplies to Europe following a maintenance shut down lasting 10 days. However, Germany’s Federal Minister for Economic Affairs, Robert Habeck, stated that “Russia as an energy supplier has become unreliable”, thus he doesn’t feel confident of Europe’s energy security relying on Russian gas.

Thus, uncertainty lingers regarding the EU’s cohesion on energy policies moving forward, and the prospect of continued supply of Russian gas. Both factors are critical, and the longer uncertainty persists, the larger the projected economic impact.

European Central Bank raises interest rates

As the eurozone deals with an unprecedented energy supply-crunch, reported inflation surged to 8.6% leading ECB’s president Christine Lagarde to announce a 50pp rate hike, whilst also vowing to fight surging borrowing costs from sparking a debt crisis amid the ongoing energy crisis, and Italy’s political turmoil.

Under president Lagarde’s mandate, several tools to tackle rising borrowing costs were thoroughly researched and discussed. Ultimately, Lagarde and governing council members decided to tackle a notorious vulnerability in eurozone’s policy by vesting the ECB with the power to buy unlimited bonds of any country it assesses to have endured a fundamentally unexplainable increase in borrowing costs. Trepidation stemming from historical precedent, has meant the ECB weighed all its options carefully before proceeding with the first rise in rates for more than a decade—which was also twice the initially agreed upon hike. Contrary to most CBs globally, the ECB delayed hiking rates due to worries that it could drag the union into a recession in the existing macro environment driven by Russia’s war in Ukraine. However, the urgency borne from swelling inflation, obliged the ECB to proceed with the rate hike.

As the head of policy and central bank strategy at Evercore, Krishna Guba, said;

“the combination of a brewing giant stagflationary shock from weaponized Russian natural gas and a political crisis in Italy is about as close to a perfect storm as can be imagined for the ECB.”

At present, growing recessionary pressures are highlighted from recent Euro Area composite PMI now entering levels indicating contraction in manufacturing. Bearish indications are mounting as investor confidence in the EU is rapidly declining.

Draghi forced to resign, plunging Italy in political & financial turmoil

Without getting into detail on what led to Draghi’s final resignation, it’s critical to understand the significant financial impact of a prolonged political uncertainty in Italy. The country is tasked with forming a new government capable of withstanding the difficult winter ahead.

In part, European officials accelerated the finalization of the bond buying mechanism aiming to assist Italy quickly if necessary. However, despite the ECB’s intention to help Italy, several analysts argue that the current political turmoil could materially change the country’s economic fundamentals. In example, if the newly formed government fails to carry out the pre-agreed structural reforms as part of the EU recovery fund, then Italy would not meet the criteria necessary to participate in the ECB’s bond buying program.

Synopsis

As the European Union combats multiple headwinds (i.e., inflation, impact of rate hikes, Italy’s political turmoil, and the energy crisis), investors ought to closely monitor the market’s reaction for signs of any buildup in momentum—particularly of selling pressures. Additionally, considering Italy’s political uncertainty, it’s recommended to steer clear, or limit, direct investments in the country. In contrast, a catalyst with substantial upside, for the Euro Area, is the possibility of a truce/treaty that results in the termination or reduction in hostilities between Ukraine and Russia.

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Sources: Financial Times, Reuters (Refinitiv), Macrobond, Bloomberg.