March 17, 2022

Frédérique Carrier
Managing Director, Head of Investment Strategy
RBC Europe Limited

Elevated energy costs, supply chain disruptions, and reduced demand as the uncertainty of the war dampens consumer spending will all conspire to dent the European economic recovery in 2022, in our opinion. This unwelcome turn comes after the region started the year on a relatively strong footing, benefiting from the reopening of economies after lifting the COVID-19-induced restrictions.

With the implications of the conflict becoming clearer, economic forecasts are being revised down. Eric Lascelles, chief economist at RBC Global Asset Management Inc., recently further fine-tuned his 2022 projection for the eurozone’s GDP growth to 2.5 percent, down from 3.8 percent early this year. Still, the decline in energy prices of late could give the region some respite.

Lascelles looks for inflation to peak higher, at around eight percent year over year. Worried about such a high level, and the impact of the war on economic growth, the European Central Bank (ECB) is angling for some flexibility. While it announced it will accelerate the reduction of its asset purchase programme, aiming to end it in Q3, the ECB also suggested it could increase bond buying again if circumstances warranted. Furthermore, the ECB’s statement after the March 10 policy meeting omitted the comment that rates could rise shortly after the end of asset purchases. RBC Capital Markets expects the ECB will only increase interest rates in 2023.

Dealing with the crisis

The EU’s response to the war has been swift and decisive, and showed strong cohesion across the region, in our view. It applied punishing sanctions, and mobilised EU funding to deliver weapons to Ukraine. With the new geopolitical order making reducing the reliance on Russian energy imports an imperative, the EU proposed an ambitious plan, REPowerEU, to decrease Russian natural gas imports by two-thirds by the end of 2022 and completely by 2030. This will require procuring natural gas from alternative sources, relying more on coal and nuclear power, accelerating the rollout of renewable energy, and pursuing various energy efficiency policies while replenishing reserves. It remains to be seen whether all this can be achieved within the set time frames, and at what cost, but the direction is clear. More details on this plan should be forthcoming over the next two months.

Furthermore, a fiscal response is in the offing that should eventually underpin growth. At an informal summit on March 10–11, EU leaders agreed on the priorities of defense, energy, and economic resilience. A spending programme of €2 trillion was discussed. There was a general recognition that the €750 billion recovery fund to help member countries weather the pandemic has been productive by providing member states with fiscal flexibility, enabling the EU to coordinate loans and transfers, and allowing for the issuance of debt at the EU level. In effect, the recovery fund is seen as a prototype with the discussion evolving towards whether there is scope to use it to underpin new initiatives as not all funds have been released. More joint debt issuance is likely, in our view. The summit also launched a dynamic framework for the meetings of the EU Council coming up later in March and June where more details should be ironed out.

Portfolio implications

We opine that in the medium term fiscal spending should underpin growth, while over the long term the EU should eventually emerge from the conflict with stronger institutions. But the short-term outlook is nevertheless more complex than it was earlier this year.

The MSCI Europe ex UK Index is down more than 10 percent in local currency terms since its January high, leaving the index to trade at 14.5x the forward consensus earnings estimate, a steeper-than-average discount to the U.S. on a sector-neutral basis. This low level suggests that the reductions in growth forecasts largely appear to be factored into the current valuation.

Yet we think it is prudent to downgrade European equities to Market Weight from Overweight given it is a market with a relatively high proportion of cyclicals.

We still believe there is an attractive opportunity in stocks related to the green energy transition. This remains very much a priority for the EU, and if anything it is now seen as a security issue and not just an environmental matter. Europe continues to be a leader in this area and we think compelling opportunities can be found after the recent correction.

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Frédérique Carrier

Managing Director, Head of Investment Strategy
RBC Europe Limited