Introduction

The war in Ukraine will drag down 2022 global GDP, especially in the Eurozone. The question is if it causes a moderate or large impact to economic activity. We go through these issues in this Econosights.

Impacts to the Eurozone

The direct hit to Russia and Ukraine’s economy from the war will be very large (probably around a 10-15% contraction in GDP). But, this impact on global GDP is minimal because the two economies make up a small 3.5% of global GDP in purchasing power parity terms. The larger impact to global GDP will be the flow-on impact from the surge in inflation and the hit to consumer purchasing power in other economies. The lift in commodity prices which we have written about here and here is being felt globally, but espeically in the Euro area. The countries of the Eurozone account for 13% of global GDP so a significant change in Euro GDP would make a noticeable impact to global GDP.

Eurozone inflation was already running high before the conflict in Ukraine started.

The latest data for February (which would have captured some of the recent moves in commodity prices) showed that Eurozone headline CPI was running at 5.8% over the year to January 2022 and core inflation was 2.7% higher on a year ago. This is the highest pace of annual growth in consumer prices on record (since the data began in 1997 – just before the Eurozone was created).

High inflation is being driven by steep price rises in electricity, gas, other household fuels and petrol. Food prices have also increased. But, broad-based inflation pressures are not as prevalent in the Euro area as they are in the US. The proportion of categories in the consumer price data with annual price growth above 3% has risen to around 38% of the total, which is the highest level since 2008 but it is not as high as in the US, where around 78% of conusmer price categories have annual inflation above 3%.

The increases to commodity prices across gas, coal, metals, oil and agriculture recently as a result of the Russia/Ukraine war will cause further upside to inflation from here. Europe is expected to be the least insulated from higher prices across the advanced countries because of Europe’s reliance on Russia’s commodity exports. On our estimates, higher commodity prices will add 0.6 percentage points to Eurozone headline inflation over the year to June, taking annual growth in inflation above 6% per annum.

In our view, the European Central Bank is understating the impact of the war on the Eurozone economy. On ECB estimates, the conflict will reduce 2022 Eurozone GDP by 0.5 percentage points, leaving GDP growth at 3.7% in 2022 and 2.8% in 2023. In contrast, we see GDP growth of 2.9% in 2022 and 3% in 2023 (our forecasts were already more pessimistic than the ECB’s before the start of the conflict because the high level of inflation). We expect very low GDP growth of 0.1% and 0.3% in the March and June quarters respectively as consumer spending declines in response to high inflation. The second half of the year is expected to be stronger as commodity prices normalise which allows consumer spending to rebound. The risk is of a recession in the first half of 2022 is high (consecutive negative GDP growth in the March and June quarters).

There are both upside and downside risks to our growth forecasts. A faster than expected de-escalation in the conflict could see a faster normalisation in commodity prices. But, the general trend for Europe to move away from Russian energy is likely to keep commodity prices elevated compared to recent years (the European Commission announced that over 2022 Europe will reduce its reliance on Russian gas by ~65%). Other positives are upcoming warmer weather in the northern hemisphere which means less heating demand and the likelihood of some fiscal stimulus being utilised to help consumers and businesses with rising prices.

The major downside risk to our forecasts is a further escalation in the war, which drags in NATO members or the complete stop of gas flowing from Russia to Europe if Russia retaliates against the sanctions imposed.

Activity trackers

Our economic activity trackers use high frequency data to give a guide to current economic conditions. Activity slowed in January from rising Omicron cases, there was an uplift in Febrauary as mobility increased and activity has stalled since then. We expect further weakness through March. Germany is underperforming the other European countries in the activity tracker and has been since December (although Italy also had a large decline in activity early in the year).

Implications for the European Central Bank

The ECB sounded more hawkish than expected at its March meeting by accelerating the tapering of its quantitative easing program which is now expected to finish in Q3 2022 (subject to the economic data). The ECB think that rate hikes are still approriate “some time after” the end of its asset purchase program which still leaves the door open to 1-2 interest rate hikes this year.

Market expectations are pricing in around 2-3 interest rate hikes over the next 12 months. If our forecasts for Eurozone GDP growth this year are correct (which are lower than the ECB’s) then this is likely to extend the ECB’s asset purchase program into Q3 2022 and it could mean only 1 hike in late 2022 or even a delay to rate hikes until early 2023 (unless the ECB decide’s to prioritise controlling inflation).

Implications for investors

An inverted yield curve (when the yield on long-dated bonds falls below short-dated bonds) can often be an early signal of a future recession (but it has also given false signals in the past) because it means that the central bank may need to cut interest rates in the future. The chart below shows the US yield curve, which is close to inverting on one measure. It is something to watch as a signal for a potential US/Euro/global recession while uncertainty remains high.

European equities have felt the brunt of the recent drawdown in shares, falling by 23% from peak (early January) to trough (early March) because of the negative impacts to growth and inflation. Euro shares have recovered marginally since then, but are still down by around 15% since January highs. While US shares did not fall as much, they have been trending sideways in recent weeks and are still down by 13% since January highs.

In the short-term, concern over the outlook in Europe could see more downside in global shares (especially in Eurpe). But in the medium-term, our view that the conflict will be contained in Ukraine and not spread to NATO countries means that we still expect shares to be higher in 6-12 months time. We still think that over 6 12 months time, non-US shares will outperform in an environment of rising global yields and a more hawkish US Federal Reserve as well as higher concentration of tech shares in the US share market index which should underperform as rates rise.