(Neil Azous, Rareview) The CEO of Euro Exim Bank Ltd. got economists thinking when he said:
A cyclist is a disaster for the country’s economy: he doesn’t buy cars and doesn’t borrow money to buy. He don't pay insurance policies. Don't buy fuel, don't pay to have the car serviced, and no repairs needed. He doesn't use paid parking. Doesn't cause any major accidents. No need for multi-lane highways. He is not getting obese. Healthy people are not necessary or useful to the economy. They are not buying the medicine. They don't go to hospitals or doctors. They add nothing to the country's GDP. On the contrary, each new McDonald’s store creates at least 30 jobs—actually 10 cardiologists, 10 dentists, 10 dietitians and nutritionists—obviously as well as the people who work in the store itself. PS: walking is even worse. Pedestrians don't even buy a bicycle!
We highlight this quasi-definition of demand destruction because gas rationing in Germany is no longer only a tail risk – it is probable over by winter.
As a reminder, Germany relies on Russia for roughly one-third of its energy.
Firstly, one of Germany’s largest importers of Russian gas – Uniper SE –is in talks with the Government over a potential €9bn bailout package to secure liquidity.
Secondly, energy poverty is now a key theme in Germany. People are considered at risk of energy poverty if they spend more than 10% of their net income on heating, hot water, cooking, and electricity. ~25% of Germany had to spend more than 10% of their net household income on energy in May. This is up from 14.5% of households in the same month last year. (Source: German Economic Institute) Note, Hamburg, Germany’s second largest city, was told over the weekend to prepare for possible warm water rationing if natural gas runs short this winter.
Thirdly, the Achilles heel of the Eurozone – Germany’s trade surplus – is gone. Yesterday, Germany’s foreign trade balance was MINUS €1bn in May, the first negative figure since 1991. This is a direct result of its energy problems and weakness in manufacturing.
Finally, Russia has reduced shipments through the Nord Stream pipeline by 60%. The pipeline is scheduled for a full maintenance shutdown from July 11-21. Germany has raised doubts that Nord Stream will resume supply after that. We have no edge regarding whether the maintenance will last longer, but we would take the “over” on the view that Germany and Russia are now engaged in economic warfare.
Also, given the magnitude of this event, we would argue that there is no contingency plan, especially because the Greens are newly in charge of the energy department.
Therefore, it is increasingly likely that Germany will move to introduce rationing, including prioritizing retail over industrial activity. The question then becomes will Germany institute a 3- or 4-day workweek?
In either case, the extrapolation is further supply chain disruptions and stagflation – it is just a question of timing, degree, and what industry is most impaired.
While not conclusive, here are some samples of the domino effect:
Underweight European Equities
Off-the-shelf asset allocation models suggest increasing emerging-markets stocks and reducing exposure to Europe. Earnings momentum is the most crowded style in Europe. The top industry group weighting in the German DAX is auto manufacturers (i.e., ~12%). In response to the gas crisis, earnings downgrades should accelerate in the coming weeks.
Long European Energy Stocks
Given their off-takes agreements, Shell and Total are the only two companies with gas supply flexibility. Their cash flows will increase. Before dismissing potential energy performance because of ESG, we would note that British American Tobacco (BATS LN Total Return: +3034%) has been the performing stock in Europe over the last 20 years.
Short Euro Exchange Rate (EUR)
The ECB is contending with inflation, the exchange rate, and ringfencing government bond spreads. While interlinked, these three variables are becoming more divergent because of the structural backdrop. Overall, interest rates are too high for Italy and too low for the euro currency, and thus not high enough to reduce inflation. Something must give. The release valve for this trinity is a weaker currency. Technically, any US dollar chart with the euro in the basket is at the precipice of breaking multi-year patterns.
All that said, what makes the outlook for the euro so extreme (i.e., a target of 0.95-0.85 over the next year) is that the scenario analysis is heavily skewed or well beyond the base case. For example, should a gas shortage play out, that should result in extreme stagflation, significant escalation with Russia, and a widening of differentials between the Fed-ECB (i.e., ECB will not have the political courage to raise interest rates as fast as the Fed).
Long US Natural Gas
On the margin, the more Eastern Europe struggles with high local energy prices, particularly natural gas, the more demand there is for floating natural gas. With US natural gas down ~40%, any update from Freeport LNG that they plan to resume operations before October would support the price.
Reduce Carbon Exposure As This Is Too Messy
The value of carbon ETFs has fallen by almost 25% YTD because of the war in Ukraine hitting carbon prices and the European Union signaling it could restrict financial access to its carbon market. These products could weaken further if carbon-related industries come offline in Germany. In times of crisis, no one will commit to their net-zero targets. While the long-run theme remains intact, the short-term tail risks trump it. Also, the Greens in Germany allowing a return of coal (good for carbon offsets) to offset gas is a low probability
