The European energy crisis deepens. Could it trigger a recession?

On the latest edition of Market Week in Review, Chief Investment Strategist for North America, Paul Eitelman, and Sophie Antal-Gilbert, Head of AIS Portfolio & Business Consulting, discussed the energy crisis in Europe. They also reviewed the market's reaction to the situation, as well as the latest steps taken by global central banks to curb inflation.

Russia halts gas deliveries to Europe, heightening fears of a recession

Antal-Gilbert opened the conversation by noting that the European energy crisis has intensified in recent days, following Russia's 2 September decision to cut off all natural-gas flows to Europe - via the Nord Stream 1 pipeline - indefinitely. Given Europe's reliance on Russian gas, Eitelman characterised the news as fairly consequential for the region, pointing out that the reduction in gas supplies has already led to a big spike in prices.

"In 2020, natural-gas prices were trading around €20 per megawatt hour - and now, prices are north of €200 per megawatt hour," he remarked. Eitelman added that although European countries have done a pretty good job of stockpiling gas supplies ahead of the cold-weather months, it's unclear if the region will be able to make it through the upcoming winter without some fairly significant rationing.

The energy crunch is also likely to place some constraints on European economic growth, with businesses and consumers constrained by the higher prices, he said. Because of this, the possibility of a recession in Europe later this year has become a baseline scenario in the minds of many analysts, Eitelman stated, including the team of strategists at Russell Investments.

However, Eitelman cautioned that the overall situation remains very fluid, with many European governments stepping up efforts to cushion the blow of high energy prices by unveiling fiscal-support programs. For instance, in the UK, newly appointed Prime Minister Liz Truss recently announced a package worth about 6% of the country's GDP that will effectively cap energy prices for consumers and businesses, he said.

"Under this plan, the British government would absorb energy costs beyond a certain level, in the form of higher deficits and more borrowing," Eitelman stated, calling the plan an important safety blanket for the UK. He added that similar programs may be implemented in other European countries in the weeks and months to come.

How are markets reacting to the European energy crunch?

Broadening out the discussion to global markets, Antal-Gilbert asked Eitelman how markets have been reacting to the energy crisis in Europe. Eitelman said that overall, equity markets have actually been fairly resilient to the latest developments, with little in the way of big moves. On the fixed income side, however, there's been some more pressure, he said, with sovereign bond yields creeping up around the globe.

As evidence, Eitelman cited the yield on the benchmark 10-year U.S. Treasury note, which rose roughly 10 basis points the week of 5 September, climbing to around 3.3% as of market close on 8 September. "Overall, the European energy crunch is contributing to high headline inflation, particularly in Europe, and this isn't a good thing for fixed income investors," he noted.

Eitelman said that globally, central banks are continuing to respond to the highest inflation levels in decades with aggressive rates hikes. Both the European Central Bank and the Bank of Canada raised rates by 75 basis points the week of 5 September, with most investors expecting the U.S. Federal Reserve to do the same at its policy meeting later this month, he said.

"It's almost becoming fashionable among central bankers to hike rates by 75 basis points now," Eitelman remarked, noting that such jumbo-sized rate increases were almost unheard of historically. He concluded the segment by noting that overall, the trend toward higher yields in fixed income markets is likely to continue in the near-term.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.