The European Union is Preparing For the Worse if Russia Cuts Off The Gas Supply

The-European-Union-is-Preparing-For-the-Worse-if-Russia-Cuts-Off-The-Gas-Supply

European stocks plunging 20%. Junk credit spreads widening past 2020 crisis levels. The euro sinking to just 90 cents.

The predictions are ominous for financial markets if Russia cuts off all the gas supply to Europe.

Shipments are currently running at reduced levels with the main pipeline shut for a 10-day maintenance, and fears are building over whether Moscow will turn the tap back on. Many investors are asking: How bad could this get?

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To that question, strategists across Wall Street have tried to put numbers on a scenario that would be unthinkable in normal times. There are so many variables, such as the length of any shutdown, the extent of supply cuts, and how far countries would go to ration energy, that anyone’s prediction is a guess at best.

“The big unknown is how the shock that starts in Germany, Poland and other central European countries will reverberate throughout the rest of Europe and the world,” said Joachim Klement, head of strategy, accounting and sustainability at Liberum Capital. “There simply is no substitute available for Russian gas.”

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In an analysis this week, UBS Group AG economists laid out a detailed vision of what they see happening if Russia halts gas deliveries to Europe. It would reduce corporate earnings by more than 15%. The market selloff would exceed 20% in the Stoxx 600 and the euro would drop to 90 cents. The rush for safe assets would drive benchmark German bund yields to 0%, they wrote.

“We stress that these projections should be seen as rough approximations and by no means as a worse-case scenario,” wrote Arend Kapteyn, chief economist at UBS. “We could easily conceive economic disruptions that lead to more negative growth outcomes.”

Markets are already pricing in some of the damage. The euro is at a two-decade low and on the brink of dollar parity. German stocks have lost 11% since June. German gas giant Uniper SE is the biggest corporate casualty, with the stock plunging 80% this year as it seeks a government bailout.

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To be sure, many investors say there’s reason to believe Russia will turn gas supply back on when maintenance on the Nord Stream 1 pipeline ends on July 21. But, as UBS points out, if European countries start voluntary gas rationing to fill up on storage, the hit to economic growth will be severe.

“Europe is currently being caught in a vicious circle,” said Charles-Henry Monchau, chief investment officer at Banque Syz. Higher energy prices are hurting Europe’s economy, driving the euro lower. In turn, the weaker euro makes energy imports even more expensive, he said.

The other worry is that central banks won’t be able to do much to help the economy with inflation already running at decade-highs, said Prashant Agarwal, a portfolio manager at Pictet Asset Management.

“I am not sure central bank tools work in this scenario,” he said. “In the past, they had leeway to address the situation because inflation was low.”

Here’s a round-up of other strategist views:

BNP Paribas SA

A full-blown gas disruption would drive the Euro Stoxx 50 to 2,800, about a 20% plunge from current levels, wrote strategists including Sam Lynton-Brown and Camille de Courcel.
They recommend hedges, such as high-quality companies and buying options skew on the European stock index. Auto, industrial and chemical industries will be under pressure, they wrote.

Nomura International Plc

Currency strategist Jordan Rochester has been urging clients to short the common currency since April. If Nord Stream 1 doesn’t resume operations, the euro may drop to 90 cents over the winter, he wrote.
“We believe Europe may fail to build up sufficient gas storage for the winter and this may lead to energy rationing,” he said. “If that’s not an economic crisis, what is?”

JPMorgan Chase & Co.

The moves in European corporate bond spreads would be bigger than the first wave of the Covid pandemic in 2020 if Russia shuts off gas supplies, according to strategists led by Matthew Bailey.
Spreads on high-grade debt may surge to 325 basis points, they wrote. For junk-rated bonds, the spread could widen to as much as 1,000 basis points.

Goldman Sachs Group Inc.

The euro is already reflecting a lot of the negativity, but the currency could fall another 5% if markets price in a full shutdown of Nord Stream 1, said strategists including Christian Mueller-Glissmann. They recommend a defensive allocation, with overweights on cash and commodities.

Bank of America Corp.

Former copper bull Bank of America also slashed its forecasts last week, warning that in a worst-case scenario where Europe experiences widespread gas shortages, prices could plunge to as low as $4,500 a ton. Copper sank 2% to $7,429 on Tuesday.
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