Views From the Floor - An Ecstasy of Fumbling: How Will Europe Cope with Record Energy Prices?

Europe scrabbles to keep the lights on, as rising gas prices threaten sovereign bond yields.

An Ecstasy of Fumbling: How Will Europe Cope with Record Energy Prices?

‘Gas! GAS! Quick, boys!—An ecstasy of fumbling…’ Dulce et Decorum Est, Wilfrid Owen

As European gas prices hit startling new highs and destabilise equity markets (Figure 1), we look towards the subsequent consequences to gauge how investors might plan for a potentially long winter of energy uncertainty.

The first point to note is the divergent approaches taken by national governments to consumer gas pricing. We face the very real possibility of gas rationing in multiple European countries, with governments forced to choose between allocating resources between consumers and businesses. Since consumer gas demand is roughly double that of industrial demand during the winter months, the extent to which rising costs are passed directly to households will dictate how much demand destruction occurs. Put simply, if consumers are left carrying the proverbial gas can, it is more likely that they drastically reduce their consumption rather than use such a large proportion of their post-tax income on heating. To illustrate this, France has chosen to cap energy price rises at 4%1 until the end of 2022, and has committed to containing prices in 2023. In contrast, while German consumers will receive temporary VAT relief on natural gas from 19% to 7%2, they also face rising bills in the form of a levy of 2.419 cents extra per kilowatt hour.3 While new relief measures were announced at the weekend, including support payments to pensioners and students, a firm price cap is promised although yet to be announced.4 With fewer consumers directly shielded, if the eventual price cap is higher, we would expect more demand destruction in Germany than France, and consequently a better outlook for industrial supply. However, the outlook for total supply is uneven, which further complicates the picture.

At an industry level, three major sectors are at risk. Chemicals, including fertiliser production, are usually energy intensive and use natural gas as a feedstock. This will in turn affect agricultural commodity and food production, and further contribute to inflationary squeeze into next year. Likewise, the production of packaging, especially carboard boxes, glass jars and bottles requires significant energy inputs, irrespective of whether the packaging is recycled.

In the meantime, the problem remains supply. While European gas inventories are building ahead of schedule and are currently just above 60 bcm (around 70% of reserve storage), supplies from Nord Stream 1 may stay shutoff for the winter, requiring significant cuts to consumption. Until reliance on Nordstream is rectified, government policies may simply amount to an ecstasy of fumbling, as Europe shivers through a winter recession.

Figure 1. European Natural Gas Prices

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Source: Bloomberg; as of 5 September 2022.

The Dangers in European Government Debt

If we concede that exceptionally volatile gas futures represent a dire economic risk in Europe, it is both strange and notable that yields are not reflecting the new reality.

Price hikes will represent a further inflationary shock. But as with the Covid-19 pandemic, if a deep economic shock threatens the solvency of both SMEs and households, it is difficult to conceive of a scenario where politicians will be able to avoid repeated bailouts. Policymakers may well become hostages to precedent. Having provided critical financial support to industries and workers deemed essential in the past, they will undoubtedly face pressure to deliver the same again, possibly on a much wider scale.

This presents two risks, one in the long term, the other over the short term. Energy-related bailouts will come hard on the heels of those given during the Covid-19 pandemic, and government balance sheets are yet to recover. Debt to GDP ratios have ballooned, with Greece, Italy, Portugal, France, Spain, the UK, Belgium and Austria all with ratios of more than 100% at the end of 2021 (Figure 2). For each country, this is higher than during the 2011 Eurozone crisis, yet government bond yields for each remain more similar to pre-pandemic levels than to those of 2011 (Figure 3). Over the medium term, the deterioration of the credit quality of major European sovereigns may occur. While inflation is positive for government balance sheets in the short term (increasing GDP and the tax take as the total pile of debt remains stable), a spike in the cost of imports without offsetting domestic growth is stagflationary. The risk presented to government tax revenues by possible stagflation remains material, and has to be factored in.

In the short-term, if positive for governments, inflation is not a good outcome for the bondholder. Eurozone inflation is running at 9.1%, and with European 10-year yields in the 2-4% range, the real return on government bonds is decidedly negative.

With prices at current levels, it seems that the market may be under-appreciating the risk to sovereign bonds in both the short and medium term. Government bond yields may now have to rise to reflect the true risk investors are taking on.

Figure 2. Selected European Government Debt to GDP Ratios

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Source: OECD; as of 31 December 2021.

Figure 3. Selected European 10-Year Government Bond Yields

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Source: Bloomberg; as of 1 September 2022.

With contributions from: Brentley Campbell (Man GLG – Portfolio Manager) and Francois Kotze (Man GLG – Portfolio Manager).



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