Europe: A gloomy outlook as the Russia-Ukraine war weighs on growth

• The impact of the Russia-Ukraine war is the most apparent on the European economy, especially due to its energy dependence on Russia. 

• With the supply-side damage to key resources including energy, agriculture, and metals, coupled with Europe’s relatively larger exposure to Russia and Ukraine, inflationary pressures have become worse than expected and production in Europe has seen cuts. 

• As such, GDP and earnings growth have been cut. Moreover, from a bottom-up perspective, German automobiles (the largest industry in the largest EU economy) have also warned of such headwinds ahead. 

• Not only has the growth outlook turned gloomy, monetary policies have also turned less accommodative with rate hikes likely beginning from July, which is much earlier than the original kick-off in 2023. 

• We downgrade GDP and earnings growth, but given the sell-off of the STOXX Europe 600, based on 2024 EPS, the target price is EUR 502, which implies a reasonable upside potential of 24.7% as of 16 June 2022. 

• Hence, we maintain our 3.0 stars “Attractive” rating on European equities, but caution investors of the downside risks, and recommend investors to position themselves in the other more attractive markets/sectors. 

Since the onset of the Russia-Ukraine war, European equities have been on a downtrend, with the STOXX Europe 600 index declining by -17.8% year-to-date (Figure 1).

Figure 1: STOXX Europe 600 index fell since Feb

Till this day, hopes of a ceasefire have yet to materialise, and the global economy is still experiencing the impact of the Russia-Ukraine war which erupted on 24 February 2022. Europe is one of the most impacted economies, due to its close proximity and heavy reliance on Russia for energy. 

The war has resulted in severe supply-side damage as shortages of raw materials persist, which has driven up inflation and hampered production, thus weighing on corporate earnings growth in Europe. 

Moreover, monetary policy has shifted to a less accommodative stance in recent months, as inflation has become worse than expected. With this deteriorating growth outlook, we remain cautious on European equities.

Supply-side damage drives inflation and hampers production

As major producers of many raw materials, the Russia-Ukraine war has led to a global supply disruption of energy, food, metals, and more, with Europe bearing the brunt of the impact.

On the inflation front, consumer prices in the Eurozone reached a record high of 8.1% YoY in May, mainly driven by rising energy prices, as the war exacerbated the energy crunch that has plagued Europe since last year (Figure 2). 

Back in 2021, the combination of a global demand-supply imbalance, an especially cold winter that depleted stored energy supplies, and low renewable energy power generation due to unfavourable climate conditions culminated in Europe’s energy crunch. Instead of an improvement, the situation turned for the worse as the war unfolded in 2022. 

Figure 2: Inflation in Eurozone has reached record highs

Europe is extremely reliant on Russia for its energy needs (Figure 3). However, the war has put the energy supply from Russia at stake and the anticipation of various new sanctions on Russia has driven up energy prices, resulting in skyrocketing energy inflation. Russian energy giant Gazprom has halted gas exports to Poland and Bulgaria over the countries' refusal to pay for supplies in roubles. More recently it has also reduced gas deliveries to several European countries by as much as 40%.

Figure 3: Russia is the largest supplier of energy for Europe

Additionally, other downside risks which could potentially worsen the inflationary pressures includes Putin stopping energy supplies to Europe or an oil embargo by the European Union (EU). Thus far, as of 16 June, the European Union has agreed on a partial oil embargo, which bans Russian oil brought in by sea, but imports delivered by pipeline are exempted. 

Related article: The Russia-Ukraine crisis and rising inflation have brought about a commodities supercycle

Apart from the energy inflation, rising food and metal prices are also an issue, as Russia and Ukraine are significant producers of agricultural and metal products (Figure 4). Again, Europe is relatively more impacted due to its high exposure to Russia. 

On top of the near-term impact of inflation, long-term the impact is potentially wider and deeper as the shortages of inputs will be a production constraint, affecting multiple supply chains from autos, to technology, to consumer staples and others. 

Figure 4: Russia & Ukraine’s combined contribution to the global supply chain

Related article: As the Russia-Ukraine war brings about a global food crisis, here’s an ETF that will benefit

Secondly, the supply-side damage has also led to production being hampered - Germany’s industrial production fell by -2.2% in April (Figure 5). This decline is likely to persist till the supply constraints ease. Factory orders also saw a decline of -6.2%, as demand from China fell due to the heightened lockdowns. With a decline in production and demand, economic growth can be expected to slow down. 

Figure 5: Europe’s largest economy is seeing a decline in industrial and manufacturing activity

Looking ahead, we expect higher inflation to weigh on the company’s margins and erode consumers’ purchasing power, which would lead to an earnings and demand slowdown. Moreover, coupled with supply disruptions resulting in production cuts, the result is an overall decline in the Eurozone economic growth. 

Major Eurozone sectors and companies see headwinds

From a bottom-up perspective, sectoral and company data paint a similar picture. Taking the largest industry in the largest European economy – German automobiles, the outlook looks gloomy, as the supply-side damage weighs on autos production. 

First, the industry already saw production disruption due to shortages of wiring harnesses from Ukraine. Second, in the medium to long term, the supply of metal parts and semiconductors remains volatile and could continue to be a constraint on auto production. 

Russia and Ukraine are major producers of these input materials (Figure 4), including aluminum, nickel, neon gas, and others. For example, neon gas, which is required for semiconductor production, could be a significant constraint. Two leading Ukrainian neon gas suppliers (Ignas and Cryoin) that produce about half of the world’s supply have halted production. If the production halt persists and no new supply is found, the already short supply of chips could likely get tighter. 

The European auto companies have also warned investors of headwinds. For example, during the April earnings call, it was announced that Mercedes-Benz expects that supply disruptions and chip shortages will hurt its business through the year and cautioned of further uncertainty around production and demand due to China's lockdowns. Mercedes also expects that the global car market will have no growth in 2022. 

Finally, production forecasts for European autos have also been cut (Figure 6), reinforcing the macro data points on declining industrial production. 

Figure 6: Global data company IHS cuts automobile production forecast

In summary, from a bottom-up perspective, the German automobile industry similarly points towards headwinds from supply disruption, inflation, and slowing demand from China. Yet, earnings estimates for the sector has been upgraded by +1.4% since the beginning of the year (Figure 7).

Earnings estimates are likely to be overly optimistic 

Despite the troubles faced by the European economy, earnings growth for the STOXX Europe 600 index have been revised up by 8% year-to-date. We think that this is overly optimistic considering that the Russia-Ukraine war has had a significant real impact on Europe’s growth outlook. 

This phenomenon is because the upward revision of earnings for sectors that do well due to rising energy and materials prices are significantly high. While in contrast, few sectors that are impacted by the war such as autos and industrials saw downward earnings revisions (Figure 7). 

Figure 7: STOXX Europe 600 EPS upward revision driven by sectors like energy, resources, and travel.

Instead, we think that the hit to earnings growth is likely to be more than what the market expects, given that inflation likely weighs on profit margins, and that the supply-side damage hampers production output, as discussed in the earlier sections. 

Moreover, when tracing the overestimation of estimates by consensus, we find that in years of huge uncertainty the overestimation is most pronounced (Figure 8). Hence, there is a likelihood for actual earnings to miss estimates and disappoint the market. 

Figure 8: Market estimates overshoot actual earnings by 22% on average

Eurozone monetary policy to turn more restrictive 

Apart from the gloomy growth outlook for Europe and the potential earnings miss, monetary policy has also turned more restrictive as the ECB ramps up its efforts to curb the persistent and worse-than-expected inflation.

The central bank is likely to end its securities purchases and kick off the rate hike cycle as early as July. This is much earlier than previously expected rate hikes to begin only in 2023. 

As of 16 June 2022, markets are currently pricing in a total of +178.7 basis points of rate hikes by 2022, which would bring the current rate of -0.58% to 1.21%. If this materialises, it will lead to less support for asset prices, and also would slow economic activity as the borrowing costs increase. 

Figure 9: Rate hikes expectations have accelerated across the past two weeks

Key investment risks

Higher than expected inflation - If the energy and raw material shortages persist, or the extent is worse than what markets or policymakers expect, inflation could be more sticky than expected, thus hampering growth. Furthermore, downside risks that could plunge Europe into a recession include 1) Increased sanctions 2) A complete oil embargo by the EU, 3) Russia cutting energy supply to Europe, and 4) policy misstep by the ECB.

How should investors position themselves 

The outlook for Europe looks bleak as headwinds plague the economy. Inflation and supply disruption looks sticky, with economic policies turning less supportive. And with the Russia-Ukraine war heading towards a stalemate, Europe’s energy security remains at risk. 

Table 1: Lowering earnings estimates to account for the impact of the war and China’s lockdowns

Applying our designated fair P/E ratio of 16.5X for the index, we project a target price of EUR 502 for the STOXX Europe 600 by end-2024, which implies a decent upside potential of 24.7% as of 16 June 2022.

Although the outlook for European equities has deteriorated, but given that share prices have fallen, the valuation upside remains decent. Hence, we maintain our 3.0 Stars “Attractive” rating for European equities, but caution investors of the downside risks.

Nevertheless, we caution against panic-selling and stress that portfolio diversification remains key amidst heightened global uncertainties.

Table 2: Recommended Products

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.