Almost all economists agree, Europe is heading for a recession. After all, Europe is seemingly dealing with a perfect economic storm.
This storm consists of four elements: sky-high energy prices, a surging U.S. Dollar, a major slowdown in China, and finally, the real possibility of a second Eurozone crisis.
Therefore, the question that most economists are now asking is not “will there be a recession in Europe?”. But rather, how bad will it be? Now, I’ve gone through a lot of their predictions, and summarized them in the following three scenarios:
The first scenario is a serious recession.
The second scenario is an apocalyptic recession.
Finally, the third scenario is a mild recession.
Now, I cannot tell you which of these scenarios will definitely become a reality. So, instead, I prefer to talk about scenarios of what might happen. How they might happen, and how likely it is that each scenario will happen.
Based on my research, I think that the serious recession scenario is sadly the most likely. I would currently assign it a probability of 45%. Then, I’d assign the apocalyptic Euro crisis scenario a 15% probability. But, there’s hope. I think the short-mild-recession scenario has a 35% probability.
Next, let me tell how I got to these probabilities and what each scenario might look like.
Because, if you know how I got to these numbers, you can adjust them up or down as you see fit. For example, if you disagree with my assumptions. Or you can update the probabilities yourself as new events unfold. For example, if Dutch politicians start pressuring the ECB to stop buying Italian debt, you can increase the probability of the apocalyptic Euro-crisis scenario.
Okay, with that all out of the way let’s start with the scenario that I think is most likely:
A) A Serious Recession
In the serious recession scenario, Europe’s GDP will soon start contracting. What’s worse, this contraction will be so large that yearly economic growth will soon be negative.
But, how bad will it be exactly?
Well, in this scenario, and in line with predictions from economists at Deutsche Bank, Europe’s GDP would drop by 1.5- 3%.
Now, the problem with throwing GDP numbers around like that, in my experience, is that they don’t mean much **to most people. Sure, we know that GDP measures total spending in the economy. So, a GDP drop means that people spend less on average. But, the consequences of reduced spending are typically not felt by most people, who have a steady job. Instead, it is typically felt by business owners, especially in those in industries that are considered ‘luxuries’ in tough times. You should also be worried if you are a worker without a permanent contract. And finally, if you are an investor, it would be good to make sure that markets have already priced in this scenario.
But, in any of these cases, should you believe in this scenario? Well, that depends on the developments in the four elements of Europe’s perfect economic storm.
To answer that question, the energy market would appear to be the most logical place to look first. Now, if you are not in Europe or have a fixed price energy contract, it is quite likely that you are underestimating how bad Europe’s energy crisis already is.
You see, the price of gas, used by most Europeans for heating purposes, went from €15/MWh to €343 per megawatt hour over the summer. And while they came down to €200/MWh, this still is more than a 10x increase compared to last year. What’s more, electricity prices have risen by up to 600% in some countries compared to last year.
As a consequence, the poorest households in countries like the Netherlands, UK, and Estonia have already seen their cost of living increase by 10 to 25%. So far, they have compensated by drawing down what limited savings they had. But, even if prices stabilize, they will soon have to rein in their spending.
And given that spending is literally how we define our economy, this is hurting the economy directly.
Now, for European businesses the picture is just as bleak. So far, just like households they were able to absorb higher energy costs. However, if energy prices remain this high, they will have reign in their investment spending as well. And once again directly hurting the economy.
A key part our serious recession scenario is that energy prices will roughly remain at their current levels. This could either be because of a particularly cold winter or because Russia reduces the gas flow even further.
Now, so far, the blow has been cushioned somewhat by European governments. However, in this scenario most European governments now choose to only help the poor and crucial industries. Either because they fear increasing government debt to much or because they want to keep energy prices high to stimulate less energy consumption.
Alright, when talking about Europe’s upcoming recession energy prices are the obvious first candidate. However, I think that this serious recession scenario is most likely to be triggered by the rising dollar and the accommodating rising interest rates.
After all, rising energy prices h ad a big impact on inflation. In Europe, almost all of its inflation is simply a reflection of 40% higher consumer energy prices. To a lesser extent, higher energy prices added to inflation in the US as well. And in response to this, Jerome Powell from the U.S. Federal Reserve is now raising interest rates rapidly.
Strangely enough, this is particularly big problem for Europe. You see, if the U.S. raises rates faster than Europe, investors will find it attractive to sell low interest rate yielding Euro’s or Pounds and buy higher interest rate yielding Dollars. This means that the value of the European currencies will fall. And, this in turn means that imports become quite a bit more expensive, increasing energy prices further as well as pushing up general inflation via these imports.
To prevent that, the Bank of England and the ECB will have to follow the Federal reserve to a certain extend and raise their interest rates. This will likely hurt their economies because it makes borrowing less attractive. And, as we briefly saw in the UK, the financial system just doesn’t seem to be able to handle much at the moment. What’s more, household levels of debt are at all time highs in Europe. And given that in many European countries mortgage rates are quite flexible, increasing interest rates might get households and businesses in to trouble rather quickly.
In the serious recession scenario, Powell will keep raising rates up to a range of 4.25 to 4.5 percent until December. Then, to prevent a collapsing pound or Euro, the ECB and Bank of England will have to follow. And with ECB interest rates rising higher than 3 per cent next year, the European economies will slow even more.
That’s pretty bad… and this scenario gets a bit worse still.
Now, so far, we have talked about European households and local firms. But, what if I told you that Europe’s strong export sector is now also at risk. The main reason is that the global economy is projected to slow down considerably thanks to rising interest rates and high energy prices. The global economy is connected, and this means fewer customers for Europe’s exporters.
Now, finally, and this is a big one, there’s China. China is currently experiencing a big economic slowdown on the back of a collapsing housing market. And, China just so happens to be Europe’s second biggest export market (given that the UK is part of Europe).
Now importantly, China’s government could rescue its economy, saving this important export market for Europe. However, in the serious recession scenario, China either is not able or chooses not to prevent a recession.
Okay, time for some good news then I guess.
Because in the serious recession scenario, while countries like Italy and Greece once again get into a lot of trouble, the European central bank rescues them. This prevents the recession from getting out of hand to the same extend that it did in 2011.
But, now you might wonder, Joeri, is that realistic? Will they actually save Southern Europe. I think there is a good chance. But, in the small chance that they don’t, Europe ends up in its apocalyptic scenario.
B Apocalyptic Recession
Now, let’s talk about something that I tried to stay away from for a long time, and that is an apocalyptic scenario. The reason for me staying away from that is exactly this situation, that is if something like that is a serious option, if you talk about it all the time, nobody will take you seriously anymore. So, with that being said, the apocalyptic scenario pretty much looks like the serious recession scenario at first. However, in this scenario a serio us recession spills over into a second Eurozone crisis.
The Eurozone accounts for most of Europe’s economic activity.
And, its common currency, the Euro, is a bit different from that of other major economies. You see, unlike in China and the United States, the Eurozone does not have a central government. Instead, it has lots of governments and a single central bank. The Chinese government cannot run out of Yuan, given that it issues them itself. However, individual European governments such as Italy and Greece can run out of Euros if the ECB decides that it will stop buying their debt. This is essentially what happened in Greece in 2011, and this caused the first Eurozone crisis.
It was only until then ECB chief Mario Draghi said “whatever it takes” that the crisis disappeared.
But, now, if say Italy’s new government needs ECB saving after spending too much, Dutch politicians might say that this is indirectly paid for by them since they partially own the European Central Bank. And thus, they might pressure the ECB to stop supporting Italy. If that happens, Italy’s government can no longer pay its bills and its economy will collapse. At that point, Italy might decide to leave the Euro. And this dynamic might spread to countries like Greece, and this could still potentially end the Euro, hitting its economy with a shock that has never been experienced before.
This small risk is why Italy has been in the news so much. And this is Europe’s apocalyptic scenario. However, I even though it is possible, I personally don’t expect it to happen because a Eurocrisis is neither in Italy’s or Europe’s interest. Therefore, I would give this scenario a 15% probability.
Okay, let’s talk about the best scenario next, the mild recession scenario.
C Mild Recession
Okay, so this is my “optimistic” scenario. And, if it makes you feel better this scenario is in line with what economists at prestigious institutions such as the IMF and OECD are currently predicting will likely happen.
Sure, in this scenario, Europe’s economy might shrink in some parts of 2022 and 2023. However, overall, its economy will still grow, slowly. How slowly? Well, GDP growth is predicted to slow from 2-3% this year to 0-1% next year.
So, how might this most “optimistic” scenario come about?
When it comes to the energy crisis, there are two reasons to be optimistic.
The first has to do with Russian supply. At the start of the war, Europe had few options to replace Russian imports. However, I don’t think that people appreciate enough that Europe has already been able to roughly double its liquified natural gas imports. This is partially thanks to increased usage of floating terminals such as this new one in the Netherlands. Even better, 18 more of these are planned all over Europe.
The second reason is all about demand. Energy analyst Pierre Andurand estimates that Europeans can do without Russian gas with a few behavioural changes. Most notably, by reducing average indoor temperatures from 22 to 19 degrees Celcius.
And I speak from experience when I say that, if prices stay high, that is quite possible.
I mean, since my energy bill tripled here in Belgium, I cut back a lot on my gas and energy usage by setting the temperature in my house to 18 degrees. What’s more, I had solar panels installed, cut wood during my summer holiday, had the fire-place cleaned, and started using electrical appliances mostly during peak sun hours. And, I know many Europeans who have taken similar measures.
What’s more, in case of a mild weather, Europe’s gas demand could be cut roughly 6% in the coming winter.
But, are there also reasons to be optimistic about rising interest rates in the U.S? Well, I think so.
You see, energy costs and interest rates are interacting in a way that’s possibly positive for Europe’s economy. For example if energy costs go down then inflation will go down and interest rates don’t need to go up this much or might even come down as well.
On the other hand, if interest rates continue to go up, then demand will slow down in the economy and this means also less demand for energy and hence energy prices are likely to come down then. What’s more several indicators such as industrial production in Europe are falling rapidly and so central bank s might even reverse some of the rate hikes or signal clearly that no more rate hikes are coming in the future.
But, even if that doesn’t pan out, raising rates does have some benefits as well for Europe. Sure, this will likely slow down the global economy which is bad for Europe’s exporters. But, it also has an upside for inflation.
3 China & EM
After all, a global slowdown means reduced global demand. And reduced demand means reduced global inflation. This in turn lowers the likelihood of more rate hikes.
Alternatively, China has already started stimulating its economy rather heavily. And it might stop locking down its economy in the near future. Therefore, it might continue to grow and demand exports from Europe.
Finally, the chance of a new Euro crisis is much lower in this relatively optimistic scenario. The economy that most risks sparking the next Eurocrisis, Italy, is stronger than many think, with a robust trade surplus in 2020 and 2021. What’s more, its right-wing politicians might talk a big game. But, before getting elected, they muted their tone considerably when it comes to the Euro. Finally, the ECB, recently introduced a new policy instrument that allows them to support specific governments, such as those in Southern Europe, and it didn’t even have to use it for Italy so far.
But, still, Europe’s economic future is clearly gloomy and uncertain.
And in this video, I’ve sketched a mild, serious and apocalyptic recession scenario. I also gave them a rough probability. And finally, I sketched the main factors to look out for: energy, the dollar, China, and signs of a Eurocrisis. This will hopefully help you better make up your own mind about how bad Europe’s upcoming recession will be.
However, as you might have noted, the probabilities of my scenarios do not add up to 100%. Hopefully, you’ve also noticed how many interactions there are possible between these factors and thus understand that it makes sense to assign a 5% probability to unforeseen scenarios such a global financial crisis, Norwegian pipelines suddenly exploding, or possibly even no recession.
But yeah, what do you think?, how likely do you think that each of these scenarios are? Let me know in the comments, or discuss it more in depth with Money & Macro members, Patrons and myself in my Discord sever.