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CIO Macro and Market Observations from Multi-Asset Solutions

October 24, 2022  |  7 Minute Read

Maria Vassalou, PhD

Co-Chief Investment Officer, Multi-Asset Solutions

Maria Vassalou, PhD

Amy Yifan Zhou, PhD

Multi-Asset Solutions

Amy Yifan Zhou, PhD


Shockwaves from the energy crunch are affecting individual European countries differently, which further complicates the European Central Bank’s (ECB) task of managing price stability. Globally, the direct impact through trade linkages may be limited, but risk transmission via financial channels can be important. Investors may see a rise in relative value opportunities due to broadening of regional divergence, and developments in Europe are likely to be a key driver of risk in the months ahead.


Europe’s Divergence Challenge

European economies are expected to face multiple challenges in the months ahead, ranging from restrictive monetary policy to soaring energy costs. However, the severity of the energy shock will be felt unevenly across the region due to varied climates, sources of economic growth, energy usage and import dependence. As a proxy for winter energy demand, the average number of Heating Degree Days (HDD) is more than seven times higher in the three highest countries from the north compared to the lowest three in the south.1 Before the war in Ukraine began, dependence on Russian oil and gas varied widely from country to country. For some, there was almost no dependence. Others relied on Russia for close to 100% of their energy needs. Among the European Union’s (EU) three largest economies, Germany has the coolest weather and is also the most industrial-oriented. Historically, its growth model has been rooted in importing commodities and exporting manufactured goods, which seems increasingly vulnerable in current conditions. Furthermore, Germany has typically relied on Russia for more than 40% of its imported gas since 1990, with some years exceeding 60%. France has EU’s second largest economy and boasts more diversified drivers of growth and higher usage of alternative energy sources. As of 2021, 37% of France’s primary energy consumption came from nuclear power, compared to 5.1% in Germany. The share of industrial usage of energy is also relatively low in France. More importantly, France also benefits from diversified suppliers, with gas imports from Norway, Russia, Algeria, Netherlands, and Nigeria, among others; the proportion of Russian imports has decreased from a bit more than 30% in the 1990s to less than 20% since the early 2000s.  Italy benefits from having milder weather and leans toward consumer goods and tourism, which may be more vulnerable to the second-order effects of weakening external demand. Oil and gas account for more than 80% of its primary energy source, and the usage of alternative sources such as nuclear is relatively limited. The country’s reliance on Russian gas imports is also high, although not as concentrated as Germany’s. This year, as geopolitical tensions continue to develop, countries have made significant efforts to diversify their energy supply. But for some, such as Germany, the negative effects from the embargo on Russian oil and the damages on the Nord Stream gas pipelines are hard to mitigate.




Exhibit 1: Imports of Natural Gas by Trading Partner (2020)


Source: Eurostat, Goldman Sachs Asset Management.



The asymmetric effects of the energy shock are likely to broaden economic divergence across European economies, and it may further complicate the ECB’s task of managing price stability. For a common-currency area such as the eurozone, economic convergence is necessary for policy effectiveness. After a brief period of deflation in 2020, European inflation has diverged noticeably across countries. Currently, France’s inflation rate is more than 3% below the rate in Italy and more than 4% lower than Germany and the aggregate for the Eurozone as a whole. In fact, some European economies are even experiencing inflation of more than 20%. 




Exhibit 2: The Paths of Inflation in the Three Largest European Economies are Diverging


Source: Bloomberg, Goldman Sachs Asset Management. As of 10/12/2022.



There are also large variations in government finances. As of 2021, EU countries had an average debt-to-GDP ratio of about 88%, with the individual national ratios ranging from about 20% to almost 200%. Public balances range from a small surplus (Denmark, Luxembourg) to deficits of up to -8% (Malta). Over the last year, European governments have allocated a significant amount of funding to subsidize energy costs for businesses and households. Going forward, monetary tightening will likely continue to increase the cost of financing, causing debt sustainability concerns to become acute for some countries. During the recent Gilt market turmoil, markets were intensely focused on UK government financing even though the country has a debt-to-GDP ratio of about 96%—the second lowest among G7 countries after Germany—and a relatively benign maturity profile. In contrast, Italy has a debt-to-GDP ratio of about 150% with a significant amount of debt due in the coming years, making it vulnerable to higher interest rates. In addition, corporate debt maturing in the coming years is a material percentage of total debt, raising the risk of corporate distress and defaults if interest rates rise further and remain elevated. While the ECB recently introduced anti-fragmentation tools to prevent speculative attacks on sovereign bonds, the specifics of its program remain unclear and member states’ ability to access these tools may depend on their fiscal health and policies. In other words, fiscal belt-tightening may in some cases be a pre-condition for using these tools, making timely deployment unlikely and potentially exposing some countries to speculative attacks. 




Exhibit 3: Comparing the Debt Profile of Italy (top) vs UK (bottom)


Source: Bloomberg, Goldman Sachs Asset Management. As of 10/14/2022.



Global Impact 

High energy prices reduce the real income available to consumers, which can result in slower global growth. So far, attempts to alleviate energy supply shortages with liquefied natural gas have had some success with prices falling significantly from their August highs. However, as winter progresses, it is likely that LNG prices will rise again. On the other hand, fiscal support programs intended to shield consumers from high energy costs may carry the risk of moral hazard by keeping energy demand at artificially high levels and generating budget deficits for the governments that provide them. Debt sustainability may come into question and lead to further increases in the cost of capital for businesses and the price of credit risk. If the situation continues to worsen, the resulting macro uncertainty is likely to hurt consumer and business confidence and potentially become self-fulfilling.


Debt sustainability in Europe may also emerge as an issue of systemic importance. The UK government’s plan to lower taxes while inflation is high and the Bank of England’s bond-buying intervention to arrest the resulting rise in long-term interest rates was a reminder that it doesn’t take much these days to roil markets. A decade ago, it took bailouts from the EU and the ECB for the bloc’s most troubled countries to end a sovereign debt crisis. Going forward, if vulnerable member states such as Italy were to need support again, Germany and France will likely be expected to bear most of the burden. Yet with the rest of Europe facing the same problems that Italy is, the willingness and capacity to participate in support programs can’t be taken for granted.


Another important challenge is the strength of the US dollar, which amplifies the effects of the energy crisis in Europe and pressures the ECB to raise interest rates despite it having little control over inflation, which is driven mainly by energy and food price increases. In fact, we think the ECB may find itself all but forced to raise rates—partly to keep inflation expectations anchored and partly to implicitly support the euro. The common currency recently fell below parity against the US dollar, which raises the cost of energy imports and the cost of USD-denominated liabilities. 


Finally, Europe’s importance in international trade may prove a headwind to global growth, should the continent’s economic woes worsen. Over the years, Europe has been a major trading partner for the US and China. As of 2021, Europe had a 167.1 billion EUR surplus in goods and -84.6 billion EUR deficit in services with the US, compared to -249.2 billion EUR deficit in goods and a 20.6 billion EUR surplus in services with China. While the US is somewhat shielded from the negative effects that a weakening Europe may have on its trade balance, countries like China may be more affected. 


Investment Implications

We expect European markets to present a high degree of dispersion over the winter months, and that may create more medium to long-term relative value opportunities and dislocations that may be exploited through both public and private markets. With sanctions against Russia expected to remain in place and potentially worsen, Europe’s energy challenges are likely to persist, at least until the transition to alternative sources of energy and renewables advances significantly. This adds up to a potentially long period of suppressed growth for the continent, with increased divergence across member states which in turn could bring about increased tensions within the EU and particularly the Eurozone.


Could Europe become a source of systemic risk for the rest of the world? Recent volatility in the capital markets as a result of the UK fiscal package suggests the answer is “yes.” The likely channel would again be the financial transmission mechanism, as pockets of leverage in one part of the financial system can quickly cause ripple effects in others. History shows that it is invariably leverage that sparks crises and recessions. What changes in each episode is where that leverage resides — or, in some cases, is hidden.




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1 Heating Degree Days (HDD) measures how cold the temperature is and for how long, which is a proxy for heating demand. Similarly, Cooling Degree Days (CDD) is a proxy for cooling demand. In 2021, Finland, Norway, and Sweden had the highest HDD, and Malta, Cyprus, Portugal had the lowest HDD.  



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