One day after the US announced Q2 GDP (gross domestic product, a government-produced measure of economic output) results, it was the eurozone’s turn last Friday—and surprising many financial commentators we follow, its results were much better. Where the US contracted last quarter, eurozone GDP grew 0.7% q/q, smashing economists’ consensus expectations for a 0.1% q/q rise.[i] That generated a heap of headlines, a few sunny on the positive result whilst most warned the fun won’t last now that Russia has reduced natural gas flows into the region substantially.[ii] We can’t help but wonder what all the fuss is about on both sides, because in our view, headline eurozone GDP is next to meaningless. It is the sum of 19 individual member state GDPs, and we find there are too many offsets amongst them for the total to be of much use, especially to investors looking for economic clues. We think this quarter’s results are a prime example.
So far, only nine eurozone member states have reported.[iii] Their results range from a -1.4% q/q contraction (Latvia) to 1.1% growth (Spain).[iv] But in our experience, whenever investors look at Continental Europe, they are mainly eyeing four countries: Germany, France, Italy and Spain, the four largest economies.[v] Of these, commentators we follow typically portray Germany as the engine, France as a ride-along and Italy and Spain as the periphery. So, if Germany is struggling, that can colour the view of the whole and raise questions about whether other nations will soon follow.
This was one of the primary angles we encountered in the news coverage Friday, as German GDP was flat in Q2 (or, as Bloomberg pointed out, ever-so-slightly contractionary when you round to 2 digits versus 1).[vi] This follows 0.9% q/q growth in Q1, which the data show stemmed largely from post-Omicron reopening boosting the services sector, and an Omicron-related -1.4% Q4 contraction.[vii] Germany’s Federal Statistics Office doesn’t release a detailed breakdown in its first estimate, but the accompanying commentary said consumer spending rebounded whilst net trade (exports minus imports) detracted. Whether the latter involves rising imports (which subtract from GDP), another drop in exports or a combo thereof, we will have to wait and see.
But even if it proves to be a maths quirk that caused Germany to stagnate rather than continued weakness, it is probably of little import to markets. In our view, markets are forward-looking and have fresher German headwinds to deal with—namely, the aforementioned Russian gas flows, which are now down to about 20% of normal.[viii] We think this is bad news for Germany, which relies on Russian gas not just for home heating and other general energy needs, but as feedstock for its mighty chemical industry.[ix] Already this week, one chemical giant reported it has cut ammonia production in order to conserve gas use.[x] This enables the company to feed gas into the grid, which potentially benefits other users, but if more production goes offline, it could cause heavy industry to contract further as the year rolls on.
In theory, that would be bad news for Germany’s economy. Yet, in our view, bad news for the economy isn’t always bad news for stocks if they already reflect that bad news. The prospect of a natural gas shortage hampering German industry isn’t new, in our experience. Financial commentators we follow have noted the possibility not since Russia invaded Ukraine, but since last August, when Russia first started throttling supply through the Yamal pipeline.[xi] At the time, many geopolitical analysts we follow theorised Russia was trying to goad German and EU leaders into giving the Nord Stream 2 pipeline the final seal of approval. In retrospect, it may have been an early test of Russia’s leverage in advance of the Ukraine invasion. Whatever the motive, though, German stocks’ November peak in euros occurred amidst a wave of chatter about potential natural gas shortages after October’s price spike.[xii] From then through the most recent low on 5 July, the MSCI Germany Index fell -26.8%.[xiii] The rest of the eurozone is down much less over the same period.[xiv] In our view, this suggests markets have long been pricing in Germany’s extraordinary vulnerability to gas shortages, making it likely that gas-induced economic weakness from here merely confirms what stocks already knew.
As for the rest of the big four, we view their results as positive overall but mixed under the bonnet. France grew 0.5% q/q, but household spending fell for the second straight quarter (-0.2%), and imports’ -0.6% slide also implies some weakness in domestic demand, in our view.[xv] Still, business and residential real estate investment grew for the second quarter in a row, and the return of tourism post-Omicron helped exports stay strong.[xvi] In Italy—which, like Germany, releases only general commentary in the preliminary estimate—heavy industry and services did well, and domestic demand was overall up.[xvii] That all helped GDP grow 1.0% q/q, a nice acceleration from Q1’s Omicron-related 0.1% crawl.[xviii] Spain, the GDP winner so far, also got a reopening boost in consumer spending, which rose 3.2% q/q, and investment in tangible fixed assets (which includes intellectual property and software), which jumped 3.4%.[xix] But in our opinion, the real star was tourism, which surged a whopping 126.7% q/q as COVID restrictions lifted.[xx]
Commentators we follow argue this positivity is temporary, and soon German weakness and the fading reopening bounce will bring a malaise. We agree, to an extent. Worldwide, we have seen reopening boomlets each time restrictions end, and they have been mostly short-lived, in our experience. So we don’t think tourism is likely to double every quarter, and domestic spending on leisure probably slows once the thrill of finally going out starts to fade and people revert to normal habits. We also aren’t totally sure how statisticians are adjusting for spectators’ full return to major international sporting events, which each of these countries hosted in Q2 (e.g., the French Open in Paris and Formula One races in Spain and Italy). These events’ being cancelled and/or closed to fans in 2020 and 2021 could very well be messing with the seasonal adjustments, potentially lending some artificial upward skew to Q2 results. Behaviour and maths returning to more normal patterns probably lends some slowness.
If the reaction to July Purchasing Managers’ Indexes is a good guide, we think people might have a hard time distinguishing between a return to pre-COVID norms and energy shortage-induced weakness if growth slows from here. But here are some general things we can observe. One, we have many examples of economic weakness in individual eurozone nations not spilling over into neighbours.[xxi] Our research shows Italy, Spain and France don’t depend on German demand. All three are diverse, big, globally integrated economies. Tourists will likely visit the great museums and cathedrals whether or not Germany is producing chemicals and automobiles. Two, all three are more insulated from Russian energy. Spain has its own natural gas supply lines and is already eyeing the loophole created for it in the EU’s voluntary natural gas conservation agreement.[xxii] France gets most of its energy from domestic nuclear reactors.[xxiii] Italy’s crude oil imports come primarily from across the Mediterranean Sea, and it has gas pipeline links with Algeria, Libya and Azerbaijan.[xxiv] Hence, we think the economic risk of Russia’s retaliation to EU sanctions is lower for all three than for Germany.
However in our experience, this doesn’t get much attention, which is positive—it can drag down expectations, making positive surprise easier to achieve. Right now, we have witnessed forecasters increasingly pencilling in a 2023 recession for the eurozone overall, foreseeing weakness in Germany and Southern Europe alike.[xxv] If Germany gets a shallow recession and everyone else muddles through, which we see as a realistic possibility, that would likely be a positive surprise indeed. We aren’t making a 2023 economic or stock market forecast, mind you, but showing how wide the gap between expectations and reality appears to have grown. Europe may not be firing on all cylinders, but it doesn’t need to be for stocks to enjoy a recovery, in our view.
[i] Source: FactSet, as of 29/7/2022.
[ii] “Russia to Cut Gas Through Nord Stream 1 to 20% of Capacity,” Staff, Associated Press, 25/7/2022.
[iii] Source: Eurostat, as of 29/7/2022.
[v] Source: World Bank, as of 1/8/2022.
[vi] “German Recession May Have Started, Even If Rounded Data Say Otherwise,” Jana Randow, Bloomberg, 29/7/2022. Accessed via Financial Post.
[vii] Source: FactSet, as of 29/7/2022.
[viii] See note ii.
[ix] “Gas shortage puts pressure on chemical feedstocks,” Angeli Mehta, ChemistryWorld, 21/7/2022.
[x] “BASF cuts ammonia production in response to soaring gas prices,” Euan Sadden, Agricensus, 27/7/2022.
[xi] “Russia is pumping a lot less natural gas to Europe all of a sudden — and it is not clear why,” Sam Meredith, CNBC, 24/8/2021.
[xii] Source: FactSet, as of 2/8/2022. Statement based on Dutch TTF natural gas price and MSCI Germany Index returns in euros. Currency fluctuations between the euro and pound may result in higher or lower investment returns.
[xiii] Source: FactSet as of 29/7/2022. MSCI Germany Index return in EUR with net dividends, 17/11/2021 – 5/7/2022. Currency fluctuations between the euro and pound may result in higher or lower investment returns.
[xiv] Ibid. Statement based on MSCI EMU ex. Germany Index return in EUR with net dividends, 17/11/2021 – 5/7/2022. Currency fluctuations between the euro and pound may result in higher or lower investment returns.
[xv] Source: FactSet, as of 29/7/2022.
[xxii] “EU agrees plan to ration gas use over Russia supply fears,” Jennifer Rankin, The Guardian, 26/7/2022.
[xxiii] Source: International Energy Agency, as of 1/8/2022. Total energy supply by source, France 1990-2020.
[xxiv] Source: US Energy Information Administration, as of 1/8/2022.
[xxv] “Euro zone growth, inflation accelerate, but recession looms later in year,” Staff, Reuters, 29/7/2022. A recession is a broad decline in economic output. Accessed via Irish Independent.
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