It’s been over a year since Russian tanks and troops rolled into Ukraine, following roughly seven years of stalemated negotiations between the two separatist republics in the Donbass, Ukraine, and the two European mediators, France and Germany, in Minsk. Russian President Vladimir Putin cited the Minsk Accords’ failure, as giving Russia the excuse to level much of what was once Ukraine’s manufacturing heartland. Their economy, already on IMF life support, is in ruins. As we are told, the Ukraine war is a European war. East Ukraine’s smoldering demise is somewhat symbolic of what is happening in Europe. There is a lot of heat under the surface of the soil. And in the right conditions, these things can lead to big brush fires. European investors beware.
Other than the obvious war-torn doldrums hitting Ukraine’s economy, and the economic impacts of sanctions against Russia, the war’s biggest real economy impacts are being felt throughout Europe.
Russia’s economy is surprisingly resilient, thanks in large part to emerging markets like India and China ignoring Western sanctions. (Within the BRICS, Russia is second to Brazil as the worst performing GDP over the last 10 years.) Russia’s discounted energy and raw materials exports to India and China went from 25% of energy revenue to accounting for 45% in 2022, according to the Peterson Institute for International Economics.
Russia’s economy is seen growing 0.7% this year and 1.3% in 2024. Russia’s 2023 growth will be better than Germany and the U.K., both seen declining by 0.3%, according to the IMF.
Ukraine’s GDP plunged 29.1% in 2022, and will be declining by 3% this year, which seems too optimistic given the ongoing war. The country’s unemployment went up to 10.6% in January 2023 and inflation averaged at 30% in 2022, and declined to 21% in March 2023. The IMF has made no predictions for 2024.
As the two countries race to the bottom, Russia is doing better than Ukraine, at least for now. Russia’s economy ministry is more bullish than the IMF. They revised Russian GDP higher on April 14 to 1.2% from a 0.8% contraction, but lowered the 2024 forecast. Americans can no longer invest in Russian securities. The Moscow Broad Market Index, a measure of all the stocks on the Moscow Exchange, is up 19.25% over the last 12 months in rubles. The FTSE Europe Index is up 2.4% in dollars. (The dollar is up 1.8% versus the ruble over the last 12 months.)
There are loud whispers of more sanctions to come out of Europe. Who will suffer, besides the obvious target?
The IMF’s annual Spring Meetings in Washington, which ended Sunday April 16, had everyone talking about a possible recession in Europe and the US. Europe is not yet out of the woods. Such was the happy hour chatter at the Gallery in IMF’s headquarters in downtown Washington DC last weekend.
The anemic growth rate of core Western European economies is being replaced with 0.5% growth – or contraction – and possible stagflation.
Germany’s GDP was -0.4% for the last quarter of 2022. It hobbled into 2023. This is Europe’s manufacturing powerhouse. France’s economy has been in steady decline since July, though it is still barely positive. The anti-Macron demonstrations about increasing the pension age from 62 to 64 do not help.
The U.K. economy has flatlined, posting zero growth in February, the most recent month for statistics, according to U.K. Office of National Statistics.
Much of the economic decline of Europe is due to the war. Russian energy bans led to higher energy prices which led to rationing. Germany’s shuttering its remaining three nuclear reactors make energy ever more expensive, and the German economy even less competitive.
Many manufacturers furloughed workers or closed third shifts. At least one major bank has failed – Credit Suisse. Regulators warned as of late March that the banks still face risks following the fallout from Credit Suisse and Silicon Valley Bank in the U.S.
The view on the Street is that the war goes on for at least another year. “You’d be missing out if you think there is a peace deal in Ukraine in the next three to six months,” says Brian McCarthy, managing principal of Macrolens, a global macro research firm in Stamford, Conn. “But that is not on my radar at all for this year. I don’t see any upside. I don’t like these markets,” he says, adding that he expects the European Central Bank to keep raising interest rates in a low- to no-growth economy.
European stocks have ignored high inflation, rising interest rates, and the potential for World War Three, all year. Year-to-date, the Vanguard FTSE Europe (
VGK
Things Fall Apart
In 1958, Nigerian author Chinua Achebe wrote the novel Things Fall Apart. It was about European colonialism and the disruption it caused an indigenous society. It short, things fell apart. This is happening in Europe now, and the political divide it is creating should not be overlooked by investors looking for another all-time-high this year.
Europe’s never-ending migrant problem has also led to an additional socio-economic burden. The International Rescue Committee, a global NGO that raises money to help refugees, says that at least 8 million Ukrainians have left, mostly moving to Poland, Moldova and Romania.
The continued pressure of politics on the economy, declining fertility rates, and a relative flatlining of GDP per capita from 2008 to 2021 caused by high taxes, over-regulation, and a weak manufacturing labor base (also see French protests over raising the retirement age,) have led to social instability in Europe. Current research shows a rise of anti-globalist Euro-skeptics in France, Hungary and in Italy. In Germany, hate crimes rose 16% in 2023 and anti-Semitic crimes rose by 29%, according to Human Rights Watch.
Recently, Europe’s future as an open democracy was the topic of an April 11 seminar by the Council on Foreign Relations. When asked for his opinion of the state of democracy in Europe, Francis Fukuyama, a CFR member and Stanford University professor said, “In general, it’s not good.”
While democracy and economy are two different things, political strife in Europe is a problem for both the political and economic landscapes. These are immediate problems for markets.
The Ukraine war will only add to that division as time goes on, with France’s president Emmanuel Macron recently siding with China to call for peace talks opposed to the U.S. and Germany sending tanks to Ukraine.
What else has the war wrought in Europe?
Inflation, of course. Cost of food in the European Union rose 19.06% in February over the same month last year, according to Eurostat. By comparison, food inflation in the United States increased at a slower 8.5% in March, decelerating from a 9.5% in February and an annualized peak of 11.4% in August 2022, according to the Bureau of Labor Statistics.
Europe’s economy also suffered from its Covid lockdown policies.
Given the impact Covid-19 has had on the EU’s economy, the volume of non-performing loans was expected to rise across the bloc, writes Italian finance journalist Mara Monti for the London School of Economics blog page on March 30. Depending on how quickly the EU’s economy recovers from the pandemic, banks’ asset quality, and in turn, their lending capacity, could also deteriorate, she said.
“This is still a zombie economy,” says Albert Marko, head of Mavarinas Management Group in Naples, Florida, a new global macro hedge fund set to launch in May. “Barring a cease fire [in Ukraine], I would not consider Europe. The war is a big headwind to the EU. It has problems with energy security, and no one is paying attention to the widening divide between Germany and France. I don’t see any political or economic solution for the foreseeable future.”
Euro area industrial production grew 1.5% month over month in February, confirming the rebound in the industrial sector as manufacturers get back to work following strict energy rationing last year.
On the other hand, euro area retail sales declined 0.8% in February, in line with the weak consumption data for France and low consumer confidence indices.
Barclays Capital said it expects euro zone PMIs to edge slightly lower but remain over the 50 mark, which is good. They expect the gains from the past two months to be erased a tad, due to the recent banking-related headwinds and strikes, not the war.
Europe as Russia’s Collateral Damage
The emerging markets have split with the U.S. and Europe on the war, with the most recent example being Brazilian president Luiz Inacio da Silva (“Lula”), calling again for peace talks during a trip to China last week. He said Ukraine and the West both share part of the blame for the breakdown in the Minsk Accords which led to the war.
Military and financial support from the U.S. and Europe to Ukraine is expected to continue. The West is poised to take over large chunks of Ukrainian business whenever reconstruction begins. At least one U.S. fund — Argentem Creek Partners – is in a battle with a Ukrainian port operator called the GNT Group over a missing $75 million payment. Times are nasty.
Estimates for the rebuild of Ukraine is expected to cost around 500 billion euros, which is multiple times greater than the support the country has received to date from both the IMF, the European Bank of Reconstruction and Development, and the U.S. government combined.
Ukraine’s GDP is only valued at around $200 billion, according to the World Bank, so where all this money will go is anybody’s guess. Anyone who has watched countries like Ukraine over the years can imagine where it will go.
Recent revelations regarding the dealings of Hunter and Joe Biden with Ukrainian energy company Burisma are one the examples of many politically ugly looking deals.
German philosopher and author Oswald Spengler predicted the “death of the West” back in 1918, saying a breakdown of the existing order would happen by the year 2000. He predicted the rise of a power elite, which he referred to as “Caesarism”, taking hold in Europe. This might look something like an autocratic government similar to Putin’s Russia or the Chinese Communist Party of today.
If Europe does not take care of its own foreign policy and military power, as Macron has called for now during his trip to China, then Spengler’s view may become reality as the emerging world, led by China, drifts further away from the West’s orbit.
Europe is grappling with what could ignite a European-wide war of mass destruction if policy makers are not careful. For now, the West continues to support Ukraine, something emerging markets leaders see as negative to their own futures. A weak Europe (or a war torn one) is bad for business and job markets in Brazil and China, too.
According to a report by The Economist Intelligence Unit, East European countries have been the hardest hit by the war. Western Europe has “weathered the situation well.” But can it continue to do so, with rising interest rates and flatlined growth?
Everyone expected the war to be costly for Russia and deadly for Ukraine. But the war in Ukraine has come at a surprisingly high price for Europe, as well.
“If I had to be invested in Europe, I’d pick Italy,” said Vladimir Signorelli, head of Bretton Woods Research in New Jersey. Italy signed an energy deal with Libya. “Countries that can do stuff like that rather than relying on the U.S. will be better off. If the war surprisingly ends, and we see sanctions relief, Europe will beat its previous highs,” he says. “But I think that would depend on the European Central Bank, which is hellbent on raising rates and killing growth.”
Be it as it may, Europe wins if the war ends quickly. The market will rise like a triple leveraged ETF. But Europe loses if the war drags on. The longer the war lasts, the more painful it is for Europe – and it appears that there is very little it can do about it one way or another.
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