The increase in European energy prices will likely lead to a slowdown in economic activity.

Most major European economies are facing all-time highs or multi-decade highs in producer and consumer prices. One of the critical developments in recent months is the acceleration of European energy prices. This increase in prices is a double-edged sword. First, higher energy prices increase producer costs, and companies will attempt to pass that cost onto the consumer. Second, higher energy prices take up a larger portion of the consumer’s budget and they will be less likely to be able to take on that added cost. This dynamic will likely compress margins on the producer side and crush demand on the consumer side, both resulting in a slowdown in corporate profitability.

Producer prices in the Euro Area are up 37.9% y/y. Consumer prices are up 9.1% y/y. Eventually, the spread between these two measures will tighten. The longer PPI accelerates more than CPI, the longer businesses are carrying the cost burden. The likely outcome is margin compression and a slowdown in corporate profitability. On the other side of that equation, if CPI catches up to meet PPI, consumer’s will not be able to pay up for long before demand drops off. The likely result is consumer demand destruction which also leads to a slowdown in corporate profitability.

Source: Macrobond.

As mentioned above, a significant driver of these price increases has been energy. PPI for energy accelerated 99.9% y/y in July. CPI for gas increased 52.2% y/y in July, and CPI for electricity rose 31.1% y/y. This means companies have failed to pass on the bulk of energy-related cost increases. On the consumer side, price increases on these essential items have led to a slowdown in real consumer spending. The longer that energy prices remain elevated, the longer consumer wallets are pinched which increases the probability of demand destruction. Electricity futures prices are suggesting that segment of energy will remain elevated into 2023 – not a good sign for consumers.

Source: Macrobond.

Government intervention is another possible solution that also likely leads to a negative outcome. In order to offset the negative impact on the private sector, European governments may look to issue more debt and run a larger budget deficit. This strategy creates risk in the local currency and interest rate markets and can alter the way investors view the risk profile of a country.

Several market indicators are pricing in rising risk in Europe as positive outcomes seem unlikely and the likelihood of an economic slowdown increases. In foreign exchange, the Euro and British Pound are at their lowest levels since 2002 and 1985, respectively. Within credit, the spread between Italian and German yields and Spanish and German yields have widened out in 2022. These spreads are used as a measure for credit risk between a higher-quality credit (Germany) and a lower-quality credit (Italy and Spain). Additionally, credit default swaps are above their six-month averages, reflecting an increased risk profile for many European countries.

Source: Macrobond.

 

Source: Bloomberg.

The macro and market setup are suggesting the European economy will likely slow moving into the end of 2022. Given its size on the global economic scale, a slowdown in Europe could make its way into global economic activity.

 

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