A Week of Risk for European Stocks
- By Henry Occleston
- 4 min read
Summary
- European stocks will face substantial risk events this week from Russian gas supply, ECB policy, and Italian politics.
- All could drive sharp moves in equity indices. Right now, equity volatility is elevated, but not extreme, especially considering the potential fallout from such events.
Market Implications
- While we are strategically bullish European Banking, we see value in paring this exposure until there is some clarity on event risk, and then consider re-entering.
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Summary
- European stocks will face substantial risk events this week from Russian gas supply, ECB policy, and Italian politics.
- All could drive sharp moves in equity indices. Right now, equity volatility is elevated, but not extreme, especially considering the potential fallout from such events.
Market Implications
- While we are strategically bullish European Banking, we see value in paring this exposure until there is some clarity on event risk, and then consider re-entering.
High Risk Events
The outlook for Europe is highly uncertain. Next week will be critical. With a war on its border, the risks of fallout to the EU have been elevated for some time. However, the recent restrictions in Russian gas supply and the current shutdown to Nord Stream flows has focused the market on how that fallout may happen (Chart 1).
We have previously covered the catastrophic economic ramifications of a gas supply cut. If Russia refuses to reopen the Nord Stream flow this Thursday (21 July), or even if the probability of that rose (such as Russia announcing new threats/conditionality around it), European equities could go into freefall.
On this basis, while we see strategic value in European banking, for now, we see best value in paring exposures there, to sit and wait and see how this week pans out.
The week will bring volatility from other sources, too. The day Russian gas should resume (21 July) is also the day the ECB announces interest rate policy (likely a 25bp rise) and more detail on their anti-fragmentation tool (likely to be a disappointment). Meanwhile, just a day before, on Wednesday, Italian Prime Minister Mario Draghi will return to parliament to attempt to win support for his government from the populist Five Star Movement party (M5S). If he fails, it will probably mean new elections (Chart 2).
Equities Have Weakened, But They Are Not Pricing Major Risk
The Euro Stoxx 50 and German DAX are down 23% from pre-invasion highs, while the Italian FTSE-MIB is down 26%. However, on Friday and this morning, they found some strength. Meanwhile, although index volatility remains elevated, it is far from extreme levels (Chart 2).
How do we quantify the risk? In a worst-case scenario, a gas supply cut from Russia would mean a certain recession across the EU. A study commissioned by the Bavarian VBW put the decline in German H2 GDP at €193bn (6% GDP). That would be at least comparable to the 2020 slowdown. If the bloc is simultaneously dealing with a tightening ECB unable to fight spread widening and an Italian government unable to enact the reforms necessary to receive EU monies, the equity selloff could be huge.
For context, the formation of a Eurosceptic Italian coalition in 2018 saw FTSE-MIB down 13% in the following month (Chart 3). And the 2020 lockdowns saw European indices down 40-45% that year. Even the most recent spike in BTP/Bund spread (on the back of ECB tightening) coincided with an 11% drop in FTSE-MIB.
Could There Be Upside?
The above risks suggest significant downside to European stocks. But gas flows could resume. And Italy may avoid elections. Such a positive resolution to these risks could boost assets in the near term.
Meanwhile, recession risks continue to be priced in. And with the ECB tightening, even such risk fading would make it difficult to declare a definite bottom to European equity weakness. However, it may mean near-term buying opportunities.
To best navigate this, understanding the relative performance and exposures of different countries is important (Charts 4 and 5). In the instance that the risk-off scenarios play out, the immediate risk-off reaction is likely to take some time to play out. However, after that there may be chances to pick up good value stocks – particularly those in the Energy space which may find a boost from the increased price of gas (we continue to see strategic value in renewables on the back of Europe’s need for energy independence).
Otherwise, if the near-term risks were to fade, it would provide an easier path to ECB hiking, and a boost to Italian stocks which are disproportionately exposed to finance. We would then see this as an opportunity to re-enter European banking.
Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank. He holds a BA in Economics from Durham University, and an MSc in Economics & Social History from the University of Oxford.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)