It should be Europe’s star year.
A post-pandemic spending euphoria, helped by heavy government spending, should boost the economy and help weary households regain a sense of normalcy after two horrific years.
But all that changed on February 24 with Russia’s invasion of Ukraine.
Normality is over and the crisis has become permanent.
A recession is now almost certain, inflation is approaching double digits and a winter of looming energy shortages is fast approaching.
While this outlook is bleak, it’s likely to get worse before a significant improvement well into 2023.
“Crisis is the new normal,” says Alexandre Bompard, managing director of retailer Carrefour. “What we were used to for the last few decades – low inflation, international trade – is gone,” he told investors.
The change is dramatic. A year ago, most forecasters were forecasting economic growth of almost five percent for 2022. Now a winter recession is becoming the base case.
Households and businesses are both suffering as the aftermath of the war – high food and energy prices – are now compounded by a devastating drought and low river levels that limit transport.
Read: Germany and Austria are returning to coal amid Russia’s cuts in gas supplies
At 9 percent, eurozone inflation is the highest in half a century, eroding purchasing power as excess money is spent on petrol, natural gas and basic necessities.
Retail sales collapse months before the start of the heating season and shoppers scale back their purchases. In June, retail sales volumes fell nearly 4 percent year-on-year, led by a 9 percent decline in Germany.
Consumers are turning to discount chains and abandoning high-end products and switching to discount brands. They’ve also started skipping certain purchases.
“Life is becoming more expensive and consumers are spending cautiously,” Robert Gentz, co-CEO of German retailer Zalando, told reporters.
Companies have fared well so far thanks to excellent pricing power due to ongoing supply constraints. But energy-intensive sectors are already suffering.
Almost half of Europe’s aluminum and zinc smelting capacity is already off-line, while much of fertilizer production, which relies on natural gas, has been shut down.
Tourism has been the rare bright spot for people looking to spend some of their accumulated savings and enjoy their first carefree summer since 2019.
But the travel sector is also being paralyzed by capacity and labor shortages, with workers laid off during the pandemic reluctant to return.
Major airports like Frankfurt and London Heathrow have been forced to cut flights simply because they lack the staff to handle passengers. At Amsterdam’s Schiphol, waiting times could stretch to four or five hours this summer.
The airlines couldn’t cope either. German Lufthansa had to apologize for the chaos among customers and admitted that it would not ease up any time soon.
recession is imminent
That pain is likely to intensify, especially if Russia cuts gas exports further.
“The gas shock is much bigger today; It’s almost twice as bad as it was with oil in the 1970s,” said Caroline Bain of Capital Economics. “We’ve seen a 10-11x increase in the spot price of natural gas in Europe over the past two years.”
While the EU has unveiled plans to accelerate its transition to renewable energy and wean the bloc off Russian gas by 2027 to make it more resilient in the long term, supply shortages are forcing it to target a 15 percent cut in gas consumption this year.
But energy independence comes at a price.
For normal people, this means colder homes and offices in the short term. Germany, for example, wants public spaces to be heated to just 19 degrees this winter, compared to around 22 degrees previously.
Further out, this means higher energy costs and hence inflation as the block has to give up its largest and cheapest sources of energy.
For companies, this means lower production, further hampering growth, particularly in industry.
Wholesale gas prices in Germany, the bloc’s largest economy, have risen fivefold in a year, but consumers are protected by long-term contracts, so the impact has been far less so so far.
Still, they have to pay a government-mandated levy, and once contracts are renewed, prices will soar, suggesting the impact will be delayed, putting continued upward pressure on inflation.
For this reason, many, if not most, economists believe that Germany and Italy, Europe’s #1 and #4 economies heavily dependent on gas, will soon enter recession. A recession in the United States, while also likely, has very different origins.
silver lining
The United States Federal Reserve, struggling with a red-hot job market and fast wage growth, has been quick to raise interest rates, making it clear it is willing to risk even a recession to curb price growth.
In contrast, the European Central Bank has hiked interest rates to zero only once and will only do so cautiously, considering that an increase in the cost of borrowing for heavily indebted eurozone countries such as Italy, Spain and Greece could stoke concerns about their ability to hold them pay their debts.
But Europe will enter a recession with some strength.
Employment is at a record high and companies have been struggling with growing labor shortages for years.
This suggests that companies will be looking to hold onto workers as they head into the downturn with relatively healthy margins.
This could then support purchasing power, pointing to a relatively shallow recession with only a modest rise in the unemployment rate from a record low.
“We are seeing ongoing acute labor shortages, historically low unemployment and a high number of vacancies,” ECB Executive Board member Isabel Schnabel previously told Reuters. “This probably implies that even if we enter a recession, companies could be very reluctant to lay off workers on a large scale.”
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