In the midst of the energy crisis caused by the pandemic, Europe’s already battered economy is suffering a new setback: the tension on the border between Russia and Ukraine. Inflation, expectations of interest rate hikes and the drums of war in a country that is fundamental for Europe’s energy supply are the major stumbling blocks to the long-awaited economic recovery in the Old Continent.
In what the United States considers a key week in the conflict in Eastern Europe, the White House National Security Advisor, Jake Sullivan, stated last weekend that Russia could invade Ukraine “any day now. Even as early as this week, before the Olympics are over.” The statements, which prompted numerous European governments to advise their citizens in Ukraine to leave the country, have also been met with an economic response.
This Monday, the main European stock market indexes have suffered a significant drop, which has been joined by the increase in the price of a barrel of Brent oil above 96 dollars for the first time since 2014 and a risk premium in Spain that exceeds 100 points, something that has not happened since June 2020.
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If there is one factor that explains the economic situation in Europe, it is the increase in the price of gas on international markets, caused among other factors by the global demand for energy during the recovery of economic activity after the pandemic standstill.
The crisis in Ukraine comes at a time when energy prices are exorbitant, which gives Russia a fundamental bargaining chip in the face of the conflict, as it is a major exporter. Around 35% of imports of this natural resource for energy production in Europe come from Russia.
In this sense, the price of a barrel of Brent oil, the reference for the European continent, adds to the increase of gas and increases the energy pressure. On Monday, the price of a barrel of oil reached over 96 dollars, which means an increase of more than 21%, while Texas (WTI) stood at 95.46 dollars.
Inflation and fear of interest rate hikes
In recent weeks, sovereign bond yields have risen sharply as investors fear that central banks will tighten their monetary policy decisions to control inflation.
If inflation rises, the only thing central banks can do is to raise interest rates sharply. This is what is evident in the market when faced with the idea of rate hikes and the war itself, which may to some extent generate a slowdown in economic growth.
On February 3, the president of the European Central Bank (ECB), Christine Lagarde, left the door open to a rate hike in 2022, although she later assured that raising them now “will not solve the current problems” and “would not help anyone”. The ECB has recalled that any rate hike will only take place after net asset purchases are reduced to zero, something that will not happen until at least October 2022.
In this context, Italy’s risk premium reached 171 basis points on Monday, while Greece’s stood at 237 basis points. In Portugal, its risk premium reached 89 basis points, while the yield on the ten-year bond is quoted at 1.09%. On the other hand, the interest on the German ten-year bond – considered the safest in Europe, and whose difference measures the country risk – fell sharply to 0.196%, from 0.294% last Friday.
Lagarde has indicated that inflation will remain high in the short term. This is because energy prices remain the main upward influence, although the ECB president has also acknowledged that price rises “have become more widespread”, with notable increases in many goods and services.
Stock market uncertainty
The crisis in Ukraine implies a more general uncertainty for the market that translates into a movement of risk aversion among investors that affects the stock market as an asset class, and not so much specific sectors as is the case with the risk of interest rate hikes.
European stock markets closed the session in the red, with falls of 1.69% in London, 2.27% in Paris, 2.02% in Frankfurt, 2.55% in Madrid and 2.04% in Milan. In addition, some sectors such as airlines and aviation have particularly suffered from the tension between Ukraine and Russia: Aena (-2.25%), Wizz Air (-5.8%), Lufthansa (-3.1%) and Air France-KLM (-3.4%).
After several months of uncertainty due to the energy crisis resulting from the pandemic, the crisis in Ukraine has become an additional factor that further punishes what is happening in the markets. Whether the drums of war will finally be consummated is still an unknown, although the economy is already foreshadowing the difficult situation that the Old Continent could face.