How inevitable is European recession?

When Russia invaded Ukraine, we highlighted that the key dynamic for the global economy and financial markets would be energy prices. Unless reversed in short order, we now believe the extreme moves seen across oil, gas, metals, and agricultural commodities in recent days makes a European recession very likely.

While the US economy is less directly impacted, and is starting from a position of relative strength, recession risk has also increased significantly there, in our view. Indeed, there are few countries that won’t be negatively impacted by rising costs and a European recession. Even China won’t be immune, although its stronger-than-expected growth target of 5.5% for 2022, announced recently during the annual session of the Nation People’s Congress, implies increased fiscal support.

Monetary policy will struggle to offset this negative impulse with major central banks either already in full support mode or, in the case of the US Federal Reserve, still set to tighten policy due to inflationary pressures. This could change, but only once the labour market becomes less tight (in other words, when unemployment starts to rise). We should see more fiscal support in the coming months alongside automatic stabilisers, but governments are unable to lower energy costs quickly if the problem is a lack of supply.

Implications for financial markets

Valuations have moved some way to reflect the deterioration in the macroeconomic background, but we think there’s further to go should a recession become the consensus base-case view. For example, there could be decompression across credit ratings, with lower-rated credit underperforming. Positioning and sentiment indicators appear bearish, but do not stand at extreme levels at the time of writing.

One area where, we believe, valuations are already at potentially attractive levels is across emerging markets, although here outflows are proving an additional headwind. Indeed, there are signs of liquidity stress building across US dollar funding markets, which is partly a reflection of extreme volatility within commodity markets.

Of course, geopolitics can change quickly and a rapid de-escalation of the conflict and fall in commodity prices would be positive for risky asset classes. But under a base case that supply concerns remain, or even intensify, and commodity prices stay elevated, the outlook is very difficult, and we would argue against taking significant portfolio risk.

To hear more about the implications of the Ukraine conflict for the energy complex, index strategies and debt markets, tune into our latest edition of LGIM Talks