Russia’s invasion of Ukraine surprised Europe and the world. But as the war stretches past six weeks, one thing is clear: Europe will never be the same again.
Before the invasion, Europe was advancing at a, well, European pace. The continent was changing, especially when it came to energy, but the economy was set to pick up again after a brief energy-induced hiccup, and nothing seemed too pressing.
Also, trying to get 27 countries to agree on anything takes time, and the European Union has for years been perfectly willing to get almost half of its natural gas from Russia, while developing long-term plans to transition to renewable sources. Defense spending was hardly on the agenda, unless the topic was Germany’s lack.
The invasion triggered a sea change. Europe suddenly realized that it had to become energy independent, and fast. The outlook for economic growth has dimmed dramatically, as countries rush to increase military spending as if their lives depend on it. However, change will not be easy or cheap. There’s a lot of pain ahead, but also the kind of opportunities that arise when you have to chart a new future.
Europe’s problems start with energy. In 2021, Russia supplied 45% of European natural gas imports, according to the International Energy Agency. In Germany, Europe’s largest economy, that figure was 55%.
Going cold turkey isn’t really possible; such a move would trigger a recession, German Chancellor Olaf Scholz warned last month, despite his country having cut spending by 40% since the start of the war.
Europe may not have a choice. The Old World must wean itself off Russian oil, but the best the European Union can do is cut Russian gas imports by two-thirds by the end of the year. European Commission President Ursula von der Leyen has said she could phase out dependency by 2027. But Russia has already threatened to cut off supplies unless countries pay in roubles, forcing the to begin planning for emergency gas rationing.
Even Europe’s limited steps have an impact. Before the war, the continent, like the United States, had problems with inflation. The invasion exacerbated these problems. Brent crude oil climbed 12.5% to $107.46 a barrel, while natural gas now costs €107.18 per megawatt hour, more than five times the equivalent price in the United States. As a result, inflation in Europe’s biggest economies: Germany, France, the UK, Spain and Italy hit multi-decade highs in March, as energy prices soared and the Eurozone consumer price index jumped 7.5%. This led BofA’s global securities research team to conclude that “European low-income consumers could be the big losers”.
It’s even worse for manufacturers. Eurozone industrial producer prices rose in February to a record high, up 31.4% from a year ago, data showed on Wednesday. According to Nick Andrews, an analyst at Gavekal Research, producer prices are rising faster than consumer prices.
This risk, however, is not reflected in European equity valuations. The Stoxx Europe 600 is trading at 14.1 times forward 12-month earnings, just slightly below the 14.2 the benchmark was trading at before the invasion. “Given the deteriorating growth outlook and rising inflation, this suggests further declines are ahead,” Andrews said. “Investors need to stay on the defensive.”
This is especially true if Europe tips into recession. EU Economics and Taxation Commissioner Paolo Gentiloni believes that won’t happen, but expects growth to slow for the 19 eurozone countries. And the German government’s Council of Economic Advisers warns of a “substantial” recession risk for the country.
In a scenario in which the conflict in Ukraine drags on and Western nations increase sanctions to the point of stopping Russian oil and gas exports, McKinsey sees the eurozone tipping into recession in 2022 and 2023. That would delay recovery of the continent after the pandemic. until 2024, when employment levels would regain the ground lost since the start of the pandemic, and growth would return to pre-pandemic levels.
But all is not lost for investors. The greatest opportunity may lie among European energy companies. Europe takes a dual approach to its energy needs. First, the EU is diversifying its gas supplies with more liquefied natural gas, or LNG, and pipeline imports from non-Russian suppliers, while using larger volumes of biomethane and renewable hydrogen production. Second, it plans to increase renewable energy and electrification.
British energy giant
(symbol: SHEL) and France
(TTE) will be at the forefront of these efforts. Both have begun to pivot to a renewable energy future, says Zach Olson, director of investment research at Drum Hill Capital, while maintaining major oil and gas companies. “These companies will probably help in some ways to wean [Europe] out of Russian oil and gas sources, but [they are also] achieve these goals to add renewables to the portfolio,” he says.
Shell left Russia last week and will take up to $5 billion in writedowns.
|Company/Title||Recent Price||52 week change||PER*||Comment|
|Hull / SHEL||$55.30||37%||6.6||Controls 25% of the global liquefied natural gas market.|
|TotalEnergies/TTE||$49.49||6.90%||5.4||The cheapest oil major in Europe.|
|RWE / RWE.Germany||€40.62||21%||19.7||A key beneficiary of Europe’s abandonment of Russian energy.|
|Hensoldt / HAG.Germany||€24.70||90%||17.1||Still relatively cheap despite the big gain.|
|Thales / HO.France||€117.45||35%||16.5||Benefits from defense and aviation spending.|
* Forward estimate over 12 months
Both stocks are cheap. Total deals at just 4.8x forecast 2022 earnings and Shell at 6.4x, compared to an industry average of 8.4. Shell, in particular, looks attractive, according to BofA Securities analyst Christopher Kuplent. It holds about a quarter of the global LNG market and will benefit from rising oil and gas prices, as well as Europe’s efforts to reduce its dependence on Russian fossil fuels. “Shell is the world’s largest LNG supplier, with above-average sensitivity to tighter LNG markets for longer as a result of Europe’s quest for energy independence,” he adds.
As Germany aims to break free from dependence on Russian energy, the country’s largest electricity supplier,
(RWE.Germany) may be worth a look. The company is the world’s second-largest developer of offshore wind energy and the third-largest supplier of renewable electricity in Europe. RWE is a favorite of BofA analyst Peter Bisztyga, who says it is “positioned to be a key beneficiary of Germany’s and the EU’s quest for energy dependence on screws of Russia,” and could trade as high as €55 ($59.79), 34% above Wednesday. Closing $41.08.
Citi analyst Piotr Dzieciolowski, who has a price target of €45, agrees. “The current geopolitical conflict may provide tailwinds to RWE in the short term through merchant electricity prices and in the long term through accelerated expansion of renewables and also through its ability to provide security of supply” , did he declare.
Energy is not the only area that Europe has been forced to reassess. Defense spending has become a priority, as nations try to figure out how to defend themselves against a belligerent Russia. Germany announced a 100 billion euro fund to increase military spending in 2022, just days after the invasion began. More importantly, the country will increase its military spending to more than 2% of GDP. A number of countries, including Italy, Sweden, the Netherlands, Norway and Poland, have also increased their spending. The increases are long-term and will not be reversed if a peaceful solution is found.
German Defense Company
(HAG.Germany) is one of JP Morgan’s top picks for the sector. The thesis is simple. “HAG is Germany’s national champion in defense electronics and a pure player in defense and security,” write the bank’s analysts. “It will be a major beneficiary of Germany’s decision to increase military spending to 2% of GDP.” While Hensoldt shares have soared 107% this year, they still trade at just 17 times forward earnings, a 20% discount to the industry average.
French aeronautical company
(HO.France), at 16 times forward earnings, is even cheaper. Jefferies analyst Chloe Lemarie, who has a buy rating on the stock, says the company is poised for growth, driven both by its defense business and a recovery in civil aerospace. Further increases in French military spending offer upside potential. In fact, the entire industry is worth a look, given the huge defense hikes expected across Europe.
(BA), a big rival, derives about 20% of its income from its defense and space unit and should also benefit from it.
In Europe, thanks to Russia, defense could suddenly become the place to be.
Write to Callum Keown at [email protected]