Rabo: A Generation Of European Policymakers Have Gambled Their Continent's Energy Security

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by Tyler Durden
Wednesday, Jul 27, 2022 - 04:11 PM

By Stefan Koopman, Senior Macro Strategist at Rabobank


The two-horse race to become the next Prime Minister of the United Kingdom is in full swing. Foreign Secretary Liz Truss and former Chancellor Rishi Sunak have until the end of August to convince the Tory ‘selectorate’ why they are best suited to lead their party towards the next general election, which isn't due until January 2025 unless an earlier one is called. The votes of the 160,000+ members will have an outsized impact on the country’s direction in the next two and a half years.

The leadership race has quickly morphed into a war of ideas. This is probably prompted by the fact that the outgoing leader had so few of them, but it also echoes some very deep divisions within the Conservative party. The two candidates have some diametrically opposed convictions on the economy, leading to rather testy exchanges.

Broadly speaking, Rishi Sunak is running as the candidate of the establishment, as a safe pair of hands that offers fiscal responsibility, a realistic focus on the seriously difficult economic conditions, and essentially a departure from his own statist response to the pandemic. Even as he advocated and voted for Leave in 2016, he appears at least somewhat mindful of the negative economic impact of Brexit. His views are broadly aligned with the New Right’s fiscal principles and economic ideas. He is also not shying away from some of the more ‘Osbornian’ idioms such as “putting debt on the country’s credit card”. This (false) household budget analogy was used to raise public support for austerity in the early-2010s. The ‘hard money’ ideas that have been floated by Sunak broadly fall within the market-friendly realm, and actually smell of a return to the pre-2016 era.

He will also be in big trouble if he continues to promote ‘sensible’ or ‘fact-based’ Toryism. He has been the favourite among the MPs, but needs to take a more ‘fact-free’ stance sooner than later if he wants to take away the initiative from Liz Truss. In her first week of proper campaigning, she has expressed her desire to swiftly cut taxes worth more than £30 billion –to be funded by additional borrowing– in order to jumpstart the economy and to avoid a (we think inevitable) recession. She wants the “biggest change in economic policy for 30 years”, rails against economic orthodoxies and rubbishes the views of economists, who almost all agree that an immediate boost to demand relative to current supply conditions will mostly add to near-term inflationary pressures. It could force the hand of the Bank of England to raise rates much further than under Sunak’s hard money approach – effectively ensuring that Truss’ brief sugar rush eventually leads to a tired, nauseous and bloated feeling.

Even as there is a clear case for a healthier fiscal/monetary policy mix, the UK’s near-term options are much more limited than Truss wants the Tory membership to believe. She places great faith in the Laffer curve, a visual representation often used to imply that lower tax rates generate stronger growth and consequentially higher tax revenues, so that these cuts magically pay for themselves. It is also a convenient trick to reconcile the opposing demands of being both the party of a fiscally ‘responsible’ government and the party in favour of low taxes. She knows how to square a circle: note that she endorsed Osborne’s austerity and campaigned vigorously for Remain in 2016. Her opinions are fluid, her ideological commitments soft. But it is precisely this reorientation from ‘defeatism’ towards ‘faith’ that makes her the ‘Boris continuity candidate’, the favourite of the party’s right wing and, consequentially, the likely winner of this election.

A generation of European policymakers have gambled their continent’s energy security on faith in Russia as a reliable supplier of natural gas; a bet that has now turned very, very sour. There was another slew of negative headlines yesterday surrounding gas supply to Europe, with Russia continuing to cut flows in such a way that it first increases leverage, volatility and uncertainty, and then creates the risk for real gas shortages in Europe over the winter. This uncertainty has pushed the European Union to come to an agreement for all 27 members to voluntarily cut use of natural gas by 15% from August to March 2023. It is the competence of the member states to find actual ways on how to implement this, as all will have different industries and interest groups that they want to shield, but the cuts could be made binding with more heavy-handed measures in a supply emergency.

Demand destruction due to exorbitant prices will do much of the heavy lifting, but extremely tight supplies are still expected to persist. The front-month Dutch TTF contract is closing in on the levels reached when the war started, with German power prices for next year reaching new highs of 380 euros a megawatt-hour. This will see electricity turning from a utility into a luxury good for many Europeans, while it severely damages industrial competitiveness even before any more heavy-handed decisions to ration energy use will be made.

The IMF cut its forecast for growth in the euro area to 2.6% from 2.8% in 2022 and to a still faithful 1.2% from 2.3% in 2023, but the risks to this forecast are “overwhelmingly tilted to the downside”. Expect more downward revisions to growth to show up next time; it has been our base case for a while now that the continent faces a recession this winter. If the remaining hopeful investors start to lose faith too, and S&P’s revision of Italy’s outlook is just another case in point, a moment could be reached when growth fears overtake those of inflation. Even large policy rate increases may then fail to lend much support to the currency, while leading only to further flattening in core rate curves. We therefore see risk that EUR/USD could drop as low as 0.95 over the next few months.