Markets plan for doomsday should Russia cut off gas to Europe

Gas-receiving station of the Nord Stream 1 Baltic Sea pipeline. Many investors say there’s reason to believe Russia will turn gas supply back on when maintenance on the pipeline ends on July 21. But, as UBS economists point out, if European countries start voluntary gas rationing, the hit to economic growth will be severe.

European stocks plunging 20%. Junk credit spreads widening past 2020 crisis levels. The euro sinking. 

The predictions are ominous for financial markets if Russia cuts off all the gas supply to Europe.

Shipments are currently running at reduced levels with the main pipeline shut for a 10-day maintenance, and fears are building over whether Moscow will turn the tap back on. Many investors are asking 'how bad could this get?'

To that question, strategists have tried to put numbers on a scenario that would be unthinkable in normal times. There are so many variables, such as the length of any shutdown, the extent of supply cuts, and how far countries would go to ration energy, that anyone’s prediction is a guess at best. 

“The big unknown is how the shock that starts in Germany, Poland, and other central European countries will reverberate throughout the rest of Europe and the world,” said Joachim Klement, head of strategy at Liberum Capital. 

There simply is no substitute available for Russian gas.” 

In an analysis this week, UBS economists laid out a detailed vision of what they see happening if Russia halts gas deliveries to Europe. It would reduce corporate earnings by more than 15%. The market selloff would exceed 20% in Europe and the euro would drop. The rush for safe assets would drive benchmark German bund yields to zero, they wrote.

“We stress that these projections should be seen as rough approximations and by no means as a worse-case scenario,” wrote Arend Kapteyn, chief economist at UBS. “We could easily conceive economic disruptions that lead to more negative growth outcomes.”

Markets are already pricing in some of the damage. The euro is at a two-decade low and on the brink of dollar parity. German stocks have lost 11% since June. German gas giant Uniper is the biggest corporate casualty, as it seeks a government bailout.

To be sure, many investors say there’s reason to believe Russia will turn gas supply back on when maintenance on the Nord Stream 1 pipeline ends on July 21. But, as UBS points out, if European countries start voluntary gas rationing to fill up on storage, the hit to economic growth will be severe.

'Vicious circle'

“Europe is currently being caught in a vicious circle,” said Charles-Henry Monchau, chief investment officer at Banque Syz. Higher energy prices are hurting Europe’s economy, driving the euro lower. In turn, the weaker euro makes energy imports even more expensive, he said.

The other worry is that central banks won’t be able to do much to help the economy with inflation already running at decade-highs, said Prashant Agarwal at Pictet Asset Management.

“I am not sure central bank tools work in this scenario,” he said. “In the past, they had leeway to address the situation because inflation was low.” 

• Bloomberg