LONDON (CNN Business) -- Europe’s economy, which accounts for almost a fifth of the world’s output, is facing its toughest test since the pandemic erupted more than two years ago. A cocktail of risks threatens to throw growth into reverse at a moment of deep uncertainty.
Like the United States and other developed economies, Europe is dealing with red-hot inflation that’s hurting consumers, potentially hastening the end of the post-lockdown spending boom. But the continent is also grappling with a volatile energy crisis, scorching temperatures and a fresh bout of political uncertainty — problems that are all coming to a head this week.
Economists are warning that a recession late this year or early next year looks increasingly possible as risks pile up.
“We are not in good shape,” said Erik Nielsen, group chief economics adviser at the Italian bank UniCredit. “I think the odds are we will have a recession in Europe over the winter.”
The biggest concern surrounding Europe’s economy is access to energy. Fears have spiked that Moscow could shut off gas supplies to retaliate for tough sanctions following the invasion of Ukraine, delivering the bloc a massive shock.
The International Monetary Fund has said that if gas from Russia were to stop flowing, vulnerable countries including Slovakia, the Czech Republic and Hungary could fall into a severe recession, taking a GDP hit as high as 6%. Germany’s top forecasters have said Europe’s biggest economy would lose €220 billion ($225 billion) over the next two years.
Already, 12 EU member states have had gas supplies from Russia entirely or partially cut off, according to the European Commission, which unveiled its emergency plan to conserve gas for next winter on Wednesday. The flow of Russian gas to Europe is less than one-third of what it was this time last year, the Commission said.
A crucial moment in the standoff looms. Anxiety has climbed since Russian gas giant Gazprom shut down the Nord Stream 1 pipeline for scheduled maintenance 10 days ago, sending European gas prices to their highest level since March. Flows via the pipeline are essential, and have historically met an estimated 12% of EU demand, according to S&P Global Platts.
Nord Stream 1 volumes to Germany already dropped sharply before maintenance began. They plunged by 60% last month, forcing Berlin to declare a “gas crisis.”
On Tuesday, Russian President Vladimir Putin said that Gazprom would “fulfill all of its obligations,” though he warned that a dispute over vital turbines, which had been caught up in sanctions, jeopardized supply.
Even if flows do resume without incident, the specter of future throttling will hang over Europe, holding back investment and confidence.
“What we will be getting is a longer period of uncertainty, which is not going to be good for the business cycle,” said Guillaume Menuet, Citi Private Bank’s head of investment strategy and economics in Europe, the Middle East and Africa.
Inflation
Annual inflation in the European Union jumped to 9.6% in June. It reached 8.6% for the 19 countries that use the euro.
To cap price increases, the European Central Bank started raising interest rates on Thursday for the first time since 2011. But it faces an uphill battle to get the situation under control.
The central bank lags peers like the Federal Reserve, which started hiking months ago. Interest rates in Europe have been negative since 2014, which means it’s further behind. And, if a shortage of energy tips the region into recession, the central bank could be forced to abruptly stop hiking rates, hampering its ability to keep fighting inflation.
“Everything that’s happening right now is limiting the scope for the ECB to really hike a lot,” said Carsten Brzeski, global head of macro at ING, a Dutch bank.
Climate Change
Wildfires tearing across Spain and France as a heatwave grips the region could also put a damper on economic activity.
Nearly half of Europe’s territory, including the United Kingdom, is “at risk” of drought, researchers at the EU Commission said Monday.
Germany, meanwhile, is grappling with a drop in water levels along Rhine river, a major trade artery. There are already signs that shipping has been affected.
“Low water levels mean that river barges will have to travel with reduced freight to limit their draft or even cease operating altogether,” Berenberg Bank said in a research note published Wednesday. “As a result, quantities shipped decrease and freight rates rise.”
That could weigh on Germany’s hugely important manufacturing sector. Researchers at the Kiel Institute for the World Economy found that in a month with 30 days of low water, the country’s industrial output fell by about 1%.