European Natural Gas: What If?

European stocks plunging 20 percent. Junk credit spreads widening past 2020 crisis levels. The euro sinking to just 90 cents. The predictions for financial markets are ominous if Russia cuts off its gas supply to Europe.

Gas shipments are currently running at reduced levels, with the main pipeline shut for maintenance for 10 days, and fears are building over whether Moscow will turn the tap back on. Many investors are asking: How bad could this get?

To answer that question, strategists from across Wall Street 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 the prospective 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, accounting, and sustainability at Liberum Capital. “There simply is no substitute available for Russian gas.”

In an analysis this week, UBS Group AG economists laid out a detailed vision of what they see happening if Russia were to halt gas deliveries to Europe. Corporate earnings would fall by more than 15 percent. The market selloff would exceed 20 percent in the Stoxx 600, and the euro would drop to 90 cents. The rush for safe assets would drive benchmark German bund yields to 0 percent, they wrote.

“We stress that these projections should be seen as rough approximations and by no means as a worst-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 projected damage. The euro is at a two-decade low and on the brink of dollar parity. German stocks have lost 11 percent since June. German gas giant Uniper SE is the biggest corporate casualty; its stock has plunged 80 percent this year as it seeks a government bailout.

To be sure, many investors say there’s reason to believe Russia will turn the 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.

“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, a portfolio manager 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.”

Here’s a roundup of other strategists’ views:

BNP Paribas SA:

A full-blown gas disruption would drive the Euro Stoxx 50 to 2,800, about a 20% plunge from current levels, wrote strategists including Sam Lynton-Brown and Camille de Courcel. They recommend hedges, such as high-quality companies and buying options skew on the European stock index. Auto, industrial, and chemical industries will be under pressure, they wrote.

Nomura International Plc

Currency strategist Jordan Rochester has been urging clients to short the common currency since April. If Nord Stream 1 doesn’t resume operations, the euro may drop to 90 cents over the winter, he wrote. “We believe Europe may fail to build up sufficient gas storage for the winter, and this may lead to energy rationing,” he said. “If that’s not an economic crisis, what is?”

JPMorgan Chase & Co.

The moves in European corporate bond spreads would be bigger than the first wave of the Covid pandemic in 2020 if Russia were to shut off gas supplies, according to strategists led by Matthew Bailey. Spreads on high-grade debt may surge to 325 basis points [bps], they wrote. For junk-rated bonds, the spread could widen to as much as 1,000 bps.

Goldman Sachs Group Inc.

The euro is already reflecting a lot of the negativity, but the currency could fall another 5% if markets priced in a full shutdown of Nord Stream 1, said strategists including Christian Mueller-Glissmann. They recommend a defensive allocation, with overweights on cash and commodities.

Bank of America Corp.

Former copper bull Bank of America also slashed its forecasts last week, warning that in a worst-case scenario, where Europe experiences widespread gas shortages, prices could plunge to as low as $4,500 a ton. Copper sank 2% to $7,429 on Tuesday.

—With assistance from Allegra Catelli, Abhinav Ramnarayan & Michael Msika.

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