CE3: bleak present, brighter future?

This year has so far been grim for markets in general and Europe in particular.

Beset by the disruption from the war in Ukraine, rising food and energy prices, and tightening monetary policy, the region faces a bleak near-term outlook.

Gas shock: betwixt, bothered and bewildered

The cause of the coming European recession is the halt in Russian gas supplies to Europe. Rationing of energy usage, supply stoppages and disruption of intermediate goods are all expected to wreak havoc on supply chains. A recession now seems inevitable, as stoppages in industrial activity and painful adjustments in spending patterns reduce output and consumption.

The three central European countries known as CE3 – the Czech Republic, Hungary and Poland – are strongly interlinked in supply chains with German industry and reliant on Russian gas for household heating.

Activity in the CE3 is weighted towards gas-intensive industries, particularly chemicals and foodstuffs, that are vulnerable to stoppages amid a regional gas squeeze. Moreover, exposure to the broader European economy, particularly Germany, as an export market leaves them vulnerable to drops in consumption.

Policy has also become less stimulative. Rising fears of inflation have prompted central bankers to hike policy rates. This is mirrored in fiscal policy. With the passage of elections in Hungary and Czechia, subsidies on household electricity prices and tax rebates to win votes have been rolled back. Poland’s monetary tightening has been counteracted (in part) by fiscal loosening ahead of the election scheduled for next year but will also likely be withdrawn once this has passed.

Through the clouds, a brighter sky

Though the near-term outlook is bleak, the longer-term profile for the CE3 remains robust. Convergence, the longstanding tailwind to growth for the economies of eastern Europe, remains unfinished. The transfer of knowledge and skills from west to east will continue, boosting productivity despite recent turbulence.

Moreover, we believe the war in Ukraine is likely to accelerate regional investment, with near-shoring of sensitive production to the CE3 economies likely to pick up amid rising geopolitical tensions. Investment in green energy is likely to accelerate as countries diversify their energy away from Russian gas. Dispersal of EU funds will eventually take place, in our view, as Hungary and Poland conclude their spat with Brussels over the rule of law by 2024.

The conflict between Ukraine and Russia also sidelines two of the largest competitors to the CE3’s strength in European manufacturing. Turkey, currently engulfed in an inflationary spiral, also offers little competition. Any effort to rebuild Ukraine will also have to be organised and supplied via the CE3, particularly Poland. Although the immediate picture for the CE3 looks bleak, there are some silver linings once the group has overcome its near-term pressures.

On a positioning basis, we are wary of the consequences of the gas shock on the wider European economy, and we remain uncertain of the damage that will be inflicted. However, within the CE3, we are also watchful for areas of excessive weakness, be they in currency, equities or credit. Given the more constructive outlook for the region in the coming years, we believe it can offer attractive returns.