Escaping the Euro doom loop

A new steady state, the power of narrative economics, and the mispricing of consensus expectations

Welcome to Carbon Risk — helping investors navigate 'The Currency of Decarbonisation'! 🏭

If you haven’t already subscribed please click on the link below, or try a 7-day free trial giving you full access. By subscribing you’ll join more than 4,000 people who already read Carbon Risk. Check out what other subscribers are saying.

You can also follow my posts on LinkedIn. The Carbon Risk referral program means you get rewarded for sharing the articles. Once you’ve read this article be sure to check out the table of contents [Start here].

Thanks for reading Carbon Risk and sharing my work! 🔥

---

Estimated reading time ~ 9 mins

Photo by Stephan Widua on Unsplash

As regular readers of Carbon Risk will know, industrial hedging demand is expected to be a powerful driver of European carbon prices towards the latter part of this decade. The carbon price exposure experienced by cement manufacturers, chemical producers, and other heavy industries is set to become more acute as free allocations are withdrawn. Meanwhile, the role played by utility hedging in determining carbon prices is set to diminish as renewable generation increases, and thermal coal and increasingly natural gas, become marginalised.

Evidence suggests that previous periods in which the EU’s carbon markets fundamentals have veered towards a deficit began to be priced in 1-2 years prior. For that to happen again though market participants need to have the foresight and the means to respond. However, as I noted in Germany's manufacturing malaise set to curb demand for EUAs, “uncertainty over their future competitiveness, exemplified by further weakness in manufacturing activity, a rebound in European natural gas prices, and rising competition from Chinese imports, is likely to discourage industrial firms from starting to hedge their long-term carbon risk.”

The narrative that Europe is on its knees, that the old continent is dying, and that anyone wanting a better life had better emigrate, ideally to the USA, pervades social media and one that is frequently used to stick the boot in by mainstream media commentators too. I should say here that some of the most popular articles on Carbon Risk reference the terms ‘Europe’, ‘deindustrialisation’, and ‘dead cat bounce’. Doom-mongering sells it seems (see here, here, and here)!

A new steady state

The negative story extends to longer-term Eurozone growth forecasts made by financial institutions and economic research firms. For example,

Alfonso Peccatiello (Alf)

published an article last month in which he shares, in his words, “one of the most depressing chart[s] you'll see.” The chart shows how longer-term expectations for Eurozone GDP growth have deteriorated over the past 25 years. The European Central Bank’s (ECB) Survey of Professional Forecasters (SPF) suggests that growth may only muster a mere 1.3% per annum in five years time, i.e., referring to the year 2029.¹

The reason the 5-year forecast is important, according to the ECB, is that it provides a perspective on the steady state of the Eurozone economy. Once the effects of both past and current shocks have died out, the economy should then revert to GDP growth in line with structural trends in the economy.

The ECB released its first quarterly SPF in 1999, the same year that the Euro was launched. A report published in 2019, marking 20 years since the survey started, found that GDP growth expectations show a remarkable record of reverting to trend over time. The ECB concluded, “In general, the further the data were from their perceived trend, as proxied by the longer-term expectation, the stronger was the movement expected back towards that trend.”

It remains to be seen whether GDP growth will bounce back from the energy crisis in the same way that the Eurozone recovered from past shocks, but if past performance is a guide then 1.3% could be as good as it gets.²

Narrative economics

Economists, market pundits and the financial media often think they are just observers of the facts. Most, I presume, would regard the assumption that the way they think about the world can also change it as being fanciful. Yet it only takes a bit of reflection to see that a lot of economics concerns self-fulfilling (or self-averting) phenomena.