How plunging gas prices bring relief in emerging Europe
Poland, Hungary and the Czech Republic are clear beneficiaries of lower natural gas prices. So, is the outlook brightening for these markets?
Natural gas prices have fallen by a stunning 87% since their peak in late August 2022. That is measured by the shortest dated futures contract, as at 9 March. The price move follows the sharp spike in prices triggered by Russia’s invasion of Ukraine.
For the central European emerging markets of Poland, Hungary and the Czech Republic, known as the CE3, this has brought much relief to their economies and financial markets. Since the natural gas price peaked, the CE3 markets have outperformed global emerging markets, as measured by the MSCI Emerging Markets, by on average 20% and as much as 24% in the case of Poland.
The fall in gas prices is important for these economies given the inflationary impact of higher energy costs for industry and households. With key export market Germany facing the same challenge over the past 12 months, exports have been weaker, and the external accounts and currencies also came under pressure.
The latest macroeconomic data across the CE3 remain generally weak, reflecting the impact of higher interest rates and still elevated inflation on real incomes. Geopolitical risk stemming from Russia’s invasion of Ukraine looks likely to remain a cloud on the horizon. There are signs though that the outlook has stopped deteriorating, and could be set to pick up.
Europe’s gas crisis has abated, at least for now…
Eurozone gas storage levels are very high for this time of year, relative to the average of the last ten years. The chart below shows current storage levels, as well as a comparison with the annual historical average and minimum and maximum levels over the last ten years. With northern hemisphere spring underway, there seems to be little risk of supply shortages, or power cuts, until at least next winter.
Near-term supply concerns have dissipated, as the fall in natural gas prices suggest. The prospect of a gas crisis in Europe, while now slimmer, has not been totally vanquished though. Storage ahead of the 2022/3 winter was filled prior to the cessation of most supply from Russia. This will not be as straightforward this summer, though the starting position of storage levels is likely to be better. Gas storage in Europe typically begins to rise again in April, as demand falls over the late spring and summer months.
A harsher, colder winter than we have seen this year would add to gas demand. This winter, a fall in demand for gas, as industry and households managed consumption and costs more tightly, also helped. Further demand destruction would risk greater economic impact. The import of liquified natural gas (LNG) replaced some Russian supplies in 2022, in an effective restructure of global energy markets. Europe and the UK together increased LNG imports by 60% last year. This has lifted global LNG demand on a sustained basis, and with China’s economy reopening the risk of price shocks in the next few years cannot be discounted. Slower economic growth in China in 2022, owing to zero-Covid policy constraints, led natural gas demand to fall slightly last year. China’s economy is expected to recover this year, and with it natural gas demand, although the degree of the demand pickup remains uncertain.
Why lower gas prices bring relief to the CE3
Like much of the rest of the world, Russia’s invasion of Ukraine led to higher energy and food prices. Europe was acutely affected, owing to the previous importance of natural gas supply from Russia. As a result, inflation soared.
As elsewhere in the world, CE3 central banks have responded to higher inflation by tightening monetary policy. Poland and the Czech Republic’s central banks lifted policy by well over 6% in this cycle, to 6.75% and 7.0% respectively. Meanwhile Hungary’s central bank has hiked by over 11% to 13.0%.
With inflation showing some signs of easing, and with gas prices on a downward trajectory since last August, central banks across the CE3 have left rates on hold in recent months. Easing concerns around the gas crisis have also lent support to CE3 currencies, dampening the inflation pass-through from higher import costs. Global food prices are projected to ease somewhat in the coming quarters, which should also support disinflation. Food as a share of the inflation basket is over 20% in Poland, and over 30% in Hungary and Czech Republic. Energy is around 10% of the inflation basket in each of the three economies.
The pace at which inflation moves towards target remains unclear though. Inflation-busting minimum wage rises, such as the 20% rise announced in Poland this year, could complicate the task of central banks. Consequently, and absent a major change in the outlook, central banks seem likely to hold policy for some time before rate cuts come into view.
The external accounts of the CE3 economies also came under pressure due to Russia’s invasion of Ukraine. As net importers of energy, import costs rose. Meanwhile, manufacturing exports fell as demand from key market Germany fell as a consequence of the gas crisis. Deterioration in the current account positions of all three economies led to currency pressure, but with the crisis now receding, at least for now, this trend is reversing.
Are there green shoots of improvement in economic data?
Higher inflation and interest rates have increasingly weighed on economic activity in recent months. Poland’s economy contracted by -2.4% quarter-on-quarter in Q3, with Hungary and Czech Republic also seeing a fall in GDP over the quarter.
The CE3 markets have hosted significant numbers of Ukrainian refugees since the conflict began. In Poland’s case, over 1.5 million Ukrainians have registered for temporary shelter in the country, with more than double that figure passing through the country to find protection elsewhere in Europe. In addition to the fiscal challenges, and additional inflationary pressure, this has also provided some support to consumption. So although consumption is weak, it has held up by more than might have been expected.
In those CE3 markets where inflation has so far shown the strongest signs of peaking, that is Poland and Czech Republic, consumer confidence has also been improving from a depressed level. Manufacturing PMI, while still in contractionary territory in Poland and Czech Republic, is also off its lows. The weaker global trade outlook persists, but energy prices have eased, and high frequency activity data look to have bottomed and the beginnings of a recovery may be underway.
Other risks to monitor
The conflict in Ukraine, which borders Poland and Hungary, remains a key risk to consider. Further escalation has potential to reignite global energy and food prices, even if European gas storage levels are now in better shape. This would lift the outlook for inflation, and likely increase risk premiums across the region.
Domestic politics is a further area to monitor. A general election is due to be held in Poland by 11 November this year. The incumbent PiS led government’s lead in opinion polls has continued to narrow. Relations with the EU have deteriorated in recent years, owing to reforms which have weakened key institutions. As a result, Poland has not been able to access EU Recovery and Resilience funding.
In Hungary, relations with the EU are in a worse position. It is also blocked from receiving EU recovery funding until agreement is reached around spending oversight. Meanwhile, Hungary has used its veto to elicit carve-outs in negotiations with the EU over sanctions against Russia.
What do valuations look like?
Even after the strong performance from the CE3 equity markets since the gas price peak in August, valuations for Poland and Hungary still look cheap on a combined basis. This incorporates trailing price-earnings, 12-month forward price-earnings, price-book and dividend yield.
It’s important to note that Hungary and the Czech Republic are small markets. In total, there are three stocks in each country index. This can skew the headline valuation figures. Indeed, in the Czech Republic, the largest and most dominant index stock is an energy company.
Currencies in Poland and Hungary are relatively cheap versus their long-term average. However, after strong performance in recent months, the degree of cheapness reduced.
Our view on the CE3 markets
We hold a favourable view towards Poland and Hungary. In Poland, the macroeconomic outlook is improving, amid signs of inflation peaking, and valuations are attractive. In Hungary, the economic outlook continues to face challenges, albeit there has been some modest easing more recently. Political risk is ongoing, but market valuations compensate for these negatives.
We remain negative towards the Czech Republic. Improvement to the macroeconomic picture is welcome, and the EU recovery fund provides support. However, stock opportunities are limited.
The broad picture for the CE3 is healthier than a year ago. The energy crisis has faded to a certain extent, and if disinflation follows as expected, the outlook could incrementally improve as we move through 2023. Russia’s invasion of Ukraine will remain a risk but should energy prices remain low and food prices cool as expected, the outlook should continue to improve.