Deutsche Bank reported decent second-quarter results on July 27, including an 8% return on tangible common equity partly thanks to higher FIC trading revenues, which helped the German lender to its best first half since 2011.
The stock edged up, but investors were in no mood to celebrate. They want to know what will happen to the German economy if Russia cuts off gas supplies to Europe in retaliation for sanctions and financial and military support for Ukraine.
Deutsche offers brief detail of its preparations on page 47 of the 112-page interim report, where it says that an immediate gas-supply shutdown would potentially result in additional allowances for credit losses of 20 basis points, likely playing out over 18 months, with 10bp of that in the first year and 10bp in the second.
That doesn’t sound too bad, does it?
“We were surprised that the modelled impact of a gas-supply shock was only 20bp,” say bank analysts at Barclays, who estimate a number almost 17 times higher in a recent severe stress test for an energy crisis in Europe.
Putin may see greater benefits in drip-feeding gas to Europe, earning a much higher price for the reduced volume he allows through, keeping Western countries dependent, maintaining high inflation and uncertainty
Deutsche’s own economics team believes that even without full gas rationing the country is already headed into recession in the second half of this year and its economy will likely shrink by 1% in 2023 as high inflation hits consumer spending.
The country’s banks and corporate borrowers can cope with that.
But if Russia turns the gas taps off, that could lead to a much more severe GDP slump of between 5% and 6% in 2023.
The team says: “The gas crisis and the switch from quite cheap (Russian) pipeline gas to more expensive LNG [liquified natural gas] could turn out to be a structural game changer for the [country’s] export-oriented business model” and for Germany as an industrial location.
This would be even worse than the Covid crisis.
Gas pressure
One of the key uncertainties is how much of the stress industry, consumers and the state would ultimately bear and, for banks, how far loan demand would also drop while cost of risk increases.
“Production affected by rationing would to a considerable extent be permanently shifted abroad resulting in a lasting loss of world market share if German producers cannot deliver and foreign (Asian, US) competitors step in,” writes Stefan Schneider, chief economist at Deutsche. “As a result, Germany’s growth potential would also suffer more permanent scars, increasing the pressure to adjust Germany Inc’s business model.”
The difficulty with all this analysis is that it may not happen. Russian president Vladimir Putin may see greater benefits in drip-feeding gas to Europe, earning a much higher price for the reduced volume he allows through, keeping Western countries dependent, maintaining high inflation and uncertainty, spreading anxiety over re-exports of Russian gas from Germany to its neighbours and fomenting disunity, all while still funding his war.
Henry Wilkinson, chief intelligence officer at security intelligence firm Dragonfly, says: “We assess that a more likely scenario is that Russia will reduce its gas flows to the lowest possible levels, which might include brief stoppages lasting more than a week or so.”
Shutting off the gas for any longer doesn’t seem rational. But then neither did invading Ukraine.
Investors are on heightened alert. Kristina Hooper, global market strategist at Invesco, says: “We will watch to see how Europe as a whole builds gas reserves and finds substitute supplies from other regions to help reduce the risk of rationing should Russia continue to restrict or even stop EU gas exports.”
Flows cut
Behind the scenes, companies and governments are in crisis management mode as authorities seek to identify companies that are heavy consumers of energy but also vital to corporate supply chains and where sudden production stops could have damaging consequences for other big employers.
Europe has cut its use of Russian gas but only through the end of a mild winter and the spring and summer following the invasion of Ukraine. Much depends on how far Germany, as a key gas distribution hub for Europe, can rebuild storage levels ahead of the coming winter and how low temperatures fall.
S&P Global ratings suggests: “Continued cuts in gas flows are likely, particularly as winter approaches, with the objective of inhibiting Western military support for Ukraine.”
Natural gas prices are already 8.5 times higher than the average from 2010 to the end of 2020, the agency points out, while the impact is just starting to be felt.
BASF reported that chemical industry production fell 2.6% in Europe in the second quarter, in contrast to a 3.1% increase in China and a 2.5% increase in North America.
Chemicals, automotive, steel and other metals, as well as manufacturing are among the most exposed sectors, while Austria, the Czech Republic, Germany, Hungary, Italy and Slovakia are the sovereigns most at risk.
LNG from more reliable countries might eventually offer greater certainty of supply – albeit at a much higher price – than Russian natural gas. But Europe can’t magic up the infrastructure to import and distribute much more LNG before the coming winter crunch.
A complete cut-off of gas and associated production stoppages is a form of severe event risk that will likely prompt swift action from lenders and from rating agencies, but only when and if it happens and not until.
Christian Sewing, Deutsche’s chief executive, tried to describe the 20bp forecast for expected losses in the event of a shut-off as conservative and to sound reassuring.
“Being here in Germany and having the possibility to talk to corporate leaders on the DAX level or the family-owned and midcap clients, the attention to the gas situation is, obviously, very, very high,” he told analysts on the earnings call. “And what I have seen as preparational work across industries, on the production side, but also on the financial resilience side, is impressive.”
Distribution wipe-out
But this all comes with government finances stretched by the Covid bailouts and central banks only just starting to tighten financial conditions having fallen so far behind the curve on inflation.
In the era of central bank stress tests, Barclays recently ran one of its own for an energy shock that causes a 10% contraction in euro area GDP across the rest of 2022 and 2023. That would result in average cost of risk of 340bp for the leading European banks, which would at the very least wipe out distributions.
Banks got through the Covid crisis unimpaired because governments bailed out their borrowers. Financing higher than expected budget deficits, coming on top of already stretched debt-to-GDP ratios, at higher rates and with central bank buying curtailed, is going to test even well-rated sovereigns and investment-grade corporates alike.
