The European economic landscape is currently facing significant challenges that echo the troubling times of previous financial crisesThe credit spreads across Europe and between nations are widening alarmingly, nearly reaching levels observed during the last Eurozone debt crisisRecent trends indicate a pervasive anxiety about the stability of the European economy, culminating in a notable drop in the euro's exchange rate.

Since the outbreak of the ongoing war, economic performance across Europe has been lackluster, heightening the risk of recessionManufacturing indices—specifically the Purchasing Managers' Index (PMI) in key nations like Germany and France—are hovering around the 50% mark, indicating stagnationMeanwhile, consumer confidence in the Eurozone took a significant hit, dropping to -17.6 in June

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This index is a leading indicator, typically signaling a downturn in consumer spending within a timeframe of three monthsThe asymmetric impacts arising from the conflict have resulted in a visible divergence in economic trajectories between the U.Sand Europe, exemplified by the dollar index surging past 109 and the euro sinking below parity against the dollar.

The bonds market mirrors these concernsThe substantial escalation in credit and nation spreads has brought them close to the levels seen in the previous debt crisisNotably, the credit spread in high-yield bonds across Europe ballooned to nearly 600 basis pointsThis trend has cast a spotlight on the rising unease within the market regarding the health of the European economyAdditionally, the spread between Italian and German bonds reached a staggering 250 basis points, reminiscent of the previous crisis’ dynamics, revealing the growing discrepancy between the so-called "core" and "periphery" nations within the Eurozone.

Despite the European Central Bank (ECB) attempting to reassure markets through intervention, there persists a palpable fear that a new debt crisis may emerge, particularly with high Credit Default Swaps (CDS) for countries like Italy remaining stubbornly elevated

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Following the last Eurozone crisis, while the overall government leverage rates in the Eurozone have seen a decline, many peripheral countries still struggle with high leverage levelsSince 2014, the Eurozone’s average government leverage has decreased from 94.3% to 83.8% by 2019, but countries such as Italy and Spain have seen little to no reduction in this regard.

The aftermath of the pandemic and the energy crisis has led to a relaxation of fiscal discipline, resulting in increased leverage for various governmentsIn March 2020, in a bid to respond to the COVID-19 crisis, the EU announced a suspension of fiscal rules, which was further prolonged in May 2022 as a response to the energy crisisThis absence of fiscal constraints saw countries like Italy and Spain engage in extensive fiscal stimulus programs, pushing their government leverage rates to historical highs.

With the ECB poised to initiate interest rate hikes, the burden of debt repayment is set to escalate, particularly for countries like Italy

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Under the constraints of maintaining inflation targets, the ECB has no choice but to accelerate its policy normalization, indicating a tightening of monetary policy that is set to begin from July, with expectations of cumulative rate hikes reaching approximately 100 basis points by year-endPreliminary assessments show that this could result in a spike in overall interest expenditures in the Eurozone by about 0.8 percentage points relative to GDP, reverting to levels reminiscent of 2014. For economies with already high debt pressures, such as Italy and Spain, these rate hikes may become an insurmountable obstacle.

The ongoing energy transition, alongside other factors, could further complicate the “quasi-stagflation” conditions in Europe, placing significant constraints on monetary policy strategiesThe fragility of the European energy system is not a new development, having been exacerbated dramatically during the second half of 2021, when energy prices soared between two to three times

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The recent conflict has only intensified the weaknesses inherent in Europe’s energy infrastructure.

The crux of the Eurozone crisis lies in the fact that while core nations like Germany are able to leverage the advantages of a stable euro for expanding trade, peripheral countries like Italy have relied heavily on the low cost of funds available within the Eurozone to finance their debt expansionHowever, the process of fiscal integration has stagnatedIn times of low inflation and low-interest rates, the ECB was able to cushion “peripheral” country debt by engaging in significant bond purchases—over 20% of Italian bonds were net acquiredHowever, in the current quasi-stagflation environment, the ECB has declared an end to its asset purchase program and is ceasing its balance sheet expansionThe constraints of an already limited monetary policy mean the structural rebalancing of bond purchases will likely be more of a temporary fix rather than a definitive solution to the long-standing issues affecting the Eurozone.

Germany and France, considered core members of the Eurozone, are themselves facing immense pressures