What If a Truce Is Weeks Away?
Against this backdrop, we believe a look below the surface of recent headlines, which we attempted recently in Russia/Ukraine – Addressing Misperceptions, is warranted.
A large-scale Ukraine rebuild has been a key focus for investors, but the scope and funding of any effort remain unclear
The most widely circulated estimate is the World Bank’s end-2023 assessment of the reconstruction need in Ukraine of US $486 billion, which has recently been updated to US$524 billion. But we would also note that this estimate assumes restoration to a higher standard versus pre-war, includes current territory occupied by Russia and is the expected spend over a 10- year period. Adjusting for these factors, we think a mid-scenario of ~US$26 billion per annum in additional reconstruction spend is reasonable, which for context would represent ~1% of annual European construction spend. As we argued in Rebuild Ukraine – Dislocations, our analysis of the cement market in Ukraine and surrounding regions suggests that any rebuild demand would largely be met by local production, with Turkey likely best positioned if imports are required.
The prospect of Russian gas flowing back into Europe is also a key debate, but this again is not straightforward
Gas-reliant European equities have enjoyed a recent rally on the prospect of lower energy prices if Russian gas is allowed to flow back into Europe. But what are the practical limitations? First, it is notable that four of five Russian pipelines to Europe face significant challenges to flow resumption, including damage repairs and regulatory hurdles. Second, in the meantime, new gas contracts have been signed with new trading partners, more US LNG is landing in Europe and demand growth remains soft, meaning that the incremental share of the pie that renewed flows of Russian gas could take is potentially more limited. It is also accurate to say that the political considerations are complex, and in conclusion our most plausible peace-related scenario could see ~10bcm/yr of Russian gas return to Europe, potentially bringing imports to ~25bcm, well below pre-war levels of ~160bcm.
Few sectors have been as squarely in the spotlight as Defence since the start of the conflict, and this remains a key area where we see spending on the rise
On our estimates, additional investment in European Defence to 2.5-3.5% of GDP (versus ~2%) could represent US$0.9-2.7 trillion out to 2035. Consistent with our Defence Dilemma work, perhaps the more important question is how this higher level of spend will be funded and over what period spending will ultimately rise. EU funds could potentially be raised to finance common projects, but in order to ensure that they do not count towards national debt and deficits (and hence provide new fiscal room), countries would have to give significant autonomy to a supranational body. This might prove challenging. So, we think that some relaxation of EU fiscal rules is likely to play a significant role in raising defence spending. The UK has now officially committed to increasing defence spending to 2.5% of GDP by 2027, funded by cuts to foreign aid, with a clear ambition to reach 3% by the next parliament.
In all potential Russia/Ukraine peace deal scenarios, we see higher costs for Europe
Our economists believe that this will ultimately put more pressure on public finances and is likely to end up in cuts to welfare spending and/or higher taxes. While the easing of EU fiscal rules can create some room for more defence spending in the near term, it is unlikely to solve medium-term budget challenges in countries like France and Italy.
Undoubtedly, the key from here will be additional details and the conditions of any sustainable proposed ending to the Russia/Ukraine war. Meanwhile, European leaders are in London today and are scheduled to meet for a special summit on March 6 to discuss joint plans on defence and security.
