Italy's 66th post-war government collapsed in January 2021 when Prime Minister Giuseppe Conte was forced to resign after former premier Matteo Renzi removed his minor Italia Viva party from the ruling coalition. President Sergio Mattarella encouraged the parties to revive the alliance so he could avoid calling a snap general election during a pandemic.

But the talks went nowhere. As concerns grew that any election might usher right-wing populists into power, Mattarella pulled off a masterstroke. In early February, Mattarella unexpectedly contacted Mario Draghi; yes, 'Super Mario' who saved the euro in 2012 with his 'whatever it takes' comment. Mattarella asked the chief of the European Central Bank from 2011 to 2019 to begin talks to form a 'national unity' government. Within days, Draghi had won a parliamentary majority to become Italy's 29th prime minister since 1946 and its fourth unelected (or 'technocratic') premier since 1993.[1]

Investors were pleased. On February 13 when Draghi assumed office, 'lo spread' - the yield at which Italian 10-year government bonds trade over their German equivalents, a number that is judged the bellwether of EU economic and political risks - had narrowed to a five-year low of just under 100 basis points.

Draghi's government retains the confidence of investors yet lo spread has widened to 200 basis points (as the German 10-year bond topped 1% for the first time since 2015).[2] What malfunction occurred that widened the gap towards the 300 basis-point level that is seen by many as the tripwire for a crisis? None that was Draghi's fault. The culprit, like elsewhere in the world, is inflation. Eurozone inflation has climbed to its highest since the euro was created in 1999. Consumer prices surged 8.1% in the 12 months to May due to the ECB's promiscuous monetary policy, mammoth fiscal support during the pandemic, rising energy prices due to the switch to renewables, and supply blockages created by pandemic disruptions. The way Russia's war on Ukraine has boosted energy, commodity and food prices is likely to keep eurozone inflation elevated.

The ECB has one objective; to maintain price instability, which is interpreted as keeping inflation below 2%. The central bank modelled on the inflation-hating Deutsche Bundesbank has little choice but to tighten monetary policy when inflation is nearly four times its target. Since 2016, the ECB's key rate has stood at 0%, while the overnight deposit rate has been negative since 2014 (and at a record minus 0.5% since 2019).[3] When the pandemic struck, the ECB added to various asset-buying programs[4] that gained heft when the bank first undertook quantitative easing in 2015. Over the past seven years, the central bank has purchased 3.9 trillion euros of eurozone assets, including 723 billion of Italian public debt, an amount equal to nearly 40% of Italy's GDP.[5] Given the record inflation, talk is mounting the ECB in July will raise rates for the first time since 2011, in what would be the first step towards boosting the key rate to a 'neutral' level of about 1.5% next year. The central bank is curtailing, and intends to end, its asset purchases.[6]

Many central banks are raising key rates to tame inflation. For most countries, the main threat is the resultant slowing in economic growth boosts the jobless rate, perhaps to worrying levels if economies slump into recession. The ramifications of tighter monetary policy for the 19-member eurozone are wider and more concerning for three reasons.

The first is the ECB is poised to stop acting as the buyer of last resort for its almost-bankrupt 'Club Med' members such as Italy, where gross government debt stood at 151% of GDP at the end of 2021.[7] No financier of government deficits (as some see it) for indebted sovereigns, especially Italy, will likely trigger a bond sell-off that puts the finances of debt-heavy governments on an unsustainable footing. Rising yields might restart the 'doom loop' that triggered the collapses of Greece, Ireland and Spain from 2010, whereby national bank bond holdings held as capital reserves plunge in value and the national government and commercial lenders become entwined in a downward spiral. The ECB would be exposed as lacking any credible way to quell such a government-bank suicide bind short of resuming the asset-buying that fuels the inflation it seeks to kill.

The second way tighter ECB monetary policy is troubling is that the resultant economic downturn will remind indebted euro-users that they have no independent monetary policy to help their economies, nor a bespoke currency they can endlessly print to meet debt repayments, or devalue to export their way out of trouble. The only macro tool domestic policymakers possess is fiscal policy. The problem is many indebted governments are already running large fiscal deficits - Rome's shortfall over 2021 stood at 7.2% of GDP[8] and is forecast to be 6.0% in 2022[9] - and their debt loads mean these dearths can't be widened or prolonged. As talk mounts that indebted countries should quit the euro to reinstall the other macro tools, populist Italian politicians are bound to rekindle plans for a parallel currency as the least traumatic way for Italy to readopt the lira.

The third means by which higher inflation is poisonous for the eurozone is that it creates a fissure between the area's creditor and debtor nations that would make it harder to find durable solutions for the euro. Inflation-phobic but inflation-ridden Germany and other creditors such as Finland and the Netherlands will squabble with France (government debt at 113% of GDP), Greece (193%), Italy, Portugal (127%) and Spain (118%) over how far the ECB should go to rein in inflation. The leaders of the creditor countries will be under domestic political pressure to ensure the ECB smothers inflation. They will battle with debtor leaders over how the ECB might support tottering governments and wobbly national banks sitting atop troubled economies. In line with this hawk-dove split, the Netherlands central bank chief Klaas Knot in July became the first ECB policy-board member to call for the bank to raise its key rate by 50 basis points to tackle inflation.[10]

To maintain its inflation-fighting credentials, the ECB must raise interest rates enough to tame inflation, even if that stance crushes economic growth. The core concern of such tight monetary policy is that it will expose how the euro's flawed structure - that it is a currency union without the necessary political, fiscal or banking unions - has become explosive due to the large debts of southern eurozone governments.

To be sure, policymakers are likely to once again thrash out some last-minute fudge that defers a denouement on the euro's fate. But temporary solutions are only, well, temporary and the euro needs a durable resolution. The indebted south could win the political tussle such that the ECB never makes a serious attempt to tame inflation. Due to generous pandemic support, creditor nations have higher government debt-to-GDP ratios - Germany's is 69%, the Netherland's 52%. They thus might tolerate faster inflation as it improves their debt ratios if their economies hold up. But that path might only delay tighter monetary policy and subsequent detonations. The war in Ukraine might undermine eurozone economic growth enough to quell inflation without the ECB doing much. The cost of servicing public debt, while rising, is still historically low, which reduces the likelihood of missed debt payments and a crisis. Eurozone governments are restarting efforts to create a proper banking union, which would mean common bank rules and eurozone, rather than national support for troubled banks.[11] But creditor nations don't want to be part of a mutual deposit insurance scheme if that means subsidising Italian banks holding Rome's debt. Nor do debtor governments want to join a banking union that could restrict their banks buying their bonds to support them. Lo spread is well short of the post-euro record 556 basis points it reached in 2011 during the first eurozone crisis that was triggered by the current-account imbalances among members.[12] But Rome's debt was only 120% of GDP then, and that gap narrowed only due to ECB support that is now waning because the problem today is inflation, not skewed trade and investment flows.

Germany's economic slump and dislike of inflation will ensure Berlin pressures the ECB to prioritise inflation. Lo spread could widen enough to threaten a flawed currency union, especially if member countries are squabbling over solutions. While Draghi the central banker could bluff investors, Draghi the politician has no similar obvious masterstroke. Of note too is that Draghi's prime ministership will likely end when Italy holds a general election next year in Europe's spring that is likely to usher right-wing eurosceptics into power. To all the world's problem, be prepared to add elevated doubt about the euro's long-term future.

The currency swap

In 1948, Chris Howland was a 20-year British private who was the most popular radio DJ in northern Germany. On the night of June 17, two British military policemen appeared at the radio station in Hamburg where Howland worked. They made Howland sit up all night before allowing him at 6.30 am to open a sealed envelope and read the content on air. The news? The military government of Britain, France and the US from June 20 would introduce a new currency. Every German would receive 40 new Deutsche marks, which had been printed in the US and shipped in wooden crates stamped 'Doorknobs', in exchange for 60 Reichsmarks. Any other swastika-emblazoned Reichsmarks people held were made worthless come June 21.[13]

A 'currency reform' of some sort was expected. But still. It's estimated that 95% of Reichsmarks were destroyed without replacement and savers were left with only 6.5% of their assets.

The instantaneous currency switch and savings savaging were at the heart of measures under the Marshall Plan designed to revive Germany's economy at a time when millions of Germans were starving, inflation was rife, the currency untrusted and bartering prevalent. The steps, which in the absence of Russian knowledge sparked the Berlin Blockade,[14] worked. The economic revival in the French, UK and US zones that became West Germany was credited with helping Germany adopt a new constitution in 1949 known as the Basic Law.

The currency changeover on top of the rampant post-war inflation and the hyperinflation of the early 1920s left a legacy. Germans adopted a mentality that the value of the Deutsche mark must be protected above all. This job was given to the Bundesbank when it was established in 1957 as the world's first and only central bank still to be granted independence under its country's constitution (whereas other central banks are granted 'independence' through acts of parliament or the goodwill of the executive).[15]

Come 1993, Germany's Constitutional Court confirmed that under the Basic Law the Bundestag (parliament) only had the authority to ratify the Maastricht Treaty that created the euro if the European monetary union was in Germany's interest. The test? "The future European currency must be and remain as stable as the Deutsche mark," the court decreed.[16] Thus the ECB ended up with the same primary objective as the Bundesbank; namely, to maintain price stability.

In Germany, the ECB's loose monetary setting and the inflation unleashed are seen as a betrayal. To the German public, tabloid media and even the German 'father of the euro' Otmar Issing, the ECB is modelled more on Italy's economic mismanagement pre-euro (when Rome's main policy response was to devalue the lira). Issing, the ECB's first chief economist, said the ECB has "lived in a fantasy" that downplayed the danger of inflation and thus the bank "has contributed massively to this trap in which it is now caught".[17]

The ECB lax stance has wiped out returns on German savings, which is seen as income foregone to subsidise lazy southern Europeans.[18] High inflation stings Germans because few invest in equities or other 'growth' assets that might act as a hedge against inflation. Most German savings head to small regional savings and co-operative banks that offer low deposit rates. The German public is unlikely to feel more generous towards the indebted south if interruptions to energy and other imports from Russia send the German economy into recession.[19]

But, as pessimism grows about global prospects, the economic outlook of inflation-tolerant and Russian-gas-dependent Italy is dimming too. Although Italy's economy is supported by consumer savings built up during lockdowns and 192 billion euros from the EU's 750-billion-euro Covid recovery fund, higher energy prices and other tremors from the Ukraine war could slow growth enough to send the country into recession.[20] Many fret about the trouble to be ignited when the ECB halts its asset buying, given how precarious are Rome's finances - the country has the largest budget deficit in the eurozone and the worst public debt ratio after Greece (193%).[21]      

In case of any crisis centred on Italy, policymakers have options such as loans from the EU rescue fund and linked ECB bond purchases of struggling members. But such aid would require approval from Germany's Bundestag and other creditor-nation parliaments. Another option is the one revealed when Draghi and French President Emmanuel Macron signed a joint letter last December that implicitly called for the transfer of all eurozone government debt since 2007 to a debt-management agency. But Germany and many other euro members would oppose such subterfuge.[22]

It's probable that sometime soon the talents of Draghi the unelected politician and other policymakers will be tested. Lo spread will reveal what bond investors think. What's unlikely in any upcoming crisis, however, is any solution that cements the euro's future.

By Michael Collins, Investment Specialist

"RECAPITALISATION" OPPORTUNITY
There was a brief period following the March 2020 COVID-19 market panic when funding looked like it would be hard to come by and companies did whatever it took to raise cash. But central bank liquidity flowed and equity capital followed. In 2022 things are different. After taking funding for granted for many years, we expect many businesses are going to become increasingly desperate for cash as the year progresses.

The $US146 billion of equity capital raised globally in the March quarter of 2022  sounds like a huge number but was down 69% from $US476 billion a year earlier and 58% from the December quarter (using dealogic data). The current quarter is running lower still.

We have identified almost 400 "cash burners" on the ASX (ex resources). Nearly half of these cash burners did not have the funds to make it past 12 months based on their March quarter cash burn. It may not be a complete surprise to you that the sector with the most companies facing one year or less of cash funding is Software and Services. Biotech and Health Care unsurprisingly represent nearly 30% of these companies.

The great opportunity in this is for investors to identify situations where capital availability can make a huge difference to valuation, either in isolation or with a few changes and greater fiscal discipline. We think this "recapitalisation" opportunity is a huge opportunity and an exciting time for a firm such as Equitable Investors that applies bottom-up, fundamental research and constructively engages with companies.

We are inviting follow-on and new investments in Dragonfly Fund to pursue such opportunities over the next 12 months. Applications (for wholesale investors only) can be made here.

In the famed 1970s thriller, Marathon Man, Nazi dentist Dr Christian Szell - who is looking for a stash of stolen diamonds - repeatedly asks the character played by Dustin Hoffman "Is it safe?" Right now, many people are likely asking the same question about investing in the share market.

With the distraction of local politics behind us, investors can return to matters that will shape their short and medium-term returns.

Given a lack of clarity about where the safe havens are, and notwithstanding the supply shocks associated with the war in Ukraine and the recent shuttering of China's economy, what follows is a summary of the issues confronting equity markets and a possible answer to the question of whether it is time to add to your investment in equities.

Inflation

Widespread and stubborn U.S. inflation, driven by surging oil and rents, as well as rising wages, has inspired inflation expectations for next year to more than six per cent, from near one per cent in 2020.

U.S. core Personal Consumption Expenditure inflation, which excludes more volatile food and energy, has risen from sub-two per cent in the first quarter of 2021 to an annual rate of 4.9 per cent, the highest since September of 1983.

Slowing U.S. economic growth

Equity investors are of course aware of this trend and the persistence of supply chain bottlenecks that are in no small part responsible. Perhaps less obvious, but no less concerning, are the rapid reductions being applied by forecasters to U.S. economic growth.

According to Bloomberg, forecast U.S. GDP growth for 2022 was above four per cent back in Q3'21 but has recently plunged towards 2.75 per cent. Meanwhile the 2.5 per cent GDP forecasts for 2023 in place at the beginning of this year have given way to forecasts of 2.1 per cent.

Falling earnings

Slowing U.S. GDP growth is important for share prices. Remembering that much of the equity market correction to date has been the consequence of PE compression - which always accompanies rising rates and accelerating inflation - a slowing rate of growth raises the spectre of reduced earnings. And when the 'E' in the PE ratio also declines, equity market losses can and often compound.

As waves of liquidation have hit U.S. equities amid a winding back of the Federal Reserve stimulus and rising interest rates, declining total returns for the S&P500 have exceeded the total return losses in treasuries. These returns are highly correlated to 12-month forward S&P500 earnings per share estimates. Consequently, the earnings estimates are now declining, from growth of circa 55 per cent year-on-year, to 27 per cent today.

The winding back of earnings expectations, and the broadening of the bear market, may still have some way to go, even as 50 per cent of NASDAQ Composite constituents - the most vulnerable being thematic and concept stocks, small cap tech and small cap growth, for example - have fallen by more than 50 per cent, and 72 per cent of constituents have fallen by more than 25 per cent (see Table 1.).

Table 1. Bear market in stealth mode

Declining U.S. real disposable incomes

Heaping burning coals on the declining earnings outlook will be the decline in real disposable incomes, which are near minus 12 per cent year-on-year and represent the sharpest decline since at least 1960.

The decline is of course partly due to the high support/stimulus payments received last year but much of it can also be attributable to the sharp rise in inflation.

Historically, when real income contractions of this magnitude have occurred, they were followed by a marked slowdown in consumer spending. We believe, therefore, at the very least, investors should not expect upgrades from, or re-ratings for, companies exposed to consumers just yet.

Is it time to invest?

However, the baby is being thrown out with the proverbial bathwater and high-quality names across a broad variety of sectors and industries are now being sold down too. As we have witnessed many times in the last three or four decades, ultimately, indiscriminate selling gives way to discernment and finally selective buying. A capitulation sell-off may therefore eventually give way to another once-in-a-decade opportunity to improve the general quality of portfolios and lock in superior returns. Remember, the lower the price one pays, the higher the return.

What are the factors investors should be watching to decide if it is safe to dip one's toe back in the water?

The current sell-off has been largely macro-driven. Concerns about inflation and rising interest rates, and now slowing growth (stagflation), are principally responsible for the current reassessment of equity investor returns. These seem likely to remain this year. It seems reasonable to conclude the expectation of good news on these fronts will be necessary for the current 'risk-off' sentiment to ease before reversing.

The question of course, is where are the revelations going to be? Will slowing growth lead to recession, which restores bonds as a safe haven, reducing their yield and setting equities up for a recovery post-recession? Or will we see high inflation and strong economic growth, empowering only companies with pricing power to improve margins through a combination of higher volumes and higher prices? Finally, do we end up with Jerome Powell's 'soft-landing' scenario, which will be positive for both equities and bonds?

In the short run, the market seems very oversold making it susceptible to a sharp short-term recovery (Figure 1.)

Figure 1. Negative change in PE historically significant and fully factored in rising rates

As can be seen in Figure 1., the pace of PE compression is historically significant and is nearing a point (red line) from which PEs have historically expanded again.

The PE compression reflects rising interest rate expectations but importantly, however, it does not appear the market has factored in any recession or even any slow-down in earnings. The slow-down in earnings growth estimates however still suggests investors are factoring in some growth.

And investors should not ignore the tax-like impact on consumers and growth from the combination of rising interest rates, rising fuel costs and the rising U.S. dollar (which of course saps capital from and fuels inflation for importing nations). The market has not factored in a contraction in earnings (keep also in mind the very steep slump in real disposable income cited above) and for this reason many commentators believe further declines in the stock market should be expected.

And unlike previous bear market episodes, the Federal Reserve does not appear to be coming to the rescue of investors. Indeed, if anything, the Fed's Jerome Powell has toughened his Hawkish stance. Meanwhile, as liquidity is being withdrawn, money supply growth continues to slow relative to bank credit growth, meaning there is less liquidity for financial assets.

Finally, while some commentators and macro economists point to evidence, and warn, of more frequent bear markets (US S&P500 drawdowns of 20 per cent or greater) during periods of rising inflation (Figure 2.), I note my firm belief long-term declines in union membership and rapid advancement in autonomous technology will keep a lid on long-term wages growth and ultimately on inflation.

Figure 2. S&P500 sell offs during rising inflation (1965-80) and declining inflation

Investors should be sharpening their pencils and working on the stocks and funds in which they plan to invest, in preparation for making additional equity market investments.

Author:  Roger Montgomery, Chairman and Chief Investment Officer