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

MONTH IN REVIEW

The Australian share market saw a small contraction in April with the All-Ordinaries Index down 0.83%, much less than the 8.7% contraction seen in the S&P 500. The modest move in the index disguised material moves in underlying sectors. Sell-offs were concentrated in Technology and Consumer Discretionary, down 10.4% and 3.2% respectively, while Utilities was the strongest sector, up 9.3%, and continuing its strong run as a safe haven against inflation. For the first time in 2022 the Materials sector fell, down 4.3%, which is an important development for the Australian market. We discuss further below. 

In terms of factor leadership, growth surprisingly outperformed value in April. While the Technology sector was week, 'growth' stocks in Consumer and Healthcare sectors traded better. The 'value' factor was also dragged down by the Materials sector which has now started to fall, as mentioned above. 

While May has started poorly for share markets globally, the hedges in our portfolio have so far protected the fund from any drawdown. The strategy is very well suited for the environment we find ourselves in. 
 
MARKET OUTLOOK

In April capital markets pivoted from reflation to deflationary bust as investors started to factor in a recession next year. We saw this play out clearly as commodities and commodity currencies fell sharply, including the Australian dollar. 

With this, late-cyclical sectors such as resources, which had held up relatively well, joining the rout in growth shares. The catalyst for this shift was a further tightening in financial conditions and lockdowns in China weighing on growth in the world's second largest economy. 

China historically has acted as a counterweight to growth trends in the west, this was particularly evident coming out of the financial crisis. With low vaccination rates amongst seniors in their community they have resolutely stuck to COVID-zero policies. Rolling lockdowns are weighing on growth and further disrupting supply chains into western markets. This is unlikely to change in the medium term given the virulence of Omicron. With China already in a recession, it is unable to play its typical role of balancing weakness in the west. 

The other major development last month was the breakdown in US mega-cap technology shares. This group of companies has led the share market higher in recent years. Together they account for one quarter of the value of the S&P 500. Until April they managed to escape the broader weakness in the NASDAQ.

 The 'Generals' as they are often called, reported disappointing results for Q1 2022, with Apple, Amazon, Netflix, and Facebook either missing expectations or providing weak guidance. The NASDAQ and Russell 2000 having fallen more than 20% now, joining emerging market equities and growth sectors in a new bear market. 

The Australian share market had been resilient through this earlier weakness in shares offshore only to fall sharply as commodities and mining shares broke down with the news out of China and broader concerns of a pending global recession. China almost certainly is already in a recession with growth in business activity and household spending in full retreat. 

If you break down the Financial Conditions Index (FCI) into asset values (falling); interest rates across the term structure (rising); and the US dollar (rising), FCI is tightening quickly, and we are only just embarking on a tightening cycle. 

The incidence of central banks tightening to combat inflation is the highest in many decades. This will likely end in recession in advanced economies. As these economies slow, profit expectations for public companies will fall along with valuation multiples as real interest rates continue to move higher. This is what a bear market looks like and we are almost certainly in one. 

Bear markets don't end until policy reverses course and financial conditions start to ease. We are still early in this tightening cycle, there is a long way to go. Liquidity will tighten further as central banks become sellers of the assets they have accumulated through COVID emergency measures. Bear markets typically last 18 months to 2 years and don't end until the liquidity spigot is turned back on again. Central banks are fully committed to combatting inflation and will not reverse course until inflation comes back into their target range of 2%. There is no central bank 'put option' this time around - falling asset values only helps Central Banks in their crusade to kill excess demand. 

While we are probably at peak inflation now and Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCE) will moderate in the months ahead as we cycle inflated data from last year, any moderation will happen slowly. Key components of the inflation basket - energy, food and shelter will remain under upward pressure for years to come. Labour markets remain acutely tight, employment needs to fall (recession) to reduce pressure on wages. 

We are in a 'secular' bull market for commodities, resource security and de-carbonisation will ensure ongoing investment in the sector for decades to come. Australia should benefit from this. While activity will slow in Australia, particularly if our major trading partner China is in recession, our economy should prove resilient even if advanced economies move into recession. There is a good chance Australia avoids the recession bullet once again. 

Having said that, commodities and mining shares are in a 'cyclical' bear along with other risk assets and will fall through the balance of this year. 

Share markets globally are over sold short term, sentiment is extremely bearish, and positioning is light. Shares should recover in the weeks ahead, an improvement in COVID cases in China would be particularly helpful. 

Any rally though should be used as an opportunity to reposition into defensive, quality names that will outperform in a slowing economy. 

Volatility will remain high into the second half of the year as financial conditions tighten further. We are still to see an exodus of retail investors who invested $1.3 trillion globally in equities through COVID. 

As markets fall in the second half of the year and investors come to realise, there is no central bank bailout this time around, a weaker tape could easily turn into a rout as we close the year. The bear is just getting started.

SECTORS IN REVIEW

The Consumer sector made a positive contribution for the month, with gains in Fuel marketing longs partially offset by losses on Agriculture shorts. 

Our long position in the Fuel Marketers has been gaining momentum as fuel security becomes an increasing issue for Western Governments. Ampol (ALD) and Viva Energy (VEA) refining assets, which are generally loathed by the market, are now generating super returns and driving upgrades for both companies. This sector is under-owned and offers defensive exposure at a cheap multiple. 

While coming at a cost to near-term performance in April, the Agriculture sector is building as fertile ground for short ideas. Share prices have risen aggressively, given the confluence of a strong domestic grain harvest, and sky-high soft commodity prices driven by supply-chain dislocation. We know however, as with all highly cyclical industries, that conditions are ever changing, and we should be careful extrapolating at either the top or the bottom of the cycle. To overcome this issue focus should always be given to mid-cycle analysis. Given decades of data on the Australian grain crop, we can predict with some certainty what mid-cycle earnings for companies like GrainCorp (GNC) might look like. On these mid-cycle earnings, current valuation multiples look extreme. 

Financials had a disappointing month in April. The primary driver was our long position in EML Payments (EML). EML delivered a guidance downgrade two months after its result in February. Given the volatility in the market, earnings dependability is currently paramount. As such, unexpected downgrades are seeing stocks punished by investors, with EML nearly halving over the month. In March, we saw press coverage that EML was being stalked by Private equity player Bain Capital, this saw the price above $3.00. We are cautiously optimistic that EML is forced to negotiate a reasonable price, which we view as the best outcome for investors. 

The TMT portfolio was a slight detractor of performance during the month. Our shorts in internet companies delivered as investors focused on deteriorating housing market drivers. They have also been caught up in a broader global technology sell off. Offsetting this was our technology portfolio, where losses were largely driven by our position in Life360 (360). 360 gave a quarterly update, where it reinstated guidance. We viewed the update as overall positive and were surprised to see the share price negatively impacted. We continue to see absolute and relative value in the name. 

The Mining sector was hit hard in April on lockdowns in China. The best performers recently were impacted the hardest with lithium names in particular retracing recent gains. Commodity prices were also weaker with lithium chemical and rare earths prices falling off peak levels. Coal continued to perform with our investment in Stanmore Resources (SMR) making a strong contribution. 

Healthcare: The medical device names are struggling with supply chain issues. Notably, ResMed (RMD) has had trouble locating components out of Asia. 

Industrials: Defensive industrial shares outperformed with Amcor (AMC) and Brambles (BXB) leading. Elsewhere housing names continued to struggle as investors adopted a more bearish view of housing activity and the property market- the building material names in particular were weak.

In this article, Michael Maughan, Portfolio Manager of the Tyndall Australian Share Income Fund, discusses the impact on the big dividend payers from decarbonisation and where he sees opportunities for equity income investors.

Knowing where a company or industry is in its economic cycle, allows investors the ability to judge when to invest, and when to wait for a cheaper opportunity. This is because companies are subject to different economic cycles.

For example, the mining sector aligns more with Chinese growth than the US. Understanding Capex cycles—including the coming decarbonisation cycle—are relevant for dividend-focused investors due to the deployment of cashflows within those companies.

Where has the Australian market's dividends come from historically?

First, we need to look at which sectors have yielded the highest dividends for investors.

Chart 1 shows that 37% of the yield over the past ten years has come from financials and materials. Not surprising given they are the largest sectors in the Australian market but perhaps surprising given mining companies often have a poor record in the capital discipline. That mix has changed over time, and those two sectors made up 56% of the yield in 2021.

Chart 1. 10 years of ASX200 dividends

Source: Tyndall, Jefferies

Banks have been consistent in their dividend payments except for a brief hiatus at the peak of COVID uncertainty. Materials have been more volatile with a big step down as China slowed and progressive dividend policies ceased in 2015/16, and a big step up in the past couple of years as commodity prices have boomed. However, going further back, the ability of miners to pay dividends was a function of the CAPEX they were spending and the prevailing commodity prices.

Over the past ten years, we have seen this trade-off between dividends and investment in energy names like Oil Search (now part of Santos) and Woodside. Oil Search prioritised LNG projects in PNG over dividend payments, and Woodside had a fluctuating dividend structure depending on its balance between producing assets and its LNG projects in WA.

As we discuss later in this piece, this balance could be changing.

So how could the energy transition impact big dividend payers' ability to maintain dividends?

Decarbonisation is a capex cycle to play out over 20-30 years. Firstly, companies are decarbonising their operations. Secondly, globally we need to spend trillions of dollars on new nickel, lithium, copper, and cobalt mines to renewably electrify the world.

While this doesn't sound great for dividends, the market has already factored much of this in. BHP and RIO Tinto have been explicit about the investments they are making to decarbonise their operations. BHP will increase capex by U$200 million p.a, for the next five years, and RIO Tinto will spend an extra U$500 million p.a. over the next three years.

The majority of this will go to renewable power generation in the Pilbara. Therefore, if there are extra costs of decarbonising operations (that may or may not be recovered in premium pricing), there is the capex opportunity to meet the demand created by the need for additional wires and batteries. Copper demand could double, and nickel demand could quadruple to meet Paris targets through ongoing electrification.

Net-net, this is a positive story for the diversified miners. Having growth opportunities to invest in that will generate cash and dividends in the future is much better than being a declining business with a high payout ratio. Share prices never assumed this level of cash flow was forever.

The banks have an opportunity to fund renewable projects through lending discussed by Brad Potter, Tyndall's Head of Australian Equities, in his article: Banks funding renewables set to drive growth. Chart 2. shows that Westpac has been skewing away from fossil fuels towards renewables for 10 years already. Whether the Australian banks will be able to compete with the global interest to lend to these projects is unknown, but it is more opportunity than risk.

Chart 2. Westpac's electricity generation lending over time and climate change solutions exposure

Source: The Westpac Group

Can dividends benefit from decarbonisation over the coming decades?

In the medium term, we expect that the traditional energy companies will be investing less capex, and concentrating on harvesting their current assets to facilitate the energy transition, meaning more cash being returned to shareholders through dividends and buybacks.

The mergers of Oil Search with Santos and Woodside with BHP petroleum create more balanced businesses with pristine balance sheets, strong cash flows, and a higher percentage of producing assets to fund growth opportunities or return cash to shareholders.

Interestingly, Macquarie is aggressively pursuing growth in both renewables and electricity infrastructure and have a model that develops assets on the balance sheet and then sells them down into funds in the same way the Goodman Group does for industrial property.

This focus has received a lot of attention and has been part of the stock's rerating. However, they also have one of the world's biggest energy trading businesses and therefore have been huge beneficiaries of the volatility in traditional energy markets.

The holy grail is a company that is exposed to the energy transition without necessarily being as capital intensive as a miner. One of the issues with the growth in renewables is that the transmission networks are not built for this decentralised generation structure.

We have lots of small producers, batteries that need electricity going in and out, and even household solar has changed the nature of the grid.

The result is that Australia need to add 10km of transmission lines to the existing 45km but current capacity to roll out is only 700m pa.

Downer Group is in a prime position to capitalize on this as highlighted in chart 3 as a leading player in electrical engineering and construction with 70 years' experience. Worley is also growing the part of their business that consults with the hydrogen industry, although their core fossil fuels business has associated downside risks.

Chart 3. Downer capabilities leveraged to decarbonization

Conclusion

While we see a peak in capital returns from miners due to unprecedented supply/demand imbalances and low CAPEX pipelines, the expected increased investment in decarbonisation programs is unlikely to wipe out the traditionally high yield of the Australian equity market.

The tax structure still incentivises Australian companies to pay franked dividends, and the index composition is skewed to cash-generating companies.

Over decades the Australian market has delivered net yields in the 4% range as shown in Chart 4 (5%+ grossed up for franking), and we don't expect that to change materially in the future.

Chart 4. The importance of dividend income to total return

Source: S&P/ASX; IRESS; Sub-periods are rolling five-years to illustrate consistency of income

Author: Michael Maughan, Portfolio Manager, Tyndall Australian Share Income Fund