Investing in global equity markets has felt like playing a game of dodgeball over the last two years.  Around every corner investors have been faced with a new surprise to navigate. Just as in dodgeball, where players run for cover to avoid the sting of those dreaded balls, equity investors have flocked to the safety of defensive stocks in 2022.  Year to date defensives have outperformed value, growth and cyclical stocks, doing what they are supposed to do in uncertain times: offer equity investors a shield against the onslaught of valuation pressures, slowing earnings growth and increased uncertainty.  As we continue to brace ourselves for ongoing volatility in equity markets, we prefer to maintain exposure to selective stocks with defensive characteristics - those that are winning by not losing.  Deutsche Boerse and Merck & Co are two such examples.

The big de-rating might not be over

Global equity markets have de-rated since the recent peak in September 2020, with a sharper deceleration in 2022 driven by rising inflation fears as reflected in higher 10-year bond yields.   In fact, most major market indices are now trading below their pre-Covid valuation levels.  The derating has been particularly evident in the more expensive parts of the market, such as Technology stocks.  For example, the Nasdaq Composite Index has fallen by -25% so far this year, with most of this occurring through forward PE multiples contracting from ~32 to ~23x currently.  In comparison, the S&P 500 has fallen 16% and contracted from ~22x to ~17x over the same time frame.

All major equity markets have derated sharply YTD to below pre-Covid levels

Source:  Bloomberg, 10 May 2022

Despite this overall market de-rating, most major indices are still trading in line or above their 20-year averages and remain relatively high when considering the sharp rise in 10-year yields (see chart below).  The Russia Ukraine War has also recently pushed commodity prices to new highs, raising inflation risks and potentially placing further pressure on market valuations.

Valuations may be at more risk as bond yields continue to surge

Source:  Bloomberg, 10 May 2022

Investors' fears are shifting from inflation to growth

US GDP has surged past prior cycle peaks but is now decelerating sharply.  Similarly, while 1Q22 earnings were modestly ahead of expectations on average, management commentary and guidance about the outlook has been increasingly cautious, prompting analysts to downgrade earnings forecasts for both '22 and '23.  In fact, earnings revisions breath has been declining since August 2021 and has recently moved outright negative.  Given the wide range of headwinds companies currently face, which include cost pressures, supply chain constraints, inventory build ups and potentially weaker demand from higher prices and lower global growth, it's likely that earnings revisions will remain negative for the foreseeable future.  This has historically been associated with weak overall market performance (see below).

Earnings Revisions and Price are highly correlated

Source:  Alphinity, Bloomberg, 3 May 2022

Earnings leadership has taken another step to being more defensive

At a sector level, we have however seen a sharp contrast with the classic defensive sectors, such as Utilities and Consumer Staples outperforming the overall market year to date, driven by a superior ratings performance as well as better earnings revisions versus their cyclical peers and the broader market (excluding the Energy and Materials).  Defensives have a strong track record of outperforming during slowing growth/recessionary periods, a relative safe-haven within periods of market stress.  With a broad range of defensives already reflecting these benefits in relatively high valuations, active investors need to remain nimble and look for new opportunities.  Some of these might not be seen as typical defensive plays, such as Merck & Co referred to below, but they offer defensive characteristics that should bode well in a volatile environment.  One such defensive earnings leader is Deutsche Boerse.

Just as in a dodgeball game, there are certain times in the market cycle when it is not always about running the fastest, but also about finding the best places to hide.

Deutsche Boerse- Leading stock exchange enjoying multiple cyclical & structural tailwinds

Deutsche Boerse (DB1) is a high-quality owner of various key pieces of financial market infrastructure in Europe across pre-trading, trading & clearing and post-trading.  These assets include Institutional Shareholder Services (ISS), Eurex (leading European financial derivative exchange), EEX (a commodities trading & clearing exchange), Xetra (cash equities) and Clearstream (a leading European settlement & custody provider).  These businesses all tend to command dominant or leading market positions within their segments, and as such enjoy significant barriers to entry and high margins.  These diversified businesses generate resilient mid-cycle digit % secular growth, which we expect to be further boosted by various cyclical tailwinds, including both higher interest rates and higher interest rate volatility, as well as further targeted M&A.  Consequently, we expect the company to exceed management's net income growth target of 10% (CAGR) for FY19-23E.  With positive earnings revisions and a relatively undemanding valuation multiple (current forward PE of ~21x), we continue to see more upside for DB1 in the current environment.

Deutsche Boerse - More defensive Earnings supported by several cyclical and structural factors

Source:  Bloomberg, 10 May 2022

Merck & Co- A high quality defensive with flagship growth products & consistent earnings

Merck & Co (MRK) is a global pharmaceutical company that delivers health solutions through its prescription medicines, vaccines, biologic therapies, animal health and consumer care products. MRK recently reported an impressive 1Q22 result with both revenue and earnings beating consensus expectations and the company raising 2022 guidance for both despite an expected FX headwind, driven by strength across the portfolio. Despite the relative outperformance and re-rating from 10x to 12x YTD, we maintain our position in this flagship defensive at this juncture with two main drivers for our investment case: 1) Product growth of the existing portfolio:  Both the flagship growth products Keytruda (the largest selling drug in the world, innovative immuno-oncology, 30% of group revenues) and Gardasil vaccine (blockbuster vaccine against papilloma virus/cervical cancer, ~9% of group revenues) continue to grow ahead of expectations with their high quality Animal Health business (the third largest in the world) enjoying above market growth rates.  2) Business development:  Management continue to look for new M&A opportunities to expand the business, underpinned by a strong balance sheet, with gearing at only ~2x EBITDA.

Earnings growth underpinned by a portfolio of strong flagship products

Source:  Bloomberg, 10 May 2022

Author:  Elfreda Jonker, Client Portfolio Manager

This information is for adviser & wholesale investors only

Fears that the global transition to a low-carbon economy will drive inflation over the long term are overblown, with the tightening of monetary policy set to have far greater implications for portfolios.

Some observers point to the energy transition as inherently inflationary, with companies compelled to invest less in fossil-fuel energy at a time when the costs for renewable energy remain elevated.

The market has labelled this green inflation - the contribution that environmental policies have on the cost of delivering goods and services that is passed on via supply chains to consumer prices.

In truth, there are a variety of regulations and policies that can influence inflation. The international push-back against globalisation - for example, the continued imposition of trade tariffs - is one of the forces putting upward pressure on prices.

While the pandemic has highlighted the fragility of global supply chains and logistical networks, Russia's invasion of Ukraine has extended inflationary drivers by delaying the recovery process and amplifying commodity price pressures as the war restricts access to energy, metals and grains.

However, the reason that the US has an inflation problem is not due to climate policies, but because its economy was overstimulated as it emerged from Covid-19. The US retained accommodative monetary and fiscal policies for too long, and now its labour market is running red hot.

A multi-year commodity boom in areas of renewable energy that require specialist components - such a rare earth metals - is possible owing to high demand and limited supply. But overall, we don't see green inflation as a meaningful contributor to rising consumer prices over the long term.

Climate policies tend to operate over decades, meaning they're a structural driver of relative prices. However, at an aggregate level, consumers will only ever experience sustained high inflation if major central banks allow that to happen. Even if we were to see sustained commodity price increases, we would not expect headline inflation to remain above central bank targets for extended periods.

We urge investors to look beyond the short term and think about the likely disinflationary consequences of prolonged global policy-tightening in the pipeline.

We urge investors to think about the likely disinflationary consequences of prolonged global policy-tightening in the pipeline.

What we're seeing now is central banks reacting to excess inflation, and we expect them to prioritise anchoring inflation over growth. We don't think we'll be debating green inflation in two years' time, rather the consequences of a US recession that came sooner than expected.

Really, the narrative around green inflation is being driven by what's happening in the West. On the whole, inflation is far lower across Asia Pacific, where climate policy is at a much earlier stage of implementation and there aren't the same constraints on the fossil fuel sector. Moreover, delays in the reopening of Asian economies post Covid-19 has led to more subdued activity levels.

Asia's growing importance

One key question for investors to consider is the role that Asia Pacific will play in the technological innovation required to effect the global energy transition, and whether that will be disinflationary.

From a macroeconomic perspective, policy initiatives by governments and central banks in Asia Pacific have been more prudent, with less willingness to prop up markets artificially. The region has far lower debt levels, fewer constraints on governments and strong state capacity to act. There's tremendous capital available to Asian governments and companies to effect the energy transition.

We believe Asian companies will play an increasingly prominent role in investor portfolios. There can be no energy transition without Asia, where industrial pollution has forced governments to act.

Heavy investment has brought the cost of technology down sharply over the past decade. Solar power became cheaper than coal-fired energy by 2015 in India, enabling it to invest in renewable energy quite aggressively.

We think the technological innovation we are seeing at Asian companies to solve real world problems should be better reflected in portfolios. Some of these companies are working hard to bring down the cost of green hydrogen.

Nowhere is this more relevant than China's highly polluting manufacturing sector, which needs to embrace new energies to clean up entire supply chains.

China wants to do for green hydrogen what it has already done for solar technology and some wind turbine technologies.

We're optimistic, since it will only take progress in countries such as India and China to have a marked impact on correcting some problems the planet is facing. Ultimately, we want to see the power of capitalism and innovation turned towards the global energy transition.

But wealthier nations need to live up to their commitments to assist poorer countries so that they don't routinely get left behind. While China will continue to play a critical role in bringing down the costs of technology, this will take time and poorer countries will need support in the interim.

Of course, asset managers have parameters on what they can and can't invest in. Poor countries often have low credit ratings, governance problems or capital markets not fully formed. We must find a way to mobilise capital to benefit these countries; it's part of the equation that needs solving.

In the near term, some solutions will appear inflationary. Electric vehicles, for example, are more expensive than those with internal combustion engines. Yet electric vehicles is where we see relative prices falling the most - and that's true of a wide range of renewable technologies, such as solar PV.

But forces that appear inflationary today can be disinflationary in future. There will also come a time when commodity prices fall, and as a big commodity importer Asia would be a major beneficiary.

What's incumbent on asset managers when promoting sustainable investments is to communicate that it's a long-term decision. Commodity and fossil-fuel-intensive businesses are doing well because production costs have risen more slowly than prices, which is good for earnings and valuations.

Conversely, valuations among renewables became expensive at times last year because many of the businesses are growth firms, so as the interest-rate structure increased, the discount rate applied to their earnings also increased - leading to significant underperformance.

What it underlines is that investors are likely to experience plenty of variance along the way. Even if you're confident that central banks will get on top of this problem eventually, strategies that seek to manage inflation and volatility will be appealing from a portfolio perspective over the near term.

• Jeremy Lawson and Ken Akintewe were speaking at abrdn's inaugural Sustainability Summit in Singapore on May 24 in a fireside chat entitled 'Green Inflation - Separating Facts from Fiction'.

Author: Jeremy Lawson, Chief Economist, abrdn Research Institute
Ken Akintewe, Head Of Asian Sovereign Debt

Has the RBA hit panic mode?

With rates on the rise, higher inflation and wages below expectation, has Australia's central bank panicked by hiking rates by 50bps, the largest monthly move in over 20 years? The RBA's charter is to ensure the economic prosperity and welfare of the Australian people, which increasingly appears to be being overlooked in favour of an inflation target that isn't easily achievable without causing recession.

As Australia resets to a more ambitious 2030 emissions target under a new Labor government, it's time we address the largest opportunity on our pathway to net zero emissions: "making dirty cleaner". David Gilmour, Portfolio Analyst and ESG Specialist, details why.

As Australia resets to a more ambitious 2030 emissions target under a new Labor government, it's time we address the largest opportunity on our pathway to net zero emissions: "making dirty cleaner".

For too long, sustainability investment has centred on future facing industries, like renewables, and blatantly ignored the dirtiest industries. The focus has been on the cure to emissions, with no consideration to prevention. Divestment has been the weapon of choice.

The Ukraine-Russia war has been a wake-up call. Fossil fuels, despite Western efforts to curb supply, are necessary for energy security when global trade is dividing into geopolitical blocks. What's more, they continue to dominate the world's growing demand for energy (Chart 1). To break their nexus with economic growth - and simultaneously transition without widening wealth inequality - we need to solve the demand side for both industry and the consumer. And that requires investor support and engagement.

According to the International Energy Agency (IEA), we cannot simply divide energy investments into "clean" and "dirty". In fact, the largest part of emissions reductions under its net zero scenario - the same one purists cite when arguing to cease new fossil fuel production - comes from a middle ground of "transition" investments (Chart 2). Examples include project enhancements to reduce methane leakage, efficiency or flexibility measures in industrial processes, coal-to-gas switching (e.g. new gas boilers), refurbishments of power plants to support co-firing with low emissions fuels, and gas-fired plants that enable higher renewables penetration.

Within Goldman Sachs' latest forecast for a 37% fall in US emissions by 2030[1] (below the Biden Administration's target 50-52% reduction), energy efficiency is the first of three themes driving emissions lower over the short term. Outside Utilities, GS forecasts the biggest reductions to come from Oil & Gas Producers, Diversified Metals & Mining and Aluminium[2] - sectors where ownership by ESG focused investors is limited.

Domestically it's a similar story. Like the US, Australia's electricity sector only accounts for around 30% of total emissions. Labor's new target for a 43% reduction on emissions to 2030 (based on 2005 levels) will require substantive efforts from Industry and Transport since, as we discussed last year, the Electricity sector is already stretched to its limit with a forecast 49% reduction by 2030 from today's levels.

When you dig into the numbers, Labor's target equates to -30% on 2020 emissions levels, from 512MT today to 356Mt in 2030. This compares to the Coalition's projection for 439MT by 2030 (-14%) (Table 1). If we assume no further emissions reductions in the electricity sector under Labor, then it needs a -22% reduction in emissions from the "Other" sources, versus the Coalition's former forecast for +1%.

The new Federal government has also committed to strengthening the existing Safeguard Mechanism (SGM) to support its national target. Currently, Australia's largest emitting facilities (>100,000 tonnes per annum) have to purchase credits (ACCUs) when their emissions rise above generously set baselines. We support Labor's proposal to reduce these baselines over time which, if enacted, will drive greater energy efficiency and lowest-cost abatement solutions.

Investors must also play an important role. We believe strongly in company engagement over exclusion; the former can lead to outperformance, while the latter shifts ownership to parts of the market with less oversight and deprives companies of capital when they need it most. That's why we are shareholders in high emitters such as Alumina (AWC), a company with a harder pathway to net zero but has the capability to benefit from the transition. AWC is already among the lowest emitters among major alumina producers, is pursuing early-stage technologies and is a clear beneficiary of green capex given the expected growth in demand for aluminium (39% demand growth to 2030[3]). We are also overweight Worley (WOR), which is well positioned to capture higher structural demand from energy transition work over and above its traditional work for the oil & gas industry.

Once we solve the demand side, we expect supply from the oil & gas industry will take care of itself as customers evaporate. Until then Australian gas producers enjoy a privileged position. They are low sovereign risk for European countries weaning themselves off Russian gas, and will contribute significantly to lowering emissions in Asia as coal-to-gas switching takes place. Early this year we established a position in Woodside Petroleum (WPL), a company which predominantly produces gas and has a new strategy to invest $US5bn in new energy opportunities by 2030. Our focus remains on working with management to strengthen its 2030 interim target and lower its reliance on offsets.

As ever, we continue to test the resolve of Australian companies to reduce their exposure to climate change risks and whether they are pursuing the right opportunities in the transition. Importantly, we have no intention of sidelining companies that provide critical products, especially when cleaning up their operations will cause the largest reductions in global emissions to a low carbon future.

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.