“There are so many different kinds of stupidity, and cleverness is one of the worst.”
– Thomas Mann
Friday 22nd July, 2022
Events in Europe have been front and centre for investors this week amidst rising political and economic instability across the continent. The slow-motion collapse of Italian Prime Minister (‘PM’) Mario Draghi’s coalition government finally reached fruition on Thursday when the Italian President accepted the PM’s second attempt to resign in only a week. Draghi’s coalition had been a liberal-technocratic government of national unity which included all parties represented in Parliament, other than the right-wing Brothers of Italy party. Opinion polls just last week had suggested that the coalition was popular among Italians, and that most voters wanted the former European Central Bank (‘ECB’) chairman to remain in office in light of the uncertain economic and geopolitical outlook facing Italy and Europe more broadly. However, it appears that in-fighting between the anti-establishment Five Star and Lega parties proved too difficult for PM Draghi to manage; and, on Wednesday evening, both parties – together with Berlusconi’s Forza Italia party – decided to abstain from a vote of confidence in Draghi’s government (and thus effectively withdraw their support for the PM). Elections are now set to be held in late September, and it looks likely that a right-wing (populist) bloc led by the Brothers of Italy will win those elections. Key figures from this grouping had gathered for lunch at Berlusconi’s plush Roman villa on Wednesday to strategize ahead of the confidence vote, and newspaper reports suggest that (other than the co-ordinated abstention), a policy programme was discussed. Should this wannabe coalition government gain an outright majority, Italy would experience a radical change of course. Stability is hard to come by when in Rome.
To make matters worse for markets, the ECB decided to surprise everyone by raising benchmark policy rates by 50bps (vs. 25bps expected) on the very same day that the Italian government finally collapsed in earnest. Just last month, the ECB had stated explicitly that a 25bps rate hike was planned for July as the appropriate first step towards policy normalisation. However, in the end, ‘twas 50bps we got. President Lagarde explained that the decision to ‘front-load’ the change in monetary policy was taken following a review of updated inflation data and the ECB’s “undesirable” inflation forecasts (which is rather worrying). However, perhaps she just wanted to steal some of the headlines from her predecessor as ECB Chair, Mario Draghi, as he crashed out as PM in Italy. Either way, this was a historic moment for the Eurozone, given that the ECB has not raised interest rates once since 2011! Moreover, a 50bps rate hiking debut means that the deposit facility is 0% (i.e., non-negative) right off the bat. This sends a clear(ish) signal to households, corporates, and investors that the ECB means business when it comes to tackling high prices. Unfortunately, the decision to directly contradict the policy that you yourself floated in June also suggests that you care little about your own forward guidance. Indeed, this attitude was made explicit by the ECB Governing Council, who stated that, from now, they would follow a fully data-dependent “meeting-by-meeting approach to interest rate decisions” given the uncertain inflation outlook.
One reason that the ECB feels able to hike rates by 50bps now, despite all of the political, economic, and market turbulence of recent weeks, is that they have just announced the creation of a new ‘anti-fragmentation’ tool to mitigate the risk of Eurozone disintegration due to tighter monetary policy: namely, the Transmission Protection Instrument (‘TPI’). As we have discussed in previous newsletters, higher rates necessary to combat inflation are likely to impact weaker ‘peripheral’ sovereigns, like Spain, Italy, and Portugal, more than ‘core’ sovereigns like Germany and France. As a consequence, the spreads (which reflect variations in credit quality) between peripheral European bond yields and German bonds are likely to widen as monetary policy is tightened. A very dramatic widening following a loss of market confidence in one or more peripheral sovereigns’ ability (or willingness) to pay back its debts, particularly during what looks likely to be a recession, could cause serious financial issues for the Eurozone. Nevertheless, failing to raise rates to combat inflation could also end in disaster and is thus not an option. The TPI aims to resolve the fragmentation issue by allowing the ECB to purchase (in unlimited amounts) any bonds issued by public sector entities in those (eligible) indebted countries that might be put at risk by wider spreads caused by higher rates. This sort of uncapped ‘selective’ Quantitative Easing (‘QE’) was once anathema to policymakers, particularly in Northern Europe. But many policy orthodoxies begin life on the sometime-lunatic fringe. Moreover, the eligibility criteria make it clear that the TPI is only open to members that comply with EU fiscal rules and are judged to be fiscally sustainable by the Commission, IMF, and European Stability Mechanism. This allows the ECB to dodge the accusation that the TPI will end up supporting profligate governments at the expense of everyone else. Finally, the TPI will not be used right away (e.g., to dampen recent spikes in the BTP-Bund spread). Instead, it will be kept in reserve “to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area”, while the Pandemic Emergency Purchase Programme (‘PEPP’) and Outright Monetary Transactions (‘OMT’) remain the principal weapons in the ECB’s arsenal.
At least initially, the market did not seem too pleased with the ECB rate hike and TPI announcement as European bonds sold-off sharply on news of the former and the BTP-Bund spread continued to widen while the latter was unveiled. However, by the close of trading on Thursday, European sovereign bond yields had fallen for the day. Moreover, the death throes of the Draghi government in Italy may explain the moves in Italian bond yields rather more than market assessments of the TPI. We believe that the TPI should help stabilise inter-sovereign European spreads, so long as Russia does not halt the supply of gas and oil to Europe this winter (in which case we really are in uncharted water). In addition, if the availability of the TPI means that the ECB will now act aggressively to combat inflation, that is also welcome news. The ECB has taken its sweet time to respond to soaring prices, no doubt in large part due to the fragmentation risks that exist every time policymakers want to adopt a bloc-wide monetary stance. But a change of policy tack is better late than never.
What does a more aggressive timetable for rate hikes in Europe mean for investors? Well, it depends to a very great extent on what is already reflected in asset prices. Until now, we have argued that the ECB was well-behind the curve and that a change in its monetary stance was desirable and ultimately inevitable. However, markets are now pricing in substantial further rate rises this year (of c.120bps) despite the uncertain economic outlook. Implementing this degree of policy tightening will prove hard (and may be undesirable) if a major recession takes hold in Europe (as most available data, including weak July PMIs, suggest that it might). Indeed, as COVID-related supply chain challenges are resolved, inventory shortages abate, and the real economy begins to slow as a consequence of tighter financial conditions and waning consumer confidence, this could well lead to a change of global monetary policy once again. We think that negative economic developments, together with the more aggressive stance taken towards inflation by most central banks (which is now priced in), materially strengthens the case for buying longer duration assets as part of a balanced approach to fixed income.
Given that monetary policy plays a massive role in driving equity multiples, and equities and bonds have fallen in tandem this year as rates have risen, what does our outlook for duration mean for stocks? Well, in short, we do not believe that equities can recover meaningfully ahead of a recession (if that is indeed what is imminent) nor while the outlook for economic and corporate fundamentals is so uncertain due to inflation. Therefore, our more positive outlook for long duration fixed income assets does not (perfectly) extend to rate-sensitive equities (e.g., growth stocks). That said, we do believe that a number of sectors and stocks look particularly cheap, having been caught up in an undifferentiated sell-off year-to-date; and it would be a mistake not to take advantage of these levels in the hope of finding the bottom first.
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