September 2021

How we did in September: The fund returned between -0.3% and -0.5% across the different share classes, compared to SPX -4.7%, SX5E -3.4%, EUR BAML HY (HE00 Index) -0.1%, US BAML HY (H0A0 Index) 0.0% and EM bonds (EMGB Index) -2.6%. Performance in September, gross of fees in EUR, was from: (i) Credit: -40bp, with -36bp from cash and -5bp from CDS; (ii) Rates: +27bp; (iii) FX: +1bp; (iv) Equity: -24bp, and (v) Other: -3bp.

In September, volatility increased and risk asset prices weakened, due to the combination of growth concerns and rising rates. Growth concerns were weighed by continued weakness in the China property sector, prolonged supply-constrains and rising energy costs. To address these concerns, central bankers have attempted to maintain an accommodative stance in recent speeches. However, with rising prices, their inflation rhetoric is shifting away from labelling it “transitory” to acknowledging that post pandemic inflation may be higher for longer. This shift, along with the Fed signaling the start of tapering in 2021, has caused rates to move wider.

What we are doing now: Investor expectations are oscillating between reflation and stagflation scenarios. While both scenarios would be negative for rates, stagflation would benefit commodity price and lower equity valuations. In this environment of slightly higher volatility and weaker asset prices, we are carefully adding in credit. We are selecting those which may benefit from higher rates (e.g. banks) or those with positive catalysts and able to pass on inflationary pressures (e.g. reopening sectors like cruises). Overall, we maintain a cautious attitude towards credit as spreads are still near all-time tights. We keep the fund 55-60% invested in selected areas, leaving room to add on weakness, as Chinese tensions and tapering discussion may raise volatility in Q4.

In credit, we focus on sectors which we think could weather a stagflationary environment– travel/ reopening (e.g. airlines, cruises), cyclicals that benefit from higher rates (e.g. financials) and defensive consumer discretionary (e.g. luxury cars). We maintain a high allocation to convertibles with low credit risk and positively convex upside/downside, in similar sectors. We added convertible exposure in airlines (e.g. Lufthansa, JetBlue) and senior bank convertibles with equity exposure to Chinese companies (e.g. JPM bond referencing Alibaba equity). We added credit protection in companies with low margins and that will be hurt by supply-chain bottle necks (e.g. Jaguar and Iceland supermarket). We remain overall lightly positioned in emerging markets, however have added on weakness in energy-exporting economies (e.g. Russia local currency bonds).

We are well positioned to capture opportunities arising from the start of Fed tapering and geopolitical risks.

September was a negative month for risk assets across geographies. Sharp increases in energy and gas prices, combined with an ongoing struggle of supply chains globally led commodities higher, boosting concerns around inflation, which in turn led credit and equities lower.

Rates sold-off in response to these growing inflationary concerns with core US 10y and Bund 15-20bps wider, fuelled in addition by ongoing discussions around tapering before year-end. That being said, credit spreads remained broadly unchanged as backstop measures should stay in place to dampen any default concerns. Meanwhile, equities were broadly negative after several months of positive returns, with few exceptions including banks. Banks outperformed broader equity markets in September, thanks to the positive correlation to rates and inflation, with the European and US banks gaining +3.7% and +2.3% respectively.

On an issuer level, September saw some ratings agencies’ updates, with the most notable being Fitch’s upgrade of Deutsche Bank’s subordinated debt back to Investment Grade. The bank has delivered successfully on its restructuring plan since the new CEO took over in late 2018 and completion should be straight forward from here. Furthermore, at a recent Financials Conference management guided to a better operating performance across its Investment Bank, leaving the potential for incremental positive ratings’ actions from other agencies.

Although the ECBs monetary policy decision meeting in September was largely as expected, the Bank has put the European financial sector on notice that it would be taking a deeper dive into individual banks’ impact from climate change out to 2050s. For the time being, this does not appear to be too concerning for the sector overall as capital levels are sufficiently robust to withstand the projected worst scenario of c8% loan losses by 2050s. That said, the range of loan losses would vary significantly across countries as those in the periphery, namely Greece, Cyprus, and Portugal, have over 65% of their loans exposed to physical risks, i.e. wildfires and flooding.

Primary issuance picked up in September to EUR30bn, with the bulk concentrated in the Senior format as banks continued to fill-out their MREL requirements. In addition, European banks with upcoming AT1 calls over the next quarters decided to pre-finance these deals early, slightly extending duration and locking in attractive reset spreads which on average were 200bps lower than outstanding deals. We continue to believe that a disciplined and selective approach is warranted with respect to new deals and overall remain unexcited by them. It is noteworthy that all $10bn worth of AT1s issued in the third quarter of this year are trading firmly below par.

• During the third quarter, Financial equities continued to grind higher, with the sector finishing up ~2% while the global equity index slipped just under 1%. Most developed market banks performed well, led by Japan (+6%) and Europe (+5%). On the other hand, Fintech names suffered, with one index down 9% for the quarter as high multiple growth names tumbled. EM financials were also generally soft, with some Chinese insurers and Brazilian banks suffering steep losses in the quarter. Interestingly during the month of September in particular, European banks began to decouple from the equity markets, rising nearly 4% during the month even as US and European markets fell anywhere from 3-5%. For what has been a notably high beta sector historically, this is encouraging (though we acknowledge it is just one month). It is also worth noting that after trading in lockstep with European rates as they declined from their peak in May, European bank equities bottomed in July even as bund yields continue to move significantly lower. Clearly, strong earnings and an emerging capital return story have focused investors’ attention on the banks. There is more here to like than just macro tailwinds – although inflation breakevens at 7 year highs in Europe is certainly helpful as well.
  One name we have been adding to recently is HSBC. The shares have been weak over the summer on the back of the emerging concerns in China.  The bank has disclosed a total exposure to Chinese property developers in aggregate of $6.3bn, or just 0.6% of its loan book.  Nevertheless, shares have traded down to 7x 2023 earnings, a significant discount for one of the largest, most diversified banks that has historically traded at a 10-15% premium to the rest of the sector vs a ~15% discount today.  In addition, HSBC is poised to benefit more than most European banks from rate hikes in the US and UK.  Based on company disclosures, every 25bps rise in interest rates in the UK, US and Hong Kong (which is implicitly tied to US rates due to the currency peg) results in an approximately 7% increase in net profits.  Trading at just two-thirds of tangible book value, we believe there is over 50% upside as the recently elevated cost of equity normalizes, earnings are upgraded as loan growth resumes, excess capital is returned, and ROTE accretes to 10%+.  With a total yield north of 8% today, shareholders are also well compensated in the meantime.
• Another European bank we find highly compelling is Societe Generale.  The stock trades at just 6.5x 2023 earnings, which falls to ~5x when excluding the value its listed subsidiaries ALD (car leasing), Komercni (Czech bank), and BRD (Romanian bank).  And this is before excluding the E8.3bn of excess capital, equal to over 35% of the market cap.  Following unexpected trading losses in its investment bank last year due to structured products tied to dividends, the market has attached a high risk premium to the whole group, as evidenced by the stock trading below 0.5x P/TBV for a 8% potential ROTE in 2023.  However, the bank has already completed the announced restructuring of its equity derivatives business, and posted record revenues in its equity business in 1H21 despite concerns that the restructuring would cause franchise erosion.  Its French retail bank is benefiting from strong mortgage and rebounding consumer loan growth, along with the internal merger of its two primary banking networks, which will reduce costs in the segment by 8%.  The bank also derives 10% of its revenues from its operations in Eastern Europe, where rates have already been hiked by 100bps+ with more hikes expected to come, helping net interest margins.  The stock yields 7% today, and we see potential upside to this via a higher payout ratio should the bank decide to run down its significant excess capital position.
• In the US, one name we have been adding to in the quarter is New York Community Bank. While valuations are not compelling for most US regional banks, NYCB is an exception. This is a stock we have avoided for years despite an optically cheap valuation. However, in April, NYCB announced it was acquiring Flagstar Bank in an all-stock deal. The merger is a gamechanger for both companies. It creates growth opportunities for Flagstar’s core businesses in commercial lending, warehouse lending, and mortgage origination, and for NYCB it can also drive their historically high cost of funding (2x peers) lower. With its robust capital position and greater earnings power, NYCB can return up to 25% of current pro-forma market cap to shareholders through dividends and buybacks over the next two years. Consensus has been lazy here and looks to be about 10% too low on ’23 proforma estimates, and potentially 40% too low if some of the more bullish (but still realistic) scenarios play out. NYCB is cheap on an absolute and relative basis, with a 2023 forward P/E of 7x versus 12x for peers and a 5.5% dividend yield versus a 3% yield for peers. The stock ticks the boxes we tend to gravitate to: upside to estimates, cheap multiple, a hated stock (10% short interest) and significant capital return to shareholders. We continue to see significant upside even after strong outperformance over the past couple months as the street slowly wakes up to the opportunity.
• Zooming out to the macro landscape, at the tail end of September we saw a hawkish inflection from two major central banks with the Fed chairman talking about a mid-2022 end date for their QE taper and the BOE hinting at a rate hiking cycle that could begin prior to the completion of their asset purchase program. Both comments caught the market by surprise and led to a material upward shift in global yields. While a steeper yield curve is typically supportive of bank equity valuations, we believe the most important fundamental driver for bank earnings is the short end, and so the pull-forward of rate hike expectations should be a meaningful tailwind for the sector. In both the UK and the US, markets are now pricing in roughly two additional hikes by YE23 relative to where they were earlier this summer (and in the US, the bond market still has another ~45 bps to go to price in where the Fed has projected policy rates to be in 2024). These incremental hikes are generally not in analyst estimates and can be extremely impactful for some banks (40% EPS upside to a 100 bps move across the curve for a bank like Wells Fargo, for instance). Of course, the sensitivity is even higher in parts of Europe (Commerzbank well over 100% upside, for instance). For now that remains a free call option embedded within European bank stocks as the ECB liftoff will clearly lag other central banks. But even in Europe, the bond market is starting to sniff out an eventual normalization of monetary policy, with 3 year projected policy rates of -20 bps versus -50 bps earlier this year. With European 5yr/5yr breakeven inflation rates at the highest levels since 2014, it is not inconceivable that the pull-forward might have further to go. If so, the embedded call option will not be free for long.