February 2021

How we did in February: The fund returned between 1.4% and 1.7% across the different share classes, compared to SPX 2.8%, SX5E 4.6% EUR BAML HY (HE00 Index) 0.6% US BAML HY (H0A0 Index) 0.3% and EM bonds (EMGB Index) -2.7%. Performance in February, gross of fees in EUR, was from: (i) Credit: 1.37%, with 1.49% from cash and -13bp from CDS; (ii) Rates: 33bp; (iii) FX: 7bp; (iv) Equity: 29bp, and (v) Other: -17bp

In February, the Fund gained from the repricing in global yields, while it was relatively protected from wider credit spreads. YTD, US 10y yields are 50bp higher, with the bulk of the selloff concentrated in February. We entered the month 50% invested in credit and with duration protection in US, Europe, Australia and Eastern Europe. The protection allowed us to return c.2% over the month despite the negative performance of main indexes. On the move higher in rates, we have marginally reduced duration hedges but have not added risk meaningfully. Equity and credit markets remain close to the highs and are at this point vulnerable to further rates widening.

What we are doing now: Risk assets remain close to pre-Covid highs, so we see no reason for a meaningful addition in risk. We maintain a high liquidity buffer as well as credit protection via CDS. Global yield curves have widened and steepened, but levels remain still low vs inflation or historical ranges, and central banks will be able to affect the pace of increase but hardly the direction of interest rates into 2021. This means that the tailwind from dovish central bank policy on fixed income assets is likely behind us, at least until the end of the year. This decreases the opportunities in the market as a whole, but it can present good sources of alpha. We see three alpha-generating themes going forward: a reopening of global economies, benefiting travel and transport sectors, a re-pricing of global yields in the countries where inflation is more likely to rise – United States, United Kingdom, Australia, for example – and a repricing of cyclical value sectors which have lagged behind over the past decade, like energy and financials.

We maintain a high allocation to convertible debt, especially in bonds with relatively low delta and limited credit risk, so to improve the portfolio convexity. In credit, we maintain exposure mostly to selected issuers in re-opening sectors, such as cruises, hotels, and selected airlines. We maintain a bullish stance on commodities and exposure to the energy sectors, both via convertibles in low beta investment grade names, like Total or BP, and credit of higher beta names, like Pemex. We believe a rise in volatility is likely to happen over the coming months, triggered by a peak in economic momentum, already-long positioning in rates and credit, and a less dovish stance by central banks. This may be an opportunity to redeploy capital in beta-sectors, including high yield corporate and financial credit as well as emerging markets hard currency debt.

February was dominated by reflationary themes with mixed results across risk assets. Tangible progress on the rollout of vaccine by some major countries (e.g. US and UK), better than expected economic data and ongoing policy support, including prospects of a new large fiscal package by the Biden administration, increased optimism around a much faster than anticipated recovery, fueling inflation concerns. Rates moved sharply higher as investors brought forward their expectations of monetary policy normalization and rotated into sectors with positive sensitivity to rising bond yields including banks and insurance. The US 10-year Treasury yield moved up c. 34bps to just above 1.4%, while the 10y Bund yield rose 26bps to -0.26%. Also, broader equities were negatively affected by the rates move, accelerating into month-end. Despite this, equity indices were broadly positive on the month, with the S&P 500 +2.8% and EuroStoxx 600 +2.5%. As unique beneficiaries of higher rates and on the back of the strong results season, European and US banks posted the most notable gains and closed February +19% and +16% respectively.

Higher rates had mixed effects on credit. IG markets, whose spreads were already tighter than pre-Covid levels due to the central bank intervention, were broadly wider across the US (+21bps) and Europe (+12bps) whereas HY markets closed flat to tighter (-5/10bps). In this context, financials outperformed led by shorter duration bonds and AT1s with spread tightening up to 40bps in February. We expect our subordinated capital space to remain resilient to further rate moves, thanks to the higher starting point of spread (380bps in AT1, 170bps in Tier 2 vs 340bps HY and 90bps IG corps), coupon reset mechanisms, and underlying issuer fundamentals’ which are geared to higher rates.

The consistent themes across 4Q20 / FY20 financial results reported throughout February were ongoing capital strengthening and improving asset quality metrics across geographies. Profitability remained strong and while a few banks reported a net loss for the year, this was mostly due to non-cash goodwill impairments or other items already deducted from CET1, hence capital neutral. Withdrawal of support measures (e.g. moratoria and government guarantees) could lead potentially to some asset quality deterioration over the next quarters, however the high level of existing provisions, built up to front-load Covid defaults, put banks in a stronger starting position to tackle it.

Importantly, February saw a change of government in Italy as President Mattarella entrusted former ECB Governor Mario Draghi to form a new government, which received broad-based support from political parties. Also, with Andrea Orcel confirmed as the new CEO of Unicredit, the management team should now focus on profitability and growth seeing as the bank has one of the highest excess capitals in Europe and robust asset quality. We reiterate our strong conviction on Unicredit, one of our top names along with Intesa, as we believe Mr Orcel is well-placed to lead successfully the bank in a new domestic political era ushered by Mr Draghi.

Issuance in February was subdued due to the increase in rate volatility which compromised both capital refinancing and MREL funding plans after the publication of individual bank’s annual results. There were only a few capital transactions across the European space, all of which had been largely expected by the market. As was the case in January, we continue to adopt a very selective stance on new deals as the new generation of longer dated lower spread instruments are not sufficiently attractive yet in the current uncertain rate environment vis-à-vis more seasoned securities.

Higher rates and hopes of reflation sparked a sharp rally in financials globally in February. While the move in yields  started with rising inflation expectations, the latter stage has been driven by real interest rates going higher. Notably, banks and insurers are the only groups in the equity market positively correlated to both higher real rates and higher inflation. We see the move in real rates as positive and potentially early-stage, coming from deeply depressed negative levels – it indicates global growth expectations are on the rise as populations get vaccinated and economies reopen. Importantly, central banks are taking this rise in yields in stride. The Fed appears to view it as affirmation that their policies are working, while the ECB has taken no strong actions as of yet.

Perhaps related to the move in yields, the month of February 2021 was the worst month for growth vs value stocks since 2000. Unlike then, however, the global economy is emerging from a recession and inflation expectations are rising. As bond yields rise, this scenario is creating headwinds for long-duration/high-multiple sectors, and tailwinds for short-duration/low-multiple sectors. Despite this rally, however, positioning in value-oriented sectors remains uncrowded – indications are that while there have been higher flows into value sectors from macro investors focused on the reflation theme, active equity managers remain significantly underweight. This is likely to cause performance pain as growth sectors continue to lag and value sectors – including financials – outperform.

European banks are off to a strong start for the year, but valuations at 0.6x TBV remain distressed, underscoring the extremely low base from which they have risen. After all, the last time reflation took hold of markets this sector traded above 1.0x TBV. And with many management teams announcing ROTE targets north of 10% there is no reason for the sector not to trade at those levels again. Our base case scenario over the next 24 months is for reflation to continue driving multiple expansion during 1H21, followed by significant capital distributions in 2H21 after the stress test results and full lift of the dividend ban, followed by 30%+ earnings growth in 2022 as loan losses normalize. A potential pull-forward of rate hike expectations as we have started to see would be incremental to this, but is clearly just a free option embedded in the stocks at this point.

In the US, fiscal stimulus is doing more than simply filling a hole. Cumulatively the COVID crisis has cost US households $400 billion in income, but they have already received more than $1 trillion in transfers – even before both the late December and forthcoming stimulus packages. Buoyant asset prices in addition have caused households to accumulate $1.5 trillion in excess saving, with this set to rise to $2 trillion (9.5% of GDP) by early March once the additional stimulus is enacted. US bank shares are responding to this sudden pull-forward in Fed-hiking expectations. However, with absolute valuations at normalized levels and loan growth likely to suffer as businesses and households are flush with cash, US insurers will likely be the next big beneficiaries of the reflation trade. In fact, rising rates benefit life insurers to an even greater degree than banks, via both the income statement and balance sheet – this has largely been overlooked by the market thus far.US insurers also have tremendous amounts of excess capital and are not subject to distribution restrictions, meaning capital return will be an important value driver over the next 24 months. And finally, public valuations remain dislocated from private transactions, suggesting potential for significant value-creating M&A catalysts ahead.