Monthly Commentaries

April 2023

Economic and investment highlights

Economic, politics and markets

Global Credit strategy

How we did in April: The fund returned between 0.5% and 0.7% across different share classes, compared to EUR HY (BAML HE00 Index) 0.5%, US HY (BAML H0A0 Index) 0.9% and EM sovereign credit (BAML EMGB Index) 0.7%.Performance in April, gross of fees in EUR, was: (i) Credit: 70bps, with 78bps from cash and -8bps from CDS; (ii) Rates: 6bps; (iii) FX: -12bps, (iv) Equity: -6bps and (v) Other: 0bps.

What we are doing now: Markets recovered a good part of March losses, and valuations in credit have started tightening. Financials have recovered less, and we remain positive given more attractive valuations than broader credit.

The Fed has clearly signaled a long pause in its hiking cycle at the early May meeting. The economy is slowing and banking stress increases tail risks, though we see the situation going towards a stabilization in the US (having stabilized already in Europe). Cuts over the next 12 months are unlikely as core inflation is still running at 5.5% in US and Europe. Still, the market is likely to price them out only gradually as the economy slows and disinflation continues. In emerging markets, instead, cuts will start as early as 2Q23, since inflation is falling fast and central banks hiked earlier and more than in developed markets.

  • Our net exposure is currently 80%. We recently added a good degree of protection via CDS in areas which tightened too quickly. Our net exposure is close to our 1-year average, suggesting the fund has room to add risk if economic weakness starts affecting credit spreads.
  • The fund duration is 2.6y, slightly higher than our 1-year average. We think momentum will continue to support tighter rates, but valuations already price in a good amount of easing. Thus, we keep duration relatively neutral.
  • Both yields and spreads remain above the 5y average, so credit markets offer several opportunities in the 9%+ yield area. Our cash book focuses on these opportunities across the various segments.
  • Net financials exposure (incl. cash short and single name CDS) represents 53% of the book. Most of the exposure is in large systemic banks in Europe. We added risk in financials in March, as banking volatility created opportunities.
  • Exposure to financials is now on the high side of the historical range, as the asset class turned attractive on a relative basis over the past few weeks.
  • Net corporate exposure (incl. cash short and single name CDS) represents 29% of the book, with exposure skewed towards Europe. We used recent weakness to add to German residential real estate, focusing on high quality issuers with depressed valuations. We maintain exposure to high yield names in high quality sectors (e.g. cable, telcos).
  • Net EM exposure (incl. cash short and single name CDS) represents 15% of the book, and we maintain a big focus on LatAm local markets, given the likely upcoming cutting cycles. We think Chile, Brazil and Peru will be able to cut interest rates over the next three months, with Mexico and Colombia following later this year.
  • The blended YTC of the fund is 9.9%, and YTM 8.5%. The average credit rating is BB+.
  • YTC vs duration and YTC vs rating continue to be among the most attractive in the history of the fund.

Financial Credit Strategy

After the recent lows caused by a few idiosyncratic events, April saw a return to calm for the financial sector as focus shifted back to fundamentals ahead of the sector’s first quarter earnings. The potential for a slowdown in inflation was partly pushed back by several global macroeconomic datapoints which came above expectations. This supported the ongoing hawkish rhetoric during the latest round of central banks’ meetings where rates across Europe and US were hiked by another 25bps, taking the trailing 6-month total to 250bps and 200bps, respectively.

In April, sovereign rates were largely unchanged across curves as the market grappled with concerns that monetary policy had been tightened sufficiently already. Furthermore, the pace of monetary tightening has been unprecedented and with lending surveys starting to point to greater difficulties for households and corporates, markets have priced rate cuts over the next 12-months.

On average, global equity markets rose 2% in April, taking YTD total return gains to c.11%; European financials outperformed as they added 3.5% for a total return gain of c.10%. Given the previous turbulent month for European banks, this is quite a remarkable achievement though should not come as a surprise given the significant improvement that regulators and banks have made collectively over the previous decade. In addition, there were some positive rating actions across both regions and single names that is testament to this progress having been achieved.

We are currently halfway through the first quarter results season and the tone has been rather balanced despite the significant events during the period. The clear positives have been manageable sequential deposit outflows of less than 2% as corporates and households on balance have marginally switched to take advantage of higher rates elsewhere. Similarly, solvency across European banks continues to grow with an average increase of c.15bps QoQ, thereby allowing for incremental capital returns in the form of share buybacks. Due to higher cost of funding and liability mix changes, investors have been focused increasingly on net interest income trends but these continue to come in c.10% ahead of expectations and are driving upward revisions in franchise income, and consequently net profit.

Issuance in April was a paltry EUR15bn and concentrated entirely in funding, of which two-thirds in the secured format. We would expect primary to pick-up in May ahead of the Summer break as banks emerge from their black-out windows though this should remain clustered in the Senior format.

After facing existentialist concerns in mid-March, AT1s were largely unchanged in April as the market continues to constructively digest the implications of recent events. Importantly, flows remain driven by new investors seeking sustainable sources of high-quality income, using the dislocation in spreads to historically wide levels as a unique entry opportunity. With both UniCredit and Lloyds announcing calls of two AT1s at their first opportunity, the asset class remains on track for a further potential EUR10bn redemptions this year which would be equivalent to a c.5% buyback.

Financial Equity Strategy

Following the short but sharp shock in March during which two US banks failed and UBS made a rescue bid for Credit Suisse, we were hopeful we would see at least a month of relative calm to allow investors to refocus their minds and await the Q1 results season. April, especially in Europe, did indeed see this calm begin to emerge. New share buybacks were approved by the regulator, decent and almost universal earnings upgrades were seen at the start of the earning season and a modest recovery in the bank sector share prices joined together to put the events of March largely in the rear-view mirror. The implications for several US regional banks were well known 6 weeks ago but these are taking time to play out. First Republic was resolved by the FDIC and sold to JP Morgan, while a couple smaller banks remain under market pressure. But overall we see deposits stabilizing and banks’ dependence on wholesale funding dramatically declining in the aftermath of the First Republic resolution. For many US banks, this was a crisis much more in their stock price than in their operating fundamentals. This, in our view, has created opportunities to build positions in quality banks trading at historically steep discounts even factoring in known and potential earnings pressures. This being said, we continue to maintain relatively modest exposure to the US banking sector given the extremely attractive risk rewards we see in Europe.

Indeed, the solid performance of the fund in April (~+2% for the month) was driven by our positions in Europe while other regions were broadly flat for the month. Our biggest contributors to performance came from some of our largest holdings including Unicredit, Barclays, BNP and ING. As just one example, Unicredit posted Q1 results in which they generated ~18% RoTE for the quarter, 20% profit upgrades, and a commitment to distribute 17% of its market cap to investors this year (and almost certainly for the next several years). Yet the stock – even after a ~40% rally to start this year – still trades on a P/E ratio of just 5x and a P/TBV of 0.5. The upside remains very significant and the immense capital return should provide powerful downside support. And if sentiment remains sour and investors do not want to buy into the story? For the first time since the GFC, Unicredit and several European banks are beginning to be material buyers of their own stock.

So, despite the turmoil created by a few banks having taken a massive wrong-way bet on interest rates, higher interest rates continue to be a positive tailwind for European banks. US banks certainly look tempting on a valuation basis (~35% of the market multiple, vs 75-80% historically) following the recent dislocation, and we have begun to nibble on a few names that look well positioned in the current backdrop in terms of capital, deposits, credit, and ability to protect their NIM. But even with the sharp moves lower in the US, the bulk of our capital remains committed to Europe where 1Q23 results have shown the three key drivers of our investment thesis – earnings upgrades, capital return, and valuation – all remain very much intact despite the events of March.