Monthly Commentaries

August 2023

Economic and investment highlights

Economic, politics and markets

Global Credit Strategy

How we did in August: The fund returned between 0.1% and 0.4% across different share classes, compared to EUR HY (BAML HE00 Index) 0.3%, US HY (BAML H0A0 Index) 0.3% and EM sovereign credit (BAML EMGB Index) -1.7%. Performance in August, gross of fees in EUR, was: (i) Credit: -30bps, with -38bps from cash bonds and 8bps from CDS; (ii) Rates: 1bps; (iii) FX: -8bps, (iv) Equity: 78bps and (v) Other: 0bps.

What we are doing now: August was a weak month for risk assets. The US curve widened and steepened, and weakness in the 10y affected credit. Chinese economic data deteriorated quickly, affecting global equity performance. Risk assets were down 1-4% in the month. We raised cash to c.7% and decreased net credit exposure by c.10% vs late May. The adjustment helped defend our performance in August, and the Fund was up 0.23% on the month as a result.

In the near future, we think economic weakness will take a more central role in the market narrative. As a result, we added back some of the risk but remain light vs history. We continue to increase duration in the Fund, now 5.2y and on the high side of the historical range. We think central banks are done hiking and data softness may start supporting the long end too.

At the time of writing, net credit exposure is c.73%. Cash levels are close to 5%. Moreover, the fund has 17% protection in credit indexes and 13% protection in single name credits (via CDS and cash shorts). The fund also has 8% protection in major equity indexes.

As of August month end:

  • The fund continues to focus on bonds with c.8-10% yield and upside potential. The fund blended YTC is now 8.6%, with average rating BBB+.
  • The fund duration is now 5.2y, the highest level since early 2021. Recently, we reduced interest rate hedges and added some long bonds with relatively high credit quality. Net Credit exposure at month end was 75%.
  • Net exposure in financials (incl. cash short and single name CDS) represents 51% of the book. We focus on subordinated debt of national champions in Europe yielding 8%+. We reduced sub bank debt post the July rally but maintain high exposure given attractive valuations.
  • Net corporates exposure (incl. cash short and single name CDS) represents 24% of the book. In Europe, we focus on 8-10% yielding bonds backed by a solid pool of hard assets and at valuations that heavily discount the underlying value. We have taken profits on position with higher beta and fewer idiosyncratic catalysts.
  • Net EM exposure (incl. cash short and single name CDS) represents 16% of the book. Since July, we have been taking down exposure by taking profit on longs in HY credit and adding hedges in vulnerable countries that participated in the risk rally. We maintain conviction on local markets but covered 50% of FX exposure (leaving it below 5% of the overall  book).

Financial Credit Strategy

The debate of higher for longer was a dominant theme in August with the long-end of the US Treasury curve selling off and pushing yields to new year-to-date (YTD) highs. Whilst it is difficult to pinpoint a single specific catalyst driving the moves, one headline that garnered more attention was the downgrade of the US credit rating by Fitch from AAA to AA+, flagging the risk of elevated budget deficits for the foreseeable future. After reaching a peak of 4.36%, US 10y rates rallied into month-end to end at 4.1% as leading macroeconomic data kept alive the prospect of soft-landing.

As a result, market assets in August largely lost ground with equities and rate-proxies broadly -3%. Rate curves steepened across most regions with front-ends rallying up to 5bps and back-ends selling off up to 10bps. Across the credit space, financials performed in line with the broader credit space; Senior and T2 spreads ended on average c5bps and c10bps wider respectively and AT1s outperformed on a beta-adjusted basis, just over 1pt lower. European bank stocks outperformed on a relative basis, dropping just 2% and leaving YTD total returns at +23%, a stark contrast to US peers which posted -8% in August and stand -17% YTD.

Second quarter earnings reached their conclusion for the European banking sector with the most eagerly awaited UBS closing out proceedings. UBS released its first set of numbers including Credit Suisse and eased concerns around the solvency of the combined entity, with both capital and leverage coming in ahead of expectations. Disclosure for 2Q23 included details of the value adjustments on Credit Suisse’s balance sheet and revealed c$25bn of negative goodwill, as well as an upgraded estimate of cost savings from $8bn to $10bn that should generate greater value for shareholders and lead to a 15% return target by year-end 2026. The next hurdle will be tackling capital issuance and an AT1s transaction may materialise soon.

Away from UBS, results for the second quarter confirmed themes that had been reported already by other banks in July. Trends in key metrics unsurprisingly remained positive, with net interest income on average +30% year-on-year, loan loss provisioning lower to unchanged quarter-on-quarter, and a further 20bps sequential boost in core capital levels due to the better earnings. With signs of macroeconomic slowdown becoming more prevalent, these trends will be scrutinised carefully in coming quarters. That said, we believe that the European financial sector retains enough flexibility on profitability and capital to cope with adverse developments.

Primary activity in August was subdued due to several factors, namely the uncertainty around higher for longer yields, c75% of FY23 issuance having already been completed through July, and the seasonal peak summer effect. Interestingly, capital issuance YTD is running c30% ahead of last year despite the Credit Suisse event in March this year; a few more AT1s were issued in August and we expect similar, if not more, into year-end as the asset class continues to attract new investors. Funding issuance YTD is c10% below last year’s levels mainly due to a c20% reduction in Senior HoldCo as banks opted for the more cheaper option of Secured / Preferred instruments.

Financial Equity Strategy

After a strong July for global financials, August brought significant volatility to the equity and bond markets. Interest rates gyrated around budget deficits, rating downgrades, and fears that inflation was not yet contained, possibly warranting further central bank tightening along with rates being held higher for longer. Indeed, rates on the 10-year US Treasury and UK Gilts spiked nearly 50bps at the peak of these fears. These concerns eased a bit in the latter part of the month given hopes around a soft economic landing and were helped by the central banks retreat at Jackson Hole in which a balanced tone was struck by Fed Chair Powell and ECB President Lagarde. Global financials ended the month down nearly 3% with European banks outperforming on a relative basis, down 2%.  US banks, however, were hit especially hard by the volatility with the BKX down almost 9% on the month, nearly wiping out all of its strong gains seen in July. In addition to higher-for-longer rate worries, concerns around new capital and other regulatory requirements in the US continue to weigh on investor sentiment.

European bank results for the second quarter were robust. Trends in key metrics unsurprisingly remained positive, with net interest income on average +30% year-on-year, loan loss provisioning lower to unchanged quarter-on-quarter, and a further 20bps sequential boost in core capital levels due to the better earnings. As discussed last month, a macro environment of minimal real GDP growth (with some degree of positive nominal growth) and a leveling out of interest rates at a relatively high level is quite a benign backdrop for investing in European banks, particularly those with strong deposit franchises and robust capital return.

Clearly the market is concerned about something around the corner with European banks, whether it be deteriorating asset quality, rising deposit costs, or more bank taxes. But let’s put some context around this. If we stress earnings by assuming: 1) 2020 level provisioning (which seems exceptionally harsh just on its own), 2) net interest margins back at 4Q22 levels (i.e., a substantial 20bps hit to our assumed ’24 NIMs), and 3) an effective tax rate inflated by an additional 5%, then we still see the sector trading at….9x ’24 earnings. This for a space that has averaged ~11x over the past 20 years! Of course, none of these assumptions are likely to be anything close to reality and yet the market is arguably pricing them all in with an additional haircut on top. Quite simply, the risk/reward profile for European banks looks significantly asymmetric with absolute and relative levels where they bottomed at in the depths of Covid, despite earnings upgrades continuing, balance sheets as strong as they have ever been, and free cash flow being plowed back to shareholders at a historically high rate.