Monthly Commentaries

December 2023

Economic and investment highlights

Global Credit Strategy

How we did in December: The fund returned between 2.7% and 3.1% across different share classes, compared to EUR HY (BAML HE00 Index) 2.9%, US HY (BAML H0A0 Index) 3.7% and EM sovereign credit (BAML EMGB Index) 5.0%. Performance in December, gross of fees in EUR, was: (i) Credit: 3.9%, with 4.22% from cash bonds and -0.35% from CDS; (ii) Rates: -10bps; (iii) FX: 3bps, (iv) Equity: -45bps and (v) Other: 0bps.

What we are doing now: December saw a continuation of the trend started in November. Financial conditions continued to ease, and global spreads tightened. The Fed meeting was dovish, with Powell opening the door to cuts in 2024 more explicitly than anticipated. Our Fund benefited from this dynamic, as we opened credit and rates risk in late October and just marginally reduced in November. Our cash longs re-priced higher, and light hedges meant just marginal weakness on the macro overlay.

We closed 2023 with a net return of 11-13% across EUR share classes.  Overall, our flexible approach allowed the Fund to deliver positive returns during the fastest interest rate re-pricing of the past twenty years.

In late December, we started reducing some of the exposure that drove returns since October. At the end of the December, core yield curves priced 6-7 cuts for 2024. We see core inflation below 3% by the end of 1Q and global cuts starting in 2Q. As a result, 3-4 cuts are more likely and we deemed market pricing excessive. We aggressively reduced our longs in duration, and started cutting credit risk too, via selling cash longs and adding hedges. We see 2024 as a year of policy easing and are overall constructive in credit. The year, though, is starting post a strong rally and with somewhat euphoric valuations, so we are tactical in our risk deployment.

At December month end, net credit exposure is 67%. Cash exposure is 98%, and CDS protection amounts to 30% (in index and single name). Rates duration is 2.2y, vs 5.2y at the end of October.

More in detail:

  • The Fund blended YTC is 9.0%, with average rating BB+.
  • The Fund duration is now 2.2y, substantially lower than in late October. We have switched longs to shorts in US and European futures, advocating for a re-pricing higher in global rates. We have reduced long-end cash bonds which performed strongly.
  • Our net exposure is 67%. We have reduced c.7% in cash longs in December, and added protection via US IG and HY spreads, European HY spreads, EM spreads.
  • Net exposure in financials (incl. cash short and single name CDS) represents 40% of the book. AT1 and financial subordinated was a key trade in 2023, and some of the bonds re-priced 25% since March. The asset class outperformed since October. We remain constructive but reduce some of the winners.
  • Net corporates exposure (incl. cash short and single name CDS) represents 35% of the book. We focus on 8-10% yielding bonds backed by a solid pool of hard assets, at valuations that heavily discount the underlying value, or with imminent refinancing events.  Overall corporates are the area with the least market beta on our cash book.
  • Net EM exposure (incl. cash short and single name CDS) represents 17% of the book. EM outperformed since October, and EM local was a key winner in 2023. The EM book focused the risk in local markets last year, with 20-30% return on our bonds. We maintain conviction in some large local markets (Brazil, Mexico, Colombia), and added risk in some high-yielding credits.

Financial Credit Strategy

Further confirmation of easing inflationary pressures in macroeconomic data combined with softening rhetoric by central banks around ongoing need to keep financial conditions tight fuelled the risk-on rally across many assets in December. Leading global equity indices rallied c4% through the month to close the year firmly in positive territory (10-30% total return) with laggards such as US small caps (+15%) outperforming this month as the breadth increased.

Underpinning this equity sentiment and momentum was a 40-50bps tightening of yields across leading rate curves. The shape of the curves was relatively unchanged with 2s10s still inverted at c40bps across the US, Germany, UK. European bank equities added 2-3% in December, taking YTD total returns to c30%, whereas in financial credit we saw spreads tighten by c20bps in Seniors, c40bps in Tier 2s, and c80bps in AT1s. We believe these remain attractive on an absolute basis across the fixed income universe.

Positive ratings actions continued to come through in December, the most notable being Deutsche Bank whose Tier 2s became investment grade rated across all agencies. Other smaller financial entities across Europe benefited from upgrades too as third quarter results confirmed that fundamentals remain robust in terms of asset quality, capital generation, and liquidity / market access. Importantly, across the AT1 space several securities were called as issuers were able to refinance at adequate levels, a trend we expect to continue into next year.

After a very active November (EUR55bn), primary issuance was subdued in December at just EUR5bn as most European financials had fulfilled their needs and, in some cases, even prefunded some of next year’s requirements. Overall issuance for 2023 ended c5% lower than in 2022, and this was driven by a c8% decline in Senior to EUR410bn; capital, both in terms of Tier 2 and AT1s, was c10% higher at EUR60bn which is noteworthy given adverse developments in the earlier part of the year.

Considering the electoral and geopolitical uncertainties this year, we expect January to be a very active month for issuers as entities seek to front-load; as an illustration, January 2023 saw EUR100bn of primary, or just over 20% of the year’s total. As ever, we stand ready to actively participate in those transactions we deem to be the most compelling from a risk reward perspective for our investors.

Financial Equity Strategy

December capped off a highly volatile year for financials, which saw powerful moves higher in many European and Japanese banks, large US bank failures, a takeunder of Credit Suisse, and a dramatic increase (and then drop) in interest rates across the US and Europe. In the end, the MSCI AC Financials index was up 16.4% in USD and 12.7% in EUR. Even regional banks in the US, which at one point were down nearly 35% on the year, finished roughly flat. In this context the Fund generated strong returns, up 23.5% in USD and 20.9% in EUR. This follows on strong performance in the prior two years as well, leaving 3-year performance of +74.0% in EUR vs the comparable benchmark return of +46.2%.

As we look forward to 2024, the year is expected to be similarly volatile (though hopefully we have had our share of Feb/March surprises after 2020, 2022, and 2023) as geopolitical events take center stage with many key elections around the globe, and with central banks continuing to attempt to stick the economic soft landing. While it is difficult to say with any certainty what the year will bring us, it is we think safe to say that European banks are entering 2024 in much better shape than at any point in the last 10 years. It has been a long, dreary decade for the sector as banks generated mid-single digit returns under the stresses of negative ECB policy rates and were forced to plow these paltry profits back into rebuilding their own balance sheets. But today, profitability has shot higher to low-teens ROTE, capital is very much in a strong excess position and being distributed in droves to shareholders, and the unemployment rate has dropped from 12% in the Eurozone in 2014 to 6.5% today. Where did the index trade then? Over 160. Today? 120. If the sector traded on the same 12x multiple today as it did ten years ago, the index would be 220. If it traded at just the average 9x multiple of the last (dreary) decade, the index would be 165. Simply put, at today’s 6x multiple the market refuses to believe in the sustainability of today’s profit stream and places a massive discount on forward earnings – which, by the way, have to at least some extent already factored in the impacts of normalizing credit and lower interest rates (note for instance that consensus already bakes in 10-20% drops in NII through 2025 from 3Q23 run rate levels for the most rate sensitive of European banks). If this discount begins to unwind, as we believe it will, the upside in the sector remains very substantial. In the meantime, dividend yields of 8% and buybacks of 4-5% above that should provide substantial support though the volatility. Of course, as always in European banks, stock selection will be paramount; even in a good year overall for bank stocks in 2023, five stocks were down and there was a 110% gap between top and bottom performers.

Life insurers in the US are in fact a similar story to European banks. The group suffered under the weight of low interest rates over the post-GFC period and valuations dropped from 80% of the market multiple pre-crisis to 40% today. This is despite the fact that long-term US interest rates, a key variable for many US life insurers, are back to 2006 levels and new money yields now significantly outpace portfolio yields (meaning spread income will continue to trend higher even if rates stay at current levels). The growth outlook for life insurers today is also markedly brighter than during the QE era as higher rates makes many life and savings products more attractive than competitor bank products; in fact management teams at companies like Equitable and MetLife have noted the fundamental backdrop for life insurers is as good as it’s been in 15 years (clearly you would not know this from looking at valuations). Similar to EU banks fixing their balance sheets during their lean years, US life insurers have transformed their businesses and balance sheets to free up capital and maximize free cash flow. The result of all this is they now trade at free cash flow yields of low to mid-teens and PE multiples well below banks despite having none of the regulatory uncertainty, capital constraints, or funding pressures that banks still face in the US today. The insurers are putting this free cash flow to good work, returning huge amounts of capital to shareholders via buybacks and dividends, very much in the same vein as European banks. And with several of these stocks trading at arguably distressed 3-4x earnings, and with excess cash and capital on company balance sheets, why not buy back?

Elsewhere in the US, we remain tactical and focused on investing in stocks that have idiosyncratic drivers, compelling valuations, and/or are positioned to do well in a range of economic and interest rate environments. For example, we own Federated Hermes (FHI), which is the largest pure play money market manager in the country. While FHI has already benefitted from strong cash inflows during the Fed tightening cycle, history shows that these flows remain very meaningful after a Fed pause. In addition, the firm has a significant fixed income franchise that stands to benefit if investors rotate into longer duration securities. These factors are underappreciated by the market as the stock trades too cheap in our opinion, and we expect management to become more aggressive with a buyback. While not part of our thesis, a takeout of this business at a premium is not out of the question either. In US banks, we have trimmed our overall exposure given their strong run into the end of year and improved valuations. Although there is much optimism around a dovish Fed and a soft landing for the economy, which would likely provide continued momentum to bank stocks, we are being selective as multiples have bounced strongly, funding costs remain under pressure, and consensus provisioning estimates appear to already be baking in a very benign macro backdrop.