Monthly Commentaries

January 2024

Economic and investment highlights

Global Credit Strategy

How we did in January: The fund returned between 1.81% and 2.15% across different share classes, compared to EUR HY (BAML HE00 Index) 0.8%, US HY (BAML H0A0 Index) 0.0% and EM sovereign credit (BAML EMGB Index) -1.4%. Performance in January, gross of fees in EUR, was: (i) Credit: 2.04%, with 2.07% from cash bonds and -0.02% from CDS; (ii) Rates: 12bps; (iii) FX: -10bps, (iv) Equity: 31bps and (v) Other: 0bps.

What we are doing now: January was a mixed month for fixed income, after the rally in 4Q. 2024 started with credit spreads at 1y tights and 6 Fed cuts priced. This “goldilocks” scenario started vacillating as US data continued to surprise on the upside. 2y rates and spreads widened c.20bp ytd, hurting fixed income performance. The fund was able to outperform the market via a relatively low duration and alpha generation within the credit book. In late December, we cut duration by more than 50%, from 5y to 2y circa. Lower duration helped insulate us from the rates re-pricing. On the cash book, our exposure to high quality real estate in Northern Europe paid off, as the sector re-priced strongly in January. We also generated alpha via participation in selected primary deals.

We continue to see a lack of opportunities in the broad market, as credit is tight and rates continue to price excessive rate cuts vs what’s justified by US macro. We keep cash levels high and focus on alpha generation on the cash book. We run a low net exposure via increased hedges on the CDS book. Duration is just above 2y.

At January month end, net credit exposure is 54%. Cash exposure is ~97%, and CDS protection amounts to ~43% (Index and single name). ~23% of the CDS protection is in the US IG index, which has a 0.25 beta to high yield. The risk-adjusted net exposure is thus 71%. Rates duration is 2.2y, vs 5.2y at the end of October.

More in detail:

  • The fund blended YTC is 8.4%, 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 credit exposure is 54%. Since December, we have reduced cash bonds, kept cash higher, 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 41% 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 16% of the book. We maintain some focus on EM local markets, but shifted some of the focus to HY hard-currency credit. We are gradually adding longs in Turkey as we are positive on the ongoing economic adjustment.

Financial Credit Strategy

The risk-on momentum carried over from year-end into January as the “soft landing” and growing “no landing” narrative gathered pace in the US. The latest round of macroeconomic datapoints surprised positively with US GDP posting an annualised 3.3% growth in 4Q23 with the unemployment rate yet to show any signs of deteriorating from 3.7%. In the Euro area, the narrative remains less rosy from an economic growth perspective but contrary to expectations a technical recession in the final quarter was avoided with GDP unchanged.

Importantly, there was further confirmation that inflation continued its downward trend, and this should pave the way for Central Bank interest rate cuts sometime this year. Although the magnitude of these cuts remains uncertain for now as policy makers prefer to err on the side of caution, investor demand for credit assets has increased significantly nonetheless over the past few months as duration and high coupons continue to be sought.

Performance across European financials’ assets got off to a steady start with credit spreads generically tightening across the capital stack (c35bps in AT1s, c20bps in Tier2, and c10bps in Seniors) and equities firming c2%. The picture was more varied for US banks after some concerns resurfaced around one US regional bank, but these should be fairly contained to that entity. In both regions, European and US banks’ equities underperformed their broader markets by c1% as markets take comfort from the better economic datapoints and potential rate cuts later this year.

The picture has been mixed during the first wave of 4Q23 results from European banks. Generally, there have been minor misses across net interest income, fees and in some cases one-off provisions though underlying asset quality remains robust. Whilst these trends create short-term volatility for equity investors, it is worth noting that on an underlying basis profitability is still expanding by c5% YoY. Accordingly, robust capital ratios continue to build higher by 10bps on average this quarter, which is undoubtedly constructive for creditors.

Unsurprisingly, the year has started quite active on the issuance front as issuers looked to get an early start on their plans given the shortened calendar in light of the increased geopolitical risks. This January’s amount of EUR80bn was the second largest monthly total ever, only slightly behind last January, and consistent across the capital structure. Capital instruments made up c20% of the total issuance with demand for AT1s (and T2s) at robust levels, furthering the resilience of the asset class. Primary activity should taper in February due to blackout period before Full Year 2023 results but should still provide interesting investment opportunities.

Financial Equity Strategy

Markets continued to trend positively to start the year, with the MSCI All Country index up 0.6% in USD terms in January and the financials Benchmark up 1.1%. Within this backdrop, the Financial Equity Fund returned 1.55% for the month.

Starting in Europe, the reduction in market rate expectations at the back-end of last year meant 4Q earnings season was set up as the latest test of resilience of European bank earnings, and once again the outcomes are reassuring. Guidance provided by management teams has typically been in-line-to-better, driving modestly positive consensus revisions to 2024 earnings (for those banks that have reported to date on average) and leaves the sector still trading on very attractive levels of c.6.5x P/E.

There have been two key supports. First, many banks have been reducing their sensitivity to rate cuts via hedging strategies and/or growing fixed rate asset exposures. Thus, the sensitivity to a 100bp move in rates which sat at close to 20% PBT 18 months ago has now fallen to c.5%, meaning NII projections are proving more resilient than the market feared even as rate expectations are lowered. Secondly, there is still no evidence of material asset quality deterioration coming through, with provisions typically lower than expected in 4Q and also supporting 2024 expectations. A reduction in rate expectations helps underpin the medium-term asset quality picture while the market has been slow to value other potential benefits (such as a recovery in loan volumes and fee-driven activity).

For sure, as we enter the monetary easing cycle we expect stock selection to become ever more important – we continue to focus on names where we see earnings expectations misplaced and more importantly where attractive distribution potential pays us to wait for a re-rating going forward (with a number of banks offering mid-to-high teen yields including buybacks).

Meanwhile in the US, after a very strong run to end to 2023, the performance of US banks in January was mixed with the money centers in positive territory but regionals seeing pressure. Earnings reports generally reflected continued near-term challenges and uncertainty around funding pressures, revenue trajectory, operating leverage, and capital constraints offset by management optimism regarding the latter half of 2024. Credit quality trends were mixed, and the question remains whether this is simply “normalization” or if conditions will deteriorate more significantly.

At the end of the month, New York Community Bancorp surprised the market by reporting a quarterly loss due to a large provision for its commercial real estate exposure, dividend cut, and material downgrade to its earnings outlook which led to the stock dropping over 50%. In 2023, NYCB was a perceived winner of the banking crisis by acquiring the remains of failed bank Signature Bank via the FDIC; however, this caused NYCB to catapult over $100bn in assets and into a new regulatory peer group. Comparatively, the bank has weaker liquidity, capital, and loan loss reserves and announced its intention to improve its positioning very quickly at a significant cost to its near-term profitability. Importantly, we have no exposure to NYCB and our positioning in US regionals is at multi-year lows given the uncertain macro environment and outlook. We remain positioned to play offense if opportunities emerge, keeping in mind that when the dust settles here it is highly likely in our view that M&A will significantly accelerate – but this is more likely a 2025 event.