Monthly Commentaries

July 2023

Economic and investment highlights

Economic, politics and markets

Global Credit strategy

How we did in July: The fund returned between 2.1% and 2.4% across different share classes, compared to EUR HY (BAML HE00 Index) 1.1%, US HY (BAML H0A0 Index) 1.4% and EM sovereign credit (BAML EMGB Index) 1.9%. Performance in July, gross of fees in EUR, was: (i) Credit: 290bps, with 313bps from cash and -23bps from CDS; (ii) Rates: 2bps; (iii) FX: -3bps, (iv) Equity: -19bps and (v) Other: 0bps.

What we are doing now: July was a strong month for risk and high yield credit. Valuations in risk assets are approaching 18-month highs, despite a marked softening in leading economic indicators in major developed countries and China. In our view, markets are underplaying chances of a recession scare later this year. We are raising cash via selling longs, and adding protection in the fund. Rates are widening and steepening due to increased issuance, despite softer data and lower inflation. We are gradually increasing duration as a result.

At the time of writing, since month end, we have continued reducing exposure. Net credit exposure is now closer to 73%. The fund has 19% protection in credit indexes and 11% protection in single name credits (via CDS and cash shorts). The fund also has 6% protection in major equity indexes.

As of July month end:

  • The fund continues to focus on bonds with c.8-10% yield and upside potential. The fund blended YTC is now 8.7%, with average rating BBB+.
  • We are moving the focus of our cash book from high yield / beta to duration / alpha as risk assets look vulnerable.
  • The fund duration is now 4.7y, the highest level since early 2021. In the last month, we reduced interest rate hedges and added some long bonds with relatively high credit quality. Net Credit exposure at month end was 81%.
  • Net exposure in financials (incl. cash short and single name CDS) represents 47% 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 32% 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 17% 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

Financial assets largely rallied in July as another 25bps interest rate hike by the FED, ECB and Bank of England increased hopes that the peak in rates is closer. The decision by the FED was viewed to be cautious move as a slowing CPI was marred by resiliently low unemployment rate and above-expectations GDP growth in 2Q. In contrast, the decision by the ECB to lift the policy rate to 3.75% was more clearcut with core inflation remaining elevated at 5.5% and total hikes still lagging those by the FED and Bank of England. There was a noteworthy change in the Bank of England’s statement where for the first time during this hiking cycle monetary policy was deemed to be restrictive.

Equity indices on average appreciated 3% in July with duration-sensitive Technology and Financials outperforming with higher moves of +6%. Across credit, indices rallied on average 1% with Financials again in the spotlight as higher beta subordinated parts of the capital structure continued to claw back the spread widening impact from March. Total return of AT1 indices is just -2% YTD considering c6% NAV was accounted for by Credit Suisse AT1s.

Second quarter reporting season for Financials continued where it left off in the previous quarter. With over half of the European banking sector by market capitalisation having already reported in July, there are unsurprisingly no material changes to key metrics across the sector. Themes remained robust with regards to net interest income (+30% YoY), no deterioration in the cost of risk (loan loss provisions largely stable QoQ), and ongoing accretion in core capital levels (c10bps higher QoQ and c70bps higher YoY).

The biennial EBA stress test was largely a non-event and confirmed the resilience of European banks under hypothetical severe macroeconomic assumptions. Despite harsher scenarios used with respect to certain pressure points like commercial real estate assets, leading European banks on average had lower core capital drawdowns than in the previous stress test conducted in 2021. Importantly, this drawdown was even better for historically weaker periphery banking entities as it came in on average at half the level of the 2021 exercise.

As expected, primary activity was subdued in July with banks having completed already c65% of their funding and capital plans for this year and the second quarter results blackout period. There were just a couple of capital transactions, one of which was a refinancing of an AT1 that was just 30bps more expensive for the issuer. Interestingly, although Senior issuance is just c5% higher YTD, capital issuance is c45% higher than the equivalent period last year, further reinforcing the view that any concerns around the sector have been short-lived.

Financial Equity Strategy

Financials continued to recover in the aftermath of the events of March, with the MSCI Global Financials index up 5.4% during July. US banks in particular saw a relief rally on no-worse-than-feared 2Q23 results, prompting a +11.6% squeeze in the BKX, though it remains significantly below pre-SIVB levels. As discussed below, European banks also saw strong earnings help maintain solid performance for the group, which was up 5.5% in July. Insurers lagged, up less than 3% and 2% in the US and Europe, respectively.

With the bulk of European bank 2Q23 earnings behind us, we can safely say they continue to beat a high bar. Pre-provision net revenues exceeded consensus expectations by a healthy 7%, while provisions came in 17% better than expected. In fact, for all the doom and gloom around the European economy that persisted throughout 2022 and into this year, consensus provision levels for 2023 have now been slashed by an astounding 23% YTD already. Together with revenue upgrades, positive EU bank earnings revisions continued coming out of the quarter, for a remarkable 140th week in a row. The earnings upgrade cycle, in stark contrast to the US banks and to many non-financial sectors, is alive and well in European banks.

The premise underlying the lazy consensus view  of late last year that “you cannot be long banks into a recession” has turned out to completely wrong. Equally wrong has been the consensus view that what happened with US bank NIMs into the Fed tightening cycle was bound to repeat itself in Europe as well. Of course, we would prefer not to see a recession in Europe but the emerging backdrop of minimal real GDP growth (with some degree of positive nominal growth) and a plateauing of interest rate levels by the ECB would be a perfectly acceptable backdrop for investing in European banks looking forward. Free cash flow and existing excess capital can be directed towards shareholders (rather than having to fund heavy balance sheet growth), cost of credit stays manageable, and net interest income levels remain elevated as higher deposit costs are mitigated by rolling-in of structural hedge books. The net of this all would be continued high profitability levels (even if we are approaching or even at “peak” net interest margins in some markets) and extremely robust shareholder payout yields. None of which, of course, is being priced in currently with our EU bank holdings trading at <6x earnings, with the market implicitly saying that sustainable profitability is roughly half the current level. We think this is altogether too punitive, and while patience may be required to prove us right, 7-8% dividend yields and 50-100% upside to normal historical valuations should attract investors that continue to look at the sector with a rear-view mirror.

Lastly, we highlight the announced takeover of portfolio holding Sculptor Capital during July. The company was acquired by Rithm Capital for about a 40% premium to the level the stock was trading at in May, at which point any takeover premium had been pulled out of the stock (in our view). While we felt the company could have commanded a higher multiple, we are pleased to have another portfolio holding taken out. In a sector that has had very little M&A activity in the past several years (certainly relative to other sectors), we have seen several of our “off-the-beaten-path” holdings acquired at significant premiums, including Creval, MoneyGram, Cowen, and now Sculptor just in the past two years. We will continue to look for idiosyncratic ideas where standalone value is substantial but also where further upside can be realistically attained in takeout scenarios.