Monthly Commentaries

June 2023

Economic and investment highlights

Economic, politics and markets

Global Credit strategy

How we did in June: The fund returned between 1.4% and 1.6% across different share classes, compared to EUR HY (BAML HE00 Index) 0.5%, US HY (BAML H0A0 Index) 1.6% and EM sovereign credit (BAML EMGB Index) 2.2%. Performance in June, gross of fees in EUR, was: (i) Credit: 176bps, with 215bps from cash and -39bps from CDS; (ii) Rates: -11bps; (iii) FX: 6bps, (iv) Equity: -15bps and (v) Other: 0bps.

What we are doing now: Markets have fully priced out the recession fears that emerged post US banking stress in March / April. High yield spreads are at 1y tights, and US equity valuations are close to all-time highs. US 10y Treasury yields are just 50bp shy of September 2022 levels despite inflation running at half the September levels. Data, on the other side, are deteriorating in both Europe and US and major economies are set for flat or just slightly positive growth in 2023. In our view, markets are underplaying chances of a “growth scare” later this year and we position accordingly: we focus cash longs in areas where valuation is dislocated vs fundamentals (rather than pure beta), we add duration to the fund, we add some protection.

  • The fund focuses on bonds with c.8-10% yield and upside potential. The fund blended YTC is now 9.3%, with average rating BBB+.
  • The cash book yields c.200bp more than comparable indexes, on average. This underscores a credit selection focused on issuers undervalued vs fundamentals and with idiosyncratic upside.
  • The fund duration is now 4.1y, the highest level since early 2021.
  • Net credit exposure is now 84%. The fund has 16% protection in credit indexes, 10% protection in single name credits (via CDS and cash shorts). The fund also has 4% protection in major equity indexes.
  • Net financials exposure (incl. cash short and single name CDS) represents 49% of the book. We focus on subordinated debt of national champions in Europe yielding 9-12%. We find this one of the most undervalued areas in global credit markets hence maintain strong exposure. We increased exposure sensibly in March and have been reducing recently.
  • 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. At sector level, we have positions mostly in communications, energy / utilities and high-quality residential real estate. In US, we own bonds with 8-9% yield and potential for upcoming refinancing.

Net EM exposure (incl. cash short and single name CDS) represents 17% of the book. The focus in EM is mostly in local markets as selected LatAm and Asia countries will be able to cut soon and fast. In hard currency we focus on EUR issues at attractive yields vs credit standing.

Financial Credit Strategy

Even as headline inflation continued to decline, Central Banks’ focus on a more persistent core inflation led to further interest rate hikes across the major economies in June. Ranging from 25bps by the ECB to 50bps in the UK, the Fed was the only major entity who unexpectedly chose to pause in order to reassess datapoints as the US economy continues to show signs of resilience. Accordingly, it remains premature to assume the June pause will be an inflection point for US rates with future hikes likely if jobs and wage growth do not moderate alongside core inflation.

The hawkish tone set by central banks helped lift the equity indices of US and European banks by +6% and +9% respectively whilst the performance in credit was far more subdued given the rate uncertainty. On average, AT1s rallied around 1pt in June as investor demand for higher yielding higher quality assets recovered further from the March lows, with Senior and subordinated spreads closing a touch tighter by 20bps and 25bps respectively.

More positive rating actions for the sector materialized in June as agencies continued to catch up and acknowledge the ongoing fundamental improvements for both leading institutions as well as second tier players. DB was raised to A- by one agency which led to upgrades across the whole of its capital structure, firming further its T2s composite Investment Grade rating. Sabadell was placed on positive outlook which increases the likelihood of a near-term upgrade that would make its non-preferred Senior IG eligible. Finally, both leading Irish banks were upgraded, and Austrian banks could soon benefit from higher state support.

European banks paid back almost half of the outstanding TLTRO (€500bn out of €1,100bn) with Italian banks accounting for a significant c.25% share of the total. Despite some concerns in the market that there could be a potential liquidity squeeze for the sector, banks have had ample time to plan this repayment and did so without much trouble. Other ECB facilities such as MRO and LTRO remain available for those entities that need liquidity, but initial indications are that these are largely surplus to requirements for the time being with only €22bn drawn or 4% of returned TLTRO funds.

Issuance continued at a healthy pace in June and at €60bn was the 2nd most active month after January (€95bn). As expected, given the TLTRO maturities, primary came mainly in the form of Senior and secured funding, accounting for c.85% of the total YTD, but it is noteworthy to highlight that capital issuance via both T2 and AT1 was some 50% higher in 1H23 compared with 1H22.

Most notably in AT1s, we saw the first two deals since the CS event in March, including one from a small issuer that was more than 10x oversubscribed, confirming that the market is receptive to new deals if priced correctly. As for the other issuer, BBVA tapped the market to refinance its upcoming AT1 call and further strengthens the case for a very limited number of AT1 extensions this year. Given c.€8bn of additional AT1 calls into year-end, we expect a few more primary trades to emerge over the coming months as interest in higher yielding securities remains robust and legacy instruments continue to be tendered / called.

Financial Equity Strategy

Global financials bounced back in June, with the sector finishing the month up 3.4% (in EUR). Japanese and European banks led the way, up over 9% and 7% respectively during June, while US banks recovered some of the post-SVB losses with a nearly 6% gain. Still, the performance dispersion between regions has been eye-opening this year, with Japanese banks +16% YTD through June, while US banks were down 19% over the same period. Generating alpha this year has not been just about regional allocation, however. Stock selection has been equally important: in Europe, the top five bank stocks have outperformed the bottom five by 56% YTD; in Japan, by 51%; and in the US, by 50%. The volatility of the sector and dispersion within it continues to create significant money-making opportunities.

One such opportunity which we have not discussed much is insurance, and in particular life insurance and reinsurance names in the US and UK. These have not been a focus in the Fund for several years, and in fact our exposure to these sub-sectors was just ~3% at the end of 2022. This has since quintupled to ~15%. The tumult around US banks has led to sharp (and in our view, unjustified) underperformance of the life insurance space in the last several months, but in reality many of these companies face none of the steep funding pressures, rising regulatory costs, or capital constraints that American banks do right now. In fact, unlike banks, higher interest rates remain a distinct positive for the likes of MetLife and Unum. Moreover, each of the life insurance names in our portfolio continues to aggressively deploy capital via share buybacks, with double-digit total payout yields that in some cases are in excess even of European banks with valuations similarly low.

In the reinsurance space, the incumbent players are benefiting from the tailwinds of a hard (strong) pricing market, positioning them well both from a top line and book value growth perspective. The pricing power of reinsurers is perhaps as strong as it has ever been, driven by a capital deficit in excess of >$100 bn in the sector. This is particularly the case in property cat reinsurance – and the enhanced pricing power will be reflected both in higher premiums but also less attractive terms and conditions for the insured. We believe the improvements in the underlying fundamentals of the sector are underappreciated with select names in both the US and UK trading at decade-low (mid-single digit) P/E multiples.

As we survey the global financials landscape after a highly volatile first half of the year, we continue to view European banks as the most compelling risk/rewards in the sector, with the bullish thesis on capital return, earnings upgrades, and valuation/positioning still very much intact. But as discussed last month, we think stock selection will be increasingly important as we approach the end of the central bank hiking cycle. In the meantime, we continue to find attractive and idiosyncratic value emerging elsewhere and have ample cash to put to work as opportunities arise across the sector.