Monthly Commentaries

May 2023

Economic and investment highlights

Economic, politics and markets

Global Credit strategy

How we did in May: The fund returned between 0.3% and 0.6% across different share classes, compared to EUR HY (BAML HE00 Index) 0.7%, US HY (BAML H0A0 Index) -0.9% and EM sovereign credit (BAML EMGB Index) -1.3%. Performance in May, gross of fees in EUR, was: (i) Credit: 59bps, with 67bps from cash and -8bps from CDS; (ii) Rates: 15bps; (iii) FX: -8bps, (iv) Equity: -21bps and (v) Other: 0bps.

What we are doing now: 2022 inflation and March banking concerns have left plenty of dislocations in credit markets. Hence areas of deep value are available to bond investors. However, index spreads are relatively tight, so that risk must be concentrated where stress is unfairly priced. Over the past month, we have been rotating financials into corporates as relative valuations adjusted. We extended duration on the EM book but left its size stable.

We expect disinflation to continue, and finally gain steam in Europe. We expect core inflation to fall below 4% in late 2023 in both the US and Europe. Global data will continue to slow down. Under these conditions, central banks will stop hiking. Hence, the recent widening in global rates is an opportunity to extend duration. The Global Credit Opportunities Fund duration is now 3.2y vs just under 2y in early April.

  • The fund focuses on bonds with 10% yield and upside potential. The fund blended YTC is now 9.9%, with BBB- rating and 3.2y duration. Net exposure is 86%, leaving some room to add risk in case of market stress.
  • Net financials exposure (incl. cash short and single name CDS) represent c.50% of the book. We focus on subordinated debt of national champions in Europe yielding 9-12%. We increased exposure sensibly in March and have been reducing recently.
  • Net corporate exposure (incl. cash short and single name CDS) represents c.31% 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 c.16% of the book. The focus in EM is mostly in local markets as inflation is falling fast in Latin America and selected Asian and European countries. Early hikers will be able to cut rates from 10-14% to 6-8% over the next 12 months. Both rates and FX will benefit.
  • Gross exposure in the fund is 142%. Net cash longs are 98% (including single name CDS), with 12% CDS index short against it.
  • The Global Credit Opportunities Fund duration is now 3.2y vs just under 2y in early April, but still lower versus main indexes (c. 4.3y for global HY and 6.9y for global IG). YTC vs duration and YTC vs rating remain the most attractive of the past five years for the fund.

Financial Credit Strategy

A rather eventful May headlined by several key developments in the USA. The month started with renewed concerns around US regional banks and culminated in the acquisition of First Republic Bank by JPMorgan, subsequently followed by asset sales from another US regional, PacWest. Both events helped shore up confidence in the US financials’ space; the US banks’ equity index recovered half of its monthly loss albeit still ended -6%, taking YTD losses to 23%. In sharp contrast, European banks remain largely unaffected by these turbulent US regional developments, losing just 3% on the month but retaining their 8% YTD gains.

Despite the unrest with the US regional banks, the Fed applied a look-through approach and followed through with another 25bp rate increase, taking the cumulative to 500bp since the start of the hiking cycle in March’22, of which 200bps in the last 6 months. Given recent comments and economic datapoints, there are growing expectations that the Fed will pause in forthcoming meetings to take stock of its monetary tightening actions.

On the other hand, the UK’s April CPI reading of 8.7% came in hotter than expected and led to a sharp upward repricing of the terminal interest rate from 4.75% to as high as 5.5%, implying at least three more rate hikes. UK rate curves understandably underperformed with parallel shifts of 40-50bps compared with average moves of just 10-20bps in core Europe and US. That said, one common feature across all regions was that 2s10s curves inverted a further 10bps in May as Central Banks got closer to terminal rates.

European banks completed their reporting season in May with the positive trends observed in the previous month unaltered. Excluding Credit Suisse, stock of deposits has been stable across Europe with some slight shifts from current to time accounts primarily led by corporates. Recall that these same entities were charged during periods of negative interest rates so naturally seek higher remuneration in a positive rate environment. Yet aggregate deposit betas remain low leaving customer margins on a positive trajectory for the quarter. Capital build across the sector averaged 20bps with entities in robust positions to pursue their announced dividend and buyback policies.

After a very subdued April, primary issuance naturally picked up with the end of results blackout and returned to its monthly run-rate of EUR40bn. Unsurprisingly, given the upcoming TLTRO maturities and MREL deadlines, this was c.90% concentrated in the Senior format with just a few Subordinated trades from issuers that completed their capital needs for the year.

Since the Credit Suisse event in mid-March, AT1s have continued their steady recovery, adding a further 2pts in May and are now unchanged YTD on a total return basis. This is testament to just how much the European banks’ financial sector has strengthened itself across a broad range of facets that sets it significantly apart from how it was perceived during previous systemic events since the Global Financial Crisis 15 years ago.

Financial Equity Strategy

Global financials continued to search for a footing in the aftermath of the events of March, with the sector down almost 4% in the month of May. The US regional bank space continued to be in focus, with the stocks down over 15% in the first four days of the month, only to then rally 20% in the following four weeks as liquidity concerns dissipated and steep valuation discounts began to attract fundamental buyers. Notably, while US regional and large cap bank stocks are still down significantly (-23% and -33% respectively) for the year through the end of May, European bank stocks are up nearly 8%.

This outperformance, in a period during which three large US banks failed and a large Swiss bank was taken under, is indicative of just how much European banks have progressed after a long decade facing the dual headwinds of negative interest rates and balance sheet recapitalizations. But despite the impressive resilience of the group, we should point out that European banks as a whole have actually derated from ~7.5x to ~6.5x since the beginning of the year. This leaves stocks trading at valuation multiples only seen before during times of crisis (and massive earnings cuts) such as the Eurozone debt crisis, Brexit, and Covid. But this time we have earnings getting upgraded – and in fact the earnings upgrade cycle continued with a very strong performance in the 1Q23 earnings just completed. 92% of EU banks beat consensus with an average beat of +17%, and these were broad-based across net interest income, fees, costs, capital, and provisioning. Profitability is back at 12% ROTCE for the sector, nearly 50% above where it was in 2018 when the European bank index was 40% higher than it is today.

The extremely depressed multiples suggest the market is sensing peak earnings. While this may well be the case for some banks, our largest holdings currently are in names which should continue to benefit on a lagged basis from the monetary tightening cycle (for instance, due to the structure of the market and/or structural hedge books on the bank’s balance sheet). Certainly, the three tailwinds that we have discussed for months around European banks – earnings upgrades, capital return, and historically low valuations – continue to be broad and significant supports for the group. But, as we near the end of the ECB hiking cycle, we suspect performance dispersion will grow and stock selection will become increasingly important.

In the US, banking regulators have been signaling the imposition of higher capital ratios for several quarters as they work through the final pieces of Basel III. Moreover, in the wake of recent bank failures, regulators have also discussed stricter regulations on banks in the $100-$250 billion assets range. The time horizon for changes to become effective is likely to be elongated; any new proposals will be subject to comment periods and final rule-writing procedures that could take 1-2 years, and then once approved, rules will likely be phased in over multiple years. In terms of changes, it is expected that regional banks will no longer be able to deduct unrealized securities losses on available-for-sale securities from certain capital ratios. In addition, the largest, most complex institutions are likely to see sizeable capital charges related to operational risks.

In all this complexity, there will be winners and losers. Our approach to navigating these changes has been to own banks that are well positioned given fortress capital positions, robust internal capital generation, strong deposit bases, and top management teams. Despite the debacle of March, these banks do exist in the US – and many are trading at a fraction of their historical valuations. Overall, US banks remain a relatively modest portion of the portfolio. But as value investors, we look at the space with interest as you can now buy quality assets on sale when valuations have overshot, fundamentals are potentially beginning to stabilize and sentiment is deeply negative. Further, M&A is likely to become a key factor in the group in the next 12-24 months as banks are forced to scale up, creating ample opportunities for alpha generation. Certainly an area to keep a close eye on.