Monthly Commentaries

October 2023

Economic and investment highlights

Economic, politics and markets

Global Credit Strategy

How we did in October: The Fund returned between -1.1% and -1.3% across different share classes, compared to EUR HY (BAML HE00 Index) -0.3%, US HY (BAML H0A0 Index) -1.2% and EM sovereign credit (BAML EMGB Index) -1.2%. Performance in October, gross of fees in EUR, was: (i) Credit: -122bps, with -136bps from cash bonds and 14bps from CDS; (ii) Rates: -10bps; (iii) FX: -3bps, (iv) Equity: 15bps and (v) Other: 0bps.

What we are doing now: October was a weak month for fixed income markets. US rates continued to widen on the back of stronger than expected macro data, and the persistence of the widening started affecting global credit. HY spreads widened almost 50bp over the month. Geopolitical risks increased, putting some pressure on commodity prices. We saw weak markets as the opportunity to take off some hedges, particularly in CDS indexes, which served us well during the month. We maintained duration close to historical highs and added long expression in the US. Towards the end of the month, data turned softer and rates started tightening. We suspect the tone into year-end may be stronger.

We continue to think that the economic slowdown will take a more central role in the market narrative. As a result, our overall beta is lighter vs the past two years. Also, we focus on cash bonds with 8-10% yield while using flow credit as a protection tool. We continue to maintain duration slightly above 5y, on the high side of the historical range. We think central banks are done hiking and data softness will support long end rates too. In EM , we focus on local markets where central banks have room to cut.

At October month end, net credit exposure is 99%, as we took off the c.30% protection in CDS indexes which we held against our cash longs. The Fund maintains c.5% protection in major equity indexes.

Financial Credit Strategy

October was dominated by the abrupt start of the Israel-Hamas conflict, with concerns around a potential larger escalation in the region leading equities lower across regions. The S&P 500 was down for the third consecutive month, recording a -2.1%, while European and EM equities lost 3.6% and 3.9% respectively. European bank equity was down 3.6% in the month, in line with the broader market, although they remain one of the best asset classes this year at +12.4%.

Performance in credit was more mixed, once again driven by central banks and macro. Resilient data in the US raised the probability of another FED hike, leading 10y Treasuries 20bps higher to 4.9%, a negative for USD credit. On the contrary economic and inflation data in Europe came out soft, leading to an uneventful ECB meeting at end-October so that European govies and bonds outperform. Financial credit was broadly in line with the market across Tier 2 and Senior, with AT1s down c.0.5% on average on a mix of rates and spreads (c.25bps higher). We remain very positive on the asset class and keep taking advantage of the inverted curves to rotate some of the front-end positions, extending duration across the names and bonds we like at 9-11% yields, as we believe these offer one of the best risk-reward of the wider credit space today.

While the prospects of a wider economic slowdown remain an overhang to a more meaningful asset repricing, the sector remains best prepared to navigate future challenges. Around half of the sector reported Q3 results through the month, characterized by ongoing profit beats (8% on average, excluding the UK), capital buildup and resilient asset quality. Revenues kept growing overall, with NII well supported by low deposit beta (10-13% in Spain/Italy), while costs were mostly in line and subject to limited inflation. With the exception of specific, well-known pockets of loans (e.g. CRE) showing early signs of deterioration, overall credit quality trends remain benign supporting lower provisions (-5% avg. QoQ). At mid-single-digit ROTE, banks have now meaningful buffer to absorb potential losses on the loan book while keep generating capital, leaving the fundamental picture for our asset class unprecedently solid.

October also saw some relevant rating agencies’ decisions in Europe. S&P upgraded Greek sovereign debt to IG after more than a decade and affirmed its BBB rating for Italy, with Stable outlook. This came as a relief for the market and the BTPs. S&P also took a number of positive actions on Italian banks, mainly UniCredit and Intesa, citing constructive fundamentals and manageable credit losses, supported by the EUR200bn of government guarantees.

Primary activity tracked lower in October due to blackout period before results. Across European financials, issuance was concentrated almost entirely in the Senior funding space with just one capital (insurance) trade. Overall EUR400bn issuance so far this year is tracking 5% lower than in 2022, with capital running 20% higher YTD at EUR50bn. Last year November was the most active month from a primary perspective and the same happen this year as issuers look to get a start on pre-funding for 2024 given what appears to be a top-out in central banks’ rates.

Financial Equity Strategy

The Fund returned -4.28% in October, outperforming US and European banks (both down over 5%) but slightly lagging the broader global financials index. Year to date alpha continues to be strongly positive.

Bank stocks stepped back in October as concerns about the bond market outweighed what was a generally positive earnings season. However, in some cases the bottom-up fundamentals were so strong that the stocks enjoyed powerful bounces despite the macro headwinds. The southern European banks in particular continue to post very impressive results which are driving substantial earnings upgrades a full three years now into cycle. The various fears around these stocks – peak margins, rising cost of risk, regulatory pressures, bank taxes – are well understood by now, and as we have discussed in the past, very much priced into the stocks and then some. The earnings results from 3Q suggest the right banks in the right markets continue to power ahead despite all the bearish concerns.

Banco Sabadell in Spain is one such example. Net profits beat expectations by 21%, with NII up another 6% in the quarter (beating consensus by a healthy 4%) and solid cost control combining to generate a 10% beat on the pre-provision line. Credit quality continues to be pristine and excess capital marches higher, providing scope for a substantial capital return story in 2024. Forward earnings were upgraded following numbers by no less than +12%. The bank is printing a robust 11.6% ROTE, with guidance for 2024 profitability to be even higher. What is this all worth? In our view, close to tangible book – yet the stock trades at half that level. Consensus is baking in a gradual decline in earnings in the next several years. If as we expect the earnings power to be more resilient, we should not only see continued earnings upgrades but also a very substantial rerating, as well. On top we have close to 1/3 of today’s market cap likely to be returned to shareholders by 2025. There are multiple ways to win here on the upside, and the strong balance sheet and low starting point valuation should protect on the downside as well.

The risk reward looks asymmetric here, and in various other key holdings for us across the portfolio.  Identifying stocks where earnings power continues to move higher and yet where forward profitability can be protected against a potential reversal lower in rates is crucial in generating alpha at this point in the cycle. We believe we are well positioned in names that are increasingly looking to lock in the benefit of higher rates as the ECB hiking cycle gets long in the tooth. As we look across our portfolio, we have core positions in banks where earnings should be resilient, capital return to shareholders is expected to be 30-60% of current market cap by 2025, and yet the PE multiples are just 4-5x. In our view this is very much an anomaly and more importantly, a highly attractive opportunity for investors on an 18-24 month view.