Monthly Commentaries

September 2022

Economic and investment highlights

Economic, politics and markets

Global credit strategy

How we did in September: The fund returned between -3.6% and -3.3% across different share classes, compared to EUR HY (BAML HE00 Index) -4.0%, US HY (BAML H0A0 Index) -4.0% and EM sovereign credit ( BAML EMGB Index) -6.8%. Performance in September, gross of fees in EUR, was from: (i) Credit: -477bp, with -476bp from cash and -2bp from CDS; (ii) Rates: 113bp; (iii) FX: 8bp; and (iv) Equity: 29bp and (v) Other: 0bp.

Rather than a fresh start and renewed optimism, the post-summer return to markets has brought more turbulence to global asset prices. September was characterized by a repricing wider of global rates and credit spreads. While the key macro themes of inflation and the Ukraine war have already been well digested by the market, the squeeze in domestic energy costs (and gas supply concerns) is starting to bite as winter approaches. On the rates front, accurately pricing policy rates into forward curves has probably become even tougher with the ECB now shifting tone to a more aggressive stance. As if the macro mix wasn’t already tense enough, the new UK government further spooked the markets by throwing the textbook out of the window and adopting a stimulatory fiscal policy in a stagflationary economy already facing a tightening monetary stance. Unsurprisingly, Sterling bonds have been among the biggest underperformers in high yield this month. Our performance was slightly hurt by the credit re-pricing but largely insulated from the move in rates thanks to extensive hedging.

What we are doing now: We have increased our net credit investment above 87% as we see credit spreads very attractive on a 6-12 month horizon given the economic risk implicit in the price is now extreme, so that actual credit stress will be lower than priced in most scenarios. We have been slightly adding risk over the past few weeks, as rates widening hurt spreads too. We have also increased our rates duration to 2.6y as we expect rates volatility to moderate. For more analysis and our full views on credit see our latest Algebris Bullet.

We deploy capital mostly in high grade / high quality bonds (both DM and EM). Our average credit rating is BB+, so we have similar amount invested but substantial less risk than the average HY or EM fund.

On the cash book, we focus longs on quality across all segments we are active in. In financials, we focus on US banks seniors and selected European AT1s. In corporate credit, we focus on quality credits with resilient cash flows, ample liquidity and manageable debt maturities. Main focus on Telecoms and Healthcare where additional tightening expected from consolidation and proactive refinancing.  In emerging markets, we focus on countries with low refinancing needs in external debt markets and selected local markets close to the end of tightening cycles.

Our protection focuses on issuers which can’t sustain their leverage in an environment of weak growth and rising interest rates. In corporate credit, our focus is on unsustainable capital structures in over-levered retail, debt collectors and real estate issuers. In emerging markets, we focus on sovereigns with limited market access and high maturity walls.

Credit markets have re-priced quickly and aggressively over the past few months. As a result, the market offers extremely high spreads on every single credit in the global space, irrespective of quality. While this mispricing can persist for a few months, valuations similar to the one currently prevailing in markets have historically been followed by strong annual returns in credit. We thus think the current set-up represents an important opportunity for long-term credit investors, and we position our portfolio accordingly.

Financial Credit Strategy

September was a brutal month for risk assets, with the USD being one of the few assets that generated positive returns. It was a highly volatile month, with sharp moves across assets, some wholly or partially reversed into month-end. There were numerous drivers behind the widespread underperformance, with no monetary policy pivot yet in sight as central banks’ stance remains explicitly hawkish to tame inflation, prioritised over the risk of slower economic growth. The FOMC’s latest projections at the September meeting showed their willingness to keep rates in restrictive territory even if there was a noticeable rise in unemployment (3.8% by FY22 and 4.4% by FY23) whereas in Europe, the energy shock continues to drive inflation higher, leading to the potential need for more widespread fiscal intervention.

Major disruptions to the Nord Stream gas pipelines were met by Germany’s unprecedented €200bn package to cap domestic energy prices. In the UK, the government announced an ambitious (and potentially unfunded) fiscal package not seen for half a century, which initially resulted in a spike in Gilts’ yields before the BoE stepped in to temporarily stem the volatility. Finally, geopolitical tensions with Russia were ratcheted up another notch as Ukraine’s swift counteroffensive led to a substantial reclamation of occupied territories before Putin responded with the annexation of four Russian-controlled regions, heightening concerns around nuclear escalation.

Financial equities outperformed broader indices in September on a relative basis driven by the improving revenue outlook from higher rates. European banks closed the month down -4.7% against a -6.4% fall posted by the Euro Stoxx 600. In US, banks closed -7.8% against -9.2% for the S&P 500. Higher sovereign rates dominated credit markets through September with curves shifting 60bps higher and inverting some 10bps in the longer-end (10s30s). Gilts were the worst performers with rates gapping out 135bps and 10s30s inverting 50bps. Within the financial credit space, yields on Seniors increased by 125bps, dated Subordinated / T2s by 175bps, with AT1s yields widening the most by over 200bps. Despite these moves, we remain firmly positive on the prospect for our funds as fundamentals across our names remain unprecedently solid whilst yields have now reached all times highs of double-digits. Importantly, from a sectorial perspective central banks’ hawkish stance on rates provide continued support to the fundamental case for the financial sector.

Delving further into the UK given the fiscal package was one of the more negative surprises in September. Markets raising their estimates for the UK base rate to 6% by November 2023 grew concerns over loan affordability through the month, as c40% of fixed mortgages in the UK are expected to reprice by the end of next year. Whilst the higher borrowing cost may cause some asset quality deterioration, as the average household could be facing an additional c10% financial burden, we believe that the larger UK banks remain well provisioned and capitalised to absorb an increase in potential credit losses. Moreover, the incremental net interest income expected for the remainder of 2022 should allow banks to almost double this year’s provisioning before utilizing any existing buffers, and this benefit should accrue next year too.

Primary across European financials in September reached EUR 50bn, largely unchanged versus the previous month. However, the composition was remarkably different as the ongoing widening in credit spreads forced issuers away from Senior HoldCo into the Secured part of the capital structure, the latter having the largest monthly activity in the last 5 years. A similar trend happened across capital instruments with issuers opting for dated subordinated Tier 2s over AT1s. YTD issuance is some 35% / EUR 85bn higher than the same period last year, entirely driven by Senior and Secured (+45% YoY, c.85% of total issuance) with capital instruments continuing to benefit from this supportive technical trend.

Financial Equity Strategy

The upward march of bond yields continued in September in both the US and Europe, as central banks increased their hawkish rhetoric and raised interest rates more aggressively than expected to tackle inflation. Stocks and bonds fell simultaneously, with the US 10-Year yield rising 70 basis points and the S&P 500 falling 9%. A proposed tax cut in the UK added more fuel to the bond market sell-off with the 10-Year Gilt yield rising by nearly 130 basis points and resulting in the Bank of England buying bonds to calm the market. Despite the negative broader market, Europe outperformed, and European banks were flat on the month, as the group continued to benefit from higher interest rates and extreme investor positioning.Concerns about the economic outlook abound, but the bond market is now pricing in terminal interest rates of approximately 5% in the US and 3% in Europe, which looks reasonable. The biggest worry for Europe’s economy was that Russia would cut off gas supplies. While this has transpired, the economic disruption may well be somewhat less than feared a few months ago. Germany, for example, has already experienced a -15% slump in gas consumption YTD that has only resulted in a -2% contraction in industrial production. Corporates are adapting, as they always do.

The new monetary order looks like the environment prior to 2008. Inflation has led to the end of accommodative monetary policies by central banks with both the US and Europe setting rates in decidedly positive territory. The end of zero interest rate policy means that US, UK, and European banks should be more profitable going forward as net interest margins materially expand. Names such as NatWest could see as much as a 50% increase in earnings. Large COVID provisions remain unused on balance sheets, and higher net interest income should more than offset credit losses from an economic slowdown for holdings across our portfolio. It is quite plausible that even with worsening cost of credit, banks are positioned to be more profitable during 2023 than during any year of the previous decade.

Markets will likely be focused on the potential of recession and energy troubles through year-end, but banks in both the US and Europe appear to have priced much of an impending slowdown. Over the next several weeks, we would expect to see some sort of resolution to the market focus on Credit Suisse (whether via asset sales or capital raise), but also potentially on another long-standing sector concern, MPS. While these banks address their capital issues, capital return continues apace for the rest of the sector, with mid/high single digit dividend yields and banks like SocGen and Unicredit undergoing significant buybacks. With the most recent move lower in bank stocks, and a continued grinding higher of earnings estimates (which we think continue to be too low), the sector’s multiple is now 5x ’24, a level lower even than the Covid trough, when we were facing mid-teens unemployment rates, near-total shutdown of economic activity, and an ECB ban on dividends. Today we sit at multi-decade lows in unemployment with central banks in catch-up mode – a very positive backdrop for bank earnings.