Monthly Commentaries

September 2023

Economic and investment highlights

Economic, politics and markets

Global Credit Strategy

How we did in September: The fund returned between -0.40% and -0.52% 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) -3.2%. Performance in September, gross of fees in EUR, was: (i) Credit: -73bps, with -78bps from cash bonds and 5bps from CDS; (ii) Rates: -28bps; (iii) FX: -11bps, (iv) Equity: 64bps and (v) Other: 0bps.

What we are doing now: September was a weak month for risk assets. The US yield curve continued to steepen, and weakness in long-end rates spilled over to credit. Over the month, high-yield credit spreads widened 50bp, and global equities lost 5%. The Fund entered the month with c.70% net credit exposure as a result of increased protection in August. Nonetheless, our cash long repriced. Hedges in credit and equity indexes provided protection, hence the Fund outperformed major credit indexes on the month.

We continue to think that the economic slowdown will take a more central role in the market narrative. As a result, our overall risk 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 increase duration in the Fund, now close to 5y and on the high side of the historical range. We think central banks are done hiking and data softness will support long end rates too.

At September month end, net credit exposure is 66%, including 27% protection in credit indexes and 12% protection in single name credits (via CDS and cash shorts). The Fund also has 10% protection in major equity indexes.

More in detail, at the time of writing:

  • The Fund blended YTC is now 9.3%, with average rating BB+.
  • The Fund duration is now 5.3y, the highest level since early 2021. The bulk of our duration increase over the past two months was via US rates, where we see most value. We also increased duration in LatAm local markets, which suffered as a result of Treasury volatility in September. We are marginally long in European rates too, but more cautiously.
  • Net exposure in financials (incl. cash short and single name CDS) represents 48% 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 30% 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 positions with higher beta and fewer idiosyncratic catalysts.
  • Net EM exposure (incl. cash short and single name CDS) represents 14% of the book. Since July, we have been taking down exposure by taking profit on longs in HY hard currency credits. In September, we added back to local currency duration and FX as the correction turned levels more attractive. FX exposure is now 6%.

Financial Credit Strategy

Ongoing hawkish rhetoric from central banks in the US and Europe tainted sentiment across financial assets in September. Sovereign rates moved higher across the curve, anywhere from 20bps to 50bps, with the longer end underperforming as curves steepened. Consequently, this fuelled the risk-off sentiment with equity indices on average some 2% lower but still holding onto decent year-to-date gains of c.11%.

In contrast, European financial equities bucked the trend with indices rallying c.1% to bump total returns this year to c.22%. Financial spreads were largely unchanged across the capital stack with the outright move lower entirely attributed to the gap out in rates. Underpinning this spread trend has been the better-than-expected operating performance of the issuers through the first two quarters of the year: ongoing improvements in profitability, no worrying signs of asset deterioration, and continued build-up of excess capital.

Greek banks took a step forward to investment grade as major agencies announced rating upgrades reflecting their improving fundamentals coupled with structural improvements in the domestic economy. Three of the four Greek banks received double notch upgrades which now leaves them firmly in the BB category. This ratings’ tailwind is not just concentrated in Greece and has started spreading to other historically challenged banking systems such as those in Ireland and Portugal.

Taxation returned to the fore as the Dutch became the latest government to turn to the financial sector to narrow its budget deficit. In an unsurprising move given the strength of the overall profitability of the sector, the Dutch government proposed to help fill its €4bn deficit through a €350mn bank tax coupled with a new tax on share buybacks. Whilst the former has a rather negligible impact on earnings at just c.3%, the structure of the latter will require refinements in its current form and perhaps is indicative of the current direction of travel.

After the usual summer lull, primary activity picked up in September across the entire capital structure and was more than in the previous two months combined (July and August). Whereas Senior issuance year-to-date has kept pace with last year at c.EUR325bn, EUR50bn of capital issuance across both Tier 2s and AT1s is some 20% higher than in 2022 despite the Credit Suisse event in March of this year.

September saw a pick-up in AT1 refinancings with entities using a novel approach of up to 6-months early tenders; these were well received by existing holders with c.65% acceptance rates. Encouragingly books for financial primary transactions have remained well covered despite higher rate uncertainty as the greater coupons remain attractive in an elevated, albeit falling, inflationary environment.

Financial Equity Strategy

Financials slipped in September, with the MSCI AC Financials index down ~2%, though the sector meaningfully outperformed the broader global index, which was down over 4% in the month. There was significant dispersion within Financials, with Eurozone banks up 25 bps while US regional lenders were down over 5%. US and European insurers were flattish.

Higher rates were the key focus during the month as the long end of the US curve backed up nearly 50 basis points with bund yields not far behind. BTP yields followed suit, up nearly 70 basis points during the month. The move has brought investor attention back to unrealized losses on bank balance sheets. This is particularly important in the US, where many regional banks screen to be poorly capitalized when factoring in mark-to-market losses on their securities portfolios. We remind that while our exposure to US banks is down significantly at just ~10% of the portfolio currently, the exposure we do have is to banks that are best in class in terms of capital (both adjusted and unadjusted for MTM losses), have manageable CRE books, and where we see margin pressures abating. While we have limited exposure for now, we are already starting to find interesting opportunities in small US banks that trade historically cheap and are likely participants in the bank M&A wave that we expect later in 2024 and 2025 as new regulations come into effect. There are crown jewel franchises now on sale and while the next couple quarters will be choppy, we continue to monitor closely for attractive entry points with asymmetric risk/reward.

The key point for European banks is that higher rates should have a relatively muted impact on capital. This is contrast to mid-sized regionals in the US where the rules changed halfway through the game, leaving them unhedged for the type of rate move we have seen in the last couple of years. The average European bank loses just 4% of CET1 capital in a 200 bps interest rate shock, and are required to keep this sensitivity to 15% or less. As we know from Silicon Valley and First Republic, this is not the case in the US. In addition, the risk from widening sovereign spreads is materially lower than historically: in Italy for instance, bank capital is eroded by just 20 bps for every 100 bps of BTP spread widening, versus nearly 100 bps erosion a decade ago. In short, the regulations which have been imposed in Europe in the aftermath of the GFC and Eurozone crisis have been effective, and European bank balance sheets are now in excellent shape. Bank shareholders have and will continue to be the beneficiaries, with significant returns of excess capital (over 1/3 of today’s market cap in the next couple of years in some cases), just at the same time that US banks are under heavy pressure from a new set of regulations that is likely to put a strong dampening effect on capital return in the next 12 months.

Banks in Europe are a clear winner of “higher for longer” via higher deposit margins, but they should continue to lock in these benefits as hedge books get recycled at much higher rates, protecting profitability even if (when) the ECB starts to cut again. They are well positioned for this interest rate backdrop, but also well positioned for a potential macro slowdown with limited recent balance sheet growth, legacy Covid reserves still substantial, and much of their SME books under government guarantees. These are all unique to this cycle and look nothing like how bank balance sheets were set up in prior down cycles. We continue to see excellent value in the sector trading at 6x earnings – which amazingly is the same level it traded at during the depths of the Eurozone crisis. While we wait for the re-rating over the next several years, banks can create significant (and risk-free) shareholder value by buying stock at the gift prices the market currently offers at significant discounts to tangible book value.