May 2021

How we did in May: The fund returned between -0.2% and -0.1% across the different share classes, compared to SPX 0.7%, SX5E 3.3%, EUR BAML HY (HE00 Index) 0.2%, US BAML HY (H0A0 Index) 0.3% and EM bonds (EMGB Index) 1.2%. Performance in May, gross of fees in EUR, was from: (i) Credit: -9bp, with -10bp from cash and 1bp from CDS; (ii) Rates: -12bp; (iii) FX: 3bp; (iv) Equity: 5bp, and (v) Other: 10bp.

In May, while credit and equity prices were largely unchanged on the month, there was an intra-month increase in volatility. This increase was caused by the rise in Indian cases and slow vaccination rates in Asia, combined with slightly hawkish Fed signals around tapering. We used this intra-month volatility to take some profit on credit protection and re-set new protection, mostly in IG credit. We also continued to rotate our rates short from the US to Europe, where vaccinations rates accelerated.

What we are doing now: Today, economies and the financial system are fragile and very sensitive to changes in monetary policy. Even a small withdrawal of central bank stimulus could mean higher yields and higher spreads, as we discussed in our recent Podcast. While central banks in smaller developed economies like Canada and New Zealand are signaling a gradual exit to pandemic-era stimulus, the Fed and ECB have remained on hold. However, we think this could change in H2, as economies almost completely reopen and inflation, possibly, remains elevated.

As a result, the portfolio remains cautiously invested in credit. In the short-term, spreads may continue to be support by the Fed and ECB maintaining a dovish-bias in their June meetings. However, spreads are near-all time tights and positioning is near record highs. Hence we remain 50% invested in credit, focusing on the areas where we still see some value: reopening linked companies (cruises, airlines e.g. CCL, Finn Air), cyclicals (financials, energy e.g. Pemex) and consumer discretionary (autos e.g. Aston Martin). We also maintain a high allocation to convertibles. We think convertibles are more attractive than vanilla credit, as convertibles’ equity-underlying offers better risk-reward and better protection to rising inflation. The convertibles are primarily in re-opening/ cyclical sectors, especially in bonds with low credit risk. We focus on those companies with exposure to Europe and Asia, as these companies equities’ have lagged their US peers and should catch-up as vaccinations and re-opening accelerates across Europe and parts of Asia (e.g. Dufry, IAG, WH Smith, Singapore Airlines).

In rates, we have taken profit on our shorts in the US and moved them into European periphery shorts. In the coming quarters, European growth may begin to accelerate with the re-openings, while US growth may decelerate as the initial reopening-boost fades and pandemic-related stimulus is gradually tapered.

We continue to expect volatility to rise over the coming months, potentially triggered by near-peak economic momentum, already-long positioning in credit and gradually less dovish central banks. We would use this opportunity to redeploy capital in beta-assets, including high yield debt and emerging market hard currency.

May was yet another positive month for most risk assets in spite of increased concerns regarding inflation risks. Developments on global vaccination and the resulting gradual ease of lockdown restrictions across major economies bolstered sentiment in May, providing support across markets. Strong data releases combined with ongoing monetary and fiscal stimulus also contributed to making inflation the dominant driver of performance, with traditional inflation hedges such as commodities and precious metals outperforming the broader market. Expectations that central banks would hike rates in response to inflation then provided strong tailwind to financials’ equities. EU and US banks indices closed the month up +7.4% and +5.2%, extending year-to-date gains to +34.7% and +37.6% respectively.

Performance in credit was mixed across geographies. US HY and IG were up +0.3% and +0.7% as income was complemented by favourable moves in spreads and rates. European HY and IG were broadly unchanged, while in our financial credit space performance remained generally positive with AT1s outperforming once again on the back of tighter spreads (c. -5bps). With rates expected to move higher, we remain positioned on the shorter end of the curve, with preference for bonds with 3 to 5-year duration and higher backend spreads, where extension risk is lower. While higher rates would generally be negative for fixed income, we expect our space to outperform the market given the relatively higher starting point for spreads and positive effect on fundamentals through bank profitability.

A constructive Q1 reporting season showed a generalised improvement in banks’ capital positions and resilient asset quality metrics. Margin pressure driven by low interest rates was generally offset by the use of TLTRO, operating cost reduction and normalised credit provisions, strengthening the already solid fundamental picture. New rating upgrades acknowledge this, with Moody’s placing DB under review for upgrade and changing the outlook on various Italian banks from negative to stable.

Issuance picked up in May to €40bn with the publication of first quarter results ending blackouts for the financial sector. Focus remained on MREL funding requirements as three-quarters of deals on a notional basis were in a senior format. The remaining €10bn amount was evenly split between T2 and AT1, and largely driven by refinancing of existing subordinated deals. In addition, call notices were announced on a couple of AT1 deals, namely Credit Agricole and Rabobank, and a handful of legacy securities, primarily out of UK entities, were redeemed as the regulatory clean-up continues. The technical backdrop remains quite constructive for issuers and we expect further issuance to continue ahead of the Summer break.

European bank earnings season is now complete – and it is safe to say it exceeded all expectations. The aggregate pre-tax profit of European banks in 1Q21 was more than triple the level in 1Q20, and perhaps more impressively, almost 20% higher than 1Q19 (and notably, the bank index remains below where it was at the conclusion of the 1Q19 earnings season). The banks collectively beat earnings expectations by an astounding 50%, and this is no one-off as it marks the third consecutive quarter where estimates were beaten by 45% or more. Clearly, the sell-side has plenty of catching up to do and as we look at updated numbers, it does appear the street remains excessively cautious on provisioning estimates and we suspect further upgrades will be forthcoming. Even on current estimates, though, the stocks look significantly too cheap, trading on ~4.5x pre-provision multiples, a healthy discount to historical averages and just half the multiple of where comparable US banks trade. Higher estimates and a cheap valuation is a typically good combination for making money – and higher dividend yields await this fall as well. The long European bank trade still has plenty of room to go, in our view.

The economic recovery continues to accelerate in Europe, providing a solid backdrop for the European bank story. As the vaccine rollout gathers pace, surveys of both businesses and consumers are starting to reflect increasing optimism towards the recovery. This past month we saw European advance PMIs ratchet to a new high (56.9), driven importantly by the services sector which has been under pressure since the pandemic began and is now above pre-Covid levels. The German IFO expectations index – a strong leading indicator for economic activity – also shot higher to a level seen just once in the past decade. As we look forward, elections in Germany could provide a further jolt to fiscal stimulus plans across Europe as the Greens party look well placed to take a prominent role in the new government.

Meanwhile, in the US, M&A bankers continue to be busy on our portfolio holdings. In May, BGC Partners (our holding) announced a sale of its insurance brokerage business to the UK firm Ardonagh for $500 mm in cash. This represents nearly 20% of BGCP’s market cap for a business segment that generated less than 10% of group revenues, was barely profitable, and where investors were ascribing little to no value. The freed up cash will be used to fuel buybacks, which should be significantly accretive to EPS with the stock trading at just 7x earnings. The next step for BGCP is likely to monetize its highly valuable Fenics electronic brokerage business – even if we apply just half the P/sales multiple of comps such as Tradeweb and MarketAccess, a sale could be worth more than the current market cap of the stock and leave the remaining businesses (which generate the bulk of the company’s earnings) for free.