April 2022

How we did in April: The fund returned between -0.7% and -0.5% across the different share classes, compared to EUR BAML HY (HE00 Index) -2.9%, US BAML HY (H0A0 Index) -3.6% and EM bonds (EMGB Index) -5.7%. Performance in April, gross of fees in EUR, was from: (i) Credit: -110bp, with -58bp from cash and -52bp from CDS; (ii) Rates: 43bp; (iii) FX: 8bp; and (iv) Equity: 0bp and (v) Other: -1bp.

In March, spreads tightened despite the war in Ukraine. The fund therefore used this as an opportunity to de-risk the credit portfolio, which helped insulate performance in April as spreads re-widened aggressively.

What we are doing now: We continue to see 2022 as a challenging year for risk assets, bonds in particular. However, as the fund de-risked at the start of April, we are using the current market weakness as an opportunity to tactically add risk. This is in senior parts of the capital structure and in sectors that benefit from higher rates (e.g. US senior financial bonds).

Overall we maintain a defensive stance on our cash book, with 60% in net long cash credit opportunities. On the cash book, we focus on bonds with low duration, high coupons and shareholder/government support. While we have reduced our overall short positions in rates, we maintain some short in duration-sensitive assets, such as BTP, and some degree of equity protection.

Our longs focus on sectors which can perform well even in a tighter monetary policy environment next year: cyclicals that benefit from higher interest rates (e.g. we have been adding exposure in US senior financials), travel/ reopening (e.g. airlines, cruises), and defensive consumer discretionary (e.g. luxury cars). In convertibles, we maintain a high allocation to firms with low credit risk and upside linked to reopening and higher commodity prices (e.g. Total and BP). Overall in EM we remain lightly positioned and keep a good degree on protection on vulnerable countries, such as Egypt and Turkey.

We continue to think higher-than-target inflation will weigh on asset prices and beta. The dramatic events in Ukraine will accelerate both inflation and volatility, meaning liquidations in beta may take place. We believe the fund should be set to outperform in this challenging environment, and will be able to capture opportunities as volatility rises further.

The negative tone from March spilled over into April, leading risk assets lower across the board. Leading equity indices closed the month down c.4% on average, doubling YTD losses, while sovereign rates widened by an additional c.30bps across curves, ending at new highs from a yield perspective. Performance was mixed from a geographical and sectorial perspective due to the varying concerns around the probability of stagflation or recession as investors grapple with different scenarios. Whilst the macroeconomic backdrop remains uncertain, we view the recent repricing in our space favourably as all-in yields can be locked in at almost double those at the start of the year without compromising on duration and issuer quality, the latter of which remains our primary focus.

From a market moves perspective, the UK’s FTSE remained the exception at +4% YTD versus the broader European index (SX5E), down 11% this year. This goes some way to explaining the difference between European banks -6% and EuroZone banks -12%; for reference US banks ended April down 11%, bringing YTD losses to -16% roughly in line with the average of a broad set of equity indices there. On average in April, financials’ credit spreads widened c.15bps in Senior and c.25bps in T2, with AT1s c.4pts lower due to their higher beta nature. The move affected the sector irrespective of underlying fundamentals, resulting in increasingly attractive risk-reward on the highest quality names.

Fundamentally the financial sector globally remains on a very sound footing. First quarter results confirmed the positive gearing of the sector to higher rates, particularly in the US on the back of market expectations around future FED policy actions. Expanding net interest margins, coupled with better than expected fee and cost dynamics as well as resilient asset quality, allowed banks to broadly beat consensus profits. Similar dynamics were reported by European based entities though rate benefits were less material due to the perception of a slower moving ECB. Importantly, provisioning has remained stable in the 30-40bps range, which is on average lower than guided for the full year due to the ongoing benefit from government guarantees and Covid-related support measures.

The only slight blemish to date during this reporting season has been erosion in capital levels due mainly to RWA inflation on increased market volatility and to a lesser extent on the negative repricing of financial assets. For the leading US banks, these capital headwinds amounted to 70bps on average and were mitigated by solid organic capital generation and flexibility on buybacks, both of which reassure us from a credit perspective. On the contrary, European banks posted lesser capital headwinds due to ongoing beneficial regulatory effects, leaving robust capital buffers on average c.400bps comfortably above minimum requirements.

Issuance momentum carried into April with YTD primary now c.15% ahead of last year, almost entirely driven by Senior Non-Preferred / HoldCo (c.90% of all primary YTD) as a result of MREL requirements and the uncertain macro environment, which incentivises front-loading. Importantly, these ongoing issuance needs should continue to provide new attractive investment opportunities. Through April, capital issuance was c.7% below 2021 levels and interestingly a couple of AT1 securities were called without having been refinanced beforehand, a first for the asset class. There are c.EUR10bn of AT1 calls remaining this year and we expect these to be redeemed at their first opportunity, reinforcing the positive technical backdrop.

From an investment perspective, valuations are now at very compelling levels after a handful of consecutive months of spread widening fuelled by Central Banks’ attempts to curtail inflation. Since the start of December 2021 when sovereign rates started to rise steadily, yields have on average doubled across the financials’ capital (and funding) stacks to absolute levels not seen in quite some time. Financials remain one of the main sectorial beneficiaries from higher Central Bank rates and with markets already pricing in a significant amount of potential monetary tightening, we are becoming increasingly constructive on the broader outlook for our funds from here.

Equity market weakness continued in April, as investors weighed the challenges of a rising rate environment, persistent inflationary pressure, the potential for an economic slowdown, and geopolitical tensions related to Russia-Ukraine. The MSCI ACWI Index fell -8.0% over the month, while the yield on the US 10-Year Treasury rose 57 basis points to 2.89%. Financials and banks struggled along with the broader market, with ACWI Financials down -8.3% and US banks down -11.1%.

The Financial Equity Fund was down -4.2% for the month, roughly 400 basis points ahead of the ACWI Financials. Much of this outperformance was due to our overweight positioning in European Banks. Top contributors to performance included Banco BPM, which announced in early April that Crédit Agricole had acquired a 9.2% stake in the bank; Standard Chartered, which beat earnings in late April and announced an increase to forward guidance; and M&T Bank, which provided a very strong guide for 2022 net interest income on its quarterly earnings call. The equity strategy was most hurt in April by our exposure to US commercial banks. The US banks industry de-rated from a forward P/E of 12x to 10x as investors showed concern over an economic slowdown brought on by Fed tightening. Core holdings in Wells Fargo, Citizens, and Citigroup were our largest individual detractors in this space.

1Q22 bank earnings globally demonstrated strong gearing to higher interest rates. Upgrades abound in the US, UK and even Europe. In the UK, NatWest, Lloyds and Barclays all made >11% RoTE after a decade of mediocre returns. In Europe, BNP posted a 13.5% RoTE, as did Santander. BNP has a >7% dividend yield, buyback, growth, earnings that are being upgraded, and a stock that trades at 0.7x TBV and 7x earnings. What is most notable to us on European banks is that while the rates market is pricing in eight hikes from the ECB in the next two years, consensus estimates generally incorporate very little hike benefit. Analysts are to be excused for being cautious on the future rate path in Europe after nearly a decade of negative rates and false hopes but incorporating next to no hikes strikes us as exceedingly dour. This conservative posture from analysts suggests a strong potential for earnings upgrades even if the ECB rate hike cycle is shorter and shallower than currently priced in by the bond market. The opportunity to take advantage of such a skeptical consensus is substantial: when Standard Chartered reported numbers this quarter they commented that 2023 NIMs may be closer to 2019 levels, well above what the street had penciled in. The stock shot up 14% on the day.

It is not all about rates, however. Despite a very challenging backdrop in 1Q highlighted by enormous rate volatility and the onset of a war, European banks beat revenue expectations and credit costs handily, with an 80% beat rate on pretax profits and an average beat of 18% above consensus. No banks missed on net interest income, the highest multiple line on a bank’s P&L. Similarly in the US, most banks beat estimates, with a particularly strong showing in credit. The top line is set to accelerate higher as loan growth improves (remember, loans are in nominal dollars not real dollars) and net interest margins ramp up. As an example, one key holding for us in the US, M&T, surprised the market by massively upgrading its net interest income guide on its 1Q22 earnings call (now looking for >50% NII growth versus 33% consensus). Like many banks in both US and Europe, they have a large cash position that they can now put to work at much more attractive yields. 2023 EPS estimates have gone from $14 early this year to $18 and we see potential upside to more than $20. The stock trades at ~8x the consensus number, a ten-year low for the stock outside of the COVID crisis. The risk-reward looks highly compelling here.

In both Europe and the US, we see scope for significant earnings upgrades across various banks. And yet stocks have derated sharply, to the point where European banks are back at their relative lows. They now trade at 50% of the market multiple versus the 60-80% range in which they traded during the prior two decades. Payout yields on many strong (and non-Russia-exposed) banks in Europe range anywhere from high-single-digit to mid-teens as capital return comes to the fore. Meanwhile in the US, banks have de-rated roughly 30% since the February peak – absolute and relative P/E valuations now sit 25% and 35%, respectively, below long-term median levels. We have steadily increased our US exposure to regional banks from a rather insignificant position two months ago to a key bet in the fund.

Why are banks underperforming despite the strong fundamental drivers? They appear to be caught in the macro crosshairs, with the immediate top-line benefit of higher rates and nominal growth being ignored for fears of a potential economic downturn taking center-stage and pressing valuations lower. Europe GDP estimates have taken a hit due to higher inflation and fear over secondary impacts of the war. But Europe’s unemployment levels are the lowest they have been since the Eurozone’s creation and appear to be going lower. €1 trillion of excess savings were built up in COVID, which should cushion the inflation shock. In the US, this savings accumulation is well over $2 trillion. Growth estimates have been slashed but still sit at 2.8%, near the upper end of the previous cycle range. This level represents a slowdown from prior estimates but is still a long way from recession. The US is further away from the epicentre of war and has energy independence. We also see significant resilience to higher rates: 86% of US mortgages are fixed (at very low rates for 30 years) and 98% of non-financial corporate bonds are fixed, with over 86% termed out beyond 2024. The numbers are similar in Europe, at 91% and 73% respectively. Simply put, both households and corporations appear well-positioned for higher rates. This means banks should benefit both from a stronger top line and a more benign credit environment than past hiking cycles.