August 2021

How we did in August: The fund returned between 0.2% and 0.4% across the different share classes, compared to SPX 3.0%, SX5E 2.6%, EUR BAML HY (HE00 Index) 0.3%, US BAML HY (H0A0 Index) 0.5% and EM bonds (EMGB Index) 0.9%. Performance in August, gross of fees in EUR, was from: (i) Credit: 26bp, with 38bp from cash and -11bp from CDS; (ii) Rates: 14bp; (iii) FX: -7bp; (iv) Equity: 12bp, and (v) Other: -2bp.

In August, global growth concerns increased due to the delta variant; central banks turned more dovish, while social inequality and national security pushed Chinese authorities to implement less market friendly policies aimed at rebalancing economic sustainability. This compounded with mixed activity data in July, triggered a re-pricing lower of value, re-opening and EM assets. Overall equity markets up, but with some weakness concentrated around EM and re-opening sectors. The global monetary policy summit at Jackson Hole had a dovish outcome, with Powell emphasizing more labor market progress is needed for tightening even in presence of strong inflation data.

What we are doing now: We added risk in re-opening sectors and selected EM assets on re-pricing. However, we maintain an overall cautious attitude towards credit. Spreads remain at all-time highs and while Fed tapering has been postponed, central banks’ liquidity withdrawal will eventually cause an adjustment in credit markets. Overall, we think current yields poorly reward investors for this risk. Market uncertainty in the next few months will be compounded by the Chinese crackdown on property / internet sectors, as we explain in our Silver Bullet | China’s Long-Term Game. Geopolitical risk is also on the rise: the government changeover in Afghanistan did not trigger a strong market reaction so far, but leaves Middle-East and Asia vulnerable to tensions in the next few months. We keep the fund 55-60% invested in selected areas, leaving room to add on weakness, as Chinese tensions and tapering discussion may raise volatility in Q4.

In credit, we continue to focus on sectors where we still see value – travel/ reopening (e.g. airlines, cruises), cyclicals (e.g. financials) and consumer discretionary (e.g. McLaren). We also maintain a high allocation to convertibles with low credit risk and positively convex upside/downside, in similar sectors. We added convertible exposure in travel-retail (e.g. WH Smith) and airlines (e.g. JetBlue). With the sell-off in Chinese equities we also tactically added in senior bank convertibles with equity exposure to Chinese companies (e.g. JPM bond referencing Ping An and Alibaba equity). We maintain a small exposure to the Chinese property sector, where the broad selloff created opportunities in a few names. We added protection in countries most vulnerable to China’s slowdown and with rising economic and political issues: Brazil and South Africa. We added some risk in EM countries where central banks have been most conservative: Russia and Mexico/Pemex. We remain overall lightly positioned in emerging markets.

We are well positioned to capture opportunities arising from the start of Fed tapering and geopolitical risks.

August was another positive month for risk assets, with investors emboldened by the ongoing macroeconomic recovery from the Covid dislocation, as measured by activity indices from leading countries, as well as the excess liquidity that remains in the system. The backdrop remained strong across equity and credit markets, despite growing expectations that global Central Banks will begin to scale back unprecedented monetary policies in the near term.

Major equity indices such as S&P and EuroStoxx rose c3%, taking YTD gains to c20%, and within these Financials outperformed adding c4% in August and boosting YTD gains beyond 30%. The asset class kept benefitting from the steepening of rates’ curves as well as 2Q21 results and in part from the ECB’s confirmation that dividend caps can be lifted in H2-21. The picture for Financial credit was largely unchanged on the month with spreads up to 5bps tighter across the capital structure, as outright levels remain tight from a historic perspective.

European Banks wrapped up their second quarter reporting season in August and the positive tone that kick started the results in late July carried throughout the sector. This was consistently due to better-than-expected trends in asset quality with Stage 2 loans that had surged due to Covid ebbing back towards their pre-pandemic levels. Covid-overlay provisions, taken in 2020, were largely retained to offset deterioration likely to come when policy support measures will be withdrawn. Encouragingly, banks’ management teams were keen to reiterate their upbeat outlook for earnings and capital repatriation in coming quarters given there continue to exist some buffers at their disposal should events take an adverse turn.

Aside from the 2Q21 results, there was very limited follow-through from the Stress Tests results released at the end of July and overall news flow was subdued for European Financials. At an issuer level, market focus was on the ongoing interest of Unicredit in Monte Paschi, with Unicredit’s CEO restating that any transaction needs to be earnings accretive and capital neutral. Also, sentiment across our financial credit space was buoyed by several issuers redeeming a handful of legacy securities and Rabobank normalising the coupon on its Certificates.

The constructive tone in the market ahead of what could be a less certain macroeconomic backdrop in the final quarter of the year drove a pick-up in primary issuance in August. Some issuers opted for early refinancing of subordinated deals with four AT1 transactions making it the second most active month for these instruments this year. Overall, issuance was concentrated in the Senior space (75% of EUR20bn) with a slight tilt to Preferred / OpCo securities. We have not changed our stance on advocating a diligent and selective approach to primary participation and perhaps promisingly have noticed more interesting transactions come through from a relative value perspective.

Financials bounced back in August after a couple of soft months with a strong earnings season supporting the sector. The MSCI AC Financials index was up 4.1% for the month, led by US banks (+5.3%) while European and Japanese banks were both up just under 3% and European insurers up 4.5%.

Investing in European bank stocks has often felt like just another way to bet on European interest rates – as bund yields fall, stocks rise and vice versa. Clearly this has some fundamental rationale given that higher yields are typically indicative of faster growth and a rising probability of policy rate hikes. But in reality long term rates have little near term impact on bank earnings and we find that the macro too often dominates the micro in European banks. So it is interesting that there has been a clear disconnect emerging between European core yields and European bank equities since mid-July. While the bund dropped rather sharply this summer to -50 bps (before rebounding slightly), European bank stocks are near their YTD highs reached when the bund was trading at -10 bps and many commentators were starting to talk about positive rates for the first time since the pandemic began. In our view, this is a rational disconnect. European sovereign debt is in negative net supply and with a huge price insensitive buyer in the ECB, there is little economic information to glean from interest rates. Meanwhile European banks began reporting yet another strong set of earnings in July, causing investors to focus on the powerful bottom-up story that we have been discussing for several quarters now. And finally, while rates have dropped sharply, it is key to point out that breakeven inflation rates in Europe continue to trend up and are currently near 3-year highs, just as the EU Recovery Fund is finally kicking in. Breakevens, unlike rates, are not manipulated. They are telling a rather more optimistic story about medium term European growth – and European bank investors are only now starting to take note.

While the Fed and ECB appear to be content with their current policy rate and QE program levels, central banks elsewhere are starting to raise rates as inflation pressures mount.  To date most of these hikes have occurred in emerging market countries that typically face the problem of too much inflation, for example in Latin America (Brazil, Mexico, Chile) and Eastern Europe (Russia, Hungary, Czech Republic).  However, last week the Bank of Korea hiked rates as well – the first central bank in a more advanced economy that has for the last decade struggled with too little inflation much like the US and Europe.  While market expectations for a hike had in recent months moved forward to late 2021/early 2022, the hike did come as a surprise, with Governor Ju-yeol citing financial imbalances as a contributing factor, in addition to expected above-target inflation.  We expect the BOK to gradually continue hiking rates as it normalizes policy, and South Korean banks to benefit from higher net interest margins which have not yet been factored into consensus expectations, which we conservatively expect to add 15-25% to earnings by 2023, bringing ROTEs comfortably north of 10% despite P/TBV multiples of 0.4x today.  South Korea’s economy tends to function as a leading indicator for the global economic cycle due to its important position in global supply chains, and thus the read across here to other countries is significant – particularly in light of South Korea’s economic ties with China, which has been easing policy recently, and Delta variant concerns that have kept a lid on most global interest rates over the last few months.

We recently initiated a position in Alliance Data Systems (ADS) on recent weakness in the stock. ADS, a provider of retail credit card loans and services, benefits from economic reopening, with loan growth accelerating to 7.7% in July and card payment volumes now at record highs. The company continues to show lower loss rates as well, with a 4.2% net-charge-off rate in July, and management expects to maintain NCOs below 6% through 2023. ADS also has several company-specific drivers that, in our view, should push the stock higher. The company is spinning off its Canadian loyalty rewards business in Q4 of this year. The transaction should push the parent company’s tangible common equity ratio into the high single digits, which would open the door for share repurchases. The spin will also create an independent rewards business that has a strong market position with Canadian retailers and generates consistent free cash flow. To enhance its retail credit offerings, ADS also acquired Bread, a Buy Now Pay Later technology platform. Bread is being deployed as an additional financing option for ADS’s existing retail partners, and it has built partnerships with Fiserv and RBC as both a lender and a third-party origination service. ADS expects to have loans receivable of at least $1B from the Bread platform by 2023. While most of the loan growth acceleration story appears to be built into the current share price, the spinoff value creation, share repurchase possibility, and incremental earnings potential from Bread are not. ADS trades at a discount to its credit card peers, with a Price/Consensus 2022 EPS of 7x versus an average of 10x for COF, SYF, and DFS and a P/23 EPS of 6x versus 9x for peers. Moreover, we expect both 2022 and 2023 EPS numbers for ADS to exceed consensus estimates. In the medium term, an acquisition of ADS by a deposit-rich (and asset-starved) bank would seem highly plausible, especially with the new management and board at ADS highly focused on shareholder value.