December 2021

How we did in December: The fund returned between 1.1% and 1.3% across the different share classes, compared to EUR BAML HY (HE00 Index) 0.9%, US BAML HY (H0A0 Index) 1.9% and EM bonds (EMGB Index) 1.5%. Performance in December, gross of fees in EUR, was from: (i) Credit: 151bp, with 64bp from cash and 87bp from CDS; (ii) Rates: 20bp; (iii) FX: -31bp; (iv) Equity: 2bp, and (v) Other: 6bp.

In December, the market re-assessed risks stemming from the new Omicron variant. As evidence on milder symptoms and vaccine effectiveness mounted, market worries about potential downside risks faded. Most governments did not introduce tighter restrictions during the festive period, and some loosened travel and isolation rules towards the end of the month. As a result, re-opening stocks and credits that were hurt in November relieved and delivered positive performance. Turkish assets were particularly volatile as deep central banks cuts were followed by unorthodox policy aimed at stopping dollarization.

The fund’s performance benefited from exposure to re-opening stocks and credits, and suffered some volatility due to shorts in Turkey’s Lira, which performed well in the first half of the month but suffered thereafter. In 2021, the Fund delivered moderately positive performance (0.5% on EUR B share class), vis-à-vis negative performance for the global bond market overall (the Barclays Global Aggregate total return was -5% in 2021), deeply negative performance of emerging market debt (-4-9%), and moderately positive performance of high yield debt in developed markets (3-5%).

What we are doing now:  We see 2022 as a potentially challenging year for risk assets, given tight valuations, crowded positioning, and the imminent reaction of the Fed to inflationary pressure. As a result, the fund maintains a defensive stance in credit, with net over 40% in selective credit opportunities with low duration and high coupons, and over 20% in out-of-the-money convertible bonds, trading around par. We maintain a good amount of hedging in rates, given the potential for more Fed-induced widening.

In credit, we focus on sectors which we think could perform well even in a tighter monetary policy environment next year – travel/ reopening (e.g. airlines, cruises), cyclicals that benefit from higher interest rates (e.g. financials) and defensive consumer discretionary (e.g. luxury cars). In the November sell off we opportunistically added in credit, focusing on investment grade credits and certain issuers, like Aston Martin, Burger King and McLaren. In convertibles, we maintain a high allocation to firms with low credit risk and upside linked to reopening and higher commodity prices. We continue to like travel convertibles with strong state support, like Lufthansa and Accor. In EM, we are overall lightly positioned. We have been short Turkey, both through the currency and credit. As we see room for the currency and credit to weaken further, we remain short the currency despite the new tools introduced by the administration. We took advantage of recent strength in commodity exporters to reduce duration in Mexico and South Africa. We have been using recent geopolitical noise to add short-dated risk in Ukraine, where the credit profile remains strong.

In 2022, we believe inflation and a hawkish Fed will push bond yields wider, while economies will gradually reopen and normalise. This will hurt passive beta. Our fund, however, should benefit in this environment. We are positioned to benefit from reopening sectors in convertible debt, while keeping a very limited duration profile in rates.

The confirmation from several medical studies that the new CoVID variant is milder from a severity perspective, combined with the firming of global macroeconomic data and a generally hawkish shift from major central banks globally were the main constructive catalysts driving the risk-on tone across most asset classes in December. The main exception were rates, with curves parallel-shifting 15-20bps between the 2y and 30y points. Interestingly there was very little steepening of curves, as the market wrestles with the idea of a potential policy mistake. Also, in Europe there was no decompression between core and periphery as the ECB remains firmly behind its “favourable financing conditions” mantra.

Equity indices firmed on average 3.5% in December, led by Europe (+6%) that took YTD gains to c25%. On a sectorial basis, European financials outperformed further, gaining 7% in December and bringing the YTD total return just over 40%, still some 20% below their pre-CoVID levels. In credit, spreads firmed some 10bps in IG and 25bps in HY, broadly offsetting the adverse rates move. Financial credit benefitted too from this momentum, with Seniors tightened by 10bps, T2s by 20bps, and AT1s up +1.25pts.

Hawkish rhetoric from the FED and a 15bps rate hike from the BoE forced the market to reassess its expectations for future Central Bank rate hikes; as an illustration, the ECB is now priced to be at 0% within 2 years (versus 4+ years at the end of November). Although the FED has yet to move on rates, it has signalled a faster taper with the market now expecting up to three hikes in 2022. The BoE followed through this time after bluffing in November and is likely to move again at its next meeting on 3^rd February given inflation remains well ahead of expectations and is unlikely to moderate anytime soon in the UK given other underlying issues.

On the thematic front, December witnessed a few more instances of European banks’ rearranging their geographical footprints and further cleaning up of legacy securities ahead of the new capital rules in January. Italy continues to be in the consolidation spotlight with BPER formally announcing its acquisition proposal for state-owned Carige, whilst Monte Paschi has announced a new 3-year standalone plan that will require a EUR2.5bn capital injection after talks with Unicredit failed earlier last summer. Separately, the FSB published its new list of Global Systemic Banks (G-SIFI), which saw BNP move one notch higher resulting in a 50bps increase of the systemic requirement. Shortly after month-end, the bank announced that it reached an agreement with BMO for the sale of its US activities, which should bring BNP back down the G-SIFI ladder and boost BNP’s capital by 110bps on the back of a EUR2.9bn after-tax gain and net of a EUR4bn buyback to offset EPS dilution from the sale.

From an issuance standpoint, December was once again subdued and in line with the three previous years. In December European financial institutions printed just EUR15bn out of a total EUR310bn in 2021 and the split by capital structure was broadly the same with only c20% in subordinated format. AT1 primary activity in 2H21 totalled EUR12bn, of which just EUR3bn in 4Q21, and was essentially a function of refinancing secondary deals that are up for their first call in 1H22. We expect similar trends in 1H22 which should continue to provide a solid technical support for the AT1 asset class given the lack of net new supply.

It is noteworthy to flag that January has historically been the most active month in the calendar year over the 2019-2021 period, and given some events this year, i.e. French elections, this trend should repeat itself this year. Our expectation remains that the combination of fewer calendar windows, a tighter monetary policy pushing medium-term rates wider, and ongoing MREL regulatory needs should provide fertile investment opportunities in 2022 in terms of both primary activity and repriced secondary levels.

European banks remain our largest regional exposure.  The subsector performed very well during 2021, rising by 40% as vaccine rollouts spurred a strong economic rebound in the first half of the year, followed by persistently elevated inflation in the second half that brought forward expectations of potential rate hikes globally.  However, despite these very strong macro tailwinds, the sector actually de-rated during 2021, starting the year trading at 10.7x forward P/E, and ending at 8.6x, as strong share price performance was more than outstripped by positive earnings revisions across the income statement. So valuations are lower today than they were a year ago, despite much greater visibility on capital return, stronger earnings momentum, and interest rate optionality that is likely much more valuable than it was twelve months ago, when interest rate hikes were not on the investable horizon.

Capital return has been a strong driver for individual banks ever since the dividend ban was finally lifted in September.  During the 1.5 year period of the ban, European banks accumulated significant amounts of capital, and loan losses came in at a fraction of what had been initially feared.  Since then, individual announcements of large payouts – including share buybacks for the first time in 15+ years for many European banks – have driven the forward-looking yields north of 10% for several of our core holdings.  We expect more such announcements to occur in Q1 concurrent with Q4 results, and/or during capital markets days where new business plans are presented.  Further, we believe such high yields are unlikely to persist – double digit yields are typically accompanied by weak balance sheets, not companies emerging from a recession with record levels of excess capital.  As the market digests these large yields, we expect them to continue driving the re-rating closer to the 3.5% long-term average for the sector.

Global interest rates, particularly in the front-end, have ratcheted up dramatically in recent months as the high levels of inflation globally have been less transitory than monetary authorities had predicted.  The Bank of England has already hiked, the Fed has accelerated its tapering of QE, and even the ECB has had to push back on market expectations for a hike as early as the end of 2022.  Needless to say, most European bank stocks do not currently embed any upside potential from rates hikes, with estimates not baking in any benefit and with multiples of rate-sensitive stocks trading at discounts (versus at a premium in the US).  However, with Eurozone inflation now running at the highest level since formation of the single currency, chances are certainly increasing that the ECB may eventually follow in the footsteps of the BOE and Fed, and any increase in the base rate would be a huge benefit to the sector.  In some cases like Commerzbank, a few hikes could double earnings.  While not currently our base case for 2022, should inflation continue to remain elevated and harder to tame than monetary authorities predict, European banks would benefit immensely and thus act as a very potent inflation hedge.