February 2022

How we did in February: The fund returned between -0.8% and -0.6% across the different share classes, compared to EUR BAML HY (HE00 Index) -3.2%, US BAML HY (H0A0 Index) -0.9% and EM bonds (EMGB Index) -5.8%. Performance in February, gross of fees in EUR, was from: (i) Credit: -204bp, with -108bp from cash and -96bp from CDS; (ii) Rates: 44bp; (iii) FX: 112bp; (iv) Equity: -7bp, and (v) Other: 0bp.

In February, risk assets were hit hard as the Ukraine war triggered a commodity rally and stagflation fears. We entered the month net short emerging markets and Russian assets, short US and European rates and long European credit. Our short in Russia helped our performance while our long in European credit subtracted from it.

What we are doing now: We see 2022 as a challenging year for risk assets, bonds in particular, as we wrote in The Silver Bullet | When the Music Stops. The fight against inflation has been moving high in the political agenda, and the Russia-Ukraine war now creates concerns for European growth. As a result, central banks are going to be less dovish, while commodity prices add to existing supply shocks.

That said, credit valuations have started widening somewhat, and value has started to emerge – especially in Europe, spread levels are now wider than in 2018, but fundamentals remain strong. Overall we maintain a defensive stance on our cash book, with net 50% in long cash credit opportunities, but added to longs in European credit via liquid instruments, including credit default swap indices. On the cash book, we focus on bonds with low duration, high coupons and shareholder/government support. We maintain short positions in rates and duration-sensitive assets, such as BTP and OAT, and some degree of equity protection.

Our longs focus on sectors which we can perform well in 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 convertibles, we maintain a high allocation to firms with low credit risk and upside linked to reopening and higher commodity prices. In EM, we remain lightly positioned and keep a good degree of protection on vulnerable countries, such as Egypt and Turkey. We remain net short in Russia as we see the impact of sanctions to trigger more economic costs.

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.

A sudden and somewhat unexpected flaring up of geopolitical tensions in February across Ukraine fuelled a broad risk off tone across assets in the market. Core sovereign rates widened 10bps in the longer duration parts (European periphery gapped out a further 30bps) with leading equity indices falling 5%.

Despite the increasingly constructive investment case around European financials underpinned by capital repatriation (shareholder total returns) and rising rates expectations (improved profitability), the sector underperformed the broader European equity indices by c6% as profit taking kicked in given what was one of the strongest starts to the year from a share price appreciation perspective.

Across the credit space, spreads widened in unison with the soggier macro conjecture; de facto, markets have slowly begun to shift from a long period of interest-free risk to a more normalised world of risk-free interest with ongoing removal of monetary support, i.e. interest rate hikes and shrinkage in Central Banks’ balance sheets. More specifically, financial spreads unsurprisingly decompressed across the capital stack with Seniors c35bps wider compared with Subordinated c60bps wider; AT1s fell on average 3.5pts though the dispersion was quite significant with more Russian-exposed entities anywhere from 8pts to 20pts lower.

At this stage, it is very difficult to ascertain precisely what the financial and economic consequences of the Ukraine-led sanctions will amount to. Except for a very select few banks with significant absolute and relative exposure in the region, none of which Algebris funds have any investment in, we remain constructive on our names and take comfort from existing overlays and prudent risk management decisions taken in the past 24 months by all other European banks with de minimis exposure to Russia. In our view, this should ensure that even the banks with operations or exposure to the affected countries could “walk away” if the capital hits were more than comfortably absorbed by current capital buffers.

On a more sector specific note, FY21 results announcements continued to surprise positively both in terms of operating income and asset quality, leading to further capital build-up even after accommodating for dividend pay-outs and some banks (re)starting share buyback programs.

Looking at idiosyncratic events, BPER signed an agreement to buy a controlling stake in Carige from the Interbank Deposit Protection Fund (‘FITD’) for EUR1. The deal, which is subject to a EUR530m capital contribution by FITD, will benefit from Carige’s DTAs and therefore be accretive for BPER. Consolidation remains a key positive driver for the domestic sector and likely foments further transactions over the coming quarters.

The combination of heightened geopolitical tensions (volatility in both rates/swaps and credit spreads) and results-driven blackout windows meant that primary activity was one of the weakest in the last five years at just EUR25bn. The bulk of this was almost entirely in the Senior (funding) space with just a few capital deals to note, of which two were in less common currencies (Singapore dollar and Swiss franc). On the legacy front, a few more securities were called, shrinking this universe even further to now stand at less than 10% of the AT1 market.  

February was a tumultuous month for both markets and geopolitics. The first two weeks of February were a continuation of the macro and market trends that dominated January, namely, inflation and rising interest rates. The BOE announced in early February that it was hiking interest rates an additional 25 bps and projected that inflation in the UK would peak at 7.25% in April. This was followed by a hot US CPI report showing 7.5% Y/Y inflation, which pulled Fed hike projects forward even further. For the month through February 15th, the MSCI ACWI Financials Index was up nearly 3% versus a flat broad market index, while the European bank index was up nearly 5.5%. While inflation concerns persisted through the end of the month, the second half of the month saw a sharp reversal in market behavior, driven by the Russian invasion of Ukraine. In a tale of two halves, stocks that led in the first two weeks of the month lagged sharply in the second half: from February 15th to February 28^th, MSCI ACWI Index declined by 2.7%, MSCI ACWI Financials fell 5.4%, and European banks fell more than 16%.

Within this backdrop, the biggest contributors to performance for the Financial Equity Fund came from two European banks, Sabadell and Commerzbank. We sold Sabadell early in the month after a large run-up to start the year and trimmed Commerzbank throughout the month. Both banks are highly levered to rising interest rates. We also received positive contributions from MoneyGram International, which we sold after the company announced a buyout offer from private equity firm Madison Dearborn, and Hana Financial, a Korean bank which performed well after a strong earnings report and continues to be a core holding. Most of the largest performance detractors came from European banks. Names like BNP Paribas, ING, and Unicredit had been big positive contributors to performance over the past year but struggled in the last two weeks of February with interest rates receding and concerns over Russia increasing.

We reduced our net exposure into the strong rally in the first two weeks of the month, stepping to the sidelines on a handful of stocks after fairly sharp moves higher in response to earnings and movements in rate expectations. We raised our cash position and continued to do so at the initial stages of the Russian invasion of Ukraine. We do think it is prudent to maintain a fairly sizeable cash position at this point but the sharp decline in equity valuations has essentially been indiscriminate, which does create interesting entry points for stocks that have been “thrown out with the bathwater”. The EUR ~175 bn of market cap destruction in our view is close to 4x the extreme case losses that European banks may absorb in Russia (and in all likelihood, losses will be lower than the extreme case given the presence of guarantees, insurance, offshore collateral and hedges) implying the stocks are now discounting a rather harsh economic correction as well. While we may well see a decline in growth, it is coming off very high levels (even a 100 bps reduction in growth would still leave European GDP growth near 3%, well above trend). And while the ECB may push back its tightening plans, a weak euro, still-hawkish Fed, and inflation that is still accelerating higher will mean rate hikes are very much on the table – and in fact European rate curves are still pricing in ~75 bps of hikes by the end of 2023.

At current valuations, rebasing the sector to 10x PE would require an earnings cut consistent with what we saw at the height of Covid – this seems highly unlikely in our view given the benefit of rising rates and the existence of substantial Covid reserve overlays on bank balance sheets. As usual, there has been a shoot-first ask-questions-later approach with these stocks, but fortunately our significant cash position allows us to be offensive. We are slowly and selectively adding to new and existing holdings with a focus on banks with strong excess capital, high pre-provision profitability, and minimal exposure to Eastern Europe.