July 2021

How we did in July: The fund returned between -0.6% and -0.5% across the different share classes, compared to SPX 2.4%, SX5E 0.8%, EUR BAML HY (HE00 Index) 0.4%, US BAML HY (H0A0 Index) 0.4% and EM bonds (EMGB Index) 0.5%. Performance in July, gross of fees in EUR, was from: (i) Credit: -13bp, with -23bp from cash and 10bp from CDS; (ii) Rates: -35bp; (iii) FX: -3bp; (iv) Equity: 7bp, and (v) Other: 3bp.

In July, the Fed and ECB maintained their patience on monetary tightening and reemphasized their view of transitory inflation. The Fed’s comments indicated that a tapering announcement may only be towards end-Q4, rather than in September following August’s Jackson Hole meeting. Therefore volatility remained low and rates tightened further, favoring credit and carry trades. Equities continued to rally, albeit at a slower pace than previous months. This more muted rally was due to investor concerns on slowing global growth, made worse by the Chinese government implementing policies that hurt private investors. The policies imply that the government will prioritize national security and social inequality concerns, over the risk of capital outflows.

What we are doing now: All-time tight spreads and US rates near January lows are due to dovish central banks, but also investors’ growth concerns from the Delta variant, slower infrastructure spending and China’s policy actions. We believe growth is likely to slow as record monetary and fiscal stimulus fades, but tactically, growth concerns seem overblown. The Delta variant is spreading in the US but as the UK and Europe have shown, it can be brought under control with higher vaccination rates. Similarly, while infrastructure spending may be priced into markets, it’s likely Democrats will keep up pressure to spend more ahead of 2022’s mid-term elections. Finally, we think China’s policy actions won’t be reversed, but Chinese growth remains strong and consumer spending seems to be gaining. Therefore, we think growth concerns will ebb towards end Q4. This, combined with a tapering announcement, could lead to higher volatility in Q4. We would use this opportunity to redeploy capital in beta-assets, including high yield debt and emerging market hard currency.

Today, we are selectively invested in credit, focusing on sectors where we still see value – travel/ reopening (e.g. airlines, cruises), cyclicals (e.g. financials) and consumer discretionary (e.g. we invested in McLaren’s new issue). We also maintain a high allocation to convertibles with low credit risk, in similar sectors. We used concerns on the delta variant as an opportunity to add 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 convertibles with low credit risk and exposure to stable Chinese companies (e.g. JPM bond referencing Ping An stock).

In emerging markets, a more proactive hawkish stance of some central banks mean FX has some room to outperform after having lagged risk assets in the past 12 months. We added some risk in then hawkish central banks like Russian Ruble, Mexican Peso and the Brazilian Real but remain overall lightly positioned, with less than 5% weight in EM local markets.

We maintain a good level of protection on areas sensitive to higher real rates (credit, gold, rates-sensitive currencies), but we move our position to benefit from a pick-up in volatility, most likely after the summer in Q4.

The positive risk-on tone across the broader asset space spilled over into July, helped by the still ongoing monetary support from central banks, fiscal policy measures from governments as well as decent quarterly results. In addition, despite growing concerns around the spread of the Delta Covid variant, the steady rate in vaccinations across Europe constructively buoyed sentiment around the pace of recovery from the pandemic. Gradual ease of lockdowns are expected to continue and foment growth in economic activity into year-end and beyond, lifting optimism around a return to normal by next year.

This normalisation should inevitably lead to the unwind of supportive measures, also known as tapering, expected to come back into the spotlight in the coming months. For the time being, sovereign rates’ markets remain unphased about these potential concerns, in part due to the (excessive) liquidity measures in place. Counter-intuitively to fundamentals, partly due to technical factors such as positioning, rates’ curves flattened 5-10bps in July and with it dragged European and US banks’ equity indices down 1-2%, still leaving their year-to-date returns at a solid 25% and 26%, respectively. Performance in credit was positive across the board on the back of tighter spreads and rates. Financials performed well across the capital structure, with European AT1s inched 15c higher on average whilst T2 and Senior spreads tightened by around 15bps and 10bps respectively.

In Europe, the main noteworthy July events across the financials’ landscape were all significantly constructive for the sector. In line with recent communication, the ECB announced lifting of the cap on dividends after it expires on September 30th. Shareholder remuneration will remain subject to capital trajectory and the stress test results, which came out right before month-end. The exercise, which covered c. 70% of the European banking sector, was the most severe we’ve seen due to the assumptions used by the supervisor as well as the post-Covid starting point. Despite the heavy hit to CET1, capital levels remained resilient as expected. Importantly for AT1, issuers’ capital remained well above CET1 triggers. Also, 22 banks faced MDA restrictions – whilst these could affect AT1 coupons, they’d be an acceptable, limited and temporary headwind for the bonds considering the extreme scenario.

Idiosyncratic headlines outside Q2 results concentrated around Monte Paschi, over UniCredit’s announcement that was in exclusive negotiations with Italy’s Ministry of Finance, Monte’s main shareholder, to take over the bank’s performing operations. UniCredit CEO Orcel clarified that a deal would only work subject to certain conditions, including exclusion of NPEs and litigation risk, and bring double digit EPS accretion but also stressed that any further step is subject to due diligence and negotiations. Monte was also the main outlier of the EBA stress test, with a negative CET1 under stress (c.10% drawdown).

From an issuance standpoint, July was one of the least active months on record with less than EUR5bn in transactions from leading institutions, of which the bulk (c70%) was concentrated in the secured part of the capital stack and just one significant capital transaction (UniCredit AT1). This inactivity by issuers can be explained largely by the dwindling investor appetite given the time of year, ongoing rate uncertainty into year-end, outright valuation levels and earnings’ blackouts. We are conservatively positioned to take advantage of pricing dislocations and attractive primary opportunities as and when these arise into year-end.

US and European financial equities continued to consolidate in July following the strong first half of the year. US financials were down half a percent on average, though US regional banks were down nearly five percent as Treasury yields fell 25 bps in the month. European banks and insurers both finished down about a percent in July.  We largely view these moves as a healthy pause, with fundamentals and valuations looking highly compelling particularly in the European bank space.

During the month, the ECB finally lifted its dividend ban on the European banking sector. Importantly, in its statement it also explicitly acknowledged for the first time the important role that buybacks will play in banks’ capital management plans. We see all-in shareholder yields for the sector in 2021 (including catch-up dividends and buybacks) of 8%, and on a more sustainable basis approaching 7% thereafter. In a world where rates are marching lower, we find the presence of such large yields extraordinary. At current share price levels buybacks will significantly accrete tangible book value per share, resulting in higher ROTEs as well. In addition, the results of the first post-COVID stress test were recently announced, with better-than-expected results for the sector despite significantly more onerous macroeconomic assumptions than in prior stress tests. For example, the assumed decline in GDP is 55% higher and peak unemployment rate is 52% higher. Nevertheless, nearly all banks fared well, with significant remaining buffers to minimum capital requirements after the harsh modeled hits to their capital ratios. While the stress test exercise is somewhat theoretical, it is just another sign that the regulator views European banks’ capital levels as more than adequately capitalized to withstand a severe potential economic shock (in addition to the COVID crisis just endured). The recent moves in interest rates have captured the market’s attention for the time being, but these extraordinary yields are here to stay (at current share prices, at least).

Also during July, European bank earnings started to roll in. In general, as in the past several quarters, numbers have been very strong and estimates continue to get revised up impressively. Perhaps it is best to focus on two of our core positions – UBS and Soc Gen to illustrate the point.  UBS reported a ROTE of 15.4% for the quarter with earnings 28% ahead of consensus with revenues 6% higher and loan loss writebacks. In its private bank Net New Money grew at a 7% annualized rate, continuing the strong momentum of the first quarter, and investment banking revenues came in 12% ahead of consensus driven by a 35% beat in underwriting and advisory revenues. And while the skeptics may respond that this strength is merely cyclical, the Street has responded by in many cases upgrading 2023 EPS by nearly double digits. Including dividends and share buybacks, we see UBS on a 8-9% total shareholder yield in 2023. This is simply a huge discount for such a strong franchise that is firing on all cylinders. We believe fair value is closer to CHF 20/share, and have been adding to the name as we don’t expect this discount to last for long.

As impressive as UBS’ numbers were, Soc Gen may have had an even better quarter, at least relative to expectations. Pre-tax profit beat consensus by over 50%. Benign credit helped – as was the case with virtually every other bank this quarter – but the beat at the pre-provision line was also a stunning 21%. This was driven by the revenue line, which beat across all lines outside of FICC (another area of softness for most capital markets banks this quarter). And importantly, capital – for many years the weak link at SocGen – continues to march higher (CET1 = 13.4%) and the company announced a catch-up buyback for its missed 2020 dividend and is accruing for a 50% dividend payout which implies a nearly 5% yield on first-half profits alone. The stock has been left for dead, trading below half of tangible book. This implies no future growth and a ROTE of ~5% into perpetuity, even as the company just printed an underlying ROTE over 10% in a soft FICC quarter and with rates pinned at -50 bps. The forward earnings power here is close to €5/share (in fact they have already made a run-rate of €4.80 EPS in the first half of this year), which in our view should justify upside of at least 50% from current levels even before considering the robust and growing dividend yield.

Finally, right at the end of the month it was announced that Unicredit has entered exclusive negotiations with the Italian government for the potential takeover of MPS. This deal has long been rumored, particularly since Andrea Orcel was tapped to be the new CEO at Unicredit. However, it was unclear whether Orcel would prefer an acquisition of the troubled MPS, or perhaps set his sights on a bank like Banco BPM, or forgo acquisitions altogether and look to aggressively buy back stock instead. Some of the key terms which have been agreed to in principle include capital neutrality, earnings neutrality (pre-synergies), immunity from extraordinary litigation risk, and exclusion of non-performing assets. In our view, while there remains much uncertainty as to the actual structure of a potential deal, it would be a significant strategic and financial win for Unicredit if they can execute a transaction on these high-level terms. The stock already is amongst the cheapest in Europe (6x ’23 earnings) even before we strip out their excess capital, which is more than half the current market cap. Adjusting for excess capital – which will still be in place after a deal with MPS according to the prerequisite terms – and assuming low double digit EPS accretion on an MPS deal, Unicredit is currently valued at just over 2x ’23 earnings.