June 2021

How we did in June: The fund returned between -0.6% and -0.5% across the different share classes, compared to SPX 2.3%, SX5E 0.7%, EUR BAML HY (HE00 Index) 0.6%, US BAML HY (H0A0 Index) 1.4% and EM bonds (EMGB Index) 0.2%. Performance in June, gross of fees in EUR, was from: (i) Credit: -30bp, with -4bp from cash and -26bp from CDS; (ii) Rates: -13bp; (iii) FX: 0bp; (iv) Equity: -2bp, and (v) Other: -7bp.

In June, the Fed and ECB signaled patience on monetary tightening even in the presence of strong inflation prints in May. As a result, volatility remained low and rates tightened, favoring credit and carry trades. We have invested inflows into high carry bonds to maintain an adequate yield, with protection for a Q3 or Q4 increase in volatility induced by monetary tightening. We maintain a cautious approach, with high allocation to cash and a good level of CDS protection.

What we are doing now: Major central banks (the Fed and ECB) maintain a dovish / patient attitude despite strong inflation prints and some signs of more permanent inflation coming from commodities and the labor markets. Outside the US and Europe, central banks are gradually giving in, turning more hawkish as inflation picks up. Brazil, Mexico, and Russia have all hiked rates in the past two months, China maintains a hawkish stance, and other developed markets’ central banks (Canada, Norway, New Zealand) are turning more hawkish in commentary. We believe the Fed will soon give in to the reality of strong data, and Jackson Hole in late August may be the opportunity for a hawkish turn. As such, summer may bring some last opportunities for carry trades and credit, but into September / October spread will likely widen and volatility will rise.

As a result, our allocation remains very cautious. We remain 50% invested in credit, focusing on the areas where we still see some value: reopening linked companies (cruises, airlines e.g. CCL, FinnAir), cyclicals (financials, energy e.g. Pemex) and consumer discretionary (autos e.g. Aston Martin). We also maintain a high allocation to convertibles. We think convertibles are more attractive than vanilla credit, as convertibles’ equity-underlying offers better risk-reward and better protection to rising inflation. The convertibles are primarily in reopening/cyclical sectors, especially in bonds with low credit risk. We focus on those companies with exposure to Europe and Asia, as these companies equities’ have lagged their US peers and should catch-up as vaccinations and re-openings accelerate across Europe and parts of Asia (e.g. Dufry, IAG, WH Smith, Singapore Airlines).

June marked the end of a fairly strong quarter for risk assets driven by growing confidence on a post-pandemic recovery that is starting to shine through in improving economic data. Performance was solid throughout the month with the main equity indices edging higher across the US (S&P 500: +2.3%) and Europe (STOXX 600: +1.5%). That said, the emergence of new Covid variants, even if likely to be temporary as vaccinations are proving effective in containing hospitalisation and death rates despite a surge in cases, fuelled a rally in sovereign rates. As a result, European and US banks’ equities underperformed the broader market in June, reversing some of the gains realised this year on the back of the hawkish turn taken by the FED due to its robust outlook tied to the post-Covid recovery.

Central banks’ ongoing QE measures continue to underpin long-end rates with the US rate curve flattening c25bps in June. This sentiment is still percolating into credit, with HY outperforming IG due to potential for more spread tightening. Financial credit performed equally well across geographies with spreads tightening across AT1 (-20bps), Tier 2 (-8bps) and MREL/TLAC Senior (-4bps). Despite the significant repricing since the March-20 lows, financial credit remains attractive relative to corporate credit due to strong fundamentals and technical backdrop. Our preference remains for lower duration bonds where risk-reward pay-off in a potentially higher rate scenario in 2H21 is more attractive due to the resettable coupon structure of the majority of our holdings and the fundamental tailwinds from inflation and the economic recovery.

There was further regulatory support for the financial sector in June as the ECB announced that central bank reserves will remain excluded from leverage calculation through 2022, a similar proposal from the Bank of England. At an entity level, Unicaja received approval for the use of internal models (c.110bps CET1 benefit) and, shortly after, the green light to complete the merger with Liberbank by the Spanish Competition Authority. On the ratings front, S&P downgraded Sabadell’s issuer rating causing its non-preferred Senior to lose the IG designation. Aside from this, the agency announced a wave of positive actions, upgrading its outlook on the entire Spanish banking sector from negative to stable, as well as for some of our key names, including Unicredit, ING, French banks, and Barclays where the latter’s outlook is now positive.

Primary issuance of EUR30bn in June was steady compared with both the previous month of May and June of last year. Composition remained largely unchanged in June, and throughout 2Q21, with entities still focusing more on their funding (Senior Non-Preferred accounted for c60-65% of all new deals in June and 2Q21) than capital (c20%). That said, with the differential across the capital stack narrowing due to global QE measures by Central Banks as well as abating (long-term) concerns around CoVID, entities have opportunistically taken advantage to bring forward some future issuance. Also, the current credit environment has permitted some less frequent issuers to access both the funding and capital markets as the “hunt” for yield continues unabated. In this regard, our stance remains quite conservative with very selective participation in new deals given ongoing rate uncertainty and seasonal illiquidity over the coming months.

There was a powerful move in global markets in the days following the June FOMC meeting, with US policy rate expectations moving up and long term yields moving lower, resulting in a rather significant flattening of the yield curve. This had reverberations across markets, with many “reflation” trades selling off as growth and inflation expectations moved lower after the meeting on the perceived policy error. This makes some sense as there was a strongly held view in the market that the Fed was going to let the economy and inflation run “hot” by being unreactive to higher inflation prints. The presumed hawkish pivot by Powell at the last FOMC meeting undercut this view and as a result, bets on inflation getting out of control were pared back. In our view, the moves have been exacerbated by rather stretched positioning with many macro investors caught offsides by betting on a continued steepening of the curve. However, we are unconvinced the Fed has made a meaningful pivot, and in the aftermath of the meeting, it has become increasingly clear that the core leadership at the Fed remains dovishly biased with a broad-based message of the need for continued substantial accommodation. Stepping back, in 1Q21, US GDP was +11% on a nominal basis, and will likely be +15% in 2Q. Core inflation is running in the mid-single digits. Even as these post-pandemic rates of growth and inflation start to subside, they are not at all consistent with nominal interest rates in the low 1% range. Simply put, we think real and nominal rates are too low and would expect yields to have an upward bias. Crowded short positioning might offset this in the near term but fundamentals should ultimately win out.

The selloff in bank equities in response to the Fed’s perceived pivot is perhaps surprising given that a more hawkish central bank is normally considered a positive for banks, but in this instance the stocks were caught in the selloff across reflation assets. Essentially, while the perceived hawkish move would theoretically be positive for bank earnings (via higher short term rates), this benefit was more than offset by the negative impact on the earnings’ multiple (which tends to decline on a flattening yield curve). However, we would make several points. First, while the last Fed taper did cause a flatter curve, the assumption that a flatter curve means lower bank stocks does not necessarily hold up. The US 2/30 curve plummeted from 300 to 50 bps as the Fed tapered (and subsequently hiked) from 2014 to 2018, and the US bank index surged from 70 to 110. Second, it is notable that despite the decline in nominal yields, we continue to see inflation breakevens tick higher in Europe where inflation swaps are sitting near YTD highs even in the aftermath of the Fed surprise (and inflation expectations are the single most highly correlated macro driver to European bank equities). And lastly, while we believe it is far too early to conclude the reflation rally is over, there is much more to like about bank equities than sensitivity to a steeper curve. Significant capital returns, accelerating earnings upgrades, a nascent M&A cycle, and historically low valuations are all key micro tailwinds which provide a strong fundamental backdrop for European bank equities in particular in the next couple of years.

As we look forward, we see bank dividends getting turned back on in September as a key catalyst for the market to return its focus to European bank stocks. The vast majority of our holdings will be trading on 6-7% 2022 dividend yields, with several boasting all-in yields (including buybacks and catch up dividends) well into the teens in 4Q21. European banks have not historically gotten any credit for their excess capital – either because they did not have it or did not return it sufficiently to shareholders. As a result we continue to observe a healthy amount of skepticism about the capital return story in Europe (whereas in the US, CCAR no longer serves as a meaningful positive catalyst as US bank investors have become accustomed to aggressively high payout ratios). It may take some time for the skepticism around European bank capital return, but we are confident that the process will begin in 2H21 and the end game will be lower cost of equity and substantially higher stock prices.

Outside of banks, flows into the European asset management sector have been strong since November 2020, when the vaccine announcements kicked off the value vs growth rotation. They remain elevated seven months later, with active equities growing at 5% annualized in May – a sharp contrast with the US where active equity saw outflows of 2% annualized. In addition, we are seeing pockets of even further strength, most notably in Italy where inflows have started to accelerate among the wealth and asset managers, with some firms seeing 10% annualized growth in May. We expect this trend to continue as excess savings are deployed and risk sentiment returns. Italian asset managers in particular is a space we have been increasingly focused on given accelerating organic growth, attractive valuations, and the scope for market share gains via bank consolidation.