How we did in June: The fund returned between -4.7% and -4.4% across the different share classes, compared to EUR HY (BAML HE00 Index) -7%, US HY (BAML H0A0 Index) -6.8% and EM sovereign credit ( BAML EMGB Index) -6.2%. Performance in June, gross of fees in EUR, was from: (i) Credit: -436bp, with -347bp from cash and -89bp from CDS; (ii) Rates: 27bp; (iii) FX: 10bp; and (iv) Equity: -46bp and (v) Other: 0bp.
June has been the worst month for risk assets since March 2020. Credit, in particular, has been aggressively hit. Global data continued to worsen, but central banks signaled more concerns on inflation, implying no market support. As a result, risk assets sold off dramatically. In credit, selling pressure accelerated and liquidity turned scarcer as a result of lower dealers risk appetite. Mark-to-market has thus been deeply negative across all sectors, geographies and rating buckets.
Rates were volatile but essentially flat over the month. Duration saw deep sell-off in the first half of June and the Fed and ECB sounded hawkish, but tightened aggressively in the second half as markets re-priced an easier 2023 stance amid growth concerns. US Treasuries closed June 10bp tighter after having been 60bp wider at some point. The US curve now prices three cuts in 2023, including one in the first quarter.
What we are doing now: We have been cautious on markets in 2022, but started seeing pockets of value in credit since May. The June sell-off corroborates our view on credit valuations, especially high grade. Spreads, including IG, now fully price a deep global recession over the next twelve months. The default rate implicit in credit indexes is in the high single-digits. High grade credit offers yields and spreads which hover around 10y highs. If the upcoming economic slowdown turns milder than priced, spreads will tighten. If it is in line, rates will tighten and high grade will outperform low grade. Higher overall risk and higher credit quality are thus the right way to position credit portfolios at this point of the cycle, in our view (see our Algebris Bullet for more analysis).
Our portfolio is currently ~80% invested. We deployed capital mostly in investment grade bonds (both DM and EM) and index longs. More than half of our net is IG rated, so we have similar amount invested but substantial less risk than the average HY or EM fund. We are currently hedging 25% of our book DV01, so our duration is currently around 1.7y. Our main risk is thus in spreads of high rated credit across US, Europe and emerging markets.
At sector level, we focus on US banks seniors and selected European AT1s in financials, quality sectors such as telecoms in corporate credit, and safe hard currency issuers (such as Chile, Mexico, or Peru) in emerging markets. As noted above, the level of spreads vs credit fundamentals suggest that high quality credit offers today very high multi-year expected returns, vis-à-vis moderate degrees of risk. Our shorts focus on unsustainable capital structures in selected European retail and real estate issuers (Takko, Signa), and on a few sovereigns which could incur refinancing risk in the current environment (Turkey, Egypt).
Credit markets have re-priced quickly and aggressively over the past few months. As a result, the market offers extremely high spreads on every single credit in the global space, irrespective of quality. While this mispricing can persist for a few months, valuations similar to the one currently prevailing in markets have historically been followed by strong annual returns in credit. We thus think the current set-up represents an important opportunity for long-term credit investors, and position our portfolio accordingly.
Financial Credit Strategy
Markets remained under pressure in June with a renewed sell-off in all risk assets. Global equity indices fell on average 8%, led by Germany -11%, with the only exception being an 8% rally in Chinese equities. Some of the factors that drove the cautious tone were growing concerns around Central Bank hawkishness to tackle inflation into what could be the start of an economic slowdown, rising geopolitical tensions around Ukraine as prospect of shortages in gas and foodstuffs resurfaces, and broad-based asset liquidations with the performance of fixed income and equities correlated strongly for the first time -20% YTD.
Across fixed income, curves parallel shifted on average c20bps with a slight c5bps inversion in the front end. After having aggressively priced in Central Bank hikes over the coming quarters, the market has started to dial these back with cuts now being pencilled in for next Summer. In credit, spreads widened by c30% across leading indices, equating to c25bps in IG, c125bps in HY, c30bps in Senior Financials, and c60bps in Subordinated Financials. AT1s dropped on average 6pts (c150bps wider) with higher beta EUR-denominated securities bearing the brunt -7pts compared with GBP-denominated -4pts and USD-denominated -5pts.
Primary issuance in June was broadly in line with last year’s but the mix was slightly skewed more towards MREL-eligible Senior. AT1 issuance was the most active since Sept-21 as banks finally capitulated on the lack of improving sentiment and had to print to refinance upcoming calls. Recent AT1 transactions have come with reset rates on average 100bps higher, perhaps setting the bar on what could be deemed an economic cost worth paying. Notwithstanding all-in attractive secondary levels, primary activity in financial Senior securities continued to reprice capital stacks wider as issuers increasingly needed to compete with other asset classes that have sold off too.
Despite the bearish undertone in the market driven by the coordinated removal of liquidity by Central Banks as they react to ongoing inflationary pressures, the financial sector has nonetheless managed to see a handful of agency upgrades come through for second tier players. We believe this is testament to the fundamental improvements that have taken place right through the entire landscape with respect to capital, liquidity, and asset quality. Furthermore, several leading European banks were cleared to proceed with their buyback programs as regulators remain comforted by the absolute level of recurrent profitability and capital in the system 2 years after the pandemic.
Our credit funds remain conservatively positioned to take advantage of these market dislocations. The cautious stance we have adopted for several quarters now in anticipation of the current turmoil is playing out as expected: new issuance is coming at attractive levels; rates and credit curves are flattening, favouring shorter duration; broadening market sell-off means cash is king. Although we are not able to predict when the risk sentiment and asset prices might trough, we believe that our funds have the potential to continue delivering attractive risk-adjusted returns over the coming years.
Financial Equity Strategy
2022’s challenging capital markets environment continued, with the MSCI AC World Index dropping -8.4% and the AC Financials Index falling -10.0%. The sell-off was triggered in large part by a hot CPI print in the US that put the peak inflation thesis into question, which in turn led to a dramatic tightening in policy rate expectations. As investors began to fear a tightening into a slowdown, banks in both the US and Europe started to trade off recession fears, with the BKX Index in the US down -13.0% and the SX7E in Europe down -12.7%. The Financial Equity Fund was only slightly better, down -10.8% for the month, but remains significantly ahead of the benchmark and peers on a YTD basis through June. For the first six months of 2022, the Financial Equity strategy is down around -6.2%, more than 950 basis points ahead of the -15.9% return for the ACWI Financials Index.
In the aftermath of the Fed and ECB meetings last month, it is clear that central banks are attempting to rebuild their credibility having spent most of 2021 saying inflation was transitory. The fear for the general investor is that central bankers are prioritizing inflation above growth. Of course, this is the normal concern in any monetary tightening cycle. Yes, the economy is slowing, but this is starting from above trend growth and unemployment levels near record lows. Most households and businesses also have increased savings compared to pre-Covid.
Credit spreads have already widened to recessionary levels. Of course, they may well overshoot, but it is clear opportunities are presenting themselves as prices reflect a significantly more stressed future economic scenario. Looking at bank equities globally, we see a similar phenomenon. Assuming market estimates for provisions double to Covid levels next year, European bank profits on average fall 24%, or only 10% if banks consume their (unutilized) excess provisions from Covid. PE multiples would rise from 6.9x to <10x in 2023 under the harsher scenario, still inexpensive relative to history. The US shows a similar story. What this means for investors, is that the underlying profits justify 50-100% upside across various European banks and 30-50% across US banks. Without recession, substantial progress at the index level should occur within 12 months; with a recession this might be delayed by an additional ~6 months. Either way, the safest place for investors might not be to sit with money under the mattress.
Inflation and higher interest rates are burning a hole in investors’ money. Banks are the most positively geared sector to higher rates. While the market obsesses over provision levels that are likely to rise over the next couple of years, the second half of 2022 will show net interest income estimates are too low both in Europe and the US, providing ample cushion for reserve builds as the economy inevitably slows from above-trend levels. It is apparent that cycles are quicker than in recent years; but this may well mean lower cost of risk during a recession as corporate and household leverage did not get to dangerous levels (in fact quite the opposite in many markets). And clearly bank capital levels are significantly more robust than heading into prior downturns, underwriting standards have been much tighter, concentrations are lower, and more risk resides outside the banking system (e.g. fintech-led securitizations, BDCs, private credit funds, mREITs, etc). In short, it seems the market has been remarkably quick to price in bad news (rising cost of risk) while conveniently ignoring the good (upside to estimates from net interest income, buybacks, valuations). In the meantime, bank earnings estimates continue to trudge higher. This is leading to very significant de-ratings – and some attractive opportunities on the long side.
Stepping back, as we survey the wreckage of the Financial sector after the first half, we find several reasons to be encouraged:
Despite the macro/geopolitical factors driving so much of the market discussion, dispersion within the sector remains extremely high – providing significant alpha opportunities for stock pickers such as ourselves. Within European banks alone, the top 5 stocks were up an average of +35% in the first six months of 2022 (we owned four of them) while the bottom 5 were down -43% (we owned none).
Similar to what we saw in the immediate aftermath of the Russian invasion, the growth scare of the past 5-6 weeks has led to a number of “baby out with the bathwater” situations, providing excellent risk-reward entry points in several new positions which we are currently building.
The portfolio now contains a significant number of stocks trading at what we view as distressed valuations, trading around 3-4x earnings, 20%+ free cash flow yields, and/or with over half the market cap expected to be returned to shareholders via buybacks and dividends in the next three years. We are well aware that valuation cushions are useless if accompanied by earnings that are being persistently downgraded. However, as noted, we see resilience in earnings across our names (and in many cases upside potential, if for instance the bond market is right on the path of ECB and Fed policy hikes) even in a more difficult macro backdrop.
Good things happen to cheap stocks – as long as earnings are heading in the right direction and management is shareholder friendly. This was very much the case for some of our big winners in 1H22 like Sabadell, Standard Chartered, and Moneygram: the bar for significant upside is low when there is a shift in narrative (in the case of Sabadell and Standard Chartered, it was rates; with Moneygram it was management seeking takeout bids). The current narrative in the market is one of universal doom and inevitable global recession (88% of a recent DB poll had investors predicting recession in the next 12 months – not many people left to convince!). While that may well play out, we believe the names in our portfolio have gone a long way already to price in the potential impacts. If on the other hand the narrative shifts yet again – or even if the recession is a short and mild one – we believe there will be a significant chance for upside across our portfolio. In other words, while the exact path is uncertain, in our view the risk reward looks compelling.
Global credit strategy
How we did in June: The fund returned between -4.7% and -4.4% across the different share classes, compared to EUR HY (BAML HE00 Index) -7%, US HY (BAML H0A0 Index) -6.8% and EM sovereign credit ( BAML EMGB Index) -6.2%. Performance in June, gross of fees in EUR, was from: (i) Credit: -436bp, with -347bp from cash and -89bp from CDS; (ii) Rates: 27bp; (iii) FX: 10bp; and (iv) Equity: -46bp and (v) Other: 0bp.
June has been the worst month for risk assets since March 2020. Credit, in particular, has been aggressively hit. Global data continued to worsen, but central banks signaled more concerns on inflation, implying no market support. As a result, risk assets sold off dramatically. In credit, selling pressure accelerated and liquidity turned scarcer as a result of lower dealers risk appetite. Mark-to-market has thus been deeply negative across all sectors, geographies and rating buckets.
Rates were volatile but essentially flat over the month. Duration saw deep sell-off in the first half of June and the Fed and ECB sounded hawkish, but tightened aggressively in the second half as markets re-priced an easier 2023 stance amid growth concerns. US Treasuries closed June 10bp tighter after having been 60bp wider at some point. The US curve now prices three cuts in 2023, including one in the first quarter.
What we are doing now: We have been cautious on markets in 2022, but started seeing pockets of value in credit since May. The June sell-off corroborates our view on credit valuations, especially high grade. Spreads, including IG, now fully price a deep global recession over the next twelve months. The default rate implicit in credit indexes is in the high single-digits. High grade credit offers yields and spreads which hover around 10y highs. If the upcoming economic slowdown turns milder than priced, spreads will tighten. If it is in line, rates will tighten and high grade will outperform low grade. Higher overall risk and higher credit quality are thus the right way to position credit portfolios at this point of the cycle, in our view (see our Algebris Bullet for more analysis).
Our portfolio is currently ~80% invested. We deployed capital mostly in investment grade bonds (both DM and EM) and index longs. More than half of our net is IG rated, so we have similar amount invested but substantial less risk than the average HY or EM fund. We are currently hedging 25% of our book DV01, so our duration is currently around 1.7y. Our main risk is thus in spreads of high rated credit across US, Europe and emerging markets.
At sector level, we focus on US banks seniors and selected European AT1s in financials, quality sectors such as telecoms in corporate credit, and safe hard currency issuers (such as Chile, Mexico, or Peru) in emerging markets. As noted above, the level of spreads vs credit fundamentals suggest that high quality credit offers today very high multi-year expected returns, vis-à-vis moderate degrees of risk. Our shorts focus on unsustainable capital structures in selected European retail and real estate issuers (Takko, Signa), and on a few sovereigns which could incur refinancing risk in the current environment (Turkey, Egypt).
Credit markets have re-priced quickly and aggressively over the past few months. As a result, the market offers extremely high spreads on every single credit in the global space, irrespective of quality. While this mispricing can persist for a few months, valuations similar to the one currently prevailing in markets have historically been followed by strong annual returns in credit. We thus think the current set-up represents an important opportunity for long-term credit investors, and position our portfolio accordingly.
Financial Credit Strategy
Markets remained under pressure in June with a renewed sell-off in all risk assets. Global equity indices fell on average 8%, led by Germany -11%, with the only exception being an 8% rally in Chinese equities. Some of the factors that drove the cautious tone were growing concerns around Central Bank hawkishness to tackle inflation into what could be the start of an economic slowdown, rising geopolitical tensions around Ukraine as prospect of shortages in gas and foodstuffs resurfaces, and broad-based asset liquidations with the performance of fixed income and equities correlated strongly for the first time -20% YTD.
Across fixed income, curves parallel shifted on average c20bps with a slight c5bps inversion in the front end. After having aggressively priced in Central Bank hikes over the coming quarters, the market has started to dial these back with cuts now being pencilled in for next Summer. In credit, spreads widened by c30% across leading indices, equating to c25bps in IG, c125bps in HY, c30bps in Senior Financials, and c60bps in Subordinated Financials. AT1s dropped on average 6pts (c150bps wider) with higher beta EUR-denominated securities bearing the brunt -7pts compared with GBP-denominated -4pts and USD-denominated -5pts.
Primary issuance in June was broadly in line with last year’s but the mix was slightly skewed more towards MREL-eligible Senior. AT1 issuance was the most active since Sept-21 as banks finally capitulated on the lack of improving sentiment and had to print to refinance upcoming calls. Recent AT1 transactions have come with reset rates on average 100bps higher, perhaps setting the bar on what could be deemed an economic cost worth paying. Notwithstanding all-in attractive secondary levels, primary activity in financial Senior securities continued to reprice capital stacks wider as issuers increasingly needed to compete with other asset classes that have sold off too.
Despite the bearish undertone in the market driven by the coordinated removal of liquidity by Central Banks as they react to ongoing inflationary pressures, the financial sector has nonetheless managed to see a handful of agency upgrades come through for second tier players. We believe this is testament to the fundamental improvements that have taken place right through the entire landscape with respect to capital, liquidity, and asset quality. Furthermore, several leading European banks were cleared to proceed with their buyback programs as regulators remain comforted by the absolute level of recurrent profitability and capital in the system 2 years after the pandemic.
Our credit funds remain conservatively positioned to take advantage of these market dislocations. The cautious stance we have adopted for several quarters now in anticipation of the current turmoil is playing out as expected: new issuance is coming at attractive levels; rates and credit curves are flattening, favouring shorter duration; broadening market sell-off means cash is king. Although we are not able to predict when the risk sentiment and asset prices might trough, we believe that our funds have the potential to continue delivering attractive risk-adjusted returns over the coming years.
Financial Equity Strategy
2022’s challenging capital markets environment continued, with the MSCI AC World Index dropping -8.4% and the AC Financials Index falling -10.0%. The sell-off was triggered in large part by a hot CPI print in the US that put the peak inflation thesis into question, which in turn led to a dramatic tightening in policy rate expectations. As investors began to fear a tightening into a slowdown, banks in both the US and Europe started to trade off recession fears, with the BKX Index in the US down -13.0% and the SX7E in Europe down -12.7%. The Financial Equity Fund was only slightly better, down -10.8% for the month, but remains significantly ahead of the benchmark and peers on a YTD basis through June. For the first six months of 2022, the Financial Equity strategy is down around -6.2%, more than 950 basis points ahead of the -15.9% return for the ACWI Financials Index.
In the aftermath of the Fed and ECB meetings last month, it is clear that central banks are attempting to rebuild their credibility having spent most of 2021 saying inflation was transitory. The fear for the general investor is that central bankers are prioritizing inflation above growth. Of course, this is the normal concern in any monetary tightening cycle. Yes, the economy is slowing, but this is starting from above trend growth and unemployment levels near record lows. Most households and businesses also have increased savings compared to pre-Covid.
Credit spreads have already widened to recessionary levels. Of course, they may well overshoot, but it is clear opportunities are presenting themselves as prices reflect a significantly more stressed future economic scenario. Looking at bank equities globally, we see a similar phenomenon. Assuming market estimates for provisions double to Covid levels next year, European bank profits on average fall 24%, or only 10% if banks consume their (unutilized) excess provisions from Covid. PE multiples would rise from 6.9x to <10x in 2023 under the harsher scenario, still inexpensive relative to history. The US shows a similar story. What this means for investors, is that the underlying profits justify 50-100% upside across various European banks and 30-50% across US banks. Without recession, substantial progress at the index level should occur within 12 months; with a recession this might be delayed by an additional ~6 months. Either way, the safest place for investors might not be to sit with money under the mattress.
Inflation and higher interest rates are burning a hole in investors’ money. Banks are the most positively geared sector to higher rates. While the market obsesses over provision levels that are likely to rise over the next couple of years, the second half of 2022 will show net interest income estimates are too low both in Europe and the US, providing ample cushion for reserve builds as the economy inevitably slows from above-trend levels. It is apparent that cycles are quicker than in recent years; but this may well mean lower cost of risk during a recession as corporate and household leverage did not get to dangerous levels (in fact quite the opposite in many markets). And clearly bank capital levels are significantly more robust than heading into prior downturns, underwriting standards have been much tighter, concentrations are lower, and more risk resides outside the banking system (e.g. fintech-led securitizations, BDCs, private credit funds, mREITs, etc). In short, it seems the market has been remarkably quick to price in bad news (rising cost of risk) while conveniently ignoring the good (upside to estimates from net interest income, buybacks, valuations). In the meantime, bank earnings estimates continue to trudge higher. This is leading to very significant de-ratings – and some attractive opportunities on the long side.
Stepping back, as we survey the wreckage of the Financial sector after the first half, we find several reasons to be encouraged:
Good things happen to cheap stocks – as long as earnings are heading in the right direction and management is shareholder friendly. This was very much the case for some of our big winners in 1H22 like Sabadell, Standard Chartered, and Moneygram: the bar for significant upside is low when there is a shift in narrative (in the case of Sabadell and Standard Chartered, it was rates; with Moneygram it was management seeking takeout bids). The current narrative in the market is one of universal doom and inevitable global recession (88% of a recent DB poll had investors predicting recession in the next 12 months – not many people left to convince!). While that may well play out, we believe the names in our portfolio have gone a long way already to price in the potential impacts. If on the other hand the narrative shifts yet again – or even if the recession is a short and mild one – we believe there will be a significant chance for upside across our portfolio. In other words, while the exact path is uncertain, in our view the risk reward looks compelling.