May 2022

How we did in May: The fund returned between 0.5% and 0.7% across the different share classes, compared to EUR BAML HY (HE00 Index) -1.3%, US BAML HY (H0A0 Index) 0.2% and EM bonds (EMGB Index) 0.1%. Performance in May, gross of fees in EUR, was from: (i) Credit: 36bp, with 4bp from cash and 32bp from CDS; (ii) Rates: 24bp; (iii) FX: 6bp; and (iv) Equity: 1bp and (v) Other: 0bp.

May was a volatile month for risk assets. Risk asset prices largely closed the month with flat performance, after being down 7% in equities and wider 60bps in HY spreads intra-month. The sell-off was triggered by recession fears following weak consumer commentary from bell-weathers Target and Walmart. The subsequent rally was likely due to a combination of stretched short positioning and up-beat commentary from retailers like Macy’s.

What we are doing now: We have been cautious on the market since the start of 2022, but are now starting to see value in pockets of the market. We cautiously deployed capital during May in investment grade bonds (both DM and EM) and in sectors that benefit from higher rates (e.g. US senior financial bonds).

During May we increased the net cash credit portfolio from around 60% to 68% of AUM. On the cash book, we had focused on bonds with low duration and high coupons, and are now tactically adding in IG bonds with longer duration and low cash prices. While we have reduced our overall short positions in rates, we maintain some short in duration-sensitive assets, such as BTP, and some degree of equity protection.

Our longs focus on sectors which we can perform well even in a tighter monetary policy environment next year: cyclicals that benefit from higher interest rates (e.g. US senior financials), commodities (e.g. oil) and travel/ reopening (e.g. airport retail, cruises). Overall in EM we remain lightly positioned and keep a good degree on protection on vulnerable countries, such as Egypt and Turkey.

We continue to think higher-than-target inflation will weigh on asset prices and beta, and hence remain tactical on adding risk opportunistically. We believe the fund should be set to outperform in this challenging environment, and will be able to capture opportunities as volatility rises further.

Markets had another turbulent month in May as leading Central Bankers vowed to remain engaged on curtailing inflationary pressures. For better or worse, re-anchoring medium to long term inflation expectations is paramount to ensuring broader economic growth prospects. However, in the short-term market participants will need to cater for a period of lower liquidity which inevitably invites greater volatility in all asset prices.

Leading equity indices on average ended May +0.5% but this masks what was a very distinct tale of two halves (i.e. S&P rallied c9% in the second half of the month) and dispersion (i.e US tech -1.5% compared with Europe +1.5%). Financials significantly outperformed the broader market by c8%, with European banks having almost clawed back to unchanged for the year; US banks remain -10% year-to-date (‘YTD’), slightly better than the S&P’s -13% YTD.

Driving the latter was a renewed sell-off in rates; an ETF exposed to US long dated Treasuries dropped another 2.5%, taking its YTD total return to c21%. Not only did curves globally steepen 10bps but across European periphery there was a noteworthy parallel shift upwards of c20bps versus core. ECB rhetoric around normalisation took a hawkish turn and expectations today are for at least 100bps higher rates by this year-end.

Although some European banks disappointed slightly on capital in their first quarter reporting season, the build was sufficiently robust overall such that share buybacks and proposed dividends remain firmly on track, while capital levels remain well in excess of management targets, leaving hefty buffers to regulatory requirements. Interestingly there was a decent number of positive ratings actioned on the more domestically focused players as two years after the pandemic agencies acknowledged the supportive developments across operating efficiency, asset quality, and solvency.

On the regulatory front, there has been a change in the GSIB methodology that could facilitate cross-border M&A for European banks as Eurozone exposures will now be treated as one area, de facto lowering capital buffer requirements. Some of the usual grooms, (i.e. BNP, ING, Unicredit), have already been touted as likely suitors for some of the more undervalued assets but accommodating nationalistic interests could still prevent those long-awaited first dances.

Primary activity in May by European banks amounted to EUR35bn. This was largely in line with last year, but the mix was different as wider credit spreads across the capital stack – 25bps in Senior and up to 75bps in Subordinated in May alone – meant that issuers focused on funding instruments instead. That said, issuers continued to optimise their capital base and a couple of UK entities tendered some legacy instruments (Barclays) as well as inefficient securities (Nationwide). Unlike their banking counterparts, European insurers issued EUR3bn of subordinated debt after two months hiatus. The refinancing of legacy instruments was the central theme from Axa and Munich Re, with a concurrent tender from Athora helping the Dutch insurer reach a more cost-efficient capital structure.

We continue to believe that our Financials-focused funds offer strong relative value and risk-adjusted returns across the broader credit spectrum. With yields having backed up significantly this year, we believe the entry point today compelling both in terms of the existing portfolio composition as well as future investment opportunities with banks still needing to comply with regulatory requirements and refinance upcoming calls.

Financials, and banks in particular, had a strong month in May, despite the continuation of choppy markets as uncertainty around the pace of central bank rate hikes, speculation around an economic recession in the US and Europe, and pressure on stock market valuations persisted. The broader global market indices continued their downtrend, with the MSCI ACWI down as much as 6% at one point, before rallying in the last week of May to close the month flat. The ACWI Financials Index up 2.2% in May, and the European bank and US bank indices up 11.6% and 6.1%, respectively, in USD terms.

Our overweight positioning in European banks was the key driver of the Fund’s >600 basis point outperformance relative to the ACWI Financials index this month. The largest positive contributors to returns were overwhelmingly European and US large cap banks. Core portfolio holdings including BNP Paribas, BPER Banca, Barclays, and Commerzbank were major drivers on the European side. On the US side, Citigroup added the most to our performance after jumping on the news that Berkshire Hathaway had taken a 3% stake in the name in the first quarter.

The strength in European banks in the month was notable but in our view was clearly supported by a significant move higher in earnings estimates. This was driven primarily by increasing net interest income (NII) estimates as equity investors begrudgingly start to bake in the significant benefits of higher interest rates. Consensus 2023 estimates for the European bank sector are now up 8% despite the negative impact to growth and provisioning from the war. This stands in sharp contrast to what we are seeing elsewhere in the market, and in our view there are more upgrades forthcoming as NII estimate still look way too low for a large portion of the sector. For many of our midcap European bank holdings, which are highly sensitive to ECB policy rates, consensus NII growth for 2023 is in the low single digit range – these numbers will have to come up significantly even if the bond market expectations for 200 bps of hikes in the next twelve months is not realized. For context, our estimates assume the ECB stops at 1% (ie, just 150 bps of cumulative hikes from current level), and we are materially ahead of consensus.

Despite the rally in European bank shares, they remain down for the year and would have to climb 55% just to get back to where they were in early 2018, the last time the market was pricing in a potential ECB hiking cycle. Unlike then, excess capital is now being returned to shareholders (in very significant amounts) and estimates are showing a sustained move higher, with forward estimates now up an impressive 78 weeks in a row. Also, unlike then (when European bank stocks traded around 10x forward earnings), the sector trades at 6.5x earnings, a multiple only breached historically in the GFC, the Eurozone crisis, and the depths of the pandemic. Higher earnings combined with attractive valuations and substantial capital return is a compelling mix and we continue to see European banks as the best risk-reward across global financials.