April 2021

How we did in April: The fund returned between 0.0% and 0.3% across the different share classes, compared to SPX 5.3%, SX5E 1.9%, EUR BAML HY (HE00 Index) 0.7%, US BAML HY (H0A0 Index) 1.1% and EM bonds (EMGB Index) 2.3%. Performance in April, gross of fees in EUR, was from: (i) Credit: 53bp, with 67bp from cash and -14bp from CDS; (ii) Rates: -16bp; (iii) FX: -5bp; (iv) Equity: 5bp, and (v) Other: 2bp.

In April, market volatility was low, with range-bound credit and equity indexes. As a result, our returns have been just moderately positive. During the month, we have rotated rates shorts from US to Europe, marginally added exposure to European re-opening, and added to Ukraine on the view the geopolitical risks would fade. We added protection in credit, mostly in the US.

What we are doing now: The portfolio remains cautiously invested in credit. We have been adding protection, as spreads have gradually tightened despite the YTD widening in rates and an uneven global recovery. The re-opening in Europe will gradually accelerate as vaccinations are catching-up with the rest of developed markets. The US outlook remains strong, but rates and risk assets are now pricing a full recovery. In emerging markets, the growth outlook keeps deteriorating, as commodity-driven inflation is adding to a slow vaccination/recovery trend.

Credit overall offers limited opportunities, as spreads are tight and positioning is long. Hence we remain 50% invested and maintain a good degree of credit protection.

Selected areas in cyclical sectors are still interesting, especially in Europe, where the market is still skeptical on re-opening despite a marked acceleration in the vaccination trend. We express this view mostly via travel-related convertible debt (e.g. Accor, Dufry), or financial subordinates that lagged the broader AT1 market (BCP). Overall, we maintain a high allocation to convertibles, especially in bonds with low delta and low credit risk. In vanilla credit bonds, we focus on companies which offer a high coupon relative to their risks, in the cyclical (financial, energy e.g. like Pemex), re-opening (cruises, airlines e.g. CCL, FinnAir) and consumer (autos e.g. Aston Martin) sectors. We added back to Ukraine risk via the sovereign and Naftogaz as recent geopolitical noise offered an entry point.

We expect volatility to rise over the coming months, potentially triggered by near-peak economic momentum, already-long positioning in credit and gradually less dovish central banks, as we wrote in our latest Silver Bullet | Dog Money. We would use this opportunity to redeploy capital in beta-markets, including high yield debt and emerging market hard currency.

Positive developments around re-openings, vaccinations, and the bounceback in macroeconomic data buoyed the constructive tone in risk assets during April. Equities led the broad-based rally across markets and were underpinned by growing inflationary pressures as witnessed by the sharp rise in key commodity prices. For now, wider outright levels and steeper curves across European sovereign rates are being taken as confirmation of the recovery rather than as potential hindrance to further asset gains. In contrast, US Treasuries took a break from the 4-months widening and rallied 20bps in April upon reassurance from the FED that it is in no hurry to withdraw stimulus. Despite the mixed rates move, ongoing credit spread tightening led fixed income higher across geographies.

Across the financials landscape, bank equity (SX7E) closed the month up +4.7% (YTD: +25.2%), as the sector remains a key beneficiary of the recovery and reflation themes. This keeps reflecting positively on the fundamentals of capital securities. Subordinated (Tier 2) credit spreads moved tighter (up to 5bps) with AT1s on average +75c as excess liquidity remains awash in the system and continues to funnel its way into the highest yielding assets. On average, the pick-up between AT1 and T2 for GSIFIs remains sufficiently attractive at c175bps considering the ameliorating economic tone for the sector. Furthermore, we expect any move wider in sovereign rates to be capped in the short-to-medium term given Central Banks’ ongoing willingness to facilitate financing conditions.

First quarter results season started with a very strong set of numbers from the US banks, with double-digit beats of consensus expectations mainly driven by better fees and release of Covid-related provisions. Reporting by European banks was also positive with an undercurrent of expected themes being confirmed, namely normalisation of provisioning, stable capitalisation ratios despite risk-weighted asset inflation, and optimism around capital repatriation towards the end of this year. Differently from their US peers, European banks have mostly opted to keep their provision overlay taken in 2020, waiting to see how the withdrawal of policy support will affect asset quality. The approach, whilst conservative, leaves bank fundamental quality at unprecedented levels.

Primary issuance in April was subdued at just EUR12bn with the vast majority (c80%) concentrated in Senior funding transactions. Overall, this was rather underwhelming given that it was approximately half the run-rate of the previous couple of years though perhaps reflective of the still uncertain financing need and outlook for corporates, and banks’ almost completed compliance with regulatory requirements. We expect issuance to pick-up ahead of the seasonally quieter Summer period once entities come out of black-out periods post 1Q21 results.

Financials had another solid month in April, buoyed by strong bank earnings and a broad rally across equity markets.

Optimism around the economic recovery is picking up as vaccination rates have surged in the US and UK, and more recently, in Europe as well.  While the continent has been dragged down by a slow vaccine rollout and continued lockdowns, we see green shoots on the macro front as vaccine deliveries are set to quadruple in 2Q and the European Recovery fund finally starts to hit in the second half of the year with perhaps more stimulus to come in the wake of German and French elections. Meanwhile, at the sector level, we have seen the largest forward earnings upgrades since 2009, with 2023 estimates up by 12% so far year to date.

We also have an important catalyst coming later this year when the ECB goes back to business as usual on bank dividends, which will be crucial as excess capital has built up to very large proportions of current market caps at banks like Unicredit and ING in particular. Many of our banks trade on dividend yields of 8-9% over the next several years and we expect some to be buying back significant amount of stock at 0.3 or 0.4x tangible book, which will be highly value accretive. Despite all this we have European banks on average trading at a 20% discount to their historical P/pre-provision multiples, and at a 50% discount to where US banks trade on the same basis. When we look across the various metrics of fair value, we find about 45% upside on average across European banks, and that is before the very substantial dividend yields that are on their way. In the US, while we still have large positions in a handful of names, the average US bank stock is not especially appealing at this time trading ~25% above historical average pre-provision multiples. In our view, a re-emergence of loan growth in 2H21 and the beginning of a new Fed hiking cycle by 2H22 is required to justify significant further upside from these levels.

European bank earnings season has once again kicked off with a strong start.  Nearly every bank has beat EPS estimates, with an average beat of 52% thus far.  This has been driven by dramatically lower loan loss provisions, even negative in some cases, as banks adjust their forward-looking expected credit loss models to reflect the much stronger economic outlook versus what was feared last year.  Revenues have also come in strong, driven by continued outperformance in investment banking fees, but also asset & wealth management flows.  Even net interest income has remained resilient, coming in slightly ahead of consensus on average despite EURIBOR remaining at all-time lows, with several banks even upgrading their NIM guidance for 2021.  While there are still several banks to report, at this pace this quarter will likely mark the third one in a row of significant beats, contributing to further earnings upgrades and “de-rating” the sector even after recent strong performance.

M&A continues to be a key theme in our portfolio and in the sector. We have discussed the takeout of two of our key positions, Athene and Creval, in recent commentary. In April we saw Credit Agricole increase its bid price for Creval to 12.50/share, which represents a 19% increase from the original price of 10.50. With the sweetened bid, the deal was accepted by >90% of Creval shareholders and the merger will go forward – we believe it is a win-win for both parties and that value will be created in this transaction. Also in April we had the announcement that Flagstar Bank (another key position in the US book) will be acquired by New York Community Bank in an all-stock deal. Our initial response to this deal was mixed as we thought the stock had much further upside given the growth in tangible book value that we projected as well as the excess capital that a slowdown in mortgage volumes was going to create. However, we do see the strategic and financial merits of the transaction which was accretive to both earnings and tangible book per share – a rarity these days. Assuming the proforma entity can get to just 10x multiple on ’23 earnings (sill a very substantial discount to peers), there is nearly 40% upside in the shares when we include the very safe 6% dividend yield.