How we did in February: The fund returned between -0.7% and -0.4% across different share classes, compared to EUR HY (BAML HE00 Index) -0.2%, US HY (BAML H0A0 Index) -1.3% and EM sovereign credit (BAML EMGB Index) -2.7%. Performance in February, gross of fees in EUR, was: (i) Credit: -142bps, with -137bps from cash and -4bps from CDS; (ii) Rates: 74bps; (iii) FX: -10bps, (iv) Equity: 12bps and (v) Other: -1bps.
February saw a takeback of the January strong performance in fixed income markets. Major global fixed income indexes are back to flat, post a rally in January. The driver of weakness has been interest rates volatility, as strong data in US and sticky inflation in Europe triggered a re-pricing of interest rates. In February, market has priced out cuts for 2023. Credit spreads held up better, also thanks to resilient economic data. As a result, high yield segments of the market have outperformed. Our strategy maintained a conservative duration profile in February and reduced credit exposure in late January, hence holding to most of 2023 gains despite the re-pricing.
What are we doing now: The fund continues to be long credit but conviction has been reduced in light of the recent tightening. We have reduced exposure to tight high-rated names to increase exposure to higher yielding areas. Net credit exposure has remained relatively stable.
The fund is 67% net invested in credit, with 2.6y duration and 7.6% blended YTC.
Net credit exposure is made of 94% net cash exposure, 20% net short in CDS indexes, and 7% short in single-name CDS.
Market has priced out cuts in 2023, and prices a terminal rate of 5.5% in US and 4% in Europe.
While the pricing in interest rates markets is appropriate as a base case, a re-pricing of US terminal rates or a strong curve steepening remain risks.
We maintain duration below major credit indexes and keep some tail protection against a scenario of very wide rates.
Data remain resilient in both US and Europe, and credit spreads are at average levels vs the past 5 years.
We thus re-focus our attention on higher yielding credits, and reduce overall long cash credit exposure to protect from a situation where rates volatility filters through into credit markets.
The overall credit quality of the cash book was down one notch in February to BB+. The relation between the fund yield and rating remains among the best ones over the life of the fund.
In financials, we reduced US senior and T2 and added to AT1 in Europe.
In corporates, we are reducing new issues that performed well, especially IG, and add more cyclical sectors (residential, aircraft leasing) in issuers with strong fundamentals. We have also been moving to lower-rated credits within sectors (e.g. Telcos).
In EM, we are rotating BBB into BBs in USD bonds, and overall rotating hard currency to local currency bonds in countries where central banks have room to cut.
Our long cash book is made by 55% financials, 31% corporates, 16% emerging markets.
Gross exposure in the fund is 157%. The credit short book is 35%, of which 8% in cash credit and 27% in CDS (20% index, 7% single name CDS).
Financial Credit Strategy
After the exceptional start to the year, February was a month of retracement as new economic datapoints brought back concerns around the persistence of inflation that would in turn make the case for continual rate hikes by central banks. It was a combination of both surprisingly strong job growth (+517k vs 188k consensus) and robust core CPI figures (+0.4% MoM or +5.6% YoY) in the USA whilst more recent country releases in the Euro area, from France and Spain, point towards further upside in core inflation. Rate expectations moved in lockstep as the markets priced in a further 50bps of increases by both the Fed and the ECB in response to the persistency of inflation.
Performance in credit was weak, reflecting this repositioning of rate expectations in February. Financials were down 1-1.5pts across the capital structure, with spreads unchanged or a touch tighter that offset partially the rates move. In contrast, European bank equities notched up another strong month with total returns of +6.2% in February, making it the second-best performing asset class and significantly outperforming its US counterparts who were down -2.3% in the same period. Performance here was driven by the strong full-year results that unveiled the full benefit of rates gearing on profits and led to a significant pickup in payouts.
With the 4Q22 results season drawing to a close, the key themes observed have been consistent; c.5% net interest income (NII) beats versus consensus driven by higher rates and low deposit betas, reassuring trends in asset quality with annualised cost of risk +c.10bps QoQ, and robust capital ratios expanding sequentially +30bps on the back of better earnings. Focusing on the headline NII, the clear winners were retail banks with more sensitive balance sheets such as those in Spain and Italy, with the latter posting the largest 4Q22 beats. Buoyed by the improved operating environment and solid capital positions, European banks continue to focus on increasing capital returns, either via increased payout ratios and/or new share buyback programmes. Santander’s most recent 2023-2025 business plan emphasises this point as management uplifted its payout ratio target from 40% to 50% whilst maintaining an unchanged CET1 target of greater than 12%.
Primary issuance naturally pulled back in February after the blowout in the prior month, as the start of the month was broadly a blackout period pre-announcement of quarterly results. Even then, total issuance from European financials reached c.€36.2bn, including c.€5.6bn of AT1s and c.€18.2bn of Senior Holdcos. Pricing remained attractive, particularly in AT1s where we participated in new deals by some of our core issuers. The most notable AT1s issued were towards the end of the month from Barclays, who printed the largest ever GBP-denominated at 9.25%, and HSBC that came with a $2bn deal at 8%, its highest AT1 coupon ever, and completes its needs for this year. The purpose of both deals was the refinancing of upcoming calls which keeps overall net issuance in the AT1 space unchanged. Away from capital, we expect funding supply to remain elevated in 1H23 before the technical backdrop improves in the second half of 2023.
Financial Equity Strategy
Global financial equities stepped back in February, falling 2.3% in USD terms after the strong start to the year. Performance dispersion was relatively wide, with European banks up 3.7% in USD terms while large cap US banks dropped 2.7% and European insurers gave back nearly 2%. Notably, though, global financials continue to outperform broader markets, with February representing the seventh month in a row in which MSCI World Financials outperformed the MSCI World index, both in strong up and big down months.
As longtime investors in the sector will attest, the consistent and significant outperformance that we have seen from financials relative to broader markets is not typical. And perhaps even more so when focusing just on European banks, which have had a miserable decade and a half of consistent and significant under-performance, both absolute and relative. So the instinctual reaction is to assume that any sort of rally that we’ve seen so far will ultimately be faded. Of course, nothing moves in a straight line but we continue to believe there has been a real inflection point in the sector, which could lead to a multi-year period of strong total returns.
It is important to note that the bulk of the rally we have seen to date in European banks has been driven by earnings upgrades – not multiple expansion. In fact, sector-level valuation remains near historical trough levels and many of our bank holdings still trade on extremely low multiples of both earnings and tangible book. It is our view that we will see a re-rating in the sector over the next several years as the resilience of bank balance sheets to Covid, war, an energy crisis, and a bond market shock combine with a very material capital return to drive down the cost of the equity from current highly elevated levels (mid-high teens COE). This is precisely what we saw in the first half of the last decade with European insurers, which re-rated following the GFC/EZ crisis from 6x to 11x as investors recognized the resilience of their business models (whether black box or not) and became increasingly attracted to a consistent return of capital. We see a similar path playing out for European banks and expect this will be the next leg up for the sector once the very strong earnings upgrade cycle begins to subside.
For now though, that upgrade cycle remains very much in place and 4Q22 earnings season was undeniably strong for our European bank holdings. Warning signs do come from the US bank sector, where funding costs have been pressured higher on a Fed hiking cycle as the terminal rate continues to push higher. While fully acknowledging the “peak NII” risks that have hit some US banks (which, despite these risks, are up 9% YTD through February), we believe that important differences exist between the US and European markets which should help at least partially insulate the latter from rising funding costs. For instance, unlike in Europe, US markets have a highly mature money market fund industry which makes substituting deposits seamless – forcing banks to pay up to retain deposits which can outflow with the click of a button. Additionally, loan growth has been strong in the US, forcing banks there to compete for funding, a very different situation from Europe, where loan growth continues to be slow. Third, the absolute level of rates remains substantially lower in Europe than in the US, which matters as the tipping point for US bank deposit costs was really in the 3.5-4% range (below that, customer inertia was palpable and deposit betas were very low). And finally, many European banks have structural hedge books which will act as a tailwind for NII for years to come as higher yielding swap rates roll into earnings. So far, this all has resulted in extremely low (mid-single digits) deposit betas in many parts of Europe. We expect this to persist and for higher rates to support NII upgrades, especially as most EU bank management teams assume much lower rates than actual (with a bank like Soc Gen assuming ECB cuts rates right back to zero by 2025, as one example).
All in, while we take note of the strong recent performance, and take heed from what we are seeing with US banks, we think the medium-term investment thesis for European bank equities remains very much intact. Zoom out from the past year and we find the bank stocks still trading 40% below where they were in 2015, when NIRP prevailed and profitability was half what it is today. There is a strong re-rating case to be made here, and while we wait, banks will be returning capital to us as shareholders for years to come. As always, stock selection will be paramount as we navigate this ever-evolving landscape.
Global credit strategy
How we did in February: The fund returned between -0.7% and -0.4% across different share classes, compared to EUR HY (BAML HE00 Index) -0.2%, US HY (BAML H0A0 Index) -1.3% and EM sovereign credit (BAML EMGB Index) -2.7%. Performance in February, gross of fees in EUR, was: (i) Credit: -142bps, with -137bps from cash and -4bps from CDS; (ii) Rates: 74bps; (iii) FX: -10bps, (iv) Equity: 12bps and (v) Other: -1bps.
February saw a takeback of the January strong performance in fixed income markets. Major global fixed income indexes are back to flat, post a rally in January. The driver of weakness has been interest rates volatility, as strong data in US and sticky inflation in Europe triggered a re-pricing of interest rates. In February, market has priced out cuts for 2023. Credit spreads held up better, also thanks to resilient economic data. As a result, high yield segments of the market have outperformed. Our strategy maintained a conservative duration profile in February and reduced credit exposure in late January, hence holding to most of 2023 gains despite the re-pricing.
What are we doing now: The fund continues to be long credit but conviction has been reduced in light of the recent tightening. We have reduced exposure to tight high-rated names to increase exposure to higher yielding areas. Net credit exposure has remained relatively stable.
Financial Credit Strategy
After the exceptional start to the year, February was a month of retracement as new economic datapoints brought back concerns around the persistence of inflation that would in turn make the case for continual rate hikes by central banks. It was a combination of both surprisingly strong job growth (+517k vs 188k consensus) and robust core CPI figures (+0.4% MoM or +5.6% YoY) in the USA whilst more recent country releases in the Euro area, from France and Spain, point towards further upside in core inflation. Rate expectations moved in lockstep as the markets priced in a further 50bps of increases by both the Fed and the ECB in response to the persistency of inflation.
Performance in credit was weak, reflecting this repositioning of rate expectations in February. Financials were down 1-1.5pts across the capital structure, with spreads unchanged or a touch tighter that offset partially the rates move. In contrast, European bank equities notched up another strong month with total returns of +6.2% in February, making it the second-best performing asset class and significantly outperforming its US counterparts who were down -2.3% in the same period. Performance here was driven by the strong full-year results that unveiled the full benefit of rates gearing on profits and led to a significant pickup in payouts.
With the 4Q22 results season drawing to a close, the key themes observed have been consistent; c.5% net interest income (NII) beats versus consensus driven by higher rates and low deposit betas, reassuring trends in asset quality with annualised cost of risk +c.10bps QoQ, and robust capital ratios expanding sequentially +30bps on the back of better earnings. Focusing on the headline NII, the clear winners were retail banks with more sensitive balance sheets such as those in Spain and Italy, with the latter posting the largest 4Q22 beats. Buoyed by the improved operating environment and solid capital positions, European banks continue to focus on increasing capital returns, either via increased payout ratios and/or new share buyback programmes. Santander’s most recent 2023-2025 business plan emphasises this point as management uplifted its payout ratio target from 40% to 50% whilst maintaining an unchanged CET1 target of greater than 12%.
Primary issuance naturally pulled back in February after the blowout in the prior month, as the start of the month was broadly a blackout period pre-announcement of quarterly results. Even then, total issuance from European financials reached c.€36.2bn, including c.€5.6bn of AT1s and c.€18.2bn of Senior Holdcos. Pricing remained attractive, particularly in AT1s where we participated in new deals by some of our core issuers. The most notable AT1s issued were towards the end of the month from Barclays, who printed the largest ever GBP-denominated at 9.25%, and HSBC that came with a $2bn deal at 8%, its highest AT1 coupon ever, and completes its needs for this year. The purpose of both deals was the refinancing of upcoming calls which keeps overall net issuance in the AT1 space unchanged. Away from capital, we expect funding supply to remain elevated in 1H23 before the technical backdrop improves in the second half of 2023.
Financial Equity Strategy
Global financial equities stepped back in February, falling 2.3% in USD terms after the strong start to the year. Performance dispersion was relatively wide, with European banks up 3.7% in USD terms while large cap US banks dropped 2.7% and European insurers gave back nearly 2%. Notably, though, global financials continue to outperform broader markets, with February representing the seventh month in a row in which MSCI World Financials outperformed the MSCI World index, both in strong up and big down months.
As longtime investors in the sector will attest, the consistent and significant outperformance that we have seen from financials relative to broader markets is not typical. And perhaps even more so when focusing just on European banks, which have had a miserable decade and a half of consistent and significant under-performance, both absolute and relative. So the instinctual reaction is to assume that any sort of rally that we’ve seen so far will ultimately be faded. Of course, nothing moves in a straight line but we continue to believe there has been a real inflection point in the sector, which could lead to a multi-year period of strong total returns.
It is important to note that the bulk of the rally we have seen to date in European banks has been driven by earnings upgrades – not multiple expansion. In fact, sector-level valuation remains near historical trough levels and many of our bank holdings still trade on extremely low multiples of both earnings and tangible book. It is our view that we will see a re-rating in the sector over the next several years as the resilience of bank balance sheets to Covid, war, an energy crisis, and a bond market shock combine with a very material capital return to drive down the cost of the equity from current highly elevated levels (mid-high teens COE). This is precisely what we saw in the first half of the last decade with European insurers, which re-rated following the GFC/EZ crisis from 6x to 11x as investors recognized the resilience of their business models (whether black box or not) and became increasingly attracted to a consistent return of capital. We see a similar path playing out for European banks and expect this will be the next leg up for the sector once the very strong earnings upgrade cycle begins to subside.
For now though, that upgrade cycle remains very much in place and 4Q22 earnings season was undeniably strong for our European bank holdings. Warning signs do come from the US bank sector, where funding costs have been pressured higher on a Fed hiking cycle as the terminal rate continues to push higher. While fully acknowledging the “peak NII” risks that have hit some US banks (which, despite these risks, are up 9% YTD through February), we believe that important differences exist between the US and European markets which should help at least partially insulate the latter from rising funding costs. For instance, unlike in Europe, US markets have a highly mature money market fund industry which makes substituting deposits seamless – forcing banks to pay up to retain deposits which can outflow with the click of a button. Additionally, loan growth has been strong in the US, forcing banks there to compete for funding, a very different situation from Europe, where loan growth continues to be slow. Third, the absolute level of rates remains substantially lower in Europe than in the US, which matters as the tipping point for US bank deposit costs was really in the 3.5-4% range (below that, customer inertia was palpable and deposit betas were very low). And finally, many European banks have structural hedge books which will act as a tailwind for NII for years to come as higher yielding swap rates roll into earnings. So far, this all has resulted in extremely low (mid-single digits) deposit betas in many parts of Europe. We expect this to persist and for higher rates to support NII upgrades, especially as most EU bank management teams assume much lower rates than actual (with a bank like Soc Gen assuming ECB cuts rates right back to zero by 2025, as one example).
All in, while we take note of the strong recent performance, and take heed from what we are seeing with US banks, we think the medium-term investment thesis for European bank equities remains very much intact. Zoom out from the past year and we find the bank stocks still trading 40% below where they were in 2015, when NIRP prevailed and profitability was half what it is today. There is a strong re-rating case to be made here, and while we wait, banks will be returning capital to us as shareholders for years to come. As always, stock selection will be paramount as we navigate this ever-evolving landscape.