January 2022

How we did in January: The fund returned between -1.1% and -1.3% across the different share classes, compared to EUR BAML HY (HE00 Index) -1.5%, US BAML HY (H0A0 Index) -2.7% and EM bonds (EMGB Index) -2.7%. Performance in January, gross of fees in EUR, was from: (i) Credit: -111bp, with -120bp from cash and 9bp from CDS; (ii) Rates: 26bp; (iii) FX: -16bp; (iv) Equity: -5bp, and (v) Other: 11bp.

In January, risk assets sold off as central banks signaled for more aggressive monetary policy tightening than the market had priced in. Fed chair Powell hinted at four hikes in 2022 and ECB President Lagarde left the door open for the possibility of a 2022 rate hike. The fund outperformed credit indices given its exposure to the re-opening sectors which performed well, positioning for wider rates through options and an overall defensive stance with a high cash balance.

What we are doing now: We see 2022 as a challenging year for risk assets, bonds in particular, as we wrote in The Silver Bullet | When the Music Stops. As fighting inflation is now a top political agenda, and central banks will likely tighten monetary policy even if asset prices fall. Said simply: the central bank intervention level, or put strike, has been lowered. Therefore, we maintain a defensive stance in credit, with net 45% in cash credit opportunities, selecting bonds with low duration high coupons and shareholder/government support. We also added protection through puts in cash credit indices, BTPs and OATs, as cash credit as well as sovereigns spreads have remained resilient and could widen further.

In credit, we focus on sectors which we think could perform well even in a tighter monetary policy environment next year – travel/ reopening (e.g. airlines, cruises), cyclicals that benefit from higher interest rates (e.g. financials) and defensive consumer discretionary (e.g. luxury cars). In convertibles, we maintain a high allocation to firms with low credit risk and upside linked to reopening and higher commodity prices. In EM, we remain lightly positioned and added protection in Russia, South Africa and other higher beta sovereigns, like Egypt.

In 2022, we think higher-than-target inflation and hawkish central banks will weigh on asset prices and beta. We believe the fund should continue to outperform in this challenging environment, and will be able to capture opportunities when volatility rises further.

Risk assets started the year on their back foot, largely due to Central Banks’ increasingly hawkish tone around the need to tackle what is proving to be “not so transitory” inflation. Accordingly, the frequency and magnitude of rate hikes required to curtail rising prices grew in January, with the ECB’s first hike brought forward 6-months and rates expected to be at 0% by next Summer versus prior expectations of late 2025. Likewise, the market priced in an additional 1-2 hikes this year in the US, with the FED signalling a potential start to its balance sheet reduction sometime after the Summer.

On the back of Central Banks’ rhetoric, core sovereign rates generally widened 20bps across the curve in January. Equity markets fell c5%, albeit with sharp dispersion across key regions, as US and Asia closed down -7%, Europe -3%, whilst the UK ended up positive +1%. Financials stood out as the best performing sector, as the expected benefit of higher rates on profitability boosted the sector equity indices up by c6% in Europe and c2% in the US. Financial credit on the contrary was broadly down, with spreads c35bps wider across the capital structure and AT1s down c2pts on average. As expected, the recent issues underperformed the sector, trading down to the mid and low 90s. We generally avoided these bonds when they came in primary last year, due to the unattractive combination of low coupon, backend spreads and longer calls.

Ahead of the start of the Full Year 2021 reporting season, the sector took a further step down its normalisation path as the regulators increased the countercyclical buffers in Germany and Switzerland, following on from a similar change in France and the UK. With macroeconomic activity recovering, this 50-100bps change could be expected and we believe preferred to other forms of regulatory requirements, as it is easier to reverse at times of inflection than Pillar 2. Importantly, excess capital remains at all times high as banks keep improving profitability and organic capital generation, all while normalising shareholder payouts. In this context, regulators opened to buybacks, with some relevant programs announced recently by a few leading European banks, a trend we expect others to follow over the coming quarters and as long as stocks trade at discount to their book value.

The political landscape in Italy reached a short-term solution that extends the current governing partnership of Mattarella and Draghi until next year ceteris paribus. Although the inability to agree on a consensual pick for a new President could be seen as negative, maintaining the status quo is reassuring for now as it eliminates uncertainty. Furthermore, the daunting prospect of general elections might not necessarily lead to an adverse outcome from a markets’ perspective.

Primary issuance picked up significantly in January with the EUR55bn amount raised across the capital stack of European banks being one of the largest going back to 2018. Volumes were up nearly 30% on last January and remained concentrated in the funding lines, with capital instruments making up just 15% of the total. Unsurprisingly French banks accounted for just under 40% of the total issuance due to a combination of their specific individual needs and the upcoming elections which eliminates one window between blackout periods. As European banks continue to print new deals with more attractive metrics in terms of outright coupon and spread, we remain positioned to take advantage of this primary activity at more rewarding levels.

January’s FOMC meeting showcased an increasingly hawkish Fed, underpinned during the press conference by Chair Powell’s refusal to rule out a hike at every subsequent meeting this year. Equity markets took this poorly, most notably the more speculative growth segments. We continue to believe that bank stocks provide a good hedge against rising interest rates. The primary risk we see from an overly hawkish Fed is that tightening will result in slowing economic growth and a flattening yield curve. This environment could put pressure on broader credit and equity markets. However, it is notable that this cycle bears strong resemblance to that of 1999-2000, when the Fed was tightening, tech/growth stocks were faltering, curves were flattening and growth was high but slowing. In this backdrop, banks were very strong performers on both an absolute and relative basis, with US banks +33%, European banks +15% in the 18 months following the peak of the tech boom, a period during which the Nasdaq was down 64%. We think banks are well positioned to continue outperforming in this cycle, with hawkish central banks a problem for many sectors but a tailwind for top line growth at banks.

US banks recently wrapped up fourth quarter earnings reporting. The stocks performed extremely well going into earnings, up more than 9% in the first week of the year against a 2% decline for the S&P 500 over the same period, as the 10-Year yield rose 25 basis points. We used this strength to take some profits in our US regional bank positions, which saw multiple expansion on the expectation of higher net interest margins and a faster hike cycle from the Fed. Once earnings hit, sentiment weakened. While banks guided higher on loan growth (which is already +10% versus a quarter ago) and net interest margins, concerns about the negative impact of higher expenses and lower fee revenues dominated investor attention. JPM led large banks in providing surprisingly high expense guidance for 2022, and capital markets and mortgage banking revenues clearly look to be normalizing from their early 2021 peaks. Sell-side analysts revised 2022 operating expenses estimates up by an average of 2% for the industry, with net -1% revision in pre-provision net revenues. All in, not a meaningful change to forward estimates but the pre-earnings euphoria has started to subside and we continue to look across the space for names that are cheap relative to earnings power and interest rate sensitivity.

UBS reported 4Q21 earnings this week, with profits coming in 25% ahead of expectations driven by beats on both revenues and costs, with beats within each operating segment as well. The investment bank continues to deliver strong revenues, while also maintain cost discipline which was well received after some cost concerns had arisen in the US. Perhaps most notably, UBS delivered well above consensus expectations on capital return – declaring a dividend of $0.50 vs expectations of $0.39, and a buyback for 2022 of $5.0bn vs expectations of $3.2bn. Put together, this implies a 10% total yield for UBS even after the 8% rally post the results. In addition, a new business plan through 2024 was presented, highlighting 10-15% annual growth in profits within the Global Wealth Management segment (vs consensus of 5%), and a ROTE target of 13-16% vs consensus of 13%, providing fuel for 10%+ earnings upgrades to estimates of long-term earnings power. We believe these targets are very achievable, particularly in light of UBS’ announced gross cost savings initiatives which will help it offset underlying cost inflation that companies globally are now confronted with, enabling operating leverage to deliver the higher targeted ROTE. Trading at 1.26x tangible book value after the post-earnings rally, the shares continue to look attractively valued for a top global franchise that is firing on all cylinders.