March 2022

How we did in March: The Fund returned between -0.8% and -0.6% across the different share classes, compared to EUR BAML HY (HE00 Index) -0.1%, US BAML HY (H0A0 Index) -0.9% and EM bonds (EMGB Index) -1.5%. Performance in March, gross of fees in EUR, was from: (i) Credit: -89bp, with -111bp from cash and 23bp from CDS; (ii) Rates: 43bp; (iii) FX: 0bp; (iv) Equity: -15bp, and (v) Other: -5bp.

In March, credit spreads partially recovered from their higher levels earlier in the month but rates continued to sell off. As a result, March was negative for cash bond prices. The Fund therefore partially compensated for the loss in long cash credits with a gain through short rates hedges.

What we are doing now: We continue to see 2022 as a challenging year for risk assets, bonds in particular. In addition to European recessionary fears due to the war, central banks have struck a decisively hawkish tone, prioritising inflation over growth.

Credit spreads have normalized to near pre-war levels. Therefore, overall we maintain a defensive stance on our cash book, with net 50% in long cash credit opportunities. We are also actively reducing our longs in European credit via credit default swap indices, given the risk of a technical recession in Europe in Q3/Q4. On the cash book, we focus on bonds with low duration, high coupons and shareholder/government support. 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 believe can 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 have closed our net short position in Russia, as prices now reflect a high probability of default. 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. The dramatic events in Ukraine will accelerate both inflation and volatility, meaning liquidations in beta may take place. We believe the Fund should be set to outperform in this challenging environment, and will be able to capture opportunities as volatility rises further.

Despite a general firming of macroeconomic indicators, March capped off what was one of the worst quarters for all risk assets with exception of commodities. Leading US and European equity indices were down 5% to 10%, while proxies for US rates are down almost 10% year-to-date (‘YTD’). The broad-based deterioration in market sentiment was driven by ongoing geopolitical uncertainty, inevitable monetary tightening to combat inflation and another wave of CoVID in China, potentially exacerbating ongoing supply issues, all of which are unlikely to dissipate anytime soon.

At the forefront of market moves was a generalised de-anchoring of front-end rates led by the US 2-year, which sold off another 90bps in March taking the YTD move to 160bps. This was the sharpest widening in nearly 40 years. ECB rate hikes were brought forward too, with the market now pricing over 125bps increase within the next year; To put it into perspective, at the start of 2022 the base case was for just one 25bps increase. Fearing that monetary tightening might be excessive, increasing the risk of a recession, rate curves flattened by some 10bps in March, dragging banks’ equities down in both Europe (-2.5%) and US (-7%). Across European banks’ capital stack, spreads widened +20/25bps in dated Subordinated and +5/10bps in Senior, with AT1 largely unchanged.

Throughout March the market remained focused on the European banks’ exposure to Russia, Ukraine and Belarus, estimated at EUR 90bn. With exception of RBI and OTP, exposed names’ reliance to the country is marginal, and a worst case scenario would be well absorbed by the ample excess capital. Furthermore, European banks have mostly retained extra provisions booked during the pandemic, so far unused and representing on average c. 50% of annual provisions. Therefore, while second and third order effects are likely to bring some additional headwinds, the sector remains robust and well prepared for potential asset quality deterioration.

Speaking at an annual conference for the European banks sector, and more recently to the Eurogroup, the head of ECB Supervision, Andrea Enria expressed a similar view. He talked about manageable exposure to conflict-affected countries and commodity traders, while reiterating the strong case for banks’ fundamentals, including capital, asset quality and profitability. At the conference he also stressed that he is opposed to indiscriminate dividend banks and that he supports buybacks that are compatible with a bank’s business plan objectives. This is not surprising, considering the additional flexibility buybacks provide management with, to hold onto excess capital for longer if need be.

After a very dry month of February, primary activity picked up in March and at just under EUR50bn was one of the most active months for European financials in the last few years. Issuance remained concentrated in the Senior layers as entities kept prioritising MREL requirements with cheaper securities. Benchmark names such as CaixaBank, ING, and Lloyds tapped senior funding in March at significantly wider levels than last year. Issue spreads came some 75bps higher on average, resulting in more attractive and defensive all-in yields relative to other secondaries. We took advantage of these primary levels on our preferred, higher quality names, to deploy some of the cash buffer and reinvest proceeds from some calls that took place through the month.

On the capital front, another batch of AT1 securities were called in March. Aside of a couple of bonds, where management took the decision to meet AT1 requirements with equity outright, most calls had already been refinanced and were therefore widely expected. This trend thus reinforced the overall constructive technical backdrop for the asset class with net issuance this year still expected to be de minimis and the next wave of selective primary not expected until after Summer.

For the month, the MSCI ACWI was up 2.2%, the ACWI Financials index was up 1%, and European banks were down 2.8%. Inflation concerns and the prospect of rapid Fed hikes continue to linger in the markets, which continue to make banks in both the U.S. and Europe viable hedges against associated macro-economic risks.

The Fund’s biggest positive contributors to performance in March were European banks, particularly Sabadell, Santander, and UBS. Outside of Europe, we also received a positive contribution from Invesco, a US asset manager that is generating consistently strong organic net flows yet remains cheap. In terms of detractors, large French and Italian banks, such as Unicredit and Credit Agricole, with Russia-Ukraine exposure were the biggest drags. We were also hurt by exposure to companies that have large investment banking operations, including Barclays in the UK and Citigroup in the US, which have struggled as capital markets activity has quieted in the first quarter. The largest portfolio detractors continue to be some of our most attractive investments from a valuation standpoint, with an average multiple of 2023 estimated earnings of 6x for the group.

As we look back, the strong start to the year for bank equities now seems a distant memory. Certainly, a lot has changed in just the past 5-6 weeks. Rates have shot higher, curves have flattened (at least in the US – not so much in Europe), commodity prices have moved with extreme volatility, and stagflation fears have set in. And as a result, bank equities have quickly retreated back near post-crisis lows on many valuation metrics.

But has the investment thesis changed? For those banks most directly affected by the war, clearly there has been a change. While we fortunately did not have significant exposure to these names, where we did have modest positions these have been worked down significantly and opportunistically. But, for many banks, the investment thesis has arguably gotten better: excess capital positions intact, rate sensitivity increasingly valuable, strong reserves (including unused Covid overlays) well positioned to absorb incremental provisioning needs, and valuations that much more attractive after the sharp derating since late February. This is particularly true for retail oriented European banks with strong deposit bases in the right zip codes including Spain, Ireland, and the UK. But it is also increasingly true, in our view, for select US and Korean regional banks. For all these banks, earnings power and dividend yields are moving higher, sentiment is souring, and multiples are dropping. This is a rare combination but one we like as the risk/reward turns increasingly asymmetric in our favor. We are adjusting our portfolios accordingly.

It is notable to us that the dream of higher rates has come faster and harder than almost anyone could have imagined even 4-5 months ago, and yet bank stocks have lagged sharply since the war began. In our view this has been driven by the increasingly pessimistic view on the global economy, as signaled by the yield curve. While we by no means dismiss the potential messages being sent by a flattening yield curve, we do wonder if we should not also consider: 1) the part of the curve most relevant to bank earnings, the 3 month/5 year curve – is steeper than it has been in over a decade; 2) flattening curves naturally happen with every single hiking cycle and banks are particularly well positioned today for their top line to benefit from higher short term rates; and 3) developed economies were already running at above-trend growth rates (meaning a slowdown does not inevitably mean a recession) and credit conditions remain on sound fundamental footing with under-levered consumers, unemployment rates at or near historical lows in both the US and Europe, corporates with strong balance sheets and low debt service costs, and (especially in Europe) supportive fiscal policy. In sum, the market in our view appears excessively concerned about the potential risks that might arise from a growth slowdown (which banks are well positioned to manage) and not at all focused on the very tangible benefits that banks are getting from the move higher in rates today. In markets like the US, UK, and Korea, we believe that we will see those benefits start accruing to shareholders as soon as this quarter, with Europe not far behind.

We believe the opportunity in bank equities remains compelling, but as always with this sector, security selection is paramount. We dig into some of the names we have been adding to below – the so-called babies in the bathwater.

With so many compelling opportunities, it is difficult to pick which holdings to discuss, but to begin with the US: Popular and Webster are two regional banks which boast extremely strong deposit franchises which will allow them to benefit massively from the Fed hiking cycle, as well as strong excess capital bases which will be used to buy back stock at valuations of just 7-8x earnings. Then, Santander: over the last 25 years, the group has had the lowest earnings volatility of the Top 20 US and European banks. This is a testament to its global diversification in the US/LATAM as well as the UK and Europe. They have one of the best franchises in banking, making a 13% RoTE, but currently trade at a paltry 0.7 x TBV. With exposure to significant growth markets and higher interest rates, with capital issues firmly behind them, the prospects for the group look very good. BNP has a current dividend yield of close to 8%, which is impressive, especially as it makes a 10% RoTE, is growing and has demonstrated this with a 7% CAGR in its TBV since 2008. And finally, we highlight Hana Financial in Korea. With a starting dividend yield of 7% and a current RoTE of 10%, the positively gearing they have into higher interest rates will see margins and profits rise, yet the shares trade on a low of 0.37x TBV.