Monthly Commentaries

May 2024

Economic and investment highlights

Global Credit Strategy

How we did in May: The fund returned between 0.69% and 1.03% across different share classes, compared to EUR HY (BAML HE00 Index) 1.0%, US HY (BAML H0A0 Index) 1.1% and EM sovereign credit (BAML EMGB Index) 1.8%. Performance in May, gross of fees in EUR, was: (i) Credit: 1.4%, with 1.6% from cash bonds and -22bps from CDS; (ii) Rates: 4bps; (iii) FX: -1bps, (iv) Equity: -31bps and (v) Other: 0bps.

What we are doing now: In May, some of the fears that hit markets in the first quarter eased. US labor market and inflation data failed to accelerate further, meaning markets don’t need to price further hikes. Geopolitical tensions took a step back, as the ongoing Gaza conflict failed to extend to broader fronts. Noise on bottom-up credit stress attenuated.

As a result, rates and equity volatility moved lower, and risk markets rallied. Credit continued its unique YTD divergence from government bonds, and US equities are making new highs.

We continue to see selected opportunities in credit but an increasing degree of vulnerability on the whole market. All-in yields are very attractive in a few market segments, but the overall level of spreads is tight. The contrast between the two allows us to position in high value longs, and sacrifice a moderate portion of this yield to own volatility. Our book thus combines medium term upside, satisfactory yield, and a good degree of protection against a re-pricing in credit spreads.

We currently give up ~60bps of yield to halve our net credit exposure, a trade-off which we consider attractive. Our blended YTC is 6.8%.

In rates, we have somewhat increased duration at fund level since the start of the year, having run it very conservatively in the first quarter. We’d need to see a more marked widening in financial conditions (as the ones seen, for example, in October 2023 or November 2022) to be comfortable with a more marked duration extension.

More in detail:

  • The Fund blended YTC is 6.8%, with average rating of BBB-.
  • The Fund duration is now 2.6, substantially lower than in late October. We see central bank pricing for 2024 appropriate but hold steepeners given strength in US data. We see value emerging in 2-5y segments of global curves and look to gradually re-engage in duration extension.
  • Our net credit exposure is 39%. We currently run 16% cash, and hold protection via US IG and HY spreads, European HY spreads and EM spreads. The protection has low carry cost thanks to tight spread hence our net YTC remains elevated.
  • Net exposure in financials (incl. cash short and single name CDS) represents 31% of the book. AT1 and financial subordinated was a key trade in 2023, and subordinated risk re-priced meaningfully in the past year. The asset class outperformed since October. We remain constructive but reduce some of the winners.
  • Net corporates exposure (incl. cash short and single name CDS) represents 28% of the book. We focus on 7-9% yielding bonds backed by a solid pool of hard assets, at valuations that heavily discount the underlying value, or with imminent refinancing catalysts
  • Net EM exposure (incl. cash short and single name CDS) represents 13% of the book. We maintain a balanced focus on hard and local currency but look to gradually increase the latter as valuations are turning dislocated as a result of the price action in US Treasuries.

Financial Credit Strategy

The constructive tone across markets flowed into May with a broad rally across most risk assets. This was in part fueled by a marginal weakening of macroeconomic data which further raised hopes of Central Banks easing monetary policy despite what appears to be still sticky inflationary pressures. US equity markets led the way +5% MoM, followed by those in Europe 2.5% MoM, though Financials, especially those in Europe, outperformed yet again +6% MoM taking YTD gains to 30%.

Interestingly, global rates had a mixed performance across the curve. US and UK were the clear exceptions, tightening by 15bps and 5bps, whereas core and peripheral European rates widened by up to 10bps as various ECB speakers started pushing back on the timing for the second rate cut after conceding the first would be in June. In European financial credit, there was spread compression across the board: Seniors 15bps, T2s 25bps, and AT1s 40bps / +1.5pts.

European banks wrapped up their first quarter results with trends that were broadly consistent across the sector. Franchise operating income, i.e. the combination of net interest income and fees, continues to hold up well and this trend should persist for the rest of the year despite growing chatter around rate cuts by the ECB. Asset quality metrics continue to surprise positively after what has been a period of elevated interest rates as borrowers, household and firms alike, adjust to higher financing costs. All in, the accretion in core capital levels continues, share buybacks are ongoing, and excess capital repatriation via higher dividend payouts are largely unchanged.

Consequently, there were further positive ratings actions from agencies who are still playing catch-up in recognition of how much the sector’s profitability has improved post-pandemic. New potential M&A combinations surface, alongside previous older ones, and we expect this theme to pick up pace over the coming quarters as financial institutions come to grips with their strategic positioning looking 3 to 5 years forward.

Primary activity picked up sequentially from the subdued level of EUR15bn in April to EUR40bn in May as issuers exited their blackout periods with the publication of 1Q24 results. YTD capital issuance is running some 65% higher than the equivalent period last year as the tactic of tenders up to 12 months ahead of initial call dates in exchange for new securities highlights the attractiveness of market conditions. In contrast, YTD secured issuance, which last year accounted for c55% of the total EUR260bn in the January through May period, has dropped off to just c45%.

We expect issuance to pick up pace in June ahead of the quieter summer months given the key geopolitical events scheduled for the final quarter of the year which could add significant uncertainty to fixed income and rates markets. Investor interest across the entire financial capital structure remains well supported as the sector continues to exhibit unparalleled solid fundamentals and on a relative basis, has one of the better risk/reward payoffs with stronger valuation support and favourable technical factors.

Financial Equity Strategy

The fund produced another strong month of outperformance with a return of +5.6% in May, while the global financials benchmark was up +3.4%. European banks yet again led the way, although US insurance stocks were also important positive contributors during the month.

The consternation we saw among many investors at the end of last year about what impacts the impending ECB rate cut cycle may have on European bank stocks has largely dissipated, with good reason in our view. First, there has been a clear step change in the level of rates that has gone very much in the banks’ favor: YE24 policy rate expectations have shifted from 2.2% in January to ~3.3% today, and 2-year forward rates have moved from 1.8% to ~2.5%.  This has supported banks’ net interest income projections, and we are already starting to see some guidance upgrades coming through as most management teams were assuming the January forward curve when setting forth their NII estimates at the beginning of the year.

But just as important, the banks have been proactively managing down their interest rate sensitivity – and effectively locking in the benefit of higher rates. The current sensitivity to lower rates for the average EU bank is <2% (drop in PBT) for every 25 bps reduction in rates, which is roughly 1/3 the sensitivity on the upside when looking at banks’ sensitivity to higher rates back in 4Q22. So, as we look ahead to the very well-flagged ECB rate cutting cycle – which could well be a shallow one if the recent uptick in European economic activity persists – banks have positioned themselves well to manage the shifting interest rate backdrop.

Clearly, political risk is – as ever – a wildcard in Europe and we saw this emerge with the snap elections called in the UK and most recently, France. Importantly, though, last year’s rhetoric on bank taxes and reserve remuneration is largely outside the current debate in most countries, so direct impacts to bank earnings may well be limited although we will be watching the impact of political uncertainty on bond yields and economic activity. Here too, though, slower loan growth simply translates into higher capital return for most banks in Europe at this point. While the cost of equity may be temporarily inflated as investors digest the new political landscape, we continue to believe there is plenty of runway to go in the rerating of the group as banks prove out their earnings resilience through the rate cycle. With absolute valuations still mired in the 6-7x forward earnings range (relative to 10x the past two decades) and relative valuations stuck below the pre-Covid low (currently 56% of the market valuation, relative to 60% pre-Covid low and 60-100% range), there is scope for significant further rerating in the next 12-18 months. In the meantime, while ECB rates come down, we continue to benefit from high-single-digit dividend yields with accretive buybacks on top.