November 2021

How we did in November: The fund returned between -2.0% and -1.6% across the different share classes, compared to EUR BAML HY (HE00 Index) -0.6%, US BAML HY (H0A0 Index) -1.0% and EM bonds (EMGB Index) -1.9%. Performance in November, gross of fees in EUR, was from: (i) Credit: -134bp, with -140bp from cash and 6bp from CDS; (ii) Rates: -19bp; (iii) FX: 35bp; (iv) Equity: -32bp, and (v) Other: -9bp.

In November, with rising cases in Europe and the risk from the new Omicron variant, parts of Europe entered partial lock downs. Despite far fewer travel restrictions relative to 2020 and indications that Omicron may be less severe than previous variants, travel-related stocks sold off aggressively and now trade near 2020 levels. In addition, central banks maintained their stance of gradually removing accommodative monetary policy next year, as consumer demand remains strong. In fact, Fed Chair Powell spoke of the upside risks to inflation and the need to potentially taper faster. Under this backdrop, spreads widened globally, especially in emerging markets. Turkish assets, which we are short, were hurt the most as the CBRT cut rates despite rising inflation.

The fund’s performance suffered from our exposure to re-opening stocks and credits, while benefiting from shorts in Turkey’s Lira and a levered credits exposed to rising input costs, particularly in the UK. We think mobility-related sectors (transport, energy, tourism) will rebound from current levels given low valuations and our expectation that travel in 2022 will be far better than in 2020. Therefore, we think that the fund should benefit as the re-opening related sectors recover. In addition, we expect our shorts to continue to perform in an environment of tightening monetary policy.

What we are doing now:  Overall, the fund maintains a defensive stance in credit, with net over 40% in selective credit opportunities with low duration and high coupons, and over 20% in out-of-the-money convertible bonds, trading around par.

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 the recent sell off we opportunistically added in credit, focusing on investment grade credits and certain issuers, like Aston Martin, Burger King and McLaren. We also tactically took profits on some credit hedges, including protection on Iceland and Intrum. In convertibles, we maintain a high allocation to firms with low credit risk and upside linked to reopening and higher commodity prices. With Omicron related weakness, we added in travel convertibles with strong state support, like Lufthansa and Accor. In EM, we have been short Turkey, both through the currency and credit. As we see room for the currency and credit to weaken further, we have only taken partial profits and have kept the majority of our shorts. Overall, we remain lightly positioned in EM and have used the sell off to add in certain credits like NaftoGas and Unifin.

In summary, we believe markets have over-reacted to the Omicron variant, with media articles covering it around five times more than Delta. We are more concerned about inflation and a hawkish Fed next year, and therefore we believe this is an opportunity to add in pro-cyclical credit and convertible debt as well adding protection to the short-end of US rates, which is likely to keep rising as the Fed withdraws stimulus.

Markets were adversely jolted in November by several factors, including the growing probability of tighter monetary policy via faster tapering in the US, uncertainty around the possibility of new lockdowns to contain a new CoVID variant. Generic tight valuations across most asset classes, at time of peak accommodation and stimulation, further contributed to the market setback.  With inflation readings continuing to surge higher across the globe and some Central Bankers beginning to jettison the “transitory” nature of inflation, embracing instead a longer lasting “structure” aspect to it. As a result and despite the market weakness into November-end, the timing of future rate hikes was brought forward. Central Bank meetings over the coming weeks should provide the market with clearer indication on this rate path.

On average, leading equity markets in November fell 2% with Europe and small caps bearing the brunt (-4%). The broad-based rally and slight flattening across yield curves put pressure across global financials with European banks’ equities dropping 8%, faring slightly worse than US peers (-6%); Despite this setback, the total return for the year remains above 30%, outperforming leading equity markets by c10-15%. Financial credit spreads widened on average 10% in November, ranging from 15bps in Senior to 30bps in Subordinated and 50bps in AT1s. As expected, recent new deals fared worse given the more convex nature of their structure due to lower outright coupons (and reset rates for AT1s) and longer duration, including from a maturity perspective too. As mentioned before, we’ve broadly avoided these deals, keeping a preference for older, higher coupon and backend vintages where risk-reward remains better in our view.

European banks wrapped up their third quarter reporting season in the first half of November without any significant blemishes. Fundamental and operating trends remain constructive with capital build providing comfort to credit investors. Furthermore, there were some positive ratings’ actions throughout the month, affirming the progress achieved by some of the more (historically) challenged members of the sector.

Issuance across European financials picked up in November to just over EUR40bn, the highest monthly level this year and just ahead of what was printed in January. Activity was concentrated in the Senior part of the capital structure (c80%) with the rest largely a handful of targeted one-off subordinated deals done by second tier issuers. As banks continue to comply with their MREL requirements over the coming years, we expect ongoing Senior issuance to dominate primary activity, on top of which some political events in the near-term horizon could bring this forward. Both factors could lead to a repricing of the junior subordinated securities and accordingly provide the market with more attractive investment opportunities in the coming quarters.

The Financial equity sector had a turbulent November, with the market swoon driving the MSCI AC Financials index down 6.1% for the month. The weakness was concentrated in the last week of the month following the Omicron news, as Financials had been up until that point been performing well with the ongoing repricing of the short end of the curve.

While the sector was predictably weak following the Omicron discovery, and uncertainty remains surrounding the potential ramifications of the new variant, we do take solace in the fact that 1) severity does not appear to be higher (and may well be lower) than prior variants, 2) vaccination appears to be at least somewhat effective in minimizing risk of hospitalizations, 3) lockdowns are extremely unpopular and likely only a last resort for most governments and 4) even with lockdowns, Oxford University and Eurostat data suggest the sensitivity of economic growth to lockdowns has dramatically lessened from 2020. What is perhaps most notable to us is that despite the new uncertainty injected into markets from the variant, the Fed has doubled down on its newfound hawkishness, with Chair Powell and several other key leaders finally acknowledging that inflation is not simply a temporary issue.  This has flattened the curve, as we would expect, with longer term inflation expectations getting tamped down by a Fed that is more focused on battling inflation than previously thought. All this has left forward rate curves meaningfully higher than three months ago not just in the US but in Europe and even the UK as well (despite the BOE’s decision to hold off on a hike at its November meeting). As we have discussed in the past, this is a key driver for banks’ top lines and we see this as a powerful tailwind for continued earnings momentum across our holdings.

Commerzbank is one such holding which has underperformed the European bank index by 12% since October 2020 – since then, we’ve seen the announcement and rollout of vaccines, economic activity approach pre-COVID levels (and in some cases exceed it), and inflation surge across the globe.  The market is even pricing in the potential for a rate hike by the ECB within the next two years.  It is thus puzzling that one of the banks most geared to higher rates in Europe would underperform.  We believe this reflects the market’s skepticism about Commerzbank’s profitability, which has long suffered despite several cost restructuring efforts.  However, we believe the new Strategy 2024 plan announced earlier this year is both ambitious and achievable, and recent signs point to it potentially even being surpassed.  The cornerstone of the plan is to reduce the cost base by 20% from 2020 levels – a step change from the last two plans announced in 2016 and 2019, which targeted cost reductions of 8% and 7%, respectively.  Third quarter results showed execution ahead of plan across several KPIs.  Further, clean revenues are expected to remain flat from 2020 to 2024 – this already looks likely to be surpassed given the pace of rate hikes in Poland, which will boost Commerzbank’s Polish subsidiary’s revenues much faster than anticipated.  Consensus expectations reflect the pessimism – 4% lower revenues and 4% higher costs, resulting in net income 20% lower than plan.  Remarkably, even on these low expectations the stock trades on just 5.3x its earnings power, which falls even further to 4.4x if management continues to execute.  Combine that with highly convex sensitivity to higher rates – profits could easily increase by 50%, but this is not baked into the plan – and we believe Commerzbank is in the sweet spot right now.  While the 2024 plan may seem a long way away, with the bank’s profitability already recovering ahead of plan, the market’s skepticism could be further eroded next year as it reinstates its dividend and contemplates buybacks for the following year. In the meantime, trading at just 0.3x tangible and with a strong market position in the strongest economy in Europe, the bank represents a potential M&A opportunity for several large continental peers.