October 2021

How we did in October: The fund returned between -0.2% and -0.1% across the different share classes, compared to EUR BAML HY (HE00 Index) -0.6%, US BAML HY (H0A0 Index)  -0.2% and EM bonds (EMGB Index) -0.2%. Performance in October, gross of fees in EUR, was from: (i) Credit: -46bp, with -67bp from cash and +21bp from CDS; (ii) Rates: +8bp; (iii) FX: 2bp; (iv) Equity: 27bp, and (v) Other: 1bp.

The market is gradually moving away from the goldilocks that prevailed since 2H20. As we discussed since May, inflation trends are proving to be persistent and bond markets have moved to re-price rate hike expectations globally as a result.  At the same time, growth surprises have weakened, creating the potential for a stagflation-like environment – especially in countries like the United Kingdom, where supply bottlenecks are tighter. Persistent inflation poses a problem to fixed income investors, eroding a lot of capital over time. We estimate that if current breakeven inflation levels turn out to be true, investors would lose a tenth of their capital in Euros and a quarter in Sterling, over a ten year period.

In October, our cautious stance on credit and our selective approach allowed us to deliver a flat performance despite losses in main credit indexes.

What we are doing now: We continue to run the fund at a cautious stance. We are playing defense in credit, with around 40% invested in selective opportunities, keep duration low. We play offense in convertibles and equity upside, which represent around 20% of our book, in sectors linked to value and reflation. Over the past few weeks,  we have added protection in hedges and shorts, particularly on commodity-importing countries in Emerging Markets and firms that might be hurt by cost pressures.

To go in more detail, we focus on credit sectors which can weather a  more stagflation-like environment: travel/ reopening (airlines, cruises), cyclicals that benefit from higher rates (financials) and defensive consumer discretionary (high-end carmakers). We maintain a high allocation to convertibles with low credit risk and positively convex upside/downside, in similar sectors. We are actively reducing bonds with strong beta to broad markets, such as subordinated bank debt in European periphery and high duration bonds in EM hard currency. We added credit protection in companies with low margins and that will be hurt by supply-chain bottle necks, and in energy importing countries within emerging markets. We remain overall lightly positioned in EM, with longs focused in energy-related sectors or countries, e.g. the Russian ruble.

We positioned to capture opportunities from the upcoming withdrawal of monetary policy stimulus and rising volatility.

The gradual shift in perceptions around inflation being largely transitory to less transitory drove moves across asset classes in October. This was most evident in front-end sovereign rates, where 2-year core points widened 15bps on average (c60% of the 25bps YTD move) and dragged the belly (5-year points) of curves along by similar magnitude. Commodities such as oil and copper, which closed up +10% month-on-month (MoM), and equities, including the S&P and EuroStoxx (+c.6% MoM), were top performers through the month, while credit rallied c.3% on tighter credit spreads on renewed optimism that CoVID headwinds are dissipating.

Market’s rates expectations in Europe repriced 40bps higher by year-end 2023, evenly split over the next two years, on the back of heightened inflationary concerns and likely Central Bank action to contain pricing pressures. This was a key driver of performance for bank equities in October, bumping the total return in the SX7E +4.2% MoM and taking the YTD gain of the index to +c.43.5%, upon expectations that higher rates will boost the sector’s profitability over the coming years, and hence their capital return story. Prospects of better profitability also strengthen credit fundamentals, making our investment case increasingly compelling, partly offsetting the implied negative correlation of fixed income with higher rates.

Third quarter results season has started out broadly positive in terms of profitability and capital generation for those European banks that have reported so far. Ongoing reversals of CoVID related impairments are mitigating operating income pressures borne out of net interest margin squeezes and lacklustre volumes. As consumers and corporates regain confidence in the macroeconomic outlook, this should translate into more fertile business activity for the financial sector. For the time being and into the foreseeable medium-term, Central Banks remain committed to providing ample monetary support such that financing conditions do not hinder the rebound in economic growth.

On the regulatory front, the European Commission published its finalised version of Basel 4 largely in line with market expectations. The start of the 5-year phase-in period has been pushed out two years to 2025 with the output floor for certain assets taking up to 8 years to be fully implemented. Net of these changes of the recent review of internal models in Europe (‘TRIM’), RWA inflation from the implementation of Basel 4 is now expected to be largely manageable across banks. Furthermore, by 2023 regulators could begin to factor ESG metrics into their annual SREP and stress testing procedures.

After a busy September, primary activity in October was more muted and largely in line with last year’s EUR15bn. This was due to a combination of results’ blackouts and vast majority of funding plans already completed this year from leading European banks. Issuance in October was evenly split between dated Subordinated and secured / preferred Senior, and overall, there was a heavy concentration (over 70%) coming from French entities.

Recent AT1 issuance that came this Summer showed tentative signs of stabilising in October after a 5pt+ move lower in the third quarter that has tainted, but to a considerably lesser degree, the structurally better securities with lower duration that we continue to prefer. For the time being, these new deals remain the least attractive securities should there be a generic risk-off tone throughout markets on further inflation concerns and consequentially higher rates given their outright lower coupons (and reset rates).

Earnings for the European banks’ third quarter 2021 have started to be released and once again we are seeing very strong performance across nearly all line items.  Net interest income is beating estimates on higher mortgage volumes, and fees continue to be much stronger than expected, driven by investment banking revenues, asset/wealth management flows, and recovering payment/transaction volumes, resulting in average net revenues 4% ahead of consensus.  With operating leverage these beats are multiplied to 11% ahead at the pre-provision profit level, and with loan losses continuing to come in some 40% below expectations, bottom-line profits are well over 30% ahead of consensus.  We see scope for continued beats going forward, most notably from recovering corporate loan demand, loan loss estimates that still remain too conservative, and potentially much sooner hikes from developed market central banks and the incorporation of hikes already seen in many emerging market countries to which European banks have exposure.  Moreover, despite the sector’s strong YTD performance, it has actually lagged the increase in 12-month forward EPS upgrades, meaning the sector has actually de-rated YTD, suggesting room for continued upside.

We have seen a significant repricing of the front end of the curve in the past several weeks across the globe. The market has begun to price in a more frontloaded rate hike cycle than previously expected as the transitory inflation thesis looks increasingly in doubt. So far we have seen some central banks already start to hike (Poland, Korea, Brazil, and Russia, among many), while larger ones (BOE, Fed) look likely to move in the relatively near term.  In addition, other developed market central banks have signaled the end of extraordinary quantitative easing (Canada) and yield curve control (Australia) measures, resulting is similarly large yield curve repricings.  Perhaps most surprisingly, the market is even starting to factor in rate hikes at the likes of the ECB: the implied policy rate in 3 years is now -6 bps, versus -45 bps just three months ago.

It is not clear at this point whether these moves are justified, but we would make the following key points as it relates to banks:

1. Should we be concerned about the curve? There is some fear that a premature and/or overly aggressive hiking cycle will represent a policy error and snuff out growth – we see this for instance in some flattening of curves and slight cooling off of longer term inflation breakevens. This is a fair concern but we would point out that the curve most relevant for bank earnings, the 3 month-5 year spread, is at new highs as the belly of the curve has repriced most dramatically – this suggests funding costs will remain subdued while asset yields start to move higher. The long end is generally less relevant to bank earnings but can be a driver of the PE multiple – and so far long yields remain near YTD highs.
2. Earnings impact even better than we thought? Fundamentally, most banks today are highly levered to a move up in short term rates. This is particularly true in Europe where rates have been negative for several years now, and in the US where banks are sitting on unusually high levels of cash. Banks disclose the positive sensitivity to a move in rates (for instance, Commerzbank suggests earnings will rise >100% with a 100 bps move in rates), but what is notable is that these bank disclosures could well be understating the positive impact. This is due to assumed deposit betas (ie the degree to which rate hikes are partially passed on to depositors) being too high. Most banks assume ~50% betas and the actual pass-through will likely be much lower, at least for the early part of the hiking cycle.  We saw this in the last US hiking cycle and we heard at 3Q earnings from multiple UK banks that their actual deposit betas will be lower than modeled – this is a clear positive for earnings.
3. What’s priced in? In the US, bank estimates already bake in 3-4 hikes over the next two years (versus just under 4 as currently priced by the bond market) and valuations are well above historical normal – so the upside to earnings and multiples on higher rates appears relatively limited at this point. On the other hand, no banks in Europe currently have higher rates embedded in earnings estimates, and the stocks trade well below historical average – a much more attractive mix than in the US, in our view.

While European bank stocks have had a good YTD run, up 33% through September, we should also put in context where we are right now. Valuations are still well below the historical range. In fact when we look at relative P/E multiples for European banks, the YTD rally has only taken them to where they bottomed at in previous crises, including the GFC, Eurozone, and Brexit. The entire market cap of the European bank sector is still only just above the market cap of JP Morgan alone. And even the highest quality banks in Europe are still trading at just 7-8x earnings with dividend and buyback yields that are 7-12%. This is a rare bastion of value in today’s markets and could be the answer to how to achieve safe and growing yield while protecting against inflation.