Company Announcements

Investment Manager's Report

1- Market Commentary

January

European banks started the year on a strong footing, with rates repricing higher, economic data coming in better than expected and earnings beating consensus. The SX7R returned 7.37% in January 2022 vs. -3.81% for the SXXR. The yield on 5-year German bunds climbed from -45bps to -20bps while the SubFin moved up 20bps to 125bps. US 10-year Treasuries sold-off with yields reaching 1.80%.

Inflation was becoming increasingly uncomfortable for governments and central banks globally. Commodity markets have not softened, lead times and backlogs were increasing, and service inflation was starting to catch up with goods. On 26 January 2022, Jerome Powell prepared the market for a more hawkish turn. Undeterred by the recent volatility in global markets, he refused to rule out the possibility of raising rates by 50bps at once or hiking at consecutive meetings. In Europe, January inflation readings came much higher than expected, more than offsetting base effects. As interest rates of -50bps in the Euro area were evidently not consistent with 5% inflation and unemployment at record lows, we expected the ECB to revise its inflation projections upwards and recognise at its March meeting that the conditions of the froward guidance were met.

In Italy, the re-election of President Mattarella was taken positively by risk assets. Mario Draghi would be able to continue his work on the allocation of pandemic funds and structural reforms. Though non-establishment parties were leading in the polls, political volatility was expected to be pushed back to 2023. In the meantime, the flexibility of PEPP reinvestments was expected to provide a put for periphery spreads. In international news, the fluid situation at the Ukrainian borders and raising concerns about Taiwan were sources of spikes in volatility.

On the M&A front, Société Générale announced the acquisition of LeasePlan for EUR5 billion. The deal would create a dominant player in the auto leasing business in Europe. Though the price tag was slightly higher than expected, the capital impact was relatively limited for Société Générale and cost synergies could surprise positively.

The start of the earnings season was encouraging. Deutsche Bank reported results 10% ahead of consensus and announced a buyback, which was not widely expected and was interpreted as a sign of the ECB's satisfaction with Deutsche's turn-around plan execution. UBS beat expectations by 13% and unveiled a strategy plan focused on capital return commitments and operating jaws. Sabadell and Bankinter also surprised positively.

February

The war in Ukraine drove risk assets lower in February 2022. The SubFin widened by 35bps to 152bps over the month. As of 4 March 2022, the SX7R suffered a 28% drawdown from its February 2022 peak. The loss was especially acute for banks deemed to be more sensitive to Russia: RBI lost 55% of its market value, while Société Générale, Erste Bank and UniCredit posted losses close to 40%. This was quite a significant move: in a typical recession (the Tech bubble, the 2011-12 Eurozone crisis or the Covid-19 crisis for instance), bank equities' drawdowns tended to be around 40 to 45%.

Several elements were likely to have contributed to the price action:

i.           Direct losses from Russian exposures;

ii.          Possible losses stemming from legal uncertainty, settlement risk and unusual price action on Russian markets;

iii.         The macroeconomic impact of the war in Ukraine and sanctions against Russia, from growth to inflation and rates; and

iv.         Higher risk premia linked to a possible extension of the conflict outside of Russia and Ukraine.

We believe that the fourth factor explained most of the movement while the first and second factors were less significant.

a.          Some early press reports have pointed to frightening possible Russian losses for European banks (as high as EUR100 billion). They ignored the fact that the exposure was largely sitting within local subsidiaries that were bankruptcy remote in the context of banking groups. The maximum total loss for the group would be the equity invested along with potential intra-group debt (which was typically very small). As an example, though Société Générale had a EUR18 billion exposure to Russia, the bulk of it (EUR15 billion) was located in its Russian subsidiary Rosbank. If Rosbank became insolvent or was seized by Russian authorities, Société Générale group would only lose 50bps of CET1 capital. They would still be well above regulatory requirements and their ability to distribute dividends would remain intact. For the sector in general, we would price a total CET1 impact of less than 30bps and a loss of future profits of not much more than 1%.

b.         The speed and extent of the sanctions imposed on the Russian financial system was unprecedented. Some banks were cut off from Swift, correspondent relationships were banned, some assets were frozen, transactions with the Central Bank were only authorised if related to energy payments, etc. This created unprecedented price action on Russian markets and significant operational and legal risks for banks. It was impossible to predict the size of the losses that would arise from trapped collateral, settlement or gap risk. As of March 2022, we could only assume that banks would have been limiting leverage on Russian assets and using leading international custodians. The Swift ban was only operational from 26 March 2022, leaving banks time to adapt. Our base case was that we would not see any major impact from this side.

c.          The main macroeconomic impact of the war in Ukraine was expected to materialise through commodities and supply chains. There were legitimate fears that higher commodity prices would slow growth. In 2020 and 2021, the EU had annual energy trade deficits of respectively EUR160 billion and EUR275 billion. In 2010-2014, when energy prices were around current levels (Brent at USD120), the deficit was EUR400 billion. A return to these levels would represent a GDP drag of 0.8%. It was worth noting that the majority of gas imports were based on long-term contracts, and that the current gas curve was very backward-dated (2025 gas futures were up less than 20% since the start of 2022). Exports to Russia would also be affected: in 2021, the EU exported circa EUR80 billion of goods and circa EUR20 billion of services to Russia. If those were halved, it would represent an additional 0.3% drag on GDP. Food prices were also going up, but the EU was a net exporter. In total, the annualised GDP impact for the EU was likely to be around 1% with an uncertainty range of 0.7%-1.5%.

However, there were several mitigants: the conflict was likely to drag on for months, but not years; consensus of real GDP growth for the EU was above 4% for 2022 before the start of the war - growth was still highly likely to be above 2% despite very high energy prices; higher energy prices would be partly subsidised by governments, reducing the impact on purchasing powers for consumers; Germany had fully abandoned its hawkish fiscal stance, reinforcing the fiscal impulse and increasing flexibility for periphery governments; and the EU was more united, paving the way for a closer banking union and more fiscal integration.

The impact on rates was more subtle. In the immediate future, there would be some delay to the normalisation agenda as central banks waited for clarity on the economic impact of the crisis. But in the medium-term, the sheer pressure of inflationary forces combined with lavish fiscal policies would make rate hikes unavoidable.

d.         The first three factors do not explain why bank equities suffered close to two-thirds of their typical recession drawdown. We believed investors feared that the conflict would extend beyond Ukraine and Russia. China could have decided to attack Taiwan. Russia could have decided to go beyond Ukraine; in a worst case scenario, a war between NATO and Russia could be inadvertently triggered. There were also scenarios of possible widespread consequences from damages to key nuclear infrastructure. The unexpected move of Putin pushed "rational" investors to review their working assumption of a mostly stable geopolitical environment. To be clear, we did not think that the conflict would escalate outside of Ukraine. Signs from China were relatively encouraging. However, we believed that the unthinkable would continue to be priced until a resolution of the Ukrainian war was in sight or the geopolitical stage had stabilised.

We were conscious that the higher risk premia would not dissipate quickly and that the market would need signs of stabilisation. We expected the conflict to drag on for weeks or months and would not be surprised to see Putin move against Transnistria. However we had a strong core bullish bias in the medium-term and could have progressively added risk in March 2022 on strong headline moves.

March

Risk assets took respite in a fall of implied volatility towards the end of the month as the Ukrainian conflict appeared to stay geographically contained. Russian gas and oil exports were more resilient than expected, which limited the increase in energy prices. High inflation readings fuelled fears that hawkish central banks could trigger a recession in their attempt to slow demand at a time when real incomes were already suffering from elevated imported prices. The SubFin ended the month slightly better by 10bps. The VIX settled 10 points lower at 20. The European bank indices SX7T and SX7R returned respectively -3.01% and -2.11% vs. +1.00% for the SXXR.

The latest EBA risk dashboard highlighted the soundness of the European banking sector. NPLs reached a new low of 2.0% while CET1 remained elevated at an average of 15.4%. ROE stabilised at levels higher than in the pre-pandemic period. Regulators were reassuring about the first-round impact of the Ukrainian conflict, noting that a default of all Russian exposures would not be a capital event for the sector and confirming that dividends and buybacks could be continued. However, they also stressed that second-round effects, such as reduced growth, increased compliance costs and higher risk premia could negatively impact profitability.

Inferring from past recessions, we estimated that a 1-point reduction in the real GDP growth outlook could lower earnings expectations for the banking sector by about as much as 8%, with 5% coming from higher provisions for loan losses, and the rest divided between lower fees and lower loan growth. However, this would be more than compensated by higher interest rates, with the sectors' results sensitivity to a 100bps parallel move being around 25%. In addition, new guaranteed loan programs and increased fiscal spending overall were likely to reduce provisioning needs and provide a boost to loan growth. As such, we found the 13% underperformance of the SX7R versus the broader European market since mid-February 2022 difficult to reconcile with Bund yields climbing from 30bps to 55bps over the period. The consensus of 2022 earnings expectations of sell-side analysts were revised down by only 3% since mid-February, with ROE expectations for the SX7E remaining above 8%, while the sector was trading at only 55% of book value.

We understood the concerns regarding inflation and the future path of real growth. There were downside risks ahead: high energy prices would hurt real income; rich real estate valuations could be tested by rising mortgage rates, resulting in lower perceived wealth and balance sheet quality; and central banks could have been required to tighten aggressively into a recession if inflation did not settle down. However, we believed the balance of risks was to the upside: consumers had barely started to tap into their excess savings; high government spending was still irrigating the European economy and protecting vulnerable businesses; though manufacturing was operating above potential, less energy-intensive services were still operating below potential, offering significant real growth prospects as economies reopened; the labour market was still reasonably elastic, with more people continuing to join the workforce without unsustainable increases in wages; and inflation expectations were not unanchored.

April

April 2022 was another down month for risk assets. Stocks were led lower by the technology sector and cyclicals. The SXXP returned -0.57% while the SX7P and SX7E respectively ended the month at -2.08% and -3.40%. The SubFin widened to 195bps. Amid higher long-term inflation expectations, Germany and US 10-year yields respectively climbed above 0.9% and 2.9%.

In defiance of the prevailing pessimistic mood, European banks had an excellent start to the reporting season. On aggregate, revenues were 7% higher than expected - the strongest positive surprise in years - while earnings were 25% better. On a year-on-year basis, revenues grew by more than 8%. Net interest income was supported by dynamic lending book growth and stable or increasing margins. Costs were in line overall, which came as a relief in the current environment. There was no evidence of deterioration in asset quality: NPLs continued to decrease, and defaults remained significantly below average. Banks nonetheless took precautionary provisions in light of geopolitical and monetary policy risks. Capital ratios took a transitory hit from mark-to-market losses in bonds not accounted at cost.

As analysts revised their expectations for the year upwards, the sector kept trading at depressed levels. The SX7E was valued at 6.7x next year earnings (and 5.9x 2023 earnings), which contrasted with a median level of 9.0x and a maximum of 12x over the last decade. Only twice was the P/E lower: in the middle of the 2011/2012 Eurozone crisis and at the onset of the pandemic. Why the disconnect between fundamentals and valuations?

Two sets of developments were unsettling markets: on the one hand, higher commodity and supply chain costs were eroding purchasing power and consumer confidence (the Putin and Xi Jinping risk): on the other hand, the risk of a wage-rent-inflation loop could have driven central bankers to slam the brakes on growth by raising rates to contractionary levels (the Bullard and Knot risk).

Though uncertainty was high (the prime example was the possibility of Russia cutting gas supply), our central scenario remained more optimistic versus the consensus: we saw a progressive improvement in commodity and supply conditions as extraction and production capacities were rebuilt; we saw growth in services sustaining employment and spending trends; and we saw central banks not willing to risk a contractionary spiral to fight inflation.

May

Risk appetite was slightly better over the month as investors pondered record inflation against a continued expansion in global demand and hints of easing supply chain pressures. The SubFin index closed the month 5 bps tighter at c.185 bps. Energy and bank stocks outperformed while retailers and media companies underperformed. The SX7R returned +6.54% versus -0.61% for the SXXR.

Eurozone macroeconomic developments pointed to a strengthening in the core inflation momentum:

·      Core CPI increased by 0.5% MoM to an all-time high of 3.8% YoY.

·      Fiscal packages aimed at protecting discretionary income against energy and food prices are being broadly adopted, fueling demand-pull core inflation.

·      Negotiated wages climbed to a 10-year high of 2.8%.

·      Growth in bank loans increased to 5.3% YoY (vs. a pre-pandemic 5Y average of c. 2.5%).

Recession risk remained hotly debated amid unusually high demand and supply shocks. Despite the current commodity squeeze, we see two consecutive quarters of negative growth in the Eurozone as unlikely in 2022:

·      Higher import prices are financed by fiscal deficits. The Euro area is heading for deficits of 4.6% and 3.1% in 2022 and 2023. The bloc is having a hard time departing from pandemic stimulus: in fact, between 2016 and 2019, the average deficit was below 1%. In contrast, a combined USD125 brent and EUR90/Mwh gas shock represents an estimated 2.2% GDP shock versus pre-pandemic levels (where they were trading closer to USD65 and EUR25/Mwh).

·      The reopening effect has not fully played out. May Eurozone activity surveys reported the highest increase in employment over the past decade as well as strong investment trends. The supply side is ramping up productive capacity, feeding a positive loop. Countries with tight labour markets, such as the UK, are much less likely to enjoy the benefits of a rising workforce and therefore the most likely to suffer from stagflation.

·      The resolve of the ECB in its fight against inflation is questionable. The shift in rate hikes expectations, though spectacular, has lagged increases in forward inflation markets - and is very far off from changes in realised core inflation. Presently, inflation is liquidating aggregate debt at record pace and Bund 20y / 10y real rates are still below -1%. As such, we believe talks of a recession induced by higher rates in the Eurozone to be premature.

That said, headline GDP should matter less than usual for banks. Traditionally, recessions are bad for banks because they are associated with: a. deleveraging; and b. rising defaults due to a negative investment / final demand loop. This is not the current set-up. Loan growth is actually accelerating to a record pace and hiring is strong. In an economy where labour markets are supported by the need to rebuild domestic energy, food and supply chain security, though living standards are likely to fall, defaults may not rise as much as suggested by headline growth.

The outlook for banks' earnings is encouraging:

·      Consensus EPS expectations for 2022 and 2023 for the SX7P are now back at their highest year-to- date, erasing the Ukraine-Russia war losses.

·      NII expectations should continue to climb as analysts update their models with the latest rate market levels - at this time, analysts are still lagging the Eurozone rates market by c. 50-75bps.

·      Analysts' assumptions for future loan losses are on the conservative side. They are forecast to be above the 2017-2019 average in spite of the Covid-19 precautionary provisions and default trends signalling the opposite so far.

·      Nominal cost trends are likely to be slightly worse than expected, though C/I ratios should be better than expected.

On the regulatory front, the Basel Committee is allegedly considering treating the Eurozone as one bloc for the calculation of the GSIB buffers. Though practical implications are limited for now, it is a new step towards more fungibility of capital and liquidity within the area. In other news, the Italian government is working on the renewal of the state guarantees on NPL transactions. The new scheme would provide for a state guarantee of 85-95%, while the senior note minimum rating should be BBB+ (one notch higher).

June

Risk Markets sold-off in June as investors grew increasingly concerned over the risk of central banks tightening in a recession. CDS indices in Europe and the US are starting to price stressed economic conditions, with implied high-yield default rates in the high single digits, well above current trends. The Xover and SubFin indices respectively closed the month around 600 bps (+ c.155 bps) and 250 bps (+c.65 bps). M/m core inflation stabilized at high levels in Europe and the US. The SX7R returned -9.11% vs. -7.09% for the SXXR.

Fundamentals remain solid. Bank lending accelerated to 5.8% in May, up from 5.3% in April and 4.8% in March, as credit demand followed strong nominal GDP. High-yield and leveraged loans annualised default rates were around 75 bps in June, well below their historical average of about 3%. The latest EBA data was also comforting for the banking sector: non-performing and forborne loan ratios reduced further on average to 1.9%.

Supervisors started to adopt a more prudent tone. The SSM asked banks to add a Russian gas embargo stress test in their capital planning, and there is a risk that the ECB may require buybacks to be more spread out over time, rather than smaller. We note that Intesa received ECB approval to carry its share buyback programme at the end of the month.

2- Company Activity

January

In Midcap Origination, the Company took part in the inaugural RT1 issuance from offshore life insurance specialist Utmost. It also came back into eSure RT1s. The Company took advantage of the sell-off in Metro Bank T2s post the withdrawal of M&A rumours to build a small position. Finally, it increased its exposure to My Money Bank T2s.

In Liquid Relative Value, the Company bought some Santander retail legacy bonds, with the expectation that they would be redeemed at par at the next call date.

February

In Liquid Relative Value, the Company closed its short position on Société Générale long-dated T2s. It bought DPB CMS following the sell-off in discos.

In Midcap Origination, the Company participated in Chesnara's inaugural T2. It also bought Quintet's AT1s. The Company took gains on Fidelidade T2s.

March

In Midcap Origination, the Company took part in the new Co-Operative Bank senior HoldCo issue in GBP at a 6% coupon.

In Liquid Relative Value, it bought some RBI 2022 T2s in CHF.

In Restructuring, the Company opened a position in a Bank of Cyprus 2031 T2, which offered a yield to call of around 9%.

April

In Liquid Relative Value, the Company took a position in La Banque Postale 3% AT1s as a play on French spreads. It added to its position in BCP both in AT1s and T2s.

In Midcap Origination, the Company divested from Leeds' PIBS to reduce its overall exposure to fixed perpetual instruments.

May

In Liquid Relative Value, the Company slightly increased our exposure to BCP and opened a position in La Banque Postale, while we closed our RBI holdings.

In Restructuring, the Company added to Piraeus and sold our GamaLife Tier 2s. In MidCap Origination, we reduced our exposure to Coop Bank.

June

In Liquid Relative Value, the Company bought Intesa AT1s at a low cash price and opened a position into Credit Suisse low-trigger AT1s. We participated in the new Credito Emiliano Tier 2 issue. We added to Quintet Private Bank.

In MidCap Origination, the Company took part in an inaugural AT1 issue from the commodity broker Marex at a 13.25% coupon.

3- Portfolio (as at 30 June 2022)