August 2023

“Just when I thought I was out, they pull me back in…” Michael Corleone

Pity the shareholders of banks.  After years of waiting for a rerating of share prices and a return to normality (rates, regulatory stability, depoliticization, etc…) they came into 2023 with the expectation that their time had come.  A resilient economy and higher rates paved the way for a return to profitability, and with the ceaseless focus on balance sheet reduction and capital strength, better times were finally here.  But the past six weeks have demonstrated that far from being in the clear, the industry remains firmly rooted where it has been since 2008, namely hostage to a distorted macro-economic cycle with a target on its back.  Far from seeing the end of 10 digit fines we have merely seen an expansion in the breadth of violations justifying such penalties, while windfall taxes have become the go-to policy choice for funding relief for the crisis-of-the-moment or vanity project.  When a bank has losses in the billions through incompetence rather than rule breaking and is then levied a fine in the billions it is the shareholders who pay (twice).  It is not inappropriate to question whether this makes sense.   Good economic times are the proverbial sunny days that allow banks to make hay (capital) that will enable them to play the intermediary role in downturns and this has been severely hampered.  Already, we’ve seen downgrades of the credit ratings of a number of US banks in anticipation of a softer economy.  Another consequence of the never-ending firefight to deal with the latest crisis is one which is rarely mentioned, namely that management teams have become numb to shareholders legitimate concerns beyond compensation.  There is very little accountability over how their capital has been invested.  And this is one of the key reasons we still see too much capital badly allocated to non-profitable businesses while cost structures are still too high.  As the next downturn approaches this will have consequences.

Elsewhere, August markets were mostly focused on government bond yields.  Early in the month, unwinding rate cut expectations in the US and an unexpected credit downgrade saw longer term yield creep up to their highest level since 2007, while soft data and solvency concerns over the Chinese shadow banking industry led to a recovery later in the month.  That softer data has also led to consensus that both the Fed and the ECB are likely to sit on their hands at their upcoming meetings, although that consensus is stronger in the US than in Europe.  In any event given that 10-year yields are between 60 and 100 bp higher since spring, the market has already done a considerable amount of tightening.  Risk assets were generally softer as a result.  September’s data will provide fresh clues but will be unlikely to deliver a clear signal to drive a new trend.  That will require more time.

From the first paragraph one might surmise that August was a very busy month for financials, and the Italian government’s surprise announcement of a swingeing windfall bank tax and subsequent clarification restricting its impact was opera buffa worthy of La Scala.  The initial volatility was largely unwound by month end.  The other significant news item was the long-awaited UBS/CS earnings report which brought little in the way of new information but confirmed the eye-watering profitability of the Credit Suisse rescue for UBS.  Otherwise, credit markets traded sideways while AT1s were softer on light volumes.  For the month, the fund’s A shares rose +0.66% driven by a gross credit contribution of +42bps and +38bps in equity.  In line with previous plans, we continued to trim positions that have performed to target while selectively using volatility to add others.  We retain a great deal of flexibility to react to market events, which is where we want to be at this stage of the cycle