December 2023

“Blessed is he who talks in circles, for he shall become a big wheel.”  Frank Dane

Markets ended the year having come full circle to where they were a year ago – expecting an end to a tightening cycle that had seen 10-year rates more than double during 2022.  But despite all the volatility we’ve seen, 10-year Treasuries are almost exactly where they were twelve months ago.  Last December’s sentiment turned out to be misplaced, as rates eventually peaked at 5%, but as we close the book on 2023 the consensus has solidified that the central banks are definitively done tightening and the only uncertainty is whether the slowdown will be hard or soft, with soft as central probability.  Economic data has definitely softened in most markets, with the Eurozone looking most vulnerable, but in our view, it is too early to say that the market’s current assumptions are correct.  To be certain, inflation has fallen, albeit not yet to target levels, but it will take more than that to see monetary policy shift to easing.  Central banks will not want to return to flat or negative real rates unless there is genuine stress in the economy.  The normal state of the world pre-2008 was positive real rates, and the current reversion to norm will be sacrificed only in extreme circumstances.  Is there currently scope for a tweaking of interest rates?  Certainly, and it would not be unusual.  In both 1984-85 and 1995 the Fed eased moderately after a tightening cycle.  But in both those cases economic recovery was just getting started after prolonged downturns, whereas we are currently in an economy cycle that is quite long-in-the-tooth.  Also keep in mind that Fed Chairman Powell is keenly aware of his legacy, and at present he appears to have nipped an inflationary spiral without destroying the economy.  But ease too early and he very quickly goes from Big Wheel to Arthur Burns…

Risk assets predictably responded positively in this environment and European banks did not buck this trend, as both credit and equity securities rallied.  Bank credit has now broadly recouped the losses experienced in March, while significant pockets of dispersion remain, and the equity index finished on the highs of the year.  For the month, the fund’s A shares ended +2.93% and +20.67% for the year.  Of that, credit contributed +350bps in gross performance, while equities had a negative -12bps impact.

Our approach to 2024 will be to maintain the existing approach to portfolio management initially, with a focus on further reducing exposure to names that reach targets as we did in December. Beyond that our strategy will be driven by market events and new issuances. Unlike last year where a narrative had been established and risk assets were carrying hefty premiums, markets at present have already priced-in benign news flow going forward that leaves little room for disappointment or exogenous shocks.  Risk assets are more susceptible to correction with any divergence in scenario and this will be a great source of opportunities.  We have been through an extraordinary period during the past three years and the market’s understanding of where vulnerabilities lie is very limited.  There are also several key elections in 2024 – the US presidential campaign will almost certainly be as contentious as any we’ve seen since 1968 – and it is not unusual for investment decisions to be postponed until afterwards.  European financials still retain considerable resilience to economic downturn, and very interesting value propositions abound in credit securities, but risk premiums have compressed significantly in the past twelve months.  We believe the best returns will be generated by reacting to events rather than sitting on a static portfolio for carry, and as such we will seek to retain flexibility in positioning while retaining a strong bias to the deep value names that still have the most attractive upside.